Monday, June 30, 2008

Push Pandemic out of Insurance Capital Markets Provide Necessary Depth

From Guy Carpenter:

Life carriers struggle with the notion of hedging pandemic risk. The probability of an event occurring in any particular year is low. Even if an outbreak does occur, the process for estimating losses and determining reserves is unclear. Capital approaches do not consider probabilistic tail scenario risks. Quite simply, managing pandemic risk is an effort mired in doubt, though the potential for a devastating, multibillion dollar, worldwide outbreak is real. Traditional risk transfer tools have only limited utility in covering pandemic exposure. However, the depth and flexibility of capital markets may provide a robust alternative to traditional reinsurance.

For more, see the complete report.

Sunday, June 29, 2008

Kurt Hess's Financial Modeling Page

In 1999, Kurt Hess migrated to New Zealand from Switzerland where he had been working for Credit Suisse First Boston in Zurich, as a Director of Fixed Income and Credit Research. He now teaches at Waikato University Management School (Hamilton, New Zealand).

Here are some models he developed for the Waikato Management School modeling courses. They are all Excel spreadsheets, sometimes enhanced by VBA code. Feel free to download them for any non-commercial purpose but give Kurt credit in your research paper .

Some VBA code modules are password protected because I use them for teaching purposes and students must at least buy a password cracker to obtain the code (some program it themselves). If you crack his files, send him at least a copy of this password cracking software. His email:

Modeling is a great way ....

to introduce students to concepts in Finance. The benefits of modeling in finance are discussed in this article (PDF format) : Modeling in Finance Courses

New credit risk papers posted on

Correlated Binomial Models and Correlation Structures

by Masato Hisakado of Standard & Poor's, Kenji Kitsukawa of Keio University, and Shintaro Mori of Kitasato University

Abstract: We discuss a general method to construct correlated binomial distributions by imposing several consistent relations on the joint probability function. We obtain self-consistency relations for the conditional correlations and conditional probabilities. The beta-binomial distribution is derived by a strong symmetric assumption on the conditional correlations. Our derivation clarifies the ’correlation’ structure of the beta-binomial distribution. It is also possible to study the correlation structures of other probability distributions of exchangeable (homogeneous) correlated Bernoulli random variables. We study some distribution functions and discuss their behaviors in terms of their correlation structures.

Generalized Beta Regression Models for Random Loss-Given-Default

by Xinzheng Huang of Delft University Of Technology & Rabobank, and Cornelis W. Oosterlee of Delft University Of Technology & CWI

Abstract: We propose a new framework for modeling systematic risk in Loss-Given-Default (LGD) in the context of credit portfolio losses. The class of models is very flexible and accommodates well skewness and heteroscedastic errors. The quantities in the models have simple economic interpretation. Inference of models in this framework can be unified. Moreover, it allows efficient numerical procedures, such as the normal approximation and the saddlepoint approximation, to calculate the portfolio loss distribution, Value at Risk (VaR) and Expected Shortfall (ES).

The death of mortgage securitization?

(Naked Capitalism) In yet another example of synchronicity, Jim Hamilton provides a chart from Peter Hooper that illustrates why the housing market is in the doldrums: securitized credit has all but vanished. This topic came up in the previous post as a explanation of why the real estate market is coming to look like a war zone.

The collapse of private sector mortgage securitization hasn't gotten the attention it deserves. To put it in crude terms, securitization became central to how we finance housing in America. Banks held only a small portion of the loans they originated; the rest were sold. As we have discussed elsewhere, securitization depends on credit enhancement. Paul Jackson reported early this year that the revival of securitization depended on having support of some form:
While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.

For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.

In fact, regulators do not expect securitization to return to anything like its former level. They expect far more bank originated assets to stay within the banking system, on their balance sheets. That in turn will require them to carry vastly more equity than they do now. It will take financial institutions some time and doing simply to secure enough equity to make up for losses and increase their capital levels to the new more conservative standards that are being implemented.

The impairment of lending capacity suggests that housing prices could overshoot their "fair" value in relationship to incomes. Expect more efforts to socialize the housing market to prevent this outcome

Saturday, June 28, 2008

Finally, some sense in the financial press

(Housing Wire) Eric Hovde penned a piece this weekend that deserves a close read, especially if you happen to be a U.S. Senator — and I know that more than a few now read HW each week.

His point is one that our editorial team has been hammering since at least August of last year: that housing prices simply must fall, and a good chunk of homeowners must lose their homes.

Attempting to fight the forces of housing gravity now at work isn’t likely to end well. To wit:

… if homeowners are able to reset their mortgage balance to their home’s current fair market value, less a 10%-15% discount, the real probability exists that borrowers who have the ability to pay their existing mortgage will manipulate the system to receive a similar benefit.

Ask yourself this simple question: If your neighbor is able to stay in their home and also receive a meaningful reduction in their mortgage principal balance, would you not want the same result? The obvious risk is that a significant, further wave of homeowners — who are already on the brink — stop making their mortgage payments …

The banking industry today is not in a position to assume the massive write-downs called for by these proposals…. the proposals place an enormous burden on the FHA, one which it is not capable of handling.

Back in August of last year, when PIMCO’s Bill Gross was crying to Congress for a bailout package, we first noted the fact that all of the Congressional “help” in the world can’t solve for all of the key factors now making key housing markets nationwide: oversupply, unaffordability relative to personal income, a dramatic shift in underwriting standards, and a rising tide of foreclosures.

Here’s what I had to say then:

Imagine if Johnny Subprime sees his $500,000 2/28 ARM forgiven and replaced with a $400,000 30-year fixed mortgage … Now, multiply that effect by at least two million.

You explain to me how the other homes in those neighborhoods continue to justify their $500,000 mortgages after that one.

By bailing out those who can least afford their mortgages, we essentially reduce home prices to their lowest common denominator — that is, to whatever price a troubled subprime borrower can bear. And that price will by its very definition be much lower than the price that the rest of the market — that is, the majority of borrowers who can afford their mortgages — would otherwise settle on.

That’s assuming of course, that the housing bill will make enough of a dent with troubled borrowers to impact the overall housing market — we’re now staring at 3 million or so foreclosures this year, and many more troubled borrowers beyond that total. The Senate housing bill is estimated by the Congressional Budget Office to aid just 400,000 at-risk borrowers. I’d submit that’s going to end up creating a perceived shortfall in much the same way that expanding conforming lending limits has.

Which is to say that even if the current controversial housing bill passes and becomes law, it’s highly likely that Congressional Democrats will be going back to the well to hammer out yet another housing aid package — and that next bill will be even larger than the one currently under consideration, if past experience with Congressional response is any indication.

Friday, June 27, 2008

How Canada stole the American Dream

(MacLeans) The numbers are in. Compared to the U.S., Canadians work less, live longer, enjoy better health and have more sex. And get this: now they’re wealthier too.

