Friday, October 31, 2008

Lehman Europe and Prime Brokerage Counterparty Risk

(Felix Salmon) Euromoney has allowed free access to its November cover story on Lehman Brothers Europe for this weekend only, so go there now and read it while you can. It starts off at much the same place as John Hempton's blog entry from a couple of weeks ago, about the critical importance of the US Securities Exchange Act of 1934. Here's Hempton, on the consequences of the act:

The result. Whilst Lehman brothers went bust, Lehman's US broker dealer did not. This pretty well saved the US hedge fund industry.
Europe however was a different story. Lehman Europe failed - and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman. Many funds have folded. Far more have been nicked. Whilst the US hedge fund business is currently looking dazed, confused and a little problematic, the UK business is on life support.
In some sense this is the end of the City of London.

Euromoney's Helen Avery gives some real-world examples, foremost among them Oak Group's John James, who has seen substantially all of his assets disappear into the maw of his prime broker, Lehman Brothers International Europe. And the losses were human, too: after hedge fund Olivant found itself unable to vote its stake in UBS because it was held by LBIE, its CFO threw himself in front of an 100mph train at Taplow station in England during rush hour.

The numbers involved are huge: Avery says that more than $22 billion of its clients' securities were "rehypotehcated" by LBIE, thereby essentially turning those clients into unsecured creditors of LBIE when it went bust.

Avery does add a layer of complexity to Hempton's take on things: while the US legal regime is certainly friendlier to prime-brokerage clients than London law, a lot of the problems ultimately stem from the fact that Lehman Brothers in the US took all of LBIE's money out of the UK just before it folded. In other words, if LBIE hadn't had a rapacious parent which stripped LBIE of all its assets in its final hours, none of this might have happened.

What's more, although UK prime brokers regularly allow themselves to rehypothecate (ie, onlend) their clients' securities, US prime brokers also do exactly the same thing, after first asking their clients' permission. Their clients often say yes, because they can essentially make free money on their long positions by allowing their prime broker to lend them out to short-sellers.

As a result, even US hedge funds are more alert than ever to the issue of their prime brokers' counterparty risk. That means a move away from broker-dealers like Morgan Stanley and towards large commercial banks with a big deposit base, like JP Morgan Chase. Morgan Stanley probably isn't crying too much over the loss of its prime-brokerage clients, since it wanted to derisk anyway. But it's yet another big change in the international financial architecture: prime brokers always used to be investment banks; now those banks are either history or being sidelined, while players such as Credit Suisse, UBS, Deutsche Bank, and BNP Paribas are seeing their prime-brokerage operations grow.

What will ultimately happen to the securities onlent multiple times by LBIE? Will they ever find their way back to their original owners? It's possible, but the best case scenario is that it will take many years. The worst-case scenario is that the money is gone forever, into the $100 billion black hole of insolvency which suddenly opened up when Lehman went bust. If that much money is being lost, it stands to reason that Lehman's hedge fund clients will count themselves among the losers.

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Leadenhall Capital Partners LLP

Leadenhall Capital Partners is a joint venture between the Amlin Group, an international underwriter of insurance and reinsurance, and John Wells and Luca Albertini, both of whom have significant experience in insurance linked-capital markets, latterly at Swiss Re.

Leadenhall Capital Partners LLP is authorised by the UK Financial Services Authority to manage and advise third party offshore funds. Its initial focus will be to manage funds investing in insurance linked assets.

Here are some presentations from Leadenhall's principals:

The 4th Annual Derivatives Trading and Technology Summit
Weather and Insurance Linked Derivatives
24th Sept 08

Marcus Evans 3rd Annual Insurance Securitisation Forum
Managing risk in the reinsurance industry
(Luca Albertini will also act as Conference Chairman)
11-12 Sept 08

Fitch ILS Breakfast Briefing
Insurance Linked Investments: An Investor Perspective
04 Sept 08

Convergence of Insurance and Capital Markets

(World Economic Forum) We are pleased to present this report on the convergence of insurance and capital markets. It stems directly from an initiative of the Financial Services Governors launched at the World Economic Forum Annual Meeting 2007, when the assembled Governors agreed to carry the dialogue and work beyond Davos in line with the Forum’s mission of being Committed to Improving the State of the World. Subsequently, working groups comprised of industry representatives, academics, experts and Forum staff took up work on several projects that Governors felt were of broad interest, not only to the financial services industry but also the public. This project, examining the convergence between capital markets and the insurance sector, focused in particular on the role new financial instruments could play to better address and syndicate particular types of risk.

Emphasis: All-Weather Insurance Securitization

(Towers Perrin) Insurance-linked securities (ILS) continue to grow in unexpected ways irrespective of recent major catastrophic events. In the past, ILS issuance spikes occurred immediately after large catastrophes, as witnessed post-Katrina/Rita/Wilma. However, even without significant events, the popularity of ILS has increased. What used to be an alternative to the hard-market pricing of traditional reinsurance is evolving into an integral part of overall reinsurance programs as cedents look for ways to diversify their overall risk management plan, lock in terms and conditions over multiple periods, and create access to long-term, stable capacity relatively unaffected by market cycle and systemic risk.

Intuitively, when reinsurers are strong and reinsurance is cheap, alternative sources of capital such as catastrophe bonds and other ILS structures may not seem necessary. However, although ILS issuance is expected to decline in the fourth quarter of 2008 compared to 2007, it remains at all-time-high levels. The up-front transaction costs and time spent bringing bonds to market require a commitment to longer-term strategic solutions as opposed to tactical responses to managing risk. Cedents should take advantage of the lower risk-transfer costs and other benefits of this alternative source of capacity.


In a typical catastrophe bond transaction, the special-purpose vehicle (SPV) issues a reinsurance contract to the sponsor while simultaneously issuing limited recourse notes to investors (see Exhibit 1). Proceeds from the notes are invested in high-quality, short-term securities and deposited in a reinsurance trust, collateralizing the transaction. Through a swap mechanism, fixed-return bonds are transformed into floating-rate notes, from which the interest-rate risk is largely removed. Over the term of the bonds, the periodic interest paid by the SPV to investors consists of the "risk premium" paid by the sponsor and the floating-rate returns earned by the bond principal. The risk premium is linked to the default probability of a bond, with higher default probabilities yielding higher premiums. In addition, some catastrophe bonds are subject to seasonal price fluctuations in the form of mark-to-market price adjustments due to the seasonality of covered events. At the conclusion of the bond term, assuming covered events have not occurred, the principal is returned to investors, just as with other fixed-income investments.

Over the past year, the industry witnessed many first-time issuers and the creation of new and innovative structures covering new perils and regions while accessing entirely new classes of investors.

What's Driving ILS?

From the cedent's perspective, there are several incentives to pursuing an ILS strategy along with elements of traditional reinsurance strategy:

  • access to long-term, stable capital market capacity
  • the ability to lock in terms and conditions for multiple periods
  • diversifying reinsurance recoverables out of the reinsurance market and into the broader fixed-income market, which is not susceptible to traditional market cyclicality.

In addition, catastrophe bonds are structured so that principal and periodic interest payments owed to investors are fully secured by high-quality investments placed in a reinsurance trust (e.g., a trust created under New York Regulation 114). The trust is structured such that the SPV makes periodic payments into the trust account of required "assets" (typically A-rated U.S. government obligations), which are held by a trustee (usually a bank) to guarantee payment of the obligation, thereby minimizing credit risk vis-à-vis traditional reinsurance.

From the investor's perspective, ILS provide an opportunity to diversify portfolio holdings with a noncorrelated asset class. Since these securities are not influenced by mortgage defaults, the stock market or commodity values, they present an attractive alternative to traditional asset- and mortgage-backed fixed-income securities. While spreads for BB-rated corporate debt widened tremendously over the past year, ILS spreads tightened, on average. Additionally, interest-rate risk is mitigated, since all catastrophe bonds are structured as floating-rate securities based on LIBOR or EUROBOR.

What's Hampering ILS Development?

As with any investment or reinsurance strategy, potential limitations and risks need to be addressed. From an investor's perspective, the market for ILS is still in its infancy and can be characterized as "illiquid," as the secondary market for this asset class is much smaller than the $30 trillion fixed-income securities market. Investors are also wary of the moral hazard associated with indemnity triggers, since the lack of transparency (within the SPV structure) can inhibit their ability to price the risk appropriately.

