Wednesday, September 30, 2009

Why Naked Shorting Isn't Really That Different From Regular Short Selling: The Two Cows Version

Posted on the Business Insider by John Carney:

Still confused about why you shouldn't be worked up over naked short selling? We understand. It's terribly complex and full of words that make your eyes glaze over.

So we decided to break it down into the simplest terms Wall Street transactions can be explained: the two cows


This is a simplification, since it leaves out the role of a clearing house. But that's the point: to simplify a very complicated process.

Traditional Short Selling: Two Cows

You neighbor Joe has two cows.

You borrow the cows.

You sell two cows your other neighbor Henry.

Henry agrees to pay you $100 for each cow.

At this point, you are net short two cows. You have the two you borrowed from Joe but you owe a total of four: two to Henry and two to Joe.

You go out into the market and look for more cows so you can give Joe his two cows back.

You hope the price is less than $100 per cow.

If the price of cows drops to $80, you just made $20 on each cow. If it climbs to $120, you lost the same amount on each cow.

Either way you close out the trade by delivering cows to Henry, collecting the money for delivery, and buying Joe the replacement cows.

Naked Short Selling: Two Cows

Your neighbor Joe has two cows.

You don’t borrow them.

You sell two cows to your neighbor Henry with a promise to deliver them in a few days.

Henry agrees to pay you $100 for each cow.

At this point, you are net short two cows. You don't have any cows but you owe a total of two: both of them to Henry.

You go out into the market and look for more cows so you can deliver two cows to Henry.

You hope the price is less than $100 per cow.

If the price of cows drops to $80, you just made $20 on each cow. If it climbs to $120, you lost the same amount on each cow.

You close out the trade by delivering cows to Henry and collecting the money for delivery.

Monday, September 28, 2009

In defence of financial innovation

Posted in the Financial Times by Robert Shiller:

Many appear to think that the increasing complexity of financial products is the source of the world financial crisis. In response to it, many argue that regulators should actively discourage complexity.

The June 2009 US Treasury white paper seemed to say this. The paper said that a new consumer financial protection agency be “authorised to define standards for ‘plain vanilla’ products that are simpler and have straightforward pricing,” and “require all providers and intermediaries to offer these products prominently, alongside whatever other lawful products they choose to offer”.

The July 2009, HM Treasury white paper “Reforming Financial Markets” similarly advocated “improving access to simple, transparent products so that there is always an easy-to-understand option for consumers who are not looking for potentially complex or sophisticated products.”

They do have a point. Unnecessary complexity can be a problem that regulators should worry about, if the complexity is used to obfuscate and deceive, or if people do not have good advice on how to use them properly. Complexity was indeed used that way in this crisis by some banks who created special purpose vehicles (to evade bank capital requirements) and by some originators of complex mortgage securities (to fool the ratings agencies and ultimate investors).

Modern behavioural economics shows that there are distinct limits to people’s ability to understand and deal with complex instruments. They are often inattentive to details and fail even to read or understand the implications of the contracts they sign. Recently, this failure led many homebuyers to take on mortgages that were unsuitable for them, which later contributed to massive defaults.

But any effort to deal with these problems has to recognise that increased complexity offers potential rewards as well as risks. New products must have an interface with consumers that is simple enough to make them comprehensible, so that they will want these products and use them correctly. But the products themselves do not have to be simple.

The advance of civilisation has brought immense new complexity to the devices we use every day. A century ago, homes were little more than roofs, walls and floors. Now they have a variety of complex electronic devices, including automatic on-off lighting, communications and data processing devices. People do not need to understand the complexity of these devices, which have been engineered to be simple to operate.

Financial markets have in some ways shared in this growth in complexity, with electronic databases and trading systems. But the actual financial products have not advanced as much. We are still mostly investing in plain vanilla products such as shares in corporations or ordinary nominal bonds, products that have not changed fundamentally in centuries.

Why have financial products remained mostly so simple? I believe the problem is trust. People are much more likely to buy some new elec­tronic device such as a laptop than a sophisticated new financial product. People are more worried about hazards of financial products or the integrity of those who offer them.

The problem is that financial breakdowns come with low frequency. Since flaws in the financial system may appear decades apart, it is hard to figure out how some new financial device will behave. Moreover, because of the low frequency of crises, people who use financial instruments often have little or no personal experience with the crises and so trust is harder to establish.

When people invest for their children’s education or their retirement, they are concerned about risks that will not become visible for years. They may not be able to rebound from mistaken purchases of faulty financial devices and they may suffer if circumstances develop that create risks that could have been protected against.

Thus, to facilitate financial progress, we need regulators who ensure trust in sophisticated products. They must work towards clearing the way to widespread use of better products, concerning themselves with both safety and creative ideas. They must not simply be law enforcers against the shenanigans of cynical promoters, but also be open to making complex ideas work that have the potential to improve public welfare. Unfortunately, the crisis has sharply reduced trust in our financial system.

At this point in history, there has been over-reliance on housing as an investment. It is an appealing investment as it is simple to understand: we see the home we own every day. But in using housing as a big savings vehicle, people have built homes that are larger than needed and hard to maintain. This extra housing would be expected to have a negative return in the form of depreciation.

The popular reliance on housing as an investment, combined with the increased leverage with newer mortgage practices, contributed to the housing bubble that has now burst, resulting in historically unprecedented numbers of foreclosures. The fact that a bubble could grow this large and burst is a sure sign of imperfect financial institutions, not of overly complex institutions.

Unfortunately, people do not trust some good innovations that could protect them better. The innovations in mortgages in recent years (involving such things as option-adjustable rate mortgages) are not products of sophisticated financial theory. I have proposed the idea of “continuous workout mortgages”, motivated by basic principles of risk management. The privately issued mortgage would protect against exigencies such as recessions or drops in home prices. Had such mortgages been offered before this crisis, we would not have the rash of foreclosures. Yet, even after the crisis, regulators seem to be assuming a plain vanilla mortgage is just what we need for the future.

Another example of a potentially useful innovation is the target-date fund (also called life-cycle fund) that invests money for people’s retirement in a way that is specifically tailored for people their age. Such a fund plans for young people to take greater risks and for older people to invest more conservatively. Target-date funds, first introduced by Wells Fargo and BGI in the 1990s, are growing in importance, but few people commit the bulk of their portfolio to such funds, or make use of target-date funds that might make adjustments for their other investments. It appears that people do not fully trust that these funds are designed correctly, or would protect them from crises.

Another innovation that is underused is retirement annuities that include protections against potential risks. There are life annuities that protect people against outliving their wealth, inflation-indexed annuities that protect against inflation, impaired-life annuities that protect against having problems in old age that require they spend more money and generational annuities that exploit the possibilities of intergenerational risk sharing. But most people do not make use of any of these.

Ideally, all of these protections for retirement income should be rolled into a unified product. Such products are not generally available yet. Certainly, people might be mistrustful of committing their life savings to such a complex new product at first even if it were available. So, such products are not offered and people often do nothing to protect themselves against most of these risks.

Behind the creation of any such new retail products there needs to be an increasingly complex financial infrastructure so that professionals who try to create them can manage a full array of risks. We need liquid international markets for real estate price indices, owner-occupied and commercial, for aggregate macroeconomic risks such as gross domestic product and unemployment, for human longevity risks, as well as broader and more effective long-term markets for energy risks. These are markets for the risks that were not managed as the crisis unfolded, and they create a deeper array of possibilities for new retail financial products.

It is critical that we take the opportunity of the crisis to promote innovation-enhancing financial regulation and not let this be eclipsed by superficially popular issues. Despite the apparent improvement in the economy, the crisis is not over and so the public continues to support government-led interventions. Doing this means encouraging better dialogue between private-sector innovators and regulators. My experience with regulators suggests that they are intelligent and well-meaning but often bogged down in bureaucracy. Regulatory agencies need to be given a stronger mission of encouraging innovation. They must hire enough qualified staff to understand the complexity of the innovative process and talk to innovators with less of a disapprove-by-the-rules stance and more that of a contributor to a complex creative process.