How did this happen? Canada often comes out ahead when you look at squishy things like quality of life. But since when were we richer? Mintz credits the rising loonie, the boom in commodities, and better public policy. He says that over the past decade productivity growth in the U.S. has slowed, while we've been hacking away at our government debt and lowering taxes. In short, as a nation, we've been doing everything right, while the U.S. has been doing everything wrong.

When you look at how individual Canadian and American families make and spend their money, it gets even more interesting. The numbers show that our median household incomes are about the same, or at least they were back in 2005 when the most recent figures came out. That year the median household income in Canada was about US$44,300, after you adjust it for the exchange rate and our lower purchasing power, while the American median was US$46,300. Since then, the loonie has gained on the U.S. dollar, so we've likely narrowed the gap. But while our incomes may be similar to American incomes, we're still much wealthier because we have less debt. What you make isn't a good measure of how rich you are — to figure out your true wealth you should add up everything you have and subtract what you owe. And Americans owe more. A lot more. Here in Canada the average amount of personal debt per person is US$23,460. In the U.S. it's a whopping US$40,250. And all those numbers are from 2005, just before their housing market slipped into a sinkhole. If you looked at the numbers now, you'd find that Americans are even further behind, because their largest asset — their home — is worth less. "There has been a lot of destruction of wealth in the U.S. over the past few years," says Mintz, "and that would affect the net worth figures significantly. I would suspect that they would be even worse off today."

Certainly Canadians who venture down to live in the U.S. say there's a huge difference in how the two countries approach spending and debt. Gerry Van Boven grew up in southern Ontario but moved to the U.S. in 1985. Now he's 57 and living in Fort Lauderdale, Fla. He says his American friends seem genuinely puzzled by his reluctance to load on huge piles of debt so he can buy a big luxury car and a monster home. "Most of the people that I know who were born and raised here are a lot farther in hock than I am, and they think that's quite normal," he says. "They're like, 'Can't afford it? I'll just put it on plastic.' Whereas I was brought up to believe that if you can't afford to buy it in cash, you can't afford it."

The numbers confirm that Americans like to spend big. They have bigger homes than we do, averaging about 2,500 sq. feet, compared to only 2,000 sq. feet in Canada. They spend about 34 per cent of their annual household expenditure on their homes, compared to just 19 per cent here. They also love big cars. In the U.S., luxury cars and SUVs make up 21 per cent of the market, whereas in Canada, they make up only 11 per cent. The most popular model overall in the U.S. is the more upscale Toyota Camry, whereas we prefer the basic Honda Civic. "They like the big SUVs here especially," says Van Boven, "or at least they did. A good friend of mine went out and bought one of those big GMC Yukons a while back, but now gas is at $4 a gallon. I saw him the other day and asked when he was going to get rid of it. 'I can't,' he said. 'I don't own it yet.' "

Bibby, the sociologist, says the great American debt load is a direct result of their relentless quest for the best. "American culture is more consumer-oriented due to a more intense and more vigorous marketplace," he says. "My sense is that more dollars are spent per capita on advertising, for example. Little wonder then that per capita debt is considerably higher in the U.S. than in Canada. It is largely a function of the aggressive and successful marketing efforts of American companies." Health care, too, is helping to keep Americans in a state of owe, and for all the same reasons. In the U.S., as long as you have a good insurance plan, you have access to the best health care in the world. MRI machines are available on an hour's notice, there's plenty of staff, and the specialists are the finest there are. But all of that comes at a cost, says Van Boven, and every American feels it. "The absolute biggest difference, financially, that I noticed was the cost of health insurance," he says. "When my wife got laid off, we found out that you could keep the insurance you got through work for a while as long as you paid for it. But it cost $5,000 a year, and that was back in 1986. We couldn't afford that. So since then I've had no health insurance." Eric Nay, who moved to Toronto from California, says that even Americans with good insurance feel the pinch. "When I taught for the state of California, I had the best health coverage on the planet," he reports. "But when my son was born — and it was totally by the book, no complications — my insurance only covered the first $10,000 of the hospital costs. The remaining $8,000 came out of my pocket. And that's with full coverage."

Meanwhile in Canada, not only are we wealthier, but we don't even have to work as hard to make that wealth. In 2004, the average Canadian worker put in 35 hours of work per week, while our American counterparts put in 38. Only 30 per cent of Canadians work 45 hours a week or more, compared to 38 per cent of Americans. We also get — and take — much more vacation time. Employed adults in Canada get about 17 vacation days a year, and we take 16 of those days, leaving just one on the table. In the U.S., they get 14 days of vacation, but they only take 11, making them the world leader in yet another category: the working drudge.

Because we have more time off, Canadians tend to have a lot more fun. We spend more time with friends than Americans do, and we're much more likely to have a sit-down dinner with the family at home each night. We also tend to drink alcohol more often, with 27 per cent of us having a drink at least a few times a week, compared to 19 per cent of Americans. Nay says that our richer social lives were one of the biggest differences he noticed when he moved to Toronto. "It was only in Canada that I found myself going to the pub with friends and colleagues," he says. "I spend more time in pubs here than I have in any other place that I've lived. It's partly the culture, and partly because the quality of beer is fantastic."

Christian Lander is another Canadian living among Americans. He grew up in Toronto, but the 29-year-old moved to Los Angeles 2½ years ago where he runs the popular Stuff White People Like website, and he's publishing a book under the same name on July 1. He also finds that Americans like to do things big, but that doesn't always mean better. "The expectations here are just different," he says. "There's more ambition. More ambition to acquire more in terms of money and career. Whereas Canadians seem to be more European in that we care more about enjoying life." He's lived all over the country and says that it's very difficult to sum up the differences between Americans and Canadians because Americans are so diverse. The gaps between rich and poor, or black and white within the confines of the U.S. are much deeper and wider than the gap between the two countries. And within that mix, he says there's a subset of Americans who are just like Canadians. "Left-wing urban Americans," he says. "Canada is just a country of left-wing urban Americans." Still, he says that the relentless zeal, the private schools, the long work hours, not to mention the fact that everyone in L.A. seems to carry a gun, well, it all gets him down sometimes. His wife, who's American, is pushing to move back to Toronto, he says. "And yeah, we probably will."

Reginald Bibby notes the irony of the situation. The U.S. is a country that aggressively pursues happiness, but Canada seems to have just stumbled onto it. While Americans are putting in overtime to pursue the American dream, we're at the pub having a few pints with friends. They may have bigger cars and bigger homes, but they're living under a mountain of debt. They look richer, but the numbers prove that they're not. The truth is that all of that competition, all of that keeping up with the Joneses, can take its toll. Getting ahead can be a lot easier when everyone is moving in the same direction. "The pursuit of happiness is ingrained in Americans as part of what it means to be an American," Bibby says. "But in Canada, happiness is almost something of a by-product of coexisting peacefully."

