Monday, May 31, 2010

The Canadian ‘good banks’ myth

Murray Dobbin claims that it is a myth that Canada didn't have to bail out its banks:

We are, according to the IMF, actually the third worst of the G7 countries, behind the US and Britain, in terms of financial stabilization costs.

First, we put up $70 billion to buy up iffy mortgages from the big five banks, through the Canadian Mortgage and Housing Corporation, taking them off the banks’ balance sheets. That is almost the exact equivalent the US bailout – it spent ten times as much, $700 billion, and its economy is about 10 times as large.

Secondly, the Harper government established a fund of $200 billion to backstop the banks – money they could borrow if they needed it. The government had to borrow billions – mostly from the banks! – to do it. It’s euphemistically called the Emergency Financing Framework – implying that our impeccable banks might actually face an emergency. It is effectively a line of low-interest credit and while it has not all been accessed, it’s there to be used. Could it help explain why credit has not dried up here as much as it has in the US?

Third, the government now insures 100% of virtually all mortgages through CMHC eliminating risk for the banks – and opening the door to the ridiculous flood of housing loans we have seen over the past few years. The result: housing has become unaffordable for tens of thousands of Canadians and new rental housing has dried up.

Why all this extraordinary effort? If Canadian banks are such paragons of conservative virtue and prudent behaviour why did the federal government have to relieve them of mortgages that, presumably, were all carefully vetted and the borrowers scrutinized?

And why is Mr Flaherty not making any connection between the growing housing bubble (which he now reluctantly acknowledges) and the banks which lend virtually all the money (backed by CMHC) that is growing that bubble?

One of the reasons that Canadians (and international commentators, other finance ministers and global financial institutions) buy this Canadian banking fairy tale is the way the government accounts for the money borrowed to support the banks.

As Bruce Campbell of the Canadian Centre for Policy Alternatives explained in 2009:

“These measures are considered ‘non-budgetary’ or ‘off book.’ They do not show up as expenditures, which increase the federal deficit and debt. Rather, they appear on the books of CMHC and the Bank of Canada. But they have increased the government’s borrowing from $13.6 billion in 2007-08 to $89.5 billion in 2008-09, or double the fiscal deficit now projected for 2009.”

Not only has the Harper government felt it necessary to prop up Canadian banks it was this same government which created financial system risk in the first place. In 2007 the Harper government allowed US competition into Canada which prompted the CMHC to dramatically change its rules in order to compete: it dropped the down payment requirement to zero per cent and extended the amortization period to 40 years. In August 2008 Flaherty moderated those rules in response to the US mortgage meltdown. CMHC then “securitized” an increasing number of its loans into bond-like investments (if you have a typical Canadian mutual fund, you’ve got some.)

At the end of 2007 there were $138 billion in securitized pools outstanding and guaranteed by CMHC –17.8 per cent of all outstanding mortgages. By June 30, 2009, that figure was $290 billion and by the end of 2010 it was $500 billion.

In an effort to prop up the real estate market in 2008 (when affordability nose-dived), the Harper government directed the CMHC to approve as many high-risk borrowers as possible to keep credit flowing. CMHC described these risky loans as “high ratio homeowner units approved to address less-served markets and/or to serve specific government priorities.” The approval rate for these risky loans went from 33 per cent in 2007 to 42 per cent in 2008. By mid-2007, average equity as a share of home value was down to six per cent — from 48 per cent in 2003. At the peak of the U.S. housing bubble, just before it burst, house prices were five times the average American income; in Canada in late 2009 that ratio was 7.4:1 — almost 50 per cent higher.

While it was CMHC that insured these loans it was still the banks that put up the money. And they knew they were effectively sub-prime. How do we know? Because they avoided direct risk like the plague - in the two years from the beginning of 2007 to January 2009, the banks themselves took on virtually no new risk. According to CMHC numbers Canadian banks increased their total mortgage credit outstanding by only 0.01 per cent. But they were happy to put Canadian taxpayers at risk by lending to high-risk borrowers knowing their money was protected by CMHC.

Conservative? Prudent? Responsible? In a pig’s eye.

Sunday, May 30, 2010

Bankers’ ‘doomsday scenarios’ under fire

The FT reports that "banks are exaggerating the economic effects of the regulations they are likely to face in the coming years" according to Stephen Cecchetti, chief economic adviser to the Bank for International Settlements:

Banks’ “doomsday scenarios” were based on their assuming “the maximum impact of the maximum change with the minimum behavioural change”.

“They are assuming they’re not adjusting their business at all to the regulatory reforms and that the result for the economy will be the worst possible,” said Mr Cecchetti.

Instead, Mr Cecchetti, who has been given a mandate to assess the economic effects of the “Basel III” reforms by the Basel Committee on Banking Reform and the Financial Stability Board, is adamant the transitional costs of requiring banks to hold more capital and be more robust to sudden demands for funds “aren’t huge”.

In the longer term, Mr Cecchetti said the result of a safer banking system would provide economic benefits not costs. “Our preliminary assessment is that improvements to the resilience of the financial system will not permanently affect growth – except for possibly making it higher.”

He gave three examples of banks over-estimating the likely effects of the new regulations, which are due to be agreed by the end of the year, with gradual implementation expected to start in 2012.

First, he said banks are claiming that new liquidity rules would force them to swap large quantities of high-yielding loans for low-yielding government bonds, which would have an impact on their profitability and lending. Instead, he said they could comply with the rules by lengthening the maturity of their liabilities so they better match those of their assets at much lower cost.

Second, he said they assumed investors would demand the same returns on new tranches of equity capital when this equity would make banks more resilient, lowering risk to equity holders and the cost to banks.

And third, he said the warnings of high costs relied on banks’ estimates that the new rules would reduce credit growth and economic growth severely. “We must always keep in mind that one of the causes of the crisis was that credit growth was too fast.”

Friday, May 28, 2010

How Wall Street Gamed Derivatives Reform

Originally published on the Business Week website:

Forcing derivatives trading out of Wall Street's dark corners is one of the most contentious issues in the financial regulatory revamp debate. No mystery here: The five biggest U.S. dealers—JPMorgan Chase (JPM), Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), and Citigroup (C)—generated an estimated $28 billion in revenue last year trading derivatives, according to Federal Reserve reports and people familiar with banks' financials.

Yet a sweeping overhaul, now in a House-Senate conference committee, likely won't have the transformative impact on the derivatives market some hope. (Derivatives are instruments that let companies hedge interest-rate risks or changes in commodity prices; they are also used for speculation.) Wall Street firms have known for more than a year that change is coming and have moved to protect their market role. Both the House and Senate bills mandate that most contracts in the unregulated $615 trillion over-the-counter derivatives market be traded on an exchange, or "swap execution facility," a creation of Congress so far only partially defined in the legislation. The measures also require third-party clearinghouses to process trades, guaranteeing the contracts.

