Contracts are not bilateral

Commenting on Nassim Taleb’s provocative agenda for fixing the world, Felix Salmon notes that

Looking at the rest of the list, how on earth do you stop the financial sector from… creating complex products? Derivatives are, at heart, bilateral contracts: how can you ban two consenting adults from entering in to such a contract?

The only bilateral contract is a gentleman’s agreement. Binding contracts involve an implicit third party, the state which (through its courts system) stands ready to enforce the terms of private arrangements. The state is not, and cannot be totally neutral in its role as contract enforcer: Communication between contracting parties is always imperfect; the universe presents an infinite array of unforseeable possibilities; even very clear contractual terms can be illegal, repugnant, or contrary to the public interest. The state makes affirmative decisions about how it will (or will not) enforce the terms of contracts. Libertarians may have perfect freedom to contract, if their agreements are self-enforcing or voluntarily adhered to. For the rest of us, every contract is a negotiation between three parties, the two who put a signature at the bottom the document, and the state which will be called upon to give force to the arrangement when disputes arise or someone fails to perform. I think of contract lawyers as two-bit psychics in fancy suits. Much of their job is to channel the voice of the incorporeal Leviathan, so that its quirks and predilections are taken into account whenever agreements are drafted.

This has something to do with derivatives, but even more to do with one of Taleb’s broader concerns: debt. At present, the state enforces debt contracts by permitting lenders to force nonperforming borrowers into bankruptcy. That is not a natural or obvious arrangement. Bankruptcy evolved as an improvement over automatic liquidations or men with big necks and brass knuckles. It serves to balance the contractual right of a lender to be timely paid with a broader interest in preserving the overall value of enterprises and preventing extremes of immiseration. To some degree, bankruptcy lets debtors to escape the terms of their own agreements and limits the right of contract (though bankruptcy is onerous enough that debtors don’t seek this sanctuary easily). The fact that creditors’ rights are limited is socially useful: it encourages lenders to discriminate between good borrowers and bad, reducing the frequency with which resources are lent foolishly and then destroyed.

One thing I think that we are learning from the present crisis is that the logic of bankruptcy hasn’t been taken far enough. Creditors’ rights are too strong. Creditors have insufficient incentive to discriminate, especially when lending to “critical” organizations, because the bankruptcy that would attend a failure to pay is too disruptive and destructive to be permitted by the state. We have seen tremendous resources lent to banks thoughtlessly, and then squandered or stolen rather than carefully invested. Similarly, those who entered into derivative contracts often ignored credit risk when a counterparty was seen as too dangerous to bankrupt. If it were possible for borrowers and counterparties to welsh on their agreements without provoking consequences as disruptive as bankruptcy, creditors would have more reason to be careful of whom they do business with, and potential deadbeats (like large financial firms) might not be able to take levered risks cheaply.

I think that, going forward, the state will have to limit the right of creditors to enforce claims via bankruptcy. Creditors and counterparties who go to the courts would run the risk of simply having their claims converted into something like cumulative (and maybe convertible) preferred equity. This would ensure that no dividends are paid to stockholders until the disgruntled creditors are made whole, but would not otherwise disrupt the operation of firms or affect other claimants. (Such conversions could be combined with tight compensation limits, to prevent shareholders and managers from taking payouts as wages and bonuses while failing to pay creditors forcibly converted to equity.) Judges would weigh the rights of creditors against the costs to other stakeholders in deciding between formal bankruptcy and ad hoc conversions, so that the risk to creditors would increase with the size and interconnectedness of borrowers.

It may be hopeless to try to control what kind of contracts private parties write amongst themselves. But we can control how contracts are enforced. There is nothing natural or neutral about how we currently enforce debt contracts. We made up some procedures that seemed to work reasonably well. The current crisis has exposed some shortcomings. Nothing prevents us from modifying how we enforce contracts in order to improve the incentives of parties to manage their own risk, and to prevent collateral damage when private contracts come undone.