ABS rises from ashes but fails to convince on long-term health

Posted on Euroweek by Chris Dammers:

The launch of two public securitisations, the first in their sectors for over a year, has in the past two days given Europe’s stagnant structured finance market a huge boost, with demand for both deals exceeding expectations.

But despite the presence of real money investors in the books, some market participants were damning in their criticism of the deals, saying that they did nothing to bring back stability to the asset class.

On Wednesday, Lloyds Banking Group priced a £3.6bn RMBS from its Permanent master trust — the first public deal from the trust since May 2008. Meanwhile Volkswagen Financial Services priced a Eu519m car lease ABS on Thursday afternoon.

Those who voiced caution argued that demand was driven mainly by technical factors, particularly the absence of sellers in recent months, and that the longer term viability of the primary market is far from assured.

Permanent 2009-1, with Barclays Capital, JPMorgan and Lloyds as joint bookrunners, was supported by what amounted to a £2.82bn lead order from JPM, but in total 56 investors from 16 countries participated in the deal — far wider distribution than had been thought possible mere months ago.

"It was the Who’s Who of European real money," said Miray Muminoglu, a director in syndicate at Barclays Capital in London. "The largest buyers were investors who were active in the secondary market and had maintained their ABS focus in the last two years."

Lloyds was able to increase the sterling ‘A2’ tranche from the £1.25bn JPMorgan agreed to buy to £1.65bn, and placed a Eu750m ‘A3’ tranche with investors.

A further £1.565bn will be retained by Lloyds to use in a securities lending arrangement with JPM. Both publicly offered tranches were roughly two times covered.

"We were extremely pleased with the final result and the investor participation both in terms of diversity of type and geography as well as that amounts far exceeded our expectations," said Robert Plehn, head of structured securitisation at Lloyds Banking Group in London.

Both of the publicly offered tranches carry a coupon of 170bp over interbank rates, although the sterling tranche was offered at a discount to yield 180bp over Libor. These margins were inside secondary levels for Permanent paper before marketing began and roughly in line with the bank’s senior unsecured paper.

All the tranches come with an effective put option to Lloyds at their five year soft bullet maturity, although any amounts accumulated on the principal deficiency ledger by then will not be recouped by investors. This feature, which mimics in concept the UK government’s proposed liquidity guarantee for RMBS, was designed to ease investors’ concerns about extension risk, which have been heightened by sharply declining prepayment rates on UK mortgages.

Other changes to the Permanent formula included a hefty increase in the Funding 2 reserve fund from 1.65% to 8.23%, while the Funding 1 reserve was increased to 7.01%. Lloyds also funded a yield reserve to counteract the difference between the high liability cost of the new issuance and the lower average margin on the portfolio — for similar reasons, the notes step down rather than up at the expected maturity.

Detrimental performance?

Permanent’s successful launch had an immediate effect on the secondary market, pulling in spreads for outstanding Permanent issues by up to 10bp on Wednesday. The real impact was felt on Thursday, however — by the end of the day the new issue was bid as tight as 125bp, nearly half the spread of a week ago. Little paper changed hands, however.

The execution and subsequent performance prompted divergent opinions among investors, with concerns mounting over the course of Thursday’s trading.

"From the initial bids we’ve seen this morning, it seems they’ve paid up a little bit to make sure it was a success, and that’s probably the right thing to have done," said one investor who participated.

"The performance we’ve seen is almost detrimental," said another investor later in the day. "If it tightens dramatically, and it already has tightened dramatically, what does that say to the real money investors? Once upon a time we had a very stable market — spreads never moved and a movement of 1bp in a day was a shock. All of a sudden Permanent has moved by over 100bp in a week. A new issue came yesterday at 180bp over and now it’s 140bp bid. For me, that doesn’t send great signals to the market."

Some investors were also concerned by the extremely rapid marketing of the deal.

"It’s very striking that there was no roadshow, there was no real information on the portfolio," said one ABS investor who declined to participate in either Permanent or VCL. "Even Fitch said in its report that HBOS was not able to disclose information on its book, so you only have performance on the master trust and the master trusts hide information because of the replenishment. It’s nice for HBOS to be able to do that, but you know why they were able to do that, because they paid 170bp, 180bp for triple-A paper and placed most of their paper with other banks. Because of that they were able not to make any effort in transparency and marketing, but I’m not sure if they can go on like that."

The syndicate said that almost all the investors were very familiar with Permanent, and that the deal required little explanation.

"Some investors wanted to see the language around the put and how that worked," said Muminoglu. "The moment the docs were out on Monday, the syndicate banks pointed out to people how that operated. That’s where we got questions and pretty much nowhere else. Once people understood that, we didn’t really need any more time since the underlying and structure of the trust is well-known to investors."

Volkswagen performs, too

JPMorgan and WestLB’s methodical marketing of VW’s VCL 11 could not be accused of excessive haste. The deal was formally announced two weeks ago, and the issuer went on the road for one-on-ones in four countries. The books were held open from Monday to Thursday (Wednesday afternoon for non-German accounts).

The market’s momentum allowed the leads to increase the German auto ABS from Eu475m to Eu519.1m while tightening pricing from the initially expected 130bp area over Euribor to 110bp for the Eu500m, 1.38 year average life triple-A tranche. The Eu19.1m, 1.8 year, A+/A+ rated tranche came at 250bp over.

At the final terms, the books were 4.7 and 3.4 times covered.

"The great demand from almost 63 investors from 17 countries confirms the high standing enjoyed by Volkswagen Leasing GmbH as the leading automobile leasing company in the market," said the originator in a statement.

VCL 11, Volkswagen’s first public issuance since 2008, is especially notable for offering subordinated notes, unlike Permanent.

Investor demand for such paper evaporated during the crisis because of fears over credit and the severe illiquidity of the small tranches.

In recent months, however, while trading has remained thin, traders have reported increased demand from investors for selected names as the extent of downside risk became more apparent and dramatic tightening at the triple-A level increased the relative appeal of lower rated paper.

While it remains very expensive compared with pre-crisis levels, the ability to place subordinated tranches will be vital to restoring the viability of securitisation as a financing tool for non-bank lenders, who generally lack the capital to retain large amounts of first loss risk.

Flash in the pan?

Despite the euphoria evidenced by the secondary market’s performance during the week, market participants remain wary of declaring the market open again.

"These were good attempts to bring back investors, but I hope it’s not a flash in the pan," said one investor. "It could be a positive cycle — more issuance, more liquidity, tighter spreads. In the context of reopening up the RMBS and wider ABS markets, we do need to bear in mind that one of the big differences now is that in the heyday you had new vehicles springing up all the time using a lot of leverage that were able to be repeat purchasers of programmes such as Permanent. Unless there is a substantial amount of new money coming into either real money or bank treasury investors, will there be the same demand for Perma 2009-2?"

Lloyds sees a future for both Permanent and the Arkle trust that securitises Lloyds-originated mortgages. "They are both important sources of funding," said Plehn. "I expect we will be issuing out of them in the future."

If master trusts are to regain some of their former prominence as funding tools for UK banks, however, they will need to bring back the US investor base which allowed such enormous deal sizes in the run-up to the crisis. Many of the old investors have disappeared, and the rest are wary of mortgage securitisation, especially in a less familiar jurisdiction.

"We are considering issuing in the US, but we will probably need to undertake some work there to explain the differences between the UK and the US in both the types of mortgage lending — higher quality, more regulated, primarily prime product in the UK — and the type of securitisation used by banks as a diversified funding source in the UK," said Plehn.

