Sunday, April 13, 2008

Large OTC Markets + Excessive Leverage + Fair Value Accounting = Systemic Risk

"Fair value" accounting is obviously appropriate for you if you are a securities broker. But should everybody else in the world be accounted for as if they were securities brokers? That is hardly obvious, indeed highly dubious. From the proponents of this dubious position we constantly hear that they are only insisting on "the facts" of market prices. Of course they admit that in many cases there is no active market or no market at all, but then we need estimates-as is true in many other areas of accounting. They also admit that markets can be panicked and reach fire sale prices that will be judged by later observers as irrational, but say that nonetheless that's "the fact" of the market price now.

Alex Pollock
, American Enterprise Institute

(Institutional Risk Analytics) Last Thursday on Capitol Hill, The IRA gave a talk regarding the crisis in the structured finance market for the Women in Housing Finance ( A staffer asked if providing financial assistance to home owners with underwater mortgages helps the securitization market. Our reply was no, fix the market for loan securitization and you help the individual home owner. The same response applies to fair value accounting: fix the problems with market structure and most complaints about FAS 157 disappear.

Or put another way, fix the problem with market structure such that implementation of FAS 157 is no longer a source of angst for CEOs, and then the involuntary credit contraction that is forcing the US economy into a deep recession also goes away. Until our political leaders and regulators recognize that allowing a significant portion of the financial markets to trade OTC increases overall systemic risk and is contrary to the interest of investors and the nation, this problem will not be resolved.

Even if you accept the premise of FVA, namely that price = value (a proposition we reject, BTW), the unpredictable and extreme secondary effects of the adoption of FAS 157 at the end of 2007, a reaction caused by the growth systemic risk due to the proliferation of OTC financial instruments, deserve as wide an examination as possible. When the percentage of OTC assets which fall into the FAS 157 Level Three bucket created for illiquid assets is significant enough to cause headlines, then that suggests a serious market structure deficiency that needs the attention of policy makers. Just ask the shareholders and employees of Bear, Stearns (NYSE:BSC).

Take an example that illustrates the difficulty of really achieving "fair value" from the FAS 157 rule in a market filled with illiquid derivative assets. We hear from the channel c/o Mike "Mish" Shedlock that the $12 billion sale of leverage loans announced by Citigroup (NYSE:C) last week at a price of 90 cents on the dollar includes terms whereby C indemnifies the buyer for the first 20 cents worth of losses, meaning that the true economic value is 70 cents, not 90 as advertised. More, apparently C is providing 80% financing for the deal.

So our question to the proponents of FVA: What is the appropriate "fair value" for the above transaction? Is this a true sale? (Our answer is no.) This example suggests that the participants in the opaque world of structured finance will arbitrage all efforts to achieve a precise description of value or even the correct price! How does a concept like FVA, which depends upon a certain degree of good faith by all market participants, operate in such a deliberately dishonest environment?

We also agree with our colleague Alex Pollock that FVA makes the most sense for financial institutions like broker dealers, organizations that need a current price for most assets to support daily operational needs. Of interest, General Electric (NYSE:GE) CEO Jeffrey Immelt said on CNBC Friday that less than $10 billion of GE's $600 billion in assets are subject to FVA and that FVA does not affect his firm's results. BTW, we don't look for FVA to result in a large number of actionable restatements outside the financial world.

BDs are supposed to limit their investments to liquid securities; this so that they may meet liquidity requirements imposed by regulators, exchanges and counterparties. Liquid securities that fall into Level 1 or 2 of FAS 157 are easy to fit into a FVA framework because the markets for them are reasonably deep and the pricing has sufficient quality to command confidence as an indicator of value.

Unfortunately, in recent years BDs and the trading book side of universal banks have increasingly violated the golden rule of liquidity. As Drexel University professor Joseph Mason said in our interview ("No True Sale: An Interview with Joe Mason" ), only academics sitting in their offices think most securities traded on most markets are sufficiently liquid to meet the price quality test. Of note, Thomas Seeberg, Michael Starkie and Carsten Zielke make a useful argument in the Financial Times for a price-averaging regime, scaling time vs. liquidity, as a possible solution to the price quality problem to apparent in FAS 157 (See FT, "Fair value move could break the writedown spiral," April 3, 2008).