Amid the collapse of the collateralized debt obligation market, there is a certain negative connotation associated with off-balance-sheet, offshore SPVs, which worries investors not entirely familiar with this relatively new asset class. Another concern is model risk, or the perceived risk associated with imperfections in the catastrophe models used to determine the probability of expected loss. The ultimate concern is that investors may miscalculate the risk of losing their entire principal if a covered event takes place. And even if no covered events take place, changes to catastrophe models could result in rating agency downgrades and subsequent mark-to-market losses.

Most important for sponsors is basis risk — the risk of an imperfect hedge — in the event an indemnity cover is cost prohibitive. Unlike indemnity or ultimate net loss covers, catastrophe bonds based on third-party reporting agencies (i.e., parametric, index or modeled loss triggers), as opposed to the sponsor's incurred losses, result in a coverage gap if not aligned properly. Sponsors are increasingly structuring ILS to cover multiple perils over multiple regions, using trigger-specific strategies to minimize this risk. Additionally, the substantial up-front transaction costs and complex structures deter cedents looking for short-term solutions or coverage in smaller amounts.

Now many cedents are making a long-term commitment to ILS, using shelf (deferred issue) programs that help spread these costs over multiple periods. As the market matures, many of the concerns will become easier to address. ILS will then more clearly benefit both cedents and investors.


The ILS issuance landscape in 2008 can be characterized as steady, though not at the same level as 2007 (see Exhibit 2).

Continued innovation in the capital markets has surprised investors and sponsors, as ILS have become a mainstream product embedded in many risk management programs. Although a direct relationship between catastrophe activity and ILS issuance still exists, sponsors are now considering this alternative means of risk transfer for reasons other than year-to-year price variation. Since 2007, we have witnessed a flurry of both new sponsors and new products (see Exhibit 3).

Additionally, several new investors have come onto the scene recently, suggesting further adoption of this once exotic and elusive product:

  • specialized catastrophe-oriented reinsurance funds including Juniperus Re, Pentelia Capital Management, Nephila Capital, DE Shaw and Citadel
  • asset managers such as Credit Suisse Asset Management, Fermat Capital Management and Goldman Sachs Asset Management
  • closed-end mutual funds such as Pioneer Diversified High Income Trust and Oppenheimer Master Event-Linked Bond Fund, following similar strategies previously implemented by PIMCO and others
  • money managers, pension funds and private bankers.


Since the market's inception in 1997, only three defaults have been reported (less than 2% of principal issuance to date): Atlantic & Western Re (PXRE), Kamp Re (Zurich) and Avalon Re (OCIL). This suggests that, while defaults have been triggered (relatively infrequently), ILS do effectively transfer risk. The total return demanded by investors can be broken into three components: floating interest earned on the principal, compensation for the expected underlying loss cost (pure premium) and the investor's risk premium. Given the low default rates, ILS yielded a return to investors of approximately 500 basis points (i.e., 5%) over and above the underlying floating interest rate — over the last six years.

Today, insurers have strong balance sheets and an ability to accept higher retentions. Reinsurers also have strong balance sheets and are competing to put their capital to use. The result is a softening rate environment for traditional reinsurance coverage, which puts downward pressure on the risk premiums incorporated into ILS pricing. Between 2003 and 2007, ILS pricing levels followed a pattern similar to traditional catastrophe reinsurance. We can expect continued activity, despite current market conditions, as cedents begin to use ILS for long-term benefits in addition to short-term problem solving.


Developments in the ILS market are helping participants better capture the potential value of this alternative coverage option.

Increased Use of Shelf Offerings

Shelf offerings allow sponsors to create a single set of offering documents summarizing general characteristics and then issue additional bonds (takedowns) up to a maximum limit over the course of a stated period. The increased use of shelf offerings is a positive sign for the catastrophe bond market, as it indicates a more broad-based intention on the part of sponsors to systematically incorporate catastrophe bonds into their risk-transfer programs (as opposed to only turning to them for one-off solutions in times of crisis).


The softening rate environment is flowing upstream to the ILS market as sponsors are creating combinations of structural elements, specifically multiperil/multi-location deals. This could be viewed as analogous to a loosening of terms and conditions in traditional reinsurance, as buyers add in as many features as possible for the same premium. In hard markets, providers of capital are likely to be more selective in the coverages they provide.

More Investment-Grade ILS

To attract a wider spectrum of potential investors, sponsors are floating more investment-grade securities. A new innovation for achieving this, first sponsored by Bermuda-based Nephila Capital, is the actively managed, model-driven CDO structure, which creates different buckets of perils (tranches). By customizing securities via the CDO structure, decisions can be made on the alpha — measuring the absolute performance of an asset, in excess of the expected yield — and beta of a single contract, allowing investors to assess the impact of an inherently diversified portfolio. ILS provide a new source of collateralized capacity to reinsurance buyers while also offering a range of securities to investors with specific risk/return appetites seeking truly noncorrelated assets. Other recent catastrophe bonds that achieved investment-grade ratings include Brit's Freemantle, Arrow's Javelin Re, State Farm's Merna Re and Swiss Re's Vega Capital.

U.S. Primary Issuances

Historically, issuance has been driven by reinsurers. Recently, however, several large U.S. primary insurers have implemented an ILS strategy in their risk management program. Over the past 12 months, U.S. primaries have issued over $2.4 billion, or 30%, of the market's bonds. State Farm recently launched Merna Re, the largest single issuance in the market's history, all of which is investment grade. The transaction uses an indemnity trigger and provides protection for U.S. and Canadian hurricane and earthquake perils, as well as tornado/hail and winter storm — a testament to the commitment to ILS as a broad-based risk management tool.


Amid the current credit crisis and recent collapse of Bear Sterns, substantial controversy surrounds SPVs. As International Financial Reporting Standards continue to gain worldwide momentum, companies must understand the differences between the two interpretations of consolidating SPVs. Now a broader consolidation model, based on risk and reward as opposed to voting control, is being applied in certain circumstances.

Furthermore, the market-consistent valuation approach of insurance assets and liabilities under Solvency II is based on economic principles; therefore, securitizations are likely to receive appropriate credit for market values, which may facilitate a substantial expansion of property/casualty securitizations beyond catastrophe bonds.


Currently, the market is dominated by non-investment-grade securities (BBB- or lower) due to the expected level of risk inherent in catastrophe bonds. Typically, ratings will be capped at BB+ for single-trigger bonds (i.e., single-peril, single-territory exposure). Sometimes, even if the single event is extremely remote, rating agencies still impose a BBB+ ceiling on the rating.

Various characteristics generate additional challenges to rating agencies. If the sponsor is nonrated, for example, evaluating indemnity-trigger transactions presents a variety of complexities. To get comfortable, rating agencies evaluate full limits, concentrations and correlations with other risks or lines of business. With respect to index triggers, rating agencies are skeptical of the credibility of reporting agencies in foreign jurisdictions. In addition, "manmade" events (i.e., terrorism or arson) present significant uncertainty, explaining why bonds with this peril are rarely assigned a rating.

Central to the rating is full scrutiny of the science and conservatism in catastrophe models. In addition, rating agencies benchmark the probability of attachment against a table of historic defaults, similar to how corporate debt is rated. Overall, stress testing, balance-sheet strength, underwriting disciplines, peak zones, concentrations, diversification and enterprise risk management all play a significant role in ILS ratings.


From the cedent's perspective, after consecutive years without major catastrophes and years without industry-changing hurricanes and earthquakes (the two most popular perils to securitize), 2009 presents an excellent opportunity for cedents to lock in terms and conditions at current levels. From an investor's perspective, noncorrelated catastrophe spreads seem attractive relative to traditional corporate debt.

Overall, the mutual benefits to both parties will likely influence future activity levels. As the market for these vehicles matures, standardization of contracts, improved data and transparency will encourage more sponsors and investors to participate in the ILS marketplace. Also, continued expansion and innovation of products will entice participants away from large insurers and toward regional and middle-market carriers. At the same time, growth of investment-grade ILS will expand the population of potential investors. A hardening reinsurance market would then lead to cedents seeking capital market solutions and investors seeking double-digit returns. And, as significant trading continues, a liquid secondary market with lower transaction costs will develop.

