Thursday, December 24, 2009

Why Goldman could go short mortgages

Original posted on Reuters by Felix Salmon:

Blake Hounshell asks (of me specifically, no less) why “other banks didn’t follow Goldman’s lead when in December 2006 the firm turned bearish on the mortgage sector”.

The answer is that Goldman never had much in the way of net mortgage exposure to begin with, and could therefore turn bearish quite easily. Banks which had tens of billions of dollars of illiquid mortgage bonds on their balance sheets, by contrast, had no real way to put on a bearish bet.

More generally, pure investment banks, like Goldman, always claim to be in the moving business as opposed to the storage business. Today’s NYT story shows that there are limits to how true that is — Goldman had significant long-term mortgage exposure which it hedged by building up a short position in synthetic CDOs. But at least its net position stayed very small.

Competitors like Merrill Lynch, by contrast, found themselves taking enormous amounts of mortgage-bond exposure onto their own balance sheets just because no one else was willing to buy the lowest-yielding tranches of their mortgage bonds. It was that exposure which ultimately doomed the bank. Merrill might have been talking the moving-not-storage talk, but in practice it was acting as a waste dump for all manner of risky paper that the bond desks couldn’t move.

And big commercial banks with investment-banking arms, like Citigroup and UBS, never even claimed to be movers rather than storers: they actively sought out high-yielding triple-A paper as part of their business model. So long as the yields were higher than their own internal cost of funds, they considered such a position to be inherently profitable — and the bigger the position, the more profitable it would be.

There was also a difference in the type of mortgage paper which each bank had in its long portfolio. While Merrill, Citi, et al were stocking up on the lowest-yielding debt, Goldman I suspect had mainly the equity tranches of the bonds it underwrote: the highest-yielding, riskiest paper. Because the equity tranche is inherently extremely risky, even in good times, it’s only natural for any bank owning such paper to want to hedge that exposure.

And this is where I think that Goldman might have gotten a little lucky. Because equity tranches can all go to zero very quickly, you need a fair amount of CDS insurance to hedge that exposure. But once you’ve bought that CDS insurance, it will continue to rise in value as the housing market implodes, long after your original equity tranche has been wiped out.

Let’s say the housing market is at 100, and you have $3 million of bonds which will get wiped out if the market drops to 97. So you hedge that exposure by buying credit default swaps which pay out $1 million for each point that the housing market drops. (This is massively oversimplifying, but work with me here.) If the market falls to 97, then you lose $3 million on your bonds, while making $3 million on your CDS — you’re even. But if the market falls even further, to 70, then you still lose only $3 million on your bonds, while making $30 million on your CDS — gravy! You don’t even need to buy any more insurance to make that extra money, you just need to keep holding the insurance you already own.

On the other hand, let’s say the housing market is at 100 and you have $50 million of bonds which will get wiped out if the market drops past 75. At that point, the temptation is to do nothing at all, since hedging costs money and your models tell you that the market will never fall that far. And by the time that the market starts falling, insurance is so expensive that you can’t afford it any longer.

More generally, if you’re starting from a market-neutral position, it’s easy to go short. But if you’re starting from a large net long position, it’s much, much harder to do that. Almost impossible, really, especially when the market seizes up and there’s no liquidity any more.

And while I’m on the subject, there’s one thing worth adding: that none of this would have happened if Goldman hadn’t been so mind-bogglingly enormous. Goldman could hold on to the short side of all the synthetic CDOs it was underwriting precisely because in some distant other arm of the Goldman empire, a mortgage desk had managed to make money by introducing lots of mortgage-backed bonds onto the bank’s balance sheet. So the logical thing to do was to create a new desk which could make money by introducing lots of mortgage CDS onto the balance sheet. That way Goldman made money on both trades, while its balance sheet was hedged and canceled itself out.

If however there was a cap on bank size, or punitive capital requirements on balance sheets above $100 billion, then those kind of shenanigans would be much harder to pull off. Goldman would then do neither the original mortgage deals nor the subsequent synthetic CDOs, and the world would be a better place.

Is there a Goldman CDO scandal?

Original posted on Reuters by Felix Salmon:

The big story on this slow news day is the NYT’s 3000-word story on Goldman and synthetic CDOs, which now has a formal response from Goldman itself.

Here’s what I think is the most interesting new information in the story:

Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Mr. Egol began creating the deals known as Abacus. From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion…

Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm, said five former Goldman employees who spoke on the condition of anonymity. On occasion, he allowed some hedge funds to take some of the short trades…

Goldman’s bets against the performances of the Abacus C.D.O.’s were not worth much in 2005 and 2006, but they soared in value in 2007 and 2008 when the mortgage market collapsed. The trades gave Mr. Egol a higher profile at the bank, and he was among a group promoted to managing director on Oct. 24, 2007.

There are a couple of things which jump out, here: firstly that Goldman was structuring synthetic mortgage-backed CDOs as early as 2004, and secondly that it held on to the short side of those deals for years.

Remember that by their nature, synthetic CDOs have equal-and-opposite long sides and short sides. Anybody buying these things from Goldman knew that someone else was betting the opposite way. And they knew that someone was Goldman, at least in the first instance.

Over 2004, 2005, and 2006, and even into the first half of 2007, demand for mortgage-backed credit assets was insatiable. That’s why so many originators started churning out low-quality paper, and that’s why Goldman got into the origination business too, both on the real-money side (although it was never a huge player there) and on the synthetic side.

Goldman’s synthetic CDOs involved it paying millions of dollars in insurance premiums every year to the investors who bought them. Because of the balance of power between buyers and sellers of credit during the boom, the people buying bonds had very little bargaining power, and the people issuing debt had a lot. As a result, private-equity shops were able to issue billions of dollars in cov-lite loans, and the likes of Goldman Sachs were able to put all manner of triggers into their CDOs — things like ratings downgrades — which would stop the money flowing from Goldman to the buyers, and start sending money flowing back in the opposite direction.

Goldman was certainly in a good position here. It had a substantial portfolio of mortgage-backed securities — so substantial, in fact, that it wrote down $1.7 billion on its residential-mortgage exposure in 2008. As a result, it had a lot of appetite for hedges against those securities, and happily held on to those hedges in 2004-7 when they were losing, rather than making, money. It liked holding the position because it had structured the hedges itself, and knew exactly how profitable they might be if and when the housing market turned.

But does that mean, as the NYT article says, that Goldman’s decision to take the short side of the CDOs “put the firms at odds with their own clients’ interests”? No, it doesn’t. In fact, I’m a bit depressed that we’re still having this argument, a full two years after everybody derided Ben Stein for saying the same thing. I may as well simply disinter what I wrote back then:

If I sell you something – whether it’s a car or a house or a stock or a ham sandwich – I have no fiduciary responsibility to you. Caveat emptor, and all that. If I am investing your money on your behalf, then I have a fiduciary duty. But if you’re looking for fiduciaries, you’re not going to find them on the sell side, only on the buy side.

When Stein accuses Wall Street banks of “betraying their clients’ trust,” he’s simply confused about who the clients are, in these transactions. If I’m an investor and I buy a stock from a broker, then I’m buying it because I think the total amount of money I’m paying is a fair amount for that security. I’m completely agnostic about whom, exactly, I’m buying the stock from: if a different broker has the same security for a lower price, I’ll go there instead. And I’m certainly not trusting the broker to assure me that my security will go up rather than down in value. In fact, at the margin I actually like it if my broker is shorting that stock and thinks it will go down in value – because that just means that I get to buy it at a slightly cheaper level.

It’s just ridiculous to think that “basic fairness” means that Goldman should be exposed to exactly the same risks as anybody who it sells securities to. Goldman Sachs isn’t Berkshire Hathaway, investing money on behalf of shareholders. It’s an investment bank: an intermediary between issuers and investors. If an investor buys any kind of financial security, he’s deliberately buying a risk product. He gets all the upside if that security rises in value. But he also gets all the downside if that security falls in value. It’s not the job of any securities firm to bail him out.

