Thursday, April 30, 2009

Repo Failure Remedy Drives Away Bond Short-Sellers

Posted on Bloomberg by Liz Capo McCormick:

Just as Federal Reserve Chairman Ben S. Bernanke revives credit markets, one of his remedies may reduce trading in Treasuries.

A Fed-endorsed industry recommendation will require traders to pay a three-percentage-point penalty on uncompleted trades, known as fails, starting tomorrow. That may reduce the number of bets on price declines, according to RBS Securities Inc. and Societe Generale SA.

While the new recommendations are meant to curb disruptions caused when traders fail to meet their obligations, some strategists are concerned it may do more harm than good in the $7 trillion-a-day repurchase market, where dealers finance their holdings. A reduction in trading would be a setback for the Fed as it seeks to lower borrowing costs by pumping cash into the banking system and purchasing as much as $1.75 trillion in Treasuries and mortgage securities.

“Making short-selling potentially costly can reduce market liquidity,” said Darrell Duffie, a Stanford University finance professor and member of the New York Fed’s Financial Advisory Roundtable. “Financial markets with relatively unencumbered short-selling perform better.”

The U.S. needs to raise $3.25 trillion this fiscal year to finances bank bailouts, stimulate the economy and service a deficit, according to New York-based Goldman Sachs Group Inc., one of the 16 primary dealers that trade with the Fed.

Trading Decline

Trading is already down, with volume done through the primary dealers averaging $363.6 billion a day this year, compared with $655.6 billion in the same period of 2008 and $533.3 billion in 2007, according to Fed data.

Interest rates near record lows and surging demand for the safety of Treasuries pushed the amount of bad trades to a record $5.3 trillion in the week ended Oct. 22.

Federal Reserve Bank of New York President William Dudley, who succeeded Geithner in January, said during a Nov. 12 interview that U.S. borrowing costs could rise if the logjam in the repo market, which dealers use to finance their holdings, wasn’t rectified. The New York Fed said Jan. 15 that it endorsed the Treasury Market Practices Group penalty recommendation, as well as other measures to reduce fails.

The changes should “provide an incentive for the prompt resolution of settlement failures, and with the expectation that these guidelines will contribute to the depth and liquidity of the United States Treasury market, Karthik Ramanathan, acting assistant secretary for financial markets at the Treasury, said in a statement yesterday.

Securities as Collateral

The penalty proposed by the TMPG, an industry committee formed by the Fed in 2007, would add an incremental cost of $833.33 dollars per day on a failure of $10 million worth of bonds, according to data compiled by Bloomberg.

In a repurchase agreement, one party provides securities as collateral to another in exchange for cash. The penalty would result in the lender receiving a reduced amount when it delivers the Treasury late.

“Where market makers may have felt comfortable in the past making outright short sales to investors, there certainly has to be a greater consideration of these negative costs,” said Ken Silliman, a Treasury bill trader in Greenwich, Connecticut, at RBS Securities Inc., another primary dealer. “The fails penalty has risk of reducing liquidity in bills and Treasuries all along the yield curve.”

Confidence Is Returning

Investor confidence in financial markets is returning after the U.S. government and the Fed agreed to spend, lend or commit $12.8 trillion to end the longest recession since the Great Depression. The London interbank offered rate, or Libor, for three-month loans in dollars fell yesterday to 1.03 percent, the lowest level since June 2003, according to the British Bankers’ Association.

Yesterday, the Fed refrained from increasing purchases of Treasuries and mortgage securities, signaling the worst of the recession may be over, as it kept the federal funds rate target at a range of zero to 0.25 percent for the third straight meeting.

There is little incentive to make good on delivery commitments when rates are close to zero because the main cost for failing to deliver a borrowed security is the loss of interest that would have been received on the money lent to obtain it.

Overnight general collateral repo rates were about 0.25 percent today, according to GovPX Inc., a unit of ICAP Plc, the world’s largest inter-dealer broker.

‘Functioning Properly’

“If you have fails, then the market isn’t functioning properly,” said Eric Liverance, head of derivatives strategy at UBS AG in Stamford, Connecticut, another primary dealer. “That is what we saw last fall when we had massive fails. If you can lend a bond out and count on it coming back the next day, then those are properly functioning markets and it enhances liquidity.”

Trading failures fell to as low as $81.06 billion in the week ended April 8, before rising to $272.4 billion the following week, according to New York Fed data.

Primary dealers typically short Treasuries as a trading strategy to hedge their holdings in other securities. That’s changed this year, leaving them “long,” in part, because of the new repo recommendations. They held $75.1 billion of Treasuries as of April 8, the most since at least 1997, compared with an average of minus $60.6 billion, Bloomberg data show. The amount fell to $60.6 billion as of April 15.

‘Being Prudent’

“That is telling you that dealers really don’t know what all this will mean,” said Donald Galante, chief investment officer and senior vice president of fixed income at MF Global Ltd. in New York. “People are being prudent and saying I am not going to have a Treasury short now and I’ll wait to see how this pans out over the next two months.”

Galante advised his traders to not take short positions in the repo market or in short-term Treasuries going into May to allow time to analyze how the penalty and movements in repo rates evolve.

The threat of penalty will likely cause repo rates to drop below zero on Treasuries that have had high levels of fails or whose rates have traded close to zero in the repo market, according to Ira Jersey, head of U.S. interest-rate strategy in New York at RBC Capital Markets. Jersey cited the current five- year note as an example. The repo rate on that security was 0.05 percent yesterday, and 0.25 percent today, according to GovPX.

A negative repo rate means that investors who lend cash in exchange for obtaining securities as collateral actually pays interest instead of receiving it on the money they loan.

‘State of Anxiety’

Penalties for uncompleted trades will begin to accrue May 1. The due date for filing claims for fails to counterparties in trades that occur in May will be June 12, and payment or claim rejections will be due on June 30. In subsequent months the filing date will coincide with the 10th business day and the payment date will be on the last business day of the following month.

Because the penalties will be imposed across the government debt market, unregulated investors such as hedge funds will be held to the same standard as banks and bond dealers. Since it’s a recommendation, some dealers are still uncertain which counterparties will need to pay the penalty.

“The market’s heightened state of anxiety looks likely to produce unintended and unfortunate consequences,” said Ciaran O’Hagan, the Paris-based head of fixed-income at Societe Generale. “The fails penalty adds to the security of the market at the cost of liquidity. All this suggests that liquidity will be hurt across the board for U.S. Treasuries.”

FASB ‘Close’ on Off-Balance-Sheet Change, Herz Says

Posted on Bloomberg by Ian Katz:

The Financial Accounting Standards Board is “pretty close” to approving rules on off-balance- sheet accounting that will force banks to add billions of dollars of assets to their books, Chairman Robert Herz said.

Rules that let the companies keep assets and liabilities including mortgages and credit-card receivables off their balance sheets “were stretched,” Herz said today at an accounting conference at Baruch College in New York. The changes would take effect next year, he said.

U.S. bank regulators examining finances of 19 large banks calculated that the institutions would record $900 billion in off-balance-sheet assets in 2010, according to a Federal Reserve report released April 24 as part of the so-called stress tests. The Fed based its calculation on data provided by the banks.