As market participants increasingly come to understand the distinct advantages of ILS, the market will continue to develop, absent catastrophe events, and become a mainstream risk management tool supplementing traditional reinsurance.

Chase further strengthens robust programs to keep families in homes

NEW YORK, Oct. 31, 2008 - Chase today announced it is expanding its already significant mortgage modification program by undertaking multiple initiatives designed to keep more families in their homes, including extending its modification programs to WaMu and EMC customers.

Chase will open regional counseling centers, hire additional loan counselors, introduce new financing alternatives, proactively reach out to borrowers to offer pre-qualified modifications, and commence a new process to independently review each loan before moving it into the foreclosure process. Chase expects to implement these changes within the next 90 days.

While implementing these enhancements, Chase will not put any additional loans into the foreclosure process. This will give affected homeowners an opportunity to take advantage of the enhancements, and applies only to owner-occupied properties with mortgages owned by Chase, WaMu or EMC, or with investor approval.

Chase will continue to work diligently with investors to get their approval to apply these programs to the loans it services for others, so its efforts have the broadest possible impact. These programs are designed for homeowners who show a willingness to pay, so Chase, WaMu and EMC customers should continue to make mortgage payments to reflect their intent to honor their commitments.

"While Chase has helped many families already, we feel it is our responsibility to provide additional help to homeowners during these challenging times," said Charlie Scharf, CEO of Retail Financial Services at Chase. "We will work with families who want to save their homes but are struggling to make their payments."

The enhanced program is expected to help 400,000 families - with $70 billion in loans - in the next two years. Since early 2007, Chase, WaMu and EMC have helped about 250,000 families - with $40 billion in loans -- avoid foreclosure, primarily by modifying their loans or payments. Both the existing and enhanced programs apply only to owner-occupied properties with mortgages owned by Chase, WaMu or EMC, or with investor approval.

Chase inherited pay-option ARMs when it acquired WaMu's mortgage portfolio last month and EMC's portfolio earlier this year as part of the Bear Stearns acquisition. After reviewing the alternatives that were being offered to customers, Chase decided to add more modification choices. All the offers will eliminate negative amortization and are expected to be more affordable for borrowers in the long term.

As a result of these enhancements for Chase, WaMu and EMC customers, Chase will:

  • Systematically review its entire mortgage portfolio to determine proactively which homeowners are most likely to require help - and try to provide it before they are unable to make payments.

  • Proactively reach out to homeowners to offer pre-qualified modifications such as interest-rate reductions and/or principal forbearance. The pre-qualified offers will streamline the modification process and help homeowners understand that Chase is offering a specific option to make their monthly payment more affordable.

  • Establish 24 new regional counseling centers to provide face-to-face help in areas with high delinquency rates, building on the success of one- and two-day Hope Now reach-out days.

  • Add 300 more loan counselors - bringing the total to more than 2,500 - so that delinquent homeowners can work with the same counselor throughout the process, improving follow-through and success rates. Chase will add more counselors as needed.

  • Create a separate and independent review process within Chase to examine each mortgage before it is sent into the foreclosure process -- in order to validate that each homeowner was offered appropriate modifications. Chase will staff the new function with about 150 people.

  • Not add any more Chase-owned loans into its foreclosure process while enhancements are being implemented.

  • Disclose and explain in plain and simple terms the refinancing or modification alternatives for each kind of loan. Chase also will use in-language communications, including local publications, to more effectively reach homeowners.

  • Expand the range of financing alternatives offered to modify pay-option ARMs, including 30-year, fixed-rate loans with affordable payments, principal deferral and interest-only payments for 10 years. All the alternatives eliminate negative amortization.

  • Offer a substantial discount on or donate 500 homes to community groups or through non-profit or government programs designed to stabilize communities.

  • Use more flexible eligibility criteria on origination dates, loan-to-value ratios, rate floors and step-up features.

The enhancements reflect Chase's commitment to continue to seek additional ways to help homeowners.

Chase acknowledges and appreciates the leadership of the U.S. Senate Banking and U.S. House Financial Services committees, the FDIC, a number of state attorneys general and community groups on this important issue, and the critical role they are playing in keeping families in their homes.

JPMorgan Agrees to Keep Customers Out of Foreclosure

(Bloomberg) JPMorgan Chase & Co., the largest U.S. bank by market value, said it won't begin foreclosure proceedings for as long as the next 90 days while it finds ways to make payments easier on $110 billion of problem mortgages.

The bank, which two weeks ago accepted a $25 billion cash infusion from the government, may agree to reduce interest rates or principal amounts, New York-based JPMorgan said today in a statement. It will also open 24 centers to provide counseling in areas with high delinquency rates.

Congress has been urging financial-services companies to work with borrowers and avoid foreclosures, which rose to the highest on record in the third quarter. Bank of America Corp. said in July it would help more than 250,000 at-risk borrowers stay in their homes. States pivotal to the Nov. 4 U.S. election, including Florida, Ohio and Nevada, had some of the highest foreclosure rates, according to data compiled by RealtyTrac.

``Politics is playing such a huge role in this process, the banks have to be very cognizant of how they're perceived,'' said Charles Peabody, partner and research analyst at Portales Partners LLC in New York. ``What they want to do is show they deserve this good deal from the government by helping out the average man.''

Federal Deposit Insurance Corp. Chairman Sheila Bair has proposed a plan to guarantee mortgages to help stem foreclosures, according to two congressional aides briefed on the matter. Her idea is to use as much as $50 billion of the $700 billion financial-services industry bailout package approved by lawmakers this month.

`Welcome Development'

Bair called the JPMorgan plan a ``welcome development'' for the $10.6 trillion mortgage market.

``A clear consensus is emerging that broad-based and systematic loan modifications are the best way to maximize the value of mortgages while preserving homeownership,'' Bair said in an e-mailed statement. That process will help ``stabilize home prices and the broader economy,'' she said.

The JPMorgan program is expected to help 400,000 families with $70 billion in loans in the next two years, the bank said. An additional 250,000 families with $40 billion in mortgages have already been helped under existing loan-modification programs.

``We felt it is our responsibility to provide additional help to homeowners during these challenging times,'' said Charlie Scharf, chief executive officer of retail financial services at JPMorgan Chase. ``We will work with families who want to save their homes but are struggling to make their payments.''

Bank of America

Bank of America helped more than 117,000 homeowners avoid foreclosure from January through June, almost double the pace in the second half of 2007, it said in July. The bank said at the time it will modify at least $40 billion in troubled mortgages by the end of 2009.

Countrywide, the mortgage lender acquired by Bank of America, agreed earlier this month to help about 400,000 customers facing foreclosure or having problems paying their loans as part of settlement with 11 states over fraud complaints.

JPMorgan said today it would hire 300 loan counselors to help delinquent homeowners and employ about 150 people to review each mortgage before it's sent to the foreclosure process. Other employees will be added to staff the regional counseling centers.

JPMorgan, which has lost 5.5 percent this year on the New York Stock Exchange, rose $3.63, or 10 percent, at 4:15 p.m. The KBW Bank Index of 24 companies advanced 4.4 percent.


The bank's program extends to customers of Washington Mutual Inc., the savings and loan JPMorgan agreed to buy last month, and to clients of EMC, the loan-servicing company the bank acquired in its takeover of Bear Stearns Cos. Loans to be modified include those on JPMorgan's books and ones in which the bank can obtain investor approval.

It is aimed only at homeowners who ``show a willingness to pay,'' the bank said. ``Customers should continue to make mortgage payments to reflect their intent to honor their commitments.''

JPMorgan said it will also donate or offer a ``substantial discount'' on 500 homes to community groups in order to stabilize local markets.

``We thought now was the right time to come out with what we hope is an industry-leading way to deal with this problem that's affecting all of us,'' Scharf said in an interview.

A total of 765,558 U.S. properties got a default notice, were warned of a pending auction or were foreclosed on in the third quarter, the most since records began in January 2005, according to Irvine, California-based RealtyTrac, which sells default data.

