Thursday, July 31, 2008

Moody's supplemental risk measures begin with U.S. vehicle ABS

New York, July 23, 2008 -- Moody's Investors Service today published a report that shows how its new supplemental risk measures for structured finance transactions will work in practice within the U.S. vehicle asset-backed securities (ABS) sector.

The report, "Assumption Volatility Scores and Loss Sensitivities in the U.S. ABS Vehicle Sector", details the assignment of Assumption Volatility ("V") Scores and Loss Sensitivities to prototypical transactions in each vehicle ABS sub-sector, illustrating the new forms of risk measurement introduced by Moody's in May.

"These measures provide greater insight on potential factors that could lead to ratings volatility and the potential impact of changes in assumptions," says Moody's Managing Director Warren Kornfeld.

Moody's found that V Scores ranged from Low for prime auto loans to Medium for subprime auto loans, rental cars, dealer floorplan loans, and auto leases. Loss Sensitivities for the senior Aaa-rated tranches ranged from two to four notches; the Loss Sensitivities for subordinated tranches rated Aa and lower ranged from six to 11 notches.

Moody's will begin reporting transaction-specific V Scores and Loss Sensitivities in pre-sale reports, new issue reports and press releases for all new transactions in the U.S. vehicle ABS sector marketed on or after July 28, 2008. Moody's will also begin the process of rolling out similar reporting for new transactions in other global structured finance sectors over the remainder of 2008, following the publication of similar sector reports for each new asset class.

In May, Moody's proposed the two additional risk measures to enhance the transparency and information content of its structured finance ratings. Over the last two months Moody's reached out to market participants and incorporated feedback received in the development and application of the newly introduced risk measures.

"Market participants have responded quite favorably to the utility of these new measures and the greater transparency into our ratings that they provide," Kornfeld added. "We look forward to further market input as we continue to roll out, adjust and finalize our approach to these measures for the other structured finance asset classes globally."

Moody's V Scores measure a transaction's exposure to factors that contribute to uncertainty in estimating credit risk and could give rise to ratings volatility. V Scores rank transactions on a five point scale by the potential for significant rating changes owing to uncertainty around the assumptions and the related modeling that underlie the ratings.

Moody's Loss Sensitivities measure the number of notches that the rating on a Moody's-rated structured finance security would likely move downward if the loss expectations assumed for the transaction's underlying collateral pool were presumed to be substantially higher at issuance than those actually used to rate the transaction.

The new Moody's report is called "Assumption Volatility Scores and Loss Sensitivities in the U.S. ABS Vehicle Sector. The May 13th report that introduced the new risk measures is called "Introducing Assumption Volatility Scores and Loss Sensitivities for Structured Finance Securities." Both reports are available on

Joint Forum: Credit risk transfer - developments from 2005 to 2007

In March 2007 the Financial Stability Forum (FSF) asked that the Joint Forum consider the extent to which its March 2005 report Credit Risk Transfer (CRT) required updating as a result of the continued growth and rapid innovation in the CRT markets. The market turmoil since the summer of 2007 led to a desire for the Joint Forum to be able to report quickly and present a brief paper at the March 2008 meeting of the FSF. Accordingly the Joint Forum sought to keep the scope of its work focused on what is achievable in that time scale, yet provide as much useful information as possible.

The main findings of the paper are summarised as follows:

    • Some of the more complex CRT instruments developed since 2004 are associated with increased leverage and - in the case of certain tranches of structured finance products - a high variance of loss or high vulnerability to the business cycle. This increased complexity, combined with a more diffuse investor base (including participants that are only recent entrants to the CRT markets), means that some investors may not fully appreciate the higher-risk nature of these products.
    • A failure to understand some of these risks contributed to the market turmoil of 2007. A few fundamental tenets of sound financial judgment appear to have been violated. The originate-to-distribute model created incentives that resulted, in some cases, in weak origination standards for products such as subprime mortgages. Some investors placed excessive reliance on credit rating agency ratings, doing minimal or no in-house due diligence on the CRT products employed. Firms also appear to have had few, if any, risk management processes in place to address risk exposures associated with off-balance sheet entities such as structured investment vehicles (SIVs).
    • Despite these shortcomings, the structured credit market is likely to survive, but will remain weak for a period of time. Market participants thought that "one-layer" CRT products, such as CLOs or corporate CDOs, make economic sense and will continue. Their assessment of the prospects for "multi-layer" securitizations was less optimistic, and a common view was that the market for ABS CDOs would either shrink dramatically or disappear.
    • Supervisors remain concerned about several aspects of the CRT market: its complexity; valuation issues; liquidity, operational and reputational risks; and the broader effects of the growth of CRT. Supervisors believe that market participants must better understand the structure and risks of the CRT products in which they invest, as well as how the rating agencies assign ratings to specific instruments and what circumstances would lead them to downgrade ratings.
    • With continued innovation in the CRT markets, the effort and resources that firms and regulators will need to expend to properly understand these instruments increases significantly. Any future "misunderstandings" of risks involving CRT instruments will probably involve a new and different flavour of products and may be no more likely to be detected in advance, with the current level of supervisory resources. Nonetheless, there are steps that the industry and regulatory community can take to enhance the robustness of their risk management and oversight of these products, which are described in Section 10 of this paper.

Full text:

Expanded Industry Commitments on OTC Derivatives (NY Fed)

The Federal Reserve Bank of New York welcomes the steps announced today by major market participants to enhance efforts to improve over-the-counter (OTC) derivatives processing. These steps represent the most comprehensive efforts to date by major dealers and buy-side firms to improve the resiliency of the OTC derivatives market. Pursuant to the March 13, 2008 policy statement of the President’s Working Group on Financial Markets, market participants are expanding the scope of their efforts from OTC credit and equity derivatives to include OTC interest rate, commodities and foreign exchange derivatives.

“These improvements to the derivatives infrastructure are important to strengthen the resiliency of the financial system.” said Timothy F. Geithner, New York Fed President.

The attached letter sets trade date matching as a key element to achieving the long-term objective of an OTC derivatives processing environment that handles growing trade volumes without material systemic risk. Market participants have also agreed to several interim steps as they further refine their long-term strategy. Of particular importance are:

    • Increasing the timeliness and accuracy of immediate post-trade processing of credit derivatives beyond the target levels set in March 2008. This will ensure market participants improve operations in the short-term while they continue to develop the long-term solution;
    • Developing a robust central clearing infrastructure for OTC credit derivatives with the objective to launch index products in 2008. This will help reduce systemic risk associated with counterparty credit exposure and improve how the failure of a major participant would be addressed;
    • Reducing the number of outstanding credit derivatives trades through multilateral trade terminations. These terminations will lower the trade count and notional amounts outstanding and reduce counterparty credit exposures and operational risk;
    • Incorporating an auction-based settlement mechanism into standard credit derivatives documentation by the end of 2008 to increase the certainty of a transparent and orderly settlement process following a credit event;
    • Processing 75 percent of eligible OTC equity and interest rate derivatives trades on electronic platforms by January 31, 2009, furthering automation as participants in these markets move toward the long-term objective of matching on trade date; and
    • Improving collateral management practices, including conducting weekly portfolio reconciliations by the end of 2008 ensuring that market participants have accurate and up-to-date trade information vis-à-vis their counterparties.

In addition, market participants outlined plans to standardize documentation and automation of commodity derivatives trades, and committed to submit regular foreign exchange operating data to regulators. Participants also agreed to provide detailed plans for achieving long-term processing goals in each OTC derivatives asset class by October 31, 2008.

Market participants are also executing an implementation plan for the buy-side community. The attached plan, submitted to regulators in June, represents a significant effort to educate buy-side firms about efforts to improve the OTC derivatives infrastructure.

