Friday, November 27, 2009

Against liquidity

Posted on Reuters by Felix Salmon:

Paul Krugman today argues in favor of a financial-transactions tax on the grounds that it would discourage over-reliance on ultra-short-term repo markets, among other reasons. In other words, reliance on repos is a bad thing, and it’s a good idea for government policy to “nudge” financial institutions away from it.

That’s something that opponents of the Miller-Moore amendment should bear in mind, when they complain that it could hit the repo market hard. Here’s Agnes Crane:

The repurchase agreement, or repo, market is a critical source of financing for dealers, hedge funds and others who use leverage to finance short-term trading positions. It’s a source of extra income for those holding virtually risk-free securities since they can squeeze out extra return by lending them out.

Such financing makes for a deeper and more liquid market that gives investors confidence that if they buy a Treasury note, for example, they can quickly sell it if they want to.

The problem is that we don’t want to encourage the use of leverage to finance short-term trading positions. Indeed, from a public-policy point of view, we’d ideally want to discourage it.

Would a less liquid repo market mean, in turn, a less liquid Treasury market? I daresay it would. But that’s no bad thing: the more liquid the Treasury market, the more that investors flock to it in times of crisis, exacerbating the systemic downside of the flight-to-quality trade, and reducing the amount of liquidity elsewhere in the markets, especially among credit instruments.

There are serious systemic consequences to living in a world where a Treasury bond — or any asset, for that matter — is considered a safe haven from all possible harm. Investing shouldn’t be about safety: it should be about calculated risk. Excess demand for triple-A-rated risk-free assets, as we’ve seen over the past couple of years, can be much more systemically damaging than excess demand for risky assets like dot-com stocks. So yes, let’s throw some sand into the wheels of the repo market, either through a Tobin tax or through the Miller-Moore amendment or both. Because liquidity is not ever and always a good thing.

Monday, November 23, 2009

Mangoes-Apples To Get Weather Insurance Cover In Himachal

Posted in My Himachal by Ravinder Makhaik:

A weather battered fruit economy in the hills hopes to find a security cover as the Agriculture Insurance Company of India gears up to introduce a weather based crop insurance for apples and mangoes in select producing blocks.

The weather based crop insurance scheme on a pilot basis has been introduced in Theog, Jubbal, Narkanda, Rohru and Chirgaon blocks of Shimla district and Ani block of Kullu district for apple crop and in Fatehpur, Nurpur, Indora and Nagrota Surian blocks of Kangra district for mango crop, said an government spokesman.

Fifty percent of the total premium would be borne by the insured cultivator and rest by the central and state governments in equal proportion. Chilling requirement, temperature fluctuations, deficit or excess rainfall are some of the weather perils which this scheme covers for apple crop and frost, temperature fluctuations, rainfall and wind speed for mango crop.

The insurance terms include that the scheme is compulsory for all those cultivators who have a sanctioned credit limit from a financial institution as on 5th December, 2009 for Apple and Mango crops and is voluntary for others.

The state level bankers committee, lead bank managers, co-operative banks and Agriculture Insurance Company of India have been entrusted the responsibility of implementation of this scheme.

To ensure remunerative prices the government has a Market Intervention Scheme (MIS) for Apple, Mango in place whereby a support price of Rs.5.25 per kg is being given for apple and grafted mango produce. Under the scheme the 44854 tons of apples has been procured this season, said the spokesman. In 2008-09 the state recorded a fruit production of 6.28 tons.

Friday, November 20, 2009

Deutsche funds hurt by rising life expectancies

Posted on FT Alphaville by Stacy-Marie Ishmael:

Betting on life expectancy, as investors in so-called life settlements do, is fraught with risk - not least that people will live longer than models suggest they will.

Investors in two Deutsche Bank funds — db Kompass Life 1 and 2 – that invested in US life settlements have learnt this lesson to their cost. According to a report by Spiegel Online,

Deutsche Bank collected some €500,000 ($750,000) from customers…But the fund quickly turned into a mega-flop. So far, not one investor has received even a single dividend payment and some may lose their entire principal.

A handful of investors in the Deutsche funds have filed or intend to file criminal complaints, according to the report. One of the complaints, filed in Frankfurt, according to Spiegel, argues thus:

There is cause to suspect “that from the very beginning, the promised dividends were not achievable using any realistic suppositions,” [attorney Gerhard Strate]wrote in his complaint. In addition, he says, investors in the two funds were not adequately informed about one aspect of the scheme’s structure: that both funds invest to a large degree in the same policies, thus “making risk management practically impossible.” Thus, he argues, the funds may have crossed the line into fraud or at least breach of trust. “Finding out exactly which is a job for the public prosecutors,” Strate said.
While Deutsche Bank has declined to comment on the complaints, they have attributed the non-performance of the funds — as compared to what was offered in the prospectuses — to the recent increase in US life expectancy:

As a result, they wrote to investors, “fewer policies matured than expected.” Mortality tables, upon which the funds are based, have changed since 2005, the bank explained.

Life settlements are already an emotive subject, and the industry is not helped by the whiff of scandal which seems to cling to it.

The AIG Bailout Is Still A Mystery Shrouded In Lies

Posted on the Business Insider by John Carney:

Will we ever know why AIG was bailed out and why its credit default swap counterparties were made whole?

When AIG first began to ask for a bridge loan from the Federal Reserve, the public was told that AIG wanted additional "liquidity" to avoid a ratings downgrade. This implied that AIG's problem was relatively modest, related only to a temporary gap between funding for liquidity and its obligations. As we now know, AIG needed far more than the $40 "bridge loan" it originally requested.

Initially, there was skepticism that the Fed would provide a loan to an insurance company. This was far outside the scope of the Fed's traditional role of lending to banks it regulated. Some thought it might not be legal for the Fed to lend to AIG--we only later learned that the Fed can do whatever it wants.

But why did the Fed bailout AIG? And why did they do it in a way that was so generous to the CDS counterparties? What overcame the initial resistance to bailout out AIG?

For the past year, the reigning theory has been that the New York Fed and the Treasury Department decided to bailout AIG to prevent collateral damage to the banks and other financial institutions that had purchased credit default swaps from AIG. The idea is that a bankruptcy of AIG would have forced, say, Goldman Sachs to mark-down the swap contracts to zero, which would then have triggered a need to mark down the insured securities. As those securities were marked down, they may have rendered some already thinly capitalized banks insolvent or at least pushed their reserve capital requirements below regulatory requirements.

This initially prompted many of those who saw the deal wonder why those creditors, many of whom might have received just pennies on the dollar in an AIG bankruptcy, were apparently made whole. Were they really so thinly capitalized that any haircut would have triggered system-wide failures? If so, AIG was just a covert bailout of the rest of the unhealthy financial firms.

We've known for a couple of weeks now that some of the counterparties believed they were healthy enough to accept at least some discount on the CDS payout. Others, especially a pair of giant French banks, apparently believed they were under legal obligations not to accept a haircut by a company that hadn't been declared insolvent by a bankruptcy court. Still others just seem to have played a game of chicken with the US government--refusing to accept any deal because they suspected eventually the government would be forced to pay them out whole.

But in his recent testimony to a Congressional panel, Tim Geithner said the CDS counterparty theory is wrong. AIG was really bailed out to save ordinary American individuals and businesses that had purchased insurance from the company. It wasn't the failure of derivative contracts or thinly capitalized financial firms but the failure of AIGs traditional insurance business that had the regulators worried.

"This is startling," the WSJ editorial page explains.

Yet, if there is one thing that all observers seemed to agree on last year, it was that AIG's money to pay policyholders was segregated and safe inside the regulated insurance subsidiaries. If the real systemic danger was the condition of these highly regulated subsidiaries—where there was no CDS trading—then the Beltway narrative implodes.

So what the hell was going on? Was it insurance contracts or derivatives? Both?

We suspect that answer is actually neither. All of these explanations assume that regulators knew what they were doing and provided a rational response to a perceived threat. But that doesn't match what we know about the regulators in the fall of 2008.

Hank Paulson only learned of the deep problems at AIG from a side conversation with private equity financier who was attempting to buy a piece of the company. Neither Paulson nor Geithner had understood that a private-sector rescue of Lehman Brothers would be impossible. The chaos in money market funds that followed Lehman's collapse caught them unaware. They were in a panic about the "unknown unknowns."

