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Friday, March 14, 2008

MAC Clauses Of Various Sorts

The crisis is now peaking, and I wouldn't believe anyone who says they know how this will work out over the next few months. All bets are off. To sum up the situation:
We can expect massive intervention by the Fed and government to at least force orderly unwinds and takeovers of failing large institutions. The mega financials are not really banks. In the wake of the repeal of Glass-Steagall they are merely massive conglomerations of unrecognized risk combined with healthy assets. Like LTCM, failure imposes a shock to the financial system. Right now the financial system is extremely stressed and cannot absorb any more shocks. Failure at any of these large institutions would force asset sales at extreme discounts due to a relative shortage of capital for the time being. Most of them are also in the credit swaps business, which would cause other cascades of disaster. This would cause everyone else to write down their assets and yank capital out of the system. We cannot afford to let this happen.

The Bear-JPM-Fed deal is just the first of several. Hopefully they will be spaced out. Based on what we know, which is relatively little, this looks to be a way of advancing capital to a private firm to conduct a private workout. The Fed is telling the markets that it will not permit a disorderly unwind in its statement.

I strongly recommend reading Feldstein's comments linked above.

The Overall Situation:
One of the first business rules my father taught us is that any contract which cannot be met is an unenforceable contract. As he explained, this principle aligns moral principle with reality. Sharp dealing which ignores the other party's interests is apt to come back and slap the "winning" party in the face, and thus, he pointed out, a contract which you feel is greatly in your favor is a contract that you should think twice about entering. To look at it in another way, a contract is either immaterial to you or material. If it is immaterial you can afford to write a contract that may expose the other party to great risk, but why should you do so? If it is material, you cannot afford to write a contract that exposes the other party to great risk, because you are really accepting a large portion of the risk that the contract purports to bestow upon the other party.

This is a principle that our markets must relearn.

About MAC clauses
Material Adverse Change clauses allow one party to default on a contract if it really cannot perform without extreme injury to itself. The invocation of a MAC clause can easily end up in court (see Bloomberg article). Courts will generally not allow the invocation of a MAC clause if it is used as a means of gaining leverage and unless it is clearly supportable.

One type of MAC clause that is hitting individuals are the HELOC terms dictated by Reg Z in 226.5b(f). These state, for example, that if the value of the collateral declines for the purposes of the plan that your ability to draw principal can be reduced or suspended. Another provision is that if a regulator informs the lender that further advances are unsafe and unsound, further draws will be terminated.

Even when an agreement has no explicit MAC clause, there is always in implicit MAC clause involving inability to perform or complete insolvency. If, for example, meeting the terms of a contract would cause an entity to become completely insolvent and thus default on the contract, there is generally no recourse for the opposite party other than allowing default or renegotiating.

In short, counterparty risk cannot be mitigated by contractual terms alone. One way to mitigate it is with due diligence and contractual clauses which allow continuing due diligence and cancellation if necessary. Another way to mitigate it is by offering a bond (a surety which guarantees performance). That bond could be in the form of actual money up front (as in a mortgage downpayment). However it usually is put up by a third party for a percentage payment (think bail bondsmen). When this type of bond is widely used in an environment of unrecognized risks, the bond guarantors themselves become a huge counterparty risk, and upon failure of any one of them, a negative correlation is established which throws additional risks upon seemingly unrelated parties.

The degree to which risk was ignored in the recent and generally global financial bubble means that everyone is now subject to counterparty risk. As any single party collapses, it increases the pressures on all remaining parties. This has created a farflung net of correlated risks, which is why the Fed is extending guarantees and lines to other CBs.

Like it or not, we are all counterparties now. China gets the counterparty risk of undercutting US trade. We get the counterparty risk of consuming more than we produced, and so being forced to sell debt around the world. Every property boom around the world is now an additional chunk of risk which will show up to some extent in the global financial system.

The upshot is that all financial assets are either somewhat impaired or have an increased probability of becoming impaired. Hence, we have a flight to commodities which is partly an attempt to trade financial assets for hard assets and partly an attempt to offset currency risks.

However a wholesale flight to commodities is a dire symptom which presages severe global risk. Commodities (except for precious metals and diamonds, to some extent) are consumption items. They are price-sensitive. The severe inequalities of income around the world dictate that commodities like diary, grains, coffee and fuel cannot serve as safe reservoirs of value beyond a certain range of values which allow for sustainable global consumption trends.

So we face risks as the hedgies move to commodities. We are outside safe levels on some of these now.

I wrote most of this because someone emailed me with questions about inflation. The questions were good, and I will answer with a post. Most of the above is the necessary background to any realistic economic discussion of inflation.

Comments:
The paragraph under "The Overall Situation" about unenforceable contracts was very profound, from both a business and moral perspective. Thank you for sharing that.