The 30,000-foot view of what happened here is that there was an enormous amount of mortgage paper flooding the market over the course of the 2000s. Goldman Sachs, as a sell-side institution which manages its risk book on a daily basis and doesn’t want to take long-term directional bets, hedged its mortgage exposure with short positions it created by structuring synthetic CDOs. The buy-side, by contrast, had an enormous amount of appetite for long positions in mortgages, and it was the job of banks like Goldman to feed that appetite: again by structuring synthetic CDOs. Goldman was killing two birds with one stone: no wonder Jonathan Egol, who was in charge of these deals, did so well there.

When the mortgage market started to turn, Goldman was smart and nimble enough to realize that it could make money on the way down as well as on the way up. That’s what traders do, and Goldman is the world’s largest and most successful trading shop.

Henry Blodget adds another important point:

Don’t forget that everything is obvious in hindsight. Goldman could have been wrong about the housing market, and its clients could have been right. In that case, we wouldn’t be talking about a scandal. We would be talking about how Goldman got greedy and made dumb bets.

The real lesson here isn’t that Goldman did anything scandalous. It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing.

Goldman Sachs Responds to NY Times on Synthetic CDOs

Background: The New York Times published a story on December 24th primarily focused on the synthetic collateralized debt obligation business of Goldman Sachs. In response to questions from the paper prior to publication, Goldman Sachs made the following points.

As reporters and commentators examine some of the aspects of the financial crisis, interest has gravitated toward a variety of products associated with the mortgage market. One of these products is synthetic collateralized debt obligations (CDOs), which are referred to as synthetic because the underlying credit exposure is taken via credit default swaps rather than by physically owning assets or securities. The following points provide a summary of how these products worked and why they were created.

Any discussion of Goldman Sachs’ association with this product must begin with our overall activities in the mortgage market. Goldman Sachs, like other financial institutions, suffered significant losses in its residential mortgage portfolio due to the deterioration of the housing market (we disclosed $1.7 billion in residential mortgage exposure write-downs in 2008). These losses would have been substantially higher had we not hedged. We consider hedging the cornerstone of prudent risk management.

Synthetic CDOs were an established product for corporate credit risk as early as 2002. With the introduction of credit default swaps referencing mortgage products in 2004-2005, it is not surprising that market participants would consider synthetic CDOs in the context of mortgages. Although precise tallies of synthetic CDO issuance are not readily available, many observers would agree the market size was in the hundreds of billions of dollars.

Many of the synthetic CDOs arranged were the result of demand from investing clients seeking long exposure.

Synthetic CDOs were popular with many investors prior to the financial crisis because they gave investors the ability to work with banks to design tailored securities which met their particular criteria, whether it be ratings, leverage or other aspects of the transaction.

The buyers of synthetic mortgage CDOs were large, sophisticated investors. These investors had significant in-house research staff to analyze portfolios and structures and to suggest modifications. They did not rely upon the issuing banks in making their investment decisions.

For static synthetic CDOs, reference portfolios were fully disclosed. Therefore, potential buyers could simply decide not to participate if they did not like some or all the securities referenced in a particular portfolio.

Synthetic CDOs require one party to be long the risk and the other to be short so without the short position, a transaction could not take place.

It is fully disclosed and well known to investors that banks that arranged synthetic CDOs took the initial short position and that these positions could either have been applied as hedges against other risk positions or covered via trades with other investors.

Most major banks had similar businesses in synthetic mortgage CDOs.

As housing price growth slowed and then turned negative, the disruption in the mortgage market resulted in synthetic CDO losses for many investors and financial institutions, including Goldman Sachs, effectively putting an end to this market.

And from the Business Insider's Henry Blodget:

Is it really a scandal? If you view Wall Street the old-fashioned way, yes: The firm sold its clients a product and then bet against it. This allowed Goldman to make money two ways instead of just one: Product origination fees and trading profits, all at its clients' expense.

If you take a more realistic view of Wall Street, however, this is just an everyday reality. Wall Street firms like Goldman sit between buyers and sellers, and they also buy and sell on their own behalf. Every single transaction these firms conduct entails a conflict of interest: Everyone is always making bets, and someone is always winning and losing them. It's just not obvious until later which party that is.

The way we suspect Goldman viewed its behavior in the housing scenario above is as follows:

  • Clients are desperate for products with which to bet on the housing market
  • We can help our clients by creating those products and get paid handsomely for doing so.
  • We're negative on the housing market, so we can use the products bet against the housing market. If we're right, we'll make some money there, too.

Don't forget that the buyers of Goldman's CDOs were among the most sophisticated investors in the world. These investors were paid to analyze the housing market and make smart investment decisions based on that analysis. The investors did their analysis and concluded that the housing market was going to go up. Goldman did its own analysis and came to the opposite conclusion. But it was at least relatively a fair fight.

Don't forget that the clients who bought the CDOs may have turned around and sold them to someone else 30 seconds after buying them. We're not talking about mom-and-pop buy-and-hold investors here. We're talking about institutions who often roll their portfolios over several times a month. We're also talking about institutions that were making an absolute killing going long the housing market--so much so that they were desperate for more products with which to continue making the same bet.

Don't forget also that these particular CDOs were likely a tiny percentage of the total products that Goldman sold to these clients over the period in question. Many of the other products Goldman sold the same clients may have performed superbly, making the clients boatloads of money. When all of the clients' dealings with Goldman are netted out, the clients may have done very well.

Don't forget that, in this instance, Goldman was not hired to manage money for its clients. Goldman in this case was acting as a product dealer. The products Goldman sold allowed clients to bet on or against the housing market (by going short or long). The products appear to have worked the way they were supposed to.

Don't forget that everything is obvious in hindsight. Goldman could have been wrong about the housing market, and its clients could have been right. In that case, we wouldn't be talking about a scandal. We would be talking about how Goldman got greedy and made dumb bets.

So is it a scandal?

If Goldman's traders and salespeople had secret information about the housing market that they did not share with clients, yes, it's a scandal. That's called intentionally screwing your clients, and Goldman deserves to be strafed for it.

If Goldman was merely creating products to address market demand and then using those products itself, however, it's inevitable. As long as brokerage firms are allowed to have proprietary trading desks (which we certainly don't need to allow), there will always be cases in which firms bet against some of their clients. To think otherwise is just being naive,

Wednesday, December 23, 2009

Regulatory Constraints on Bank Leverage: Issues and Lessons from the Canadian Experience

Bank of Canada Discussion Paper by Etienne Bordeleau, Allan Crawford, and Christopher Graham:

Abstract: The Basel capital framework plays an important role in risk management by linking a bank's minimum capital requirements to the riskiness of its assets. Nevertheless, the risk estimates underlying these calculations may be imperfect, and it appears that a cyclical bias in measures of risk-adjusted capital contributed to procyclical increases in global leverage prior to the recent financial crisis. As such, international policy discussions are considering an unweighted leverage ratio as a supplement to existing risk-weighted capital requirements. Canadian banks offer a useful case study in this respect, having been subject to a regulatory ceiling on an unweighted leverage ratio since the early 1980s. The authors review lessons from the Canadian experience with leverage constraints, and provide some empirical analysis on how such constraints affect banks' leverage management. In contrast to a number of countries without regulatory constraints, leverage at major Canadian banks was relatively stable leading up to the crisis, reducing pressure for deleveraging during the economic downturn. Empirical results suggest that major Canadian banks follow different strategies for managing their leverage. Some banks tend to raise their precautionary buffer quickly, through sharp reductions in asset growth and faster capital growth, when a shock pushes leverage too close to its authorized limit. For other banks, shocks have more persistent effects on leverage, possibly because these banks tend to have higher buffers on average. Overall, the authors' results suggest that a leverage ceiling would be a useful tool to complement risk-weighted measures and mitigate procyclical tendencies in the financial system.