"We would hope that investors in the US will be re-attracted to Permanent both by the structure of the deal and the quality of collateral but also the relative value given how much spreads have tightened in the US compared to Europe."

Friday, September 25, 2009

Unresolved [Canadian Bankruptcy System] Access Issues

Posted on Credit Slips by Stephanie Ben-Ishai:

Yesterday’s post on means-measuring versus means-testing offered a positive perspective on the Canadian bankruptcy reforms. The focus was on debtors who are currently able to access the bankruptcy system and how this will change with the enactment of the reforms. Unlike the American system, the Canadian surplus payment requirements do not impose additional front-end administrative and financial burdens that in themselves will prevent the poorest of potential bankrupts from accessing the bankruptcy system. However, a number of obstacles hinder access to the bankruptcy process for the poorest debtors. In particular, such debtors will have difficulty paying the approximately $1800 in costs associated with the administration of a bankruptcy. The reforms go some way to address this concern by providing a mechanism for the bankrupt to reach an agreement with the trustee to continue paying for bankruptcy services after the bankruptcy period.

Professor Saul Schwartz of Carleton University and I have been working on issues around debt, low-income households and insolvency remedies for some time now. Jason Kilborn blogged about our 2007 article at: In that article, we pointed out that, for two reasons, the conventional wisdom is that the poor are not likely to have needed the insolvency system. First, creditors are reluctant to extend credit to the poor because the risks of non-payment are high. Not having been able to borrow, the poor are not over-indebted and are therefore not in need of bankruptcy protection. Second, some poor debtors - lone parents on social assistance for example - are judgment-proof meaning that judgments for money recoveries obtained by their creditors are of no effect because these debtors do not have sufficient non-exempt property or income to satisfy the judgment.

Developments in two areas challenge the conventional view. The “democratization of credit” has allowed borrowing even in the lowest income groups. Even a short-term, low-wage job can bring a credit card to the doorstep of the poor and the slogan “no credit, no problem” testifies to the availability of retail credit. In addition, we now know that poverty is often a temporary state for many Canadians, with many moving in and out of low-income. Accordingly, the judgment-proof state is not a permanent condition, but a temporary status for many. While this may be welcome news in some respects, it means that debts can be accumulated during periods of relative economic well-being only to go unpaid when a job ends or when hard times return. These developments suggest the possibility that some of those who are poor at any point in time are in fact in need of bankruptcy protection. They have debts that they are unable to pay and little likelihood of being able to repay in the near future.

We begin the paper by presenting evidence from the 1999 Survey of Financial Security on indebtedness among families in the lower income deciles. We then turn to the main question: should the Canadian bankruptcy process be more readily available to poor debtors? We draw on two sources to make this case: a) a comparative analysis (considering England and Wales, the United States, Australia and New Zealand) and b) a series of semi-structured interviews with Canadian bankruptcy trustees and other insolvency professionals.

We have a new article that is going to be published in the Spring 2010 issue of the Queen’s Law Journal entitled “The Role of Governments in the Overindebtedness of the Economically Disadvantaged.” We will have it up on SSRN very shortly. In this article, we examine several ways in which the government becomes a creditor of economically disadvantaged Canadians and its role in limiting the options available for resolving the resulting overindebtedness. Specifically, we explore how government transfer programs, and the debts that result from benefit overpayment, affect those already marginalized by poverty. We note that Jason Kilborn has studied the importance of debts to government in the context of European bankruptcy reform.

We then argue that the two main remedies available to Canadians facing insolvency — credit counselling and bankruptcy — are simply too costly for low-income individuals. Low-income Canadians coping with government debt are shown to be in a unique and difficult position with respect to repayment. Using the overpayments that can occur within transfer programs such as the Ontario welfare program (Ontario Works or OW) and the Ontario Disability Support Program (OSDP) to illustrate the particular issues affecting low-income individuals, we demonstrate the lack of recourse this group has when dealing with insolvency. We analyze this issue using the statutory framework, interviews with government program officials and data on social assistance overpayments to cast doubt on the assumption that those with low income have no need for bankruptcy and credit counselling. In so doing, we ultimately question whether existing insolvency remedies are serving the needs of all Canadians.

Still unresolved, however, is the question of how many Canadians have limited access to bankruptcy. We simply do not know whether there is a large pool of debtors who would seek bankruptcy is the price were lower or if the problem is limited to a small subset of debtors.

The Deviant Canadian Debtor

Posted on Credit Slips by Stephanie Ben-Ishai:

The reforms we’ve discussed so far signal that a paradigm shift with respect to consumer bankruptcy in Canada is well under way. A key component of consumer bankruptcy in Canada has, since 1919, been the non-waivable or mandatory consumer bankruptcy discharge. In a similar, but more mediated fashion than our American neighbors, bankruptcy’s discharge of past debts that cannot be contracted out of has in recent times been regarded as part of economic rehabilitation, which is equated with a “fresh start.” However, the 1997 amendments attempted to effect a move from rehabilitation of the debtor to asking debtors to rehabilitate their debts by making payments out of surplus income. The 1997 amendments required trustees to assess whether bankrupts could have made a viable consumer proposal and whether they cooperated with the trustee by meeting any surplus income requirements.

Despite the underlying assumption that many bankrupts have an ability to make repayments to creditors, in practice these amendments had a limited impact on the majority of bankrupts who could not make a proposal because they did not have surplus income. Over a decade later, the current reforms will take the 1997 amendments further, as these reforms impact bankrupts with surplus income and also expand the group included in the paradigm shift to include certain debtors who do not have surplus income but owe tax debt or student loan debt to the government. While the 1997 BIA amendments had limited practical impact, they signaled a return to the “deviant debtor” construct, which positions bankruptcy law as a response to deviant behavior. The current reforms hold the potential to further entrench this construct in Canada’s consumer bankruptcy system. The following are three examples.

(a) Government Debts

The reforms soften the current student loan provisions in some respects, but leave the basic scheme untouched. In particular, the reforms do not remove the need for the debtor to make a costly discharge or relief application; the debtor may have limited access to assistance in handling the application; the statute provides little direction to the courts in the exercise of their discretion in hardship applications; contrary to the Senate Report and PITF Report recommendations, there is no provision for partial relief; and most importantly, there is no empirically-based rationale for excepting student loans from the discharge.

The introduction of a special discharge procedure for tax debts meets one criticism of the student loan provisions: previously student loans were the only form of government debt excepted from the discharge. Now tax debts will also be excepted in certain circumstances. However, this is where the consistency ends. A student loan debtor will be unable to apply for discharge of the debt until at least five years after ceasing to be a student, whereas a tax debtor can apply for a discharge as early as nine months after filing for bankruptcy. In addition, the statute provides a specific list of factors to be taken into account at the tax debtor’s discharge hearing. Furthermore, while an absolute discharge cannot be granted, a suspended or conditional discharge may be granted with some measure of partial relief. Unlike the majority of student loan debtors, many tax debtors that fit within these provisions will have the resources to engage counsel to represent them at the discharge hearing and assist them in obtaining partial relief.

Taken together, the treatment of debts owed to the government push at the rehabilitation model of consumer bankruptcy without a clear or principled underpinning. Historically, the small list of exceptions to the discharge in bankruptcy is consistent with the position that where the bankrupt acts in good faith, she is entitled to the discharge. This is the case even where the bankruptcy is the result of poor financial decisions. Accordingly, by excepting student loan debt and tax debt, the legislature characterizes bankrupts with this type of debt as deviant and dishonest. Student loan debtors are the most deviant, while tax debtors deserve a symbolic slap on the wrist. By contrast, other bankrupts, such as those who owe fines imposed by a court and damage awards arising from civil proceedings other than for bodily harm, sexual assault, or wrongful death, remain entitled to have those debts discharged. In addition, both measures run counter to the bankruptcy policy, in place since 1992, that the Crown should not be afforded special treatment in bankruptcy.