Because of the scope of these efforts, a summary document of the new and continuing commitments can be found here: Summary of OTC Derivatives Commitments .

The New York Fed will continue to work with domestic and international industry supervisors to monitor progress and encourage further efforts to improve the OTC derivatives infrastructure.

Participants' July 31 Letter
Participants' July 31 Letter Supplement
Implementation Plan
Summary of OTC Derivatives Commitments

European Commission Consultation on Rating Agencies

The European Commission has published two consultation documents on CRAs seeking views from all interested parties by 5th September. The first document relates to the conditions for the authorisation, operation and supervision of credit rating agencies. The second proposes policy options in order to tackle what is felt to be an excessive reliance on ratings in EU legislation.

Commissioner McCreevy declared: "I have been listening to many advisory bodies to the Commission and watching developments in the industry and in other jurisdictions for the last year. I am convinced, like others in Europe of the need to legislate in this area at EU level. CRAs will have to comply with exacting regulatory requirements to make sure ratings are not tainted by the conflicts of interest inherent to the ratings business. The crisis has shown that self-regulation has not worked. I am also convinced that excessive reliance on ratings in EU legislation might have discouraged banks and other financial institutions from exercising their own due diligence. They should not be encouraged by law to rely solely on ratings for their risk assessment processes. I intend to present my proposals to the Commission for adoption this autumn and I look forward to receiving the views of all interested parties".

It is generally accepted that CRAs underestimated the credit risk of structured credit products and failed to reflect early enough in their ratings the worsening of market conditions thereby sharing a large responsibility for the current market turmoil. The current crisis has shown that the existing framework for the operation of CRAs in the EU (mostly based on the IOSCO Code of Conduct for CRAs) needs to be significantly reinforced. The move to legislate in this area was recently welcomed by the Ecofin Council at its meeting in July. The documents published today aim at ensuring the highest professional standards for rating activities. They do not intend to interfere with rating methodologies or rating decisions which will remain the sole competence and responsibility of CRAs. The envisaged proposals also take account of existing standards and developments at international level. The US has had rules on CRAs since the mid-seventies and is at present also considering changes to its rules.

The consultation paper suggests the adoption of a set of rules introducing a number of substantive requirements that CRAs will need to respect for the authorisation and exercise of their rating activity in the EU. The main objective of the Commission proposal is to ensure that ratings are reliable and accurate pieces of information for investors. CRAs will be obliged to deal with conflicts of interest, have sound rating methodologies and increase the transparency of their rating activities.

The consultation document also proposes two options for an efficient EU oversight of CRAs: The first option is based on a reinforced co-ordination role for the Committee of European Securities Regulators (CESR) and strong regulatory co-operation between national regulators. The second option would combine the establishment of a European Agency (either CESR or a new agency) for the EU-wide registration of CRAs and the reliance on national regulators for the supervision of CRA activities.

The consultation document on reliance on ratings identifies the references made to ratings in existing EU legislation and looks at possible approaches to the issue of excessive reliance on ratings.

The documents are open for consultation until 5th September. This short consultation period is justified by the need to issue a proposal in the autumn to allow the Council of Ministers and the Parliament to agree before the next European Parliament elections in June 2009.

For more information :

Freddie Mac Pushes Out Foreclosure Timelines

(Housing Wire) Pressure to raise servicer spreads may have just gotten a little more intense on Thursday, with Freddie Mac (FRE: 8.17 -6.41%) announcing a huge, mixed bag of changes to its servicing guidelines — including doubling the amount of money it pays for each workout alternative, and lengthening foreclosure timelines in key states. The GSE also said it would start reimbursing servicers for the cost of door-to-door outreach programs, and make administrative changes intended to streamline the workout process.

“We are taking these steps because we want to reinforce the tremendous importance of workouts and reward their use,” said Freddie Mac vice president of servicing and asset management Ingrid Beckles.

“Giving our servicers more time and greater compensation to help troubled borrowers is fundamental to preserving homeownership and maximizing our efforts to minimize foreclosures.”

Tweaking timelines
Foreclosure timelines have been the lifeblood of the servicing industry for decades; and, while many borrowers may have been unaware of it, servicers have long been compensated by the GSE for their annual performance relative to timelines.

But no more. Perhaps the boldest move by Freddie Mac on Thursday — and one that won’t get much press attention — was its decision to eliminate foreclosure timeline compensation altogether for servicers, effective immediately. In other words, servicers will no longer earn a bonus based on how quickly they can foreclose.

If that doesn’t scream “modify more loans,” then the GSE’s decision to double compensation for servicers in completing workouts certainly will. Freddie said it will now pay servicers $800 for a loan modification, $2,200 for a short payoff or make-whole preforeclosure sale, and $500 per repayment plan. Deeds-in-lieu of foreclosure didn’t get Freddie’s same endorsement, however, and will remain at the current incentive level of $250, the GSE said.

The decision to eliminate timeline compensation, however, was only part of a much broader program change rolled out by Freddie; the mortgage finance giant also said that it was increasing its allowable foreclosure timeline in 21 states to a whopping 300 days from last of date payment, and 150 days from initiation of foreclosure, effective on Friday.

Included in the list of 21? California, the epicenter of the nation’s foreclosure mess, of course.

For servicers, news of increased workout incentives came as welcome news; extension of foreclosure timelines, however, did not. The reason? Longer foreclosure timelines mean increased servicer advances, and given that most servicers are operating on 25 to 50 basis points in a servicing fee, pushing out reimbursement timelines means that servicers will feel the squeeze.

A review of the servicer bulletin by HW found that no mention of changes to servicer reimbursement policies accompanied the change in timelines.

The GSE also revised its loan modification guidelines, eliminating a prior requirement that a mortgage must not have been previously modified; the idea here is to allow servicers the ability to re-modify a previously modified loan, and signals capitulation on data showing that many previous loan modifications aren’t sticking.

Freddie Mac also said it will temporarily reimburse the cost of leaving a door hanger up to $15 per mortgage, and up to $50 per mortgage for a door knocking that results in the borrower contacting their servicer — certainly good news for companies like Titanium Solutions and the servicers that use firms like them. Freddie will also reimburse servicers up to $200 for additional fees paid to vendors for door knocking if the contact made leads to a workout, the GSE said.

Related links: full servicer bulletin

Wednesday, July 30, 2008

Housing Bill: Change to Home Sale Tax Exclusion Rule

(Calculated Risk) A little mentioned provision in the Housing and Economic Recovery Act of 2008 amends the Home Sale Exclusion Rules.

I've copied the main portion of the provision at the bottom.

This applies to homeowners that move into a nonqualifed residence (that they already own) like a vacation home or rental unit. Here was the old rule from the IRS:

To exclude gain, a taxpayer must both own and use the home as a principal residence for two of the five years before the sale. The ownership and use periods need not be concurrent.
Under the new rule, the owner only gets a percentage of the exclusion based on a ratio of how long the property is their primary residence divided by how long they owned the property. This prevents people from moving into vacation homes or rental units for two years and then obtaining the entire exclusion. Here is an excerpt (see the bill for the entire text):
(a) IN GENERAL.—Subsection (b) of section 121 of the Internal Revenue Code of 1986 (relating to limitations) is amended by adding at the end the following new paragraph:

(A) IN GENERAL.—Subsection (a) shall not apply to so much of the gain from the sale or exchange of property as is allocated to periods of nonqualified use.
(B) GAIN ALLOCATED TO PERIODS OF NONQUALIFIED USE.—For purposes of subparagraph (A), gain shall be allocated to periods of nonqualified use based on the ratio which—
(i) the aggregate periods of nonqualified use during the period such property was owned by the taxpayer, bears to
(ii) the period such property was owned by the taxpayer.
For purposes of this paragraph
(i) IN GENERAL.—The term ‘period of nonqualified use’ means any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.
EFFECTIVE DATE.—The amendment made by this section shall apply to sales and exchanges after December 31, 2008.
Just another interesting provision.