I am looking forward to your post on inflation.
 
M.O.M.

Good Post.

As a business owner, I learned the hard way about counter party risk. A painful lesson.

In several instances, we acted on an "anticipatory breach" of contract basis to protect ourselves. I suspect we'll be seeing a lot of this as the fear meter redlines. Many are in roach motels. You can get in, but you can't get out. They're nightmares are coming true.
 
One of the things I noticed in the economic field over the last few years was the idea that if a thing was written, it would be.

For example there was the idea that Joe 6 Pack was plain stupid for borrowing beyond his means to buy toys. Joe was only stupid if he had to repay those debts. Joe got toys immediately in exchange for a promise at some vague time in a future that may never come on an unenforceable promise.

In short without the debt, Joe would have never had the toys. Or plainly put, our former foes sold us lots of toys for electronic versions of engraved pictures of dead presidents.

Now Joe will have to do without stuff he would have had to do without. Some of us who saved and sacrificed will be totally screwed from inflation, teaching our children a lesson about saving and sacrifice.

There is moral somewhere.
 
Thank you MoM.I find Epictetus the most helpful of philosophers when it comes to questions of Morality.As far as the reasonably near term future,I expect that many people will be making decisions based on fear,and they will not be good decisions.Once Cole's Law is invoked,and Denial is no longer possible it is usually Murphy's turn.Cole's Law states that "No matter how you slice it,it is still cabbage" and murphy...well, google "Miserable Failure".
 
Anon - I'm working on it. Entire books have been written on inflation, so I need to strive for brevity. Brevity is not my strength.

MAB - thanks for chiming in. The very worst aspects of counterparty risk is that they generally hit when we are least prepared to deal with the situation, and that counterparty risk is generally not accounted for in planning.

My father was in manufacturing, but all lines of business can be hit by counterparty risk.

Yes, Epictetus is highly relevant! His insistence upon not pursuing illusionary benefits applies. If you seek truth you will not seek victory by dishonorable means, and if you find truth you will become invincible.
A good Epictetus link. It's got a basic description of his principles plus links to the Discourses and the Handbook.
 
Vader - I tend to think of the progression of the last 15 years as an exercise in remoteness from practice.

In business, it seems that MBAs dominated by the belief that one can manipulate statistics in a spreadsheet and create a corresponding reality have prevailed. The idea of uncertainty is almost discarded. (MBAs are not all like this. Some are very good. But MBAs who have little real business experience can come to believe that the spreadsheet is reality. It's a dangerous syndrome.)

Anybody who seeks to live in a self-described world ends up doing himself or herself in. It's far safer to live with the idea that your theories and ideas are incomplete and need constant checking and correction.
 
Ah. If I owe you a million, that's my problem. If I owe you a billion, that's your problem.
 
http://www.bloomberg.com/apps/news?pid=20602007&sid=a1th0wrV0J5Q&refer=rates

In times of trouble some contracts are not worth the paper their written on.

The average complete cycle time for our legal disputes that enter the court system is FIVE years. An absolute field day for the attorneys.
 
If I owe you a billion, that's your problem

Well, according to Bloomberg some banks have 2 billion Lehman problems. So I guess you are not giving me the billion dollar loan, eh?

Wow, MAB. That's a kicker:
SCA is seeking to terminate seven contracts on CDOs with an entity that it said hadn't met its obligations under the deal. The termination is being disputed by the other party, SCA said without identifying the entity.

The insurer moved to end the so-called credit-default swaps this quarter after the counterparty failed to meet requirements ``in a fundamental way,'' Giordano said. He said he wouldn't discuss the details of the issue, citing the recommendation of lawyers. The contracts represented more than half of the 13 that caused SCA to boost reserves last quarter.


We are certain that the legal industry is going to have some boom years!
 
It's great that some others know about Epictetus and his philosophy.


That's why I'm always referring to what these univs. have been doing to hurt the country.(and still doing pumping out warm bodies, hot air, papers, garbage mouths, etc.most of them clueless re self-discipline to what the eighty-five+ yr. olds possessed).
__________________

We need to squeeze out the excesses
and simplify. (return to the basics the eighty five yr. olds+ passed on to us)

Ratchet it all down ...including legal prof.(devil is in the details & piles of circular reasoning) this society vs. use of Bus. Eng. &
Logic superseding all, etc.
__________________

Other side of an agreement?
Remember the old saying, have to have some skin in the game ...


Independent

________________
(Anon.,please and just a polite suggestion not to mix the great phil. with the pop refs.
 
BTW,
When say skin in the game we mean skin in the game for restitution as in the old style rather than letting these snakes slither away with their
off shore bank accts. and multi-million dollar homes after crooking others.


independent
 
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