For regulators and companies, this would be a big improvement. Banks now conduct most trades over the phone, keeping bid and ask prices private and spreads, the main driver of profits, high. Until the credit markets crashed, regulators had little idea how much derivatives-related debt banks were taking on or how interconnected they were.

Big bank derivatives dealers hope to keep a tight grip on the $25 trillion credit-default swaps market by sending a large volume of that business to ICE Trust, a U.S. clearinghouse owned by Atlanta's Intercontinental Exchange (ICE). ICE Trust has processed more than $5 trillion in credit-swap transactions since March 2009, while its sister operation in London, ICE Clear Europe, has done close to $3 trillion. And as of April, ICE Trust is sharing 50% of its profits with the Big Five and other large banks—ensuring continued order flow.

The profit-share agreement gives the banks an incentive to send all their trading to ICE Trust, says Mark Williams, who teaches finance at Boston University. In contrast, Chicago's CME Group (CME), the world's largest futures exchange, and LCH.Clearnet, Europe's largest clearinghouse, have taken only a fraction of the business. "Regulators need to monitor the relationship between these profit-sharing partners and Intercontinental," Williams says. "There's a potential conflict of interest." ICE Trust has an independent board of directors and advisory committee, counters spokeswoman Kelly Loeffler. Regulators in the U.S. and Europe have reviewed Intercontinental's governance and oversee its operations, she adds.

One of Congress's goals with derivatives legislation is to increase competition and lower the cost of hedging. ICE Trust, however, requires members to have a minimum net worth of $5 billion, a pricey admission ticket for smaller brokers.

The biggest players in the $349 trillion interest-rate swaps business, the largest OTC derivatives market, have also moved to protect how they buy and sell swaps with customers. One example: Goldman and nine other dealers own stakes in Tradeweb, a trading system majority-owned by Thomson Reuters (TRI). Tradeweb lets asset managers swap interest rates with dealers over an electronic system, or by phone. Earlier this month, Tradeweb said it would apply to become a swap execution facility. Created in 2005, Tradeweb has helped conduct more than 55,000 rate swaps, with more than $5 trillion in notional value. Inter-dealer brokers, firms that arrange trades between banks, could also enter the picture as swap facilities, says Christopher Giancarlo, chairman of the Wholesale Markets Brokers' Association Americas. Bloomberg, the parent company of Bloomberg Businessweek, which already has an interest-rate swap platform, also plans to register as a swap facility, says Ben MacDonald, Bloomberg's global head of fixed-income products.

The bottom line: The regulatory rewrite may dent the profits of Wall Street firms even as their stakes in trading and clearing companies benefit.

Thursday, May 27, 2010

Inching closer to the derivatives end-game?

Posted by Richard Raeburn on his EACT Blog:

There’s an enormous amount happening on all economic and financial fronts as I write – with the equity and other markets in freefall and the USD soaring – so I am almost reluctant to blog again about OTC derivatives. In addition I am about to go to Prague for the latest (six monthly) EACT meeting. But I do think we are approaching the beginning of a very extended end-game on derivatives regulation, so here briefly are some not totally random thoughts.

We are about to be faced with a further consultation by the European Commission on its regulatory proposals (now branded as ‘EMIL’). Depending a little on whom you talk to, you may believe that the fact there is this further consultation reflects an acceptance by the Commission that the views of non-financial end users need a further airing. I suspect that the consultation is part of a long-planned process, at the end of which the Commission staff will be more than happy to hand over the topic to ESMA and other interested parties for the real implementation.

There is increasing transparency (to coin a phrase) on what will be involved going forward. The main elements that I have gathered are as follows.

The consultation is almost certain to propose that corporates are out-of-scope of the regulatory initiative – so no central clearing, cash collateral etc etc – unless a local regulator considers that hedging activities breach an investigation threshold. If that happens there will be a friendly conversation with the regulator, at which the corporate should focus on explaining the rationale for its activity; if I have been right in a lot of what I have been saying (when given the chance) the conversation will be almost entirely about risk mitigation.

If activity breaches a second and higher level then there will be a more searching – but retrospective – examination of the transactions around the legitimacy of the hedging. Systemic risk will be strongly on the minds of the regulator and I assume that if the examination fails to convince the authorities, there will be some sanction in the form of obligatory central clearing.

The devil is of course in the detail and that’s where it seems to me that ESMA and the national regulators will have a huge challenge. The particular elephant in the regulatory room is the notion of systemic risk and how that can relate to the higher of the two thresholds. The overall approach is based around the concept that that the Commission team has been talking about publicly, which is that the lower threshold is ‘qualitative’ and the higher is ‘quantitative’.

So….we need to get through what we expect to be a short consultation period with the Commission; then – whilst the rest of the Brussels governance structure turns it wheels on the Commission’s output – focus even more on what is happening on CRD IV and the BIS work to produce Basel III. The core concern here remains: what we may be in the process of winning with the OTC regulatory discussions we may promptly lose, with the application of what officials in Brussels have in the past happily described to me as ‘punitive’ capital requirements to sweep away the remaining OTC market.

In brief that is where we seem to be. The EACT meeting will be discussing the topic amongst many others over the next two days in Prague. We are also planning to mobilise additional resources, in common with some larger individual corporates, to ensure that the concerns of end users are probably articulated and communicated in Brussels and elsewhere.

MBS Ratings and the Mortgage Credit Boom

By Adam Ashcraft, Paul Goldsmith-Pinkham, and James Vickery

Abstract: We study credit ratings on subprime and Alt-A mortgage-backed-securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly rated securities in each deal is decreasing in mortgage credit risk (measured either ex ante or ex post), suggesting that ratings contain useful information for investors. However, we also find evidence of significant time variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses and large rating downgrades) among deals with observably higher risk mortgages based on a simple ex ante model and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.

Download here:

Tuesday, May 25, 2010

Extend and Pretend Reaches A New Level

Posted on FT Alphaville:

The accounting standard known as FAS 157 gained not-a-small amount of notoriety last year.

In March of 2009, the US Financial Accounting Standards Board (FASB) changed the rule, which governed how companies should mark their assets to market and was established in September 2006.

It was a controversial move to say the least, and many commentators still think the easing was one of the things that helped propel banks to some hefty profits that year. Others argue that mark-to-market helped exacerbate the financial crisis and FASB’s decision was a prudent one.

One of the features of FAS 157 was its codification of categories for asset valuation: Level 1, Level 2 and Level 3. You can read a full description here, but suffice to say, Level 1 asset values were those based on readily observable market prices. Level 2 asset values were based on quoted prices in inactive markets, or based on models but the inputs to those models are observable. Level 3, meanwhile, was the least marked-to-market of the categories, with asset values based on models and unobservable inputs.

Last year, the Board changed FAS 157’s name to Topic 820 as part of its overhaul of fair value rules. It still seems to be tinkering with some of them, but the basic text of 820 is up and running.

Posted on Deux Ex Macchiato:

Why should you care, dear reader? Well, there are two things in 820 that struck me as apposite; one good, one bad...

The good one first.