Home prices in 20 U.S. metropolitan areas fell in July at the fastest pace on record, and sales of previously owned homes in August were 32 percent below the peak reached in September 2005.

The state of the U.S. economy has become a key issue in the presidential race between Democratic Senator Barack Obama of Illinois and Arizona Senator John McCain, a Republican.

Obama supports an economic stimulus plan to boost the economy, while McCain wants the government to purchase troubled mortgages.

Lenders Join HOPE for Homeowners Program

(Housing Wire) The HOPE for Homeowners program that went into effect Oct. 1 finally has a list of lenders willing to participate. Released midday Friday, the list continues for 25 pages and contains mortgage lenders licensed in various states that are willing to refinance loans under the HOPE for Homeowners (H4H) program, which was part of a the housing bill passed back in July. Read the list of participating lenders.

Although three months has passed since the creation of the Act, Department of Housing and Urban Development spokesman Lemar Wooley said in an interview the delay is often exaggerated.

“The way we look at it, it hasn’t been that long,” he said. “It’s only been four weeks.”

People who question the speed of a program that was signed into law in July and began rolling out only hours before calendars roll into November don’t consider that the H4H program went into effect on Oct. 1, Wooley said.

“Under the law, we were mandated to put the program together along with three other agencies working together on it - that was in late July - and we were told to have it ready to roll Oct. 1 and we met that deadline,” Wooley said. “The problem is all the details relating to it obviously came out Oct. 1 and the lenders have to get the word and so on.”

But the too-little-too-late sentiments circulating among participating lenders argues that the program may not be of much use if investors aren’t willing to buy the loans of struggling borrowers who want to take advantage of H4H.

John Sorgenfrei, president of Assurance Home Loan, Inc. - which is licensed in Florida - said he receives calls from eight to 10 borrowers daily about participation in the program. For the time being, he has been forced to make them wait, as no investors so far have bought into the program.

“I wish I could say we have something in the works,” he said. “We’re waiting for the investors to decide whether it’s going to be a third-party participation or just exclusively held for the lenders.”

Robert Paduano, managing director at Allegro Funding Corp. - which is licensed to operate in 24 states and signed up on the H4H list - also said in an interview that the hold-up on the program has resulted from investors unwilling to accept rewrites on existing loans.

“The (H4H) program is a joke,” Paduano. “It’s not going to materialize into what we had hoped for because most lenders are unable or unwilling to write down the principle balance to 90 percent because their investors won’t let them.”

Few loans have been redone because no one has signed up to buy them, he said.

“Everybody’s been waiting since Oct. 1 and nobody can help them because nobody’s buying the loans - even though the government’s insuring them,” he said.

Allegro receives hundreds of calls a day from borrowers wanting to rewrite their loans. Paduano said the company sends out a package and a simple statement: “As soon as something’s about to be rolled out, we’ll give you a call.” Although most of the borrowers who call Allegro are learned in the program and have already contacted their existing lenders and received permission to participate, Paduano said he cannot help them until investors step forward to buy the loans.

Efforts by the Federal Deposit Insurance Corp. to guarantee $40 to $60 million in distressed mortgages will not address the looming foreclosures, either, he said.

“The government’s not going to get ahead of this,” he said. “Foreclosures are going to double in the next two years and what they’re proposing to do now is what IndyMac did, which was to lower the interest rates.”

But borrowers who owe $100,000 more than what their homes are worth are not going to care about lower interest rates when it’s cheaper to rent, Paduano said. People will start walking out of their homes and the government will not keep ahead of the foreclosure rates unless immediate action is taken to get lenders on board with the H4H program.

“We should be pushing for the government to insist that whoever got money from the bailout has to participate in HOPE for Homeowners,” he said. “It shouldn’t be optional.”

ICE deal signals new clearing house for credit default swaps

(FT) IntercontinentalExchange, the US-based electronic futures exchange, yesterday raised the stakes in its effort to expand in the $54,000bn credit default swap market by announcing a deal to take over The Clearing Corporation (TCC), the bank-operated clearing house.

The move is the latest salvo in a battle between ICE and the CME Group, the world's largest futures exchange, to develop central counterparty clearing infrastructure for the CDS market.

Shares in ICE rose 40.8 per cent yesterday to $87.

US regulators are keen to see a clearing house established for the opaque over-the-counter contracts as soon as possible, since the absence of a central counterparty - which would guarantees pay-outs should a trading party be unable to do so - has exposed the risk of massive market disruption.

Last month the CME struck a deal with Citadel, the hedge fund, to form an electronic marketplace with central counterparty clearing for CDSs.

ICE first signalled its intention to move into CDSs in June, when it paid $625m for Creditex, an interdealer credit derivatives broker.

This month, the company agreed with TCC to create a "global clearing solution" for CDSs - although there has been a question mark over the proposal, since its principal backers are the same financial institutions most affected by the crisis.

ICE's takeover demonstrates both the seriousness of its plan and the extent to which Jeff Sprecher, chief executive, wants to work closely with the Federal Reserve to develop his solution.

The company will form a limited-purpose bank, ICE US Trust, which will be a member of the Fed system and will serve as its over-the -counter derivatives clearing house.

Mr Sprecher said building a separate clearing entity was an important difference between his proposal and that of the CME, which is planning to clear CDSs through its existing futures clearing house.

"We concluded that the [CDS] contract design and the risk profile differed too significantly from that of futures," said Mr Sprecher. "The existing collateral and liquidation provisions of futures-style clearing would not be sufficient, nor would combining CDS with futures positions be prudent in terms of adding systemic risk."

Mr Sprecher said he had signed memoranda of understanding with nine of the biggest traders in the CDS market - Bank of America, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Merrill Lynch, Morgan Stanley and UBS - to clear their global CDSs.

The CME has said that it could begin operations as soon as next week, if regulators allow it.

Mr Sprecher said his solution could start "in the very near term" but said regulatory approval would hold things up.

ICE also announced yesterday its profits increased by 12 per cent in the third quarter compared to the same period last year - in line with analysts' expectations - as the dramatic fall in crude oil prices prompted a jump in the volumes of energy futures.

Net income was $75m or $1.04 per share, up from $67m or 93 cents per share for the third quarter of 2007.

Creditex and Markit Announce Successful Completion of Four CDS Portfolio Compression Cycles

London and New York – Markit and Creditex today announced the successful completion of four industrywide credit default swap (CDS) portfolio compression runs in North America and Europe during the week ended October 31, 2008.

Compression runs were completed this week in North America for CDS contracts referencing consumer products companies and in Europe for CDS contracts referencing industrial, energy and utilities companies as well as European sovereigns. Compressions carried out across a total of 61 reference entities this week achieved a gross notional reduction of 44%, or $150 billion across all participating counterparties.

This follows the successful completion of four compression runs during the week ended October 24, 2008 when $200 billion of gross notional value was compressed for CDS contracts referencing 62 North American and European companies.

Portfolio compression is a process that reduces the overall size and the number of line items in credit derivative portfolios, without changing the risk parameters of the portfolios. This is achieved by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cash flows as the initial portfolio but require a smaller amount of regulatory capital to be held against the positions. Markit and Creditex run portfolio compression cycles on a regular basis to compress the most actively traded single name CDS contracts systematically across all major sectors.

Markit and Creditex were selected by the International Swaps and Derivatives Association (ISDA) to provide infrastructure to support commitments made by major market participants to the Federal Reserve Bank of New York relating to improved operational efficiency and risk reduction.

The first North American compression run was held on August 27, 2008 for widely traded telecommunications companies. Compression runs for CDS referencing European technology, media and telecommunications companies occurred on September 4, 2008 and September 11, 2008. Markit and Creditex have now conducted 13 compression runs since August 27, 2008, resulting in a total gross notional reduction in excess of $550 billion.

7.6 Million Borrowers Underwater on Mortgages: Study

(Housing Wire) The nation's ten "leading" markets for negative equity, according to new research from First American CoreLogic. (Source: First American CoreLogic)

A ground-breaking look at negative equity effects among U.S. homeowners, released Friday morning, paints a staggering picture of just how bruised the national housing market really is. The study, conducted by researchers at First American CoreLogic, paints a troubling picture estimating that 7.62 million borrowers in the U.S. are currently underwater on their mortgages — or 18.3 percent of all properties with a mortgage.