In July, FASB postponed by at least a year the effective date of the changes after banks including Citigroup Inc. and trade groups complained. The Securities Industry and Financial Markets Association and the American Securitization Forum said the measure may make companies appear to be short of capital during regulatory reviews.

Investors are wary of a company’s unknown obligations as the world’s biggest banks and brokerages reported more than $1.3 trillion in writedowns and credit losses since the start of 2007, some stemming from losses at off-balance-sheet vehicles.

Many lenders made profits before the subprime-mortgage market collapsed by selling pools of loans to off-balance-sheet trusts, which repackaged the pools into mortgage-backed securities. Some banks then sold those securities to other off- balance-sheet vehicles they sponsored, concealing from investors that the securities were backed by souring mortgages.

The Fed report last week was part of the U.S. government effort to restore public confidence in banks, some of which have reported that capital was “substantially reduced” by the recession and financial crisis. Results from the bank tests are due for release as soon as May 4.

EU states give nod to new bank capital rules

Posted on Reuters by Huw Jones:

European Union states have approved new rules that will force banks to retain 5 percent of securitised products they originate and sell in a bid to make markets safer for investors, an EU diplomat said on Wednesday.

The reform is an attempt to apply lessons learnt from the financial market crisis by ensuring banks set aside enough capital to cover different risks on their books.

EU member state ambassadors gave the nod to a reform of the capital requirements directive, but some lawmakers in the European Parliament, which has joint say and votes next week, has been pushing for a higher retention rate on securitised products.

The text endorsed by EU states on Wednesday was the outcome of a joint deal with representatives of parliament but after that deal was struck, a group of lawmakers tabled amendments to increase retention to between 10 and 15 percent.

An official in parliament close to the talks said the joint deal includes a provision added this week calling on the European Commission to consider by year-end the need raise the retention figure and make proposals accordingly.

The hope is the pledge will soften the opposition enough to allow parliament to adopt the measure into law next week.

Securitised products, such as mortgage-backed securities, are at the heart of the credit crunch.

Despite being highly rated, they quickly became untradable as underlying home loans defaulted, forcing banks to make huge writedowns and triggering a series of government rescues.

Banks have warned the securitisation market is moribund and that a high mandatory retention requirement would stop its revival, but say privately they can live with 5 percent.

The capital requirements reform also caps how much a bank can lend to another bank in order to stop the wider financial system from being hurt if loans turn sour.

It will also set up colleges of supervisors for all big cross-border banks, so that all the national regulators that oversee operations across the EU meet regularly to share information and spot any problems early.

The reform is set to take effect in 2010 but another round of reform to the rules is already being planned.

EU Internal Market Commissioner Charlie McCreevy will propose in June giving supervisors powers to require a bank to top up its capital if its remuneration policy is encouraging very risky activities.

The Basel Committee, which drafts high-level principles on bank capital, will propose changes later this year to its Basel II rules which the EU's capital requirements directive has put into law.

The changes are set to include the requirement for banks to stick to a simple leverage ratio and this will be introduced into the EU through a future reform of the capital requirements directive.

Wednesday, April 29, 2009

Treasury Press Release on PPIP Manager Applications

Treasury Announces Receipt of Applications to Become Fund Managers under Public Private Investment Program

Washington, DC -- The Treasury Department today announced the receipt of more than 100 unique applications from potential fund managers interested in participating in the Legacy Securities portion of the Public Private Investment Program (PPIP). A variety of institutions applied, including traditional fixed income, real estate, and alternative asset managers.

Successful applicants must demonstrate a capacity to raise private capital and manage funds in a manner consistent with Treasury's goal of protecting taxpayers. Treasury will also evaluate the applicant's depth of experience investing in eligible assets. Finally, the applicant must be headquartered in the United States.

Treasury expects to inform applicants of their preliminary qualification around May 15, 2009. Once a fund receives preliminary qualification, it can begin raising the expected minimum of $500 million in private capital that will serve as the investment that, pending further approval, will be matched with taxpayer funds. As we have stated previously, Treasury anticipates opening the program to smaller fund managers in the future, which may result in a lower minimum private capital raising requirement.

Since announcing the program details on March 23, Treasury has encouraged small, veteran, minority and women owned private asset managers to partner with other private asset managers. On April 6, Treasury extended the deadline for fund manager applications to provide more time to facilitate these types of partnerships. We are pleased to see a number of creative partnership proposals among the applications we are currently evaluating.

Today's announcement is the latest milestone in making operational the PPIP for legacy loans and securities, a key part of the Administration's efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

For further information on the PPIP, please visit:

Sorry, America, We're Too Corrupt To Fix The Financial System

Posted on the Business Insider by John Carney:

Everyone talks about implementing serious reform of the financial system, starting with the way we regulate large, complex systemically important financial institutions. Unfortunately, we lack even the basic political equipment to implement any worthwhile reforms.

As Thomas Frank points out in the Wall Street Journal, the reforms that were implemented following the crash of 1929 were the product of the famous Pecorra Commission. Led by a former New York attorney general named Ferdinand Pecorra, the Senate Banking Committee delved deep into the practices of Wall Street to discover what was working, what was thoroughly corrupt and what needed to be reformed.

While there are grounds to critique the Pecorra Commission, it was a sober and sane affair. It exonerated some publicly loathed business practices, such as short-selling, and concluded that some of the biggest financial institutions needed to be broken-up. The public nature of the hearings, closely covered by journalists at the time, provided something of an education for the citzenry on the structure of the financial system. This created broad political support for reforms, most of which were relatively straight-forward rules easily understood by at least the more informed members of the public. The Glass-Steagall Act, the Securities Exchange Act, and other financial regulations of the Roosevelt era were all products of its investigation.

None of that is likely to happen this time around. Our lawmakers are too throughly involved in this crisis too hold anything as comprehensive as the Pecorra Commission. The head of the Senate Banking Committee, Chris Dodd, is widely viewed as thoroughly compromised by the financial sector. Barney Frank, who leads the House's financial oversite board, was one of the greatest defenders of Fannie Mae and Freddie Mac, those housing bubble centers of corrupt accounting, dangerous securitization and politicized lending.

Here's Frank:

The crisis today is not solely one of bank misbehavior. This is also about the failure of the regulators -- the Wall Street policemen who dozed peacefully as the crime of the century went off beneath the window.

We have all heard the official explanation for this failure, that "the structure of our regulatory system is unnecessarily complex and fragmented," in the soothing words of Treasury Secretary Tim Geithner. But no proper Pecora would be satisfied with such piffle. The system was not only complex, it was compromised and corrupted and thoroughly rotten even in the spots where its mandate was simple.

This is good as far as it goes but it doesn't go far enough. Frank believes that poltical leaders in both parties will be too embarrassed by their support for financial deregulation to launch anything like a Pecorra II. Perhaps. But something else is at work here too.

In the 1920s, the financial sector was far less intertwined with the poltical apparatus than it was after the reforms that emerged from the Pecorra Commission and the New Deal. This meant that lawmakers were less compromised by ties to Wall Street, less involved with the crisis. They could take an outsiders view because they were outsiders.