There is something annoying about having to speculate about the bailout. Under an allegedly republican form of government, major decisions by the US government should come with publicly articulated explanations that can be judged on their merits. What we're stuck with now is more like Kremlinology, trying to judge the secret rationales and beneficiaries of government policy. If that proverbial martian landed on earth and noticed the celebrations of 20th anniversary of fall of the Berlin Wall, we'd have to excuse some confusion on his part about whether the east or west had triumphed.

Thursday, November 19, 2009

Microinsurance provides opportunities for all

Microinsurance, insurance for low income individuals, can play an important role in helping communities in developing countries mitigate and adapt to climate change, and to provide the security needed to develop long term sustainability projects, according to Lloyd’s, the world’s largest specialist insurance.

In a new report produced by Lloyd’s 360 Risk Insight and the Microinsurance Centre, Insurance in developing countries: exploring microinsurance and other commercial opportunities, the size of the potential market is estimated to be between 1.5 and 3 billion policies, with significant demand for a range of products, including health, life, agricultural and property insurance. Over 135 million people are currently covered with microinsurance which around 5 % of the potential market. Annual growth rates are currently over 10%.

Launching the report, Lloyd’s Finance Director, Luke Savage, said:

“Bringing insurance to three billion low income individuals is a real opportunity to reduce poverty and give individuals the ability to invest in sustainable projects without the fear of loss from natural catastrophes or other destructive forces.

““But it is not a one way trade. There are benefits for commercial insurers too, which include larger and diversified risk pools, first mover advantage into new markets, market intelligence and innovations that can be applied to other business activities,” he said.

The demand for microinsurance is set to rise on the back of the global recession, with 50-90 million people predicted to be plunged back in to poverty over 2009.

While recessionary pressures will influence the amount seeking microinsurance, the policies and business itself will be further shaped by numerous variables, including: economic growth; urbanisation; financial sector development; climate change; and information technology.

Mr Savage pointed out that the partnership between business and government in this field is not new, highlighting the success of government subsidised schemes.

The report looks at the role of regulation in building and improving the provision of microinsurance, including:

- Responding to the implications of limited data and information on policyholders and different risk structures.

- Ensuring that products are appropriate to the needs of low-income consumers in terms of coverage, structure and even language.

- Recognition and if necessary regulation of fast and cost-effective settlement mechanisms, which may include simpler documentation requirements and claims handling by the distribution channel

Eurex launches new hurricane futures for 2010

Posted on Reuters by Sarah Hills:

European derivatives exchange Eurex will this week launch contracts for hurricane futures on wind damage for the risk period of January to December 2010.

Eurex, jointly operated by Deutsche Boerse (DB1Gn.DE) and SIX Swiss Exchange, was the first European exchange to offer hurricane futures in June 2009 [ID:nLG71891], but as yet has not traded any futures because of a quiet US hurricane season.

Hurricane futures will allow asset managers, hedge funds, banks and insurance companies to trade or hedge against insured losses from storms.

Despite a depressed market, Eurex's new contracts have been launched to complement traditional Insurance Linked Securities' (ILS) and Industry Loss Warranties (ILW), which will facilitate hedging and trading of catastrophe risk.

Steve Emmerson, a broker at Tullett Prebon, said the arrival of Eurex Hurricane Futures has prompted many investors to investigate and revisit the advantages that futures bring.

"Many investors in the ILS sector are considering their strategies closely, be it to hedge against Cat Bond positions, put surplus funds to work, or take advantage of trading profits," he said.

Insurance futures exchange IFEX recorded a record month in notional transactions in the run up to the hurricane season this year, with $41.1 million in April 2009. This was higher than IFEX's previous peak of $40 million in December 2008, after the costly 2008 disasters such as Hurricanes Ike and Gustav.

The volumes during August through to October this year slowed down as it became apparent 2009 was a lighter hurricane season than the previous year. There has been no activity on IFEX this month as the hurricane season came to a close.

Eurex will offer the futures for three regions -- the United States nationwide, the Gulf Coast states and Florida -- with different trigger levels based on estimates for insured losses for each region.

The USA trigger levels range from $10 - $50 billion, the Gulf Coast States from $10 - 20 billion and the State of Florida range from $30 - $50 billion. The contracts will settle at the given amounts if the damage estimate meets of excess the trigger level.

Tullett said activity levels in hurricane futures have disappointed this year, but moving into 2010 and trading volume will continue to develop, especially as more counter parties come into the space and true market pricing is established.

"Once liquidity and more activity is created, the market will open up beyond just those with specific insurance interests because hurricane futures will allow all interested parties, for example Energy companies, to hedge or simply speculate against US Wind risk," he added.

Eurex said it hopes to attract new players to the market - such as specialist ILS funds, reinsurance companies and multi-strategy hedge funds. Hurricane losses are uncorrelated to financial markets, giving investors an opportunity to diversify.

"We attempt to widen the list of participants in this market to those who are traditionally confined to financial markets. As a result, this should in due time create extra capacity, transparency and liquidity in the catastrophe insurance market," said Christian Baum, Director of Product Strategy at Eurex.

Monday, November 16, 2009

Weird waterfalls and the synthetic CDO stumper, part deux

Posted on FT's Alphaville by Tracy Alloway:

Last week, the machinations of two Goldman Sachs synthetic CDOs made waves across the internet and structured finance industry.

In short, Goldman Sachs paid off (at face value) some junior tranches of two CDOs — Abacus 2006-13 and Abacus 2006-17 — at the expense of senior tranches.

That’s a practice virtually unheard of in CDO circles — and is extremely surprising given that one of the basic ideas of structured finance is to have clear and legally-binding payment waterfall structures. Holders of the A tranche get paid first out of available CDO cashflows, followed by the B tranche and then the equity tranche, etc. But the documentation for the two Abacus deals seems to have allowed the issuer (Goldman) to use its “sole discretion” to redeem the notes without regard to seniority.

The Abacus events came to light thanks to a ratings action from Fitch, covered by Bloomberg journalist Jody Shenn, and then migrated to the blogosphere, where there was speculation that bailed-out insurer AIG may have been the counterparty to the two deals. That wasn’t a stretch of the imagination given that a number of other Abacus deals (these are the CDO deals Goldman supposedly used to short subprime) reportedly had AIG-bought CDS.

On Monday, we have a bit more detail, courtesy of Janet Tavakoli, president of Tavakoli Structured Finance:

In my November 10, 2009 commentary I mention that among the “bailout” credit default swaps that AIG was required to mark-to-market, Goldman bought credit default protection from AIG on seven Abacus deals apparently underwritten by Goldman Sachs. (Goldman also bought credit default protection on CDOs underwritten by others for a total of around $20 billion).

To the best of my knowledge, the deal that Bloomberg’s Jody Shenn mentioned in his article is not among them. It is interesting that Goldman bought credit default protection on the higher rated tranches from AIG, and was made whole by a U.S. government engineered bailout. Now Goldman is reportedly paying off the junior tranches of separate Abacus CDO first, presumably because it is allowed in the documentation.

I warned in my CDO books that this sort of cash flow game changer (among other unpleasant clauses) can blind-side unwary investors (or credit default protection providers) in senior tranches. One wonders about the identity of the senior investors (or senior protection sellers) and what they think about this.

In the secondary trading market, structures like this are called WTF deals.

WTF indeed.

Yves Smith over at Naked Capitalism has some comment from a source claiming to have seen the documentation for the Abacus deals. The incredulity is patent:

I have read hundreds of securtization [sic] disclosure documents (and drafted quite a few) and dozens of cdo dox. I have never seen any sort of “sub bond cross over date” that would apply for a deal that was taking losses. This would be such an unusual feature it would need to be highlighted in red and underlined, if I am understanding the facts in this article.

I have seen structures that deliberately fast paid sub bonds via excess spread (ie not locked out from principal for the first 3 years). But this was permitted because it did not harm the senior notes - ie sub bond was replaced by overcollateralization via excess spread (it also lowered the coat of the liability structure… And allowed bbb holders to get out ahead of senior holders). And it was always clearly disclosed and well discussed and understood.

This is happened on a 3 year old, under performing deal, so excess spread is not likely available.

I can’t think of a situation where a manager would get this type of discretion - most deals are written to protect against this type of “discretion” because it creates uncertainty about what a bond is likely to get. Changes in priority or cashflow ia always set up as something that happens by operation of triggers or events clearly labeled in the dox.