As more and more of the Street's business migrated off exchange in search of wider spreads and bigger profits, counterparty risk has multiplied. Now the collapse of the once $3 trillion market in private label OTC securitizations threatens the entire global economy. Mason told The IRA on Friday: "The disarray in the securitization market is an open wound on the global economy. The longer we leave this wound open and fail to address the underlying problems with market structure and ratings agencies, the greater the chance of infection hitting market sectors like finance, airlines or autos."

On that same note, author Martin Mayer makes an interesting comment on the BSC debacle and leverage generally in this week's issue of Barrons:

"In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It's an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit. The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps... Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don't know who will wind up with obligations they thought they had insured against and they can't meet."

For some months now, we've been pondering what happens to all of those net short credit default swap portfolios at dozens upon dozens of hedge funds that will be going out of business this year due to the Great Unwind. Hedge funds have no permanent capital, thus there are no assets available to support the defeasance of a book of net-short OTC derivatives positions should the fund be forced into involuntary liquidation.

In such a scenario, you can forget about netting; won't be nothing left to net, in or out of bankruptcy. And since the old habit of simply writing more CDS contracts is not available once the fund starts liquidating, we wonder if leading CDS dealers like JPMorgan (NYSE:JPM) won't be forced to take these trades back as hedge funds expire. What's the "fair value" of a book of short OTC derivative positions taken by a dealer in payment of other debts?

Indeed, if you think of BSC not as a broker dealer, but instead as a clearing customer of JPM, then the logic of the acquisition makes perfect sense. JPM could not let BSC go into Chapter 11 because doing so might have started a chain reaction among the OTC derivative counterparties of both firms.

Between JPM, BSC and BSC's customers there were three levels of leverage, making the ratio of Economic Capital to Tier One Risk Based Capital computed by The IRA Bank Monitor (4.7:1) for JPM at the top of the leverage pyramid seem entirely too generous! If you impute even a fraction of the downstream leverage residing with clearing customers to JPM, the giant bank's capital shortfall becomes alarming.

A bank holding company, after all, is thinly capitalized and in many ways was the precursor of the hedge fund model. On a parent-only basis, JPM's $314 billion asset balance sheet includes $200 billion representing investments in its subsidiary banks and non-bank units, supported by half as much equity and more than $200 billion in debt.

And remember that JPM's on-baance sheet capital does not even partially support the counterparty risk of its vast OTC derivatives businesses, thus the BSC acquisition was a "must do" deal for Mr. Dimon. Think of it this way: JPM is essentially an uncapitalized,�$76 trillion�OTC derivatives exchange with a $1.3 trillion asset bank appendage. By the way, we are working to include factors for OBS securitizations in the next iteration of our Economic Capital simulation in The IRA Bank Monitor.

But you understand that Fed officials still believe, even today, that the US markets are not over-leveraged.

The story goes that shortly after Ben Bernanke was confirmed as Fed Chairman, he attended a dinner in New York attended by the heads of the major banks. All the big banksters were there. After dinner, Chairman Bernanke gave a speech and he at one point reportedly commented that the financial markets were "not very leveraged," causing audible laughter from the audience.

According to one attendee, Lehman Brothers (NYSE:LEH) CEO Dick Fuld eventually spoke up and, while declaiming any intention to disagree with Chairman Bernanke publicly, told the newly minted Fed chief that his comments about the degree of leverage in the financial markets were mistaken. JPM CEO Jamie Dimon, who also attended the dinner, was reported to second Fuld's comments.

Who would have thought that only several months later, Fuld and Dimon, both of whom are directors of the Federal Reserve Bank of New York BTW, would be calling upon Chairman Bernanke to rescue them from leveraged OTC swamp? Guess they're not laughing now - or are they?

No comments: