Limited recourse: Difference between revisions

Investment funds and structured note issuance vehicles tend to be purpose-built single corporations with no other role in life. They issue shares or units to investors and with the proceeds, buy securities, make investments and enter swaps, loans and other transactions with their counterparties. These counterparties will generally be [[Capital structure|structurally senior]] to the fund’s investors (either as unsecured [[creditor]]s, where the investors are [[Shareholder|shareholders]], or as higher-ranking secured creditors, where the investors are also [[secured creditor|secured creditors]]).  

So the main reason for limiting the [[swap dealer]]’s recourse to the [[espievie]]’s assets is not to prevent the [[swap dealer]] being paid what it is owed. It is to stop the [[SPV]] going into formal bankruptcy procedures ''once all its assets have been liquidated and distributed [[pari passu]] to creditors''. At this point, there is nothing left to pay anyone, so launching a bankruptcy petition is kinda — ''academic''.

And that would be fine, if it ''were'' like a ring-fenced repack. But it is not ''quite'': for one thing, poor swap dealer has no [[Security interest|security]] over the pool. It gets no “quid” for its “quo”. It is ''limited'' to that pool of assets, but it has no ''priority'' over them, as against other general creditors of the fund, as it would if it had security. It may find itself not only limited to the pool of assets but ''even then'' only recovering cents in the dollar on them. ''Double whammy''. You could fix that by having the fund represent that ''all'' other creditors are similarly limited to ''other'' pools of assets, so every creditor has its own dedicated bucket — but that is messy and unreliable. Are there really no other creditors? What about people claiming under a tort?<ref>Okay, I know, I am reaching here a bit. But still, the principle.</ref> Granting security is much cleaner and neater — but you’ll never get it. Somehow, asset managers have won this battle. Swap dealers the world over run this structural risk. One day this might come back to nip them on their bottoms, like an angry [[black swan]]. Who can say?  

Note that the [[principal]] — or more likely the [[agent]] — is engaged in some dissembling here. So the principal wants its agent on a short leash. Fine; understood. Fair. But whose problem should ''that'' be? Who should carry the can when an [[asset manager]] exceeds its mandate, goes [[crazy-ape bonkers]], or just, in the vernacular, ''royally fucks up''? Not, we would submit, an arm’s length swap dealer trading in goo faith, for value and without notice of turpitude. The incentives are all wrong.

The general principles of agency, we submit, say this should be the [[principal]]’s problem. ''Choose your [[agent]]s wisely, and monitor them''. If not the [[principal]] (“I did! I even conducted [[due dilly]]! I monitored! Daily!”), then the ''[[agent]]''’. For if the agent’s own principal can’t be expected to have rooted out this canker, what chance did a poor old swap dealer have? 

The one person whose problem it should ''not'' be is the poor, weather-beaten old swap dealer. ''Yet this is what agent-pool recourse limitation does''. It transfers ''[[agent]]'' screw-up risk — perhaps a [[second-loss]] risk, but still a material risk, since you have unreasonably limited the [[first-loss]] to an arbitrary number — to the swap dealer. It is hard to understand why a swap dealer would ever agree to this. The answer likely to come: “Well, [[all our other counterparties have agreed this]].” Alas, in this particular case, the [[agent]] is probably right.

Thirdly, and critically: a limitation to “a specified pool of assets under management” is, make no mistake, a limitation on the ''numeric value'' of your claim. You risk leaving money on the table. That is not what limited recourse is meant to do. This ought to be ''trading'' decision, not a ''credit'' decision. It is as if you have sold your ]]swap dealer]] a [[put option]], limiting its exposure under your contract. Ask yourself why your [[credit]] team, rather than [[trading]], are being asked to approve this. Ask yourself, too, whether the principal isn’t going to be inclined to keep a tight rein on the value of that pool, and tend to keep it shorter rather than longer.