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Now the bad part. They have made this a lot less useful than it would otherwise be by extending (or at least clarifying the extent of) level 2.

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied is in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Comment from Naked Capitalism:

Eeek. Having crawled in the bowels of some financial firms, I’ve been skeptical of whether an investor can make head or tails of the performance of a financial institution of any complexity. This move should give the skeptics even more cause for pause.

Monday, May 24, 2010

Put the Rating Agencies Out of Their Misery Before It's Too Late

The Motley Fool on the "pig and the lipstick":

A pillar of the financial crisis was rating agencies slapping triple-A ratings on junk mortgage products only to be mystified when the securities blew up. In the 2007 transaction involving the recent Goldman Sachs (NYSE: GS) CDO fraud saga, almost half of the debt was downgraded from triple-A (perfect) to junk (perfectly worthless) in short order.

Fool me once ...
Now, a sober person would think the rating agencies have learned from these flubs. But that makes too much sense. Truth is, they're as miserably inept as ever.

Last summer, Standard & Poor's invoked the ghost of 2005 when it rated a set of CDO-esque securities triple-A, which implies essentially zero probability of default.

Last week, it downgraded the same securities all the way to junk. That's triple-A to junk in less than a year. Again. Recall Einstein's definition of insanity, and feel free to smash your head against the nearest wall.

"The downgrades reflect our assessment of the significant deterioration in performance of the loans backing the underlying certificates," cried S&P. This is mildly true at best, and more likely a product of the same deceptive shell games rating agencies are now infamous for.

Here's your pig, there's your lipstick. Have at it.
These securities, you see, weren't new products created last summer when S&P initiated the ratings. They're called "re-remics," born from an alchemical process of taking existing bonds struggling for survival, slicing them up anew, and giving the new pieces a fresh set of ratings. The idea is that you can take a low-rated mangled mortgage bond, extract the pieces that still have a heartbeat (even though they share the same characteristics as the rapidly defaulting mortgages), and pronounce the new security triple-A.

So to be sure here, the same material that S&P called triple-A last summer was, at nearly the same time, rated far below that. David Blaine can't even fathom this stuff.

During a flood of re-remics last fall, The Wall Street Journal wrote an article questioning their validity "partly because re-remics rely on ratings firms -- faulted for failing early on to identify problems with mortgage-backed bonds -- to rate the new securities." That was spot-on, as was a comment by Rep. Dennis Kucinich, who warned, "The credit-rating agencies could be setting us up for problems all over again."

That's exactly what's happening, and it's time we do something about it. One of the central flaws in the rating agency world is that large-scale investors such as money market funds are required to hold assets scored by a rating agency registered as a Nationally Recognized Statistical Rating Organization, or NRSRO. Only a handful of raters are blessed with this status, and Moody's (NYSE: MCO), S&P, and Fitch are kings of the court. They're privileged to what amounts to guaranteed business and no threat of new competition.

While it's certainly well-intentioned, there's fairly universal agreement that the NRSRO has created the ability, if not the incentive, for rating agencies to produce wildly flawed work. They have nothing to lose. Investors have to use their services. S&P can recklessly issue wacky ratings (as it just did), and business goes on as usual.

Hedge fund manager David Einhorn summed it up perfectly: "Nobody I know buys or uses Moody's credit ratings because they believe in the brand. They use it because it is part of a government-created oligopoly and often because they are required to by law." In any normal market, new competition and customers' disgust over shoddy analysis wouldn't let this happen.

Let's do something about this
Fortunately (though long overdue) Congress is waking up. Two amendments in the just-passed Senate financial overhaul bill could euthanize the flawed parts of the rating system.

One amendment would eliminate all mention of the NRSRO from federal regulations. The organization could still exist, but language requiring investors to use products rated by an NRSRO rating agency would vanish. Competition from eager rivals like Morningstar (Nasdaq: MORN) and KPMG could then step in and sanitize the industry.

A separate amendment would create a clearinghouse set up to assign rating agencies with deals. That way, banks that issue credit products couldn't shop around for the morally bankrupt rater that's willing to assign triple-A status to toilet paper just to bag a nice fee. Both amendments aim to end a kink in the financial system that benefits exactly nobody except the rating agencies and the banks that sell glorified debt products.

We'll be patiently watching as the Senate and House reconcile their respective versions of the financial overhaul bill. Stay tuned.

See also the FT Alphaville and Wall Street Journal pieces on the rating agency you’ve never heard of (DBRS).

Sunday, May 23, 2010

Naked Credit Default Swaps--the Role of Dealers

Posted on Credit Slips by Adam Levitin:

CDS are often done through dealers, and a naked position for a dealer is different from a naked position for an end-user. A CDS dealer's swaps desk is unlikely to have any stake in the underlying asset. Instead, if the swaps desk is well run, it will only execute perfectly matched swaps, so that it will never have any exposure itself to the underlying assets, only counterparty risk. (And dicey counterparties have to post collateral). If naked CDS were banned without a dealer exception, covered CDS would become quite difficult to arrange and execute. much harder to execute.

To illustrate the role of dealers, consider the Abacus deal. It is usually presented as Goldman Sachs simply arranging a swap between Paulson and the CDO. That's the economic essence of the deal, but not how it worked technically. The deal was actually structured as two completely separate swaps. (I think this is what Goldman means when it says it was just a market maker--it means it was a dealer.) Swap 1 was between the CDO and Goldman. Goldman took the short position on the CDS on the underlying CDO assets. Swap 2 was between Goldman and Paulson. These two swaps were separate deals, in that they did not formally reference each other or depend on each other.

In reality, Goldman would never have done Swap 1 with the CDO unless it could hedge its risk in that deal through Swap 2 with Paulson. (Some of this is surmise, as, to my knowledge, only the documentation from Swap 1 is publicly available.) Of course, in the Abacus case, Goldman did not have perfectly matched CDS, and it got screwed (luckily for its sake, as that helps its defense).

The point here, is that dealers play a critical role in the swaps market, and if they happen to have a position in the underlying asset, that is completely by the chance of what an affiliated proprietary investing desk is doing. A naked position by a dealer is different from a naked position for an end-user.

Also, I'm not sure that I'd agree with Stephen [Lubben] that "credit is not a commodity." A bespoke corporate loan is not, but what about when that corporate loan is bundled into a CLO and churned out as securities? Or how about the consumer context, where there are standard form contracts, frequent resales of the debt, and sometimes no collateral involved (e.g., credit card debt)?

And click here for the ISDA analysis of all the permutations and combinations of the BaFin ban:

Wednesday, May 19, 2010

Barnier press conference on financial regulatory reform

17/05/2010 - On his return from his first official visit to the United States, and following recent calls by Heads of State and Government to accelerate the pace of financial reform, Commissioner Barnier held a press conference setting out where the EU and the US stand on delivering G20 commitments on financial regulation reform, and the next steps to fulfill those commitments. This was also an opportunity for Commissioner Barnier to debrief journalists on the outcome of his first official visit to the US.