Download the paper here.

Tuesday, December 22, 2009

Task Force on Tri‐Party Repo Infrastructure Payments Risk Committee

The Task Force on Tri‐Party Repo Infrastructure (“Task Force”) was formed in September 2009 under the auspices of the Payments Risk Committee (“PRC”), a private sector body sponsored by the Federal Reserve Bank of New York.

The Task Force’s objective is to develop a set of recommendations for improving and mitigating risks related to triparty repo transactions, given the important role such transactions play in supporting the liquidity and efficiency of U.S. securities markets and in the implementation of monetary policy. The primary areas of focus for this effort are clearance and settlement arrangements, credit and liquidity risk management practices and tools, and arrangements for facilitating the orderly disposition of collateral in stress scenarios.

This report summarizes the progress of the Task Force as of mid December, 2009. In the interest of transparency, this progress report is being made public [website]. The Task Force intends to continue developing its recommendations and will also sponsor a broader forum in early 2010 to reach out to representatives of firms not represented directly on the Task Force and provide a basis for wider industry discussion.

The Task Force expects to complete its work during the first quarter of 2010. The Federal Reserve has indicated that it plans to incorporate the Task Force’s report and recommendations into a white paper that it will issue for public comment to enable all interested stakeholders to review and comment on the work.

The full report can be downloaded here.

View from the Top with OSFI's Julie Dickson

Originally published in the Financial Times:

Chrystia Freeland, US managing editor, interviewed Julie Dickson, superindendent of financial institutions for Canada about regulation, the Canadian banking model and the resilience of Canadian banks in the financial crisis. This is a transcript of that interview.

PART 1: On the resilience of Canadian banks in the financial crisis

FT: Thank you for joining us, Ms Dickson. Why do you think Canadian banks have proven so resilient in this global financial crisis?

JD: As the regulator I can talk a bit about the role that regulation played. I do think that Canadian banks themselves were prudently managed so they deserve some credit for that, but on the regulatory side we point to a couple of key things. First: capital. We had tier one target of 7 per cent going back to 1999.

FT: And at that moment the Basel target was ... ?

JD: Four per cent. We also paid attention to the quality of capital, so 75 per cent of that tier one had to be in common shares. That was very important. Leverage ratio was very important, we think. Not only to keep as a backstop to risk-based capital, but also as a supervisory measure.

FT: And the leverage ratio was 20 to one?

JD: Yes. With approval you can go to 23 but most of our banks are around 16 to 18 times. The quality of supervision is something that I think can be overlooked. In Canada we’ve spent a lot of time focusing on staff at Osfi and trying to get that mix of private-sector people and lifetime regulators. We’ve got a mandate that I think is very good, a legislative mandate which required us to focus on solvency and early intervention. That was extremely important, and I might say the country Canada was not afraid to be subject to an FSAP process, Financial Stability Assessment Program. We’ve been looked at twice now, most recently in 2007. I think you have to open yourself to those kinds of external exams to see whether you are doing what you should be doing.

FT: Do you rate those FSAP examiners? Do you think they did a good job?

JD: I think that they came up with some recommendations that were useful and we did adopt them. Going back to the first FSAP, they noticed that we needed an extra power, the power to remove directors and officers, so the government promptly changed that. More recently in 2007 they suggested that we needed some more resources, that we were too reliant on the financial institution senior management and boards, so we have added staff since then. I think that having an international group come in and look at your processes is really quite key to be sure that you’re on the right track.

FT: Some of the rules that you’ve mentioned; the capital requirement, the quality of capital, the leverage ratios, these were much tougher in Canada than they were in other parts of the world. Wasn’t there any resistance to that, especially during the go-go years when other banks were able to expand more, were able to do more and the poor Canadian banks were labouring under these tougher rules?

JD: I think at the get-go when the 7 per cent tier one target was introduced there was a lot of resistance but what I’ve found over the years was that that faded away, and in fact Canadian banks were way above those targets. If you look at the third quarter of 2008 when things really got difficult in the financial sector they were 9.5 to almost 10 per cent tier one. Why was that? I think that that is a tribute not only to Canadian banks and their prudence, but we spent a lot of time on what we call the internal capital adequacy assessment process which was part of Basel II, so we spent a lot of time with banks trying to ensure that they themselves were looking at the capital that they needed for the risk that they had. I don’t recall a lot of pushback when it came to capital requirements in the years leading up to the crisis. On the leverage ratio, no one was very happy with the leverage ratio all along, and when Basel II was being developed we heard a lot about the need to get rid of the leverage ratio. You’re going to a risk-based capital regime you need to get rid of the leverage ratio. At that time we said let’s just see how Basel II unfolds, let’s just see how this all works out. What we’ve now learned is that that was a very important backstop and it’s also a prime supervisory tool, so if we find an institution where we have identified some issues and we don’t think they’re fixing it fast enough, if you reduce the leverage ratio you get an immediate reaction and all eyes are focused on fixing the problem.

FT: If you as the supervisor come in and say I’m reducing your leverage ratio?

JD: Yes. What that does too is it caps the growth while you’re trying to sort out the problem that you’ve identified, so I think it’s a very important tool both from a capital perspective and it’s a useful thing to have in your toolbox.

FT: Some of these protests around the idea of the leverage ratio, what were people saying? Were they saying this is limiting the ability of our banks to compete internationally, this is limiting access to credit in our country and therefore economic growth? What were the arguments?

JD: Usually competition is noted and if you look around the world and don’t see a leverage ratio in many places, that is a big point. Although they did know there was a leverage ratio in the United States and that is a big competitor.

FT: And you have the unilateral authority to cut the leverage ratio?

JD: Yes, and I think that’s another key ingredient as to why we’ve had some success in Canada. We have a lot of freedom to act. That needs to be talked about internationally. People are so focused on the rules. What should tier one be? What should the leverage ratio be? That’s only part of it. You can have all the capital in the world but if you don’t have a supervisor who has the independence and the authority to act quickly, then you have a system that I think is prone to risk-taking and a build-up of excesses.

FT: Would you say that the leverage ratio is your most powerful way of getting a bank’s attention?

JD: I think it is a powerful way. Is it the most powerful way? I think that it is extremely powerful, yes.

FT: How close is your relationship with the board? How often would you attend a board meeting of a regular bank?

JD: If we’re talking the major banks, a minimum of once a year.

FT: You personally?

JD: Yes. Sometimes we will do it twice a year. Some boards want more interaction with the supervisor so they like to have a meeting halfway through the year just to see how things are going, but the annual meeting which takes place generally every January is to discuss our findings from a year’s worth of supervisory work. If you have an institution that is staged or that has problems they might see the supervisor more.

FT: How do you find the bank management, the independent directors, respond to you during those meetings? Do they pay attention? Is it a sense of being given a report card or are they pushing back more?

JD: It depends. I’ve seen both, I’ve seen boards that immediately spring to action and are very concerned that the supervisor has an issue. I’ve also seen boards that push back and side with the CEO, so it really depends on the situation and the problem that has been identified. It’s far easier when it’s clear. There have been big issues. It’s clear. Everyone agrees. Where it is very difficult is when you have identified a problem very early, before any losses occur, before any other regulators say anything around the world. If you are in there early then you really get the pushback, but that’s an effective system you’re in early.

FT: What kind of moments do you recall where you’ve been in early?

JD: Lots of moments, but a good example would be where you just see red flags. You might have done some kind of in depth drill-down and you just see some red flags, either with controls, controls have lagged the growth in the business but there’ve been no problems, but the controls have lagged the growth in the business. Say management is pursuing a bit of a new strategy without informing the board, no losses, everything is fine, but it’s not good to have a new strategy and not to have informed the board. Those are a few examples.