Ironically, the very reforms of those outsiders transformed them into insiders. "Launching Pecora II would automatically raise this question: Whatever happened to the reforms put in place after the first go-round?" Frank asks. The answer to that question is that the reforms were self-devouring because the political dynamics of active regulation are a recipe for corruption and capture. Like Orwell's farmers and the pigs sitting at the table playing poker, it wasn't too long before it became hard to tell who was playng which role in the relationship. It really shouldn't be a surprise that politicized finance gave the system swine flu.

Is there any hope? Perhaps we can find a ground for hope in the fact that we are now familiar with this swinish dynamic in a way the Pecorra and the Senate Banking Committee of the 1930s were not. In attempting to reduce the costs of corruption on Wall Street, they didn't anticipate the risk of corrupting politics. We know better. That, at least, is a starting point.

Politics threaten CPP Investment Board integrity

Posted by on Globe & Mail StreetWise by Andrew Willis:

Canada runs a pension plan that's the envy of the world, crowned by a well-funded, professionally staffed, independent fund manager in the CPP Investment Board.

The integrity of that fund manager is in danger.

The problem is money – bonus money. CPPIB recruited top executives on the strength of two promises: They could make their own investment decisions, free from political interference, and their compensation would be comparable to peers in the private sector. On the basis of those guarantees, professionals left lucrative private sector jobs to run the country's retirements savings.

There is now pressure to break that second promise.

Grandstanding Liberal, NDP and Bloc members of Parliament grilled CPPIB executives yesterday over the bonus payments they will likely receive, despite expected losses at the fund this year. The $109-billion CPPIB fund was down 13.7 per cent or $13.8-billion in the first nine months of the year ended March 31, 2009.

The strongly-worded advice from a few MPs was to turn down long term bonus payments.

Bad idea, on every level.

The populist posturing from MPs could derail a very good thing for the Canadian people.

First, the CPPIB board worked long and hard to set up a compensation system that is largely focused on long-term performance – a big chunk of paycheques reflect the fund's results over four years. That encourages the long-term investment thinking a pension fund demands – managers have no incentive to swing for the fences to make short-term targets.

Second, the comp structure was set out in employment contracts. Companies don't tear up these contracts with employees without suffering grave consequences. Sticking with the swinging-for-the-fences analogy, a big league slugger with big-time guaranteed money still gets paid, even if the team doesn't win the World Series.

Compensation is a matter to be decided by the CPPIB's board, not by an MP in Ottawa.

And what seems lost on the MPs, who have their own gold-plated pension plan, is that CPPIB is likely going to outperform benchmarks. Yes, they will have lost money last year. Welcome to the club. But the team likely lost less than peers, or their performance standards.

If CPPIB executives are forced to turn down bonus payments, despite meeting performance goals, the best people on this team should quit, and some will quit. The fund's ability to recruit will be destroyed. That would be an enormous setback for Canada.

Why is it MPs can't step back from Parliament's partisan poison, and recognize that CPPIB fund managers did a decent job in a lousy market? Is everything in Ottawa about scoring points?

If you're wondering, here's how compensation broke for CPPIB chief executive officer David Denison in 2008: $475,000 salary, $1.2-million annual bonus, $1.9-million LTIP.

(See also the Pension Pulse commentary.)

Derivatives Hit Austrian Railroad With Record Loss

Posted on Bloomberg by Zoe Schneeweiss:

OeBB-Holding AG, Austria’s state- owned railroad company, reported a record 966 million-euro ($1.3 billion) loss after writing down the value of derivatives that went awry.

OeBB’s 2008 loss compared with a profit of 42.4 million euros a year earlier after the company wrote down the entire 613 million-euro notional value of synthetic collateralized debt obligations. The Vienna-based company, which bought the contracts from Deutsche Bank AG in 2005 and 2006, is appealing a February court ruling dismissing a claim that the lender didn’t disclose the risks associated with the derivatives.

State-owned companies and local authorities from Germany to Italy reported more than 1.13 billion euros of losses on derivatives that allow buyers to speculate or protect against risk, leaving taxpayers to pick up the tab.

“There was a climate that pressured publicly owned companies to look for creative ways to finance themselves,” said Thomas Hofer, the Vienna-based owner of H&P Public Affairs, which advises political campaigns. “They were given the feeling of being financially negligent if they didn’t invest in derivatives.”

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or weather. CDOs, which package other bonds and loans into notes of varying risk and yields, are losing money as their holdings get downgraded.

‘Didn’t Fully Disclose’

“Deutsche Bank didn’t fully disclose all the risks attached to the CDOs,” Bettina Gusenbauer, an OeBB spokeswoman, said in a phone interview from Vienna.

The derivatives and the risks were fully reviewed with OeBB, a Deutsche Bank spokesman, who declined to be identified, said in an e-mail. OeBB initiated the transaction, not Deutsche Bank, the e-mail said.

Taxpayers shouldn’t “have to pick up the bill for speculative investments,” said Susanne Enk, a spokeswoman for Austria’s Federal Ministry of Transport, when asked about OeBB’s investment.

OeBB’s CDOs package credit-default swaps tied to debt including asset-backed securities and company bonds and expire between 2013 and 2015, the company said. OeBB made provisions on the securities of 420 million euros in 2008, and 157 million euros the year before, it said today.

‘Precautionary Measure’

The provisions are a “precautionary measure,” OeBB Chief Financial Officer Josef Halbmayr said at a press briefing in Vienna today. “We’ve taken all relevant measures to ensure that deals of this kind won’t take place again,” he said.

Credit-default swaps are derivatives used to protect against debt losses or speculate on credit quality, and pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to meet its obligations.

Municipal authorities across Europe are reporting losses from derivatives since credit markets unraveled in the slump triggered by the collapse of the U.S. subprime mortgage market in August 2007.

Milan’s financial police seized 476 million euros of assets from UBS AG, Deutsche Bank, JPMorgan and Depfa Bank Plc this week in an investigation into alleged fraud linked to the sale of interest-rate swaps, which are designed to protect buyers against losses caused by fluctuations in borrowing costs.

The city is suing the banks after losses on derivatives purchased in 2005, and alleges the lenders misled municipal officials on the advantages of the securities. Officials at the banks declined to comment, as did a spokesman for Milan’s city council.

Interest-Rate Swaps

In Germany, the Wuerzburg Regional Court ordered Deutsche Bank in March 2008 to cover a third of the 2.6 million euros city utilities lost in interest-rate swaps bought from the lender. A court reduced a loss claim against Frankfurt-based Deutsche Bank in July by the city of Hagen, Germany, to 1 million euros, from 47 million euros. Both decisions are being appealed.

A Deutsche Bank spokesman said the bank disclosed all risks and informed the municipalities “comprehensively” when selling derivatives in Germany.

“Swaps are like anything else where there’s a sophisticated seller and a simple-minded client,” said Anthony Neuberger, Professor of Finance at Warwick Business School in Warwick, England. “Anything complex can have effects that are different from those anticipated.”

French local authorities are susceptible to buying derivatives because the country’s rules are lax, according to a July report by Fitch.

