Asset managers such as Pacific Investment Management Co. look
set to lose hard-fought protections against the cost of a bank
failure, when the Federal Reserve on Tuesday proposes yet another
rule aimed at preventing taxpayer bailouts for financial firms.
The draft regulation to be voted on by the central bank's
governing board would force changes to derivatives and other
esoteric financial contracts of the type that destabilized broader
financial markets after the 2008 collapse of Lehman Brothers
Holdings Inc.
The proposal, if adopted, would see investment firms lose
certain contractual rights to terminate financial deals with big
banks—rights that essentially have allowed them to claim payments
in the event of a bankruptcy filing without having to stand in line
with other creditors. Big banks already agreed to waive such rights
in 2014, but asset managers and hedge funds have resisted the
change because it threatened to put them in a weaker contractual
position.
While the broad outlines have been under discussion for years,
key details were announced for the first time Tuesday. One
potentially controversial provision could make the rules
retroactive by requiring changes to existing contracts as soon as a
bank and its counterparties enter into any new contracts..
"Pimco believes that this retroactive removal of a client's
existing rights in exchange for the ability to continue to trade is
an overreach and removes a very valuable protection designed to
help reduce risk," William De Leon, global head of portfolio risk
management at Pimco, said before the rule proposal was released
publicly.
Tuesday's rule would govern contracts between banks and hedge
funds as well as large asset managers, a rare example of the
central bank indirectly regulating investment firms that don't fall
under its direct authority.
Officially, the rule is voluntary, and firms would have the
choice not to rewrite their contracts. However, fund managers and
their clients are likely to sign on because they have few
alternatives. The big U.S. banks overseen by the Fed are the
largest providers of some derivatives. Big banks are also
considered to be safer and less likely to fail than non-banks or
smaller firms.
The proposal would effectively ask the investment firms to waive
their rights to terminate derivatives and other relevant contracts
for at least 48 hours after a bank bankruptcy filing.
Regulators have said the move will help ensure a big bank
bankruptcy won't get so messy that it destabilizes the whole
financial system. When Lehman filed for bankruptcy, regulators were
scrambling to contain the damage in part because the firm's trading
partners had the right to terminate certain financial contracts and
receive payments instantly from the firm after it had failed.
Lehman's trading partners terminated thousands of derivatives
known as swaps, effectively sending money—in the form of cash and
collateral such as bonds—flying out Lehman's door to counterparties
who were owed money by the failed investment bank. That complicated
matters for authorities, who were simultaneously trying to unwind
the firm's financial obligations in an orderly way.
Regulators also worry that similar early-termination provisions
in other types of financial contracts, such as repurchase
agreements, would allow a failing bank's counterparties to seize
bonds and sell them at fire-sale prices to raise cash, which can
drive down prices across financial markets and spread a panic. Fire
sales spread contagion after the Lehman bankruptcy.
In pushing for the freeze in derivatives termination rights,
U.S. authorities are moving to prevent a replay of that 2008
meltdown.
The two-day delay is aimed at giving regulators time to
stabilize the remaining, healthy parts of a cratering firm using
other bailout-prevention tools. These include new requirements that
banks issue debt that could be converted to capital in a crisis.
Fed officials on Tuesday told reporters that by allowing regulators
time to stabilize the bank, the new rule would help bank
counterparties who otherwise might be exposed to a failing
firm.
Regulators in other countries, including the U.K. and Germany,
have already set out their versions of the rule. The International
Swaps and Derivatives Association, a trade association, has created
a protocol for investment firms to adhere to the changes.
The changes are likely to be opposed by some in the asset
management industry. The Managed Funds Association, a hedge fund
trade group, published a paper last fall suggesting the rules would
actually harm financial stability by encouraging investors to exit
trades at the first sign of trouble, lest they be hemmed in by the
termination restrictions after a bankruptcy filing.
Investment firms see the rule as a backdoor way to rewrite how
derivatives are treated under the bankruptcy code—a policy change
that they say should be left to Congress, the paper said.
Fed officials said they envisioned the rule as a sort of new
normal that would make big-bank counterparties subject to the same
delay, and therefore less likely to panic. They noted that under
the rule, a hedge fund could still terminate its contract if its
direct counterparty went bankrupt. The rule applies to scenarios
like Lehman, where the parent company files for bankruptcy but
subsidiaries that deal with clients remain open. Asset managers
also would retain the right to terminate the contract in the event
that the bank failed to make a required payment or delivery of
collateral, officials said.
Asset managers have also said they have a duty to their clients
not to give up any legal protections.
Before drafting the rule, regulators first asked asset managers
and hedge funds to follow banks in waiving voluntarily their
contractual rights to make it easier to work through the failure of
a large bank, according to people familiar with those talks. MFA,
the hedge fund trade group, met with the Fed to discuss the
ramifications of early termination rights on Oct. 20, 2015.
The rule applies to the eight U.S. banks considered by
regulators to be "systemically important" to the global economy, as
well as the U.S. operations of foreign banks that have that label.
The Fed is taking comments on the proposal before finalizing it,
and the rule would take effect more than a year after it becomes
final.
Write to Ryan Tracy at ryan.tracy@wsj.com and Katy Burne at
katy.burne@wsj.com
(END) Dow Jones Newswires
May 03, 2016 14:15 ET (18:15 GMT)
Copyright (c) 2016 Dow Jones & Company, Inc.