Risks remain after distressed exchanges

Reported in the Financial Times:

Nearly one-third of the companies that completed distressed exchanges during the financial crisis, such as casino operator Harrah’s Entertainment and media company Clear Channel Communications, are at high risk of defaulting again in the next one to five years, Moody’s Investors Service said on Tuesday.

Without the ability to refinance or raise money to reorganise in bankruptcy, companies convinced creditors to exchange existing debt for new debt or a package of securities, cash and assets that amounted to less than what they were owed...

A quarter of the companies were able to improve finances enough to have higher ratings. Most notably Ford Motor retired about $10bn of debt with a distressed exchange in April of 2009 and Moody’s has upgraded the carmaker several times since.

“While distressed exchanges clearly put some companies on steady ground, for many others they were a temporary fix that only postponed the need to address excessive leverage, weak liquidity or other difficulties,” Moody’s said.

Barnier to pin credit rating agencies under EU thumb

Original posted on

EU Internal Market Commissioner Michel Barnier has told EU finance ministers today (18 May) how he plans to put credit rating agencies under the thumb of an EU agency, blaming the uncertainty in financial markets on the downgraded ratings of Greek and Portuguese debt.

Though the EU has already passed legislation regulating credit rating agencies such as Standard & Poor's and Moody's, it will table further proposals in two weeks' time. The new proposal will ask ask leaders to agree to put credit rating agencies under the centralised supervision of a new agency called the European Securities and Markets Authority (ESMA).

Barnier has presented his proposal to EU finance ministers at a meeting today (18 May) to discuss EU efforts to prevent further contagion from the debt crisis in the euro zone (EurActiv 18/05/10) and plans to regulate hedge funds.

In addition to the previous regulation, which would see rating agencies register in a central European database, the commissioner now wants EU regulators to have access to both the agencies' methodologies and to information on past ratings.

All of the above would ideally be operational by 1 January 2011, a Commission source said.

"We don't want someone getting a bad rating in one place and then going over the road to try their luck elsewhere," another Commission official told EurActiv.

Worries of ratings' contagion risks

Barnier's plans will likely strike a chord with the German and French leaders, Angela Merkel and Nicolas Sarkozy, who at the beginning of the month asked the European Commission to examine agencies' role in worsening the Greek debt crisis.

In April, Germany's Angela Merkel even indicated her support for the creation of a European credit rating agency to offset the dominance of the 'big three'.

"It is not normal for these rating agencies to play such an important role and to be so few in number," the commissioner said ahead of his presentation yesterday, reiterating concerns that a market dominated by three agencies, Moody's, Standard & Poor's and Fitch, badly needed new competitors.

"I am bothered by the automatic nature of the consequences made by ratings," he added, referring to the 1.5% fall of the euro following Standard & Poor's decision to downgrade the debts of Greece and Portugal at the end of April.

"The problem with Greece and with the banks was the same: both did not see the crisis in advance," a Commission official said in defence of more EU oversight of ratings and more competition.

In April, the European Commission sent a thinly-veiled warning to rating agencies urging them to act "in a responsible way" after Greek and Portugese downgrades (EurActiv 03/05/10).

"We would expect that when credit rating agencies assess the Greek risk, they take due account of the fundamentals of the Greek economy and the support package prepared by the European Central Bank, the International Monetary Fund and the [European] Commission," a spokesperson for Commissioner Barnier said (EurActiv 12/04/10).

Next Steps

  • June: Commission proposal on centralised supervision of rating agencies.
  • 1 Jan. 2011: Planned entry into force of new rules.


Credit rating agencies entered the EU's firing line when the agency, Standard & Poor's decided to downgrade Greek debt to "junk" status, spreading widespread gloom across EU markets.

Credit rating agencies have been widely blamed for their role in the financial crisis which has swept the world since 2007.

They stand accused of over-evaluating borrowers' capacity to pay back their household loans in the so-called sub-prime crisis. They were also accused of potential conflicts of interest, because they are paid as consultants by the very banks whose debt they rate.

The failure of credit rating agencies to uncover the true value of securities, which were later labelled 'junk', has resulted in calls for greater regulation of the sector.

Despite some initial divergences on competence-sharing, EU governments and the European Parliament backed a tough line and supported increased oversight of a sector worth almost €4 billion and dominated by American multinationals, such as Standard & Poor's and Moody's (EurActiv 17/04/09).

More on this topic

Conspiracy of Banks Rigging States Came With Crash

Bloomberg reports on a nationwide GIC bid-rigging scheme:
West Virginia was just one stop in a nationwide conspiracy in which financial advisers to municipalities colluded with Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co., Lehman Brothers Holdings Inc., Wachovia Corp. and 11 other banks.

They rigged bids on auctions for so-called guaranteed investment contracts, known as GICs, according to a Justice Department list that was filed in U.S. District Court in Manhattan on March 24 and then put under seal. Those contracts hold tens of billions of taxpayer money...

The workings of the conspiracy -- which stretched from California to Pennsylvania and included more than 200 deals involving about 160 state agencies, local governments and non- profits -- can be pieced together from the Justice Department’s indictment of CDR, civil lawsuits by governments around the country, e-mails obtained by Bloomberg News and interviews with current and former bankers and public officials.

“The whole investment process was rigged across the board,” said Charlie Anderson, who retired in 2007 as head of field operations for the Internal Revenue Service’s tax-exempt bond division. “It was so commonplace that people talked about it on the phones of their employers and ignored the fact that they were being recorded."

Read the whole piece here:

Tuesday, May 18, 2010

NY Fed Releases White Paper on Tri-Party Repo Reform

The Federal Reserve Bank of New York today announced the publication of a white paper on the work of the Tri-Party Repurchase Agreement (Repo) Infrastructure Reform Task Force. The white paper highlights policy concerns over weaknesses in the infrastructure of the tri-party repo market and seeks public comment on the task force’s recommendations to address these concerns.

The recommendations set forth by the task force in its final report, when implemented, should:

  • dampen the potential for problems at one firm to spill over to others,
  • clarify the credit and liquidity risks borne by market participants, and
  • better equip them to manage these risks appropriately.

Feedback on this paper received during the 30-day public comment period will help New York Fed staff, and others with regulatory and supervisory responsibilities, to assess the task force proposals and identify any additional or alternative measures that should be considered.

“We are grateful for the work of the task force and encourage all stakeholders to provide comments,” said William C. Dudley, president and chief executive officer of the Federal Reserve Bank of New York. “The Federal Reserve is committed to initiating actions, as necessary, to promote strong risk management practices by all market participants and the stability and resilience of financial markets more broadly. The work of the task force represents an important step in this direction.”

The tri-party repo market and short-term funding markets will continue to evolve as broader regulatory reforms take shape, and enhancements to infrastructure, such as those proposed by the task force, are implemented. Going forward, it will be imperative to monitor the evolution of these markets closely.