TriOptima announces that tear-ups total nearly $18 trillion this year

(CreditFlux) TriOptima announced that its portfolio compression service, triReduce, has so far terminated $17.8 trillion notional in credit default swaps this year. It says this represents more than 50% of the $32 trillion total interdealer CDS notional principal outstandings as reported by the BIS for year end 2007.

TriOptima's press release:
TriOptima announced today that since the inauguration of its credit default swap portfolio compression service triReduce in 2005, it has reduced the notional principal outstandings of credit default swaps by 32 trillion USD versus a total outstanding of 62 trillion USD. Through portfolio compression cycles, TriOptima has achieved elimination ratios of 95% in credit index portfolios and 72% of credit single-name portfolios.

TriOptima's CEO Brian Meese commented, "TriOptima introduced portfolio compression to the market in 2003, expanding into CDS and other products in 2005. Today the 25 most active dealers all use TriOptima’s portfolio compression services. We are pleased with the industry’s response to our initiative, and we support the efforts of the industry to expand the process. Of the 32 trillion USD TriOptima has eliminated, 16 trillion USD have been removed in the first six months of 2008 alone, showing a significant increase in focus by the industry on this process as a way of addressing regulators’ concerns. We believe that terminating over 50% of total outstanding is an excellent start, and we look forward to working closely with our clients and all participants in the market to achieve further success."

TriOptima will be running 20 regularly scheduled compression cycles in both single-name and index credit derivatives during the second half of 2008.

The Bank for International Settlements (BIS) recognized TriOptima's achievements in its December 2007 Triennial Report. TriOptima has also won several awards for its innovative service, including Risk Magazine 2006 Technology Platform of the Year, labeling triReduce a "godsend" for the credit derivatives market, and the Risk Magazine Industry Trade Processing Platform Award in 2007

Rethinking Merrill's Purge Cycle

(Housing Wire) Maybe the good news on Merrill Lynch & Co. (MER: 26.22 -0.11%) yesterday wasn’t really all that good, after all.

That’s the consensus that seems to be creeping into the Street’s collective psyche Wednesday morning, as analysts scrutinize the details of the deal to sell $30.6 billion in gross notational amount of ABS CDOs to an affiliate of Lone Star Funds. Merrill suggested in its press statement that it sold the securities for roughly 22 cents on the dollar, a figure that major financial press immediately hooked onto as establishing a price point in the battered secondary market.

That figure, however, has quickly come under fire, as details of the sale have been digested by market participants.
In particular, the fact that 75 percent of the deal is financed by Merrill itself meaning Merrill only received $1.7 billion in cash for the deal had more than a few market pundits, including the Financial Times’ Lex, suggesting that the implied sale price was actually much lower.

“In putting up three-quarters of Lone Star’s funding, secured only on the assets it is shedding, Merrill gets about $1.7bn in cash, and effectively swaps $5bn of direct exposure to CDOs for credit exposure to the buyer,” according to the Lex column. “A fall of 25 per cent could see this risk return to Merrill, hardly a comfort when the assets have apparently dropped 40 per cent since the end of June.”

For the record, a 25 percent drop translates into a drop of just another 5 cents or so.
Analysts at Bank of America reversed course Wednesday morning after calling the deal “the endgame” for CDO risk on Tuesday; Bloomberg News reported that the same BofA analysts said they had originally “overstated the positive implications” of the CDO deal.

“Merrill must be hurting worse than we thought,” one analyst told HW via email yesterday afternoon.
Citi’s woes, speculation grows
All of the analysis over Merrill’s deal is proving to be rather problematic for firms like Citigroup Inc. (C: 18.57 +0.65%), which holds a lot of these sort of securities none of which are really marked anywhere close to the implied value here of 5.5 cents. Or even 22 cents, for that matter.

Mike Mayo, an analyst at Deutche Bank, was among the first to sharpen his pencil and said Tuesday that Citigroup could face a write-down of $8 billion on its ABS CDO portfolio, cutting his earnings estimates for the bank, as a result. Mayo suggested that Citigroup has its CDOs valued at 53 cents on the dollar in his report.

William Tanona at Goldman Sachs & Co. (GS: 183.19 +0.86%) went even further, suggesting a $16 billion write-down.
Rating agency DBRS downgraded long-term ratings for Merrill, suggesting that the deal limited Merrill’s future prospects for capital.

“While successful in lowering the company’s risk profile, this combination of actions continues to draw down the company’s potential resources,” the agency said in a press statement.

And, of course, there’s the not-so-little issue of Merrill CEO John Thain’s credibility on Wall Street and among investors or, more appropriately, what’s left of it. The fact that Thain had so recently said fresh capital wouldn’t be needed, and that the company recently reported earnings on July 17 without so much as a peep about the asset sale or its terms, left more than a few market commentators and HW sources either scratching their heads, or incensed.

“Existing shareholders have been diluted 38 percent by this,” said one source, who asked not to be named. “And that’s after Thain swore up and down no more capital would be needed.”

There are those that have said the market’s malaise is as much about investor sentiment as it is about market fundamentals. If true, it’s clear that Merrill Lynch did little yesterday to clear up the picture on either front.

And from Felix Salmon's blog... The most important and most ignored sentence in Merrill's press release: "The sale will reduce Merrill Lynch's risk-weighted assets by approximately $29 billion."

How is this possible? After all, last month the CDOs being sold were valued at $11.1 billion, and indeed "Merrill Lynch's aggregate U.S. super senior ABS CDO long exposure" has been reduced by precisely that amount.

A CDO is not, in itself, a leveraged instrument: you can't lose more than you invested in it. If you're carrying a CDO on your books at $11.1 billion, there's no way that CDO can be responsible for $29 billion in losses, since its value can't fall below zero.

But there's more: since Merrill is lending Lone Star $5 billion to buy the CDOs, and the loan is non-recourse to Lone Star itself, the maximum that Lone Star can lose is its equity investment of $1.7 billion. If the CDOs went to zero tomorrow, then Merrill would suffer a further $5 billion of losses, and that contingent exposure should appear on the bank's balance sheet somewhere, as the risk associated with the loan to Loan Star.

Maybe that's where the $29 billion number comes from? Up until the sale, Merrill owned the CDOs outright, and if the CDOs all performed then those assets would have more or less their face value of $30.6 billion. Merrill took mark-to-model losses of $19.5 billion on those assets, but it still owned them, and kept them on its balance sheet under risk-weighted assets, valued at face.

Now, however, the CDOs have now been moved off Merrill's balance sheet, and Lone Star gets all of the upside (minus the interest it's paying on its $5 billion loan, of course). The $1.6 billion difference between $30.6 billion and $29 billion would then be Merrill's risk-weighted exposure to the final $5 billion of possible losses: after all, the $5 billion loan to Lone Star is surely now a Merrill Lynch risk-weighted asset of some description.

Let's say that Merrill considered the CDOs to be $30.6 billion of risk-weighted assets before the sale, and $0 afterwards. Then risk-weighted assets will have fallen from $30.6 billion in CDOs, to $5 billion in loans to Lone Star: a drop of $25.6 billion, not $29 billion.

So the only way I can see that Merrill could have got to $29 billion would be by risk-weighting the loan to Lone Star at just 32%: the $5 billion loan, once risk-weighted, would be counted as entailing risk of just $1.6 billion.

But even that doesn't make sense. Before the sale, Merrill would have been counting 100% of the CDO assets as risk assets; after the sale, Merrill would be determining that $3.4 billion of the assets are essentially risk-free. It seems to me there's some kind of weird remarking going on; if anybody could help me out, I'd be much obliged.