There are an additional 2.1 million mortgages that are approaching negative equity, as well, defined as mortgages within 5 percent of being in a negative equity position. Negative-equity and near-negative equity mortgages combined account for over 23 percent of all properties with a mortgage, according to researchers at First American CoreLogic.

Nearly half of all borrowers in Nevada are currently underwater on their mortgages, with an estimated 48 percent of properties with a mortgage upside-down on value. The state was among the most overheated during the recent housing bubble, and has been hit hard as prices struggle to correct. Michigan ranks second in the study, with an estimated 39 percent of mortgages now underwater. Five other states have negative equity shares in excess of 20 percent, according to the study: Florida (29%), Arizona (29%), California (27%), Georgia (23%), and Ohio (22%).

Percentages aside, both California and Florida have by far the most underwater borrowers of any other states: an estimated 1.8 million loans are underwater in California, and another 1.2 million loans are estimated to be underwater in Florida.

Previous numbers are tough to come by, but it is widely believed that never before have so many homeowners been a negative-equity position; and early data are indicating that borrowers facing negative equity positions are a significant risk of default. HousingWire’s recent analysis of performance data at FirstFed Financial Corp. (FED: 9.69 +18.03%) found that more than 40 percent of borrower defaults on the bank’s loans involved borrowers estimated to be in a negative equity position.

The top six states in terms of negative equity accounted for over 58 percent of all negative equity mortgages in the study, although they only account for 36 percent of all mortgages, driving the notion that much of the nation’s real estate pain is centered in a few key locations. In fact, excluding the top 6 states, the average negative equity in the remaining 44 states is 12 percent, well below the national average — but still a number large enough to matter on a national scale.

Nobody should be surprised to see the boom-bust states leading the way, or Midwestern states facing economic stagnation also having problems. But what’s more telling than anything in the data is an emerging picture of troubled in Southern states that did not necessarily experience a housing boom: places like Texas, Georgia, Arkansas and Tennessee.

In fact, comparing mortgages already underwater with those estimated to be nearing negative equity, Oklahoma, Alabama and North Carolina lead the way in terms of negative equity growth likely to be seen in coming months.

The study excluded Maine, Mississippi, North Dakota, South Dakota, Vermont, West Virginia, and Wyoming due to a lack of sufficient real estate data.

DTCC to Provide CDS Data from Trade Information Warehouse

New York, October 31, 2008 – The Depository Trust & Clearing Corporation (DTCC) announced today that it will begin to publish aggregate market data from its Trade Information Warehouse (Warehouse), the worldwide central trade registry it maintains on credit derivatives.

Starting Tuesday, November 4 and continuing weekly, DTCC will post on its website the outstanding gross and net notional values ("stock" values) of credit default swap (CDS) contracts registered in the Warehouse for the top 1,000 underlying single-name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency.

The data will be shown in two sections. Section 1 will show the outstanding notional values at a given point in time (the end of each week). Section 2 will show data relating to the weekly confirmed trade volume, or "turnover," with respect to the same underlying reference entities and indices, as well as similar aggregations of such data. Section 2 data will be published beginning the week after the initial publication of outstanding notional values.

The Trade Information Warehouse is a service offering of DTCC Deriv/SERV LLC, a wholly-owned subsidiary of DTCC, and is the market’s first and only central registry and automated trade database supporting the post-trade processing of over-the-counter derivatives contracts over their lifecycles, from confirmation through to final settlement. Established in November 2006, the Warehouse is the OTC derivatives industry’s electronic central registry for credit default swaps. With a client base that includes virtually all global derivatives dealers and more than 1,100 buy-side firms in 31 countries, DTCC’s Warehouse has registered the vast majority of all credit default swaps traded worldwide.

New York Fed Welcomes Further Industry Commitments on OTC Derivatives

The Federal Reserve Bank of New York welcomes the letter released today by major market participants to further strengthen the operational infrastructure for over-the-counter (OTC) derivatives. Consistent with the objectives of the March 2008 Policy Statement of the President’s Working Group on Financial Market Developments, market participants outline in this letter concrete plans for building a stronger integrated operational infrastructure capable of supporting the important and rapidly growing OTC derivatives market.

The commitments presented in this letter will help address weaknesses in the OTC derivatives market. Although efforts by the Federal Reserve and other U.S. and European regulators over the past three years have led market participants to significantly improve many operational elements of the OTC derivatives infrastructure, financial market events have demonstrated that broader action is warranted to address additional market design elements.

The following areas constitute our central priorities for addressing both operational and market design concerns for OTC derivatives:

Institute a Central Counterparty (CCP) for Credit Default Swaps (CDS). As the primary authorities with regulatory responsibility over U.S. CDS CCP proposals, the Commodity Futures Trading Commission, the Securities and Exchange Commission and the Federal Reserve have strongly encouraged CCP developers and market participants to accelerate their efforts to bring a CDS CCP to market. The U.S. regulators are cooperatively reviewing the risk management designs of the U.S. CDS CCP proposals with the objective of granting regulatory approvals as soon as they are determined to meet risk management standards. We are hopeful that one or more CCPs can begin operations in November or December 2008, enabling market participants to rapidly move trades onto a CCP.

A well-managed CCP for credit default swaps will reduce the systemic risk associated with counterparty credit exposures. In addition, a CCP can help facilitate greater transparency of market prices and volumes and support an open trading environment that includes exchange-traded CDS contracts.

Reduce Levels of Outstanding Trades via Portfolio Compression. Market participants continue to reduce the number of outstanding CDS trades through multilateral trade terminations (tear-ups) which lowers outstanding notional amounts, reducing counterparty credit exposures and operational risk. Regulators have instructed firms to maximize the efficiency of trade terminations in CDS tear-ups and have begun monitoring the detailed results to ensure the fullest participation. To date in 2008, tear-ups have eliminated more than $24 trillion of CDS trade notional amounts, reducing the notional amount outstanding by more than one-third. Expanding the efforts from CDS, market participants will start coordinated trade compression cycles for the largest OTC derivatives asset class, interest rate derivatives, in early 2009.

Enhance Market Transparency. Regulators are also seeking to increase the information about CDS that is available to the public. In that regard, we welcome the announcement today by the Depository Trust & Clearing Corporation (DTCC) to publish aggregate market data from the central repository it maintains on credit derivatives. Starting Tuesday, November 4th and continuing weekly, DTCC will release a set of aggregate stock and weekly trade data, including the levels of both gross and net notional CDS traded on the 1,000 largest CDS reference entities. Regulators will continue to work with market participants and service providers to further expand the public release of market data.

Continue Operational Improvements. Regulators continue to demand that market participants improve the back office processes that support OTC derivatives trading. The attached letter details how those efforts are expanding to encompass all major OTC derivatives asset classes and to improve collateral management practices in these markets. Key long-term objectives and milestones in the letter include:

  • Use of central counterparty clearing for trades to significantly reduce counterparty credit risk exposure and notional amounts outstanding.
  • Target of submitting 85% of eligible CDS trades (including novations) on T+0 by June 30, 2009. (Current target is submitting 92% on T+1).
  • Increasing the portion of equity derivatives eligible for electronic matching from 40% to 60% and raising the matching target to 85% for all counterparties.
  • Developing plans for central trade repositories for equity and interest rate derivatives.

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

Participants' October 31 Letter ››
October 31 Summary of OTC Derivatives Commitments ››
DTCC to Provide CDS Data from Trade Information Warehouse



NEW YORK, Friday, October 31, 2008 – The International Swaps and Derivatives Association, Inc. (ISDA) today applauded a number of industry initiatives that have had the beneficial effect of reducing notional amounts outstanding in credit default swaps (CDS), significantly reducing operational, legal and capital costs for industry participants and improving operational efficiency in CDS.

In 2008, efforts to reduce notional outstanding amounts have been rewarded by a decrease of over $25 trillion in CDS notionals. This reflects a range of activities, including compression exercises run by Trioptima, Creditex and Markit. In addition, auctions and settlements of the recent series of credit events, including Fannie Mae, Freddie Mac and Lehman Brothers, have proceeded smoothly.

