Saturday, May 31, 2008

Getting Case-Shillered: Can you spell conflict of interest?

(Realtor Magazine) If the unemployment rate is historically low yet your customers are waiting for home prices to drop 30 percent before they buy, you’ve just been Case-Shillered. The S&P/Case-Shiller Home Price Index is the benchmark the financial press uses to tell us how terrible the housing market is. One must wonder why. The index’s findings are notoriously softer than the indexes used by the Office of the Federal Housing Enterprise Oversight, NAR, and even Realogy.

In 2007, home prices went down for the first time in decades, but by how much? OFHEO said by 0.3 percent, NAR 1.4 percent, and Realogy 1 percent. Case-Shiller? 8.9 percent. Yale economist Robert Shiller, cofounder of the index, is scaring home buyers with proclamations that home prices “will fall further than the 30 percent drop in the historic depression of the 1930s,” as he told the Associated Press in April. Prognostications like that are a problem because financial journalists such as Michael Grynbaum of The New York Times, Les Christie of CNN, and Rex Nutting of CBS MarketWatch, as well as securities investors and analysts, call his index “the best gauge” of real estate values.

Since when do reporters feel the need to fluff a source, and why are analysts so enthralled with the index? One reason might be its Wall Street seal of approval: It was launched to provide information for hedge funds. Created by Shiller and Karl Case, an economics professor at Wellesley, the index is licensed exclusively to Macromarkets LLC for “developing, structuring and trading financial instruments,” says the Macromarkets Web site. Among Macromarkets’ products is the Housing Futures and Options index, which forms the basis for “directly investing in and hedging U.S. housing” on the Chicago Mercantile Exchange, where futures and options on the index are traded. “Every time a CME hedge is made, revenue flows to Macromarkets,” says NAR’s chief economist, Lawrence Yun. “People would hedge only if they believe price movements will be volatile.” Shiller is a founder and chief economist of Macromarkets.

So, is the index biased to the negative? Its divergence from OFHEO’s findings is so wide that Andrew Leventis, the agency’s senior economist, has undertaken studies to find out why. A January 2008 study, “Real Estate Futures Prices as Predictors of Price Trends,” showed that while “implied price forecasts” were reasonably accurate for the most recent round of expiring futures contracts, the index’s contract prices have tended to significantly “overshoot” actual price declines. A February 2008 paper, “Comparison of House Price Measures,” found the index uses a very different mix of markets and weights than OFHEO. Among other things, it gives more weight to the Pacific Coast, where prices have been volatile.

A third paper, “Revisiting the Differences between the OFHEO and S&P/Case-Shiller House Price Indexes,” tried to overcome the differences in outcome by mimicking how Shiller weights its data. For example, it added data on nonconforming loans, which are dominated by subprime loans. Even after these changes, OFHEO’s test index only came within 4.7 percentage points of Case-Shiller’s 8.9 percent plunge. By making other adjustments such as adding weight to faster selling homes, OFHEO whittled the difference even further, but still came within only 1.6 percentage points of the index.

What this shows is that the “weights” are selective. In any case, OFHEO researchers admit that they don’t really know the source of divergence between their index and Case-Shiller’s; indeed, NAR’s Yun has said that the lack of transparency with the Shiller index has been a problem for economists.

Case-Shiller might be lauded by the financial press, while NAR is assumed to be promoting a positive spin, but let’s be clear: OFHEO and NAR don’t have relationships with hedge funds on the side.

Writer Blanche Evans is editor of Realty Times and publisher of Agent News. She is also the author of The Hottest E-Careers in Real Estate.

Another nefarious Countrywide plot

(Tanta @ Calculated Risk) From Housing Wire:
Last week’s Investor’s Business Daily painted a pretty rough picture of everyone’s favorite industry whipping post Countrywide Financial Corp., after getting wind of a servicing policy that requires some delinquent borrowers to pay 30 percent of arrearages before the lender will begin discussing loan modification options — fees that the reporter, Kathleen Doler, called “a steep entrance fee.” . . .

It’s not a blanket policy, as Doler notes, but some borrowers are seeing this policy while others are not. And, of course, Doler finds a few consumer advocates more than willing to demonize the policy, and Countrywide as well. Not hard to do these days.

For its part, Countrywide told IBD that the policy was intended to be a good-faith demonstration, and suggested that the 30 percent policy is only applicable to borrowers staring down a scheduled foreclosure auction. . . .

Allow us to paraphrase what we think the nicely-worded press statement really says: look, if we’ve tried and wasted our resources trying to contact a borrower anywhere from the past 8 to 12 months and they don’t bother to return any of our calls, read any of their mail, or answer the door when we send countless loss mit specialists out there in person, you’ll have to forgive us for calling bullshit when they decide to call asking for a loan mod the day before the foreclosure sale.
I'm pretty sure Angelo was in favor of using "bullshit" in the statement but his PR people told him he's already in enough trouble over "disgusting."

As far as the policy itself, of dealing with eleventh-hour workout requests from borrowers who have been blowing you off until the week before the trustee's sale? I have two words to respond to that: Laura Richardson. You will recall that the good Congresswoman let three homes go into the foreclosure process--and she has admitted that she made no attempts to work with the servicer until all three foreclosures were well advanced and the legal fees had started piling up--and then got all righteous with WaMu because her request for a modification the week before the scheduled sale didn't magically make everything go away. I am not suggesting that Richardson is a "typical American borrower," but she suggested that, so there. Would I make her put cash down on the table before bothering to start a last-minute workout with her? You bet your sweet eclair I would.

What really frustrates me about the criticisms of this specific policy is the complaint that it's "inconsistent": it is exactly a policy that is applied only in certain circumstances. On a case-by-case basis. When appropriate. (I am not affirming excessive faith in Countrywide's ability to determine what is and is not "appropriate" in all situations. But saying they need to do better at that is not to say the policy is wrong.) But as I have argued since the "Hope Now" thing first emerged last year, one-size-fits-all paint-by-numbers workout strategies are doomed to fail.

The fact of the matter is that not all borrowers are the same, and not all circumstances are the same. I am reminded of this article from the Washington Post we looked at several weeks ago, which contained some pretty level-headed advice from Diane Cipollone, of the Sustainable Homeownership Project:
Then, said Cipollone, contact a nonprofit housing counseling agency or an attorney. Avoid any unsolicited offers from people who say they can save your house. Do not avoid mail or phone calls from your lender. And if your lender stops accepting payments because it is moving toward foreclosure, save that money for a contribution toward the loan workout. "If you've missed eight mortgage payments and have spent all that money because the lender stopped accepting payments, that is not a good outcome [nor] a good way to start negotiations," said Cipollone.
The article then describes the successful modification workout that a couple named Ramsey received, after having made a $3000 "down payment" to the servicer.

The fact of the matter is that no one is going to modify your mortgage payments down to zero in any scenario. If you have made no payments for months on end, and have made no attempt to contact your servicer to request a repayment plan or anything else during those months, and at the last minute before foreclosure you do not have any money in savings--the equivalent of several months' worth of a reasonably modified payment--why should the lender bother with you? You can try telling the lender that for the last six months or more your other expenses were so high that you could not set aside even two or three hundred dollars a month that would otherwise have gone toward the mortgage payment, but in that case, how will you afford the modified payments? If you can document a "temporary" financial hardship, why haven't you contacted the servicer until now?

I am personally willing to bet that if Countrywide asked you for 30% of back payments, late fees, and legal charges, and you were only able to scrape up 20%, they'd probably play ball with you, assuming you have a good story about why there is reason to believe that you can and will make the modified payments. Workouts are a process of negotiation; that's the point. And I'll eat my blog if it turns out that Countrywide is the only servicer with a policy similar to this for late-stage modification requests. My sense is that the animus here is against Countrywide, not any coherent objection to a policy of asking borrowers to put down some "earnest money" before being given a deal that may be in everyone's financial best interest, but which is inevitably beset by moral hazard.

Friday, May 30, 2008

Countrywide wants up-front payments to discuss some loan mods? So what?

(Housing Wire) Last week’s Investor’s Business Daily painted a pretty rough picture of everyone’s favorite industry whipping post Countrywide Financial Corp., after getting wind of a servicing policy that requires some delinquent borrowers to pay 30 percent of arrearages before the lender will begin discussing loan modification options — fees that the reporter, Kathleen Doler, called “a steep entrance fee.”