PART II: On her approach to regulation

FT: How would you describe your philosophy of regulation? Is it more rules-based or more principles-based?

JD: Most often it’s described as principles-based. This is an interesting discussion. By principle we’re saying we want an effective system here. We want the industry to communicate with us. We want to be told everything that is going on. We want to all use our brains. We don’t want to have a list of boxes that we tick because that’s not very effective. We do have a lot of rules. The leverage ratio is a rule. Tier one 7 per cent is a rule.

FT: Quality of capital.

JD: Yes. We have some rules, and I think those rules served us well, but you need a lot of interaction between the regulator and the institution because they’re out there operating day to day. They know what their competitors are doing. They know what foreign regulators are doing sometimes even before we do, so you do need that interaction. I really stress that communication.

FT: Some people would describe the relationship between the US banks and their regulators as a fairly legalistic one where there is an effort to try to engage lawyers and maybe accountants in complying with the rules at the least possible cost. Do you think that’s what happens in Canada?

JD: It’s not what happens in Canada. Sometimes I do see it, though. I think that there’s an appreciation in the industry for the fact that we don’t work that way. Having lawyers looking at this line or that clause and debating with you about whether something is doable or not is not the right conversation to have. The right conversation to have is the principle. You have to have adequate capital liquidity. You have to know the risks you’re undertaking. You have to manage those risks. That’s what you really should be talking about, not about what this word says or that word says. On occasion I do find that seeping in, but usually that’s with an institution that perhaps has a US owner as opposed to a financial institution.

FT: Really? You can see that national difference?

JD: You can see it, yes.

FT: Why is that the wrong approach?

JD: I don’t know that I’d say it’s the wrong approach. I’m used to a system where I can pick up the phone and make half a dozen phone calls and see some change.

FT: Really? That’s all it takes? Six phone calls a day changes behaviour?

JD: We have a small system in Canada, you can get your arms around it, and I think both sides value the relationship that we have as a result. We have a lot of powers at Osfi. We have a lot of tools in the toolbox. I think people are aware of that, so I don’t think they want to get to the point where we actually have to start using those tools. I’m not saying we’re always right either. I can have a discussion with a CEO and my colleagues as well, and we can be persuaded, but I would say that for the most part we’ve done a few things right, I think, in terms of seeing some risks and trying to have them dealt with. We’re not perfect, but I think for the most part our record has been good.

FT: The one moment in the financial crisis where things were tougher in Canada than for everybody else was with the commercial paper market. Some people have described that to me as a wake-up call, and as something that prepared them better for what was to come. Did you feel that way?

JD: I don’t know. I think it’s a bit late to get the wake-up call. I mean, that was August 2007, so maybe that gave people three quarters to prepare for the third quarter of 2008. It’s always nice to be prepared before then. I think really what matters is what you’ve done in that long period of time before the crisis. What were your capital requirements? What kind of supervisory system were you running? It’s a bit late if you have to start preparing three quarters ahead of a major problem.

FT: With hindsight, do you think that the commercial paper was not ideally structured and that the get-out clause that the banks found they had maybe was good for individual institutions but lead to more systemic instability?

JD: I think that what we saw in Canada was an unregulated sector that grew in leaps and bounds and securitisation vehicles without adequate access to liquidity. That was an issue and something that I think we’ve all learned from.

FT: Are you an advocate of a clearing system for the trading of credit derivatives?

JD: I think everyone sees a lot of merit in that, so the challenge is to try to ensure that that central counter party, or whatever it is ultimately, is very sound and very well put together, but that does eliminate a lot of the risk that we saw in the lead-up to this crisis, yes.

FT: You’ve talked about the relatively small size of the Canadian banking sector as being an advantage to you. Does it make it easier that the market is dominated by five or six banks?

JD: Yes, I’m fairly confident that being able to pick up the phone and making a few phone calls and taking action early is very important and being able to pick up the phone and reach 90 per cent of the system in a couple of hours I think is a competitive advantage, let’s say.

FT: Don’t you worry about the flipside, that having your market dominated by such big institutions means that if one were to fail things would be a lot more devastating?

JD: I think that is one of the biggest issues that people need to focus on. It’s interesting when you talk about size, in terms of competition policy we all know that if you’re so big that you’re substantially impeding competition the solution is to break you up, but size as it relates to prudential issues is far more difficult. I recall about nine months ago asking for all the literature on why size is important from a global economic development perspective and I was quite surprised to see how little came back. There is not a lot of research on this, and I think we’ve got to look at that.

FT: You mean the case hasn’t been made?

JD: Not in the literature, that size is really important for global economic growth. I do see everyone talking about that and making that assertion, but I haven’t seen it in the literature. One of the things that we’re doing now is looking at assessing the need for a capital surcharge on these big institutions, and that will be interesting work because the idea there is that they’ve got externalities, so when they fail there are social costs imposed, so it’s like a polluter or traffic congestion and if you’re a polluter or if you’re in London and you’ve got traffic congestion the solution is to tax, but in this case it’s a moving target – what is systemically important? We haven’t sorted that out yet. We’re talking about indicators like size and substitute ability and interconnectedness, but everyone is also saying that it really depends on the circumstances. Imposing a tax to deal with externalities is going to be incredibly challenging and related to that would be the idea that you might have to identify institutions as systemically important, which I think would be a very bad idea. That seems to me to be a licence to take risk.

FT: It would make explicit the government guarantee.

JD: Yes, so you have an incentive to take more risks. People who are lending to you have no incentive to follow what you’re doing, so what we’ve been promoting internationally is the idea of contingent capital. The idea would be that you restore some of the market discipline by restoring tension between bondholders and shareholders and by making it clear that what we’re suggesting is that it triggers that if governments ever have to support an institution, that before they can do that, subordinated debt must convert into tier one. That way you’ve doled out penalties, you’ve diluted or wiped out the common shareholders, the debtholders pay the price.

FT: Would you apply your contingent capital solution after the fact as it were, because it’s one thing to talk about it in Canada where the government haven’t had to bail out institutions? What do you do in countries where the institutions have been bailed out and already enjoy that now explicit government guarantee?

JD: But this would be going forward, so this would be around the world. The G7 issued a press release on Thanksgiving 2008 I guess, where they all indicated they would support the financial system, so that’s been done. So we all have to look at what you do going forward. How do you restore market discipline? You can not rely on regulators. Some regulators have had more success than others, but regulatory agencies are small, relative to the institutions that they are overseeing. You’ve got to have other mechanisms and you’ve got to have market discipline. If you don’t have that I think that you have not learned much from this crisis. We really do need to focus on that.

PART III: On the Canadian banking model

FT: What’s your view on the debate right now about narrow banking versus universal banking? A lot of people are blaming the existence of big universal banks for the crisis.

JD: In Canada the model worked. Why did it work? Maybe because the prudential supervisor saw the whole thing so banks owned the major investment dealers. That meant the leverage ratio applied. It meant that the kinds of risk management that we expected in banks also applied in the investment banks, so we had a model that worked here. I’m watching with interest that international debate. I think I would agree with some of the points that Adair Turner of the FSA has made. He’s talked about the fact that we’re increasing trading-book capital two to three times through Basel. We’re also looking at the whole trading book, the capital requirements in general going forward for the trading book, even beyond that. That’s going to have some impact on your appetite for expanding the capital markets business. I think he’s also pointed out that true narrow bank proponents want the narrow bank regulated and everything else outside. I think we saw in this crisis that it might not be a good idea to have an unregulated sector, so to speak, thriving alongside of a narrow banking sector, so I think I would be more inclined to agree with Adair Turner on that.

FT: What constitutes strong risk management? When you look at a bank, what makes you say yes, this is going to work?

