Financial Instrument Equivalents That Don’t Turn Out to Be Legal Equivalents

by Kenneth Anderson

The front page of the Wall Street Journal, Nov. 3, 2008, has a very important, very well researched and reported, story (I think it’s behind the WSJ subscriber wall) on the breakdown of AIG’s risk models that led not so long ago to its collapse and rescue by the US government – tens of billions of dollars have poured into AIG so far, and there is not really an end in sight as yet.  The story is a global one because, of course, the funds supplied to AIG came from global sources, AIG is operationally a global insurer based out of NY, and the insurance coverage that AIG supplied was to a global market.  (Carrick Mollenkamp, Serena Ng, Liam Plevin, and Randall Smith, “Behind AIG’s fall, risk models failed to pass real world tests,” WSJ, Nov. 3, 2008, p. A1.  Great research.)

The point in passing I want to make is a few paragraphs into the article:

AIG relied on those models to help figure out which swap deals were safe. But AIG didn’t anticipate how market forces and contract terms not weighed by the models would turn the swaps, over the short term, into huge financial liabilities. AIG didn’t assign Mr. Gorton to assess those threats, and knew that his models didn’t consider them. Those risks have cost AIG tens of billions of dollars and pushed the federal government to rescue the company in September.

The insurance issued by AIG against the possibility of default on the mortgage securities, in other words, were understood by the finance people and their models in one way – but, as it turns out, not in the way that the contracts actually said.  The words in the contract actually said something else.

And if you look back across various market disasters, you can see other situations in which the financiers thought the financial instruments were one thing, but when you actually had to read the contract, it said something different.  E.g., Roger Lowenstein, in his wonderful book on the collapse in the late 1990s of Long Term Capital, notes that the finance people at the hedge fund seemed not to have noticed that the standard swap agreement, into which they had entered in notional amounts around a trillion dollars but in very pint sized bits all designed to hedge each other to a neutral risk position, contained a standard cross default term.  In other words, default on one and you’re automatically in default on them all – and your risk position has gone from neutral to, well, over the rainbow.  A lawyer asked to read the agreement might have noticed the discrepancy between the words on paper and the assumptions of the financial engineers.  Maybe, maybe not.

For that matter, one of the most mundane of securities – preferred stock – also has something of this.  It is used as a financial proxy for debt, with a fixed dividend treated for most financial purposes as a fixed income stream equivalent to interest.  That’s true – but it isn’t that way once you reach bankruptcy, for example.  It still is a form of stock, not debt, as a legal matter.

As with many of these instruments, the equivalence is just fine – until a crisis hits.  Then, when you move from routine to meltdown, someone has to read the contract.  For that matter it might not be a contract – after all, equity is governed by corporation law which, despite all the inroads of contract law doctrines, remains historically rooted in agency, not contract.  And then you may well discover that precisely at the crisis margin is where the security does not behave as the equivalent the financial engineers thought it was.  It veers into something different precisely at the most difficult moment.  Nor is this simply some accidental feature of the instrument – preferred stock has its features, for example, including its priority in bankruptcy or its place on the balance sheet, for particular reasons.

I think we will see more examples of this emerge in the global credit crisis.  The thought that these instruments are not always legally what they are assumed to be financially has large implications for things like valuation – in which one technique is to price according to presumed equivalents – and really any attempt to establish financial proxies of one thing for another.

I’m thinking about an article to write next year on this topic, and if anyone has suggestions of other financial instruments of which this mismatch is true, I would be grateful to hear of them.  The article will, of course, be something of a plea for full lawyer employment – make sure someone has actually read the underlying contract as written in words.

2 Responses

  1. This is more likely a general example, but the doctrine of rectification based upon unilateral or mutual mistake may offer some insights on how the courts deal with the financial vs. legal dichotomy. The leading Canadian authority is the Supreme Court of Canada decision in Performance Industries Ltd. v. Sylvan Lake Golf & Tennis Club Ltd., 2002 SCC 19, [2002] 1 S.C.R. 678 available at:

  2. Response…
    “Behind AIG Fall…” failed to reveal naked truth

    This article, like most of the media coverage of the credit default swap business, fails to deal with the dirty little secret that no one really wants to discuss. The sale of “naked” CDS contracts are fundamentally illegal being at best insurance without an insurable interest, or at worst illegal gaming contracts frought with insider trading. The sales of these “naked” contracts where the “counterparty” or purchaser did not own the insured underlying security at the time the contract was issued, or at any time thereafter are probably outlawed by the common law or by statute in every jurisdiction where they were purchased where unlicensed gambling is illegal. Had governments taken swift and stern action to force the rescission of these contracts, the extent of the liabilities of the issuers would have been greatly diminished, and the current crisis could have been avoided. Instead our governments have bailed out the bookies and they have rewarded them for their crimes by allowing them to pay off the bets and stay in business.

    Although there is no public register of the extent of these naked contracts, they are estimated to far exceed the total amount of the issued underlying securities. They apparently account for a substantial portion of the increase in the value of outstanding derivatives sold worldwide since 2002. Some estimates are as high as 50% of the reported $600 Trillion of the total derivatives issued according to the latest IBS figures, though the ISDA does not make public disclosures of the extent of “naked” contracts issued by its members.

    Instead of outlawing such naked contracts, the ISDA fought piously, with the help of paid lobbyists and elected officials, to keep these contracts unregulated. What is even more remarkable is that unlike the insider trading rules that apply to regulated securities, the very people who were responsible for securitizing the subprime mortgages could purchase insurance covering the default on the bonds issued by the companies who bought their dubious products. The promoters who knew these mortgages were doomed to default at the reset dates once the honeymoon of less than market interest and no capital repayment was over, these same people were free to buy CDS contracts betting against the very companies who issued bonds secured by these dubious assets. They were betting on a horse to lose that they knew would collapse before it reached the finished line.

    The premiums paid on these “naked” contracts should all be returned to the purchasers by their issuers with interest at T-Bill rates with a note saying, “Unless you can provide evidence of your ownership of the insured securities at that time you purchased your coverage, and that you continue to own these securities, your contract is unilaterally rescinded as it is absolutely null, being illegal, and in violation of the laws which outlaw insurance without an insurable interest and gaming without a license.”

    There is simply insufficient money in circulation in the world for governments to bail out the full extent of these “naked” contracts, and if the governments of the world were to run the presses to the point where there would be enough money, their currency would suffer the fate of that in Zimbabwe.

    To understand the extent to which the U.S. Government is either unaware of or unwilling to recognize the need to order the rescission of these “naked” contracts, look at the op-ed page in the New York Times last month where Chairman Cox of the SEC, while bemoning the lack of transparecy in the Credit Default Swap business, failed to even mention that a substantial portion of the CDS contracts are held by unknown purchasers who never owned the insured securities and that they will be making a fortune at tax payers expense from the payoffs for the defaults on the bonds they never owned. Without any regulatory framework, we may never know who these bettors are and we will never know if they were the very people who had insider information which allowed them to predict the underlying bonds would be in default.

    Leonard E. Seidman
    Montreal, Quebec, Canada

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