The New York Fed tasked the Payments Risk Committee (PRC), a private-sector group of senior U.S. bank officials sponsored by the New York Fed, to form a group of industry stakeholders to address tri-party repo market infrastructure weaknesses exposed during the financial crisis of 2008 and 2009. The PRC created the Tri-Party Repo Infrastructure Reform Task Force in 2009, and included
tri-party repo market participants, service providers and representatives from industry groups. The task force met regularly since its creation to discuss enhancements to the policies, procedures and systems supporting the tri-party repo market. The final report of the task force was also issued today.

FAQs pdf
For the New York Fed white paper and task force report, visit:
For the Tri-Party Repo Infrastructure Reform Task Force final report, visit: offsite

EU to deal severely with CDS; leaders seek ban

Reuters reports on the anti-CDS rhetoric coming out of Europe:

Greek Prime Minister George Papandreou told Germany's Handelsblatt newspaper, "Angela Merkel, Nicolas Sarkozy, Jean-Claude Juncker and I have suggested in a joint letter to Barack Obama whether the markets for credit default swaps ... should not be closed. The G20 countries want to discuss this."

European political leaders for months have been blaming speculation in the CDS market for increasing the cost of borrowing for Greece, Portugal, Spain and Ireland.

Papandreou's call appeared to go further than anything proposed so far and is likely to meet opposition from banks, companies and investors who rely on credit derivatives.

Meanwhile, European Union Commissioner Michel Barnier told a news briefing that regulators intended to force more transparency on the CDS market.

"I have stated that in October we intend to deal with this matter very severely," he said. "These people don't like to come out in the light of day. We are going to flood them with light."

The euro hit a four-year low on Monday and gold rose after a sell-off on Friday in European stocks, CDS and peripheral government debt, despite a $1 trillion rescue package for the euro zone unveiled earlier in the week.

Buyers of protection use CDS either to hedge against risk in their cash bond portfolios or to make a bet that a company or country will default on its debt.

Papandreou criticized financial markets for overreacting to Greece's debt crisis and accused speculators of helping to provoke panic reactions.


However, European Central Bank council member Ewald Nowotny said that while the CDS market needed reform, there was no need to close it down.

Credit market commentators say officials are blaming the messenger as the slumping CDS market only mirrors real underlying problems of heavy government debt burdens and fiscal deficits.

"The problem isn't evil speculators but that the finances of governments are so bad that your classic long-term investors are either taking risk off the table or are not interested in buying as much," said Gary Jenkins, head of fixed income research at broker Evolution Securities.

The CDS market gives banks, insurance companies and other investors an alternative to reduce their risk exposure rather than just selling government bonds into a falling market.

Special EU programmes last year provided banks with 614 billion euros of one-year funding, much of which was invested in sovereign bonds and most of which comes due on July 1, Jenkins said.

"A huge pile of banks did the same trade, and now they are all offside and looking to sell," he said.

If regulators ban the use of CDS, then the market's aversion to government risk will be reflected in the cash bond market, said Mehernosh Engineer, a credit strategist at BNP Paribas.

"They are trying to mask something that's apparent and that was not caused by the CDS market," he said.

A ban on CDS might act to calm the market somewhat, because derivatives can be more liquid than cash bonds, making it easier for investors to hedge quickly, Jenkins said.

But that effect is likely to be overwhelmed as investors take fright at a retrospective change in the rules, he said. "It would be a huge error. All it would do is spook the market."

Monday, May 17, 2010

BIS Working Paper: Attributing systemic risk to individual institutions

By Nikola Tarashev, Claudio Borio and Kostas Tsatsaronis

Abstract: An operational macroprudential approach to financial stability requires tools that attribute system-wide risk to individual institutions. Making use of constructs from game theory, we propose an attribution methodology that has a number of appealing features: it can be used in conjunction with popular risk measures, it provides measures of institutions’ systemic importance that add up exactly to the measure of system-wide risk and it easily accommodates uncertainty about the validity of the risk model. We apply this methodology to a number of constructed examples and illustrate the interactions between drivers of systemic importance: size, the institution’s risk profile and strength of exposures to common risk factors. We also demonstrate how the methodology can be used for the calibration of macroprudential capital rules.

Download the paper here:

Rating Agencies May Squeak Through

Original posted on the Integrity Research Associates website:
Senator Al Franken’s rating agency amendment has grabbed headlines, but the Senate’s version of rating agency reform would be less damaging to the rating agencies than the House version. Rating agencies may not acknowledge it, but they will owe much to Senator Franken if his amendment makes it into the final legislation.

Franken’s Amendment

Senator Al Franken (D-MN), the former Saturday Night Live comedian, introduced an amendment to the Senate’s financial overhaul legislation which passed the Senate 64 to 35, garnering support from 10 Republicans. Franken’s measure requires the SEC to establish a Credit Rating Agency Board to assign an NRSRO (‘Nationally Recognized Statistical Ratings Organization’, which are rating agencies approved by the SEC) to provide an initial credit rating on a structured product when an issuer seeks a rating. To be eligible for selection by the Board, an NRSRO must apply to the Board to become a “qualified NRSRO” for the class of structured product (such as mortgage-backed or asset-backed securities) in question.

The Board is to be comprised primarily of representatives of the investor industry, with at least one representative of the issuer industry, one from the credit rating industry, and one independent member. The bill directs the Board to “evaluate a number of selection methods, including a lottery or rotating assignment system.” It also requires the Board to evaluate each qualified NRSRO each year, with the findings made available to Congress.

The idea behind the Franken amendment is similar to mechanisms which various stock exchanges have put in place to provide issuer-paid coverage of under-followed stocks. The London Stock Exchange launched a program in 2008. Previously NASDAQ, along with Reuters, had set up an ‘Independent Research Network’ in 2005, which was shut down in 2007. None of the equity market mechanisms have been especially successful, primarily because the equity markets, unlike the debt markets, have never embraced the issuer-paid model.

What the Senate Bill Left Out

As we have been saying since 2007, the most certain ratings agency reform is to weaken the rating agencies’ liability protections. Each version of proposed ratings agency reform includes language to this effect. However, little attention seems to have been paid to a very important component of ratings agency liability defenses, which is an obscure SEC rule which exempts rating agencies from the liabilities faced by underwriters, legal counsel and other insiders to a security transaction. Rule 436(g) exempts NRSROs from ‘expert status’ under Section 11 of the 1933 Act, which makes it easier for investors to sue experts than would be the case under common law.

Under Section 11, an expert may be held liable if the expert is responsible for an untrue statement of material fact or omitted a material fact necessary to make statements not misleading, unless the expert can establish that it had reasonable grounds to believe and did believe at the time that the statements were true. Expert status wipes away the common law protections of scienter (intent to deceive), reliance (proof that the investor relied on the rating when making the investment) and causation (that the misleading information from the expert caused the loss to occur).

The House rating agency reform bill nullifies Rule 436(g). The Senate bill makes no mention of the rule, although it does contain language to increase rating agency liability.