From the story, an indictment:

They said Countrywide is requiring homeowners to pay 30% of the amount they are in arrears on payments, plus 30% of accrued late fees and 30% of attorney fees already incurred in the foreclosure process.

The payment doesn’t guarantee a loan modification, they said. It is only the price some consumers must pay to begin discussions with Countrywide, based in Calabasas, Calif.

The policy seems to go against Countrywide’s advertising and public statements about its efforts to help troubled borrowers stay in their homes. It comes amid a major drive by Congress and the Bush administration to steady the housing market and help homeowners avoid foreclosure.

It’s not a blanket policy, as Doler notes, but some borrowers are seeing this policy while others are not. And, of course, Doler finds a few consumer advocates more than willing to demonize the policy, and Countrywide as well. Not hard to do these days.

For its part, Countrywide told IBD that the policy was intended to be a good-faith demonstration, and suggested that the 30 percent policy is only applicable to borrowers staring down a scheduled foreclosure auction:

“It is Countrywide’s fiduciary duty to our investors to ensure that borrowers seeking workouts have the wherewithal to stay in their home,” the statement said. “For those who have not contacted the company and are seriously delinquent, the company views a 30% payment as good faith towards a modification and a demonstration of the borrower’s ability to resume and make payments in the future.”

Which is another way of saying that this policy likely doesn’t even enter into the equation with a one month delinquent borrower. Probably not even a 3 month delinquency. (It probably would behoove Countrywide’s press folks to learn the value of actually communicating with the press, but that’s a story for another day.)

Allow us to paraphrase what we think the nicely-worded press statement really says: look, if we’ve tried and wasted our resources trying to contact a borrower anywhere from the past 8 to 12 months and they don’t bother to return any of our calls, read any of their mail, or answer the door when we send a countless loss mit specialists out there, you’ll have to forgive us for calling bullshit when they decide to call asking for a loan mod the day before the foreclosure sale.

That’s what we’d suspect the policy really is, although we can’t be sure, since Countrywide has decided to play coy with the press on this.

I’m sure, given Countrywide’s recent track history in the servicing arena, that some borrowers have been assigned the 30 percent fee erroneously; I’m also pretty sure that many borrowers can’t negotiate Countrywide’s maze of a loss mitigation department fast enough to formally request a loan modification before their account gets flagged for the 30 percent requirement. And that’s a real problem — problem enough even to suggest that the up-front loan mod fee should be rescinded.

But that’s a very different argument than simply suggesting that the policy is inherently wrong to begin with, and that Countrywide’s policies “change with the wind” — an allegation made by one Glenn Neely of American Mortgage Resolution Advocates LLC in the story. (I tried to find the company on the Web, but apparently they have no Web site.)

Loan modifications are costly, and can be time consuming — if you’ve ever worked in servicing for a meaningful period of time, you learn pretty quickly that the borrowers who go AWOL until right before the foreclosure sale, or right before an eviction, aren’t usually the ones interested in keeping their home and negotiating in good faith. It may not be pretty to say, but it’s absolutely true, and it happens all the time.

Beyond that, by deciding to hide from the servicer for months on end, fees and arrearages have been piling up — totals that must be paid by the servicer and/or borrower regardless of whether the loan is restructured or not. Which means qualifying for a viable loan modification is that much harder to do, even if the borrower isn’t playing games; after all, isn’t the entire point here for servicers to invest their limited resources in preventing avoidable foreclosures?

If so, I’d argue that such a policy — unpopular as it may seem — could be helping Countrywide do just that; and borrowers making good-faith and early efforts to work with their servicer on a solution should be thanking their lucky stars that it exists.

April Workouts Move Higher; Evidence of Success?

(Housing Wire) HOPE NOW, the well-known alliance of mortgage servicers, counselors, and investors pulled together by Treasury officials last year, said Friday morning that mortgage servicers provided loan workouts to approximately 183,000 homeowners in April 2008, up 23,000 from the total recorded in March — the highest monthly amount since the program was begun in July 2007. Since July 2007, nearly 1.6 million troubled homeowners have been extended loan modifications and repayment plans, the group said in a press statement.

“These numbers clearly demonstrate that HOPE NOW is succeeding at helping homeowners avoid foreclosure and stay in their homes,” said HOPE NOW executive director Faith Schwartz.

Estimates from the group show that approximately 106,000 of the prime and subprime loan workouts conducted by mortgage servicers in April were repayment plans, while approximately 77,000 were loan modifications. The current pace set in April would translate into just over 548,000 loan workouts in the second quarter; that total would be well above the 502,520 recorded during Q1.

Like most housing news these days, however, the good news comes with requisite ominous; HOPE NOW also reported 80,926 foreclosures in April, a total that would translate into 242,778 if extrapolated through the second quarter. That total would be an 18 percent jump in foreclosures during the quarter — meaning that while more borrowers are getting help, more borrowers are troubled in total as well.

To normalize comparisons, it’s worthwhile to look at total workouts against foreclosure activity.

In 2007’s third quarter that ratio stood at 2.95, meaning that for every 3 borrowers helped, one lost their home. By Q4, that ratio had risen to 3.13 — good news. In the first quarter of this year, the workout:foreclosure ratio fell to 2.44 despite an increase in workouts, suggesting servicers were having trouble keeping up with an influx of troubled borrowers.

April’s ratio? 2.26 borrowers in workout per foreclosure, the worst reading yet.

(Tanta @ Calculated Risk) Meanwhile, the Hope Now folks released a pathetic set of data charts on mortgage loss mitigation through April 2008. For heaven's sake, we're the financial industry, people. We're supposed to be able to use Excel properly.

There are some really puzzling features of this data, like why the total loan counts have not changed since October (see the first page). Since those loan counts are used to calculate the 60+ day delinquency percentage, the failure to update the total count makes those numbers rather dubious. On page two, I found myself unable to make sense of the completed FC sales/FC starts calculation using any possible definition of "five months" I can think of. Perhaps I am misreading the footnote. In any event, I gave up on my ambition to put this data into a more sensible format for you, after I lost confidence in the data integrity.

So here's from the press release, instead:

The April report from HOPE NOW estimates that on an industry-wide basis:

* Mortgage servicers provided loan workouts for approximately 183,000 at-risk borrowers in April. This is an increase of 23,000 from the number of workouts in March 2008 and is the largest number of workouts completed in any month since HOPE NOW’s inception.

* The total number of loan workouts provided by mortgage servicers since July 2007 has risen to 1,558,854.

* Approximately 106,000 of the prime and subprime loan workouts conducted by mortgage servicers in April were repayment plans, while approximately 77,000 were loan modifications.

Maybe next month the report will be cleaned up a little and we can look in more detail at these numbers. If we can shame Hope Now into issuing something readable.

HUD: Brokered Loans More Expensive

(Housing Wire) Clearly seeking to buttress its proposal to reform the Real Estate Settlement and Procedures Act, the U.S. Department of Housing and Urban Development released a study late Thursday suggesting that brokered loans are, on average, more expensive for consumers than borrowing direct from a lender — and that brokers were pocketing nearly all of the benefits of so-called yield spread premiums for themselves, rather than passing any cost savings on to consumers.

According to the study, which was conducted by researchers at the Urban Institute and used data on originations from May and June of 2001, borrowers saw no reduction in out-of-pocket fees when they agreed to higher interest rates and a yield spread premium. In fact, many borrowers saw no reduction at all in fees and often paid more in total loan fees, compared to borrowers that did not agree to pay a higher interest rate.

The study suggested that loans made by mortgage brokers were approximately $300 to $425 more expensive than those made by direct lenders, other loan characteristics being held equal. Depositories (banks, thrifts, and credit unions) were the lowest cost originator, followed by large mortgage banks. Smaller mortgage banks were found to have terms closer to those of mortgage brokers than to large mortgage banks and depositories, according to the study.

The Urban Institute’s study found significant disparities in closing costs even when it compared borrowers with identical credit scores, loan terms and mortgage amounts; in addition, variations appeared to be based on education level, geography, race and ethnicity as well. Even after accounting for these factors, there remain very substantial variations in what consumers pay at settlement.