JD: It can be a lot of things. First you have to have some management information systems that give you the information that is needed, so that’s going back, that’s trying to look forward, so stress testing is a very good example of the kinds of things that people need to be doing and doing in a much more robust fashion. Independence. You need chief risk officers who are independent and can do their job and have clout, who get paid properly.

FT: What does that mean? Do they have to be paid as much as the star traders?

JD: That’s a really good question. Do they have to be paid as much as the star traders? I don’t think that anyone has the answer to that. We certainly know that we can’t pay them a pittance and pay the business people a fortune. That doesn’t quite work. I think you need to start looking at a balance scorecard. If a bank is staged you wouldn’t want to be paying your chief risk officer a huge bonus, I don’t think. There are a lot of things that have to be thought about, and even aside from compensation. others point to things like prestige. Who takes you out to lunch as the chief risk officer? All kinds of little subtle things like that which can drive your actions even more than what you’re ultimately paid. I think what we’ll learn in the crisis is that supervisors need to spend a lot more time thinking about that. What makes people tick? What are the incentives that drive their behaviours?

FT: Are internal reporting lines important to you? Does the chief risk officer have to report to the CEO?

JD: They’ve become much more important. A number of Canadian banks have made a change in that regard because various international reports came out and said that this was important. But again, you need to use judgement. Just because the chief risk officer reports to the CEO doesn’t mean that it’s working well.

FT: Compensation in the financial services has been a hot issue in many places around the world. Is that something you’re concerned about?

JD: We are implementing the financial stability board principles and recommendations that were endorsed by the G20. We’re spending a lot of time on that. I think all regulators would agree, and the industry agreed, frankly, in the Institute of International Finance report, that compensation was a factor, and the failure of most institutions to adjust for risk was a shortcoming in governance and in the way that they ran institutions, so we are paying attention to it.

FT: Don’t you have Canadian bankers say, ‘Come on, we were okay. Why should we be limited? We didn’t make the mistakes everybody else did.’

JD: They’re not really saying that. They are saying I’m glad - maybe they’re just saying this for me. They’re saying they too need to learn the lessons even though they perform well. There are some lessons to be learned, and that is one of them. They don’t really have a choice either because we are implementing the principles. I think we’re trying to be sensible about it though. I don’t think that this is something where you look at what they’ve done this year and you say you’ve done that, we will turn our attention away and look at some other things now. This should evolve because adjusting for risk is new and I don’t think that there is a cookbook that tells you how to do it and you’re sure that you have it right, so I see it evolving over time. I think it’s an area that we will pay attention to over time and as you know, there’s a lot of continuing discussion about that internationally.

FT: With Canadian banks in particular, is there any danger that now will be a sort of Icarus moment? That having done well in the crisis, having gone way up in international league tables, this will be the moment in which they will make some crazy acquisitions or do something else equally unwise?

JD: I think there’s always the risk – what is the saying – you learn more from your mistakes than from your successes. I think we all need to keep that in mind. I certainly talk about that at Osfi too. I think that everyone at Osfi should continue to pay close attention to the risk and not assume that we’re very good identifying them all because it’s constantly changing. For financial institutions, they need to bear down on risk and not assume that they are smarter than anybody else.

FT: What level of capital requirement are you in favour of?

JD: We haven’t talked about that yet at Basel. What I’ve said in some of the speeches that I’ve done is that, if I look back we had it about right in Canada, so we had a 7 per cent tier one requirement going into ... at the worst part of the crisis banks were at 9.15, 9.19, something like that in terms of tier one, common shares at 8 per cent. Those are nice levels. We had enough capital that banks maintained the confidence of the marketplace and they were able to raise more, so now they’re way above even those levels, so what I’ve said is I don’t think you should have enough capital to get you through every tail event that we could ever possibly see. That would impose too many costs on the banking system, but you have to have enough to maintain market confidence in you when you face a severe event, so I would say we had it about right, and that would be what I would be suggesting internationally.

PART IV: On Canadian culture and Osfi

FT: Has the Canadian economy paid a price for its relative conservatism in terms of credit less available, less financial innovation, maybe less economic innovation?

JD: I would say that Canadian banks entered this with a lot of strength behind them, so they were well situated to continue to lend, so we haven’t seen the kind of credit crunch I know that other countries have been concerned about, so I’d like to say that good regulation and supervision is a competitive advantage. It may not seem like it when everyone is at the party, but it certainly is the case when the party is over, so I see it as more of a competitive advantage and on the innovation side I’ve been saying I don’t really talk up innovation, I don’t talk it down either. I talk about risk management around it.

FT: Some people have attributed the relative resilience of the Canadian banking sector to Canadian culture. Do you think that’s fair, or is it more about institutions and rules?

JD: That gets into psychology and that sort of thing which is not my forte, but it probably played a role. My sense is that Canadians in general tend to be a bit more conservative and prudent, so that could be.

FT: How about gender? There have been some studies, particularly in the wake of the crisis, talking about how maybe women tend to be more risk averse, more prudent. Do you think that’s played a role?

JD: I don’t know. If you look at a lot of the policies we had, they’ve gone back a long way, and it was men who introduced some of those policies, so I don’t usually spend a lot of time thinking about that. We’re one team at Osfi and I don’t actually see a different view coming from women versus men. We all seem to be singing from the same hymn book and perhaps that reflects our mandate, which I think is very important, and our focus on risk. I don’t know, good question, but ...

FT: You’ve been described as a reserved person. In fact a magazine article about you this year didn’t have your picture. It just had the crown of your head on it, but you also call up the CEOs of banks and tell them what they have to do. Is that ever hard for you?

JD: I enjoy that. Part of the reason why I didn’t want my picture on the front page was because it’s an Osfi effort, and as I said earlier, a lot of the things that Osfi did were things we did in the good times and there are a lot of people at Osfi who deserve credit for what was done, and that is very important. It’s a team effort, and I don’t think that I should be singled out for all the credit. I think this was truly a team effort. All Osfi employees, present and past, participated in that.

FT: What’s the risk you’re most worried about now?

JD: I don’t think that I would say this one particular risk. I think that it’s the range of risks that I talked about. Exit strategy. Timing. Low interest rates for a sustained period of time, what does that mean? Is the deleveraging process not even halfway finished, is the stock market overvalued, will these global imbalances that created the problem ultimately be resolved. On the regulatory side I see a lot of risks. The idea of identifying an institution as systemic I think is a very bad idea. I would not like to see that happen. I think that would be a recipe for enhanced risk-taking. Those are the things that are on my mind.

FT: Thank you very much.

JD: Thank you.

LONG/SHORT

FT: Now we are going to play long/short, Ms Dickson. Are you ready?

JD: Yes.

FT: US dollar. Are you long or short?

JD: Well, I don’t have any money to invest, so I’m neither.

FT: Canadian dollar.

JD: No money to invest, so I’m neither.

FT: Gold.

JD: No money to invest, so I’m neither.

FT: Oil.

JD: No money to invest.

FT: China.

JD: You have to ask private-sector people those questions because as a regulator we’re not permitted to invest in financial institution stocks but we don’t have money to go investing in, or shorting US dollars, or whatever.

FT: I guess we’re going to have to give you a break on long/short.

JD: Yes you are.

FT: Thank you very much.

JD: Thank you.

Details of Canadian ABCP settlement released

Originally posted on PrefBlog:

The ABCP settlements have been released:

In the Scotia agreement, the “Contraventions” section is one paragraph long:

71. The Respondent admits to the following contraventions of IIROC Rules, Guidance, IDA By-Laws, Regulations or Policies:
Between July 25 and August 10, 2007, the Respondent failed to adequately respond to emerging issues in the Coventree ABCP market insofar as it continued to sell Coventree ABCP without engaging Compliance and other appropriate processes for the assessment of such emerging issues, contrary to IDA By-law 29.1 (ii) (now Dealer Member Rule 29.1(ii)).