Different Approaches to Rating Agency Reform

Besides increasing rating agency liability, the House version of rating agency reform moves to systematically expunge references to credit ratings in existing regulation and to make government agencies reliant on different standards than credit ratings issued by NRSROs. The House bill, largely authored by Rep. Paul Kanjorski (D-PA), compels federal agencies to look for references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards. It also directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness “to the extent feasible.” The Senate provision includes none of this language.

The House approach is to remove the regulation and legislation that encourages the use of NRSRO ratings, distancing government from ratings. The Senate approach, through Franken’s amendment, inserts government in the middle of the rating process as a mechanism to reduce conflicts. While not wholly incompatible, the two bills have very differing underlying philosophies.

Which is Worse?

The ratings agencies became an oligopoly largely because of government support. Thanks to government regulations, credit ratings determine bank, investment banking and insurance capital levels, define what money market funds can or cannot own, and are allowed to have access to material non-public information. Rule 436(g) exempts ratings from expert status. Eliminating these privileges would weaken credit ratings significantly. However, the impact would take time, partly because of the size and difficulty of the task of eliminating ratings from regulation.

Under any scenario, rating agency liability will increase. All versions of legislation have language to this effect. Even if the repeal of Rule 436(g) is not included in the final legislation, the SEC may rescind the rule anyway. It issued a concept release late last year considering whether to eliminate the rule.

The Franken amendment, unlike the House approach, does not upend the status quo. Rather it preserves the current regime while trying to reduce the inherent conflict. Conflicts remain, however. Franken’s amendment allows issuers to get ratings from other agencies as long as the initial credit rating is provided by the agency assigned by the Board. Since the structured market has tended to require two ratings, this would allow the ‘majors’ (Moody’s, Standard & Poor’s and Fitch) to retain market share.

The Franken amendment will be positive for new competition (contrary to public statements made by some of the NRSROs opposing the legislation). It will make it easier for upstart firms to get ratings assignments. Overall, the Franken amendment perpetuates the implicit support which government agencies have provided rating agencies. The House ‘cold turkey’ approach would be far more damaging, but it does not offer the quick fix of the Franken amendment.

Another Approach

One way to radically reform the rating agencies is to cut their tie with investment banks. As we have noted in the past, the rating agencies are the creation of the investment banks. The current NRSRO regime was implemented after Goldman Sachs was nearly destroyed by the bankruptcy of Penn Central in 1970. Goldman decided it no longer wanted the liability associated with credit research, preferring to outsource it to the ratings agencies. To upgrade the staff of the sleepy ratings agencies to produce the kind of research required, they had to generate higher fees. Goldman, and other investment banks, brought the deals to the ratings agencies, facilitating the adoption of the new business model. The investment banks also used their lobbying power to obtain Rule 436(g) and other regulatory perks.

So, if Congress really wants to change the rating agencies, require the investment banks to provide credit analysis as part of a new bond issue. Investment banks already have the expertise to evaluate the debt since they are instrumental in creating it. They are already highly regulated, as is the research they currently provide for equities and other asset classes. And they already have liability standards as experts which hold them more accountable than under common law. Conflicted? Sure, but no less than the current issuer-pay model.

This would very quickly deflate the rating agencies ability to charge issuers, because most issuers would balk at paying incremental fees for an analysis already covered by their banking fees. (Banking fees might increase, of course, to cover the incremental costs to the investment banks.) Investors would continue to have credit analysis available if they do not have the willingness or ability to invest in their own credit staff.

Rating agencies have been impervious to previous attempts at reform. They will not be so lucky this time. However, the degree of damage to their models varies greatly in proposed legislation, and, thanks to the Franken amendment, it is possible that they can come through the current crisis with their model relatively intact.

Saturday, May 15, 2010

How to implement the Franken & LeMieux NRSRO Amendments?

Interesting post on the Baseline Scenario on how to implement the Franken and LeMieux credit rating agency-related amendments to the Senate financial sector reform bill:
The two (perhaps contradictory) amendments each try to implement a proposed solution that runs into some of the critiques. The Franken amendment has rating agencies assigned to debt issues by a neutral arbiter; critics maintain that lack of competition may reduce the quality of analysis. The LeMieux amendment removes legal mandates to obtain a NRSRO rating and the preferential treatment those issues currently receive. However, it leaves out details about whose advice agencies and public trusts should seek out instead.

This is not such a difficult problem. We already have an example of a successful private rating agency, whose imprimatur is desired or in some cases required by law, that is paid for by fees on the seller, and has been operating since 1894: Underwriters Laboratory. The UL publishes safety standards for almost 20,000 different types of products, many of which are adopted by other standard-setting organizations like ANSI (American National Standards Institute) and Canada’s IRC (Institute for Research In Construction). Although generally not actually required by federal law, the sale of many types of products in the US would be difficult without UL listing. Also, many local jurisdictions responsible for building and fire codes mandate the use of UL approved products. In all cases, the manufacturer must submit samples and pay fees to UL in order to win approval.

The comparison to NRSROs is apt. In both cases, a third party sets standards based on theory, models, and best practices. In both cases, the issue is the assessment of risk by experts in that type of risk. In both cases, approval is desired by the market or required by local ordinance or rules. And in both cases, the seller pays the fees; so the third party might be led to relax their standards in order to capture some extra fee income. Yet in the case of fire safety the model has been functioning well for over 100 years, but in financial safety there has been a rash of fires as one rated product after another has blown up. Why?

There are a few key differences. Until 2007, UL was completely non-profit, so as long as user fees covered their costs there was little incentive to chase extra revenue by relaxing standards. There is no real competition in the US market for UL (although Europe has its own standard-setting body that manages the ), so manufacturers have little leverage to push for easier standards. The LeMieux amendment could allow for the creation of a not-for-profit entity to take the place of NRSROs, while the Franken amendment would reduce competition, limiting it to delivering a better, more reliable rating rather than adjusting standards to capture fees.

Critics of the amendments, including those who support a buyer-pays model, need to address the question of why the UL model for risk assessment has worked well, and why it can’t be applied to debt rating. Is the model broken? If so, I expect a rash of building fires any day. Is rating of financial safety fundamentally different than, say, electrical safety?
Some of the comments are kind of interesting too:
The analogy between UL and the NRSROs doesn’t take one very far. The products that the organizations rate are just too different, and the chief difference is simply that UL-rated products are tangible. As a result, it doesn’t generally pay for manufacturers to game the approval process by adding complexity that hides fundamental safety deficiencies. In the world of tangible products, increased complexity almost always equals increased manufacturing costs and lower expected profit. By contrast, in the securities world, increased complexity has a negligible impact on the cost of “manufacturing” the security and can result in a higher expected profit to the issuer and underwriter by hiding features that accrue to their benefit....

When a fire happens, it can generally be traced to a single root cause, or maybe two (e.g., somebody was smoking in bed + the sprinkler system failed).

Put another way, the conditions that cause physical failures do not change from year to year, because the laws of physics do not change.