French Rules

“The French rules, which do not limit the risk taken by local authorities using structured debt, favored the growth” of derivatives, the ratings company said.

About 25 percent of the 132 billion euros of debt owed by local public administrations in France was tied to derivatives as of January, according to Christophe Parisot, a Fitch analyst in Paris.

French Budget Minister Eric Woerth said in February that structured finance holdings don’t pose “a systemic financial and budgetary threat.”

“Structured credits are proposed only to certain clients with significant borrowings and with teams capable of following them,” Dexia SA, which received a 6.4 billion-euro bailout last year by France, Belgium and Luxembourg and which is the biggest lender to local governments, said in a January report to clients.

Derivatives Banned

Losses on derivatives led some European governments to ban local authorities or state-owned companies from investing in derivatives.

The U.K. High Court ruled that about 3.2 billion pounds ($4.7 billion) of swap contracts entered into by Hammersmith and Fulham Council were unenforceable in the 1980s. The 1997 Local Government (Contracts) Act banned investment in the derivatives, according to a spokeswoman at the Department for Communities and Local Government.

Polish municipalities can’t use derivatives, according to local-government Web site, which cites the Finance Ministry’s May 2008 interpretation of the Law on Public Finances.

In Finland, “city fathers learned it the hard way -- there’s no speculation” in the derivatives market because, “in the previous recession, some municipalities speculated on currencies” and lost, said Reijo Vuorento, planning manager at the Association of Finnish Local and Regional Authorities.

Tuesday, April 28, 2009

Milan police seize €476m of assets in bond probe

Posted on the Financial Times website by Vincent Boland:

Police in Milan said on Tuesday they had seized €476m in assets from four international banks in a dramatic escalation of an investigation into controversial municipal bond issues.

The city’s financial police began the investigation last year into a €1.6bn bond issue the city of Milan launched in 2005, and were probing the role of four banks – Deutsche Bank, JP Morgan, UBS and Depfa, a German bank specialising in public finance – in that and other transactions.

In a statement on Tuesday, the financial police said they had taken control of €476m in assets from four banks, though they did not name them. The assets seized included the banks’ stakes in Italian companies, real estate, and accounts.

The move marks a sharp escalation of the probe into the bond issues. Milan, Italy’s financial capital and one of its wealthiest cities, is already suing the four banks, claiming that derivatives contracts linked to the bond issues allowed the banks to earn around €90m in “hidden commissions”. It also complains that the bond issues were not in the city’s best financial interests.

None of the banks had any immediate comment on Tuesday.

The case is being watched closely by cash-strapped Italian local authorities who issued billions of euros of bonds with similar contracts until the Bank of Italy stopped the practice in 2007. The municipalities now face deteriorating fiscal positions as the global financial crisis begins to bite.

Many of the derivatives contracts exposed the authorities to rising debt service costs between 2005 and 2008, when eurozone interest rates rose from 2 per cent to 4.25 per cent. Estimates of the losses facing Italian authorities vary. The government has denied speculation that the losses could reach €30bn, but analysts say a more conservative estimate of up to €10bn may be more accurate.

At issue in the Milan case are provisions in the bond issue that enabled the city to set aside sums at regular intervals towards repayment of the principal. But as interest rates rose, the authorities found that funds earmarked for the sinking fund were being eaten up by debt servicing. The municipality claims the banks argued that the structure of the bond would reduce debt service costs.

Hong Kong Banks Sell Lehman Notes to Mentally Ill

Posted on Bloomberg by Nipa Piboontanasawat and Kelvin Wong:

Hong Kong banks sold notes linked to failed Lehman Brothers Holdings Inc. to elderly, poorly educated and mentally ill people, according to a central bank investigation that may fuel demands for better protection of the city’s investors.

The Legislative Council released previously blacked-out sections of a Hong Kong Monetary Authority report showing 102 cases in which “vulnerable” investors were sold the credit- linked notes, which plunged in value after Lehman’s Sept. 15 bankruptcy.

The disclosure was held up after the HKMA sought to keep some of its findings private and follows almost daily street protests by elderly investors who claim that banks had said the securities were low-risk. A total of HK$13.9 billion ($1.8 billion) of the credit-linked notes arranged by a local unit of Lehman were sold to Hong Kong individuals, according to the Securities and Futures Commission.

“If more restrictions are placed on the sale of investment products it could add a lot onto banks’ operating costs,” said Paul Lee, an analyst at Hong Kong-based Tai Fook Securities Ltd. “Customers may also be more reluctant to invest because of all the extra documents they have to go through.”

The central bank identified 102 cases where complex and risky investments were sold by banks to “vulnerable” investors, according to information contained in the blacked-out section of the HKMA report made public at a hearing in the city’s Legislative Council today.

Investor Interest

Some investors have alleged that banks and brokerages misrepresented the potential risks when selling the notes.

“What’s important right now is what the HKMA is preparing to do to help investors get their money back,” said Chim Pui- chung, a legislator representing the financial services industry. “So far they haven’t offered much on this part.”

The central bank had previously refused to disclose parts of its findings, arguing that it would be “against public interest.” It later agreed to reveal in closed meetings deleted parts of the report to legislators.

Sun Hung Kai & Co., the city’s biggest local brokerage by market value, in February agreed to pay back investors in the notes, making it the first vendor to decide to provide a full refund. It didn’t admit to any liability or wrongdoing in selling the products.

BOC Hong Kong Ltd., Bank of East Asia Ltd., Wing Hang Bank Ltd. and Dah Sing Banking Group Ltd. were among the 19 firms that sold the notes, according to the Hong Kong Association of Banks.

Clarina Man, a spokeswoman for BOC Hong Kong, declined to comment on the HKMA report. Vera Lung, a spokeswoman for Bank of East Asia, didn’t immediately return calls from Bloomberg seeking comment.

UK issuers grapple with Moody’s threat as Britannia programme gets ‘very high’ TPI

Posted on Euroweek:

Several UK financial institutions are exploring ways to stave off downgrades of their covered bonds or find alternative sources of liquidity after Moody’s last week threatened to strip the issues of their triple-A ratings, thereby restricting their access to the Bank of England’s Special Liquidity Scheme.

Some UK issuers had set up programmes solely to access the SLS, but covered bonds used as collateral in the scheme must have two triple-A ratings.

Moody’s downgraded Chelsea Building Society’s covered bonds from Aaa to Aaa3 on April 16 and left them on review for downgrade after earlier last week downgrading its issuer rating from A2 to Baa3 as part of a group of negative actions on UK mortgage lenders.

Its covered bonds are no longer eligible for the SLS, only having one triple-A rating now from Fitch, and the building society has said that it is in talks with the Bank.

Moody’s also put on negative review the triple-A rated covered bond programmes of Standard Life Bank and six UK building societies: Coventry, Newcastle, Norwich & Peterborough, Principality, Skipton and Yorkshire.

These issuers are now in discussions with the rating agency about how they can maintain top ratings for their covered bonds.

"We are currently talking to Moody’s about the rating action," said Guy Thomas, finance director at Principality Building Society. "They have made some suggestions about enhancing the cover pool, for example by increasing overcollateralisation or introducing a standby service provider.