(b) The Collective Element of the Bankruptcy Process

In its purest form, the pari passu principle means that each creditor must be paid pro rata in accordance with the amount of her claim (“equity is equality”). However, it has long been recognized that, in the Canadian context, equitable treatment does not always require equal treatment. As Thomas Jackson has argued, bankruptcy rules should reflect the “creditors’ bargain” – essentially, different types of creditors have different arrangements with the debtor and this should be reflected in bankruptcy rules. For example, secured creditors should be treated differently from unsecured creditors.

The introduction of incentives for creditors to oppose a discharge runs counter to even a modified pari passu principle. This may lead to private deals between the bankrupt and an opposing creditor. Rather than encouraging creditors to cooperate with the bankruptcy trustee to maximize realization on the estate, creditors will be encouraged to withhold information until the discharge hearing. At that point, the objecting creditors may disclose the information and seek an order that payment be made directly to them. On the other hand, less powerful, involuntary creditors who are currently protected by the priority scheme (for example, spousal support creditors) are likely to have fewer less resources available to them to participate in the discharge process and in certain instances they may not realize anything from the bankruptcy as a result.

(c) Judicial Discretion

Most consumer bankruptcy cases in Canada result in automatic discharge and there is no court hearing. Nevertheless, there are still a substantial number of debtors involved in hearings. The reforms remove the need for a court hearing in the case of second-time bankrupts, impose a hearing on tax debtors, create an incentive and a more accessible vehicle for creditors to oppose a discharge (which will result in a discharge hearing), and retain the possibility for an application for relief from the exception to discharge for student loans. It is unclear whether the reforms will result in a net increase or decrease in the number of court hearings.

In any event, in each of these instances, the court is instructed to use its judicial discretion in different ways, and different controls operate in the discharge process without clear policy rationales. For example, in the case of student loan debt, the legislation gives the court very little guidance in the exercise of its discretion to grant relief. By contrast, in the case of tax debt, the new provisions set out a detailed list of factors the court must consider in ruling on an application for a discharge. For oppositions to discharge in all other instances, the court is given a list of factors on the basis of which it may refuse or suspend the discharge or impose conditions. This list differs from the list provided for tax debtors.

The reforms overlook a key issue, namely the role and form that dispute resolution should take with respect to the consumer bankruptcy discharge. More particularly, should the hearing continue to play a role in the discharge process, and if so, what principles should guide the process?

For a more detailed account of these issues see: “Means Measuring versus Means Testing Consumer Bankruptcy” in Stephanie Ben-Ishai and Tony Duggan, eds. Canadian Bankruptcy and Insolvency Law: Bill C-55, Statute C.47 and Beyond (Toronto: LexisNexis Canada Inc., 2007).

Regulating Systemic Risk

Posted on the Baseline Scenario by James Kwak:

David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”

The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.

On stricter prudential regulation:

“[A]n important advantage of the proposed system is that it would provide financial institutions with a strong incentive to avoid becoming systemically significant. This is exactly the opposite of the existing situation, where financial institutions have a strong incentive to become ‘too big to fail,’ precisely in order to exploit a free implicit guarantee from the federal government.”

On making systemically important institutions pay for their guarantees:

“One option for doing this would be to create an explicit system of federal capital insurance for systemically significant financial institutions. Under such a program, covered institutions would be required to pay regular and appropriate premiums for the coverage; the program would pay out ‘claims’ only in the context of a systemic financial event (determined perhaps by a presidential declaration); and payouts would be limited to pre-specified amounts.”

Moss thinks there needs also needs to be a receivership process in place as a backstop should both prudential regulation and capital insurance fail.

I think this all makes sense in concept, although I still prefer the idea of simply breaking up the large financial institutions and preventing them from reassembling, either through size caps (yes, I know, this is a complicated issue) or new antitrust laws. One problem I see is that better regulation is based on the premise of better regulators, and until that problem is solved (pay them more? inspect them more closely?) nothing else follows. Moss favors a new agency dedicated to systemic risk regulation (read: not the Fed). However, I previously referred to this as the “posit a good regulatory agency” premise. I prefer the idea of just having smaller financial institutions because it doesn’t require this particular can opener.

Thursday, September 24, 2009

Asset-backed revival could follow Lloyds, VW deals

Posted on Reuters:

Germany's Volkswagen (VOWG.DE) and UK bank Lloyds (LLOY.L) on Wednesday tested investor appetite for asset-backed bonds with two deals that could resuscitate European securitisation markets shut for more than a year because of the credit crisis.

A strong response could encourage more securitisations that could help ease the flow of money into the wider economy.

Since the start of this year, most areas of the financial markets have gradually reopened, allowing companies to raise financing via the credit and equity markets.

But markets for asset-backed or securitised products - used before the crisis by banks to expand lending - have remained shut until now.

Securitisation was singled out as one of the causes of the credit crisis, where bonds backed by U.S. sub-prime mortgages helped to cripple the global financial system.

It is also seen as part of the solution.

The International Monetary Fund said this week reviving complex securitisation markets would be critical to recovery from the crisis. [ID:nN2128269]

The Lloyds (LLOY.L) deal, which is backed by residential mortgages from UK mortgage lender HBOS, is viewed as a positive sign in terms of investor sentiment towards the UK housing market and also towards these complex financial products.

"It is really positive news that investors want exposure to the UK housing market," said James Zanesi, structured credit analyst at Unicredit.

"The spreads are really tight considering the life of the notes (bonds)," he said, referring to the initial pricing details and the term of the issue which is five years.


Initial details of the price levels where the asset-backed bonds from Lloyds and VW are being offered to investors were mostly in line with market expectations.

Guidance on the sterling-denominated part of the Lloyds' mortgage-backed issue was set at 3-month Libor plus 180 to 185 basis points. Guidance on the euro-denominated issue was at 3-month Euribor plus 170-175 basis points.

At the start of the year, spreads on similar mortgage-backed bonds were as much as 500 basis points over Libor, according to investors.

The final size of the Lloyds' issue is yet to be determined, depending on the level of investor demand.

The Lloyds deal does not have any government backing, but includes an option for Lloyds to buy the securities when they mature.

Allen Twyning, credit analyst at Aviva Investors, said it was a compelling deal because extension risk due to slow repayment of mortgages was removed by the Lloyds "put" option.

The VW deal, backed by car leases, has initial guidance on pricing of 1-month Euribor plus around 115 basis points on one tranche and 1-month Euribor plus 250-300 basis points.

The deal is in two parts, one of 457.5 million euros ($676 million) and one of 17.5 million euros.

The VW issue, announced on Sept. 7, was seen as a logical step to reopen the asset-backed market because car leases are short-term and standardised.

But the Lloyds securitisation of home loans could be the real gauge of whether investors' have regained their taste for structured products.

"Both asset classes (HBOS mortgages and VW leases) are squeaky clean," said one credit investor, who pointed to banks, insurance companies, institutional investors and money market funds as potential buyers.

"It's a useful searching excercise to discover who's interested," the investor said. "It feels hopeful."

Wednesday, September 23, 2009

Moody's Insider Explains The Workings Of A Deal He Calls Fraudulent

Posted on the Business Insider by Yael Bizouati:

Sylvain Raynes, the ex- Moody’s vice president who says that the agency should be punished for its "pattern of fraud," explained to us one of the deals he witnessed which he believes was fraudulent.

In 1997, Raynes was working on two deals backed by rental cars.
During the rating of the first deal, there was a bug in the code that rated the deals. (Similar to what happened at Moody’s last year.)