Be it sports, health care, business or wealth, Americans are still competing to be the best. And it's true that the best in the U.S. is the best you'll find on the planet. But when you look at the medians and the averages, their accomplishment pales. As the hard numbers in this report show, Americans have shorter lives, poorer health, less sex, more divorces, and more violent crime. Which may mean that perhaps America isn't the greatest nation on earth. After all, you can't judge a nation by the best it produces, you have to judge it by the success of the average Joe. And the average Joe in Canada is having a way better time.

What's your social status?

(Information Processing) Calculate your social status using this tool from the NY Times. (Click on the components of class tab.) The inputs are occupation, education level, income and wealth. The tool was created to run with a week long series of articles on class in America, back in 2005.

While social status can be crudely modeled by the average of the percentile results from the four inputs (higher average = higher social status), the figure doesn't actually represent the percentage of the population with lower status, since the four inputs are correlated and the score assigned to occupation isn't really a population percentile.

Homes Less Affordable as Prices Fall, Rates Rise, Zillow Says By Sharon L. Lynch Enlarge Image/Details June 27

(Bloomberg) -- Rising mortgage rates are driving up the cost of buying a house even as prices fall, making property more expensive across the U.S., according to a new study by, an online provider of home valuations.

Monthly payments on 30-year fixed mortgages are 6 percent to 10 percent higher in 41 of the top U.S. housing markets than they were two months ago. First-quarter prices have declined from a year earlier in 88 percent of those areas, Zillow said.

``We're going to need about a 30 percent decline in house prices if you are going to keep payments stable,'' said Morris Davis, a former senior economist with the Federal Reserve and now a real estate professor at the University of Wisconsin-Madison's School of Business.

Seven Federal Reserve benchmark cuts since September have failed to lower mortgage rates as banks have curtailed lending after taking writedowns or credit losses of more than $400 billion from investments in mortgages. Rates for 30-year fixed-rate home loans were about 6.3 percent when the Fed first reduced its target federal funds rate nine months ago. They're now just under 6.45 percent, data from show.

Zillow based its calculations on almost 25,000 mortgage offers to potential homebuyers with credit ratings of at least 680 out of a possible 850. The would-be buyers sought bids through Zillow's Mortgage Marketplace, a new service that helps consumers shop for home loans. Zillow's main business provides U.S. home valuation estimates based partly on sales data.

`Unfortunate Pickle'

The average monthly mortgage payment rose $131, or $1,572 a year, since the beginning of April in the 41 areas surveyed, Zillow said. The figure is controlled for population.

``The story here is not so much how much more it will cost you over the life of the loan, but how much less house you can buy,'' said Greg Rand, managing partner of Prudential Rand Realty in Westchester County, New York. ``It's an unfortunate pickle that we're in.''

Prudential Rand has more than 700 sales associates and a mortgage brokerage that arranges financing.

Home prices in 20 U.S. metropolitan areas fell in April by the most on record, according to the S&P/Case-Shiller home price index, and new home sales declined 40 percent in May from a year ago, according to the U.S. Census Bureau. Sales of previously owned homes in the U.S. rose in May from the lowest level in at least nine years as a slide in prices lured some buyers into the market, the National Association of Realtors said yesterday.

Fed Actions

U.S. housing was less affordable in April than the previous month even as sales increased in some markets, the Realtors data show. The composite homebuyer index fell to 129.8 in April from 130.6 in March. A value of 100 means that a family with the national median income has exactly enough income to qualify for a mortgage on a median-priced home.

Fed rate reductions have historically lowered mortgage rates. From Jan. 3, 2001, to June 25, 2003, the Fed cut rates 13 times. Mortgage costs fell eight times and rose five times, according to North Palm Beach, Florida-based

Changes in mortgage rates have the biggest impact when those rates are near the historic lows they are now, Davis said. If interest rates were at 1 percent and rose to 2 percent, house prices would have to drop 50 percent to keep a buyer's house payment the same.

Mortgage payments rose the most in the California metropolitan areas of Ventura and Santa Rosa, gaining 10 percent, according to Zillow. That added $220 a month to loan payments in Ventura and $189 in Santa Rosa. Home prices in those areas fell about 20 percent in the first quarter from a year earlier, the company said.

Higher Payments

The annual cost for a 30-year fixed-rate mortgage to buyers with good credit in the Ventura area is now $2,640 more now than 60 days ago. That amounts to $79,200 more over the life of the loan, without adjusting for inflation, Zillow said.

The trend holds true in California metro areas including Sacramento, San Francisco, Los Angeles, San Jose and San Diego, where mortgage payments on median priced homes range from 7 percent to 10 percent more now than in April.

California is among the states hardest hit by the biggest drop in U.S. home sales in 26 years. One in every 183 households in the state was in some stage of foreclosure in May, more than double the national average, according to Irvine, California-based RealtyTrac Inc.

Sales Gain

Foreclosures drive down prices by contributing to the higher inventory of unsold homes, forcing prices lower and reducing home equity, said Ryan Ratcliff, an economist with the UCLA Anderson Forecast in Los Angeles.

Home sales in California rose 18 percent and exceeded an annualized, seasonally adjusted rate of 400,000 last month for the first time since early 2007, the state Realtors Association said in a news release on June 25. The increase in sales volume came because of more ``distressed sales,'' the Los Angeles-based group said.

In New York, New Jersey, Long Island and parts of Pennsylvania, where the median estimated home value is $418,500 and APRs have risen from 5.9 percent to 6.5 percent, today's buyers can expect to pay $1,656 more a year while home values for the region have dropped about 1.4 percent.

The price of condominiums and co-operative apartments in Manhattan are an exception, with the median increasing 13.2 percent to a record $945,000 in the first quarter, according to an April 2 report by New York-based real estate appraiser Miller Samuel Inc. and broker Prudential Douglas Elliman Real Estate.

Jumbo Pain

Buyers in markets including New York and coastal California, where more than half of all homes cost more than $417,000, are feeling the most pain. Jumbo loan rates have risen from about 7 percent to about 7.4 percent over the nine months the Fed has cut rates, according to

The cost for 30-year fixed-rate jumbo mortgages has increased more than 2 percentage points since June 2003, according to data from Over the past year, the average spread between jumbo and so-called conforming mortgages has been about 93 basis points, or 0.93 percentage point. That gap is now about 111 basis points.

``While it's a buyers market in terms of home prices, that is definitely being mitigated by the cost of financing,'' said Stan Humphries, Zillow's vice president for data and analytics.