"The difficulty is not knowing categorically what steps would avert a downgrade."

Time for pass-throughs?

One possibility that has been suggested is for issuers to restructure their programmes to try to achieve a higher Timely Payment Indicator (TPI) from Moody’s. This is a measure assigned by the rating agency that determines how closely an issuer’s rating is linked to its covered bond rating.

The programmes of Newcastle, Norwich & Peterborough and Principality have TPIs of "probable-high" because they have partial pass-through structures. The other issuers’ have TPIs of "probable" and one way in which they might be able to stave off a downgrade of their covered bonds would be to restructure their covered bonds and adopt a pass-through structure.

A change from probable to probable-high would, for example, be enough to raise the ceiling rating for the covered bonds of Skipton and Yorkshire from Aa1 to Aaa at their current rating levels.

And Britannia Building Society this week finalised a £3bn covered bond programmes that has been assigned a TPI of "very high" by Moody’s, meaning that its issuer rating could fall as low as Baa2 without its covered bond rating being constrained below Aaa.

Britannia said its covered bond programme is structured on a pass-through basis, "specifically to seek to de-link it from the business generally and thereby avoid the issues that the Moody’s review has posed for other societies."

Britannia executed a £1.4bn debut transaction this week. "The timing is entirely accidental," it said. "Like any sensible organisation, we are looking at diversifying our funding sources. Covered bonds may not have been necessary in the past given our activity in the securitisation market, but that market is not what it was. Covered bonds have an important part to play in our wholesale funding mix, which accounts for around one-third of our overall funding."

Britannia is rated A2 by Moody’s. The rating was placed on review for downgrade last week, but its programme was rated triple-A by Moody’s and also Fitch.

"We’re comfortable that the issues that Moody’s has with the other building societies won’t apply to our covered bonds," said Britannia. "There is clear water between Britannia and the other building societies in the sector."

Britannia members are set to vote on a proposed merger with The Co-Operative Bank at the annual general meeting next week.

BNP Paribas, HSBC, JPMorgan and Royal Bank of Scotland arranged Britannia’s programme.

However, although pass-throughs hold out the prospect of more stable ratings for UK covered bonds, one banker suggested that restructuring programmes was an unenviable task within the timeframe before Moody’s could take further action — 30 days — and given that the Bank of England might anyway relax the SLS criteria by, for instance, making them the same as for the Discount Window.

Those issuers that have only issued for the purpose of accessing the SLS could find it easier to restructure their programmes that have sold bonds publicly.

"It’s fair to say that it’s a lot easier to restructure those programmes where only a single series of covered bonds has been issued because then you are just dealing with one noteholder," said Sally Onions, a senior associate at Allen & Overy. "Obviously it is a lot harder to get approval to restructure a programme when you have a disparate group of noteholders that must agree."

Yorkshire Building Society was the first of the institutions affected to issue covered bonds, first tapping the public markets in October 2006. It has sold several covered bonds publicly and could therefore face the most difficulty materially changing the terms of its programme.

Market participants have also pointed out that European investors that had bought bullet bonds would be unlikely to want to be left holding pass-through securities.

Contingency planning

The issuers are also looking beyond maintaining their ratings at alternative measures.

"There are a wide range of options available to us, including taking steps to maintain the triple-A rating of our covered bonds. We are looking at the relative cost and appropriateness of those options," said Jonathan Westhoff, finance director at Newcastle Building Society. "All these things are about choices."

Indeed the institutions have played down talk of the possible downgrades of their covered bonds causing a "crisis", stressing that they have other options open to them, even if their covered bond ratings are cut.

"Ninety-five percent of our mortgages are funded through retail funds," said Principality’s Thomas. "We have one of the lowest wholesale funding ratios against our peers, and have a good level of liquidity.

"Clearly this issue is a challenge, but not an overbearing one. We have a number of options at our disposal, and will work through this."

One option for the issuers, if their covered bonds no longer have two triple-A ratings, is to use them to access the Bank of England’s Discount Window. Covered bonds are eligible for this facility as long as they were triple-A rated at launch and are rated A3 equivalent or higher.

Richard Wells, finance director at Norwich & Peterborough, outlined several possible outcomes, which are dependent on what actions Moody’s and the Bank of England take.

"It’s early days yet, and we have a certain amount of time to review the different options that are available to us," he said. "There are several features of the bonds that we can work with, for example by bringing in a third party swap provider.

"If a rating reduction is confirmed, we would then most likely have to repay any element of the covered bond that we have with the Bank of England, for which we have adequate liquidity. What we are waiting for, however, is a response from the authorities."

Wells highlighted another two options that are available should it no longer have access to the SLS.

"We are eligible for the government guarantee scheme, which was extended to the end of this year, and could therefore do a guaranteed deal instead," he said. "It could be slightly larger than the funding received from the covered bond, and so that would be fine from a liquidity point of view.

"Another option that we have if the covered bond rating is reduced would be to see if there are more investors on the public market that may be interested in taking our covered bonds."

One banker pointed out that government-guaranteed bonds can only be issued up to 7% of sterling eligible assets and said that in Chelsea’s case, at least, the amount it could raise would be lower than the amount it appears to have raised from the SLS.

Monday, April 27, 2009

Don’t forget to worry about the German banks

Posted on the Financial Times's Alphaville by Stacy-Marie Ishmael:

In the very early days of the crisis - circa August 2007 - Germany’s Landesbanken were daily in the headlines in the financial press. But as the meltdown of the global financial world continued apace, attention shifted from the subprime IKB, Sachsen and their ilk to the bond insurers, and the German banks moved out of the spotlight.

Their problems, of course, did not go a way - as this recent FT piece reminds us:

Berlin will unveil plans to help German banks shed their troubled assets within two weeks, a move senior coalition politicians said could leave taxpayers facing a bill of up to €1,000bn ($1,290bn, £882bn).

Economists see ridding the banks of toxic assets as a vital stage in efforts to repair the financial system. Berlin has already established a €500bn bank rescue fund, including €400bn of guarantees and €80bn of capital. About €210bn has been tapped by banks.

Otto Bernhardt, a Christian Democratic MP and banker, said the total cost could be between €500bn and €1,000bn, with the latter figure reflecting the - unlikely - loss of the assets’ entire value. However, Mr Weber, speaking before the Berlin meeting, said mending banks’ balance sheets could be done within the overall headline figure of the €500bn set aside for the bail-out fund by focusing on the most impaired assets and illiquid market segments.

Nonetheless, Lisa Hintz, analyst at Moody’s Capital Markets Research Group - which is like the hipster younger brother of the more staid ratings unit - thinks “not enough attention has been focused on the degree to which the various levels of government in Germany may need to provide financial support to their banks.”

In a note published on Friday, Hintz argues thus (emphasis and link FT Alphaville’s):

the degree to which the federal government can be called on is unclear, because it is tied up with “Federalism Reform II,” which is hostage to current political uncertainty.