This year to date, Trioptima has reduced by $24.5 trillion the amount of CDS notional outstandings through its series of compression cycles (also known as tear-ups), which have included index, tranche and single-name trades. Trioptima’s triReduce Credit service has been in effect since 2005.

Additional efforts implemented by Creditex and Markit that focus on the single name space began as recently as September now account for $550 billion in compressions.

“This reduction in notionals is major progress by anyone’s standards,” said ISDA Chairman Eraj Shirvani, Co-Head of Credit Sales and Trading at Credit Suisse. “That we have been able to reduce outstanding CDS by more than $25 trillion during this period of immense growth and activity for our products is testament to the will and force behind the industry’s efforts to keep operational issues firmly in check.”

“Notional outstandings are often misunderstood,” said Robert Pickel, Chief Executive Officer of ISDA. “While they tend to give an exaggerated impression of amounts at risk, reducing notionals helps both front and back offices. Cancelling out economically offsetting transactions reduces the cost and operational workload of managing those transactions. ”

According to ISDA's semi-annual survey to mid-year 2008, the notional amount outstanding of credit default swaps (CDS) decreased by 12 percent in the first six months of the year to $54.6 trillion from $62.2 trillion. For the same period, Trioptima reported $17.4 trillion in completed CDS tear-ups. Subsequent notional reductions would bring CDS notional outstandings to $46.95 trillion before accounting for new trades since July 1, 2008.

The notional principal, or notional amount, of a derivative contract is a hypothetical underlying quantity upon which interest rate or other payment obligations are calculated. Notional amounts are an approximate measure of derivatives activity and reflect the size of the field of existing transactions. For CDS this represents the face value of bonds and loans on which participants have written protection.

The Promise of Index Insurance

(World Bank) Index-based insurance is an innovative financial product, which has been introduced in recent years in countries as diverse as India, Mongolia, Malawi and Thailand. It allows individual smallholder farmers to hedge against agricultural production risk, such as drought or flood. The product pays out in events that are triggered by a publicly observable index, such as rainfall recorded on a local rain gauge. Advocates argue that index insurance is transparent and inexpensive to administer, enables quick payouts, and minimizes moral hazard and adverse selection problems associated with other risk-coping mechanisms and insurance programs.

Figure 1 presents an example of a policy against deficient rainfall. As one can see, upper and lower rainfall thresholds are specified. The policy pays zero if accumulated rainfall exceeds the upper threshold; otherwise, the policy pays a fixed amount for each millimeter of shortfall relative to the upper threshold, until the lower threshold is reached. If rainfall falls below the lower threshold, the policy pays a fixed (higher) payout.

Figure 1 -Weather insurance brief

As mentioned in President Zoellick’s 10-Point Plan, this financial innovation holds significant promise for rural households. Shocks to agricultural income, such as a drought-induced harvest failure, generate fluctuations in household consumption that are not perfectly insured; at the extreme they may lead to famine or death. The evidence suggests that households in developing countries are only partially insured against income shocks. Moreover, weather events tend to affect all households in a local geographic area, making other risk-sharing mechanisms, such as inter-household transfers and local credit and asset markets, less effective at reducing the impact of the shock.

Index-based insurance policies can be sold as a stand alone product or linked with credit.
A series of papers [India-WBER, barriers] study a stand alone rainfall insurance product offered in recent years to smallholder farmers in the Andhra Pradesh region of southern India. Another paper [Malawi - JDE] studies the demand for insurance when it is bundled together with a loan.

These policies are typically sold without subsidies. The premium is calculated as the sum of the expected payouts, a share of its standard deviation and of the maximum sum insured in a year (loading factor), plus a percent administrative charge and government service tax.

A basic research question for the study of these micro-insurance products is estimating the determinants of household insurance take-up, and identifying the factors which prevent the remaining households from participating.

Evidence from India suggests credit constraints and low household income appear to be an impediment to purchasing insurance. Households with less land and less wealth, as well as those households which report being credit constrained, are less likely to participate in insurance. Insurance participation increases with wealth. Second, a variety of results together suggests that limited familiarity with the insurance product plays a key role in participation decisions. Take-up rates are higher among existing customers of the insurance vendor. Risk-averse households are less likely to purchase insurance, but only if they are unfamiliar with insurance or with the insurance provider. Respondents who likely have lower cognitive costs of understanding and experimenting with insurance, such as young farmers and self-identified progressive farmers, are more likely to purchase the product. And a significant fraction of households cite advice from other farmers and limited understanding of the product as important determ12:17 PM 09/17/2008inants of participation decisions.

The finding of the significance of credit constraints has practical implications for insurance contract design. One is that insurance payouts should be made as promptly as possible after rainfall is measured and verified. A second implication is that it may be advantageous to combine credit with insurance, as has been done in Malawi. The results there suggest that the lender is already providing a lot of implicit insurance through limited liability. In other words, in case of a drought, the lender will forgive the loan without future negative consequences. In this context, then, clients are not very interested in additional insurance.

Thus, there are barriers to the demand for these insurance products which have not yet succeeded in proportionately reaching the most vulnerable households, which presumably would benefit the most.

In the case of Malawi, the focus has been on the client’s demand for insurance, not the lender’s. When one takes into account the lender’s perspective, a much clearer picture emerges. For the lender, weather insurance is an attractive way to mitigate default risk and thus, it can become an effective risk management tool with the potential of increasing access to credit in agriculture at lower prices.

Report: almost half of Nevada homeowners underwater

(Calculated Risk) The WSJ reports on a new report from First American CoreLogic that estimates 48% of homeowners with a mortgage in Nevada owe more than their homes are worth. The WSJ reports that First American CoreLogic estimates 18% of homeowners with a mortgage nationwide are underwater.

Using the Census Bureau 2007 estimate of 51.6 million households with mortgages, 18% would be 9.3 homeowners with negative equity. This is less than the recent estimate from Moody's of 12 million households underwater.

Percent Homeowners with Negative Equity Click on graph for larger image in new window.

This graph shows the percent of homeowners with mortgages underwater by state (data from First American CoreLogic via the WSJ)

Note: there is no data for Maine, Mississippi, North Dakota, South Dakota, Vermont, West Virginia and Wyoming.

It's interesting that the two worst states are Nevada and Michigan - one a bubble state, the other devastated by a poor economy. That pattern continues - everyone expects the bubble states of Arizona, Florida and California to be near the top of the list, and Ohio too because of the weak economy - but what about Arkansas, Iowa and even Texas?

DTCC May Raise Credit-Default Swap Disclosure Amid Criticism

(Bloomberg) The Depository Trust & Clearing Corp., which operates a central registry for the $55 trillion credit- default swap market, may agree to disclose more data to counter criticism the derivatives amplified the financial crisis.

New York-based DTCC has discussed with banks, brokers and others that own the company ``whether or not there's any broader access to information we might provide,'' spokesman Stuart Goldstein said in an interview yesterday, declining to elaborate on what data may be published.

The DTCC earlier this month began releasing some information on trades in the registry to clear ``misconceptions'' about credit-default swaps following the bankruptcy of Lehman Brothers Holdings Inc., among the market's largest dealers.

Credit-default swap traders have come under increased scrutiny since Lehman collapsed last month and the U.S. government was forced to rescue American International Group Inc., which faced bankruptcy after rating downgrades forced it to post more than $10 billion in collateral on credit swap trades that had plunged in value.

Officials from U.S. Securities and Exchange Commission Chairman Christopher Cox to New York Insurance Superintendent Eric Dinallo have called for increased regulation of the swaps. Dinallo, in an interview that aired Oct. 26 on the CBS news show ``60 Minutes,'' called the market ``legalized gambling.''

After estimates from analysts that as much as $400 billion in credit swaps may have been tied to Lehman, raising concerns that hedge funds and others may struggle to make good on the bets, DTCC said only $5.2 billion had to be paid out from among the $72 billion of total contracts in the registry.


``The market would benefit from the information that DTCC has,'' said Brian Yelvington, a strategist at fixed-income research firm CreditSights Inc. in New York. Had data on Lehman been released sooner, ``there would not have been as much fear- mongering,'' he said.

About 90 percent of credit swap trades are electronically matched and confirmed through the DTCC's network, according to the company's annual report, suggesting that most trades since the end of 2006 are recorded in the registry. DTCC has said it has backloaded ``the vast majority'' of outstanding trades into the registry, known as the Trade Information Warehouse.