Raynes was responsible for the code, so when he found the mistake, which had given a higher rating than warranted, he went to his superiors: Paul Stevenson, a managing director, and Brian Clarkson, the former head of the agency who got fired last year.

I told them ‘we need to tell investors. I’ll take the hit.’” Raynes says Stevenson told him to “forget it.”

"They told me to shut up,” Raynes says.

The Class A was rated AAA and the Class B was rated Aa3.

Meanwhile, another deal based on similar collateral was rated properly-–Baa2--but that rating raised ire from investors who didn’t understand how two deals with essentially the same collateral could have such a difference in ratings.

Asked how his superiors handled the situation, Raynes says his best guess is that they had to “make something up.”

Raynes believes that Kolchinsky’s testimony tomorrow could bring down the firm. He doesn’t see how it can “recover at this point.”

Congress Takes On Credit Ratings

Posted in the Wall Street Journal by Serena Ng and Aaron Lucchetti:

Throughout the financial crisis, major credit-ratings firms were criticized for their overly rosy ratings of complex debt securities, which deteriorated soon after and led to billions of dollars of investor losses.

Despite months of regulatory scrutiny and some internal changes at the firms, a recently departed Moody's Corp. analyst says inflated ratings are still being issued. He has taken his concerns to congressional investigators.

The analyst, Eric Kolchinsky, said Moody's Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.

"Moody's issued an opinion which was known to be wrong," Mr. Kolchinsky wrote in a July letter to the rating firm's chief compliance officer, a copy of which was reviewed by The Wall Street Journal. In the letter, Mr. Kolchinsky cited other instances in which he believes inflated ratings were given to securities.

A Moody's spokesman says the firm "takes any allegations of misconduct very seriously." The spokesman said Mr. Kolchinsky "refused to cooperate with an investigation" into the issues he raised and was suspended for this refusal, with pay.

The spokesman declined to comment on the January rating that Mr. Kolchinsky questioned because a review of the matter "is in progress." Before he resigned, Mr. Kolchinsky was a managing director in a nonratings unit and wasn't involved in ratings of the securities in question. He was previously a Moody's ratings analyst for six years and had experience with complex securities.

On Thursday, Mr. Kolchinsky is scheduled to testify on ratings-firm reform before the House Committee on Oversight and Government Reform, with panelists including a lawyer representing rival ratings firm Standard & Poor's, owned by McGraw-Hill Cos. Mr. Kolchinsky talked to congressional investigators after his suspension and says they invited him to testify.

Mr. Kolchinsky's allegations come amid a debate on Wall Street and in Washington over the role and influence of credit ratings, and whether recent reforms are sufficient to prevent a repeat of past missteps. Last week, the Securities and Exchange Commission passed rules to improve disclosures from ratings firms and reduce conflicts of interest.

Mr. Kolchinsky raised his concerns with Moody's officials in July but says his superiors didn't treat his complaint seriously enough. The 38-year-old, who had worked at Moody's for eight years, was suspended in early September and left the company two weeks later. In December, according to internal memos reviewed by Mr. Kolchinsky, Moody's executives approved changes to their ratings methodology that they expected to lead to the downgrades of many securities backed by corporate loans. The notes issued in January were tied to those types of securities, but Moody's analysts still gave the deal a high rating.

At issue in Mr. Kolchinsky's internal complaint with Moody's is what ratings firms should do when they are planning to downgrade securities that were the building blocks for other rated products. These securities can go bad weeks or months before the impact registers on the product itself.

That could become a growing issue now that Wall Street bankers are again bundling assets into securities that can be sold to investors or pledged as collateral for short-term loans from central banks.

Between 2000 and 2007, Mr. Kolchinsky worked in the ratings group, rising to oversee credit ratings of mortgage-linked securities known as collateralized debt obligations, some of the hardest-hit investments during the credit crisis. Mr. Kolchinsky said he feels "some moral responsibility for the poor CDO ratings" issued under his watch.

"I was part of the process that did all this damage, and I feel I should try to do something now to make sure it doesn't happen again," he says.

Mr. Kolchinsky previously raised concerns with senior Moody's officials about high ratings given to new CDOs in September 2007. Moody's soon after adjusted its ratings approach, says Gary Witt, a former Moody's managing director who helped Mr. Kolchinsky raise his concerns at the time.

In October 2007, Mr. Kolchinsky was told there was no role for him because the CDO ratings group was downsizing. He joined Moody's Analytics, a separate unit.

A year later, Mr. Kolchinsky filed an internal complaint with Moody's, citing "retaliation" against him. A Moody's spokesman says that the firm "has a strict nonretaliation policy" and that Mr. Kolchinsky "has made an evolving series of claims of misconduct within the company and we have conducted multiple separate reviews." In each case, Moody's "found that his claims were unsupported," the spokesman said. Mr. Kolchinsky says he believes Moody's didn't do a thorough investigation.

In July, Mr. Kolchinsky raised questions about the rating on notes issued by Nine Grade Funding II Ltd., an investment vehicle arranged by Guggenheim Capital Markets, a unit of Guggenheim Partners LLC.

The notes were backed by slices of securities known as collateralized loan obligations, which were in turn backed by corporate loans. In October 2008, Moody's gave Nine Grade a Baa2 rating.

In mid-December, Moody's analysts and managers had come to the conclusion that the bulk of CLOs would be downgraded to reflect new default assumptions, according to internal memos viewed by Mr. Kolchinsky. One December email he reviewed said those rated double-A and below were likely to be downgraded by three to six "notches."

In January, Nine Grade issued more notes. Moody's confirmed the deal's ratings and gave some newly issued notes the same Baa2.

In February, Moody's announced its CLO methodology changes. By April, ratings of all the CLOs held by Nine Grade had been cut or put on watch for downgrade, according to Moody's data Mr. Kolchinsky says he reviewed. In May, Nine Grade was put on review for a downgrade. Mr. Kolchinsky says in his letter that Nine Grade was determined within Moody's to be worthy of just Caa1, deep in "junk" territory and eight notches below its public rating of Baa2.

Nine Grade's managers avoided the ratings cut by switching out some of the downgraded assets for higher-rated assets. A Guggenheim spokesman said the firm arranged the Nine Grade transaction for an investor in October 2008, but wasn't involved in subsequent changes to the deal.

Meanwhile, Moody's investigated Mr. Kolchinsky's concerns. On Sept. 3, a Moody's human-resources officer asked Mr. Kolchinsky to meet that day with an external lawyer retained by Moody's to discuss his July letter. He declined, saying he had spoken to that lawyer on the phone the previous week and that his 13-page letter contained everything he knew. Moody's suspended Mr. Kolchinsky because of his refusal. He left the firm 13 days later.

Extraordinary Popular Delusions . . .. . . and the madness of politicians pitching banker pay curbs

Posted in the Wall Street Journal:

Meetings like the G-20 summit this week in Pittsburgh aren't famous for their accomplishments, but this one bids to be different in at least one area: Cementing the notion that banker paychecks were the financial weapons of mass destruction that blew up the markets last year.

In most of Europe, the notion that "bank pay did it" is now settled truth. Nicolas Sarkozy wants a pay czar to set compensation levels at French banks. Angela Merkel, up for re-election this weekend, is campaigning against banker bonuses. The Federal Reserve is now joining the act with a proposal to regulate pay structures as a way to police safety and soundness and contain systemic risk. The Fed's idea, which doesn't propose to cap pay, is perhaps the least damaging, although it still sets a terrible precedent and makes more comprehensive wage and price controls in the future a difference of degree, not kind.

Governments can't get incentives right most of the time in their own policies. So the idea that regulators can better align banker incentives than a competitive marketplace fails the laugh test. What's more, the evidence does not show that bonus incentives caused the late, unlamented credit mania. It is certainly true that bankers (like most human beings) prefer higher bonuses, and that bankers made risky bets on which they booked big fees. But the reality of this mania-turned-panic is how widespread the excesses were, across big banks and small, foreign banks and domestic. The companies that fared relatively better paid huge bonuses too, but they had better risk management controls.