IKB proved how problematic bank intervention can be. The call to set up “bad banks” looks stuck in regional and political debate over terms and asset types. German bank spreads have been among the tightest in Europe, owing to the solid fiscal position of the government, its early intervention, and partial public ownership through the Landesbanken. However, with poor economic performance of the first quarter, and Germany increasingly being called upon to be “lender of last resort for Europe” by virtue of its largest position in the ECB and the regional component of the IMF, the system is under increasing stress. We feel that these factors are not yet fully expressed in German bank spreads.

Moody's chart of average CDS-implied rating for European banks

Worth keeping an eye on.

Dual US stance on valuing bank securities

Posted in the Financial Times by Krishna Guha and Aline van Duyn:

A decision by US bank regulators when conducting stress tests to take a hard line on the marking-tomarket of securities will force banks to hold more capital than would otherwise have been the case, officials acknowledge.

The decision in effect sets aside accounting guidance recently adopted by the Financial Accounting Standards Board, which gives banks greater latitude to depart from observed market prices when valuing securities held in "available-for-sale" portfolios.

The FASB made the change under pressure from Congress and from bankers who argued that the practice of marking securities to prices in illiquid and distressed markets was aggravating the financial crisis.

However, in a white paper issued on Friday, the Federal Reserve said supervisors disregarded the new FASB guidance when assessing how much capital banks needed to be confident they would comfortably survive a deep recession.

The Fed said regulators made this decision "in order to reflect greater uncertainty about realisable losses in stressful conditions".

The decision means the US authorities are now maintaining two approaches to valuing securities - a hardline approach when it comes to establishing how much capital banks need to hold pre-emptively against risks, but a softer approach when it comes to reporting losses relating to the same risks as they materialise.

This two-track approach could create an additional buffer between the amount of capital lined up now and the way banks report the erosion of that capital.

However, they believe shareholders will not be unfairly disadvantaged, as banks will be able to take the capital required to cover these potential losses in the form of government convertible preferred stock that converts into equity only as needed to cover losses.

There remains considerable ambiguity as to whether the conversion of such securities would be based on erosion of equity as assessed under the new accounting guidelines or under the hardline approach adopted for the purpose of the stress tests.

The difference in the valuation of illiquid securities under the hardline and softer approaches is also not clear.

The FASB guidance that was adopted was not as dramatic a scaling back of mark-to-market rules as had been called for by some politicians and bankers, meaning that the difference under the two approaches is not always significant.

The stress tests - part of a plan unveiled by Tim Geithner, Treasury secretary, to restore confidence in the financial system - were designed to ensure that the 19 leading banks in the US have enough capital in general, and equity in particular, to be able comfortably to survive a deeper downturn.

Analysts have wildly differing views as to the total amount of capital that the stress tests will identify as needed.

Saturday, April 25, 2009

Bear, AIG Dumped $74 Billion in Subprime, CDOs on Fed

Posted on by Mark Pittman:

The Federal Reserve took on more than $74 billion in subprime mortgages, depreciating commercial leases and other assets after Bear Stearns Cos. and American International Group Inc. collapsed.

In its biggest disclosure of the securities accepted to stabilize capital markets, the Fed said yesterday it had unrealized losses of $9.6 billion on the assets as of Dec. 31. The bonds, swaps and notes were taken in from Bear Stearns, once the fifth-biggest Wall Street firm by capitalization, and AIG, which had been the world’s largest insurer.

The losses on securities backed by assets such as home loans in Florida and California signal that U.S. taxpayers may be forced to reimburse the central bank through the Troubled Asset Relief Program, according to Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics.

“The numbers basically confirm that Treasury is going to have to take some TARP money and reimburse the Fed,” said Whalen, whose financial-services research company analyzes banks for investors. “It is essentially up to the Treasury to get the Fed out of this.”

The central bank lent $2 trillion to financial institutions and hasn’t disclosed information about most of the collateral backing those loans.

Treasury spokesman Andrew Williams declined to comment.

Pressure to Disclose

The Fed report follows requests from lawmakers to identify the collateral and a lawsuit by Bloomberg News. Fed Chairman Ben S. Bernanke pledged to expand disclosure, assigning Vice Chairman Donald Kohn to lead the effort.

The central bank has refused to name the borrowers, the amounts of loans or the assets banks put up as collateral under most of its programs, arguing that doing so might set off a run by depositors and unsettle shareholders. That would be less of a concern for New York-based AIG, now 80 percent owned by the federal government, and Bear Stearns, taken over by New York- based JPMorgan Chase & Co. a year ago.

Bloomberg, the New York-based company majority-owned by New York Mayor Michael Bloomberg, sued Nov. 7 under the Freedom of Information Act on behalf of its Bloomberg News unit. The public is an “involuntary investor” in the nation’s banks, according to an April 15 court filing by Bloomberg.

Maiden Lanes

In the report, the Fed detailed its assets in three limited liability corporations, all called Maiden Lane, after a street in Lower Manhattan that runs past the New York Fed.

The $9.6 billion in losses are unrealized because they represent the difference between the fair value of the security under accounting rules and the amount outstanding. The losses become real if the principal isn’t returned.

Maiden Lane I is a $25.7 billion portfolio of Bear Stearns securities related to commercial and residential mortgages. JPMorgan refused to buy them when it acquired Bear Stearns to avert the firm’s bankruptcy.

The Fed’s losses included writing down the value of commercial-mortgage holdings by 28 percent to $5.6 billion and residential loans by 38 percent to $937 million as of Dec. 31, the central bank said. Properties in California and Florida accounted for 45 percent of outstanding principal of the residential mortgages.

AIG Counterparties

Maiden Lane II contains almost $11 billion of outstanding subprime mortgage-backed securities from the AIG transaction that the Fed said lost $180 million so far. The fund also contains $6.2 billion of Alt/A adjustable-rate mortgage-backed securities that the report said has $936 million of unrealized losses. The Fed values $11.4 billion of assets in Maiden Lane II with mathematical modeling, the same methods used by banks and AIG itself.

About 19 percent of the mortgage-backed securities are rated speculative grade, or BB+ at Standard & Poor’s, according to the Fed. About 40 percent are given the top rating of AAA.

Maiden Lane III has lost $2.6 billion after being created Oct. 31 to buy collateralized debt obligations from AIG counterparties, according to the Fed. CDOs in this unit include three parts of a high-grade asset-backed security known as TRIAX 2006-2A, totaling about $3.2 billion. Maiden Lane III also has two parts of a commercial mortgage-backed CDO called MAX 2007-1 A-1 with a face value totaling $7.5 billion. The fair value of those two is less than half that much, or $3.3 billion, according to the central bank.

A third of the amount outstanding in the Maiden Lane III CDOs are speculative grade, or deemed by ratings companies as having a greater chance of default. Another 27 percent are rated AA+ to AA-, the second-highest tier of S&P’s scale, the Fed said in its report. All but $155 million of the $26.8 billion in CDOs are classified as Level 3 assets, or those valued with mathematical models instead of market prices.

The case is Bloomberg LP v. Board of Governors of the Federal Reserve System, 08-CV-9595, U.S. District Court, Southern District of New York (Manhattan).

Friday, April 24, 2009

Rosner, Davis, Investors Comment on Fed Model for Stress Tests

Posted on Bloomberg by Michael J. Moore:

Eight analysts and investors commented on the Federal Reserve’s description of stress tests that have been conducted on 19 large U.S. banks.

