A Practical Guide to the 2016 ISDA Credit Support Annexes For Variation Margin under English and New York Law

Paul Harding, Abigail Harding

• Publisher: Harriman House
• Year: 2018
• ISBN:
  9780857196767
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Finanzas corporativas

In the aftermath of the global financial crisis many regulatory reforms were made. One of these was more frequent revaluation of OTC derivatives risk exposure and related margining. Regulators now expect this to be addressed every business day.Variation margin relates to collateral used to cover changes in OTC derivatives mark to market risk exposure and such collateral is normally cash in major currencies and/or highly rated government bonds.In April 2016 the International Swaps and Derivatives Association, Inc. (ISDA) published two Credit Support Annexes For Variation Margin under English and New York Law in readiness for new regulations which started to be implemented in the USA in September 2016 and in the European Union early in 2017.A Practical Guide to the 2016 ISDA® Credit Support Annexes For Variation Margin under English and New York Law is the essential book for all who need to know about the new detailed regulations for margining in the European Union and the USA and most of all need to understand the contents of these two credit support annexes so that they can negotiate them safely and confidently.The book is written by two of the world's leading commentators on the subject, Paul C. Harding and Abigail J. Harding, and its coverage is comprehensive.This first edition principally offers readers a detailed guide to these two credit support annexes through a clause-by-clause commentary on each of them. This commentary is written in clear English for a good, swift understanding of the implications of each provision.The full texts of each Credit Support Annex are reproduced in the appendices with the kind permission of ISDA.As well as the commentary mentioned above, the book also contains chapters on the causes of the global financial crisis and the detailed regulatory response to them and the most recent developments in the OTC derivatives markets including ways the "too big to fail" problem has been addressed, MiFID II and the implications of BREXIT as far as they are currently known.This one-stop book is principally aimed at lawyers and paralegals who need to negotiate these two new credit support annexes. Other professionals in the European and US OTC derivatives markets will also find this book useful. These could include traders, credit officers and regulators as well as academics specialising in collateralisation. Such professionals may work for commercial or investment banks, law firms, treasury units, collateral departments, central banks, pension funds and fund managers. Such is the broad potential appeal of this must-have book which caters for the novice and seasoned negotiator alike.

Chapter 1 – The new regulatory scene for OTC derivatives and collateral

Causes of the global financial crisis 2007-2009

It has been traditional when a recession or financial crisis hits a country to blame it on banks making bad property loans.

The causes of the 2007-2009 global financial crisis were, of course, more widespread but “bad property financing” did have a role to play as we shall see shortly. It should also be pointed out that the financial crisis was not just confined to 2007-2009. There is evidence that it continued after 2009 with the Eurozone sovereign debt crisis and some still seeing vestiges of it today in those European countries whose GDP is still below 2008 levels.

A list of the causes of the global financial crisis and the worst recession in 80 years would include the following:

• Bad property lending as mentioned above.
• Years of low inflation and stable growth before the crisis which created complacency and excessive risk taking by banks.
• A savings glut in Asia leading to low interest rates which caused huge amounts of Asian money being invested in US Treasury securities on which the interest yield also fell.
• Cheap financing causing banks and investors to take on greater risks in order to increase returns which in turn led to a huge increase in debt.
• Banks inflating their balance sheets but not increasing their capital reserves for losses. Under Basel II Rules big banks could calculate their own capital coverage if they had the systems to do so. This led to over favourable evaluation of asset quality in many cases.
• Regulators being too lax in their oversight of banks particularly in relation to the use of leverage.

There is much useful literature on the global financial crisis and the above points are an outline summary only and others might well want to add further bullet points in apportioning responsibility between banks and regulators. However, although this is not the focus of this book, it is useful to describe a little further how the crisis developed in the USA and Europe.

The crisis in the USA

The two prime causes of the crisis in the USA were deregulation and sub-prime mortgage securitisation.

Deregulation

In 1999, the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act of 1999) repealed part of the Glass-Steagall Act of 1933 which had separated US investment and commercial banking activities. In the years before 1933, overzealous commercial bank lending for stock market investment was deemed the main cause of the financial crash then and it was considered that commercial banks had taken too much risk with depositors’ money.

The repeal of the Glass-Steagall Act allowed banks to use deposits to invest in derivatives (often with hedge funds) and enabled them to take hugely leveraged positions. Then in 2000 while attention was focused elsewhere on the court battle over the US presidential election, the Commodity Futures Modernization Act came into being. This Act clarified and effectively exempted OTC derivatives from regulation by the Commodity Futures Trading Commission. It also contained an exemption for energy derivatives trading which became known as the “Enron loophole”.

Big banks had the resources to become sophisticated in the use of complex derivatives. The banks which sold the most complicated financial products made the most money. That enabled them to buy out smaller, safer banks. By 2008, many of these major banks had become too big to fail and too interconnected. Ironically despite numerous regulatory safeguards since the crisis, some of these banks have grown even bigger through mergers and acquisitions of smaller banks.

Securitisation of mortgages

Securitisation is a process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets concerned are passed through to the purchasers of the securities.

With mortgages a bank would lend money to house buyers and then pool them under a mortgage backed security often with tranches of different risk which made them difficult to value. These pooled securities were often called Collateralised Debt Obligations (“CDOs”). The bank then sold the CDOs to investors who were often other banks, municipalities, hedge funds, mutual funds and pension funds.

Investors tended to buy the less risky tranches because they trusted Triple A ratings often given to them by major ratings agencies like Moody’s Investors Service, Inc. (“Moody’s”) and Standard & Poor’s Financial Services LLC (“S&P”). This turned out to be a mistake because the banks paid these agencies to assign the ratings to the CDOs and so there was a conflict of interest and the agencies were often over optimistic about the quality of the CDOs.

Since a bank sold the mortgage(s), it could make new loans with the money it received. It still collected the mortgage payments of principal and interest and sent them to their investors. While the mortgages were basically risk-free for the bank, it was the CDO investors who took all of the default risk unless they entered into credit default swaps which were sold by banks and insurance companies like American International Group, Inc. (“AIG”). These investors considered the combination of a highly rated CDO and a credit default swap from a solid, reputable insurance company like AIG to be a safe investment.

A CDO combined with a credit default swap was a very profitable transaction for their providers. As the demand for these derivatives grew, so did the banks’ demand for more and more mortgages to back the CDOs. To meet this demand, banks and mortgage brokers offered home loans to just about anyone. Banks offered interest only sub-prime mortgag...