Update History:

  • 22-Jun-2016, 2:40 p.m. PDT: “the state will have to limit the right of debtors creditors to enforce claims by via bankruptcy.”; “run the risk of simply having their claims converted”

25 Responses to “Contracts are not bilateral”

  1. raivo pommer-eesti writes:


    NORDBANK-drei million euro

    Demnach hatte die Bank im Vorgriff auf die ursprünglich geplanten Ausschüttungen in Höhe von 64 und 200 Millionen Euro zum Zeitpunkt von Wiegards Angaben bereits gut acht Millionen ausgezahlt.

    Der Minister habe sich auf Auskünfte der Bank verlassen müssen, weil es sich um rein operatives Geschäft handele, sagte der Sprecher. Das Ministerium überwache nicht den Zahlungsverkehr der Bank. Es habe sie nun aber aufgefordert, die Vorgänge zu erklären.

    Die HSH Nordbank hatte im März angekündigt, aus EU-rechtlichen Gründen auf die Ausschüttung zu verzichten. Die ausgezahlten Summen würden daher zurückgefordert, heißt es in der Antwort auf die Kleine Anfrage des Hamburger Abgeordneten Stefan Schmitt (SPD).

    Hamburg und Schleswig-Holstein helfen ihrer gemeinsamen Landesbank mit einer Kapitalspritze in Höhe von drei Milliarden Euro sowie Garantien über weitere zehn Milliarden Euro aus der Klemme. Die Parlamente beider Länder hatten dem Rettungsplan in der vergangenen Woche zugestimmt.

  2. mittelwerk writes:

    i’m not sure why taleb’s pronouncements are being treated with such reverence. they’re actually pathetic and infantile. more to the point, they’re absolutely bristliing with normativity — are people not getting that?

    every one of the oracle’s, ahem, “rules,” implies at the very least the existence of a massively powerful authoritarian state. i’d go so far as to say totalitarian — that is, a total identity of social actors and state functions. who else is policing every transaction? who else is backing up every single one of taleb’s should-nots, do-nots, will-nots?

    the most hilarious part is that he still considers it “capitalism” — which is by definition dependedent precisely on inequality of exchange, information, and compensation, and the social stratification that necessarily results from it. and with all these rules, why doesn’t taleb mention the underground economies that will proliferate as the necessary reaction? wouldn’t those have more to do with capitalism per se?

    i think taleb is a huge part of the problem: bourgeois (or in his case, actual ruling-class) mathematical-finance dweebs with a weak understanding of poitical philosophy taking a stab at being social scientists. watch out.

  3. Free Spirit writes:

    This exchange of debt for equity is justice, but it has a serious practical downside:

    Cash flow is the lifeblood of business. If you impair the creditor’s cash flow, they can be pushed into bankruptcy. This may be justice, since they should be careful to whom they lend. However, if there is a chain of leverage, then everyone in the chain might go down if debt-equity exchange is the rule. Under the current system, the first link in the chain goes bankrupt to satisfy the debt, thus probably preserving the rest of the chain.

    Finally, how do you extend this to individuals? You cannot take equity in someone who has no real assets, and owning part of their home or vehicle is not necessarily attractive.

    When the creditors and debtors are enmeshed (as seems to be the case with derivatives), equity-debt swaps might be preferable, as these are rightly bets and not investments. “Settling up” after the race is over would see a lot of equity sloshing from balance sheet to balance sheet!

  4. jimbo writes:

    mittlwerk –

    So is the SEC or FDIC totalitarian? Because there’s nothing on Taleb’s list that is fundatmentally different from the sort of stuff they do all day. Markets exist in box – the box that is the rules a society agress to run them by. Every once in a while, those markets get out of their box and start doing doing damage. When that happens, it’s the perogative of society to change the rules, and put the markets back into a newer, hopefully better box. Markets are a great way to allocate resources, but they exist to serve the public purpose. If they aren’t doing that, change them so that they do.

  5. alou writes:

    The creditors of the banks would not get very much in a bankruptcy court even now so I dont think that limiting their rights would make them more careful.