“This report demonstrates once and for all that the process consumers endure when they buy their homes is entirely too confusing,” said HUD Deputy Secretary Roy A. Bernardi. “Clearly, we need to open the window and allow consumers to understand the fine print and shop more effectively for the largest purchase of their lives.”

Minorities still paying more?
The study found evidence — sure to fire up consumer advocates — that both Hispanic and African-American families paid more for their mortgages, on average, than did non-minorities. African-American families paid an average of $415 more in total loan origination fees than non-minorities, according to the study; Hispanic borrowers paid an average of $365 more.

A closer inspection of the study’s findings in this red-hot area, however, suggests that the conclusions are less than conclusive evidence of predatory lending practices than one might think. The study’s author cautions as much.

“The interpretation of the race differentials cannot be entirely clear from the data available in this
study,” the study’s author, Dr. Susan Woodward, writes. “The discussion in the later chapter on defaults will reveal that borrowers who live in neighborhoods with a high fraction of African Americans have higher default likelihoods than do other borrowers, other things equal, while Latino borrowers have lower default likelihoods than other borrowers.”

Woodward notes that “default patterns are in the same direction as some of, but not all, the differences in pricing by race.”

Brian Montgomery, HUD Assistant Secretary for Housing and Federal Housing Commissioner, said the study paints an overall picture suggesting that informed consumers pay less.

“The core problem is that too many Americans sign a mountain of documents they don’t understand and pay thousands of dollars for services that they’ve probably never heard of. This report proves that the more informed you are, the less you pay.”

HUD’s proposal to reform RESPA is part of the agency’s effort to reduce what it calls “junk fees” at origination.
In particular, HUD wants to change what information is provided in the so-called Good Faith Estimate that lenders provide to borrowers prior to mortgage closing; HUD wants a standard GFE for both brokers and lenders that discloses key elements of the loan and sources of compensation for third-party brokers.

The proposed GFE would consolidate closing costs into major categories, and display total estimated settlement charges prominently on the first page, a move HUD says will help a borrower more easily compare loan offers. In addition, HUD’s new proposed rules would specify the charges that can — and cannot — change at settlement; for those fees that can change, HUD also would limit the amount of allowable changes.

Bloomberg's weird foreclosure and delinquency numbers

(Tanta @ Calculated Risk) Forgive me for once again falling into despair over the media's inability to report sensibly and critically on foreclosure and delinquency numbers. I should be immune by now. If you are wiser than I, just skip to the next post. If you still cradle to your wounded heart the battered but indomitable belief that even media outlets like Bloomberg can learn to spot the flaws in a reported statistic, and that there is a point to doing this, click the link below.


The headline: "New Overdue Home Loans Swamp Effort to Fix Mortgages in Default." We will take this as a promise that the article is going to demonstrate something about the relationship between newly delinquent loans and workout efforts.

The lede:

    May 30 (Bloomberg) -- Newly delinquent mortgage borrowers outnumbered people who caught up on their overdue payments by two to one last month, a sign that nationwide efforts to help homeowners avoid default may be failing.

    In April, 73,880 homeowners with privately insured mortgages fell more than 60 days late on payments, compared with 39,584 who got back on track, a report today from the Washington-based Mortgage Insurance Companies of America said.

The last of eighteen paragraphs:

    Last month's 54 percent "cure ratio" among defaulted mortgages compares with 80 percent a year earlier and 87 percent in March. The comparison may not be valid because one lender changed the way it calculated defaults and cures reported to the insurers.

So we start with an eye-popping number, and then only at the very end do we note that this number may mean much less than meets the eye. This is, in fact, what MICA said in its data release:

    WASHINGTON, D.C. May 30, 2008 Mortgage Insurance Companies of America (MICA) today released its monthly statistical report for April which includes a one-time adjustment to the number of defaults and cures and also notes an 11.7% increase in new insurance written year-over-year.

    As a result of a major lender’s change to its methodology for recording delinquencies, and to how it reports them to MICA’s members, there was a sharp increase, to 73,880, in reported defaults in April. The increase includes both newly reported defaults for the month, as well as previously unreported defaults by this lender.

    MICA’s members reported 39,584 cures in April. This statistic also reflects the above noted change in reporting defaults.

I assumed when I read this that somebody--a large somebody, since it significantly impacts the data--switched over from the OTS method to the MBA method of delinquency reporting. I do not know if this is the case or not. Before I published this article, however, I might have called MICA for a comment. In any case I might have been more cautious with headlining a number that is described as a "one-time adjustment" to the data collection. Burying that in the last paragraph is . . . disingenuous.

I'm also a touch troubled by the statement that "Last month's 54 percent 'cure ratio' among defaulted mortgages compares with 80 percent a year earlier and 87 percent in March." That is literally true. However, the
cure rate in December of 2007 was 54.1% and in January of 2008 was 51.4%. Could there be some seasonality in these numbers? Another confounding factor besides new delinquencies?

So what about the second half of the claim?

    "Modifications are not occurring nearly at the numbers necessary to stem the foreclosure crisis," Allen Fishbein, housing director for the Consumer Federation of America in Washington, said in a May 19 interview. "People are still going into foreclosure when, with a writedown on existing principal, they could still stay in their homes."

    In the first two months of 2008, lenders modified loans for 114,000 borrowers while starting 346,000 foreclosures, according to a study by the Durham, North Carolina-based Center for Responsible Lending. In April, 22 percent of the homes in the foreclosure process had been taken over by lending banks; a year earlier, that figure was 15 percent, according to Irvine, California-based data provider RealtyTrac.

Did you assume, when you read that second paragraph, that the 114,000 modifications were exclusive of (not the same loans as) the 346,000 foreclosure starts? It seems you were supposed to assume that. But is is true? "Foreclosure start" simply means that a legally-required preliminary filing (a Notice of Default, Notice of Intent, or Lis Pendens, depending on the state and the type (judicial or non-judicial) of foreclosure) has been made. That is a "start" because in most jurisdictions it will be another 90 to 180 days, or even more in some states, until the auction can be scheduled, the home sold, and the foreclosure "completed." My own view is that the "best practice" is to work hard to negotiate a modification, if possible, in the early days of delinquency before starting the foreclosure process. However, that is not always possible, and it is also "best practice" to continue to attempt reasonable workouts during the foreclosure process all the way up the day before sale, if necessary. There are certainly cases in which a borrower simply cannot be brought to talk to the servicer until the initial FC filing galvanizes him into it. All of this means that it is impossible to look simply at modifications completed in a period compared to foreclosures started in a period and conclude that the starts will never get a mod or that the mods were not effected after the FC start.

Besides that, where is the data to back up the idea that a 30% ratio of modifications to foreclosure starts is poor performance? I am personally not sure that much more than 30% of recent vintage loans can be saved. Back out fraud, flippers and speculators, and borrowers whose loan balances would have to be reduced by half in order to get a workable payment--which would most likely exceed the cost to the investor of a foreclosure--and 30% doesn't sound so shabby.

As far as the second claim--the increase from 15% to 22% of homes in foreclosure "taken over by lending banks," I'm prepared to read that literally. There is no jurisdiction in which a foreclosed home must be purchased by the lender at the foreclosure sale; all jurisdictions require public auctions in which third parties can bid. An increase in REO (lenders "winning" the auction) does not necessarily mean an increase in completed foreclosures; it can mean that fewer third parties care to bid on foreclosed homes. All the data I have seen recently suggests that this is the case: buyers are still wary of further price declines, and lenders are still bidding higher than potential RE investors. One therefore expects the FC-to-REO numbers to increase. But they can do that even in the absence of an increase in total foreclosures. In order for this statistic to mean much, we have to know how much of the increase is due to more foreclosures, and how much due to fewer third-party bidders.

So put these dubious statistics together--the rest of the Bloomberg article is basically filler--and you get anomalous data on new delinquencies, ambiguous data on modification-to-foreclosure-starts, and a claim about REO rates substituting for a claim about foreclosure completion rates. How about taking back that headline, Bloomberg?

You know, last year I might have had some more sympathy for these reporters. We were just newly into the whole problem and a lot of concepts--delinquency reporting methodology, foreclosure processes, various ways of reporting "cures" and "starts"--were all new to everybody except industry insiders and a handful of totally Nerdly blog readers. But surely by now we can have moved the ball forward a couple of yards? I am here to affirm that if you have been reporting on "the foreclosure crisis" for a year or more and you still can't ask basic questions about the press releases you read, you aren't doing your job.