Oh, and one other thing from the press release: there was some commentary yesterday saying that the sold-off CDOs were mostly of 2005-and-older vintage. That's not true: it's Merrill's remaining $8.8 billion of CDO exposure which is the older stuff.

Comment from "JCK": the super senior abs cdo were downgraded and so were the insurers/monolines/hedges counterparties, this means under basel II ( the IBs are subject to basel II) they have to risk-weight to 100% of notional value hence they had a charge of $30.7bn to carry that stuff.

After the sale they have a simple loan to loan star credit enhanced by an equity tranche, that cuts the risk-weight assets by $29bn since ML no longer carries any risk for the super senior. the deal is very clever if i interpret it correctly [ not guaranteed...

I suspect they sold mostly post june 2005 mezz abs cdo, these have high attachment points in the 30s. suppose it is 30, then lone star equity attach at 85 and the merril loan attach around 88.5, the portion 30 to 85 having been written down by ML. This means that 85% of the cdo has to be wiped out by credit losses [ as opposed to mtm losses] before touching the lone star attachment point. If it doesn't happen I believe but am not sure that ML can recover some of the writedowns.

In any case this is no way near as bad as some of the permabears would have us believe. it's just catching up with reality.

What is the Fed's new TOP facility?

The FOMC has authorized the Federal Reserve Bank of New York to auction options for primary dealers to borrow Treasury securities from the TSLF. The Federal Reserve intends to offer such options for exercise in advance of periods that are typically characterized by elevated stress in financial markets, such as quarter ends. Under the options program, up to $50 billion of draws on the TSLF using options may be outstanding at any time. This amount is in addition to the $200 billion of Treasury securities that may be offered through the regular TSLF auctions. Draws on the TSLF through exercise of these options may be collateralized by the full range of TSLF Schedule 2 collateral. (Schedule 2 collateral includes Treasury securities, federal agency debt securities, mortgage-backed securities issued or guaranteed by federal agencies, and AAA/Aaa-rated private-label residential mortgage-backed, commercial mortgage-backed, and asset-backed securities.) Additional details of this program will be announced once consultations with the primary dealer community have been completed.

Here's and excerpt from their FAQ (“TOP”: Term Securities Lending Facility Options Program)

What is TOP?
TOP offers options on a short-term fixed rate Term Securities Lending Facility (“TSLF”) bond-for-bond loan of general Treasury collateral against a pledge of eligible collateral. The term of the loan typically spans a short period of traditional collateral market dislocation, such as a quarter-end dates. While the price of the loan is fixed, the price of the option is determined by competitive bidding.

What is the purpose of TOP?
TOP is intended to enhance the effectiveness of TSLF by offering added liquidity over periods of heightened collateral market pressures, such as quarter-end dates.

How is TOP related to TSLF auctions?
TOP offers options on short-term TSLF loans at a future date. Option holders have the opportunity to exercise the option and borrow up to the amount awarded in the TOP auction at a fixed rate or allow the option to expire without a claim. Loans made through TOP are shorter in term than the 28-day TSLF loans. In most cases, the term and settlement of the loan will not coincide with regularly-scheduled TSLF auctions.

What is the typical length of a TOP-related loan?
TOP-related loans are shorter than TSLF loans, with terms of two weeks or less. They are targeted to span potentially stressed financing dates.

FASB's new QSPE rule implementation delayed

( The quest to "kill the Q," or qualified special purpose entities, by amending accounting rules is still on track to happen. But banks and other companies won't have to consolidate the assets held in their QSPEs until 2010, a year later than originally expected.

On Wednesday, the Financial Accounting Standards Board said its upcoming exposure drafts on revisions to two securitization-related rules — FAS 140 and FIN 46(R) — will likely propose an effective date of November 15, 2009. FAS 140 is the accounting rule that specifies the conditions for keeping securitized assets off the balance sheet, while FAS 46(R) focuses on when a company should consolidate variable interest entities (known as either VIEs or SPEs.)

Originally, FASB looked to stagger the deadlines, forcing companies to comply with a revised FAS 140 by the end of 2008, and an updated FIN 46(R) by the 2009 date. But board members agreed that with an exposure draft likely to be out in August, followed by a 60-day public comment period, the accelerated deadline would be impractical from a compliance perspective.

However, banks shouldn't really count the delay as a win, at least not yet. For one thing, the proposed changes to FIN 46(R) will probably force banks and other companies to bring billions of dollars worth of assets back on their balance sheets. What's more, FASB's vote to delay the deadline was quickly followed by another vote to improve disclosures around securitization transactions.

The new disclosure rules, which will be included in the upcoming exposure drafts, will likely go into effect in January 2009. The draft rules call for information about the nature, purpose, and activities of VIEs — including how the entity is financed, as well as the terms of arrangement that could require the company to provide financial support to the VIE — such as liquidity commitments and obligations to purchase assets. The comment period for the disclosure rules will be 30 days.

SPEs have a checkered past, mainly because they were the structures used by Enron's Andrew Fastow to hide massive losses before the energy company collapsed in 2001. Since then, FASB beefed up its SPE rules, adding the QSPE to the accounting literature. Indeed, for an SPE to "qualify" as one that can stay off a company's books, U.S. accounting rules require that its activities be strictly limited to passively receiving and disbursing securitized funds. But when the subprime crisis hit, banks — with the blessing of regulators — took a more active role in QSPEs.

Specifically, banks invaded the trusts to rework subprime mortgages that were in danger of default, essentially violating current accounting rules. FASB's response was to rewrite FAS 140 to eliminate QSPEs, since the structure could not withstand a credit meltdown the size of the current crisis. "I think [QSPEs] were tolerable until recently," opined FASB chairman Robert Herz in April. He continued that once subprime mortgages were put into QSPEs, they were, "and I'll use the pejorative term, ticking time bombs ... and the bombs started to explode."

FASB members said today that some constituents — particularly financial-statement preparers — complained that the accelerated deadline was unrealistic because it did not allow time for implementation. Banking regulators chimed in that the end-of-year deadline would not leave them enough time to factor in new regulatory capital requirements under the updated accounting rules.

Regulators require banks to hold a certain amount of capital in reserve to protect investors, with the amount based on the assets carried on a bank's balance sheet. The update to FIN 46(R) will likely cause banks to bring billions of dollars of securitized assets back on the balance sheet, thereby triggering new capital requirements.

Further, earlier this month, two trade groups — The American Securitization Forum and the Securities Industry and Financial Markets Association — argued in a letter to FASB that the proposed changes to FIN 46(R) would "swell the balance sheets" of affected companies with losses and shatter loan covenants. The letter also claimed that FASB's "fast-tracked deliberation on Statement 140 and Interpretation 46(R)" will bring sweeping changes to securitization accounting. Most notably, financial services companies, including the troubled mortgage lenders Fannie Mae and Freddie Mac, may be forced to consolidate the results of some or all of their SPEs.

But FASB members were loud and clear about why they agreed to push back the deadline. It was done in response to "practical realities," asserted Thomas Linsmeier. He emphasized that he would have no sympathy for comment letters whose sole purpose was to delay the effective date further.

For his part, Herz said it was clear that the notion of a QSPE was "stretched" during the subprime crisis, and that type of misuse was disappointing because "the system can do better."

Despite voting in favor of the delay and saying that the time issue was a valid consideration, the FASB chairman was not happy about the deferral. "It does pain me to allow something that has been abused by certain folks to go along for another year," said Herz. "Concentration of risk [in QSPEs] was not made clear .... People viewed those risks as remote and immaterial, and they were not."