Mbs historically permitted a limited amount of discretion to manage defaulted loans (modify, short sale, pursue deficiency) which had some opportunity for conflict between them and the bond holders. As a result, there would be many checks in the dox to limit conflicts, such as requiring that the servicer not be a holder of the senior bonds…

I can’t figure this issue out. I know the abacus deals (and deutsche’s Start deals) - i reviewed them briefly before turning them down (the sales men were relentless on these deals). I saw enough to know they were different from normal transactions. All of the normal rules were off on the sales process, structuring, review etc.

Despite that, in reviewing the offering term sheets, I didn’t see broad cash flow priority discretion left to the manager. I would have been very surprised if I had.

As you might have gathered by now — what’s at stake here is the de rigueur waterfall structure of CDOs.

Goldman’s two Abacus deals may have had “sole discretion” built into the deal documentation — but it seems that many in the industry were caught unaware. Given that CDO documents can run into the thousands of pages, we wonder whether senior Abacus noteholders would have noticed the clause.

Weird waterfall structures of course do nothing for the (already suffering) CDO industry as a whole.

Related links:
CDO guide: tranching - Incisive Media (from the ABC of CDO)
Goldman and AIG, redux - FT Alphaville

Friday, November 13, 2009

Marathon raises eyebrows with CLO repurchase

Posted on Asset-Backed Alert:

Marathon Asset Management pocketed millions of dollars over the past few months by buying back securities from a collateralized debt obligation it issued in 2005 and then retiring them at higher prices.

The move has rankled market players. They say the tactic is untoward at best - and illegal at worst - as it was based on allegedly concealed information and could result in losses for junior bondholders.

The deal in question is Marathon CLO 1, which had an original balance of $330.1 million spread among several senior and junior classes. At some point this year, Marathon repurchased most or all of the issue's triple-A-rated senior notes from Bank of America at prices that industry participants peg at 85 cents on the dollar.

At the end of September, the New York firm, in its capacity as the CLO manager, started liquidating the transaction's underlying leveraged loans with the intention of using the proceeds to retire the repurchased senior classes at par. That money started flowing to Marathon on Oct. 26.

The CLO had two senior classes with a total face value of about $245 million, little of which had previously been paid off. The quick turnaround netted Marathon more than $40 million, by some estimates.

Where does that leave junior investors? According to a report issued by trustee Bank of New York on Oct. 16, Marathon liquidated about two-thirds of the remaining collateral for the deal - assets with a face value of almost $219.2 million - from the end of September to the middle of October. The sales brought in almost $200.7 million.

That means other bondholders could wind up eating the difference of roughly $18.5 million, at a time when asset-performance troubles have already cut into the deal's credit cushions. As of Oct. 16, loans with a face value of almost $102 million remained in the collateral pool.

The deal still has $73.2 million of outstanding junior and mezzanine obligations.

To orchestrate an asset sale as large as the one Marathon pulled off, a CLO's manager has to justify its actions. According to the Bank of New York report, Marathon referred to one of three justifications for most of its moves: credit risk, improved credit profiles or manager discretion.

However, one market player said the maneuvers could result in accusations of insider trading, as Marathon knew it was going to retire the deal's collateral before it bought back the senior notes. "This smells bad," he said.

Others said insider-trading charges are unlikely, but that the firm could be held accountable for shirking its responsibility as manager to act in the interest of all noteholders. "It means they screwed all the junior guys," another source said, adding that it wouldn't be surprising to see lawsuits from some investors.

The theory is that if Marathon hadn't accelerated payments on the senior securities, lower classes would have a better chance of getting all their money back.

A source close to Marathon said the firm acted appropriately and with the full permission of its legal department. The firm, known as a savvy debt investor with $10 billion under management through a variety of vehicles, has issued seven collateralized debt obligations overall. Those deals, all completed in 2005 and 2006, had a combined face value of $3.2 billion, according to Asset-Backed Alert's ABS Database.

Marathon CLO 1 priced on March 31, 2005, with Merrill Lynch serving as bookrunner.

Goldman Pays Junior CDOs Before ‘Junk’ Senior Classes

Posted on Bloomberg by Jody Shenn:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

Goldman Sachs, the most-profitable securities firm, applied its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes, Fitch said yesterday in separate statements.

The moves are unusual in that the most senior creditors are typically the first in line to get paid. Fitch analyst Karen Trebach said the use of reserve funds may help cause or add to losses for holders of the CDO’s remaining classes.

“We are not aware of the use of this feature in other transactions we rate,” Trebach said in a telephone interview.

Michael Duvally, a spokesman for New York-based Goldman Sachs, declined to comment.

Goldman Sachs packaged $1.4 billion of credit-default swaps into the CDOs when they were created in September 2006 and December 2006, Fitch said. The derivatives were intended to pay off a Goldman Sachs unit if commercial-mortgage bonds defaulted.

CDOs, which repackage assets such as mortgage bonds and buyout loans into new securities of varying risk, were among the biggest contributors to $1.7 trillion of writedowns and credit losses reported by the world’s largest financial firms since the start of 2007, according to data compiled by Bloomberg.

TPG Credit

The disclosure of Goldman Sachs’s move adds to signs that some firms are compounding investor losses by exploiting wrinkles in CDO agreements that can run hundreds of pages.

TPG Credit Management LP, a fund associated with buyout firm TPG, has attempted to purchase $355.8 million of trust preferred securities for 5 cents on the dollar from six CDOs. The fund is offering holders of lowest-ranking classes, including JPMorgan Chase & Co., an additional 5 cents on the dollar to allow the sales.

Wells Fargo & Co., the trustee, has asked a federal court for guidance because senior investors are concerned they will be hurt as the CDO collateral gets removed without sufficient compensation.

Ratings Cuts

In July, KKR Financial Holdings LLC, an affiliate of buyout firm KKR & Co., canceled portions of junior notes it held from three high-yield, high-risk corporate-loan CDOs, allowing cash to continue being paid on the rest instead of being diverted to senior classes, according to Moody’s Investors Service.

Moody’s downgraded the senior slices of one of the CDOs as a result, saying it previously had projected a “low likelihood” of such a maneuver.

Fitch, citing a deterioration of securities still in the reserve account and swaps in the CDOs’ holdings, downgraded the classes of Abacus 2006-13 that weren’t redeemed to CCC, or seven steps below investment grade. Classes of Abacus 2006-17 that weren’t paid down were lowered an additional step to CC. Some of the debt in each portion was originally AAA rated.

The repaid classes had face values of $66 million and the rest totaled $553 million, according to data complied by Bloomberg.

The transactions also contained separate credit-default swap classes that were even more senior-ranking and weren’t rated by Fitch, Trebach said. Such so-called unfunded senior- senior swaps and other classes are in some cases retained by issuers.

Credit-default swaps on asset-backed debt offer payments if securities aren’t repaid as scheduled, in return for regular insurance-like premiums.

Investment Account

Goldman Sachs bet against $1.4 billion in commercial-backed securities and other CDOs through default swaps that were inserted into the Abacus issues, and it then sold notes from the CDOs equal to part of that amount, Fitch said. The cash raised was put in an “eligible investment account.” As with similar “synthetic” deals, securities bought for that account could be used to repay the CDOs, make payouts on the underlying swaps or both partially.

Goldman Sachs also had the ability to use “principal proceeds from the eligible investment account” to redeem Abacus classes “without regard to sequential order,” which it chose to do to retire junior classes, Fitch said.

Motivations for such action could include ownership of the notes or separate bets against higher classes, according to Howard Hill, a former Babson Capital Management LLC portfolio manager who founded securitization-related departments at four of the primary dealers that trade with the Federal Reserve, among them Deutsche Bank AG and UBS AG.

Positions Unknown

“You just don’t know without seeing who owns all the positions related to the deal,” Hill, who now runs a blog from New Milford, Connecticut, said in a telephone interview.

The reserve account may also be depleted because, while a Goldman Sachs unit entered into an agreement to buy securities in it at par to enable payouts if needed, that’s not true in all situations, according to Fitch.

The “put option” can be voided if any of those securities default, which is now likely as 38 percent of Abacus 2006-17’s investments are rated CC, Fitch said. Investments, which had to be AAA rated, may have included notes such as mortgage securities or other CDOs, Trebach said.