BBA Avoids Changes to Libor, Seeks to Bolster Review

(Bloomberg) -- The group that oversees the London interbank offered rate will implement no changes to the way the measure is set, confounding critics who said it has become unreliable as a gauge of the cost of borrowing.

``The committee will be strengthening the oversight of BBA Libor,'' the association said in an e-mailed statement today. ``The details will be published in due course.'' The composition of the bank panels that contribute rates were left unchanged.

The BBA, an unregulated trade group, has been under pressure to overhaul the 24-year-old system after the Bank for International Settlements said in a March report some members understated their rates to avoid being perceived as having difficulty raising financing.

In the first four months of 2007, the difference between the highest and lowest rates for three-month dollar Libor didn't exceed 2 basis points, according to JPMorgan Chase & Co. In the same period this year, it was as wide as 17 basis points.

``The next time Libor spikes you don't want market participants looking at Libor and wondering whether it's a completely artificial number or shows a dislocation in borrowing costs,'' Brian Yelvington, a strategist at bond research firm CreditSights Inc. in New York, said in an interview yesterday.

Every morning the London-based BBA asks member banks how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them at about 11:30 a.m. in London.

Gained Attention

Libor gained attention last August as banks suddenly became wary of lending to each other because of mounting losses linked to U.S. subprime mortgages. Three-month Libor soared to 2.40 percentage points above yields on Treasury bills on Aug. 20, the widest margin since December 1987 and up from 0.39 percentage point a month earlier. The figure was 0.79 percentage point as of 4:30 p.m. in London.

Today's statement followed a meeting of the BBA's independent Foreign Exchange and Money Markets Committee following a review conducted by director John Ewan.

Libor is used to calculate rates on at least $350 trillion of derivatives and corporate bonds as well as 6 million U.S. mortgages. Financial products worth about $150 trillion are indexed to Libor, according to the BBA's Web site.

The credit crisis exposed Libor's flaws, according to Peter Hahn, a London-based research fellow for Cass Business School and a former managing director at Citigroup Inc. That's because the BBA publishes the names of contributors and their rates, giving lenders an incentive to underestimate borrowing costs.

Misstated Costs

Banks routinely misstated borrowing costs to the BBA to avoid the perception they faced difficulty raising funds as credit markets seized up, turning Libor into ``a lie,'' according to Tim Bond, head of asset allocation at Barclays Capital, a unit of Barclays Plc

Rates offered by UBS and Lloyds TSB, the U.K.'s largest provider of checking accounts, underscore the range in quotes to the BBA since July. UBS, which took $38 billion of writedowns and losses, replaced its chief executive officer and chairman and saw its stock tumble 60 percent, quoted rates below Libor on 85 percent of the days between July and mid-April. The average was 1.3 basis points less than its peers. Lloyds TSB quoted rates that were 0.04 basis point above Libor on average.

The BBA threatened on April 16 to ban any member deliberately understating rates and said it would accelerate its annual review. The cost of borrowing in dollars for three months rose 0.18 percentage point to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze in August.

Loss of Confidence

The last time the BBA changed the system was in 1998, when the deteriorating creditworthiness of Japanese banks inflated the rates they contributed to yen Libor. The association responded by changing the contributor panels.

The loss of confidence in Libor spurred the world's biggest banks to recommend fixes. Morgan Stanley, the second-biggest U.S. securities firm by market value, said Libor should be based on trades rather than a survey. Credit Suisse, Switzerland's No. 2 bank, suggested increasing the number of U.S. participants. Zurich-based UBS, the world's largest wealth manager, advocated calculating the rate later in the day, while Barclays Capital said rates should be based on anonymous quotes.

Some strategists predicted little change to Libor because it's so ingrained in the global financial system.

``You can't change the rate completely,'' Kornelius Purps, a fixed-income strategist at UniCredit SpA in Munich, said in a Bloomberg Television interview before today's announcement. ``It would be like changing how crude oil is being refined and then having no car in the world that can drive on it.''

Banks spell out position on ‘fair value’

(FT) A group of leading banks has clarified its position regarding “fair value” – or mark-to-market accounting – after its proposals to alter the rules caused a storm among its members and provoked criticism by leading regulators.

Under fair value, most financial instruments are recorded at their current market price and values are adjusted as markets fluctuate.

As a result of the market turmoil flowing from the subprime crisis, the values of many structured products have plummeted.

That forces many financial institutions into multi-billion-dollar writedowns that have weakened their capital bases and forced them to seek fresh funding.

In a paper written last month and seen by the Financial Times, the Institute of International Finance, which has 300 banks among its members, proposed to relax some of the classifications for financial instruments and to ease the rules in times of financial stress. It claimed that taking prices in illiquid markets “results in valuations that do not provide a true picture of the financial positions of firms”.

This week, it said: “There is a view that [to apply] new techniques, or greater flexibility, in current circumstances would be fraught with difficulties.”

The Financial Times’ reporting of the original paper last week prompted Goldman Sachs to threaten to leave the IIF, calling the proposals “Alice in Wonderland” accounting.

There is growing recognition by regulators that the introduction of fair value accounting on a wide scale has changed the dynamics of how the financial system responds to crises.

“This has been a big structural change,” says a senior regulator.

But while some recognise potential disadvantages, they stress there have also been benefits and there is reluctance to endorse suggestions that the change should rapidly be reversed.

Malcolm Knight, head of the BIS, says: “In my opinion, while fair value accounting can lead to over-depreciating assets in distressed market conditions, it has the advantage of focusing everyone’s mind on the impact of the deleveraging process on asset values.”

Who rates the ratings agencies?

(FT) It was a debacle. The large ratings agencies – Moody’s, Fitch and Standard & Poor’s – completely misjudged the creditworthiness of subprime mortgages and bonds backed by them. But while there is an urgent need for change, intrusive regulation would utterly fail to prevent similar problems in future, while imposing considerable costs.

Some have gone as far as blaming the subprime mortgage crash on the ratings agencies because, in retrospect, their judgments were wrong. But a lot of other intelligent people were wrong as well. A separate issue is the report by the Financial Times last week that a computer bug resulted in Moody’s awarding incorrect triple A ratings to billions of dollars-worth of one type of complex debt product. That is something that Moody’s must resolve but it is not the primary basis for wider debate about credit ratings.

That debate must rest on what went wrong with the ratings on asset-backed bonds. First, there was fraud in the underlying mortgage applications, so ratings were based on false data. Second, subprime mortgages are a recent innovation, so there were few data on how they perform in a downturn. Third, mortgagors seem to have become more willing to walk away from their homes as prices fall, and ratings agencies did not spot the change.

A fundamental, though intractable, question is whether the inadequacy of the ratings was linked to the conflict of interest faced by all of the ratings agencies. Credit ratings are used by investors but paid for by the issuers of bonds, so the agencies have a financial incentive to keep issuers happy. This conflict could be solved – by, for example, creating an independent body to commission credit ratings using issuers’ money – but that would require the will to push through a fundamental industry upheaval.

Some have proposed straightforward regulation as an alternative – but it would not work. Confronted with byzantine new forms of structured finance and little time to assess them, regulators would either be captured by the agencies, or block all innovation. It would be far better to open up the methodology behind ratings to wider scrutiny, debate and understanding.

That is a change the credit raters must make themselves and it is not the only one. Credit ratings were not just wrong, they were misunderstood, and the agencies’ use of the familiar triple A nomenclature contributed to that. Structured bonds are different to normal corporate bonds both in legal structure and in how they behave. The ratings agencies should adopt new labels to describe them forthwith.

Lex on Credit ratings

The retreat of the credit tide left more than the rating agencies swimming naked. Certain buyers of highly rated structured products were shown up for not understanding what they were shoving onto their balance sheets or into their investment funds. Even those who created and sold the structures did not seem to appreciate the real risks. Just look at the huge write-downs taken by leaders in collateralised debt obligation production such as Merrill Lynch.

Incentives were skewed. Big mistakes were made. These were compounded by an unprecedented boom and slump in the price of US houses, which were the underlying asset in many struggling structured products. But there also appears to have been a misunderstanding among many of how different a structured product is from a corporation when it comes to ratings.