If we have a look at Rule 29.1:

29.1. Dealer Members and each partner, Director, Officer, Supervisor, Registered Representative, Investment Representative and employee of a Dealer Member (i) shall observe high standards of ethics and conduct in the transaction of their business, (ii) shall not engage in any business conduct or practice which is unbecoming or detrimental to the public interest, and (iii) shall be of such character and business repute and have such experience and training as is consistent with the standards described in clauses (i) and (ii) or as may be prescribed by the Board.

For the purposes of disciplinary proceedings pursuant to the Rules, each Dealer Member shall be responsible for all acts and omissions of each partner, Director, Officer, Supervisor, Registered Representative, Investment Representative and employee of a Dealer Member; and each of the foregoing individuals shall comply with all Rules required to be complied with by the Dealer Member.

The agreed statement of facts for Scotia’s “Response to Emerging Issues” is:

60. Notwithstanding the events described above, the Respondent failed to fully assess the information in the July 24th e-mail in a meaningful way. The Respondent did not notify its Compliance Department (“Compliance”) of the July 24th email or its contents until after August 13, 2007.

61. Notwithstanding its concerns about emerging market issues for Coventree ABCP, the Respondent failed to engage an adequate process to fully assess the impact of those concerns. The Respondent did not notify Compliance of its concerns.

62. Notwithstanding the emerging issues relating to the Coventree ABCP market as described above, the Respondent continued to sell Coventree ABCP to institutional clients, primarily by way of newly issued paper.

63. From July 25 to August 3, 2007, the Respondent sold Comet E from inventory, as noted in paragraph 56, and newly issued Planet A ABCP in the amount of $35,400,000, to institutional clients who the Respondent was not aware had knowledge of the US subprime exposure.

64. On August 3 the Respondent sold $28 million and from August 7 to 10 the Respondent sold $235 million in newly issued Aurora A, SAT A, and SIT III A to institutional clients (excluding sales of ABCP that matured prior to August 13, 2007 and sales to the CDPQ and other certain professional counterparties).

Monday, December 21, 2009

Canada banks to pay C$139 mln in ABCP settlement

Original posted on Reuters by Pav Jordan and Jennifer Kwan:

A group of Canadian banks and brokerages will pay about C$139 million ($131 million) in penalties for allowing investors to buy asset-backed commercial paper that traded in a market that seized up during the U.S. subprime credit crisis.

A total of seven banks or brokerages on Monday were ordered to pay fines by regulators in Ontario, British Columbia and Quebec.

National Bank of Canada (NA.TO), the country's sixth-largest lender, agreed to pay C$75 million in fines and fees, including C$4 million for a financial education campaign.

Canadian Imperial Bank of Commerce (CM.TO) and its capital markets arm will pay C$22 million, including legal fees, while Scotia Capital Inc. (BNS.TO) agreed to C$29 million in fines and fees.

Smaller settlements were reached with HSBC Bank Canada, (C$6 million), Canaccord Financial Ltd. (CF.TO), (C$3.1 million) and Credential Securities (C$200,000).

Laurentian Bank Securities Inc (LB.TO) agreed to a settlement of C$3.2 million.

Banks and brokerages accepted the settlements after hearings with Canadian regulators, including securities commissions in the provinces of Quebec, Ontario and British Columbia, and the Investment Industry Regulatory Organization of Canada (IIROC), a self-regulatory body, in Toronto.

In each case the banks or brokerages are accused of failing to take appropriate steps to protect the interests of their clients by selling them the asset-backed commercial paper. The short-term investments had been considered to be a relatively risk-free investment but their complex structure proved a decided weakness when the housing crisis hit in 2007.

"CIBC has admitted it engaged in conduct contrary to the public interest," the OSC said in announcing the settlement.

Similar statements came with the rulings for the other banks and brokerages involved in the ABCP saga, which began when the market collapsed in August 2007.

The market seized up because investors balked at rolling over the paper on concern that the securities were backed by subprime mortgages during a wave of defaults and foreclosures in the U.S. housing market. The frozen market left those holding the ABCP unable to redeem some C$32 billion ($30.2 billion) of the paper.

"There's lessons (here) to investors in understanding what they are buying. There's lessons to brokers in understanding what it is they're selling," Dan Williams, a partner at Kilgour Advisory Group and expert on ABCP, said as regulators were mulling Monday's settlement rulings.

"Hopefully, there's lessons to structurers as well in that there was a fairly significant underestimation of the risk that was underlying these assets."

The former sellers of the ABCP, a short-term debt instrument with typical maturities of 30 to 180 days, also agreed in the settlements on Monday to submit to a review of their compliance practices and procedures.

Friday, December 18, 2009

The Canadian Pension Debate?

Original posted on Pension Pulse:

Terence Corcoran of the National Post reports on the pension debate:
In Whitehorse today, Canada’s finance ministers meet to discuss the future of Canada’s pension system. No agreements are expected on how to enhance Canadians’ retirement savings. A pension summit is expected to take place later this year.

Today, FP Comment launches the first in a series on The Pension Debate. Is Canada’s pension system a shambles, as some argue? Are Canadians ill prepared to meet their financial futures post-retirement? Is the private defined-benefit system permanently impaired? Are mutual funds and other savings vehicles, including RRSPs, up to the job of protecting Canadians?

Do we need a new, government-backed secondary pension regime to accompany the Canadian Pension Plan and associated government retirement relief?

The Canadian pension management industry, in today’s first commentary, argues against new government intervention and in favour of reforms to enhance the role of the private sector. Our second commentary, from the C.D. Howe Institute, raises another volatile issue: the high cost of federal pension plans for government employees.

Tomorrow: How bad is our pension system?

BIS Reforms Grind One Step Closer

Original posted on the PrefBlog:

The Bank for International Settlements has released a consultative document titled Strengthening the resilience of the banking sector, which fleshes out some of the proposals made when the granted most of Treasury’s wish list immediately prior to the last G-20 meeting.

Naturally, the regulators gloss over their own responsibility for the crisis:

One of the main reasons the economic and financial crisis became so severe was that the banking sectors of many countries had built up excessive on- and off-balance sheet leverage. This was accompanied by a gradual erosion of the level and quality of the capital base. At the same time, many banks were holding insufficient liquidity buffers. The banking system therefore was not able to absorb the resulting systemic trading and credit losses nor could it cope with the reintermediation of large off-balance sheet exposures that had built up in the shadow banking system. The crisis was further amplified by a procyclical deleveraging process and by the interconnectedness of systemic institutions through an array of complex transactions. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. Ultimately the public sector had to step in with unprecedented injections of liquidity, capital support and guarantees, exposing the taxpayer to large losses.

They emphasize their disdain for Innovative Tier 1 Capital, which has been reflected in the ratings agencies evaluations:

The remainder of the Tier 1 capital base must be comprised of instruments that are subordinated, have fully discretionary noncumulative dividends or coupons and have neither a maturity date nor an incentive to redeem. Innovative hybrid capital instruments with an incentive to redeem through features like step-up clauses, currently limited to 15% of the Tier 1 capital base, will be phased out.

Due to conflicts with the legislation to outlaw income trusts, Canadian IT1C may be cumulative-in-preferred-shares and has a maturity date. It will be most interesting to see how that works out.

Of particular interest is:

The Committee intends to discuss specific proposals at its July 2010 meeting on the role of convertibility, including as a possible entry criterion for Tier 1 and/or Tier 2 to ensure loss absorbency, and on the role of contingent and convertible capital more generally both within the regulatory capital minimum and as buffers.

Contingent Capital is discussed regularly on PrefBlog - I don’t think it’s a matter of “if”, but “when”.