Bankers who owned large equity stakes in their banks—and therefore had a strong incentive not to see them fail—also did not outperform their peers in the crisis. And as Jeff Friedman of Critical Review notes, banks on the whole bought AAA- and AA-rated securities almost exclusively for their own portfolios. Thus they sacrificed the higher yields of the lower-rated tranches for the perceived safety of a AAA seal of approval—hardly the behavior of people seeking short-term gain, whatever the long-term consequences.

Far more important than bonuses were the incentives to issue and take on debt, especially housing-related debt, created by . . . the politicians who now want to blame banker pay. There's the systemic risk that the Federal Reserve created with the ultralow interest rates that subsidized credit for so much of this decade; the privileged status bestowed upon the ratings agencies by the SEC and others; and regulatory capital rules that favored securitized mortgages over the same loans when held in portfolio by the banks. True reform would grapple with these issues, rather than the calculated distraction of bank pay.

Going forward, the biggest systemic risk is the emerging reality that the politicians consider our biggest financial institutions too big to fail. This is a much greater incentive to excessive risk-taking than any bonus pool because it means the bankers get the profits while taxpayers absorb the risk of failure.

Bankers themselves know this as well as anyone, which may explain why the likes of Vikram Pandit (Citigroup) and Lloyd Blankfein (Goldman Sachs) have lately been paying lip service to pay controls. The real money maker now for the too-big-to-fail banks is the subsidy they get from the implicit and explicit government guarantees they enjoy. If these CEOs bow before the political class's pay obsessions, then the pols might let them keep this subsidy.

Too big to fail also masks the market signals that might warn about the risks of getting too big. Fannie Mae and Freddie Mac are now black holes for taxpayer money because government guarantees juiced demand for their debt and allowed them to grow almost without bound. Even multibillion-dollar accounting scandals didn't quell demand for their debt or equity because investors were confident the government would never let them default. A private debt issuer receives vital information about market perceptions of the risks it's taking on from the prices it pays for incremental capital.

If the political class wants to do something about banker pay, it could help normalize profits by addressing the ways that governments subsidize those profits through regulation, deposit guarantees and barriers to entry. But that's so much harder than denouncing bonuses.

Tuesday, September 22, 2009

Bank regulation, capital and credit supply: Measuring the impact of Prudential Standards

The UK FSA's William Francis and Matthew Osborne: Bank regulation, capital and credit supply: Measuring the impact of Prudential Standards:

Abstract: The existence of a “bank capital channel”, where shocks to a bank’s capital affect the level and composition of its assets, implies that changes in bank capital regulation have implications for macroeconomic outcomes, since profit-maximising banks may respond by altering credit supply or making other changes to their asset mix. The existence of such a channel requires (i) that banks do not have excess capital with which to insulate credit supply from regulatory changes, (ii) raising capital is costly for banks, and (iii) firms and consumers in the economy are to some extent dependent on banks for credit. This study investigates evidence on the existence of a bank capital channel in the UK lending market. We estimate a long-run internal target risk-weighted capital ratio for each bank in the UK which is found to be a function of the capital requirements set for individual banks by the FSA and the Bank of England as the previous supervisor (Although within the FSA’s regulatory capital framework the FSA’s view of the capital that an individual bank should hold is given to the firm through individual capital guidance, for reasons of simplicity/consistency this paper refers throughout to “capital requirements”). We further find that in the period 1996-2007, banks with surpluses (deficits) of capital relative to this target tend to have higher (lower) growth in credit and other on- and off-balance sheet asset measures, and lower (higher) growth in regulatory capital and tier 1 capital. These findings have important implications for the assessment of changes to the design and calibration of capital requirements, since while tighter standards may produce significant benefits such as greater financial stability and a lower probability of crisis events, our results suggest that they may also have costs in terms of reduced loan supply. We find that a single percentage point increase in 2002 would have reduced lending by 1.2% and total risk weighted assets by 2.4% after four years. We also simulate the impact of a countercyclical capital requirement imposing three one-point rises in capital requirements in 1997, 2001 and 2003. By the end of 2007, these might have reduced the stock of lending by 5.2% and total risk-weighted assets by 10.2%.

Key Canadian Consumer Bankruptcy Reforms p

Posted on Credit Slips by Stephanie Ben-Ishai:

Today’s post is a summary of the key Canadian consumer bankruptcy reforms. The most significant aspects of the consumer reforms touch on the following nine issues:

1. Automatic Discharge
2. Creditors’ Participation and Pay Out
3. Bankrupts with High Income Tax Debt
4. Bankrupts with Student Loans
5. Treatment of RRSPs and RRIFs (tax sheltered retirement savings accounts)
6. Tax Refunds
7. Consumer Proposals
8. Ipso Facto Clauses
9. Trustee Fees

Below is more detail on each of these reforms. I also have a short annotated book out on the reforms if you are interested in reading about them in more detail:

Stephanie Ben-Ishai, Bankruptcy Reforms 2008 (Toronto: Carswell, 2008):

1. Automatic Discharge

For most Canadian debtors, bankruptcy is a simple nine-month process that can be filed electronically by a bankruptcy trustee. When a consumer assigns herself into bankruptcy, there is an automatic stay that stops collection efforts by her unsecured creditors, such as telephone calls and letters demanding repayment. Following an assignment into bankruptcy, all of the bankrupt’s non-exempt property vests in the bankruptcy trustee to be sold for the benefit of her creditors. If the bankrupt earns an income above the modified low-income cut off rate provided for in the Office of the Superintendent in Bankruptcy directives, she will be required to make surplus income payments to the trustee.

In practice, many Canadian consumer bankrupts have little or no exempt property to be distributed among their unsecured creditors and earn incomes below the modified low-income cut-off line. Accordingly, the reforms to the automatic discharge will only impact a small number of debtors. The reforms seek to increase the availability of the automatic discharge, while at the same time increasing for some debtors the period of time before eligibility for an automatic discharge. Taken together, these reforms will result in fewer discharge hearings and will provide less discretion to trustees.

a. Bankrupts with Surplus Income

Bankrupts with surplus income are required to wait for the expiration of a 21-month period before becoming eligible for an automatic discharge. During this period they must continue to make surplus income payments to the bankruptcy trustee.

b. Second Time Bankrupts

Second time bankrupts are entitled to an automatic discharge following the expiration of a 24 month period. If a second time bankrupt has surplus income they must wait for the expiration of a 36 month period. The second time bankrupt must make surplus income payments to the trustee during this period.

2. Creditors’ Participation and Pay-Out

Only a small number of discharge applications actually result in a court hearing. In these cases, opposition most frequently comes from a trustee for non-payment of the trustee’s fees and expenses. As a result, for many bankrupts, the bankruptcy process is merely a gateway to their unopposed discharge, which extinguishes most of their debts. The reforms seek to increase creditor participation in the consumer bankruptcy process in two ways.

a. Opposition to Discharge

A party opposing discharge may submit evidence orally under oath, by affidavit or otherwise.

b. Pay-Out

A court may order payment to a particular party or parties of amounts payable by the bankrupt under a conditional discharge order. Further, parties opposing a discharge may also be awarded legal costs incurred for their opposition. This amount will come out of the estate.