As a result, if UL failed to do their job properly, it would be pretty easy to tell. It would not even take an expert.

In the financial sector, the top experts always disagree about what is safe and what is dangerous. That is the nature of the sector.

The financial sector is different because its “laws” change daily. The cause of the crisis was not ratings agency failure. The cause was a universal desire to get something for nothing combined with low interest rates. Had the ratings agencies tried to be careful, they would simply have been ignored, because nobody wants to hear about risks when they see their neighbors are getting rich doing nothing year after year after year.

Leads and lags in sovereign credit ratings

Published in the Journal of Banking & Finance (Rasha Alsakkaa and Owain ap Gwilym):

Abstract: This paper analyses lead-lag relationships in sovereign ratings across five agencies, and finds evidence of interdependence in rating actions. Upgrade (downgrade) probabilities are much higher, and downgrade (upgrade) probabilities are much lower for a sovereign issuer with a recent upgrade (downgrade) by another agency. S&P tends to demonstrate the least dependence on other agencies, and Moody’s tends to be the first mover in upgrades. Rating actions by Japanese agencies tend to lag those of the larger agencies, although there is some evidence that they lead Moody’s downgrades.

Download the paper here ($$).

Friday, May 14, 2010

Ooops Again! S&P Cuts to Junk Re-Remics It Rated AAA in 2009

From the Bloomberg story:

Standard & Poor’s cut to junk the ratings on certain securities, backed by U.S. mortgage bonds, that it granted AAA grades when they were created last year by Credit Suisse Group, Jefferies Group Inc. and Royal Bank of Scotland Group Plc.

The reductions were among downgrades to 308 classes of so- called re-remics, or re-securitizations, created from 2005 through 2009, the New York-based ratings company said today in a statement. About $150 million of the debt issued last year, as recently as July, with top rankings were lowered below investment grades, according to data compiled by Bloomberg.

Such re-securitizations, used by Wall Street after the credit crisis began to help create more valuable debt to sell or to restructure investors’ holdings, last year expanded from home-loan bonds to commercial-mortgage securities and collateralized loan obligations backed by company loans.

Residential re-remics exceeded $40 billion last year, according to newsletter Asset-Backed Alert. The notes differ in several ways, such as by including fewer underlying bonds, from the so-called collateralized debt obligations created during the credit boom that in some cases had AAA rated classes that defaulted and returned nothing to investors in less than a year.

Remics, or real estate mortgage investment conduits, are the formal name of certain mortgage bonds. Some of the new securities created in re-remic deals offer investors an additional layer of protection from losses and downgrades, which boost the capital needs of banks and insurers and can force some investors to sell debt.

For more on Re-Remics see Box 2.3 in the October 2009 IMF Global Financial Stability Report here.

AIG Buys $425 Million in Protection With Cat Bonds

As reported on Bloomberg:
American International Group Inc.’s property insurer bought $425 million of protection from U.S. hurricanes and earthquakes through catastrophe bonds in the firm’s first purchase of reinsurance through capital markets. The securities involve two portions, one for $175 million and the second for $250 million, New York-based AIG’s Chartis unit said today in a statement. Both mature in 2013...

The purchases, through a special-purpose entity called Lodestone Re, reflect AIG’s “pursuit of increasing financial flexibility and enhancing our risk management,” Kristian Moor, chief executive officer of Chartis, said in the statement.

The $250 million slice will pay 8.25 percentage points more than three-month Treasury bills. The second yields 6.25 points above the benchmark. AIG divested its majority stake in reinsurer Transatlantic Holdings Inc. by selling shares in the past year.

And here's the Chartis press release:
Chartis today announced that it has entered into a reinsurance transaction with Lodestone Re, which will provide $425 million of protection to Chartis against U.S. hurricanes and earthquakes. This represents a substantial increase from the $250 million of protection originally sought by Chartis. To fund its obligations to Chartis, Lodestone Re issued a catastrophe bond in two tranches -- $175 million of Class A notes and $250 million of Class B notes.

The transaction closed on May 12, 2010 and provides Chartis with fully collateralized coverage against losses from U.S. hurricanes and earthquakes on a per-occurrence basis until May 2013 using an index trigger with state-specific payment factors. Risk analysis for the transaction is based on Risk Management Solution's (RMS) Hurricane Model Version 9.0 and RMS North America Earthquake Model Version 9.0.

Kristian P. Moor, President and Chief Executive Officer of Chartis, said "As part of our first effort to obtain reinsurance coverage supported by capital market instruments, this transaction represents another important milestone in Chartis' pursuit of increasing financial flexibility and enhancing our risk management capabilities."

Lodestone Re is a special purpose insurer, incorporated under the laws of Bermuda, which has established a program structure enabling potential future catastrophe bond issuances.

One Provision Overlooked in Senate version of reform leglislation

Shahien Nasiripour in the Financial Fix:

In passing a measure that attempts to end their oligopoly, the Senate purposely did not include a provision in the House bill that forces major credit rating agencies to be accountable to investors by scrapping a Securities and Exchange Commission rule that has shielded them from civil lawsuits for nearly 30 years.

The provision, known as Rule 436(g), insulates the 10 credit rating agencies recognized by the government as "Nationally Recognized Statistical Rating Organizations" from liability if they knowingly make false or misleading statements in connection with securities registration statements to dupe investors. Other experts -- like the rating agencies not part of the group of 10 -- are legally liable for their statements "to assure that disclosure regarding securities is accurate," according to a 2009 SEC document supporting the removal of the exemption.

In short, if a Standard & Poor's or Moody's Investors Service knowingly tries to deceive an investor, under current law that investor can't sue.

Here's what was in the House version:

Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.

Shahien Nasiripour continues:

But the Senate bill, like the House bill, does provide investors with an improved ability to sue credit raters for faulty ratings. A spokesman for LeMieux pointed to these provisions when asked why his amendment did not include the House language on the 436(g) rule.

The agencies have enjoyed a near-perfect legal record by claiming that their ratings fall under the protection of the First Amendment -- free speech, they've successfully argued. The House and Senate bills attempt to address this by strengthening investors' hand when it comes to suing the rating agencies, but the First Amendment defense may be hard to overcome, as ultimately the courts decide -- not Congress.

Still, according to experts like Barbara Roper, director of investor protection at the Consumer Federation of America, the bills are a big improvement over the status quo. Many consumer groups say the provisions approved Thursday strengthened the Senate bill.

Elsewhere in those amendments were measures that remove various references in federal law to credit ratings, which had compelled their use and guaranteed the majors' oligopoly, and a government mechanism that would inject government officials into deciding which agency rates which securities.

Regarding the removal of the references, federal regulators will largely be forced to define creditworthiness, rather than regulations that currently rely on the credit rating agencies for that.

However, there are open questions about the LeMieux-Cantwell provision. The House bill, largely authored by Rep. Paul Kanjorski (D-Pa.), directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness "to the extent feasible." The Senate provision includes no such language.

Also, the House bill compels federal agencies to look for other such references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards. The Senate amendment doesn't include this, either.