  6. free spirit — you’re right, the debt-to-preferred-equity thing doesn’t extend to individual bankruptcy well. actually, individual bankruptcy already has something like it — “workout plans” are basically a way of ensuring cash flows go to old creditors under different and more sustainable terms. regardless, the debt-to-preferred-equity is intended for business entities. workable variants can be defined for any sort of business where the business accounts are separate from those of a sole proprietor.

    the point of the plan is to change creditor behavior so that ex ante very brittle webs are less likely to develop. it’s basically a back-door way of turning business credit into a more equity-like instrument, forcing creditors to provision for more uncertainty in value and payment and reducing the likelihood that creditors of creditors will supply cheap leverage. that is to say, it might be true that in a world where any business debt claim can be arbitrarily converted to equity at the discretion of a judge, we might not end up with such fragile networks of creditors that the knock-on effects that you describe obtain. further, creditors of the creditor whose debt has been converted also can’t reliably force bankruptcy, since their claims can be converted as well. so rather than cascading failures, we might see whole networks of interwoven creditors converted to pure equity financed going concerns. in the end, this would hurt households that owned “debt” and expected timely payment, but that’s really their problem, the whole discipline thing. fiduciaries (pension funds, insurers and the like) would not be able to hold corporate debt so freely, since it would be equity-like in its risk characteristics. so the knock-on effects to “innocents” of converting networks of fragily interwoven creditors to mutual equityholders should be minimal.

    i do want to mention that i think courts would have to discriminate between transactional claims and claims that serve as financing (and that there are no bright lines here). that is to say, a supplier who extends minimal credit to avoid cash-on-demand frictions (e.g. 30 day net terms) ought not be easily converted, where the same supplier who offers more-than-transactional credit (say 90 day terms at some premium and a continuous and growing float) has entered into a vendor financing arrangement, and ought to be in jeopardy of conversion to equity. laws and courts would have to develop tests, but the point would be that the credit intended to lubricate ordinary commerce, attached to specific current transactions and not likely to give rise to ongoing future obligations, should not be subject to uncertainty over its debt/equity status, while arrangements that create obligations to repay in the distant or indeterminant future, particular those not attached to near-current performance in goods and services, should be subject to such conversions.

    alou — this proposal does very little for the current crisis (although allowing net derivative gains to be payable in preferred equity would make it easier to unwind “too-interconnected-to-fail” banks). it’s intended for the future, largely to prevent creditors from extending funds cheaply to organizations without productive investment opportunities, on the theory they’d be repaid come hell or high water (which theory has turned out to be sadly correct during this crisis).

  7. alou writes:

    I mean if the creditors have to enforce their claims in a bankrupcy court I dont think that they will get their money back. I dont think that the bondholders of Lehman Brothers got much back. I dont think that they would have lost more if they had been restricted to receiving preferred equity or something in the case of a default.

  8. alou — no, the question is whether they’d have extended so much credit in the first place if they knew there were a non-disruptive way that their claims could be abrograted.

  9. alou writes:

    But they werent thinking that they were safe because of the legal force of their claims. That is not why they made risky loans. It is because they didnt take the danger seriously in the first place.

  10. alou — i’d argue they didn’t take the danger seriously because they believed that failure to be repaid was unthinkable, because the only circumstance in which they’d fail to be repaid would involve traumatic bankruptcy of incredibly interconnected organizations. it wasn’t the legal force of their claims that gave the illusion of safety, but the fact that as a practical matter, imposing upon them the vulnerability to which they were legally subject would provoke cascading failures in the financial system. bank bondholders thought (correctly) that they had the world financial system hostage, and needn’t fear actual default of legally defaultable claims. letting bonds convert to equity in an ad hoc way would make it practical to effectively default, not just legally possible, or at least that’s the theory. i think lots of investors were aware and took seriously that 40:1 levered institutions are inherently unsafe. the only such institutions they were willing to invest in cheaply were the ones for whom any default would hurt us more than them. that’s the situation this suggestion aims to change.