First, corporations do not have a finite life. Structured products do, given that mortgages, for example, are repaid. Second, companies have flexibility. They can cut costs, sell assets or raise new money in order to pay their debts. Structured products are straitjacketed. They have a set of rules, with limited room for manoeuvre, especially if events move against them. Given their characteristics, structured products are very different investments. Investors should be acutely aware of this even without an extra label on credit ratings to remind them.

For example, companies face detailed rating analysis only every six months or so, unless there is a big event such as an acquisition. The performance of a pool of mortgages, in contrast, can be updated monthly, with real information on early payments, arrears etc. Ratings should probably be changed more often as a result.

If investors want better structured product information, they might also have to brace themselves for more ratings volatility than they have been accustomed to historically.

Fed considering adding foreign currency instruments to its facilities

(Naked Capitalism) The Term Auction Facility is considered within the Fed and by the Street to be a success, even though academic studies have found that the TAF did not achieve its intended goal of reducing risk premia in the money markets (high spreads are a Bad Thing, a sign banks aren't willing to lend to each other). And there remains the looming, unanswered question of how to wean the financial services industry off such a substantial support.

Of course, now that the Fed is stuck with rolling these loans until the banking industry is healthy enough to remove this prop, the monetary authority has tried to put a good face on the situation, rebranding the TAF as a tool and hinting it might be ongoing. As Vice Chairman Donald Kohn said in a speech Thursday:
I start from the premise that central banks should not allocate credit or be market makers on a permanent basis. That should be left to the market--or if externalities or other market failures are important, to other governmental programs. The Federal Reserve should return to adjusting reserves mainly through purchases and sales of the safest and most liquid assets as soon as that would be consistent with stable, well-functioning markets...

However, the Federal Reserve's auction facilities have been an important innovation that we should not lose.... The new auction facilities required planning and changes in existing systems, and we should consider retaining the new facilities for the purposes of bank discount window borrowing and securities lending against OMO-eligible paper, either on a standby basis or operating at a very low level when markets are functioning well in order to keep the new facilities in good working order.

That's nice in theory, but in practice, it's going to be very hard to wean banks off the TAF. The central bank certainly can't do it when either the banking system or the economy look weak, and you can be sure banks will howl about possible damage and risk even in better times. As the comic said, when the bank loans you $10,000, it owns you, but if it lends you $100,000,000 in this case, add a few more zeros), you own it.

So why is the Fed looking at broadening the types of collateral it is willing to accept? Perhaps it sees or worries about new problem areas, which in some sense suggests that the TAF hasn't yet achieved the hoped-for results (indeed, there are signs of continuing money market stress). But persisting in a course of action that is not succeeding is not intelligent. As we noted earlier:
Yet again, the Fed is acting out the cliche, "if all you have is a hammer, every problem looks like a nail." Central banks know how to deal with liquidity crises; the TAF and its other facilities are well suited for that sort of problem. But fundamentally, the financial services industry is suffering from a solvency problem. Too many of the assets on its balance sheets contain loans to borrowers who lack the ability (and in some cases the desire) to make good on their debts. Forcing interest rates into negative real interest rate territory will only help a portion of the underwater borrowers. In addition, a distortion this severe is almost guaranteed to produce more misallocation of capital, which is not good for the US in the long term. And if the Fed miraculously manages to keep asset values from falling further, it is merely delaying the day of reckoning, and Japan is the poster child of the results of such a Phyrric victory.

Kohn also suggested that not only might the US central bank accept foreign securities as collateral for loans, but that central bankers might set up a joint facility for global financial institutions. While this on one level sounds practical, a creation of such a vehicle represents a serious erosion of national sovereignty:
Globally active banks manage their positions on an integrated basis around the world, and pressures originating in one market are quickly transmitted elsewhere. Central banks should consider how to adapt their facilities to help these institutions mobilize their global liquidity in stressed market conditions and apply it to where it is most needed. That approach will require the consideration of arrangements with sound institutions in which central banks would accept foreign collateral denominated in foreign currencies. Those arrangements are under active study and a number of issues need to be resolved. It is possible that over time, major central banks could perhaps agree to accept a common pool of very safe collateral, facilitating the liquidity management of global banks. The stipulation that the institutions be sound is important: Decisions about lending to troubled banks should be made by home country authorities with knowledge and responsibility.

Dani Rodrik positied that countries cannot simultaneously have democracy, national sovereignty and global economic integration. I wonder which two of those three the US will choose.

Is the CDS market the next to unravel?

(Naked Capitalism) Satyajit Das has a very useful post, "The Credit Default Swap (“CDS”) Market – Will It Unravel?," in which he describes some of the ways that CDS may fail to perform as expected in real world situations, ie, when companies start getting in trouble. While this work isn't quite at the Tanta Uber-Nerd level of detail, it does get more granular than most discussions, which I thought was useful.

Two aspects of Das' article merit mention. First, he goes through what most may find a surprisingly long list of various ways CDS might not fully cover the risks they are supposed to guarantee even before getting to the big bugaboo of counterparty failure. One case that Das has mentioned elsewhere is that in the one big test of the CDS market to date, Delphi. CDS protection buyers got 37 cents on the dollar when the recovery value on the senior bonds was set by Fitch at 1-10%, meaning the fall in the value of the credit was 90+ cents per dollar, yet the CDS holder got only about 40% of that. That's a considerable shortfall.

Second, he alludes to rather than spells out the coming-to-a-courtroom-near-you battles over defaulting LBO debt. In this world of covenant lite deals, creditors lack the big stick they had to force either bankruptcy or a restructuring of the debt, namely, if you breached the covenants, the lender could accelerate (demand payment of) the debt. Now if borrowers don't pay, creditors don't seem to have much (any?) leverage.

How does this affect CDS? Per Das, for many CDS, non-payment is NOT an event of default. So what good is insurance if it doesn't cover the most likely outcome for the debt in question? This will make for some interesting theater.

This post also provides some third party estimates of possible losses from CDS counterparty failures. From Das:
The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments...

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band ....

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work...

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented....

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested.

Waiting for the BBA LIBOR verdict

(FT Alphaville) We know you’re all on tenterhooks. But it sounds like the BBA statement/report/musings on Libor is unlikely to be available until the latter part of the afternoon, after the committee has met. We’re told that the meeting kicks off at 1.30pm.

The WSJ on Thursday cast further aspersions on the validity of the interbank benchmark with their study, which drew criticism from Alea and Felix Salmon.

But the consensus seems to be that Friday’s output from the BBA will be undramatic, likely to raise issues, table ideas and leave to ferment. For a start, as the FT points out, the fragile state of interbank lending means that now may not be the time for an upheaval in calculating the widely-used benchmark.

1342.jpgIn the meantime, Morgan Stanley’s team adds their take:

Criticisms of LIBOR that it is unrepresentative have some strength: certainly, it is true that the term interbank lending market barely trades. But although on the face of it this is a damning flaw, it actually isn’t. Crucially, the LIBOR fixings are so well-correlated with other money market lending rates that LIBOR continues to fulfil its chief function as a reference index (see Exhibit 1).

[Thursday]’s critique in the WSJ is interesting, but it falls down by trying to combine generic term lending rates with the cost of idiosyncratic default protection. By doing so, it paradoxically reinforces the value of the LIBOR fixing process in producing a generic reference rate, even during stressed periods when bank risk is more heterogeneous than usual.

Of the potential changes that could be made to the LIBOR fixing process, perhaps the most interesting would be to initiate a system similar to that in the AUD and NZD money markets, where the fixings are preceded by a brief period of trading of bank bills. This could improve the transparency and credibility of the fixings to some degree; we would applaud its introduction.

Other possible changes include: changing the timing of the USD fixing; increasing the number of US-domiciled banks in the USD fixing; expanding the number of reporting banks; and preserving the anonymity of contributing banks.

We expect none of these potential changes to alter the level at which LIBOR fixes to any great extent, because LIBOR is already a good reflection of money-market lending rates. If the LIBOR methodology were to be replaced, it would be by something that would give almost exactly similar results, in our view.