S&P Revises Most U.S. RMBS Loss Assumptions, Again

(Housing Wire) Never has a “we told you so” felt less fulfilling. Starting in May, we began suggesting that Standard & Poor’s Ratings Services’ estimates of loss severity were looking too conservative relative to observed loss levels; it was a stance we reiterated in mid-June, as well.

On Wednesday, the rating agency capitulated, saying it had modified both its method for projecting lifetime losses and its loss severity assumptions for U.S. subprime, prime jumbo, and Alt-A RMBS transactions.

“Earlier this month, we affirmed our loss assumptions for the U.S. RMBS 2006 vintage, and we projected that house prices would decline an additional 10% by June 2009,” said Standard & Poor’s credit analyst Frank Parisi.

“Now, however, we believe that the influence of continued foreclosures, distressed sales, the increase in carrying costs for properties in inventory, the costs associated with foreclosures, and more declines in home sales will depress prices further and lead loss severities higher than we had previously assumed.”

S&P said it had increased expected loss projections for 2006 subprime RMBS to 23 percent from 19 percent; early 2007 subprime deals saw expected losses pushed out to 27 percent from previous assumptions of 23 percent.

On short-reset hybrid Alt-A loans, total losses are now expected to reach 12.2 percent — almost double S&P’s earlier estimate of 6.3 percent. Early 2007 originations saw loss projections jump to 15 percent from 7.5 percent, as well.

2007 vintage option ARMs are now expected to produce a loss cumulative loss rate of 14.8 percent, instead of the 8.8 percent that had previously been projected, S&P said.

Cue more write-downs, more losses
The change in loss assumptions invariably means more losses for investors as numerous deals now face the specter of further downgrades. On Tuesday, for example, S&P said it had placed 1,614 ratings on 187 U.S. RMBS transactions backed by U.S. first-lien Alt-A mortgage collateral issued during 2005, 2006, and 2007 on CreditWatch with negative implications. All told, the affected classes represented an original par amount of
approximately $56.82 billion.

As of the June 2008 distribution, S&P said that severely delinquent loans (90-plus days, foreclosures, and REOs) for the affected transactions made up an average 17.85 percent of the current pool balances. Over the past three months, severe delinquencies had increased by an astounding 28.70 percent, underscoring just how bad things are getting in Alt-A and just how fast it’s taking place.

Most importantly, S&P said it had raised loss severity assumptions for 2006 and 2007 Alt-A hybrid and negative-amortization transactions to 40 percent from 35 percent.

That assumption may yet prove to be too conservative relative to the loss numbers we’ve been seeing recently; but that’s an issue we’ll cover in a separate story with updated statistics.

S&P’s updated assumptions weren’t just limited to first lien pools — the rating agency also updated its loss assumptions for 2005-2007 vintage U.S. HELOC RMBS deals on Tuesday, and the picture wasn’t exactly pretty: for 2007 deals, the loss ranges span from 1.49 to 74.44 percent with an average estimate of 37.89 in cumulative losses. For 2006 deals, the cumulative loss expectation is slightly better, but still eye-opening: 22.62.

If you weren’t sour on second liens yet — most existing loans in this area haven’t yet begun to exhibit the default patterns close to such huge loss estimates — it may be time for you to get there. (Unless, of course, you’re content to accept a 10 percent hike in dividend payout as proof that seconds won’t be a problem.)

Note to Next President: Avoid Computers

(Lee Gomes at the WSJ) Should a president -- of the United States, or even of a company, for that matter -- use a computer? Or, are there jobs that are too important for the office holder to be spending the day deleting spam or closing pop-up windows in a browser?
Getty Images

The two presidential candidates this year, in addition to all their other, more-significant differences, also present two contrasting perspectives about the extent to which personal-computer technology can be integrated into someone's everyday life.

Sen. Barack Obama lives the life of every modern road warrior, checking a BlackBerry as easily as he checks his wristwatch, and decompressing in his downtime with an iPod. That latter preference is one of the few he shares with the current president, who is known to take along an iPod, preloaded by his White House staff with classic rock, on his mountain-bike runs.

Sen. John McCain, by contrast, represents the last generation that will be able to claim imperviousness to the machines. Judging by the way his self-acknowledged computer illiteracy is mocked in YouTube videos, it's probably a safe bet that his campaign wishes he were more fluent in technology, especially considering the number of his contemporaries who have taken up the machines without a problem. But anyone who has ever been flustered by a gadget, or who has watched a teenager work a cellphone, won't be unsympathetic to Sen. McCain.

It's a fair question to ask: Can someone who never touches a computer truly be in touch with what is happening in the world? The computer industry has worked very hard over the past few decades to cause us to suspect as much. But what about the opposite question: Does anyone who spends all day in front of a PC, forging a river of data posing as information, have any time to think?

A group of technology reporters once received the CEO of a midsize, low-tech company eager to impress his listeners with his connectedness. He described his day as one long session checking emails and news alerts, save for the occasional interruption of a staff meeting or a sales call.

All this was related with pride, as though it was what modern executives were doing. His listeners, though, were struck by how he seemed to have no time left in the day to think, which was surely why he had yet to realize that he was spending his day consuming the information version of junk food.

If I were the chief of staff at the White House, I would have some sort of computer, not in the Oval Office itself, since it wouldn't match the furniture, but one office away. I'd push the president to spend, say, 20 minutes a day on the machine -- whether he would complain about the limit or about the mandated time.

The president wouldn't need to worry about his email inbox; a staff would be standing by ready to handle it. Memos, position papers, summaries of newspaper reports and all the rest, would be delivered via printouts, since words on printed paper appear to have more of an impact than words on a flickering screen.

The president could use his computer time any way he wished: a favorite blog, YouTube videos, a mind-clearing game of Spider Solitaire. So many of his constituents would be doing the same thing at the same time, it would be a good way to keep up with the common folk.

The severe time rationing is necessary because a computer, far from making you more productive, instead loads you down with things to do, and it's important for the machine to know who is boss. Most people don't have the luxury of off-loading their email-reading chores to a group of competent assistants. It's an office perk that presidents are still important enough to deserve.

Everyone has heard the puzzle about whether Bill Gates, upon walking to work, should bother to stop and pick up a quarter he saw on the sidewalk. Yes, the quarter is bright and shiny, but a careful assessment of the situation would reveal that, for someone of that earning potential, the time spent retrieving the coin could be spent much more profitably at the office. At least in theory.

For a president, a computer can be a similar distraction. Sure, he could spend five minutes reading an especially insightful blog post from one of his core constituencies. But it would be better for him to be spending the time having coffee with the person thinking the thoughts that the world will be blogging about a week or a month hence.

With the world at his beck and call, a president is one of the few people lucky enough to be able to learn more off-line than he would chained to a keyboard. The 20-minute limit would be good for the country. The rest of us are stuck reading emails -- and picking up quarters.

Felix Salmon comments:

I suspect even the author of this piece, Lee Gomes, doesn't really believe it. It simply can't be better for a president to have all his information filtered through assistants playing office politics, rather than getting it directly from trusted sources who also have the advantage of not being paid employees.

Gomes claims it's a better use of time for a president to have coffee with a blogger rather than to simply read that blogger's thoughts online. But one can get much more information much more quickly by reading than one can through having coffee, even if the coffee is more enjoyable - although given the social skills of most bloggers, even that is far from a sure thing.

In any case, the president is the elected representative of the people, and the internet is the best way yet discovered for a president to keep in touch with his constituency. Does McCain's computer illiteracy disqualify him from the presidency? No. But it is a severe handicap.

Bush Signs Bill for Homeowners, Fannie, Freddie

(Bloomberg) -- President George W. Bush signed into law legislation that helps 400,000 homeowners facing foreclosure and extends a lifeline to Fannie Mae and Freddie Mac.