DTCC is controlled by a board of members, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and other dealers that created and control trading in the credit-default swap market. Trading exploded the past decade as the market went from being largely a tool for banks to hedge loans to a place where hedge funds, insurance companies and other asset managers could speculate on the creditworthiness of companies, governments and other borrowers including homeowners.

Misguided Criticisms

Many criticisms leveled at the market are misguided, according to Robert Pickel, head of the International Swaps and Derivatives Association in New York, the industry group that sets standards for traders. The contracts are an effective tool to hedge against losses, and the losses that toppled firms such as AIG were triggered by the underlying loans, not the derivatives, he said.

``We do need to look at how more information, certainly to regulators if not to the general public, can be distributed,'' Pickel said in an interview this week. ``We certainly understand the interest now in having that more widely available, and the Trade Information Warehouse is probably the best source of that.''

Thursday, October 30, 2008

Never Mind the Fed — Watch Libor

(WSJ MarketBeat) Forget about the Fed. What needs to be watched in coming weeks is Libor, if you’re looking for cues on the direction for equities in coming days and weeks.

Some believe rate decisions from the Fed no longer carry the paramount importance they once did for markets because the link between that target and what banks actually charge one another has broken down to some extent.

Other measures, including the distressed asset repurchase program and the Treasury Department’s bank bailout, are just as important as rate policy, said Zach Pandl, economist at Barclays. For a sign that those liquidity efforts are taking effect, watch the London Interbank Overnight Rate, or Libor, rate, he said. “That’s the canary in the coal mine,” Mr. Pandl said.

The overnight dollar Libor rate fell to 0.73% from 1.14% Wednesday, below the then-Fed target rate. The spread between the federal-funds rate and the three-month interbank lending rate fell to 2.46 percentage points from 2.58 percentage points Wednesday, still quite elevated. For a sign that bank lending is returning to “normal,” Mr. Pandl said, the three-month spread would have to narrow to 12 to 15 points.
The three-month rate remains “stubbornly high,” and banks demand for money relative to supply remains tight, said Stephen Gallagher, an economist at Societe Generale. And until the spread narrows, Mr. Pandl said, rate cuts won’t have any traction to assist the economy. That’s because the availability and cost of loans to corporations and consumers depends on the interbank lending rates.

On Tuesday, Sept. 17, stocks rallied despite the Fed’s unexpected decision to leave its target overnight lending rate unchanged. This time, stocks bounced around the flat line even as the Fed cut rates.

Since the failure of Lehman Brothers Holdings Inc. (LEHMQ) in mid-September, the Fed has flooded markets with liquidity, but that hasn’t pushed banks to increase lending significantly, Mr. Gallagher said. The commercial paper market has begun to respond to action from the Federal Reserve, as the total amount of commercial paper outstanding increased by $100.5 billion to $1.549 trillion for the week ended Wednesday, the first increase in seven weeks.

“A low fed-funds rate helps bank profitability to the point banks are willing to continuously refinance themselves, but the benefits to the economy are muted,” he wrote.

However, there are disagreements as to the efficacy of these moves — whether the improvements in commercial paper and Libor rates truly reflect an improvement in underlying credit conditions, or not much more than a propping-up by the authorities. “To argue that the credit crisis is easing because government-controlled interest rates are falling is to argue that inflation is abating because the government-controlled target funds rate was getting cut,” writes James Bianco, president of Bianco Research LLC. “It is true that some companies have gone from no access to in the commercial paper market to a government subsidy. Why is this a sign things are getting better?”

The other reason traders aren’t swayed by the Fed’s U.S. policy: the global nature of markets and economic activity. To that end, the Fed also unveiled a program to cooperate with Brazil, Singapore, Mexico and South Korea by establishing “swap lines.” Signals from the Bank of Japan and the European Central Bank that they will follow the Fed’s moves cheered stock markets overseas, which featured a 10% rally in the Nikkei.

One trader said it was significant that the Fed highlighted the coordinated interest-rate cuts worldwide. Even the Fed is taking a global view, said Craig Peckham, head of equity trading at Jefferies, who will watch the actions at the European Central Bank and other central banks worldwide.

Commercial paper rates have snapped back, but some wonder whether this would have happened without government support. (Source: Federal Reserve)

The Ackman TARP Plan: Finance But Don't Buy

(Clusterstock) We still don't know how the Troubled Asset Relief Program is going to work. Right now it looks like the government is gearing up to buy illiquid assets from banks, although which assets and at what prices remains a deep mystery. Bill Ackman thinks he has a better plan.

Speaking on CNBC's Squawk Box this morning, Pershing Square's Ackman proposed an alternative plan. He would have the government provide financing to private firms that would bid on the assets in an auction.

"What I would do instead of the government being a buyer of complicated mortgage assets, is if the right thing to do create liquidity for these assets, the best way to do it is to actually have the government be a lender," Ackman said.

Under Ackman's plan the government would lend money at interest to buyers of illiquid mortgage related assets. This would avoid the problem of overpricing pricing assets because private buyers would still be bidding on the assets.

"There's an auction. There's competition among the private sector. The private sector loses their money first," Ackman said.

Ackman's plan appears to address one of the central problems facing the market: the lack of funds available to purchase the "troubled" assets. Right now these assets would have to be bought with cash because no one in the private sector is willing--or perhaps able--to finance the purchases. But with bank balance sheets bleeding and hedge funds facing huge redemptions, cash auctions for the assets could only bring in pitiful amounts that would force banks to take huge losses and write downs. In short, no one can buy, and no one wants to sell. Hence the illiquid market.

This assumes, however, that the Treasury and the banks holding the illiquid assets are right in their contention that the market is undervaluing the assets due to illiquidity. If the real problem is simply that the assets basically aren't worth anything, providing financing for their purchase won't help a thing.

Ackman thinks the private sector money would "no question" flow into the market.

"I think there's a shortage of private debt capital to finance complicated mortgage assets," he said. "I don't think there's any shortage of private equity capital."

DTCC Successfully Closes Out Lehman Brothers Bankruptcy

(DTCC Press Release) The Depository Trust & Clearing Corporation (DTCC), the leading post-trade clearance and settlement infrastructure for the U.S. capital markets, announced today that it successfully closed out over $500 billion in market participants' exposure from the Lehman Brothers, Inc. (Lehman) bankruptcy which occurred the week of Sept. 22. This was the largest close-out in DTCC's history. DTCC reports it does not expect there to be any impact to its retained earnings or to market participants' clearing fund deposits as a result of closing out these pending trade obligations.

"The liquidation of Lehman was complex, involved multiple asset classes, and required a methodical approach to mitigate potential losses from outstanding trading obligations," said Donald F. Donahue, DTCC chairman and CEO. "Without question, our ability to manage risk and see exposure from a central vantage point was instrumental in helping us ensure that market risk – and systemic risk – was avoided.

"During the crisis, DTCC also seamlessly processed four consecutive days of record high equity trading volume, which reached 209 million transactions in a single day on Oct. 10, thus providing certainty and stability for the financial system at a time of extreme market volatility."

Lehman was a leading participant in DTCC's depository, clearing corporations and OTC derivatives business. It ranked as a top three user of DTCC's Mortgage Backed Securities Division (MBSD); in the top five largest users of the Government Securities Division (GSD) and Deriv/SERV and in the top 10 participants of National Securities Clearing Corporation (NSCC) and The Depository Trust Company (DTC). Lehman Brothers International (Europe) was a participant of DTCC's European Central Counterparty Ltd. (EuroCCP) subsidiary.

DTCC subsidiaries, NSCC, the Fixed Income Clearing Corporation's (FICC) GSD and EuroCCP, are central counterparties (CCPs) guaranteeing that most trades outstanding at the time of a bankruptcy of a member firm such as Lehman will be settled on the original terms. By acting as CCPs, the clearing corporations step in between the seller and buyer of each trade to assume the counterparty risk and the responsibility to deliver the securities to the buyer and payment to the seller.