The “probable” default of account investments may also trigger the unwinding of the Abacus CDOs, and the amount garnered in sales may not be enough to terminate the underlying default swaps as would also be required, Fitch said. About 98 percent of swaps held by Abacus 2006-17 are tied to bonds with “junk” ratings or near that level and under review, the firm said.

If Goldman Sachs hadn’t used some of the cash in the accounts to redeem notes, the senior securities would be “less exposed to losses,” Trebach said. If what’s left is insufficient, even the Abacus CDOs’ super-senior swap classes may be called upon to make up the difference, she said.

Wednesday, November 11, 2009

Royal Bank of Canada Global Covered Bond Programme

DBRS has today commented on the latest AAA-rated issuance (Series CB3 or the Series) from the EUR 15 billion Royal Bank of Canada Global Covered Bond Programme (the Programme):

The Series is the first covered bond issuance by a Canadian financial institution after a period of inactivity of more than one year. It has a principal amount of $750 million and is issued under the Programme and qualified for distribution in Canada under prospectus supplements filed under the Programme’s short-form base shelf prospectus dated September 23, 2009. After issuance of the Series, the total Programme outstanding amount is approximately $5.5 billion, which is supported by a collateral pool of $11.6 billion Canadian prime residential mortgages (as of September 30, 2009), representing 110% of overcollateralized assets. This percentage is well above the required minimum 7% based on the current asset percentage of 93%.

It is DBRS’s understanding that this is the first Canadian covered bond issuance purchased predominantly by Canadian investors. DBRS considers this to be a positive step for Canadian covered bonds as investors in Europe have commented to DBRS on the importance of establishing a domestic investor base for the development of a robust Canadian covered bond market.

Tuesday, November 10, 2009

Goldman’s Undisclosed Role in AIG’s Distress

Posted on Janet Tavakoli's website:

Goldman wasn’t the only contributor to the systemic risk that nearly toppled the global financial markets, but it was the key contributor to the systemic risk posed by AIG’s near bankruptcy. When it came to the credit derivatives American International Group, Inc. (AIG) was required to mark‐to‐market, Goldman was the 800‐pound gorilla. Calls for billions of dollars in collateral pushed AIG to the edge of disaster. The entire financial system was imperiled, and Goldman Sachs would have been exposed to billions in devastating losses.1

A Goldman spokesman told me its involvement in AIG’s trades was only as an “intermediary,” but that isn’t even close to the full story. Goldman underwrote some of the CDOs comprising the underlying risk of the protection Goldman bought from AIG. Goldman also underwrote many of the (tranches of) CDOs owned by some of AIG’s other trading counterparties.

Even if all of Goldman’s CDOs had been pristine, it poisoned its own well by elsewhere issuing deals like GSAMP Trust 006‐S32 that—along with dodgy deals issued by other financial institutions—eroded market trust in this entire asset class and drove down prices.

By September 2008, Goldman had approximately $20 billion in transactions with AIG. Goldman was AIG’s largest counterparty, and its trades made up one‐third of AIG's approximately $6.1 billion2 in transactions requiring market prices.2 Societe Generale (SocGen) was AIG’s next largest counterparty with $18.7 billion. SocGen, Calyon, Bank of Montreal, and Wachovia bought several (tranches) of Goldman’s CDOs and hedged them with AIG.3

On November 27, 2007, Joe Cassano, the former head of AIG's Financial Products unit, wrote a memo about the collateral AIG owed to its counterparties. Goldman, Soc Gen, Calyon and others required more than $4 billion. Goldman asked AIG for $3 billion of the $4 billion required in collateral calls. (Click here to view the nine‐page memo uncovered by CBS News in June 0092.) By September 2008, Goldman had called $7.5 billion in collateral from AIG.

AIG lists its transactions as negative basis trades. This suggests Goldman earned a net profit by purchasing—or holding its own—CDO tranches and then hedging them with AIG.4 As AIG’s financial situation worsened, Goldman bought further protection in the event AIG collapsed.

SocGen’s negative basis trades totaled $18.6 billion. For example, SocGen bought protection from AIG on two tranches of Davis Square VI, a deal Goldman underwrote. According to AIG’s documentation, SocGen got its prices for marking purposes for Goldman’s deals from Goldman. As of November 2007, Goldman marked down these originally “AAA‐rated” tranches to 67.5%, down by almost one‐third.5
SocGen’s list includes other deals underwritten by Goldman: Altius I, Davis Square II, Davis Square IV, the previously mentioned Davis Square VI, Putnam 2002‐1, Sierra Madre, and possibly more. SocGen hedged this risk by purchasing protection (in the form of credit default swaps) from AIG.
Calyon had $4.5 billion of negative basis trades with AIG. Calyon and Goldman were co‐lead on at least two deals: Davis Square II and Davis Square V. According to AIG’s memo, Calyon got its prices for these deals from Goldman.

Goldman’s list of negative basis trades prominently featured many of Merrill’s CDOs (as underlying risk), and Merrill had its own list amounting to around $9.9 billion (as of November 2007). In Sept 2008, at the time of AIG’s near collapse, Bank of America had just agreed to merge with Merrill, which held $6 billion of super senior exposure to CDOs hedged with an insurer, now revealed to be AIG. Both Ken Lewis, then CEO of BofA, and Hank Paulson received tough questions about the merger, but not tough enough. Lewis later testified that Hank Paulson (then Treasury Secretary and formerly CEO of Goldman at the time of the AIG related trading activity) urged him to be silent about Merrill’s troubles. Merrill later received a $6.3 billion bailout payment from AIG.

Bank of Montreal had $1.6 billion in negative basis trades with AIG, and at least two Goldman transactions (Davis Square I and Putman 2002‐1) made up 6 of its 9 positions with AIG. Wachovia had 6 trades with AIG, all related to Davis Square II, a deal that Goldman underwrote.

Goldman questioned PriceWaterhouse, Goldman’s and AIG’s common auditor, about prices. Goldman wanted lower prices, which meant that AIG would have to produce more collateral. When AIG was downgraded in September 2008, AIG was required to put up an aggregate amount of $14.5 billion in additional collateral to equal the full difference between original prices and market prices. But “market prices” in this illiquid market were influenced by Goldman Sachs.

Goldman was right to question the prices, make calls for collateral, and protect itself. Goldman’s activity was not the same as that of an arsonist buying fire insurance, but its trading activities with AIG and others were accelerants of AIG’s problems.

During AIG’s bailout, Goldman had influence over the decision to use public funds to pay 100 cents on the dollar for these CDOs (the underlying risk of the credit derivatives), but none of the information about the volume of Goldman’s trades with AIG—or the Goldman CDOs hedged by AIG’s other counterparties—was made public.

Goldman’s public disclosures in September 2008 obscured its contribution to AIG’s near bankruptcy and the need to bailout Goldman’s trading partners in AIG related transactions. Goldman’s trading activities played a starring role in the near collapse of the global markets.


1 Goldman’s current and former officers were influential in varying degrees in AIG’s bailout. Hank Paulson was then Treasury Secretary and a former CEO at the time Goldman put on its trades with AIG and underwrote deals bought by some of AIG’s counterparties. Lloyd Blankfein was CEO of Goldman and was influential in the bailout discussions. Stephen Friedman, then Chairman of the NY Fed, also served on Goldman’s board.

2 AIG’s Nov 007 report2 showed Goldman’s positions at $23 billion, but something may have happened before Sept 2008 to reduce that amount. AIG was required to price these credit derivatives using market prices, and if applicable, AIG had to provide collateral if the prices moved against it. Terms varied, but after the downgrade, AIG owed collateral for the full mark‐to‐market value to several counterparties. This is the difference between the original value and the price that Goldman and others put on the credit default swaps.

3 AIG’s other trading partners for the CDSs requiring mark‐to‐market prices included French banks Societe General (SocGen) and Calyon, Bank of Montreal, Wachovia, Merrill Lynch, UBS, Royal Bank of Scotland, and Deutsche Bank.

4 AIG may have used the term “negative basis trade” loosely. Whether Goldman was an intermediary (stood between AIG and yet another counterparty), or whether it booked negative basis trades, Goldman had to manage its risk in the event AIG went under.