May You Live in Interesting Times: The Sequel

William C. Dudley's remarks at the Federal Reserve Bank of Chicago's 44th Annual Conference on Bank Structure and Competition, Chicago

Exhibits (slides) PDF

I gave a speech last October entitled “May You Live in Interesting Times.” In that speech I listed a number of events that I never, ever expected to see. These included AAA-rated mortgage backed securities selling at 85 to 90 cents on the dollar, asset-backed commercial paper backstopped by real assets and a full bank credit support yielding more than unsecured commercial paper issued by the same bank, and a Treasury bill auction that almost failed at a time that there was a flight to quality into Treasurys going on.

The list has gotten much longer since then. To mention just a few: AAA-rated collateralized debt obligations (CDOs) that may turn out to be worthless; monoline guarantors, some still with AAA ratings, but with credit default swap spreads higher than many non-investment grade companies and a major investment bank’s demise in a few short days in March.

The number of liquidity facilities developed and introduced by the Federal Reserve is another list that has gotten much longer. Policymakers have responded to the persistent pressures in funding markets by introducing several new liquidity tools.

Today, I want to focus on what we’ve been up to in terms of these liquidity-providing innovations. Before I begin in earnest let me underscore that my comments represent my own views and opinions and do not necessarily reflect the views of the Federal Reserve Bank of New York or of the Federal Reserve System.

Let me first define the underlying problem. The diagnosis is important both in influencing the design of the liquidity tools and in assessing how they are likely to influence market conditions.

As I see it, this period of market turmoil has been driven mainly by two developments. First, there has been significant reintermediation of financial flows back through the commercial banking system. The collapse of large parts of the structured finance market means that banks can no longer securitize many types of loans and other assets. Also, banks have found that off-balance-sheet exposures—such as structured investment vehicles (SIVs) or backstop lines of credit that are now being drawn upon—are adding to the demands on their balance sheets.

Second, deleveraging has occurred throughout the financial system, driven by two fundamental shifts in perception. On one side, actual risks—due to changes in the macroeconomic outlook, an increase in price volatility, and a reduction in liquidity—and perceptions about risks—due to the potential consequences of this risk for highly leveraged institutions and structures—have shifted. Many assets are now viewed as having more credit risk, price risk, and/or illiquidity risk than earlier anticipated. Leverage is being reduced in response to this increase in risk.

On the other side, the balance sheet pressures on banks have caused them to pull back in terms of their willingness to finance positions held by non-bank financial intermediaries. Thus, some of the deleveraging is forced, rather than voluntary.

In some instances, these two forces have been self-reinforcing: In March, the storm was at its fiercest. Banks and dealers were raising the haircuts they assess against the collateral they finance. The rise in haircuts, in turn, was causing forced selling, lower prices, and higher volatility. This feedback loop was reinforcing the momentum toward still higher haircuts. This dynamic culminated in the Bear Stearns illiquidity crisis.

During the past eight months, the financial sector as a whole has been trying to shed risk and to hold more liquid collateral. This is a very difficult task for the system to accomplish easily or quickly for two reasons. First, the financial sector, outside of the commercial banking system, is several times bigger than the banking system. So, with some hyperbole, you are, in essence, trying to pour an ocean through a thimble. Second, this process of deleveraging tends to push down asset prices for less liquid assets. The decline in asset prices generates losses for financial institutions. Capital is depleted, increasing the pressure on balance sheets.

One consequence of this reintermediation and deleveraging process has been persistent upward pressure on term funding rates. For example, the spreads between 1- and 3-month LIBOR and the comparable overnight index swap rates have widened sharply during this period. The overnight index swap rate is the expected effective federal funds rate over the stated maturity of the swap. As shown in the two exhibits on page two, this pressure on term funding rates has occurred in the United States, Euroland, and the United Kingdom. It is a global phenomenon.

In fact, the increase in LIBOR to overnight indexed swap (OIS) spreads may understate the degree of upward pressure on term funding rates. Note that after a Wall Street Journal article on April 16 questioned the veracity of some of the LIBOR respondents and the British Bankers Association threatened to expel any banks that they discovered had been less than fully honest—LIBOR spreads increased further.

The foreign exchange swap market indicates that the funding costs for many institutions may be even higher than suggested by the dollar LIBOR fixing. As shown in the next slide, the funding cost of borrowing dollars by swapping into dollars out of euros over a 3-month term is about 30 basis points higher than the 3-month LIBOR fixing.

So what explains this rise in funding pressures more precisely? Some have argued that the rise in term funding spreads reflects increased counterparty risk; others that the rise stems from a reduction in appetite of money market funds to provide term funding to banks. Over the past eight months, there is some validity to both of these arguments. But neither explanation provides a very satisfactory explanation.

Credit default swaps spreads for major commercial banks have narrowed considerably over the past two months. This indicates that counterparty risk assessments are improving—yet LIBOR-OIS spreads widened over this period. Thus, it is hard to pin this widening in LIBOR-OIS spreads on an increase in counterparty risk.

Similarly, the notion that money market mutual funds have lost their appetite for term bank debt has not been particularly compelling recently. The split of money market fund assets between Treasury-only versus prime money market funds has been relatively stable, the weighted average maturity of the funds has been increasing, and prime funds have increased their allocation to both foreign and domestic bank obligations. In contrast, when there was a flight to quality to Treasury-only money market funds last August, this was a more compelling explanation.

So what has been driving the recent widening in term funding spreads? In my view, the rise in funding pressures is mainly the consequence of increased balance sheet pressure on banks. This balance sheet pressure is an important consequence of the reintermediation process. Although banks have raised a lot of capital, this capital raising has only recently caught up with the offsetting mark-to-market losses and the increase in loan loss provisions. At the same time, the capital ratios that senior bank managements are targeting may have risen as the macroeconomic outlook has deteriorated and funding pressures have increased.

The argument that balance sheet pressure is the main driver behind the recent rise in term funding spreads is supported by what has been happening to the relationship between other asset prices—especially the comparison of yields for those assets that have to be held on the balance sheet versus those that can be easily sold or securitized. Consider, for example, the spread between jumbo fixed-rate mortgages and conforming fixed-rate mortgages, which is shown in the next slide. As can be seen, this spread has widened sharply in recent months, tracking the rise in the LIBOR/OIS spreads.

Why is this noteworthy? Jumbo mortgages can no longer be securitized, the market is closed. Thus, if banks originate such mortgages, they have to be willing to hold them on their balance sheets. In contrast, conforming mortgages can be sold to Fannie Mae or Freddie Mac. Because the credit risk of jumbo mortgages is likely to be comparable to the credit risk of conforming mortgages, the increase in the spread between these two assets is likely to mainly reflect an increase in the shadow price of bank balance sheet capacity.

If this is true, then the same balance sheet capacity issue is likely to be an important factor behind the widening in term funding spreads. After all, a bank has a choice. It can use its scarce balance sheet capacity to fund a jumbo mortgage or to make a 3-month term loan to another bank.