Bush signed the measure at the White House shortly after 7 a.m. Treasury Secretary Paulson, Housing and Urban Development Secretary Steve Preston and Federal Housing Administration Director Brian Montgomery were present for the Oval Office signing, among others.

``We look forward to putting in place new authorities to improve confidence and stability in markets, and to provide better oversight for Fannie Mae and Freddie Mac,'' Fratto said.

The law is aimed at stemming foreclosures and halting a free-fall in housing prices by providing federal insurance for refinanced 30-year mortgages for homeowners struggling to make their monthly payments.

The measure also is designed to restore confidence in Fannie Mae and Freddie Mac by tightening regulations and authorizing the Treasury secretary to inject capital into the two biggest U.S. providers of mortgage money.

The measure passed the Senate July 26 and the House three days earlier.

The recession in the housing market, the worst since the Depression, along with higher fuel prices and a shrinking job market, is weighing on consumers and the economy.

The White House Office of Management and Budget this week cut its February forecast for economic growth this year to 1.6 percent from 2.7 percent. The OMB said it expected the economy to expand 2.2 percent next year, compared with its earlier forecast of 3 percent growth.

Lead Lobbyist

The foreclosure-prevention measure, unveiled in March, was bolstered after Treasury Secretary Henry Paulson sought and received temporary authority, through Dec. 31, 2009, to lend money or to buy the stock of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac. The goal is to avert a collapse of the companies that buy or finance almost half of the $12 trillion of U.S. mortgages.

The treasury chief, who was the lead lobbyist for the White House, persuaded Bush to back off a threatened veto over a section of the legislation that provides $3.9 billion in grants to states to buy and repair foreclosed properties. Bush said he regarded it as a bailout of lenders. Democrats said it would stabilize neighborhoods.

New Regulator

The law creates a new, independent regulator called the Federal Housing Finance Agency. It would ensure that Fannie Mae and Freddie Mac adhere to minimum capital requirements, limit the size of portfolios and oversee executive pay for the two government-sponsored enterprises.

Under the law, the Federal Housing Administration can now insure higher loan limits, up to $625,500 from $417,000 in high- cost areas. The law also raises the nation's debt limit to $10.6 trillion from $9.816 trillion to accommodate the Paulson plan.

A new FHA program, a unit of the U.S. Department of Housing and Urban Development, would insure up to $300 billion in refinanced 30-year fixed loans for about 400,000 borrowers struggling with their monthly payments after loan holders agree to cut their mortgage balance.

The measure would offer $15 billion in tax breaks, including provisions offering the equivalent of interest-free loans worth up to $7,500 for first-time homebuyers. States would be able to offer an additional $11 billion in mortgage revenue bonds to refinance subprime loans.

Bank regulators can't agree on leverage calculation

(FT) Like drunken sailors on a stormy sea, bank regulators and investors long for solid ground. Both will feel sure-footed only when capital positions are beyond danger and there are no more surprises like Monday’s cash grab by Merrill Lynch. Unfortunately, few agree on what “solid” is. US regulators prefer to view leverage as defined by a bank’s tangible equity versus total assets. In the UK and Europe, tangible core equity – which strips out forms of hybrid equity – tends to be measured against risk weighted assets.

Switzerland, however, is considering stricter targets based on the US concept of pure leverage. The regulator knows the importance of banking to the economy and never wants to see a UBS-style crisis again. Other European regulators are unlikely to follow suit, but investors remain concerned because UK and European banks look far less healthy than US peers on this measure. For example, the leverage ratios for UBS, Barclays and Société Générale are down to about 2 per cent. That is less than half the level for Bank of America and JPMorgan.

Leverage* at Europen and US banks is not leagues apartYet comparisons fail to consider accounting differences. Under IFRS standards, European balance sheets include securitised assets, conduits and structured investment vehicles – US GAAP ledgers do not. European banks also gross up their derivative exposures and carry insurance assets and a higher proportion of repo lending. Morgan Stanley reckons that after adjusting for these quirks, capital ratios become closer on both sides of the Atlantic.

However calculated, regulators want more capital. The Swiss Federal Banking Commission is supposedly considering a minimum leverage ratio of 5 per cent. Even on the more generous US GAAP approach, UBS, for example, would have to halve its dividend and sell SFr400bn of assets to hit that target by 2010, according to Morgan Stanley. Not that US banks can breathe easy. If regulators move to a 4 per cent floor, Citigroup would hypothetically have to cut its dividend by 75 per cent or reduce assets by a quarter. As sailors find, life on land can sometimes be tough.

The Homeownership Obsession

(Robert J. Samuelson in the Washington Post) The real lessons of the housing crisis have gotten lost. It's routinely portrayed as the financial system run amok; the housing market became a casino. The remedy, we're told, is to enact rules that prevent a repetition. All this is partly true. But it ignores a larger truth: Our infatuation with homeownership, embedded in dozens of government policies, has turned housing -- once a justifiable symbol of the American dream -- into something of a national nightmare.

As a society, we're overinvesting in real estate. We build too many McMansions. They use too much energy, and their carrying costs, including mortgage payments, absorb too much of Americans' incomes. We think everyone should become a homeowner, when many families can't or shouldn't. The result is to encourage lending to weak borrowers who are likely to default. The avid pursuit of a few more percentage points on the homeownership rate (it rose from 64 percent of households in 1994 to 69 percent in 2005) has condoned enormously damaging policies.

Does every house need a "home entertainment center"? Well, no. But when you subsidize something, you get more of it than you otherwise would. That's our housing policy. Let's count the conspicuous subsidies.

The biggest favor the upper middle class. Homeowners can deduct interest on mortgages of up to $1 million on their taxes; they can deduct local property taxes; profits (capital gains) from home sales are mostly shielded from taxes. In 2008, these tax breaks are worth about $145 billion. Next, government funnels cheap credit into housing through congressionally chartered Fannie Mae and Freddie Mac. Long perceived as being backed by the U.S. Treasury, Fannie and Freddie could borrow at preferential rates; they now hold or guarantee $5.2 trillion worth of mortgages, two-fifths of the national total. Finally, the Federal Housing Administration insures mortgages for low- and moderate-income families that require only a 3 percent down payment.

Congress's response to the present crisis is, not surprisingly, more of the same. The legislation enacted last week adds new subsidies to the old. It creates more tax breaks; most first-time home buyers could receive a $7,500 tax credit. It expands the lending authority of Fannie Mae and Freddie Mac. Previously, the permanent ceiling on their mortgages was $417,000; now it would be as much as $625,500. And the FHA would be authorized to support, at much lower monthly payments, the refinancing of mortgages of an estimated 400,000 homeowners who are in danger of default.

More subsidies may -- or may not -- stabilize the housing market in the short run. But there are long-term hazards. Make no mistake: I'm not anti-housing. I believe that homeownership strengthens neighborhoods and encourages people to maintain their property. It's also true, as economist Mark Zandi shows in his book "Financial Shock," that today's housing collapse had multiple causes: overconfidence about rising home prices, cheap credit, lax lending practices, inept government regulation, speculative fever, sheer fraud.

Still, the government's pro-housing policies contributed in two crucial ways.

First, they raised demand for now suspect "subprime" mortgages. The Department of Housing and Urban Development sets "affordable" housing goals for Fannie Mae and Freddie Mac to dedicate a given amount of credit to poorer homeowners. One way Fannie and Freddie fulfilled these goals was to buy subprime mortgage securities -- many of which have now gone bad. Second, government's housing bias created a permissive climate for lax lending. Both the Clinton and present Bush administrations bragged about boosting homeownership. Regulators who resisted the agenda risked being "roundly criticized," notes Zandi.