5 SocGen’s total margin calls were not available in the November 007 memo2. It is possible that like Calyon—and like troubled Citigroup—SocGen provided a liquidity put on commercial paper (CP) distributed by Wall Street firms to a variety of investors. Calyon agreed to buy the CDO’s commercial paper (short term debt backed by the longer term tranches of the CDOs) if demand in the market dried up when it came time to roll the CP. Calyon hedged the risk of the liquidity puts by purchasing credit default protection from AIG

Bondholders Extract Revenge on Fee-Hungry Bankers

Posted on Bloomberg by David Reilly:

Companies in dire straits often roll the dice in a bid to stave off bankruptcy. The problem is that last-ditch efforts to raise new funds or restructure often come at the expense of bondholders.

Struggling companies, their advisers and lenders should think twice about such strategies after an almost $700 million judgment last month against Citigroup Inc., Bank of America Corp., Wells Fargo & Co. and other lenders, in connection with the bankruptcy of homebuilder Tousa Inc.

With bankruptcies rising, the decision may push creditors in other cases -- those of Tribune Co., Lyondell Chemical Co. and CIT Group Inc., for example -- to pursue more aggressively what are called fraudulent conveyance claims.

The Tousa case has caused the legal and bankruptcy communities to sit up and take notice because fraudulent conveyance claims rarely result in a sizeable judgment. Such claims seek to claw back money for a bankrupt entity by claiming a transaction was fraudulent because, while insolvent, it had transferred funds or assets without receiving something of equivalent value.

Fraudulent conveyance claims are usually settled or fizzle because they face a tough road at trial, essentially requiring a bankruptcy judge to play Monday-morning quarterback.

The Tousa case has turned that thinking on its head.

“This case will undoubtedly embolden people in other cases, like Tribune,” said Douglas Baird, a University of Chicago law professor.

Tribune Creditors

Creditors of Tribune have alleged that fraudulent transfers took place as part of that company’s $8.3 billion going-private buyout. Tribune Chairman and Chief Executive Officer Sam Zell has denied the allegations, telling Bloomberg News, “In this particular case, I don’t think it’s valid, but ultimately it becomes a basis for negotiations.”

Baird said the Tousa decision will make such negotiations tougher. “I can go back to a lender and say that there’s a serious fraudulent conveyance risk here, and they’d say those claims never get anywhere,” Baird said. “If I say that someone just got tagged to the tune of half a billion dollars, this becomes a real risk.”

The Tousa decision also offers a window to some behavior that marked deal-making in the waning days of the credit and housing bubbles.

One example: AlixPartners LLP, the firm issuing a solvency opinion for Tousa, was to receive $2 million for a favorable opinion, and less than half that for an adverse one. Guess how that worked out.

Citigroup, Wells Fargo

Banks such as Citigroup, Bank of America and Wells Fargo, as well as other lenders, are appealing the Tousa decision. Last week, U.S. Bankruptcy Judge John K. Olson ordered them to post bonds of about $700 million while pursuing the appeals.

Tousa is a Hollywood, Florida-based homebuilder that expanded earlier this decade through a series of acquisitions, taking on $1 billion in debt.

In 2005 the company entered into a joint venture to buy Transeastern Properties Inc.’s homebuilding business. Tousa issued unsecured guarantees related to more than $500 million in borrowing by the venture, which quickly ran into trouble.

Tousa faced claims due to its guarantees and in January 2007 agreed to pay more than $421 million. Tousa didn’t have that kind of cash, though, and its business was rapidly souring as the housing meltdown began.

Secured Debt

To finance the settlement, Tousa issued $500 million in new, secured debt on July 31, 2007. This was secured by Tousa subsidiaries that weren’t at risk from the failed joint venture. Those units were home to most of the company’s assets, meaning claims from the new lenders would compete with those of existing bondholders.

Six months later, in January 2008, Tousa filed for bankruptcy. The company’s existing bondholders cried foul.

They claimed the 2007 financing had fraudulently transferred value from the subsidiaries, which didn’t see any money from the deal and weren’t on the hook for the joint venture’s failure. The bondholders also argued that the subsidiaries were insolvent both before and after the new round of financing.

Judge Olson agreed. His decision noted that banks and other lenders involved ignored ample evidence in early 2007 that Tousa was in bad shape and that taking on more debt wouldn’t benefit the company. He also found that:

Layers of Fees

-- Those involved with the financing had big incentives to get the deal done, no matter the risks. Half the chief executive’s target incentive bonus of $4.5 million was contingent on the deal’s completion. So too was a $3.5 million fee for the company’s investment bankers, Lehman Brothers Holdings Inc., along with a $2.9 million financing fee. And Citigroup “saw the proposed new financing as a highly attractive opportunity for fees,” the judge wrote. It ultimately collected $15 million.

-- Citigroup bankers arranging the financing knew early on that Tousa was in trouble. The judge noted that after looking over financial models for Tousa, a Citigroup banker wrote in an e-mail, “I don’t think the downside model should be shown to anyone outside of here. It’s too scary.”

-- The company’s board was warned in a letter from Capital Research and Management Company, an investor in Tousa’s existing bonds, that the new financing could put Tousa into the “zone of insolvency” and that it might be a “fraudulent transfer.”

-- Some lenders swallowed whatever management fed them, failing to question housing-market forecasts. That failure, Olson wrote, “was the result of either gross negligence or a willful decision -- motivated by a desire to generate fee income -- to turn a blind eye toward the obvious reality that Tousa was in a death spiral.”

Now, Tousa’s bondholders have rightfully gotten some revenge, while fee-hungry bankers and lazy lenders have been warned.

Banks don’t just have an asset problem, says Moody’s

Posted on FT Alphaville by Tracy Alloway:

Here’s the Moody’s report that is making waves in financial media circles on Tuesday morning.

The basic premise: The average maturities of new debt issuance by Moody’s-rated banks around the world fell from 7.2 years to 4.7 years over the last five years — the shortest average maturity on record. In graphic terms, that looks like this.

Average maturity of global debt issuance - Moody's

That means banks will face maturing debt of $10,000bn between now and the end of 2015, or $7,000bn by the end of 2012, according to Moody’s.

Now, a debt profile skewed towards short-term maturities can make a bank more vulnerable to market volatility (increases in official interest rates and/or swings in investor confidence) which rather helps explain why banks got into it in the first place. Here’s Moody’s:

Before the crisis, banks tended to issue two to three times more new debt than what came to maturity during a given year, highlighting the rapid asset growth that occurred across banks and systems in recent years and their active management of liabilities to lower funding costs. The trend towards shorter debt maturities reflected banks’ increasing confidence in their market access as well as the availability of alternative funding channels, notably through the use of securitization. It also appears that, presumably for similar reasons, banks have increasingly relied on instruments with option features (step-up, call or put options) that expose the issuer to periodic changes — the risk being an increase — in the rate they pay on their own debt (for the purpose of our graph, we have generally referred to these instruments as medium-term notes, or MTN).

As the above should suggest, the danger here is that investors don’t return in time for banks to refinance their shorter term debt. Uncharacteristically perhaps, Moody’s is actually concerned here. At the very least, the ratings agency says the banks will experience a step-up in funding costs:

Driven by either internal risk management or regulatory considerations, we expect that affected banks will want to extend their debt maturity profiles by replacing some of their short-term debt instruments and MTN-like instruments with new, longer term wholesale debt in the coming months and years. However, spreads on long-term corporate debt are already substantially wider than short-term debt currently, and it is probable that rates will rise in the future when considering the historically low interest rates currently prevailing and some other forces that may also push up rates, such as the imminent exit of government support to the financial sector and the fact that these governments will also compete with banks for debt raising in order to finance their large deficits. Therefore, funding costs would increase from the mere fact of moving out on the yield curve, with the risk of funding costs being pushed up further by the rising tide of benchmark rates.

And just to get really wonky — here’s a demonstration of that increased funding cost:

Suppose, a Baa-rated bank had issued short-term debt under an Aaa-rated government guarantee programme and had been paying a coupon of about 1.3 per cent. It would need to pay a 7.75 per cent coupon for issuing a 10-year bond on its own today — a 645bp increase. The same move by a Ba-rated bank would result in a 929bp increase. Considering that the issuance of Aaa-rated government-backed unsecured debt for banks globally (ex-US) is up 23 per cent, while issuance without government backing is down 22 per cent — you can get a sense of just how much money banks have actually been saving due to the guarantee programmes.

Those government-guarantee programmes around the world will of course expire in coming years. At the same time you will also probably get a wind-down of central bank asset purchases and further regulatory pressure on banks’ capital — all of which means significant upward pressure on banks’ funding costs, at a time when many will still be dealing with copious amounts of bad debt, according to Moody’s.