If balance sheet capacity is the main driver of the widening in spreads, this suggests that there are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed’s actions cannot create bank capital or ease balance sheet constraints materially.

That said, the Fed can reduce bank funding risks by providing a safe harbor for financing less liquid collateral on bank and primary dealer balance sheets. Reducing this risk may prove helpful by lessening the risk that an inability to obtain funding would force the involuntary liquidation of assets. The ability to obtain funding from the Fed reduces the risk of a return to the dangerous dynamic of higher haircuts, lower prices, forced liquidations, and still higher haircuts that was evident in March.

In essence, the Federal Reserve’s willingness to provide liquidity against less liquid collateral allows the reintermediation and deleveraging process to proceed in an orderly way, which reduces the damage to weaker counterparties and funding structures. One can think of the Federal Reserve’s actions as smoothing and extending the adjustment process—not preventing it—so that the adjustment causes less damage to the financial system and less pernicious macroeconomic consequences.

The Federal Reserve has introduced three new liquidity facilities during the past five months. For depository institutions, the Term Auction Facility (TAF) was introduced in December. This is a complement to the Primary Credit Facility (PCF), often referred to as the Discount Window. In the TAF, 28-day term loans are auctioned by the Federal Reserve every two weeks in single-price auctions. Any sound depository institution with suitable collateral can participate. A summary of the terms of the two facilities available to depository institutions—the TAF and the Primary Credit Facility—are shown in the next slide.

For primary dealers, we have introduced two new facilities—the Term Securities Lending Facility and the Primary Dealer Credit Facility. The terms for these two facilities are shown in the next slide. These can be thought of as analogues to the TAF and the PCF for depository institutions.

The Term Securities Lending Facility auctions the right to dealers to exchange AAA-rated residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS) or asset-backed securities (ABS) collateral in exchange for Treasury securities. The dealers take the Treasury securities obtained in the auction and use them as collateral to obtain cash in the Treasury repo market. The bid price is in basis points. The spread between the one-month Treasury repo rate and the one-month term repo rate on the AAA-rated collateral is the metric that drives the price dealers are willing to bid to swap AAA-rated collateral for Treasuries.

The Primary Dealer Credit Facility is a standby borrowing facility for primary dealers, akin to the Primary Credit Facility. But there are a number of important differences. First, the PDCF, like the TSLF, is built to utilize the infrastructure of the triparty repo system managed by the two clearing banks—Bank of New York Mellon and JP Morgan Chase. In contrast, the PCF is administered by the 12 Federal Reserve Banks through the discount window function. Second, the scope of eligible collateral is a bit narrower—confined to most major types of investment grade securities. In contrast, the discount window accepts a broader set of collateral, including certain types of whole loans. Third, the PDCF is a temporary facility that must, by law, disappear once market conditions normalize.

In addition to the TAF, TSLF, and PDCF, the Federal Reserve has undertaken two other liquidity initiatives. First, the Federal Reserve has entered into foreign exchange swaps with the European Central Bank (ECB) and Swiss National Bank (SNB). These central banks disseminate the dollars obtained through these swaps in conjunction with our biweekly TAF auctions. Second, the Federal Reserve has conducted a series of 28-day term single-tranche open market repo operations. Theoretically, these term repos can provide funding against any open market operation eligible collateral—that is, Treasuries, Agencies, or Agency mortgage-backed securities. In practice, the single tranche operations are used predominately to finance Agency MBS debt because it is typically more expensive to finance than Treasury or Agency debt in the marketplace.

So how are these facilities supposed to work? What’s the theory? The notion is that the auction facilities should be the main means by which the Fed provides liquidity support to depository institutions and primary dealers. The PCF and PDCF are standby facilities designed to provide reassurance to market participants that sound depository institutions and primary dealers have access to backstop sources of liquidity. But the actual amount of funds advanced through these facilities is likely to be limited in most circumstances.

The Primary Dealer Credit Facility essentially puts the Federal Reserve in the position of tri-party repo investor of last resort. This helps to reassure the two triparty repo clearing banks and the triparty repo investors that the primary dealers will be able to obtain funding. This bolsters confidence in the triparty repo system and reduces the risk of the type of funding run that led to Bear Stearns’ illiquidity crisis.

The auction facilities have several advantages relative to the backstop facilities. First, they are dynamic—the results shift from auction to auction. The information obtained through the auction process facilitates price discovery and helps policymakers assess market conditions and sentiment. Second, the auctions appear to have less stigma than the backstop facilities. Stigma is the word used to describe the unwillingness to use a liquidity facility because of fears that such use could send an adverse signal about the health and viability of the borrower.

For the auction facilities, stigma is very low for several reasons. First, many participants participate in the auctions. This provides cover against the potential for an adverse signal from participation. Second, the auctions are conducted for settlement on a forward basis. For example, in the TAF auction, the bidding takes place on Monday and settlement on Thursday. This time lag makes it clear that participants are not bidding because they need immediate funds and are having serious liquidity problems.

So how have the facilities performed in practice? As designed, most of the dollars have been disbursed via the auction facilities, the FX swaps, and the single-tranche OMOs, rather than via the backstop facilities.

The results for the TAF auctions are shown in the next slide. As can be seen, the spread between the stop-out rate and the minimum bid rate has risen and fallen as term funding pressures have fluctuated over the past five months. Interestingly, the recent expansion of the size of the TAF program to $150 billion from $100 billion and expansion of the FX swaps program with the ECB and SNB has led to a sharp fall in the stop-out rate.

In comparing the results of the TAF auctions to the results of the ECB and SNB auctions, the bid-to-cover ratio in the TAF auction is currently somewhat lower than the bid-to-cover rations in the corresponding ECB and SNB auctions.

So have the TAF and TSLF auctions been helpful in improving market function? Although it is impossible to know what the counterfactual would have been without the auctions, most evidence suggests that the TAF and TSLF auctions have improved market function.

Although a recent study by John Taylor and John Williams found no statistical evidence that the TAF auctions have had an effect on term funding, its choices in terms of econometric design made it very difficult for this study to have found an impact. For example, the paper tests whether there was an impact on the spread only on the day of the auction, not before—with the announcement—or after, when the auction results are announced or when the auctions settle. Interestingly, minor changes in the specification used by Taylor-Williams produce statistically significant results with the expected sign, i.e., the TAF auctions reduced the spread.

They say that a picture is worth a thousand words. The next slide documents the Federal Reserve’s major initiatives over the past eight months relative to the LIBOR-OIS spread. Note that virtually all of the Federal Reserve initiatives aimed at improving market function have been associated with a decline in the LIBOR-OIS spread. Perhaps this just represents an announcement or placebo effect. More study is obviously needed. However, it is interesting that those market participants who are the patients have been clamoring for more medicine in the form of both an increase in the size of the TAF auctions and auctions with longer maturities.