3. Bankrupts with High Income Tax Debt

a. Mandatory Application for Discharge

For bankrupts with more than $200,000 (including principal, interest and penalties) in personal income tax debt (federal and/or provincial), representing 75 per cent or more of their total unsecured proven claims, an application for discharge is required. For first and second time bankrupts, such an application may be made when the bankrupt would have been eligible for an automatic discharge. For all other bankrupts, the hearing may not be heard until 36 months have expired.

b. Discharge Hearing

The court may refuse the discharge, suspend the discharge, or provide a conditional discharge. The burden is on the bankrupt to justify the relief requested and the court is directed to take into account:

i. The bankrupt’s circumstances at the time the personal income tax debt was incurred;

ii. The efforts made by the bankrupt to pay the personal income tax;

iii. Whether the bankrupt paid other debts while failing to make reasonable efforts to pay the personal income tax debt; and

iv. The bankrupt’s financial prospects for the future.

A discharge order may be modified after one year.

4. Bankrupts with Student Loans

Since 1997, government funded student loans incurred within first a two-year period and, after 1998, a ten-year period from the bankruptcy date have formed an exception to discharge. The reforms shorten this period and modify the process for discharging these loans somewhat.

a. Exception to Discharge

Government student loans are non-dischargeable for seven years after the debtor ceases to be a student.

b. Application to Discharge

Where a bankrupt has non-dischargeable student loans at the time of bankruptcy they are entitled to make an application for discharge of these student loans after seven years. In addition, such a bankrupt may make an application for relief on hardship grounds after five years.

5. Treatment of RRSPs and RRIFs

The protection of RRSPs and RRIFs (tax-sheltered retirement savings plans) provided by provincial law is restored such that they do not become property of the bankrupt divisible among his or her creditors. Where RRSPs and RRIFs are not protected by provincial law, they will be afforded protection under the BIA. An exception is provided for any contributions made in the 12 months preceding bankruptcy. Such contributions are not excluded from property of the bankrupt divisible among his or her creditors.

6. Tax Refunds

Bankruptcy trustees are typically paid in part out of the bankrupt’s tax refunds. The reforms clarify the legality of this practice.

A bankrupt’s tax refund for prior years and for the entire year of bankruptcy become property of the estate.

7. Consumer Proposals

This set of reforms deals with the practice that had developed where consumers were filing commercial proposals because their debt exceeded the $75,000 limit for consumer proposals.

A consumer proposal may now be filed by a person with up to $250,000 in debts, excluding the mortgages on their principal residence.

8. Ipso Facto Clauses

Limits are now placed on creditors’ ability to terminate a contract or a supply of service to a bankrupt. The main ipso facto clauses for consumers relate to basic services, such as telephone, gas, electricity and leases.

9. Trustee Fees

Subject to any directives issued by the Office of the Superintendent in Bankruptcy, trustees are permitted to enter into binding contracts with debtors for payment of their fees for up to a year following the debtor’s discharge. This provision applies even where the debtor has no surplus income.

Liquidation of CDOs aids banks

Posted in the Financial Times by Aline van Duyn:

Billions of dollars’ worth of the complex securities at the heart of the financial crisis are being liquidated, enabling banks, insurance companies and other investors to clear toxic assets from their books.

Market participants say the unwinding is occurring in the market for collateralised debt obligations (CDOs), complex securities backed by the payments on mortgages, corporate loans and other debt.

Hundreds of billions of dollars of CDOs have defaulted, but the structures can only be liquidated if the underlying collateral can be sold. In recent weeks, more investors have been buying the underlying assets at deep discounts, leading to increased trade and boosting prices for some existing CDOs.

“There has been a significant increase in the amount of CDO liquidations,” said Vishwanath Tirupattur, analyst at Morgan Stanley. “The rally across asset classes has given investors an incentive to liquidate.”

CDOs were one of the main vehicles through which risky US mortgages were repackaged and sold to investors around the world. Much of their value was wiped out amid a wave of defaults on subprime mortgages. The inability to sell or unwind complex securities such as CDOs was one of the prime problems of the financial crisis. Now, the option to sell these so-called toxic assets is re-emerging. “For a long time it may have made sense for investors to liquidate CDOs, but this was not possible when there was no market for the underlying collateral,” said Ed O’Connell, partner at Jones Day.

The recent rally has been particularly marked for CDOs backed by corporate bonds and loans. Of the more than $500bn of CDOs backed by asset-backed securities sold in the boom years, $350bn have already experienced an “event of default”.

Once that happens, the holders of the top tranches, those once rated triple A, can opt to liquidate the CDO. This involves selling off the collateral. CDOs backed by corporate loans are now trading at levels last seen nearly a year ago, shortly after the bankruptcy of Lehman Brothers. Morgan Stanley estimates about $123bn of these defaulted CDOs have been liquidated.

Monday, September 21, 2009

Introduction to the Canadian Bankruptcy Reforms

Posted on Credit Slips by Stephanie Ben-Ishai:

On Friday September 18, 2009, the remaining amendments contained in Chapter 36 of the Statutes of Canada, 2007, and Chapter 47 of the Statutes of Canada, 2005 (c.36 and c.47) came into force: The coming into force of these amendments to the Bankruptcy and Insolvency Act (BIA) and the Companies' Creditors Arrangement Act (CCAA) brings to a close a long, frustrating, and confusing reform process. While there are a number of promising components in the reforms, there is still much that could have been done. Hopefully we (academics) won’t lose steam in pushing for future reforms and the regulators won’t feel that their work is done. In today’s post, I’ll restrict my comments to background on the reforms and the process. In the next post, I’ll briefly highlight the key consumer bankruptcy reforms. For the last three posts I’ll offer a critical analysis of the consumer bankruptcy reforms. Outside of the references to the commercial reforms in this post I will not focus on them this week, as time does not permit me to do a thorough job on both consumer and commercial reforms. That being said there are significant commercial reforms that will have an impact on consumers, in particular the labour reforms.

Background to the Current Reforms

Canada is currently at the end of what has been described as the third major phase of bankruptcy reform since our first federal bankruptcy legislation was enacted in 1919. This phase began roughly in 2002. The 1997 amendments had called for a further parliamentary review of the legislation in 5 years time, which was the genesis for the current reforms. Three key reviews took place. In 2000, the Superintendent of Bankruptcy established the Personal Insolvency Task (PITF) Force, which produced a report in 2002: The Insolvency Institute of Canada and the Canadian Association of Insolvency Professionals formed a Joint Task Force to report to government on business insolvency reform and this report was completed in March 2002:$Topic/indexID$10/a$index.html. Finally, the Standing Senate Committee on Banking, Trade and Commerce, charged with carrying out the parliamentary review mandated by the 1997 amendments, held hearings during 2003 and released its report in November of that year: The commercial recommendations drew heavily from the Joint Task Force report and the consumer recommendations drew in part on the PITF report.

Bill C-55 to Statute C-47

Bill C-55 – aimed at implementing the Senate Report’s key recommendations – was given first reading on June 3, 2005. The Bill was widely criticized for technical as well as broader reasons, including a lack of consultation. It was referred for review to the House of Commons; however, hearings were terminated not long after they started and the Bill was rushed through parliament at the end of the federal Liberal government. [A quick side note for American readers – the federal Liberal party had just lost power to the Conservative party]. The Senate was confronted with a difficult choice as to whether to oppose or support legislation that was described as both very important and very problematic. It was important because it contained many amendments to the existing legislation, especially a complex regime of wage earner protection that would provide for payment of unpaid wages to workers whose employer had gone into bankruptcy—a most welcome and socially desirable initiative. It was problematic because it contained a number of serious flaws that needed to be addressed before it came into force. Accordingly, the Senate agreed to let Bill C-55 through unchanged based on a commitment from the government of the day that the legislation would not be proclaimed into law until at least June 2006, so that further amendments could be made. Bill C-55 received Royal Assent on November 25, 2005 and following its enactment became Chapter 47.