In other words, the banks don’t just have an asset problem — they also have a looming liability problem.

Back to Moody’s:

Investors have returned to the market in 2009, providing significant amounts of funds, but this should not be confused with a return to a normal operating environment. We believe that the “thawing” of debt and equity markets was largely driven by calculated, opportunistic risk-taking in the context of the extraordinary support provided by government programs and very low short-term interest rates. We would therefore not describe the investor resurrection as a return to strong financial fundamentals in the markets.

In fact, we expect that credit-related losses to continue to cause damage to banks’ financials. In our view, losses are still on a rising trend, mainly because of the delay that exists between the end of a recession and a fall-off in provisions and actual charge-offs.

To use the US banking system as an example, banks have not provisioned for the full amounts of loan and securities losses that we believe they will incur over the coming year, which we expect to reach $470 billion in credit costs by the end of 2010. Approximately only one quarter of this has been recognized to date and we expect earnings to be insufficient to offset these costs during that period, resulting in many banks being unprofitable.

The risk premium on bank debt is unlikely to fall in such a poor credit quality context. If anything, it may actually increase, especially for long-term debt which already commands a significantly higher premium. Additionally, a close look at recent results reported by banks in various systems reveals that asset quality prospects for both consumer and commercial credits remain bleak.

Therefore, credit costs should continue to put banks’ earnings and profitability under considerable pressure, which might cause investors to seek additional risk premia, as governments gradually exit from the direct support they have so far provided. In other words, we see weaknesses on both sides of the balance sheet, and we are concerned that the risks associated with both assets and liabilities may fuel each other, cause losses and undermine investor confidence.

Moody’s — we didn’t know you could be so (bank) bearish.

Friday, November 6, 2009

Was it “Nobody Saw It Coming” or “Everybody Who Saw It Coming Was a Nobody”?

By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side. (Guest post on Naked Capitalism)

A number of economists, economic policymakers, regulators, and central bankers have attempted to explain away their failure to both foresee and mitigate the current financial crisis by asserting that no one saw it coming. The inference is that they cannot be held accountable for something so unusual, so extraordinary, and so unforecastable that that no one saw it coming. Robert Shiller, in a November 1, 2008 NYT OP-ED, noted the following example:

Alan Greenspan, the former Federal Reserve chairman, acknowledged in a Congressional hearing last month that he had made an “error” in assuming that the markets would properly regulate themselves, and added that he had no idea a financial disaster was in the making. What’s more, he said the Fed’s own computer models and economic experts simply “did not forecast” the current financial crisis.

However, the Fed and other policymaking agencies cannot honestly claim that no one saw it coming. There is ample evidence that:

• Economist and commentators “saw it coming”; and

• Economists and others repeatedly brought their observations to the attention of the authorities including the Fed, but were ignored.

In fact, the Fed increasingly exhibited a willingness ignoring critics and criticism. The existence of this pattern at the Fed can be illustrated by looking at two presentations by Kohn. The first is from 2003 and the second is from 2005. But first, a return to Shiller’s OP-ED piece:

Mr. Greenspan’s comments may have left the impression that no one in the world could have predicted the crisis. Yet it is clear that well before home prices started falling in 2006, lots of people were worried about the housing boom and its potential for creating economic disaster. It’s just that the Fed did not take them very seriously.

Schiller blamed self-censorship and group think. Shiller reports that while he was a member of the economic advisory panel of FRBNY, he felt the need to use self-restraint and stated that he only gently warned about bubbles in the housing markets.

It is one thing for someone to practice self-censorship. It is another thing all together for an institution charged with a public responsibility to allow and foster an atmosphere in which someone well respected enough to be asked to sit on an advisory board feels as though he or she must temper their statements or pull punches. What was the role of the advisory board, if the members did not feel free to raise and discuss competing views or alternative policy paths? In the context of the dynamics of globalization and financial innovation, why was conformity to a static consensus tolerated and even encouraged?

Furthermore, while the Fed had a responsibility to promote economic and financial stability, Shiller did not. Once well respected economists and analysts highlighted the possible risks the Fed had an obligation to assess those risks. Shiller also reported that the group-think that ignored signs of the impending financial crisis extended well beyond the halls of the Fed:

I gave talks in 2005 at both the Office the Comptroller of the Currency and at the Federal Deposit Insurance Corporation. I argued that we were in the middle of a dangerous housing bubble. I urged these mortgage regulators to impose suitability requirements on mortgage lenders, to assure that the loans were appropriate for the people taking them.

The reaction to this suggestion was roughly this: yes, some staff members had expressed such concerns, and yes, officials knew about the possibility that there was a bubble, but they weren’t taking any of us seriously.

Returning to the Fed, a speech by Kohn in February 2003 indicates that while Shiller was self-censoring, other commentators had been pointed enough in expressing their concerns to merit a response:

In particular, a number of commentators have raised the specter that imbalances are being created in the markets for consumer durable goods and houses–unsustainably high prices or activity–that will produce macroeconomic strains when, inevitably, they correct. These concerns obviously echo those expressed by some observers that monetary policy allowed run-ups in equity prices and capital spending in the 1990s that ultimately proved to be destabilizing.

In a footnote, Kohn went on to say:

Another possibility is that the buildup of debt associated with the strength in household investment will feedback adversely on financial conditions, especially as the boom unwinds. Such consequences could occur even in the absence of a “bubble” in housing prices if households were overextended and lenders had not taken adequate precautions against even a measured drop in collateral values… Moreover, loan-to-value ratios on mortgages have been about flat, leaving ample cushion for moderate housing price declines, should they occur. These observations suggest that widespread credit difficulties with important macroeconomic effects are unlikely when interest rates rise.

Kohn not only acknowledged the existence of the commentators and their concerns and took them seriously enough to present evidence that he thought should lay to rest those concerns to rest. He also suggests that the likely short-lived nature of the interest rate -driven increases in housing prices and real estate investment implied that any resulting macroeconomic or financial problem would be of a manageable scale:

Judging from this analysis, and bearing in mind its inherently tentative–if not speculative–character, it seems likely that as the economy strengthens and interest rates rise in response, household investment and prices are likely to soften some relative to recent trends, but not to break precipitously. Houses and cars would not be providing the impetus to economic activity they often have in past recoveries…

At the Jackson Hole Conference of 2005, a speech by Rajan, the then Chief Economist at the International Monetary Fund, “Has Financial Development Made the World Riskier?” and a response by Kohn allows us to get a read on Fed policymakers reactions to warnings about possible economic or financial dislocations two years later. In the opening paragraphs, Rajan argued that the transformation of the financial sector had made it more efficient, but at the expense of increased risk:

The expansion in a variety of intermediates and financial transactions has major benefits,…However, it has potential downsides, which I will explore ..

… the incentive structures of investment mangers today differs from the incentive structures of bank managers in the past in two important ways. First,… managers have a greater incentive to take risk. Second, their performance relative to other managers matters.

The knowledge that managers are being evaluated against other managers can induce superior performance, but also perverse behavior.

One is the incentive to take risk that is concealed from investors—since risk and return are related , the manger then looks as if he outperforms peers,,, typically the kind risks that can be concealed most easily… are known as tail risks.

Both behaviors can reinforce each other during an asset price boom…An environment of low interest rates flowing a period of high rates is particularly problematic, for not only does the incentive of some participants to “search for yield” go up, but asst prices are given the initial impetus which can lead to an upward spiral, creating conditions for a sharp messy realignment…..

…the most important concern is whether banks will be able to provide liquidity to financial markets so that if tail risk does materialize, financial positions can be unwound and….the real consequences to the real economy minimized.”

The balance of the Rajan paper was a development of these ideas along with the presentation of considerable amount of supporting evidence. He referenced over 50 plus scholarly papers. Rajan never forecasted or predicted the crises which were to follow relatively quickly. However, he concluded:

a risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy and through macro-prudential measures. I argue some thought also should be given to attempting to influence incentives of financial institutions mangers lightly, but directly.

Kohn was a Discussant, but his response was not so much a discussion or rebuttal of the Rajan theses as it was simply a restatement of his and presumably the Fed’s belief that the greater dispersion of financial risk away from banks necessarily implied lower levels of systemic risk. There was no discussion of the implication of the changes in incentive structures or herding behavior. Kohn dismissed concerns about tail risk citing reduced volatility of output and inflation over the previous twenty years. However, who believes that tail risk has to either manifest itself in a twenty year period, or be non-existent. Furthermore, the factors cited by Rajan had come to dominate the financial sector only during the prior ten years.