Demand for Treasury collateral in the TSLF auctions has been less robust than demand in the TAF, as shown in the next slide. This may reflect several factors. Compared to other programs, the eligible collateral is narrower and the TSLF was scaled up to a large size—$175 billion was auctioned in the first four weeks of the program—much more quickly than the other programs. Alternatively, the less robust demand may be due to primary dealers’ ongoing deleveraging. Their needs for funding may be diminishing making it easier to meet their demands in the repo market.

In addition to providing liquidity to the primary dealers, the TSLF auctions have helped to generate a significant improvement in Treasury market function. As shown in the next slide, prior to the first TSLF auction, overnight Treasury repo rates were unusually low and the Treasury market was distorted by a growing number of security fails (i.e., dealers unable to deliver promised securities) and a large number of securities trading special (i.e., with a repo rate below the rate on general Treasury collateral).

It will take time for market function to return to normal. The reintermediation and deleveraging process has, in my view, a considerable ways to go. The Federal Reserve is committed to supplying liquidity to banks and primary dealers as needed to ensure an orderly adjustment.

The end of exceptionalism? IMF to examine US financial system

(Naked Capitalism) Der Spiegel, in "The Shrinking Influence of the US Federal Reserve," (hat tip reader Saboor) discusses how the US is submitting to a detailed, comprehensive investigation of it financial system under the Financial Sector Assessment Program.

While Der Spiegel claims that this program is a humiliation to the US, the real significance may be that this is another blow to American exceptionism. While the exam is far-reaching, which means intrusive, Canada, the UK, Italy, indeed 2/3 of the IMF members have participated in the program. However, the Bush Administration has resisted it strongly, and agreed only on the condition that it be completed after a new President is at the helm.

One has to wonder whether a president less dismissive of international organizations would have been this high-handed. The FSAP was created in 1999; it's unlikely its sponsors, the IMF and the World Bank, would have wanted to road test a new program on a large, complex financial system like America's. Thus it is unlikely any request would have been made under the Clinton Administration. However, there could well have been predecessor exams that went under different names, so this practice may be long-standing.

Similarly, a very quick check on Google raises some questions. Canada proudly announced in February 2008 that it was the first G-7 member to participate in the FSAP. Yet an FSAP report on the UK is dated 2003. Perhaps there are targeted and more comprehensive versions of the exam. If so, there may indeed be more to the politics of this than meets the eye.

From Der Spiegel:
No Fed chief in US history has been forced to submit to the kind of humiliation that Ben Bernanke is facing.
This is partly down to circumstances,,,

After years of growth, the United States is now on the brink of a recession, one that is more likely to be deepened than softened by a tight money policy...

Some of Bernanke's personal adversaries are also contributing significantly to his current humiliation. In the past, the chairman of the Federal Reserve was a pope among the priests of the financial elite. But unlike his predecessor Alan Greenspan, Bernanke is finding that his policies are not universally accepted, even within the Fed.

The last seven decisions reached by the Federal Open Market Committee, which sets monetary policy, were accompanied by a growing number of dissenting votes. Bernanke's critics say that with his policy of cheap money -- in other words, recurring rate reductions -- he in fact helped fuel the inflation problem he is now trying to combat....

Officials with the International Monetary Fund (IMF) have informed Bernanke about a plan that would have been unheard-of in the past: a general examination of the US financial system. The IMF's board of directors has ruled that a so-called Financial Sector Assessment Program (FSAP) is to be carried out in the United States. It is nothing less than an X-ray of the entire US financial system.

As part of the assessment, the Fed, the Securities and Exchange Commission (SEC), the major investment banks, mortgage banks and hedge funds will be asked to hand over confidential documents to the IMF team. They will be required to answer the questions they are asked during interviews. Their databases will be subjected to so-called stress tests -- worst-case scenarios designed to simulate the broader effects of failures of other major financial institutions or a continuing decline of the dollar.

Under its bylaws, the IMF is charged with the supervision of the international monetary system. Roughly two-thirds of IMF members -- but never the United States -- have already endured this painful procedure.

For seven years, US President George W. Bush refused to allow the IMF to conduct its assessment. Even now, he has only given the IMF board his consent under one important condition. The review can begin in Bush's last year in office, but it may not be completed until he has left the White House. This is bad news for the Fed chairman.

When the final report on the risks of the US financial system is released in 2010 -- and it is likely to cause a stir internationally -- only one of the people in positions of responsiblity today will still be in office: Ben Bernanke.

Will ratchet rights produce zombie banks?

(Naked Capitalism) If you think the headline above is overly dramatic, BreakingViews ($, free trial) sees the possible outcome of ratchet right provisions in bank capital infusions as a "death spiral".

This potentially ugly situation arises out of a nasty confluence of pragmatism, greed, and desperation. Anyone who invests in bank equity now has to be concerned that what looks cheap can still get cheaper. Viola! Ratchet rights!

Ratchet rights protect the investor in the event subsequent rounds of fundraising take place at a lower price. In the "full ratchet" version, the investor gets cash or shares to put his original investment on the same footing as the new money. The problem is that the repricing for the old money makes the new fundraising even more dilutive to the other shareholders.

Now consider how this plays out in our world of troubled banks. Because they need a great deal of money to shore up their balance sheets, executives are unable and unwilling to raise all the dough at once. "Unable" because the amount would be large in absolute numbers and would probably give a heart attack to existing equity owners; "unwilling" because dilutive equity raises hurt option-based management pay. The top brass has an incentive and a bias due to denial about how bad things could get to raise less and hope for the best.

But canny investors, who have a keen appreciation for the vagaries of fate, asked for full ratchet rights in some recent bank fundraisings. TPG has 18 month protection for its share of the $7 billion equity + converts investment in WaMu (the other institutional investors get nine months). National City had to give three years ratchet rights protection (cut to two in certain circumstances) on its $7 billion equity + converts deal. Merrill's sale of $6.6 billion in mandatory convertible preferred stock to certain foreign investors also has a full ratchet provision, but it is somewhat less onerous, since it does not come into play until the conversion date three years from issuance.

However, this clever device may not prove so advantageous. The presence of ratchet rights makes fundraisings at lower prices painful and thus discourages such activity. But as Thursday's stock market action attests, we aren't just in a deteriorating market for banks but for shares generally. More financial firm losses are almost certain to be in the offing, and with them, the need for more capital. Deals with ratchet rights can serve as an impediment to doing what is right for the business, even if it is unpleasant for shareholders. Trying to defer a needed fundraising runs risks on other fronts, particularly with rating agencies.

Funny, when I first wrote the headline, I typed "Ratched" as in Nurse Ratched. Wonder if my subconscious is on to something.