The central bank released a so-called white paper today describing methods used by examiners from the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency to calculate the capital buffer the banks will require through 2011 under two economic scenarios.

“The anticipation over the white paper appears to be much ado about nothing,” said Josh Rosner, an analyst at independent research firm Graham Fisher & Co. in New York. “The most significant numbers provided by the Fed in the paper appear to be the page numbers.”

The report was “completely worthless,” said David Trone, an analyst at Fox-Pitt Kelton Cochran Caronia. “We were looking for the translation of the economic forecasts to loan losses and we didn’t get that.” He said he was also disappointed there was no disclosure on how regulators will measure “adequate capital.”

“My problem with this is sort of like Garrison Keillor and Lake Woebegon, where all children are above average,” said Nancy Bush, an independent bank analyst at NAB Research LLC., referring to the host of public radio’s “A Prairie Home Companion” weekly broadcast. “We need to have some children who get punished for what they have done.”

“If they start focusing on tangible common equity and it’s going to be a significant part of Tier 1, banks will have to raise more capital,” said Paul Miller, an analyst at FBR Capital Markets in Arlington, Virginia.

“A lot of triple talk,” said Jim Glickenhaus, who helps manage more than $1 billion, including shares of Bank of America Corp., at Glickenhaus & Co. in New York. “I think they’re going to say while things are bad, the end is not at hand. Maybe.”

“The question I have, by using fourth-quarter numbers, is this skewed positively?” said Lawrence Kaplan, an attorney with Paul Hastings, who served as a senior attorney in the chief counsel’s office at the Office of Thrift Supervision. “Because January and February were pretty lousy, and as a result that’s when it hit the fan.”

“I didn’t walk away with anything new out of this,” said Frederic Dickson, who helps manage $20 billion as chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. “We’re missing a big piece and the big piece of the puzzle is what does the government assess is the appropriate level of tangible equity relative to risk-based capital. That’s a wild card that’s going to be very significant.”

“The assumptions the regulators have used here seem to imply that they’re anticipating a bottoming out of the economic downturn,” said Jeff Davis, director of research at Howe Barnes Hoefer & Arnett in Chicago. “The momentum in the economy might potentially make the alternative more adverse scenario the baseline scenario.”

The attraction of Lending Club

Posted on Reuters by Felix Salmon:

I just had a very interesting meeting with Renaud Laplanche, the CEO of Lending Club, the peer-to-peer lender, and I’ve come out very enthusiastic about what he’s doing there.

Lending Club is the most advanced of the US peer-to-peer lenders, in that it has gone through all the legal pain needed to get full SEC registration and therefore has less in the way of legal question marks hanging over it. It also seems in some way the most professional: rather than scrolling through sob stories looking for someone sympathetic to lend to, lenders never even know the identifying details of the individuals they’re lending to, and generally just invest a lump sum over a couple of hundred different people.

The returns so far have been good: according to a report from Javelin Research,

At the close of November, the overall investment return averaged 9.05%, with a median return of 10.48%, based on a Weighted Average Return on Invested Capital (WAROIC). That calculation accounts for Lending Club’s 1% service charge, as well as for loans paid off early, hobbled by late payments or defaulted.

That’s a healthy return, for a fixed-income investment, without being usurous as far as the borrowers are concerned. Indeed, that’s one of the reasons I like this model so much: it allows people to pay off their credit-card debts, which might be well over 20% or even 30% per annum, at a much cheaper rate, over a reasonable three-year time period. You can even prepay your loan at any time without penalty.

Lending Club isn’t trying to lend to people who can’t borrow money elsewhere: indeed, it has pretty stringent underwriting standards, and turns down 90% of the would-be borrowers at its site. The ones who do qualify end up paying somewhere between 8% and 19% interest, depending on their creditworthiness; the interest rate is set by Lending Club, rather than bilaterally between borrowers and lenders.

The company’s default rate is more or less where you’d expect, in the 3% to 4% range; once a loan has defaulted, the recovery is very low. But recoveries on loans which are 60 days delinquent are actually very high, in the 75% range: borrowers really want to repay these loans, and don’t hate Lending Club in the way they hate their bank or credit-card company. What’s more, because the loans amortize over three years, a substantial chunk of the principal amount has generally already been paid back even by those borrowers who do end up going into default.

Another thing I like about Lending Club is that it isn’t only stringent about its borrowers; it’s stringent about its lenders, too, requiring an income of at least $70,000 a year and liquid assets of at least $70,000. In California, where right now most of the lenders are based, those numbers actually rise, to $100,000. For the time being, substantially all of the company’s lenders are individuals — there are a lot of angel-investor Silicon Valley types who consider this kind of investing to be extremely low-risk and a way of making the world a better place. But moving forwards, there’s no reason why Lending Club shouldn’t get substantial institutional investments as well, especially once it’s been going for three to five years.

That said, this kind of investment is particularly well suited to retail investors, because of its three-year time horizon. (It recently launched an IRA product, too, with income reinvested.) There is a secondary marketplace for loans, but it’s not a major feature of the site, and most investors are very much buy-and-hold.

Lending Club is not the best way of looking for particularly sympathetic borrowers, or for lending in an arm’s-length and legally-binding way to a friend. (Virgin Money is the place to go for that.) Instead, it’s just a way of disintermediating a banking system with which many Americans have become increasingly disgusted, with both sides happy with the deal.

How safe an investment is Lending Club? This is the bit I like the most: it’s safe, but not too safe. The desire for safety was one of the main drivers of the financial crisis, and I believe that people with thousands of dollars to invest over a three-year time horizon should be comfortable taking a certain amount of risk. Going forwards, it’s possible that Lending Club will find an insurer willing to offer a principal guarantee in return for a certain insurance premium of say 300 basis points, but in a weird way I like it more this way: it forces investors to worry just a tiny bit about the prospect of losing some of their money, and that worry is ultimately healthy.

No investment yielding 9% a year can ever be risk-free, but I don’t think the amount of risk embedded in a diversified portfolio of Lending Tree loans is at all excessive, given the yield. It’s certainly much lower than the risk of investing in a diversified portfolio of stocks, which is something that hundreds of millions of Americans do as a matter of course. Plus, you get to help out people who are really grateful for your money. So if you want to diversify out of the markets and make more money than on a bank CD, it’s definitely something to consider.

Should you borrow from Lending Club? Well, you can try — but most people who do try, fail. For the time being the demand for loans greatly exceeds the amount of money available, so there’s not a great chance you’ll get what you want. But if and when Lending Club takes off, it could become a great place to borrow money easily and at much lower rates than your credit-card company is charging. Banks have been making it increasingly difficult to get a personal loan in recent years, because they make so much more money from credit cards. Lending Club is now offering a product which really the banks should have been offering all along, but weren’t. I wish it very well.

Finger of blame points to shadow banking’s implosion

Posted in the Financial Times by Gillian Tett:

These days, banker-bashing is a popular sport for politicians of all stripes. For not only are the banks being blamed for unleashing financial disaster – while paying the bankers fat bonuses – they are also being blamed for slashing loans in a way that is now triggering a recession.