Bill C-62 to Statute C-36

On December 11, 2006, a Ways and Means motion to amend C-47 was tabled. The Ways and Means motion was left on the Parliamentary order paper but the Bill that was attached to it reappeared with one change as Bill C-62 in June 2007. The delay was the result of opposition to the provisions dealing with the treatment of Registered Retirement Savings Plans. The Bill was passed at Third Reading by the House of Commons on June 14, 2007 and received First Reading in the Senate on the same day. However, the Bill died when Parliament was prorogued on September 17, 2007, ending that Session of Parliament.

In October of 2007, the government introduced Bill C-12, an exact copy of the previous Parliamentary session’s Bill C-62. In December, 2007, the Senate approved Bill C-12 without subjecting it to scrutiny in the form of hearings and the Bill received Royal Assent on December 14, 2007. Following its enactment it became Chapter 36. Parts of c.36 and c.47 came into effect on July 7, 2008, but the bulk of the amendments came into effect on Friday September 18, 2009.

There was very little opportunity for hearings or consultation involving a wide range of stakeholders in this reform process. However, when we thought there would be an opportunity for hearings that would impact the reforms that were going to be enacted, a group of law professors put together submissions to the Standing Senate Committee on Banking Trade and Commerce. Professors Tony Duggan and Jacob Ziegel (from the University of Toronto Law School) representing the group did have an opportunity to present this submission to the Senate committee, but it was at a point where it was clear that it would not impact the substance of this set of reforms.

While we agreed with a number of the reforms, given the limits on space here, the following is an excerpt of what we disagreed with:

[1] We disagree with the implementation of many of the above measures in their existing format either on policy grounds or because of ambiguities or other drafting difficulties. In particular,
a. With respect to the Wage Earner Protection Program Act, we believe that claims on the Wage Earner Protection Programme should be met not out of the Consolidated Revenue Fund, as is provided, but out of a newly created self-financing insurance fund or, preferably, out of an enlarged Canada Employment Insurance Programme);
b. With Respect to the Commercial Insolvency Provisions, we are concerned about the duplication of many of the new provisions in the BIA and CCAA and believe it to be unnecessary.
[2] We have particular concerns about the provisions governing:
a. the disclaimer, affirmation and assignment of executory contracts;
b. priorities;
c. transfers at undervalue;
d. preferences;
e. adoption of the UNCITRAL Model Law on cross-border insolvencies; and
f. the subordination of equity claims and treatment of equity claims for voting purposes. (BIA s.140.1, CCAA s.618) and 22.1).
[3] We also believe that there is no longer any justification for a separate CCAA and that the provisions that are special to and appropriate to the reorganization of large insolvent entities can be accommodated in a revised BIA, just as has been done in the British and US insolvency legislation.
[4] With respect to the CCAA Amendments, we oppose on grounds of principle:
a. the Court’s power under the CCAA’s new s.11 to make “any” order it sees fit in relation to the proceedings that the Court “considers appropriate in the circumstances;” and
b. the power to remove a director from the debtor corporation’s board if the court is satisfied that the director “is unreasonably impairing or is likely to unreasonably impair the possibility of a viable compromise” (CCAA s 11.5).
[7] Consumer Insolvency Provisions. We are opposed to the following provisions in Statute c.47:
a. Proposed new s.168.1(ii) postponing from 9 months to 21 months a consumer bankrupt’s entitlement to an automatic discharge where the debtor has surplus income and regardless of the size of the surplus;
b. Giving trustees the power to enforce surplus income payment obligations against exempt property of the debtor;
c. Permitting trustees to enter into enforceable fee contracts with indigent consumer bankrupts who have no surplus income and making such contracts enforceable even after the debtor’s discharge; and
[8] We are concerned about the exclusion from Statute c.47 of the following recommendations in the PITF Report (recommendations that were also endorsed in the Senate Committee’s Report of November 2003):
a. an optional federal list of property exempt from the trustee’s reach that may be invoked by bankrupt individuals;
b. avoidance of non-purchase money security interests in exempt consumer goods given by a bankrupt debtor;
c. regulation of express and implied reaffirmation of a debtor’s pre-bankruptcy obligations after the bankrupt’s discharge or completion of the terms of a consumer proposal.
[9] We are also concerned about the amending legislation’s failure to address the following significant consumer issues:
a. the conflict of interests to which trustees are regularly exposed in seeking to serve the interests of both debtors and the debtors’ creditors;
b. the absence of low cost simple bankruptcy and discharge facilities for indigent debtors without surplus income;
c. removal of the terminological stigma attaching to the word “bankrupt” when applied to individual debtors resorting to liquidation insolvency proceedings under the BIA;
d. the failure to recognize that the easy availability of consumer credit to most Canadians and a general consumption culture are substantially responsible for Canada’s record high consumer insolvency rates and, consequently, the amending legislation’s failure;
e. to require the credit industry to absorb a higher share of the cost of administering consumer insolvencies and providing assistance to insolvent individuals;
f. to require the credit industry to adopt much stronger measures to prevent consumers from over-committing themselves; and
g. to ensure that consumer representatives, academics knowledgeable in these areas and other qualified independent individuals, are included as advisors in the drafting and administration of the consumer insolvency provisions of the BIA and other federally administered legislation and in the drafting of directives by the Superintendent of Bankruptcy under the BIA.

I will pick up on a number of these issues in my next two posts.

IMF defends securitisation markets

Posted on the Financial Times website by Chris Giles:

Restarting securitisation markets is “critical” to a wider economic recovery, the International Monetary Fund claimed on Monday as it warned new regulatory proposals might kill the market.

The Fund welcomed efforts to tame many of the pre-crisis excesses in securitisation markets, which have been blamed for allowing money to flow to households that had little chance of paying it back, but signalled that the current proposals were too draconian.

“As these proposals currently stand ... they may be so blunt that they will either be ineffective at providing incentives for better securitiser behaviour, or alternatively may further slow the market recovery, effectively closing it under some configurations of portfolio characteristics and economic conditions,” the Fund said.

The private sector market for new securitisation has collapsed since the financial crisis started in 2007. It seeks to parcel up individual loans offered by banks to customers and sell them en masse to investors including pension funds and insurance companies which are often able and willing to manage the risks.

The Fund insisted the market’s resumption is “critical to limiting the real sector fallout from the credit crisis amid financial sector deleveraging pressures,” in the analytical chapters of its twice-yearly Global Financial Stability Report.

It said that in spite of the disastrous consequences in the crisis, distributing credit risks to investors outside the banking system still would place risks with those best able and willing to manage it.

Before the market’s collapse, asset-backed securities and covered bonds provided between 20 and 60 per cent of the funding for new residential mortgage loans originating in the US, Western Europe, Japan and Australia.

The crisis was caused in large part as a result of incompatible incentives regarding securitisations. Banks made money from fees rather than the performance of loans.

They did not not take adequate care in originating loans because they wanted to pass them on quickly. Credit ratings agencies underestimated the risk of the products, often keen to earn fees in rating products. Banking regulation gave financial institutions incentives to hold securitised loans in off balance sheet vehicles. And the products were excessively complex.

The Fund supported many of the changes to rules and regulations that will address these problems, calling for much more standardised products. “Policies should not aim to take markets back to their high octane levels of 2005–07, but rather to put them on a solid and sustainable footing,” it said.

But it was particularly concerned about US and European proposals to force banks that originated loans to hold on to the first 5 per cent of losses in all securitisations. This idea, the Fund said, was not flexible enough and might backfire.

In bundles of low credit-quality loans, originators would always expect to lose the full 5 per cent portion in a downturn and would still have no incentive to screen those applying for loans, the Fund said.

It indicated that a more sophisticated policy to keep the originators’ “skin in the game” was required, which would depend on the credit quality of the underlying loans.

In another chapter of the GFSR, the Fund called on governments to wait until there is “lasting confidence in the health of financial institutions and markets” before withdrawing the emergency interventions to support financial markets.