  11. mittelwerk writes:

    so basically moral hazard is no longer a hazard at all, but an operational maxim.

    i liked the dark musings better. at least they accounted for the presence of venality. i personally tilt 80-20 in favor of venality over stupidity as the appropriate theory. or maybe one should posit pareto-optimal venality, in which no player in this could possibly get more venal without some other player having to perform a stupidity offset.

    also, it seems pretty clear that the gearing of debt involved in this “crisis,” as well as its structure, which penetrates every economy and every pair of pockets in the world, fundamentally changes the nature of concepts like “contract” and “bankruptcy.” they don’t even apply — since there’s no authority big enough to enforce or wind down anything.

    this is not a financial problem at all, but a social one.

  12. carpingdemon writes:

    Bingo, mittelwerk!

  13. dave writes:

    So you think bank debtholders should be given a haircut and accept an equity conversion. That’s pretty much how bankruptcy works. All you’re really saying is that we should use the bank version of bankruptcy, nationalization, and make sure the terms of that nationalization are punitive to bank creditors. I’d be in agreement with that, with the condition that the goal of nationalization was to reprivatize after cleaning out the balance sheet via creditor haircut, and not to make banking a permanent arm of the state and have Barney Frank setting my mortgage rate.

    Unfortunetely, that isn’t what is happening. Off in the real world banks are going to get a few trillion giveaway from the treasury and bank creditors look like they are gonna get paid off in full (except Lehman, but they promise that will never happen again). Also off in the real world AIG uses a few hundred billion to pay off its bad CDS bets at 100 cents on the dollar.

    As for the idea of the state, which has to enforce the contract (a cost), having a say in what contracts people can make I think that is reasonable, but how far are you willing to go with it? It is very difficult to prevent two willing individuals from making a contract with eachother, even if you’ve got an army of regulators. Add to this the fact that regulation can often be misplaced or have unitended consequences. Not to mention the specific issues of ex post contract rewriting (yes, it happens, but its always messy). I’m not against the idea, but I don’t think it alone is going to solve the problem. People find a way around regulations.

    To me the ultimate regulator is peoples own fear of loss, the natural regulator of the market. All the guarantees and “too big too fail” nonsense nueter the markets regulator, leaving only fallible human regulators and institutions to try thier best. In some cases they may be useful, but overall I think they are doomed to failure unless they have help from the markets natural regulator. That means letting some of these companies go under, which for banks means nationalization, shareholder and creditor haircuts, and breakup into smaller entities. If we try to regulate without doing that I think we end up back in this situation pretty quick.

  14. dave — i agree with almost all of what you have to say, but want to emphasize that the proposal in this post wasn’t intended as a way of dealing with the present crisis, but as a change going forward to discourage underpriced lending to “too-big-to-fail” institutions.

    re the present crisis, though, i agree that no scheme for fixing things next time will be credible unless we are willing to be tough on some of this round’s spectacular miscreants. i am, unfortunately, terribly pessimistic that that will happen. i think we are in this mess for some time yet, with false dawns and progressively greater crises, because we are unable to impose the losses on those who incurred them. we will fight for years about which relative innocents will bear the losses the government is now assuming, while the unreformed financial system will find ways to make new and better losses for us. sigh.

  15. alou writes:

    I guess that the bondholders werent really thinking of being bailed out. I guess that they were just over confident.

  16. Taunter writes:

    Disagree completely. The problem is not that creditors have too strong a hand in bankruptcy and are therefore not discriminating – it is that, at least in the financial meltdown, a third party (the taxpayer through Fed/Treasury) is stepping in to spare both parties the logical outcomes of their agreements.

    If we had the courage to push AIGFP into bankruptcy, creditors would get pennies on the dollar. Some of them might go bankrupt themselves. You can have some confidence that this event would be seared into the collective memories of many in the financial community, amnesiacs though they may generally be.

    The system works fairly well, or could with minor adjustments (perhaps some sort of “involuntary commitment” for key industries where the government can force a declining business into restructuring without waiting for the business itself to file). But Geithner would rather spend the taxpayer’s money than find out.