Good intentions led to bad outcomes: an old story. Fannie's and Freddie's losses impelled the Treasury Department to propose a rescue; given the companies' size and the government's implicit backing of their debt, doing otherwise would have risked a financial panic. Personal savings have been skewed toward housing. Many Americans approaching retirement "have accumulated little wealth outside their homes," concludes a study by economists Annamaria Lusardi of Dartmouth College and Olivia S. Mitchell of the University of Pennsylvania. Even some past gains from the pro-housing policies are eroding; the homeownership rate has now dropped to 68 percent.

We might curtail housing subsidies without exposing the economy to the disruption of outright elimination. The mortgage interest deduction could be converted to a less generous credit; Fannie and Freddie's expanded powers could be made temporary; the FHA's minimum down payment could be set at a more sensible 5 percent. But even these modest steps would require recognizing that the homeownership obsession has gone too far. It would require a willingness to confront the huge constituency of homeowners, builders, real estate agents and mortgage bankers. There is no sign of either. When tomorrow's housing crisis occurs, we will probably find its seeds in the "solution" to today's.

Tuesday, July 29, 2008

Dealers may change some CDS contract terms

(Reuters) -Credit derivative dealers are considering changes in the way some credit default swaps are traded to require larger upfront payments, as concerns about corporate credit risk rises.

Dealers are in talks about changing contracts that insure the debt of individual companies so that they are more similar to corporate bonds or credit derivative indexes, by requiring larger upfront payments and a set coupon, instead of only making payments on a quarterly basis, analysts said.

This would reduce the risk of protection sellers not receiving payments from the contracts as the risk of companies defaulting on their debt rises, and would make it easier for dealers to manage a myriad of positions they have on corporate debt.

The move may also impact the liquidity of the market, helping high yield trading though potentially scaring away some investment grade protection buyers.

"There are several problems to trading everything on an on-market spread basis," said Brian Yelvington, analyst at credit research company CreditSights.

At present, buyers of protection against a single company defaulting on its debt pay a quarterly coupon for the life of the contract, which is most commonly for five years. This coupon is set by the spread the swap is trading at when the contract is entered into, and is referred to as the on-market spread.

For example, to protect against a default by New York Times Co, one of the widest trading names in the U.S. investment grade index, a buyer would pay an annual rate of 3.95 percent of the sum insured, based on Monday's prices, or 0.98 percent per quarter.

Contracts on individual companies only require upfront payments when their spreads near the 10 percent mark, a level generally considered as distressed.

As the economy weakens and credit spreads widen, however, protection sellers want to be paid more for the default risk at the outset of a greater number of contracts.

"This wasn't a problem when spreads were benign but now that spreads are wider, this indicates a higher degree of risk in the market, meaning those future cash flows are more in doubt," Yelvington said.

"Moving to a standard coupon would make pricing a lot more transparent and should improve the speed of trading," he added.

Also, "when you have to exchange cash, mistakes are found earlier since if the mistakes were material to the calculation, they will impact it and the money delivered will not be correct per one counterparty or the other," Yelvington said.


In spite of these benefits, the challenges over changing the terms of the contracts could be significant.

"I think it is a step forward in simplifying the entry and exit of positions but brings up as many problems as it solves," said Tim Backshall, chief derivatives strategist at Credit Derivatives Research in Walnut Creek, California.

Some dealers have floated the idea that the coupon for investment grade credits be based on the spread of benchmark credit derivative index, with prices then adjusted for a company being weaker or stronger than the index.

However, as a new series of the index is introduced every six months, credit default swaps on a single company could have various coupons, and some may risk being less liquid than others.

Also, spreads on individual companies can be wider, and more volatile than on the indexes.

"The big difference is that the single-names can be considerably more volatile than the indexes and so upfronts can become very large and potentially negate any liquidity improvements," Backshall said.

Large upfront payments may make some protection buyers more hesitant to put on a trade than if they were only required to make quarterly coupon payments.

"High yield investors are more likely to favor coupon payments because the spreads of high yield companies are so wide, though some investment grade investors may be worried about losing liquidity depending on standard coupon assumptions," CreditSights' Yelvington said.

Lehman Pushes to Make Credit-Default Swaps Like Bonds

(Bloomberg) -- Dealers including Lehman Brothers Holdings Inc. are considering changing credit-default swap contracts to more closely resemble cash bonds, following pressure to reduce risks in the $62 trillion market.

Lehman last week began offering clients the ability to trade some credit-default swaps with a fixed coupon, much like a corporate bond, and is advocating making it a standard across the market. Right now, the contracts trade on yield spreads that fluctuate.

``It's our opinion that standardization at this stage would promote more market participants and more liquidity,'' said Jason Quinn, head of high-grade trading at New York-based Lehman. ``It makes the market cleaner.''

Lehman, Goldman Sachs Group Inc., JPMorgan Chase & Co. and 14 other firms that handle about 90 percent of trades in credit- default swaps have been under pressure by regulators to better manage risks in the market, which over seven years grew almost 100-fold from $632 billion. Lehman's experiment would complement industry efforts to create a central clearinghouse and to curb duplicate trades by compressing them into new, smaller ones.

Trading on a fixed coupon ``makes a lot of sense'' to improve market operations, said Jeffrey Kushner, a managing director at BlueMountain Capital Management LP, one of three asset management firms that met with the banks and regulators in June to seek ways to ease market risks.

``If you start couponing things at the same level, it makes it much easier to collapse them,'' Kushner said. ``It also makes it easier to value them.''

`Intriguing Idea'
Lehman is only offering the fixed-coupon option so far for contracts linked to homebuilders, Quinn said. The company would consider extending the fixed-coupon option for credit-default swaps to other sectors if customers demand it, he said.

``It's definitely been discussed and is an intriguing idea,'' said Doug Warren, head of North American credit trading at Barclays Capital in New York. ``I wouldn't say that at this point there's a resounding demand that we move that way. The problem is it's clearly a big change from the way business is done today.''

The move could reduce so-called jump-to-default risk, which in some cases has curbed investors' ability to unwind trades because of the risks dealers would face by doing so.

The banks are establishing a central clearinghouse through Chicago-based Clearing Corp. that's designed to absorb the collapse of a major dealer. The dealers also are working with broker Creditex Group Inc. and data provider Markit Group Ltd. to eliminate duplicate trades. The effort may, on average, cut the amount of some contracts outstanding by at least 50 percent, said Mazy Dar, Chief Strategy Officer at New York-based Creditex.

Credit Crisis
Goldman spokesman Michael DuVally declined to comment. JPMorgan spokeswoman Tasha Pelio didn't return a telephone message. Deutsche Bank AG spokeswoman Renee Calabro and Morgan Stanley spokeswoman Jennifer Sala didn't respond to requests for comment.

Dealers already use fixed coupons when trading contracts on benchmark indexes such as the Markit CDX North America Investment Grade Index, which is linked to 125 companies with investment- grade ratings in the U.S. and Canada. Upfront payments also are exchanged for contracts on companies that trade near or at so- called distressed levels, typically more than 1,000 basis points.

For most contracts linked to individual companies there is no fixed coupon. Effectively, it's as if dealers each day create hundreds of ``synthetic'' bonds with different coupons, or the premiums paid to the investor taking on the risk that the company will default. The actual payments on those trades are pushed out to future dates each quarter, and no cash is exchanged upfront.

Jump-to-Default Risk
That hadn't been much of an issue until the credit crisis that began last year caused the cost to protect against a default to rise from almost record lows to record highs, said Brian Yelvington, a strategist at CreditSights Inc. in New York.

Banks and securities firms including Lehman and JPMorgan profit from credit-default swaps by selling default protection at one level and then buying it at a lower level. A bank, for example, may demand $45,000 a year to protect $10 million of Caterpillar Inc. bonds from default for five years. The bank may then buy five years of protection from another bank at $40,000 a year.