Thursday, May 29, 2008

LIBOR Mess Promises to Squeeze ARM Borrowers

(Housing Wire) An international uproar over allegations that some banks intentionally manipulated LIBOR, a key interest rate used to determine rate adjustments for many adjustable-rate mortgage holders, is likely to have a real-world impact for many adjustable-rate mortgage borrowers, sources told Housing Wire Thursday.

At the heart of the debate is a report by the Wall Street Journal, first published on April 16, that questioned the accuracy of the benchmark lending rate; the Journal provided evidence that suggested some major banks were helping keep reported LIBOR rates artificially low. See interactive charts.

The WSJ Journal revisited the story on Thursday, ahead of adjustments to the LIBOR system that appear likely to be introduced by the British Bankers Association on Friday:

    The Journal analysis indicates that Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase & Co. and UBS AG are among the banks that have been reporting significantly lower borrowing costs for the London interbank offered rate, or Libor, than what another market measure suggests they should be. Those five banks are members of a 16-bank panel that reports rates used to calculate Libor in dollars.

    That has led Libor, which is supposed to reflect the average rate at which banks lend to each other, to act as if the banking system was doing better than it was at critical junctures in the financial crisis.

The one-month and six-month dollar LIBOR is used to benchmark a large number of adjustable-rate mortgages in the U.S.; the one month rate has remained extremely low, currently at 2.46 percent, and has fallen dramatically from 5.22 percent just six months ago. The six month LIBOR follows a similar trajectory.

The result has been an veritable erasing of any potential adjustable-rate payment reset shocks for subprime and Alt-A borrowers certainly a positive outcome for millions of potentially troubled borrowers, given that the U.S. is still facing a flood of subprime resets through the end of this year (Alt-A resets don’t begin in earnest until the middle of 2009, according to available data).

The WSJ estimates that an artifically-depressed LIBOR may have given homeowners and other consumer debtholders a $45 billion break through the first four months of this year. What happens with that sort of unintended stimulus vanishes?

It’s not known exactly how many borrowers with adjustable-rate mortgages are tied to LIBOR, versus the yield on short-term Treasuries, but HW’s sources suggest that number could be as large as half of ARM borrowers. That number is likely even higher among subprime borrowers, our sources said.

“We’ve got an entire class of borrowers right now that is absolutely dependent on LIBOR sitting low,” said one source, an MBS analyst who asked not to be identified by name. “Tinkering with the how the rate is calculated doesn’t seem likely to push it down, although I can see plenty of reasons it might jump upward.”

The Journal, citing sources close to the BBA, said that any changes to LIBOR calculations aren’t likely to represent a “radical redesign.” Which means that even if only for a brief moment the interests of millions of subprime borrowers and those of the banking crowd are in alignment.

A 10-point plan for tackling the food crisis

(Robert Zoellick in the FT) As leaders gather in Rome to discuss the global food crisis, our task is clear, but not sim­ple: to help those in danger today and ensure that the poor do not suffer this tragedy again.

What has been described as a silent tsunami is not a natural catastrophe, but is man-made. The nexus between high energy and food prices is unlikely to be broken, and will be exacerbated by global climate change. The results have been rising production and transport costs for agriculture, falling food stocks and land shifted out of food production to produce energy substitutes. This is a 21st century food-for-oil crisis.

In April, ministers from 150 countries, meeting at the World Bank, endorsed a new deal for global food policy. The United Nations summit next week in Rome, the Group of Eight leading industrialised nations’ finance ministers meeting in June and the G8 summit in July offer opportunities for action. We need co-ordinated steps on policy, backed by resources. Let me suggest a 10-point plan.

First, we should agree in Rome to fund fully the World Food Programme’s emergency needs, support its drive to purchase food aid locally and ensure the unhampered movement of humanitarian assistance. Second, we need support for safety nets, such as distributing food in schools or offering food in return for work, so that we can quickly help those in severe distress. The World Bank, working with the World Food Programme and the Food and Agriculture Organisation, has already made rapid needs assessments for more than 25 countries. In Rome we should agree on co-ordinated action.

Third, we need seeds and fertiliser for the planting season, especially for smallholders in poor countries. Together, the FAO, the International Fund for Agricultural Development, regional development banks and the World Bank can expand this effort by working with civil society groups and bilateral donors. The key is not just financing, but fast delivery systems.

Fourth, we need to boost agricultural supply and increase research spending, reversing years of agricultural underinvestment. We must be neither Luddite nor advocates of a single scientific fix. The Consultative Group on International Agricultural Research has been receiving about $450m a year. We should double this investment in research and development over the next five years.

Fifth, there needs to be more investment in agribusiness so that we can tap the private sector’s ability to work across the value chain: developing sustainable lands and water; supply chains; cutting wastage; infrastructure and logistics; helping developing country producers meet food safety standards; connecting retailers with farmers in developing countries; and supporting agricultural trade finance.

Sixth, we need to develop innovative instruments for risk management and crop insurance for small farmers. Next week the World Bank’s board will consider weather derivatives for developing countries, with Malawi being identified as a likely first client. Should Malawi suffer a drought it would receive a payout to offset the price of imported maize.

Seventh, we need action in the US and Europe to ease subsidies, mandates and tariffs on biofuels that are derived from corn and oilseeds. The US’s use of corn for ethanol has consumed more than 75 per cent of the increase in global corn production over the past three years. Policymakers should consider “safety valves” that ease these policies when prices are high. The choice does not have to be food or fuel. Cutting tariffs on ethanol imported into the US and European Union markets would encourage the output of more efficient sugarcane biofuels that do not compete directly with food production and expand opportunities for poorer countries, including in Africa. We need to find ways to advance to second-generation cellulosic products.

Eighth, we should remove export bans that have led to even higher world prices. India has recently relaxed its restrictions. But 28 countries have imposed such controls. Removing these could have a dramatic effect. With only 7 per cent of global rice production traded on markets, if Japan released some of its stocks for humanitarian purposes and China sold 1m tons of its rice, we could damp the price immediately.

Ninth, we should conclude a Doha World Trade Organisation deal in order to remove the distortions of ag­ricultural subsidies and create a more adaptable, efficient and fair global food trade. The need for rules that are agreed multilaterally has never been stronger.

Tenth, there should be greater collective action to counter global risks. The interconnected challenges of energy, food and water will be drivers of the world economy and security. We might explore an agreement among the G8 and key developing countries to hold “global goods” stocks, modelled on the International Energy Agency, governed by transparent and clear rules. This would act as insurance for the poorest people, offering affordable food.

To support this agenda, the World Bank is launching a global food crisis response facility. We will fast-track $1.2bn to address immediate needs arising from the crisis, including $200m of grants for especially vulnerable countries such as Haiti, Djibouti and Liberia for seeds, fertiliser, safety net programmes and budget support. Overall, the World Bank Group will expand assistance for agriculture and food-related activities from $4bn to $6bn over the coming year.

The danger is now clear to everyone. The Rome and G8 meetings need a clear plan to overcome it.

Defending Libor

(Felix Salmon) Carrick Mollenkamp and Mark Whitehouse got some pretty heavyweight backing for their Libor investigation today: before running it on the front page of the WSJ, they got sign-offs from Darrell Duffie of Stanford, Mikhail Chernov of London Business School, and David Juran of Columbia. In the blogosphere, their findings have been received uncritically by Ryan Chittum ("Lying about Libor" is his headline), Angus Robertson, Paul Jackson, and others.

But Alea is not convinced at all, and neither is JP Morgan, and neither am I.

One thing I find extremely suspicious is the fact that the WSJ's interactive graphic shows implied rates only back to August 2007, thereby only showing what's happened since the credit crunch hit. If they went back further, their methodology might be exposed:

Pre-credit crunch, pre-August 9th 2007, when OIS-Libor spread was below 10 bp, the Journal calculation would have resulted in a "risk-free Libor" below the OIS fixed, a proxy for a risk-free rate.

What's more, there are lots of places where banks actually borrow real cash, like the commercial paper market. Why would the WSJ try to use credit default swaps to gauge what cash borrowing rates should be, when they can look to something like the CP market instead? Clearly, I think, the answer is that the CP market wouldn't give them the answer that they're looking for.