No mention was made of LTCM or the Tech bubble. Concerns that low interest rates may contribute to increased risk in the financial system were dismissed on the grounds that those policies contributed to greater stability in output and inflation. Kohn never addressed the point that the shift away from bank-center finance might leave the system short of liquidity should risks materialize.

In short, Kohn’s response to Rajan’s theses was nothing more than a curt dismissal when compared to his detailed response to the specter of imbalanced -induced concerns voiced by the unnamed commentators in 2003. It appears that the perceived need to respond, even if only in words, to well researched warnings by prominent economists had disappeared.

Furthermore, Kohn on this occasion and presumably others, never publicly revisited (to my knowledge) the contingencies which were in part the basis of his rejection of the warnings in 2003. Interest rates had risen very slowly amidst a jobless recovery and a failure of investment spending to propel the economy. Ten year Treasury yields were only about 25 bps higher and monetary policy remained accommodative. Loan to value ratios had started to erode as had lending standards. If Kohn had re-checked the reasons he cited in his in 2003 rejection of warnings he would have found that the conditions he had cited for being sanguine no longer obtained.

In summary, numerous people, including well respected economists and officials saw the grounds for economic and financial crises being laid. Furthermore, these warnings were brought to the attention of US policymakers. Assuming the two presentations cites above are representative, the warnings were at first treated as worthy of a serious response. However, even as evidence of serious imbalances and bubbles grew, the responses to warnings became perfunctory and devoid of serious analysis.

Houston, we have a problem.

Thursday, November 5, 2009

Boomers in Denial About Retirement Savings

Posted on CNBC by Christina Cheddar Berk:

No doubt last year’s financial crisis dealt a body blow to many investors, but many Boomers approaching retirement have yet to turn their reaction to last year’s events into action.

Wells Fargo just released the results of its Retirement Fitness survey and looked hard at the investment habits of pre-retirees ages 50 to 59. What did they find?

“There is a sense of denial among the pre-retirees,” said Lynne Ford, head of Wells Fargo Retail Retirement.

Even after suffering significant losses last year, many remain overly optimistic about their investment returns and the ability of their savings to fund their expenses after they stop working.

Only 23 percent of pre-retirees are saving more for their retirement than they were a year ago, the survey found. Most, some 57 percent, are saving the same amount, and 20 percent are saving less.

Perhaps even more startling is the extent to which their savings are falling short of their goals. On average, these pre-retirees expected they would need $800,000 to fund their retirement. However, most had only saved about $300,000.

Despite their inadequate savings, nearly two-thirds of the group lack any formal plans for retirement savings or spending strategies.

Of the 35 percent of those who had a written plan for retirement, only slightly more than half — about 52% percent — say they had updated it in the past year during the market downturn.

According to Ford, the results of the survey cry out for people to take more control over their retirement.

“The bottom line is you have to have a plan and pull it out and retest your assumptions,” Ford said.

Among the biggest mistakes people are making is over-estimating their investment returns and the amount of money that can safely be withdrawn each year in retirement.

In the survey, both those who were about to retire and those who already had said they expected their savings to grow by 8.7 percent each year, on average. However, the compound annual growth rate of the S&P 500 from 1958 through 2008 was only 6.6 percent.

People also under-estimate how long they will live in retirement, she said. A healthy person in their mid-sixties can easily expect to live into their eighties or even nineties. However, few people are prepared to support themselves in retirement for more than twenty years.

Wednesday, November 4, 2009

Only the strongest survive (and thrive) in the CP markets

Posted on the Sober Look:

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).

With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).

And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,

source: FRB

driving up the overall CP notional.

source: Bloomberg

This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:

source: FRB

The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

Does Financial Innovation promote Economic Growth?

Posted on Rick Bookstaber's blog:

I participated in an Oxford-style debate at The Economists’ Buttonwood Gathering a couple of weeks ago. The proposition for the debate was Financial Innovation Boosts Economic Growth.

On the pro side of the proposition were Myron Scholes, the chairman of Platinum Grove and Robert Reynolds, the CEO of Putnam, and on the con side were Jeremy Grantham, the CEO of GMO and me. This was the first time I had participated in a formal debate, as I suspect it was for the others. When we came out onto the stage, I overheard one person in the audience say, with a British accent, “Well, they obviously have never been in an Oxford debate before.” I don’t know what we did wrong, but it looks like we even messed up our entrance.

The entire debate is available here. It includes five-minute opening remarks by each participant – first Robert for the pro, then me for the con, then Myron and finally Jeremy. This was followed by one-minute rebuttals and then questions from the moderator and audience. It is pretty interesting, but for those who do not want to spend the time watching it, here are the main points I made.

I elected to restrict my discussion of financial innovation and economic growth in two respects.

First, I focused only on the so-called innovative products. I grant that there are some innovations in the financial markets that have been beneficial; Robert Reynolds gave a summary of many of these. I take as a given that electronic clearing, the adoption of telecommunications, the development of futures, forwards and mutual funds have all had a positive impact.

So what do I mean by innovative products? Well, I could just say you know them when you see them. But when I think about innovative products, I think about them in a three dimensional space. I look at where the product fits in the dimension of simple to complex, standard to customized, and transparent to opaque. The things I term innovative products congregate in the {complex, customized, opaque} region.

Second, I focus on the impact of financial innovation over the past ten or fifteen years. I am looking to the past rather than forecasting to the future for two reasons. One is that I do not have a crystal ball, so I cannot project what innovations will occur in the future. Another is that if the future is like the past, then at least the past can provide a guide. Behavior being what it is, absent regulation to bridle our actions, this is a reasonable assumption to make.

So, defining innovative products in this way and looking over the past ten or fifteen years, let’s look at the ways financial innovation might promote economic growth.

Do innovative products improve market efficiency?

If we were in an Arrow-Debreu world, the answer would be yes. But the incentives behind innovation move in the other direction. The objective in the design and marketing of innovative products is not market efficiency, but profitability for the banks. And market efficiency is the bane of profitability. The last thing a bank would want is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand an price. And the second is by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

Do innovative products allow us to better manage risk?

Hardly. They create risk, or, if you don’t want to go that far, they hide risks. They put risks off balance sheet, obfuscate them through complex schemes, create non-linearities and correlations that only become evident in times of large market changes. They also push more risk into the tails, so that in the day-to-day world things look more stable, but in an extreme event the losses are accentuated.

Earlier in the conference, Larry Summers gave an address where he remarked that since the early 1980s we have had a major financial crisis roughly every three years. Whatever financial engineering and the innovations it creates is doing for the markets, it is not tempering risk.

Do financial innovations help meet investors’ needs?

Unfortunately, the answer is yes. Well, not investor needs, but investor wants. They allow investors to lever when they aren’t supposed to lever, take exposure in markets where they are not supposed to take exposure, avoid taxes, take on side bets in markets where they have no economic interest. I go through some of the uses of derivatives for gaming and gambling in my Senate testimony from June.

Do innovative products promote capitalism?

The answer to this is yes and no. We get capitalism when things are going well, and socialism when things are going poorly. I went through this in a recent post.

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without some form of derivative – and all leading to these sorts of return characteristics.

This was a debate, so we all took the polemic positions. Though the positions were assigned based on our pre-existing views. I am not so extreme as to hold that all innovative products, even those that do fit in the {complex, customized, opaque} corner, are devoid of value. But just because we are able to take some cash flow and turn it into an instrument doesn’t mean we should. Here are three questions we can ask to determine if a new, innovative product makes sense.

Is there a standard, simple instrument that could do the job – either one that already exists or one that can be created.

Is the primary purpose of the new instrument to meet economic objectives (i.e. helping to get capital to the producers or helping producers layoff risks) or to meet non-economic objectives (i.e. gaming the system, making side-bets on the market).

Does the instrument create negative externalities; on the margin does it increase the risk of market crisis, by making the market more levered or complex?

Monday, November 2, 2009

Too Smart to Fail

Posted on the Kamakura blog by Donald van Deventer:

Throughout the 2007-2009 credit crisis, we’ve heard “too big to fail” over and over again. Somewhat less frequently, we’ve heard “too small to succeed,” a phrase about those banks who were in trouble but not big enough to be rescued by the U.S. government. What these troubled times call for are banks that are “Too smart to fail.” This blog looks at what it takes to meet that standard.