  17. RueTheDay writes:

    There are a couple of fantastic books on the history of Bankruptcy Law in the US out there:

    Debt’s Dominion: A History of Bankruptcy Law in America


    Republic of Debtors: Bankruptcy in the Age of American Independence

    The story of how bankruptcy law came about is quite fascinating. Before bankruptcy law established bankruptcy proceedings, debtors were thrown in debtors prison, their assets were seized by the sheriff and sold (often for pennies on the dollar) to pay off debtors (sheriff’s sale), and debts remained literally forever until paid off, even being passed down to heirs. The problem with this approach is that debtors cannot repay their debts from debtors prison with no assets (and thus it’s a poor solution for creditors as well as debtors) and even more importantly, it causes the entire system to lock up during economic downturns. Bankruptcy law was a huge improvement, and it evolved over many years in fits and starts.

    What I believe Steve (and others) are saying is that it must continue to evolve to accomodate a changing environment. Bankruptcy law as it exists now cannot effectively deal with interconnected “too big to fail” institutions.

  18. raivo pommer-eesti writes:



    Den Verbrauchern und der Industrie in Europa drohen höhere Energiesteuern. Die Europäische Kommission will die Steuern auf Energie künftig stärker am Kohlendioxidausstoß ausrichten und dafür einheitliche Mindeststeuersätze einführen. Das geht aus einem internen Entwurf der Behörde hervor, wie ein neuer Regelungsrahmen für Steuern auf Energie und Elektrizität aussehen soll. Konkret sollen die Staaten künftig auf Kraftstoffe zusätzlich zu den heute bestehenden, weitgehend am Verbrauch ausgerichteten Mindeststeuern eine Steuer von mindestens 3 Cent je ausgestoßenem Kilogramm Kohlendioxid erheben. Für Heizstoff soll es mindestens 1 Cent sein. Zudem will die Europäische Kommission die bestehenden Steuerprivilegien für Kraft- und Heizstoffe aus Biomasse untersagen. Die EU-Mitgliedsstaaten sollen zwar keine Kohlendioxidsteuer auf solche Kraftstoffe erheben. Alle anderen Privilegien sollen aber wegfallen.

  19. vlade writes:


    I think the changes should also incorporate the tax treatment of debt vs. equity. It has been talked of often enough, so I won’t be going on it much, but I will speculate that if there was equivalent tax treatment for debt and equity, companies would prefer issuing preference non voting shares to an outright debt. This in turn would have impact on the conditions debt had to have attached to it to be attractive to companies again.

  20. raivo pommer-eesti writes:


    Bank of America.

    The last three months have been a painful time for the Charlotte, N.C.-based banking giant. There has been the never-ending string of headaches associated with last year’s fateful purchase of Merrill Lynch, including a bonus scandal that the company can’t seem to shake.

    At the same time, there has been no shortage of criticism from shareholders about its stock price. Management has also been working hard to convince investors that last year’s purchase of mortgage lender Countrywide was a smart move.

    Elevating the stakes even further is the fact that many of Bank of America’s peers, such as JPMorgan Chase (JPM, Fortune 500), Wells Fargo (WFC, Fortune 500) and Goldman Sachs (GS, Fortune 500), have shattered profit expectations so far this quarter.

  21. vlade — i very much agree. the differential tax treatment of interest and dividend payments is a deeply counterproductive abomination. (i’ve written about this before, e.g. here.)

  22. raivo pommer-eesti writes:




    Die Finanz- und Wirtschaftskrise hat in den USA zwei weitere Regionalbanken in die Pleite getrieben. Damit sind dort seit Januar so viele Institute zusammengebrochen wie im gesamten Vorjahr.

    Nummer 24 und 25 waren zum Wochenende die Great Basin Bank im Bundesstaat Nevada und die American Sterling Bank in Montana. Wie in den meisten früheren Fällen fanden die Behörden für beide Häuser einen Käufer. Die Kundengelder sind gesichert.

    Der staatliche Einlagensicherungsfonds FDIC rechnet angesichts der Wirtschaftskrise mit weiteren Zusammenbrüchen unter den noch rund 8300 US-Banken. Die Schließungen erfolgen meist zum Wochenende, damit bis Montag genug Zeit zur Wiedereröffnung unter dem neuen Besitzer bleibt.

    Die Great Basin Bank hatte eine Bilanzsumme von gut 270 Millionen Dollar (207 Mio Euro), wie die Einlagensicherung FDIC mitteilte. Die Nevada State Bank übernimmt das Geschäft. Die zuletzt rund 180 Millionen Dollar schwere American Sterling geht unter Vermittlung der FDIC an die Metcalf Bank (Missouri).