But is that perception really right? If you take a look at some recent research produced by Citigroup, it might seem not. For if Citi data are correct, the real source of the current credit crunch is not a collapse in bank loans, but the implosion of the shadow banking world.

And that in turn provokes a wider question: namely whether there is anything that policymakers could, or should, be doing now to revive the activities that were once performed by those peculiar shadow banks.

The numbers highlight the scale of the challenge. According to Citi (which has crunched its own figures and those of Dealogic), almost $1,500bn worth of new corporate loans were issued across the global financial system in 2008. That was well down from 2007, when more than $2,000bn of loans were made.

But the loan total last year was similar to that seen in 2006, and twice the scale of activity in 2004. Moreover, when non-financial loans are measured, an even more notable pattern crops up: at the end of last year, the volume of non-financial corporate loans was still growing at an annual rate of 10 per cent in both the US and Europe. That was well below the 20 per cent expansion seen in Europe before the peak of the boom, and in some sectors new bank-lending has tumbled. But those figures do not point to a credit drought. After all, from 2002-2004, loans to non-financial companies in the US shrank at an annual rate of more than 5 per cent.

What is imploding though is the securitisation world. If you exclude agency-backed bonds, in 2006 banks issued about $1,800bn of securities backed by mortgages, credit cards and other debts. Last year, though, a mere $200bn of bonds were sold in markets, and this year market issuance is minimal.

Indeed, the only group really acquiring repackaged debt now are western central banks, which have taken huge volumes of securities on to their own books (and away from the market), as part of their liquidity-injection measures.

So far this pattern has prompted relatively little wider political debate. After all, before the summer of 2007, most non-bankers had no idea that a shadow banking world even existed.

But the longer that this drought continues, the bigger the policy issues become. After all, no politician wants to see the government buying mortgage-backed bonds forever; but nobody really believes that traditional, old-fashioned lending can take up all the slack. So either the system needs to find a way to restart securitisation or we face a world where credit will remain a highly rationed commodity for a long time to come.

Is there any answer? This week the UK government made one attempt to break the impasse by unveiling a scheme to provide state guarantees for some mortgage-backed bonds (the idea, as my colleague Paul J Davies explains, is to prod the banks into repackaging such debt again). In America, officials are playing around with similar ideas. One concept being mooted, for example, is that the Federal Deposit Insurance Corporation should help troubled banks securitise a swathe of assets.

On both sides of the Atlantic, industry leaders are also drawing up plans to make the securitisation process much more transparent, and thus, hopefully, more credible to future investors. Another idea is to impose a so-called “5 per cent rule”. This would force banks that issue securities to retain at least 5 per cent of them on their own books, to ensure they have a vested interest in monitoring the creditworthiness of end borrowers.

On paper many of those ideas look sensible. And if they are all implemented, they might eventually enable the securitisation market to return to life, albeit on a more sober scale. But “eventually” is the key word here: right now, most parts of the securitisation market are all but dead. The longer that politicians wail about the supposed “failure of banks to lend”, while ignoring the bigger source of the credit crunch, the harder it will be to wean the system away from government support.

Fannie Mae Creates Housing Mirage With Bum Loans

Posted on Bloomberg by David Reilly:

Give money away. That was a solution to the housing crisis mortgage giant Fannie Mae hit on last year.

Faced with growing numbers of homeowners unable to make mortgage payments, Fannie decided to fund loans to borrowers that were instant losers.

The point was to buy time. Even though those loans resulted in a $453 million loss, they helped keep troubled homeowners from defaulting. That meant Fannie for now didn’t have to make good on loan guarantees that may have cost it as much as $2.4 billion.

The big game of kick the can strikes at a deep-seated fear among many investors -- that banks and others faced with mounting housing losses are finding all manner of dubious ways to push a day of reckoning into the future.

If that’s the case, any improvement in the housing outlook might be a mirage obscuring even greater pressures building in the financial system. That would eventually counter better-than- expected first-quarter results from many banks.

Investor angst was made worse by the knowledge that the government is leaning hard on banks to modify troubled loans any way they can. Prevent foreclosures and worry about the consequences later is the mantra of the day.

In a perverse way, there is some logic to such maneuvers. Today’s troubled borrower may be in better shape if given time to wait for fractured markets to heal. Or, if today’s losses can’t be cured, the company facing them may be better able to deal with them at a less-stressed future date.

Big Gamble

Still, that’s a big gamble. Markets may not rebound as quickly as some investors expect, meaning time might not heal the wounds of borrowers who can’t meet payments today. That would leave them in even worse shape in the future. And by failing to deal with problems now, financial institutions may cause them to grow even bigger.

That’s sure to lead to nasty surprises down the road at individual banks. It also promises to lengthen the economic slump by preventing markets from finding natural bottoms that allow excess inventory to be sold.

Fannie’s program shows how potentially big losses are still festering within the system, unbeknownst to investors.

Known as the “HomeSaver Advance” plan, Fannie used the program to provide “foreclosure prevention assistance to distressed borrowers,” according to its 2008 securities filing.

The plan entailed Fannie funding loans to help distressed borrowers get current on their mortgage payments. Fannie said there were about 71,000 advances made in 2008 with an average value of $6,500.

Really Thinking

Fannie funded $462 million in such loans during 2008. The company tells investors in notes to its financial statements, though, what it thinks the loans are actually worth.

Based on market prices, Fannie said the loans had a value of just $8 million. That’s right, the loans, which are in many cases just months old, were worth 1.7 cents on the dollar.

In a footnote, Fannie said there were several reasons for the huge markdown. Among them: the loans aren’t secured by any collateral; and they are second loans, or liens, that serve as catch-up payments for borrowers who can’t pay their primary debt.

This is reminiscent of the piggyback loans given out during the housing bubble to home buyers unable to come up with the usual 20 percent down needed to buy a house. Deals like those led to big losses.

Reality Intrudes

Granted, the HomeSaver Advance program isn’t a general loan modification program. It’s targeted at people who were current on payments and due to a big event like a divorce or loss of a job fell behind. The loans are meant to get them over that hump.

Still, these borrowers are probably at greater risk of future financial problems. And if Fannie wasn’t able to get them current, it could face even bigger losses. Because it has guaranteed the mortgages, Fannie would have to repurchase them at their full value in the event of a default.

After doing that, Fannie would have to work the mortgage out, likely selling the home, to recoup value. Because of the housing crunch, such recovery values slumped during 2008.

Fannie’s loss on such repurchases rose to 56 percent by year’s end from 40 percent at the start of 2008, its filing shows. For the year, the loss averaged 49 percent.

Based on this average loss, and using an average mortgage value of $175,000, Fannie would face a loss of about $2.4 billion if it had to repurchase the 71,000 loans covered by the HomeSaver program.

Not to mention that having to process 71,000 additional foreclosures might further depress real estate prices, driving Fannie’s recovery rates even lower.

Be that as it may, Fannie’s sobering writedown of these loans shows that even it knows the program may be an exercise in futility. The likelihood is many of these loans will go bad anyway.

The housing market will have to deal with that one day. In the meantime, Fannie is simply burning taxpayer dollars to create a housing smoke-screen.