Alea does a good job of explaining the theoretical weaknesses behind the WSJ's methodology. But my gut reaction that the methodology is flawed was based on none of those. Rather, I mistrust any calculation which assumes that since last summer there has been a clean and predictable and precise relationship between cash credit products, on the one hand, and credit default swaps, on the other. Yes, Libor is a borrowing rate, and yes, there is some kind of credit spread baked in to it. But to assume that Libor equals a risk-free borrowing rate plus a default-risk premium is silly and simplistic - especially when you don't back-test your model to a time when things were much less volatile.

It's worth remembering that the interbank markets are based on long-standing relationships which are necessary to any smoothly-functioning financial system. Yes, Citigroup's credit default swaps might be pricing in a relatively high probability of default, but that doesn't mean that Citi's counterparties will charge it a similar premium to insure against default risk, as the WSJ seems to think. Maybe they trust Citi more than the rest of the market does, or maybe they realise that any possible world in which Citi defaults is a possible world in which they've got much bigger things to worry about than their interbank lines.

Do I think that Libor is perfect? No. In this world, no spread measure is going to be perfect, especially at tenors of longer than a couple of weeks. But Libor is not nearly as flawed as the WSJ makes it out to be.

What the WSJ has done is come up with a marginally interesting intellectual conundrum: why is there a disconnect between CDS premia, on the one hand, and Libor spreads, on the other? But the way that the WSJ is reporting its findings they seem to think they're uncovering a major scandal. They're not.

JPM on WSJ's dodgy LIBOR analysis (Alea):

See previous post for background info.

The article uses spreads in the CDS market to conclude that Libor fixings are too low. We find the article to be deeply flawed and highlight below some of the main shortcomings of the analysis.

First, the methodology is based on too high a risk free rate which produces a large upward bias in the Journal’s measure of bank borrowing costs. For example, on April 16th, the WSJ calculates a risk-free rate of 2.47%. This is 50 bp higher than 3-month OIS on that date and 80 bp higher than 3-month GC. By adding bank CDS to this artificially high risk free rate, they generate a Libor rate of 2.97%, or 25 bp higher than the actual reported Libor of 2.73%. If instead, bank CDS spreads were added to OIS, GC repo or another more appropriate risk-free rate, the Journal article might have concluded that BBA Libor is fixing 25 or 50 bp too high rather than too low relative to the actual rates banks fund themselves at.

Second, the methodology inappropriately combines 1-year CDS with 3-month Libor in assessing the accuracy of Libor. Besides the obvious flaws in mixing rates and spreads of different terms, 1-year CDS should be expected to have much greater dispersion than 3-month Libor across banks because of the increased uncertainty associated with longer term credit risk. This increased dispersion produces unrealistically high 3-month borrowing rates using the WSJ methodology for some of the banks in the panel.

Finally, the implied rates calculated by the WSJ using 1-year CDS are well above the rate in virtually every short term financing market used by banks. Three-month commercial paper issued by financials has averaged 11 bp below BBA Libor fixings over the last year. As discussed in our recent research note, Eurodollar deposit data has averaged slightly above BBA Libor but the differences can easily be explained by a funding advantage that exists for the largest banks that make up the Libor panel.

As discussed in our recent research note, while Libor has a number of shortcomings, we don’t find evidence that it is biased too high or too low. Moreover, we expect any changes that the BBA makes to the definition of Libor will have virtually no effect on where it fixes relative to OIS over the long run. Instead Central Bank efforts to inject liquidity are likely to cause Libor to narrow sharply relative to the funds rate over the next several months.

JPM [thanks S... ?....]

Alternatives to Libor gain ground

(Financial News Online) Swaps traders are reporting record interest in alternatives to Libor, in the first indication that the market may start to shift away from the international benchmark that has dominated the capital markets for more than two decades.

The alternatives, the overnight interbank average rates known as Sonia for sterling and Eonia for euros, represent the weighted average of actual deposit rates reported by banks.

Libor and Euribor are instead calculated each day as the average of what contributing banks think their own funding costs are. Libor and Euribor are three-month rates and Sonia and Eonia are overnight rates.

Swaps are pegged against the overnight fixings are known as Overnight Indexed Swaps, or OIS. The OIS market is a small sub-segment of the interest rate swaps market that has traditionally concentrated on short maturities of under two years.

Frits Vogel, head of swaps at interdealer broker Icap, said he had seen a marked increase in OIS in the past few weeks.

He said: "The vast majority of business is still fixed against Libor but there has been a big push from some of the major firms to foster liquidity in OIS across the curve. There is market demand for two rate curves,”one against Libor and another against the overnight fixings."

Gilles Saiagh, head of short-term derivatives at money and interest rate brokerage HPC in Paris, said: "Customers increasingly want to see liquidity in long-term OIS and if the dealers are going to be aggressive quoting these prices, they need to create a proper liquid market."

However, traders said although interest levels are high, volumes to date remained small.

Christophe Coutte, head of swap, cash, inflation and emerging rates trading at Societe Generale, said: "The most developed is Eonia on the long end, where we have received more requests than usual, and typically around maturities that we didn't used to see in the market. We had a price of 10-year/30-year spread Eonia in the market and I can't recall the last time I saw this."

Goldman Sachs hosted an investor day on OIS markets for clients earlier this month and other banks, including Barclays Capital, Societe Generale and BNP Paribas confirm growing interest in the overnight fixings.

Icap is preparing to publish indicative OIS prices on screen and Barclays Capital is to introduce executable prices in OIS out to 50 years on its Barx electronic trading platform, which will increase the visibility of these products in the market.

Interest in the alternative overnight fixings has grown on the back of doubts over Libor, the lack of three-month unsecured funding and because of the dramatic widening in the spreads between the two types of fixings.

Nat Tyce, head of sterling and Scandinavian rates trading at Barclays Capital, said the OIS market has grown faster than the Libor market in the past two years for a particular type of trade, where hedge funds and bank proprietary traders used the benchmarks to gain exposure to expected outcomes of central bank meetings.

He said: “Since July last year we have seen interest explode as the difference between OIS, reflecting central bank policy expectations, and Libor/Euribor, which reflect bank funding costs, has become apparent to everyone.

"So we are seeing interest from cash, forward FX traders, hedge funds, real money accounts, mortgage lenders, asset swap traders and even some corporates."

Traders said they saw OIS as a complementary product to Libor interest rate swaps, rather than replacing it.

A spokeswoman for the British Bankers Association said: "We have seen no interest from our members to establish another benchmark other than Libor. One of the strengths of Libor is that it is subjected to rigorous and open scrutiny, which gives it an edge over any of the potential ratings. Libor is, and will remain the benchmark for fixing of currencies in the spot and forward market."

France calls for rating agency registry

(FT) Christine Lagarde, the French finance minister, plans to push for registration of credit ratings agencies that want to operate in Europe when France takes over the presidency of the European Union in July.

Registration will not necessarily lead to direct regulation of Moody’s, Standard & Poor’s and their rivals in Europe, Ms Lagarde told the Financial Times, but her comments add to the pressure on the industry to overhaul its standards.

Ms Lagarde was speaking after the International Organisation of Securities Commissions (Iosco), the policy forum for the world’s leading financial watchdogs, published its beefed-up code of conduct for ratings agencies in Paris on Wednesday.

“I want to introduce the topic so that all European members can discuss how ratings agencies can be registered,” Ms Lagarde said.

“I’m not narrow-minded with regulation, regulation, regulation but I am obsessed with the stability of the financial markets and the due role of all the players.”

The new Iosco code comes in response to the industry’s role in rating the complex debt and mortgage-related products at the heart of the credit crisis.

It explicitly calls on the agencies to introduce new ratings for mortgage-backed bonds and other structured debt because of the perception that such debt behaves differently than traditional corporate or sovereign debt in times of stress.

The main ratings agencies have talked down this idea, which was also proposed by the Financial Stability Forum, a group of central bankers and supervisors.

Michel Madelain, the new head of Moody’s, told the FT this month that his agency would continue to give complex bonds traditional tags such as triple A.

But Michel Prada, head of the French regulator and chairman of Iosco’s executive technical committee, told the FT on Wednesday that international regulators would “seek and demand differentiation”.

“It might be different symbols, it might be otherwise but we are seeking differentiation that today doesn’t exist,” he said.

“When such a demand is made by the president’s committee of the US, by the Financial Stability Forum and by Iosco, I think it will be difficult [for the agencies] not to do anything about it,” he said.