We had some fun in our October 19, 2009 blog entry where we relayed a New York Times quote from a senior executive at Citigroup who said that deposed CEO Charles Prince didn’t understand the difference between a CDO and a grocery list. It’s becoming increasingly obvious that one of the best predictive variables when it comes to understanding failures of financial institutions is the brain power of the CEO and the people around him, both at the Board level and in senior management. Why are we as an industry just coming to this realization?

One of the reasons brainpower hasn’t historically been important in choosing a bank CEO is that, in the old days, it was only one of many attributes of a CEO that determined success. Charismatic leadership, when you’re running a retail bank with hundreds or thousands of branches, has been more important to a bank CEO’s success in the past than the CEO’s ability to understand the difference between a collateralized debt obligation and a grocery list. That’s all changed now, thanks in large part to Wall Street. I once posed a question to one of the smartest people ever to work at Kamakura, David Kuo. David was a mathematician who got to Harvard from Taiwan after living in Harlem for a few years. After David graduated from Harvard, he went to a boutique securities firm in the arbitrage department. “What have you learned since you started?” I asked. David answered “Arbitrage is the process by which people who are smart take money from people who are not.” A bank CEO has to be smart enough to understand that the only reason Wall Street exists is to take the bank’s money. It’s as simple as that.

The fact that brainpower matters isn’t a new idea. One of my favorite books is the controversial but wonderful book by the late Richard J. Herrnstein and Charles Murray, Bell Curve: Intelligence and Class Structure in American Life. This extraordinary book remains one of the best sellers on even 13 years after it was published:

Recognizing that there is no high quality measure of intelligence in a single index, the authors can still make a very strong case that people who are not very smart make mistakes (e.g. teenage pregnancy) a lot more frequently than people who are smart. In banking 30 years ago, when I started, the mistakes you could make in banking weren’t very numerous. Here were a few of the things people did to avoid making common mistakes:

  • Make sure the tellers in the branch don’t steal your cash
  • Make sure the computer experts in the IT department are not paying themselves the rounding error on interest rate payments to depositors
  • Make sure the instructions for wire transfers are real. One of the most fun incidents I witnessed as a young banker at Security Pacific was the theft of $7 million dollars by an IT consultant in the wire transfer department who just called up and gave instructions to wire $7 million from a corporate client’s account to his new Swiss bank account. Senior management didn’t know where the money went until the FBI discovered the guy paying retail price in Zurich for diamonds sold by the Russians
  • Make sure the traders can’t trade much.
  • Make sure that retail borrowers are not liars.
  • Make sure that the collateral exists and you have done all the right things to secure the collateral
  • Make sure you price loans and deposits correctly. If you are getting much more volume than your peers, you’re making a pricing mistake.
  • Make sure no one responds to that letter from “Saudi Arabia” offering to buy $500 million of the bank’s bonds at Treasuries less 200 basis points, because it’s a scam.

Now, banking has become a lot more complicated because banks aren’t just buying Treasury bonds from Wall Street any more. Banks, insurance companies, and pension funds have the world’s biggest bull’s eye on their chests because the menu of what Wall Street sells is much longer and much more complicated. Wall Street is selling loans it didn’t make. It’s selling life insurance policies it didn’t originate. All Wall Street does is wrap the package and put ribbon on it, and they get paid more for what’s inside the box than the merchandise cost them. How can people not understand this? “Arbitrage is the process by which people who are smart take money from people who are not.”

In addition to all of the mistakes that bankers had to avoid 30 years ago, there is a longer and more complicated list of things that financial services CEOs and Boards have to worry about. Because the Wall Street bonus system has become more common in the full range of financial institutions, from the CEO to the lowliest clerk the misincentives are as common as they are among the teenagers collecting for drug dealers in David Kuo’s home town of Harlem. Don’t believe it? I personally worked with three people who later served time in prison or have been convicted of felonies—One each from Lehman Brothers, Salomon/Merrill Lynch, and Countrywide. “Just because they wear a suit doesn’t mean they’re not a crook” is a saying one shouldn’t forget. Being smart as a board member or CEO in financial services means remembering things like this:

  • When the CEO’s bonus is in the tens of millions of dollars, he will not report problems to the Board until after he’s received the wire transfer of his bonus
  • When a member of the Board needs the compensation as a Board member, he will never ask the hard questions a Board needs to ask (“I could never raise that issue. Angelo would have fired me from the Board,” one director of Countrywide once told me).
  • Derivatives traders on a bonus system aren’t making profits—they’re just arbitraging your credit rating. They will do as much volume as possible until your rating sinks to a level at which you can’t do any more business
  • When a bonus system is in place, not a single person in that business unit has an incentive to tell senior management “this business is no longer profitable.”
  • When a financial institution doesn’t know what a security is worth, Wall Street will try very hard to sell them a lot of that security
  • When a financial institution doesn’t know what a security is worth, its own staff will originate them, sell half (by tranching) at a profit which drives their bonus, and put the other half (which has a loss identical in amount) on the balance sheet of the financial institution. Charles Prince and Stanley O’Neal, please note—this is how you lost money in CDOs
  • When bonuses are large and lies can increase your bonus, at least in the short run, people will lie

These points are now obvious. In the current environment, the CEO of a financial services company has to be just as shrewd as an old time mafia boss who knows that everybody working for him could be stealing from him. In the old days, I truly believed that the bankers I worked with were much more honest and intelligent than average, and it was true. Of the bankers I worked with 30 years ago, not one went to prison. By comparison, 2 of my 400 public high school classmates went to prison and, as mentioned above, 3 of my former co-workers in investment banking and finance in recent years have gone to prison.

Being “too smart to fail” means much more than being cynical about people’s motives both on Wall Street and inside one’s own organization. It means avoiding mistakes like these:

  • The head of Phibro is not worth $100 million dollars when the Phibro business unit can only be sold by Citigroup for $250 million. Citi’s size and former credit rating simply allowed an above average human being to take big positions. He’s not worth 1/20th of what he was paid, and Citi management didn’t know it. See the luck and skill bullet point below for more on this.
  • “We just lost a lot of money in our credit portfolio, so our budget for credit risk management technology has just been cut” is such an embarrassment that even the people who have to relay that message laugh when they say it
  • Harvard’s recently announced losses of almost $500 million on swap contracts resulted in margin calls that Harvard came dangerously close to being unable to meet. Clearly, you can’t take positions which have variable margin requirements unless you can meet the margin calls, no matter what happens to the price of the position
  • “The margins in this business are so small that we can’t afford the expense of a risk management system” means you need to get out of the business before it’s too late
  • “We’re managing risk in the Group Treasury, but we don’t need to use the same technology in our mortgage business. Our CEO has total confidence that the line guys in the mortgage business totally understand the business.” That institution failed.
  • In trading and investment management performance measurement, there’s an enormous difficulty in distinguishing between luck and skill. More than 20 years ago while I was at Lehman, we used to joke about it. You start with 16 traders. After a year, half had losses and 8 of the group would be left. After another year, you’re down to 4. After still another year, you’re down to 2. And finally, there’s 1 left. He’s been right for five years in a row and gets a huge bonus. Ironically, at “the old Lehman” management understood this and was legendary for just taking nickels and dimes that were sure arbitrage bets, with no huge open positions, unlike recent Wall Street fashion.
  • “In a crisis, all correlations go to one” is a confession that one’s understanding of finance is not good enough to be “too smart to fail.” As this chart from the recent crisis shows, when home prices drop by more than 20%, more banks fail in the United States:

  • The correlation of home prices with bank failures wasn’t obvious in the data when home prices changed by relatively small amounts. Nonetheless, being “too smart to fail” means understanding that you have a problem if you are making 80% loan to value mortgage loans and the home price drops in value by 20%.

We’ve made the point in this blog before that you need a license to drive a car in the United States, but you don’t need a license to be the CEO of a financial institution that can draw on the full faith and credit of the United States when the CEO makes a mistake. We need to replace “too big to fail” with “too smart to fail.” We need CEOs who meet a higher standard that Dick Fuld, Angelo Mozilo, Charles Prince, and Stanley O’Neal. And that responsibility rests with the shareholders and the Board of Directors. They need to take that responsibility to avoid a repeat of the last two years.