The risk of losses from such trading strategies has been amplified amid the credit crisis, Yelvington said, as the cost of protecting companies including mortgage lenders and bond insurers, in some cases, jumped 20-fold.

Managing the Book
For example, an investor that had bought five years of protection on Armonk, New York-based bond insurer MBIA Inc. last year at 85 basis points, or $85,000 per $10 million in debt, would have made $1.41 million by selling the contract when the cost later jumped to 450 basis points, Glen Taksler, a credit- default swap strategist at Bank of America Corp., wrote in a note in November.

While the investor typically would get a $1.41 million payout from a bank to exit the trade, the bank would have to wait at least four years before being able to start earning a profit on income from a new trade where no cash would be exchanged upfront, according to the report. If the company defaulted the next day, the dealer, having not yet received any income from the new trade, would lose the $1.41 million he paid to the investor, something known as jump-to-default-risk.

If all credit-default swaps were traded with fixed coupons, the dealer in such a case would get an upfront payment on the second leg of the trade, reducing the risk of losses and improving liquidity, Barclays' Warren said.

``It does reduce your jump-to-default risk, and it will change the way you risk-manage your book,'' Warren said.

Maple bond market goes stale

(Globe & Mail Streetwise) Tim Hortons may be able to sell maple-covered donuts, but investors are turning up their noses at Maple bonds, made-in-Canada debt that was flying off the shelves until credit crunch hit.

Maple bonds - Canadian dollar-denominated debt sold by foreign companies - were all the rage through 2006 and the first half of 2007. With rates low and domestic investors hungry for diversity, more than $10-billion of new Maple issues were sold in each of the first two quarters of last year, according to statistics released Monday by the Investment Industry Association of Canada (or IIAC).

Then came the credit crunch, and Maple bond underwriting fell to a “dismal” $500-million of issues from four companies in the first three months of 2008, according to the IIAC, down 79-per-cent from the previous quarter and 96-per-cent from the same quarter last year.

“Investor appetite for less recognizable foreign names, particularly in the banking sector, has diminished,” noted the IIAC commentary on these grim statistics.

RBC Dominion Securities and Merrill Lynch are the only houses to bring Maple bond issues to market in 2008, according to data supplied by Bloomberg.

Dealers took justified pride in building the corporate bond market in Canada, dedicating employees and resources to Maple issues. Unless credit conditions improve, much of this infrastructure will vanish, as bond financers and traders will be redeployed or laid off.

New issues of government debt also declined, partly reflecting the fact that many provinces and the federal government were actively raising money last year, when rates were near historic lows. IIAC statistics show total government bond underwriting fell 22.8-per-cent, to $23.3-billion, over the first three months of the year.

Overall fixed income issuance fell to $41.4-billion in the first quarter of 2008, down 18 per cent from the previous quarter and 11-per-cent from the first three months of 2007.

The one salvation in these statistics for fixed income-focused dealers - that's all the bank-owned firms - is that IIAC data shows bond trading remains relatively stable, up 5.7 per cent in the first three months of 2008 from the previous quarter.

RBC Dominion Securities is the No. 1 underwriter of both Canadian corporate and government debt so far this year, Bloomberg league table data shows.

Talk of quick fix recedes as Libor gap fails to close

(FT) Libor, the measure of inter-bank interest rates that is a key barometer of the health of the credit markets, continues to signal problems a year into the credit crunch and raises doubts about whether the financials' share prices are close to a bottom.

The daily setting of floating interest rates is used to calculate prices on loans, mortgages and the vast derivatives markets. There is a growing realisation that the all-clear signal for the banking sector will not sound until the difference between Libor and the overnight rates set by central banks narrows from its current elevated levels.

Jim Paulsen, chief investment strategist at Wells Capital Management, says: "The persistence of fear one year later remains very troubling.

"The equity market is still fearful and that is fanned by what investors see in the present level of Libor, credit default swaps and interest rate swap spreads."

Swaps, which measure the expected difference between overnight rates set by central banks and three-month Libor, remain wide. In the US, the so-called Overnight Index Swap (OIS) is about 73 basis points, while in the UK it is 67bp and for the eurozone 62bp. Prior to last summer these swaps were trading at about 15bp.

At least the situation appears no longer to be deteriorating. OIS rates have pulled back from their peaks of about 100bp touched last December and in the weeks leading up to the collapse of Bear Stearns in March.

George Goncalves, strategist at Morgan Stanley, says: "We are not seeing widening pressure in Libor, which is the only silver lining at the moment".

He expects that OIS swaps should narrow to about 35bp but adds that forward starting swaps for 2009 indicate the swaps will ease to only about 50bp next year.

He says: "The Fed is on hold and we are now getting a decent read on how much it will cost banks to fund their balance sheets".

At the heart of the elevation in Libor are concerns over the health of bank balance sheets, where weakness can spill over to the broader economy because it limits the availability of credit to companies and consumers.

Dominic Konstam, head of interest rate strategy at Credit Suisse, says: "Libor has been a barometer of the need for banks to raise capital. The main problem with Libor is the capital strains facing banks."

When Libor started rising last August, some analysts compared money market rates to oil for the financial markets engine. While the warning light was flashing red, there was a debate whether this engine needed a quick top-up of fresh oil or whether it was signalling a full seizure was imminent.

Bank writedowns were expected to last one or two quarters. However, the writedowns keep coming a year later and many institutions are still seeking capital and restricting their lending.

Mr Goncalves says: "The first shock was specifically about writedowns at the banks. Now it is about ascertaining what their balance sheets are worth in an environment of declining credit availability."

Such worries about the health of banks and their need to raise further capital will keep money markets on the defensive, with institutions reluctant to lend to each other. That restriction in lending is filtering through to the broader economy and poses a threat to future growth.

Mr Konstam says: "We now face something worse than elevated Libor and the deleveraging of the financial system, and that is an outright recession".

Some of the problems in Libor stemmed from banks in Europe who required dollar funding to finance their holdings of dollar assets. As the funding strains grew, so institutions sought to borrow in the euro and sterling money markets. This pushed money market rates higher in the major currencies, a situation that still persists.

This month, the European Central Bank auctioned $25bn to banks and attracted heavy demand. Meanwhile, US banks continue to borrow for a period of 28 days from the Federal Reserve's Term Auction Facilityand a total of $150bn is outstanding.

The Federal Reserve established the TAF in December to arrest the upward pressure on Libor ahead of year-end, when financing demand usually climbs. While that programme helped ease some strain, money markets endured fresh upheaval this year, culminating in the collapse of Bear Stearns in mid-March. Just before Bear was sold to JPMorgan, the Fed announced the creation of the Primary Dealers Credit Facility (PDCF) for at least six months. Ben Bernanke, Fed chairman, has said that that PDCF is likely to be extended into 2009.

Traders have argued that the terms of the TAF should be extended to three months. That would help ease three-month Libor but such a move would involve the Fed more deeply in propping up the money market.

Bankers note that central banks in Europe offer funds for terms of three and six months or, in the UK, for even longer. But so far, the Fed has resisted extending its TAF programme.

Another issue for Libor was raised this summer. Some analysts said the problems with Libor reflected the way the measure was being calculated. The daily fixings are set in London by the British Bankers' Association. Of the 16 banks who supply quotes for dollar Libor, only three are US based.

That prompted the BBA to announce in June that it would consider two alternative daily fixings for dollar Libor.Anxiety over the mechanics of Libor has eased as a daily fixing set in New York by banks contributing quotes to Wrightson Icap, the interdealer broker, has shown little difference.

Mr Konstam says: "Initially there was some confusion that Libor itself was the problem, with talk of the rate being manipulated and not representative of the true cost of borrowing".

Quick fixes are now no longer part of the discussion.