Moody’s said on Wednesday that it implements the code of conduct drafted by Iosco through its professional code of conduct and that it would further change its code in response to Iosco’s changes where appropriate.

S&P is also looking at the changes. “We announced in February a proposal to add an identifier to all structured finance ratings in order to clearly distinguish them we will shortly be consulting with the market on this,” it said.

Libor Analysis: Wall Street Journal Edition

(Alea) The Wall Street Journal discovers the “default-insurance market” ( CDS market for you and me ).

The Journal used this risk-premium information to construct an alternative “borrowing rate” for each of the 16 banks. There were two steps to the process: First, the Journal estimated what Libor would be if there was no risk that any of the banks would default. Then, it added each bank’s risk premium to that number, yielding 16 different “borrowing rates.”

If there was no risk that any of the banks would default, “Libor” would be the same as the OIS fixed leg with the same tenor. CDS premium are above Libor by arbitrage and it is not correct to use Libor-CDS spread to get a “risk-free Libor”, we already know what it is [OIS fixed leg].

To back the default risk out of Libor, the Journal made one important assumption: The cost of default insurance on the most credit-worthy bank provides a reasonable estimate for the default-risk compensation contained in Libor. That’s because all 16 banks have been reporting nearly the same Libor rates — as if they were all equally credit-worthy.
On April 16, for example, the lowest rate reported by the 16 banks to the Libor panel was 2.72%. The cheapest default insurance was for Bank of Tokyo-Mitsubishi: 0.25 percentage points. So the Journal’s estimate of what Libor would be if there were no risk of defaults came to 2.72 minus 0.25, or 2.47%.

Pre-credit crunch, pre-august 9th 2007, when OIS-Libor spread was below 10 bp, the Journal calculation would have resulted in a “risk-free Libor” below the OIS fixed, a proxy for a risk-free rate.

Banks launch central clearer for derivatives

(FT) Efforts to tackle the risk surrounding privately negotiated credit derivatives will take a step forward on Thursday when 11 of the world’s biggest investment banks announce the creation of the first central clearer for the opaque contracts by September.

The absence of a central clearer has made such contracts risky because there is no guarantee that parties will pay out.

This systemic risk has fuelled the global credit crunch, prompting regulators to step up pressure on banks to show they are trying to make the system more dependable.

Credit derivatives allow investors to make bets on the creditworthiness of baskets of corporate debt. Global growth in the notional value of such contracts grew by 81 per cent last year to a value of $62,200bn.

Credit derivatives contracts are predominantly negotiated privately between traders who rely on their assessments of each other’s ability to pay under the terms of the contract. A clearer uses funds contributed by traders to guarantee against default.

“The credit crisis has definitely heightened interest in this kind of solution among the regulators,” said Kevin McClear, chief operating officer of The Clearing Corporation, the Chicago-based institution backed by the banks that will act as the new clearer. “We don’t think there’s a better approach to reducing systemic risk.”

The need to act fast to pre-empt stiffer regulation in the wake of the credit crisis has given impetus to a proposal that has been 18 months in the making. It has also been accelerated by attempts by other clearers, such as LCH.Clearnet, Europe’s largest independent clearer, and the CME Group, the Chicago-based derivatives exchange, to muscle in on the business potential of clearing such over-the-counter derivatives.

Thursday’s proposal is the result of an agreement between The Clearing Corporation (also known as CCorp) and the Depository Trust and Clearing Corporation (DTCC), the New York-based clearing group.

CCorp’s backers – including Goldman Sachs, Citigroup, JPMorgan, Bear Stearns and Morgan Stanley – will establish a guarantee fund to cover losses if any firm should fail.

While Thursday’s announcement is sure to be welcomed, questions remain about whether the proposal will raise industry standards or if it is largely cosmetic.

Clear chance to transform world of derivatives

(FT) The headquarters of the Clearing Corporation in downtown Chicago are an unlikely setting for an institution that has set its sights on transforming the financial world in the next four months.

Unoccupied cubicles dominate the main working area, several of the adjoining offices are vacant and the overall atmosphere is soporific.

The organisation has not had a chief executive since the last one left in 2006 and it has cut its staff back to about 40.

Since it became independent in 2003 from the Chicago Board of Trade – where it had been the clearing house since 1925 – it has not been a significant clearer of derivatives contracts.

So there is bound to be scepticism about the Clearing Corp’s ambition to launch itself as the world’s first clearing house for the $62,200bn credit derivative industry.

Most obviously, there is the question of whether an institution that has been out of the spotlight can refocus itself as a clearer for the dynamic over-the-counter derivatives sector and achieve meaningful volumes before more thrusting competitors emerge to steal its thunder.

Kevin McClear, chief operating officer, takes umbrage at the notion that the Clearing Corp has been snoozing. “We’ve been off the radar but we’ve been active,” he says.

The firm currently clears trades for small exchanges such as the Chicago Climate Futures Exchange, but its total volumes are relatively small. Also it has been touted three times in the past decade as the institution that could be used by competitors to the Chicago Mercantile Exchange to break that exchange’s near-monopoly on futures clearing. None of those attempts succeeded.

Mr McClear points to the firm’s recapitalisation last December as a sign of its intent. Twelve big OTC dealing houses and three inter-dealer brokers pumped in about $60m with the idea of re-creating the organisation as an OTC derivatives clearer.

He further notes that in spite of not having a chief executive (it is searching for one), the Clearing Corp retained many of its experienced executives as it cut employee numbers back. It aims to double staffing at lower levels in the next two to three years.

The Clearing Corp also hopes it can begin in its new role using its existing technology. Initially it will clear only OTC credit default swap contracts that are based on North American high-yield and investment-grade indices.

“Those trade more like futures contracts,” Mr McClear says. “They’re highly liquid, we can clear them using our legacy systems, and we can manage the risk like we do with futures.”

In later phases the organisation hopes to move on to clear CDS products such as iTraxx indices, index tranches and single-name products, for which Mr McClear says it will need to introduce more up-to-date technology and risk systems.

Another doubt over the new venture is whether its sponsors are serious or are merely using it to get regulators off their back. The Financial Stability Forum has been calling for counterparty risk to be reduced as part of a wide-ranging set of reforms proposed in a report issued last month.

Regulators say they want a tangible response from the banking industry in the coming months.

“The regulators want to see some concrete action,” one senior banker says. “This is very tangible.”

The large investment banks are due to meet the New York Federal Reserve in the next few weeks to discuss reform. The New York Fed has informally indicated that it would welcome a more robust clearing mechanism and the issue is a central theme of a high-level report that Gerry Corrigan, former New York Fed president, is preparing with senior Wall Street figures.

Separately, the Corrigan group is discussing other possible measures to reform the credit-derivatives sector, such as introducing more standardised contracts. It plans to report in July.

Some sceptics even speculate that the investment banks behind the Clearing Corp’s agreement with the Depository Trust and Clearing Corporation have no real interest in the project. The advantage of OTC contracts is that they are customised. If such products become standardised and commoditised, the argument goes, banks’ margins would come down.

With a nod to the doubters, Mr McClear recognises that his organisation needs to prove it is up to the job by making its initial roll-out demonstrably effective in just a few months.

“Our goal is to get something up and running and show everyone its usefulness,” he says.

Mr McClear believes that – through multilateral netting of contracts, trade guarantees, collecting forward-looking margin to protect against adverse price moves, and daily marking-to-market of cleared positions – the initiative should be able to show quickly how it substantially lowers risk.

“It’ll be interesting if we can share the significance of the systemic risk that we’re reducing through the initial clearing efforts when we net down these huge positions,” he says.

Another concern is that the venture could reinforce the dominance of a small group of banks in credit derivatives. But Mr McClear says he is open to new clearing participants as long as they are well capitalised.

Whereas many start-up initiatives in clearing have failed, Mr McClear says the difference with the Clearing Corp is that it aims to tap into a huge book of transactions that are already housed at theDepository Trust and Clearing Corporation’s “warehouse” of OTC credit derivatives.

“There’s a huge trade out there of these products right now and it resides in DTCC in their warehouse,” he says. “We’ll be in a position to get between many of those bilateral transactions that are currently registered there and clear them. We’ll be a new counterparty in the warehouse. That’s where we can get the biggest bang in the shortest period of time.”