Mortgage-backed and Government Securities

FICC's MBSD handled the liquidation of a gross position of $329 billion in par value of Lehman's book of "to be announced" mortgage-backed securities trades that were outstanding at the time of its bankruptcy. Working with all the dealers, banks and other firms with which Lehman had conducted trades, and acting as a "CCP for a day," FICC MBSD was able to net down and resolve almost 90% of the forward trades. Over the following few weeks, FICC gradually sold the remaining net obligations into the market with no losses assessed against MBSD members' clearing deposits and with no observed market impact.

Lehman's pending U.S. Government securities trades ran to $190 billion (gross positions) at the time of the bankruptcy. FICC's GSD guarantees the settlement of these trades once it accepts them for clearing. In order to make good on its guarantee, FICC had to close out the various positions, which ranged from repos to government bonds. FICC successfully closed out these positions without impact on customers.

Equities, Municipal and Corporate Bonds

NSCC, which is responsible for clearing and settlement of virtually all broker-to-broker trades in the U.S. in equities and corporate and municipal debt securities, faced total exposure of approximately $5.85 billion from Lehman Brothers at the time its accounts were closed.

NSCC's goal at this stage was to mitigate risk for its members and avoid significant disruption in the marketplace. This included processing and guaranteeing $3.8 billion in options exercises and assignments from The Options Clearing Corporation for the quarterly expiration on Friday, Sept. 19. The close out of these Lehman positions at NSCC is substantially complete. Most of these positions have been liquidated, and there are not expected to be any losses in excess of the Lehman clearing fund held, resulting in no losses to be allocated to other NSCC members.

A portion of Lehman's obligations at NSCC was successfully resolved when DTCC's subsidiary, The Depository Trust Company (DTC), took the lead in working with Lehman's pledgee bank to arrange for the release of $1.9 billion in securities, which were used to satisfy open trades at NSCC. As a result, NSCC did not need to go to the marketplace to purchase securities to complete these trades. In addition, DTC managed the net debit cap controls on Lehman's accounts throughout this period to limit any potential loss to the depository and its participants.

FICC and NSCC retained an investment manager to assist in liquidating positions held by the clearing corporations. The investment manager provided advice and helped determine the best strategy to hedge the portfolios, minimize risk and conduct an orderly liquidation without disrupting the markets.


EuroCCP, a U.K.-based subsidiary of DTCC which is providing pan-European clearing and settlement services for multilateral trading facilities, also had to deal with closing out trading positions for Lehman Brothers International (Europe) just one month after its start of business and even before EuroCCP officially went into full production on Sept. 22.

EuroCCP suspended Lehman from new trade input on Sept. 15, but continued to settle as many of the open positions as possible with Lehman's agent banks so it could deliver the securities to other participants on the same day. Lehman had open trades in 12 markets and six currencies, totaling almost €21 million. About €5 million in trades were settled by Lehman's agents on Sept. 15.

The next day, EuroCCP ceased to act for Lehman once it became clear that Lehman's agent banks would no longer be settling the remaining positions. EuroCCP engaged a broker to close out the €16 million in remaining positions. EuroCCP settled with the broker on T+1, instead of the usual T+3 cycle, which accelerated the fulfillment of its obligations to participants who were awaiting delivery of securities. EuroCCP successfully completed its closeout of Lehman's open positions without the need to use EuroCCP's Guarantee Fund.

OTC Derivatives Trade Information Warehouse

DTCC also acted to minimize risk for its OTC derivatives customers from the Lehman bankruptcy. The actions included stopping the automated central settlement of credit default swap (CDS) payment obligations on Sept. 15 that were maintained in DTCC's Trade Information Warehouse (Warehouse) for counterparties of Lehman Brothers International (Europe) and Lehman Brothers Special Financing, Inc. DTCC also assisted counterparties in removing from the Warehouse more than 300,000 CDS contract positions that market participants held with Lehman.

On Oct. 21, DTCC also completed, without incident, the automated credit event processing of Lehman Brothers Holdings Inc. (LBHI) involving $72 billion of credit default swaps. DTCC calculated and bilaterally netted all amounts due on credit default swaps written on LBHI. This resulted in approximately US$5.2 billion owed from net sellers of protection on LBHI to net buyers of protection. The portion of this net funds settlement allocable to trades between major dealers was handled through the normal settlement procedures of CLS Bank International, DTCC's settlement partner for the Warehouse and the world's central settlement bank for foreign exchange.

DTCC's Comprehensive Risk Management and Strategy

With a 35-plus year history in clearance and settlement, DTCC was able to draw upon its proven experience in effectively managing and controlling risk associated with a financial firm failure. As part of its comprehensive risk process, DTCC regularly puts its risk and operating systems, as well as staff, through intensive testing that simulate the possibility of a crisis. These exercises involve simulating the steps DTCC would have to take to respond to a major financial firm failure. Even though it seemed like a far-fetched scenario at the time, on two occasions over the past 12 months, DTCC actually conducted tabletop exercises simulating the failure of a major investment bank. Members of DTCC's Board and representatives of various regulatory authorities participated in the second of these exercises as observers.

"Although we didn't really expect to have to put the experience we gained from those exercises to work any time soon, events proved otherwise," said Donahue. "They both provided highly useful practice runs for what DTCC and our market participants have been dealing with in recent months."

The CDS sector is not the central villain

(Robert Pickel, ISDA CEO @ FT) Last week saw an important milestone in the credit default swaps sector, when counterparties to CDS trades on Lehman Brothers cash-settled their transactions.

Based on a protocol and auction process developed by ISDA, protection sellers paid 91 cents on the dollar to protection buyers. An estimated $6bn to $8bn was paid out. Over the past 25 years, the privately negotiated derivatives industry has developed a robust framework – one that governs and guides participants through such an event, and which includes procedures and processes for valuing and unwinding trades. Recent defaults show the value of these efforts – the industry’s infrastructure clearly works.

Just as clearly, the Lehman default and settlement are not the financial catastrophe CDS critics claimed they might be. The widely cited industry estimate of $400bn in notional amount of Lehman CDS trades outstanding includes a significant number of offsetting transactions. Dealer firms generally have minimal net exposure via CDS; if they sell protection, they also generally buy protection to offset the risk. Net these positions out and net amount of risk transferred is a low single-digit percentage of the notional amount. Cash payments on Lehman were about 91 per cent of that net amount.

Two more points must be kept in mind. First, companiees are required to mark positions to market, and they have already calculated the impact of Lehman’s default on their financials. Second, companies require counterparties to post collateral to back their exposures, so most of the $6bn-$8bn paid out was already collateralised. The bottom line is that groups had little incremental exposure to the Lehman cash settlement.

It’s also worth noting that, in spite of the failure of Lehman, as well as several other large counterparties, the CDS business continues to function effectively. CDS have proven to be the main – and sometimes the only – way to shed risk or express a view on market behaviour. While cash, securities and money markets have seized up, the CDS business still operates.

Why, then, all the drama about CDS? It starts with some fundamental misperceptions. CDS, like other privately negotiated derivatives, are bilateral, privately negotiated contracts between counterparties.

The business is conducted within a sound policy framework fashioned by regulators, legislators and participants; within that framework, CDS trading is subject to extensive regulatory oversight, risk management control, corporate governance and financial reporting requirements.

Banking supervisors, and other financial regulators in each country, oversee and limit the risks taken by those they supervise, including the risks of exposure to counterparties on CDS and other credit products. The exposures of systemically important institutions to CDS are known, both by the managers of those institutions and by their regulators. Because of their ability to provide real-world solutions to real- world companies, the volume of CDS notional outstanding has increased significantly. Today, it measures about $55,000bn. This number represents the protection sold on more than 1,000 CDS “reference entities” across the world. After factoring out offsetting positions, the number is about $1,000bn, a big reduction but still a large number. Most of this amount is, as per Lehman, collateralised.

Perhaps the biggest misperception about the CDS sector is its role in today’s financial crisis. The root cause of the financial sector’s woes is too many bad mortgage loans. While some observers point to AIG’s use of CDS as contributing to its downfall, the truth is that the company, like others, took on the risk of too many defaulting mortgages and troubled loans.

Global policymakers intend to review the regulatory framework for financial institutions. The industry welcomes this discussion as it will provide a forum for explaining and the benefits privately negotiated derivatives offer. Such derivatives are a global activity – as well as an important source of innovation and growth.