One part is simply crazy:

To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems to establish strong standards for central counterparties and exchanges. Banks’ collateral and mark-to-market exposures to central counterparties meeting these strict criteria will qualify for a zero percent risk weight.

A centralized institution will never fail, eh? I guess that’s because it will never, ever, do any favours for politically well-connected firms, and Iceland was the last sovereign default EVER. I think I know where the next crisis is coming from.

There is also a section on liquidity management, but it does not address a key fault of the Basel II regime: that banks holdings of other banks’ paper is risk-weighted according to the credit of the sovereign supervisor. This ensures that problems accellerate once they start - it’s like holding your unemployment contingency fund in your employer’s stock.

Let us suppose that ABC Corp. issues $1-million in paper to Bank A. Bank A finances by selling some of its paper to Bank B. Bank B has an incentive - due to risk-weighting - to buy Bank A’s paper rather than ABC’s, which makes very little sense.

They’ve finally figured out that step-ups are pretend-maturities:

“Innovative” features such as step-ups, which over time have eroded the quality of Tier 1, will be phased out. The use of call options on Tier 1 capital will be subject to strict governance arrangements which ensure that the issuing bank is not expected to exercise a call on a capital instrument unless it is in its own economic interest to do so. Payments on Tier 1 instruments will also be considered a distribution of earnings under the capital conservation buffer proposal (see Section II.4.c.). This will improve their loss absorbency on a going concern basis by increasing the likelihood that dividends and coupons will be cancelled in times of stress.

Their emphasis on “strict governance” in the above is not credible. They had all the authority they wanted during the crisis to announce that no bank considered to be at risk - or no banks at all - would not be granted permission to redeem. Instead, they rubber-stamped all the pro-forma requests for permission, making it virtually impossible for banks to act in an economically sane fashion (as Deutsche Bank found out). It’s the supervisors who need to clean up their act on this one, not the banks.

I’m pleased by the following statement:

All elements above are net of regulatory adjustments and are subject to the following restrictions:
• Common Equity, Tier 1 Capital and Total Capital must always exceed explicit minima of x%, y% and z% of risk-weighted assets, respectively, to be calibrated following the impact assessment.
• The predominant form of Tier 1 Capital must be Common Equity

I am tempted to refer to the Common Equity ratio as “Tier Zero Capital”, but I have already used that moniker for pre-funded deposit insurance.

Their list of “Criteria for inclusion in Tier 1 Additional Going Concern Capital” is of immense interest, since this will include preferred shares:

8. Dividends/coupons must be paid out of distributable items

11. Instruments classified as liabilities must have principal loss absorption through either
(i) conversion to common shares at an objective pre-specified trigger point or (ii) a
write-down mechanism which allocates losses to the instrument at a pre-specified
trigger point. The write-down will have the following effects:
a. Reduce the claim of the instrument in liquidation;
b. Reduce the amount re-paid when a call is exercised; and
c. Partially or fully reduce coupon/dividend payments on the instrument.

Regretably, they do not provide a definition of “distributable items”. I suspect that this means that preferred dividends may not be considered return of capital and that they must come out of non-negative retained earnings, but it’s not clear.

One interesting thing is:

Minority interest will not be eligible for inclusion in the Common Equity component of Tier 1.

The next quotation has direct impact on Citigroup, particularly:

Deferred tax assets which rely on future profitability of the bank to be realised should be deducted from the Common Equity component of Tier 1. The amount of such assets net of deferred tax liabilities should be deducted.

All in all, the document has a certain amount of high-level interest, but the real meat is yet to come.

Accountability and Canadian 3rd Party ABCP

Original posted on the Globe & Mail's StreetWise by Andrew Willis:

If I were a bank CEO – perish the thought – I would be doing a bit of weekend reading.

I would ask, politely, for a copy of the settlement agreement that regulators have struck with a number of the institutions involved in the ABCP fiasco.

If I’m the boss at National Bank, CIBC or Bank of Nova Scotia, I want to understand just why my institution is going to have its name dragged through the mud on Monday.

The heads of Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal would want to know just how they dodged this bullet.

The rest of the world won’t see these settlements until Monday, when they are approved, but it’s pretty clear what the CEOs would be reading.

First, they will see their banks and regulators agreeing that well-paid financial professionals – that would be Canadian money market traders – sold their customers products that the traders didn’t understand. That should ratchet up the blood pressure of three CEOs.

Then the bank bosses may read something really disturbing. The settlements are expected to state that the banks learned of potential problems in the ABCP market in late July and early August of 2007, when Coventree Capital began to tell fixed income desks just what was in the products it was selling. Armed with this knowledge, the banks are expected to agree with regulators that they dumped their own holdings of this supposedly low-risk commercial paper onto unsuspecting customers.

The banks ripped the faces off their clients, to quote the immortal words of derivative trader Frank Partnoy in a book called FIASCO. (I’ve got a copy, given to me by friends at Canso Fund Management, and it’s a great read.) And if I’m a bank CEO, news that my best and brightest abused a trust relationship with clients would totally wreck my Sunday morning.

Because we know what happened in the second week of August, in 2007. The ABCP merry-go-round stopped turning. Those still on the ride had their holdings frozen for the better part of two years, and anyone with more than $1-million of the paper suffered horrendous losses.

After finishing a run through the ABCP file, a bank CEO might want to write a short list of questions to ask the fixed income team on Monday morning, when all the details of this settlement become public. That list might include the following inquiries:

- Which of our clients ended up stuck with ABCP sold by this institution in the summer of 2007, and what exactly have we done to support that customer?

- Who exactly sold third party ABCP to customers in the summer of 2007? What have we paid that person since that time, and what training, if any, have they received?

- When ABCP creator Coventree Capital advised the bond desk of its woes in July of 2007, how was that information shared within the bank? How do we now deal with such disclosure?

If I was a bank CEO, or a bank director, there are a couple of things about this regulatory penalty that I would really want to understand.

I would want to know why several banks – most notably Toronto-Dominion Bank – steered clear of this whole sector, while others were in it up to their eyeballs. I would want to know what’s been learned from the ABCP meltdown, and how those lessons have been embedded in the culture of the organization.

Finally, I would want to know the exactly status of every investment bank employee involved in 2007 decisions that put clients in harms way.

And if satisfying answers to these questions were not forthcoming, I would make Monday morning very uncomfortable for the individuals involved.

Thursday, December 17, 2009

Insurers to launch reputational risk product

Original posted in the Financial Times by Andrew Edgecliffe-Johnson:

Insurers are planning to introduce a new product to help companies limit the financial fall-out when their brands or high-profile spokesmen such as Tiger Woods suffer reputational damage.

DeWitt Stern, a 110-year-old US insurance broker, has already received expressions of interest from London underwriters about backing a reputational risk product it aims to launch early in 2010.

Scott Brady, Dewitt Stern managing director, told the Financial Times that the product could develop into something akin to directors’ and officers’ liability insurance, designed to protect boards from shareholder lawsuits. Over 30 years, “D&O” cover has grown into a multi-billion dollar market, he said.

DeWitt Stern has been working on the product for six months. But the business turmoil caused by Mr Woods’ admission of infidelity has starkly highlighted companies’ vulnerability if the reputations of their brands or pitchmen are struck by scandal.

Accenture, the consultancy, dropped the golfer from its advertising this weekend as other sponsors began to distance themselves from the sportsman. Accenture said it had seen no material impact on its business, however.

Many consultants predicted in 2005 that brands would be wary of using celebrities to endorse their products after Hennes & Mauritz and others dropped Kate Moss from their advertising following drug allegations.

DeWitt Stern would insist on individuals it covers undertaking a pre-screening process, including a detailed questionnaire about their lifestyle, and would attempt to limit the losses from any reputational damage with a crisis communications strategy. Companies’ demand for background investigations when hiring new executives or assessing business partners have already created a lucrative business for security groups such as Kroll.