Credit Crisis: The 4th Wave?

(Calculated Risk) The TED spread is starting to rise again and is back above 1.0 for the first time since the beginning of May. Here is the TED Spread from Bloomberg. The spread is still far below the previous three waves, but well above the normal level (below 0.5).

And from the WSJ: European Bank-Lending Anxiety Returns

Tensions in Europe's short-term lending markets are on the rise again, repeating a pattern that central bankers had hoped to end by pumping in hundreds of billions of dollars in recent months.

The pressure partly reflects an end-of-quarter effect, as banks hoard cash to make sure their finances look healthy when they report second-quarter results.

But it also demonstrates that fears of further write-downs and possible failures aren't going away.
And from the Fed Commercial Paper report, the A2/P2 less AA spread has risen to 82 bps. Note: This is the spread between high and low quality 30 day nonfinancial commercial paper.

A2/P2 Non-Financial Spread

Perhaps it's a little premature to worry about a 4th wave, but these are worrisome signs.

Wednesday, June 25, 2008

Vital Part of Housing Bill Is Brainchild of Banks

(Washington Post) A key provision of the housing bill now awaiting action in the Senate -- and widely touted as offering a lifeline to distressed homeowners -- was initially suggested to Congress by lobbyists for major banks facing their own huge losses from the subprime mortgage crisis, according to congressional staff members and bank officials.

Credit Suisse, a large investment bank heavily invested in mortgage-backed securities, proposed allowing hundreds of thousands of homeowners to refinance their mortgages with lower-cost government-insured loans, relieving financial institutions of the troubled debt.

After the bank proposed this to Congress in January, it became known as the "Credit Suisse plan" among congressional staffers and lobbyists. It later formed the basis of housing provisions in both the House and Senate.

Bank of America, which is acquiring Countrywide Financial, the country's largest mortgage lender, followed with a similar and more detailed proposal, principal negotiators on the legislation said.

In approaching congressional aides, the lobbyists suggested that banks take less than full payment for the distressed loans on their books. But the measures would allow financial institutions to get cash out of foreclosed properties that would otherwise sit on their books as dead weight.

Since the new loans would be guaranteed by the Federal Housing Administration (FHA), taxpayers would ultimately pay for defaults. The Congressional Budget Office projected that this could cost $1.7 billon over five years.

During the first week of January, three officials from Credit Suisse -- two from Washington and one from the mortgage-trading desk in New York -- spent a day on Capitol Hill briefing the staffs of the committees that oversee housing. They gave a brief PowerPoint presentation to the House Financial Services Committee in the morning and to the Senate Banking Committee in the afternoon.

They remained in close touch afterward, especially with House Democratic aides. They also met with officials from the FHA. The bank lobbyists provided the FHA with statistics, run through their company's computers, about the potential impact of new rules.

Bank of America executives presented a 28-page "discussion document" on March 11 to the same congressional staffs, which was marked "confidential and proprietary." It was filled with detailed explanations of how a system similar to Credit Suisse's plan might work, complete with flow charts and graphs.

Afterward, congressional aides checked with Credit Suisse officials to hear what they thought about Bank of America's suggestions. They generally agreed with Bank of America's direction but thought such elaborate legislation was not needed, people familiar with the talks said.

"The first bank that I remember recommending something like this was Credit Suisse," said House Financial Services Committee Chairman Barney Frank (D-Mass.).

But Frank said the legislation was the result of many conversations with interested parties, including fair-housing advocates. Lawmakers and bank officials defend the provision as a balanced compromise, tempered by extensive input by government regulators, that gives homeowners a chance to stay in their homes while preventing the government from having to appropriate billions of dollars to buy nonperforming mortgages.

"The alternative to having the banks as participants was a massive federal bailout," Frank said. "They [the banks] benefit, but they benefit by losing less."

Still, critics expressed disappointment that banks were given such a large hand in writing legislation designed to ease a foreclosure problem they helped create.

"It is ironic that Congress, responding to a crisis that was created in large part by irresponsible lending, would produce a bill, the main beneficiaries of which are likely to be those lenders," said Dean Baker, co-director of the Center for Economic and Policy Research, a liberal research group. "There are aspects that work hugely to the banks' advantage."

Credit Suisse reported a $2.1 billion loss in the first quarter, one of its worst in years, because of a $5.3 billion write-down in mortgage-related assets and other loans. Bank of America reduced the value of its mortgage-related assets by $2 billion in the first quarter, on top of a $5.7 billion write-down in the last three months of 2007. Bank of America is also putting the finishing touches on its acquisition of Countrywide. Countrywide had $3 billion in losses in the first quarter alone and set aside $1.5 billion for bad loans and wrote down another $1.5 billion on souring loans.

The pursuit of legislation to help strapped homeowners began last year. Several scholars, from both the political left and right, recommended plans based on the Depression-era Home Owners' Loan Corp., which put the federal government in the business of providing mortgages. But that was eventually seen by lawmakers, including Frank and Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.), as too expensive a program to win congressional approval.

Then in December, Credit Suisse officials proposed a different approach to the White House's economic advisers, according to people familiar with the plan who spoke on condition of anonymity because their employers did not allow them to speak publicly. The bank recommended to the White House -- and soon after to congressional staffers -- the broad outlines of the provision now headed for passage in Congress.

The banks would have to accept a reduction in the value of the troubled loans while qualified borrowers could then get federally insured loans to replace their private ones. The homeowners would avoid foreclosure and pay less each month. The banks would get a payment rather than a potentially nonperforming asset. Mortgage holders typically lose about 40 percent of the value of their loans on foreclosed homes.

Congressional aides said they did not simply accept the banks' proposals. Rather, they said, they worked with others, especially financial regulators, to refine the package. The Federal Deposit Insurance Corp., for instance, urged that financial institutions accept a larger cut in the borrowers' principal than first proposed, and the House measure reflects this recommendation.

Congressional staffers said they also consulted with other banks, such as Citigroup, and industry groups such as the Securities Industry and Financial Markets Association. It also hashed out concepts with La Raza, the NAACP and low-income housing groups.

But Credit Suisse and Bank of America were instrumental throughout the process. "They helped us understand the notion of how many loans were going to default based on the coming waves of foreclosure," a House aide said. "They helped us dimension up the scope of the program."

Credit Suisse said it made its suggestions to improve the mortgage market. "We've participated in a series of conversations with government entities and offered a discreet regulatory solution to improve existing affordable mortgage programs," said Duncan King, spokesman for Credit Suisse. "We hope to improve existing affordable mortgage programs."

Bank of America said its participation came at the request of congressional aides. "They were reaching out to all sorts of people who have been thoughtful about this crisis," said Peter McKillop, a spokesman for Bank of America. "They were talking to us and talking to every bank that had a sophisticated mortgage business. We wanted to come up with a bipartisan solution that stabilizes the housing market."