  23. raivo pommer-eesti writes:


    DEUTSCHE BANK 25% Rendite

    Damit dürfen aber nicht die Zeiten zurückkehren, in denen die Rendite das Maß aller Dinge war. Josef Ackermann, Chef der Deutschen Bank, propagierte ein Gewinnziel von 25 Prozent des eingesetzten Kapitals ausgerechnet, als erstmals fünf Millionen Menschen in Deutschland ohne Arbeit waren. Seither gilt diese Zielvorgabe als Symbol für die Maßlosigkeit auf den Finanzmärkten.

    Ackermann orientiert sich an einer globalen Banker-Elite, die gerade kläglich versagt hat. Er sollte deshalb nicht nur die auf kurzfristigem Gewinnstreben basierende Bezahlung der Manager anprangern, sondern auch sein strittiges Renditeziel beerdigen.

    Wissenschaftliche Untersuchungen zeigen, dass die 25-Prozent-Rendite nur unter Inkaufnahme hoher Risiken und undurchschaubarer Geschäfte außerhalb der Bilanz zu erzielen war. Auf diesen hohen Risiken sind die großen internationalen Banken in der Finanzkrise sitzengeblieben.

  24. raivo pommer-eesti writes:



    Die Bank of America hatte sich im vergangenen Herbst am Blitzkauf der Investmentbank Merrill Lynch verhoben. Im Zuge der Finanzkrise hatte sie zuvor bereits die Hypothekenfirma Countrywide übernommen, die als mitverantwortlich für die Kreditkrise gilt. Der Staat griff der Bank bisher mit allein 45 Milliarden Dollar an direkten Hilfen unter die Arme.

    Merrill Lynch habe im ersten Quartal ohne Berücksichtigung von Kosten der Übernahme zum Gewinn 3,7 Milliarden Dollar beigetragen, so die Bank. Die Erlöse verdoppelten sich zum Jahresauftakt auf rund 36 Milliarden Dollar, die Vorjahreszahlen beinhalteten aber Merrill Lynch und Countrywide noch nicht und sind daher kaum vergleichbar.

    In den vergangenen Tagen hatten unter anderem J.P. Morgan Chase und Goldman Sachs Milliardengewinne vorgelegt. Selbst die zu den größten Krisenverlierern zählende Citigroup hatte ihr Ergebnis klar verbessert und vor Dividendenzahlungen sogar wieder schwarzen Zahlen geschrieben. Analysten warnen trotz des positiven Trends jedoch, dass eine endgültige Erholung der Finanzbranche noch nicht sicher sei.

  25. raivo pommer-eesti writes:


    MEGA-REZESSION in Europe im Jahre 2010

    Anders als bislang erwartet wird die deutsche Wirtschaft voraussichtlich auch im Jahr 2010 schrumpfen. Sowohl der Internationale Währungsfonds (IWF) als auch die führenden deutschen Forschungsinstitute rechnen inzwischen mit einem zweiten Krisenjahr. Knapp fünf Millionen Menschen sollen dann arbeitslos sein. Zudem werden die Staatsschulden dramatisch steigen, urteilen die Institute.

    Während diese lediglich einen Rückgang des Bruttoinlandsproduktes (BIP) von 0,5 Prozent erwarten, rechnet der IWF mit einem Minus von einem Prozent. Auch für 2009 sind die Prognosen weitaus schlechter als erwartet. So kommen die Institute zum Ergebnis, dass die Wirtschaftsleistung um sechs Prozent schrumpfen wird. Der Fonds geht von einem Minus von 5,6 Prozent aus. Die Regierung will auf die Prognosen reagieren, indem sie ihre eigenen Erwartungen nach unten korrigiert – nach Worten von Bundesfinanzminister Peer Steinbrück (SPD) auf ein Minus von fünf Prozent oder mehr. Im Januar hatten die Experten der Regierung noch damit gerechnet, dass das BIP nur um 2,25 Prozent sinkt.