Amy Lashinsky, managing director of Alaco, a London business intelligence consultancy, said many “responsible” companies already used due diligence to manage reputational risks. “Crises are not cheap. A reputational event could cost you billions of dollars,” said Robbie Vorhaus, a crisis communications executive working with DeWitt Stern.

Figures from TNS Media Intelligence this week estimated that Accenture was Mr Woods’ biggest backer, using him in 83 per cent of its $50m advertising spending last year, while he appeared in 27 per cent of Tag Heuer’s marketing and 4 per cent of Nike’s.

They also underscored the threat to the $600m spent by marketers on PGA golf broadcasts in the US each year, noting that for matches in which Mr Woods played advertisers paid a 53 per cent premium last year over those from which he was absent.

According to Willis, one of the world’s biggest insurance brokers, there is already cover available for reputational risks as part of some D&O policies. It is often referred to as “spin-doctor cover” because it helps pay for the publicists and brand consultants needed to help manage hits to reputation.

Monday, December 14, 2009

Lifeline for longevity risk trading

Original posted in the Financial Times by Steve Johnson:

Asset managers are gearing up to start trading in longevity risk, potentially opening the way for pension funds to begin hedging one of their biggest risks en masse.

The involvement of specialist longevity and hedge funds offers a lifeline to a market that was in danger of being strangled at birth by a chronic lack of capacity.

The pension schemes of Babcock International and RSA Insurance have already signed deals with investment banks to protect against the risk of their scheme members living longer than expected, an eventuality that would increase their liabilities.

Similar deals covering an estimated £20bn (€23bn, $33bn) of liabilities are in train, yet Watson Wyatt, the consultancy, has estimated that the current market capacity is just £10bn-£20bn because reinsurance companies – which are exposed to the risk of higher mortality via life assurance policies – are the only natural holders of longevity risk for the banks to pass the exposure on to.

“There are £1,000bn of UK pension liabilities. There is nowhere near enough capacity for that,” said Steven Dicker, senior consultant at Watson Wyatt.

“We think £10bn-£20bn of deals will be done in the next two years. After that we are worried about replacement capital. You definitely don’t want to be last in the queue.”

The emergence of investment funds, which are not natural holders of longevity risk but are happy to trade any asset perceived as providing an attractive risk/return trade off, should allow many more pension schemes to lay off this risk.

London-based Centurion Fund Managers has just gained regulatory approval for a Luxembourg-based fund that would specialise in trading the longevity swaps spun off by pension schemes.

A number of London and Geneva-based hedge funds specialising in insurance-linked securities (ILS) are also believed to be in talks with banks about entering the market for both UK and Dutch longevity derivatives.

“Finding new holders of this risk is of paramount importance. We are scratching the surface of the additional capital that is available,” said Eugene Dimitriou, head of alternative risk transfer at Royal Bank of Scotland, which orchestrated a deal by which Aviva, the insurer, laid off some of the longevity risk in its annuity book. “It’s probably safe to say the outstanding capital that is available from non-traditional sources is 100 times larger than the available capacity of the reinsurance industry.”

But pension funds may have to price in higher longevity expectations in order to attract hedge funds.

Andrea Cavalleri, head of life origination at Securis Investment Partners, a London-based ILS hedge fund group, said he believed the deals that had been struck so far had been absorbed entirely by reinsurers because pricing terms were not yet attractive enough for the capital markets.

David Rawson-Mackenzie, chief executive of Centurion, said: “I think we are going to see some of the large hedge funds getting into this space but the big issue is whether the pension funds want to recognise the cost of this extended longevity. From what I understand every pension fund manager would love to do this but they are not prepared to pay the cost of doing it.”

However one banker involved in the sector said pricing was becoming aligned and he expected to see two to three deals a quarter being struck.

Goldman’s collateral damage

Cast your mind back to that SigTarp report, published last month.

Readers will recall there’s been a persistent stink over whether the efforts of the Federal Reserve and the US Treasury to prop up AIG had the effect of bailing out Goldman Sachs — its largest trading partner. Goldman Sachs always denied that idea, saying its exposure to AIG was collateralised and hedged against the mega-insurers’ fall. Others, were not so sure.

Last week the Wall Street Journal continued that particular line of thought with an article titled “Goldman fueled AIG gambles“, which examined GS’s role in acting as a middleman between the insurer and other banks. In short, Goldman offered banks protection on some of their investments (for instance on CDOs of home loans), which it in turn hedged with AIG in the form of CDS.

The other issue with Goldman and CDOs was its position as originator.

From the article:

Goldman’s other big role in the CDO business that few of its competitors appreciated at the time was as an originator of CDOs that other banks invested in and that ended up being insured by AIG, a role recently highlighted by Chicago credit consultant Janet Tavakoli. Ms. Tavakoli reviewed an internal AIG document written in late 2007 listing the CDOs that AIG had insured, a document obtained earlier this year by CBS News.

The Journal analysis of that document in conjunction with ratings-firm reports shows that Goldman underwrote roughly $23 billion of the $80 billion in mortgage-linked CDOs that AIG agreed to insure.

One such deal was called Davis Square Funding VI. That CDO, assembled by Goldman in March 2006, contained mortgage securities underpinned by subprime home loans originated by firms such as Countrywide and New Century Mortgage Corp., one of the first subprime lenders to fail in 2007.

A big investor in Davis Square’s top layer was Société Générale, which bought protection on it from AIG, according to the internal memo. The French bank was the largest beneficiary of the New York Fed’s Nov. 2008 move to pay off banks in full on their AIG insurance contracts.

A company financed largely by the New York Fed ended up owning both the Davis Square and South Coast CDOs. Société Générale received payments from AIG and the New York Fed totaling $16.5 billion.

Goldman received $14 billion for its trades that were torn up, including $8.4 billion in collateral from AIG.

A representative of Société Générale declined to comment.

The special inspector general for the Troubled Asset Relief Program, which recently reviewed the New York Fed’s effort to stanch collateral calls last year, said Goldman officials said the company believed it would have been fully protected had AIG been allowed to fail because of collateral it had amassed and the additional insurance it had bought against an AIG default.

The auditor, however, questioned that conclusion. The report said Goldman would have had a difficult time selling the collateral and that the firm might have been unable to actually collect on the additional insurance.

What the WSJ probably means is that Goldman would have had a difficult time collecting on the hedges it bought to protect itself against an AIG bankruptcy. That’s a fair point, given that the failure of AIG could easily have knocked out the counterparty to Goldman’s hedges, whoever it might have been.

And on the collateral issue — Janet Tavakoli notes in some recent commentary:

if A.I.G. had gone bankrupt, a sensible liquidator would have clawed back collateral that A.I.G. had already given to Goldman due to the extraordinary circumstances. After it saved the day by extending the credit line, the FRBNY should never have settled for 100 cents on the dollar. In August 2008, one month prior to the FRBNY providing A.I.G. with an $85 billion credit line to pay collateral to its counterparties, Calyon, a French bank that bought protection from A.I.G. (including on some Goldman originated CDOs) settled a similar $1.875 billion financial guarantee with FGIC UK for only ten cents on the dollar.

And for a glimpse into the underlying collateral of those Goldman-underwritten CDOs, Ms Tavakoli has also provided us with this link. Click it and you can see the collateral breakdown of Abacus 2005-2, part of Goldman’s supposedly subprime-shorting CDO series, and Davis Square Funding IV — the one mentioned in the WSJ article.

They are full of goodies like Blackrock-managed Tourmaline CDO 2005-1, which won deal of the year in 2005, and then hit an event of default and went into acceleration in April 2008. There’s also tons of that Countrywide goodness mentioned in the WSJ article — the same Countrywide stuff that ended up as collateral of CDOs against which monoline insurers MBIA and Ambac sold protection.