"The benefit to the bank," he added, "would be having a more stable housing market."

Move to bring in greater ABS transparency

(FT) An initiative designed to provide more transparency in the opaque world of asset-backed securities - one of the markets most severely hit by the credit crunch - is to be launched in response to demands from regulators.

Markit, the data provider, and nine leading banks have joined forces in developing plans to give investors more information on how these highly complex products are priced and structured in the European market.

The European Commission warned bankers last month that these products faced a regulatory clampdown unless they provided greater clarity on the market, which froze in the wake of the credit squeeze last summer as investors shunned all types of complex security, regardless of the quality of the underlying collateral.

Only $36bn of ABS products - bonds backed by cash flows from assets such as mortgages, credit cards or car loans - have been issued this year compared with $315bn during the same period in 2007, according to Dealogic.

Ben Logan, managing director of structured finance at Markit, said: "We will provide investors with documentation on how the deals are structured, what collateral is backing the bonds and how they are performing.

"Knowing which assets are backing a deal is key for investors. The whole market has been tarred with the same brush, yet many bonds have good quality collateral backing them."

Markit is working with the banks to create a website, which will be up and running by September, that will consolidate prospectuses and investor reports for European asset-backed securities.

Markit said it hoped other banks will join BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, JPMorgan, Lehman Brothers, Morgan Stanley, Royal Bank of Scotland and UBS in developing the website.

The move follows a similar initiative launched this month by Lewtan Technologies, another data provider. Lewtan's web portal also covers mortgage-backed bonds and other ABS, giving access to original offering memoranda and the latest investor monitoring reports.

US benchmark confirms dollar Libor

(FT) A US benchmark launched two weeks ago to measure funding pressures in the American dollar markets has produced results similar to the pattern in the dollar Libor index calculated in London, bankers have said.

The borrowing rate reported in the new index, which is run by Icap and known as the New York Funding Rate, is now tracking the official Libor rate set by the British Bankers Association.

This development might remove some heat from allegations that the London dollar Libor index is a misleading guide because it is set outside the US markets.

If so, this is likely to be welcomed by US policymakers and bankers, many of whom had feared that Libor's loss of credibility was undermining investor confidence in the money markets more widely.

The BBA, which sets dollar Libor based on the average borrowing costs of 16 banks, fixes the rate in London before the US market opens and only uses three US-based banks. The BBA fixes Libor rates for 10 currencies, including the euro, sterling and the dollar.

The NYFR polls at least 16 New York banks after the US market opens. Some western policymakers and bankers believe that polling banks after the market opens is more appropriate, given the scale of US contracts now linked to Libor.

Since NYFR started life on June 11 it has fixed at similar levels to dollar Libor.
Icap's three-month NYFR, for example, yesterday was fixed at 2.7992 per cent compared with a three-month dollar Libor rate of 2.8043 per cent.

One-month NYFR set at 2.4962 per cent compared with a one-month dollar Libor rate of 2.4825 per cent.
Some bankers think the levels of one-month and three-month Libor compared with overnight rates set by the US, UK and European banks since the credit squeeze reflect tougher financial conditions.

Laurence Mutkin, head of European interest rates strategy at Morgan Stanley, said: "Bank funding costs or Libor rates are higher because the way banks are now rationing their balance sheets means they are putting up the price of borrowing. You can see that in the wider economy with higher lending rates. In that situation, it would be surprising if Libor didn't go up."

Willem Sels, head of credit strategy at Dresdner Kleinwort, said: "On the interbank rate issue, you need to bring back confidence to the market that these rates are reflecting funding costs, so having another fixing in New York, which is using US-based banks, may help to do that."

The rising controversy about the dollar Libor index has been closely watched by central bankers, not least because some officials fear that the debate could be contributing to a broader sense of investor unease in the money markets.

The problem has been exacerbated because it has become clear that a far larger proportion of the market in the US is tied to the Libor index than many observers had previously realised.

Libor is used by about $350,000bn of financial products, the most widely used interest rate benchmark.

Tuesday, June 24, 2008

Moody's: Recovery on Defaulted U.S. Corporate Debt Likely Below Historical Average

(Moodys) Holders of bank loans and bonds from US corporate issuers in default can expect to recover less of their investment than in past years, says Moody's Investors Service.

The ratings agency attributes the lower expected recovery rate to the increase in issuance of secured bank loans over the past several years, which has created top-heavy capital structures for many spec-grade issuers.

"The substantial increase in bank loans' average share of total debt will reduce average recoveries for both loans and bonds," says Moody's Director of Corporate Default Research Kenneth Emery. "Loans have less junior debt below them which will serve as a drag on recovery rates, while bond recovery rates will suffer from being in a more subordinated position relative to loans."

Moody's recovery outlook is based on its Loss Given Default (LGD) assessments, which it has published for non-financial speculative-grade corporate issues since 2006.

The LGD assessments signal that the average expected ultimate recovery rate on US 1st lien senior secured bank loans is 68%, which compares with an actual historical average recovery rate of 87%, says Moody's.

Moody's expects recovery rates on US 2nd lien loans to be only 21%, compared to the historical average of 61%. Most of these loans have been made to 'loan only' issuers with only bank debt—no bonds—so that they sit at the bottom of the capital structure.

For senior unsecured bonds of US speculative-grade issuers, Moody's expects an average ultimate recovery rate of 32%, which is below its historical average of 40%. Subordinated bonds are expected to recover 18%, which is also below their 28% historical average.

The number of speculative-grade issuers relying solely on bank loans has risen from about 10% of all speculative-grade U.S. issuers in 2004 to 34% today. Of speculative grade issuers with bank loans, nearly 60% are loan-only issuers, compared to under 30% in 2004.

"The rapid growth of issuers having only rated loans, without any bonds outstanding, has played a substantial role in increasing loans' share of total debt across rated issuers," says Emery. "It will reduce recovery rates on both bank loans and bonds."

Moody's LGD assessments are calibrated to a large extent on the experience of the 1990-91 and 2001-02 recessions, and therefore already largely incorporate downturn economic conditions, says Emery. However, if the US economy were to experience a recession that was more severe than the past two US recessions, debt recovery rates could be even lower than currently given by Moody's LGD assessments.

The upside risk to the outlook is if creditors are able to minimize declines in issuers' enterprise values at the time of default resolution by, for example, forcing distressed issuers into bankruptcy at a relatively early stage of distress. While large loan shares imply that loan holders have an incentive to be more vigilant in maintaining issuers' enterprise values, weak or no loan maintenance covenants will likely prevent such an outcome, says Moody's.

The full title of this Moody's Special Comment is "Strong Loan Issuance in Recent Years Signals Low Recovery Prospects for Loans and Bonds of Defaulted U.S. Corporate Issuers."