The measures in the LeMieux-Cantwell amendment won't take effect until two years after the bill is enacted into law; the House provisions take effect within six months.

Thursday, May 13, 2010

Big U.S. Banks Making Hay While the Sun Shines

According to Bloomberg, the big U.S. banks have thrown off the hair shirts and are making hay while the sun shines:
Four of the largest U.S. banks, including Citigroup Inc., racked up perfect quarters in their trading businesses between January and March, underscoring how government support and less competition is fueling Wall Street’s revival...

“The trading profits of the Street is just another way of measuring the subsidy the Fed is giving to the banks,” said Christopher Whalen, managing director of Torrance, California- based Institutional Risk Analytics. “It’s a transfer from savers to banks.”

The trading results, which helped the banks report higher quarterly profit than analysts estimated even as unemployment stagnated at a 27-year high, came with a big assist from the Federal Reserve. The U.S. central bank helped lenders by holding short-term borrowing costs near zero, giving them a chance to profit by carrying even 10-year government notes that yielded an average of 3.70 percent last quarter.

The gap between short-term interest rates, such as what banks may pay to borrow in interbank markets or on savings accounts, and longer-term rates, known as the yield curve, has been at record levels. The difference between yields on 2- and 10-year Treasuries yesterday touched 2.71 percentage points, near the all-time high of 2.94 percentage points set Feb. 18...

It’s an awkward moment for the largest banks to be reporting more profitable trading. President Barack Obama is seeking to prohibit banks from trading solely for their own profit, a proposal favored by Paul Volcker, the former Fed chairman who is now a White House adviser.

“The banks are getting while the getting is good because you have regulatory reform and the Volcker rule and possible bank taxes down the road,” said Matthew McCormick, a banking analyst at Bahl & Gaynor Inc. in Cincinnati, which manages about $2.8 billion including bank stocks. “It’s statistically improbable to have three firms batting 1,000 and also pitching a perfect game. You wonder why the rest of America has some suspicion about proprietary trading.”

...“It was like a perfect storm for the fixed income market where you had very low volatility, tightening spreads and a buyer of last resort in the Federal Reserve,” said Paul Miller an analyst at FBR Capital Markets in Arlington, Virginia. “Even if a trade was going against you, you could just dump it on the Fed very quickly.”

The CDO-prosecution bandwagon gathers more steam

FT Alphaville's Gwen Robinson reports that:
New York’s ever-vigilant attorney general Andrew Cuomo is at it again, this time with an investigation into whether eight banks gave misleading information to rating agencies in order to boost the ratings on particular mortgage securities.

As the New York Times reports:

The agencies themselves have been widely criticized for overstating the quality of many mortgage securities that ended up losing money once the housing market collapsed. The inquiry by the attorney general of New York, Andrew M. Cuomo, suggests that he thinks the agencies may have been duped by one or more of the targets of his investigation.

Those targets are Goldman Sachs, Morgan Stanley, UBS, Citigroup, Credit Suisse, Deutsche Bank, Crédit Agricole and Merrill Lynch, which is now owned by Bank of America.

The companies that rated the mortgage deals are Standard & Poor’s, Fitch Ratings and Moody’s Investors Service. Investors used their ratings to decide whether to buy mortgage securities.

The probe parallels federal inquiries into a wide range of financial companies in the years leading up to the collapse of the housing market. But, as the Times notes, whereas the federal probes have focused on interactions between the banks and their clients who bought mortgage securities, “this one expands the scope of scrutiny to the interplay between banks and the agencies that rate their securities”.

For the rest of the article go to: See also Yves Smith's post at Naked Capitalism:

The interesting bit is from a legal standpoint, the logical response for the investment banks would be to say the credit agency models were bunk, the way that correlation models that were developed in the corporate loan market were repurposed to the asset backed securities market was problematic. But the difficulty here is the banks were hawking correlation products and correlation trading strategies; they were even deeper into these approaches than the rating agencies. So Cuomo may indeed be able to land a very solid blow if his inquiry does establish that the investment banks misrepresented

And at Reuters Felix Salmon updates us on the Abacus situation:

Meanwhile, the WSJ has a bit more information on the case against Morgan Stanley, adding that it’s not only Dead Presidents but also deals named ABSpoke and Baldwin being looked at:

Some CDO offering documents indicated that mortgage assets selected for the deals may have factored in the interests of market players whose interests were “adverse” to other investors. But none went as far as to state that hedge funds or banks’ trading desks were making bets against the deals for their own accounts, according to documents reviewed by the Journal.

This is essentially a slightly weaker version of the case against Goldman in the Abacus deal. In that case, the SEC is saying that Goldman implied to investors that the person structuring the deal was long when in fact he was massively short. In these cases, the banks did make a disclosure about adverse interests, but didn’t go as far as they should have done in terms of revealing that they themselves intended to hold on to the short position.

Again, the same political calculus applies: it’s incredibly dangerous to take the Goldman route of fighting the accusations aggressively. Better, I think, to just cooperate fully with the SEC and see what happens. And, of course, if and when the relevant Wells notice arrives, to disclose that fact to investors immediately.

For the rest of the article go to: Also Tracy Alloway at FT Alphaville is providing more detail on the Morgan Stanley "Dead Presidents" deals here:

Tuesday, May 11, 2010

FDIC Board Approves NPR Regarding Safe Harbor Protection for Securitizations

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a Notice of Proposed Rulemaking (NPR) to clarify the safe harbor protection in a conservatorship or receivership for financial assets transferred by an insured depository institution (IDI) in connection with a securitization or participation. This action was necessitated by the changes adopted by the Financial Accounting Standards Board in June 2009 to the accounting standards on which the FDIC's prior rule, 12 C.F.R. Part 360.6, was based.

In March, the FDIC Board extended a transitional safe harbor that permanently grandfathered securitization or participations in process through September 30, 2010. Earlier this year, the FDIC Board approved for public comment an ANPR regarding what standards should be applied to securitizations seeking safe harbor treatment for transactions created after September 30th. Conditions for safe harbor treatment focused on greater clarity in the securitization capital structure, enhanced disclosure requirements, and risk retention and origination requirements.

The FDIC received comments on the ANPR from a wide variety of interested parties. In response, the FDIC has proposed some changes to the standards in the NPR, but has retained a clear focus on improved transparency and a better alignment of incentives for strong underwriting in the securitization process. Among the key proposed changes from the sample regulatory text included with the ANPR, the FDIC is proposing 1) a 5% reserve fund for RMBS in order to cover potential put backs during the first year of the securitization, rather than the prior 12 month seasoning requirement; 2) required disclosure of any competing ownership interests held by the servicer, or its affiliates, in other loans secured by the same property; and 3) requiring deferred compensation only for rating agencies, rather than all service providers. The NPR also includes clarifications of the prior text to simplify compliance. Significantly, the FDIC's proposed disclosure and risk retention requirements are aligned with those proposed in April by the Securities and Exchange Commission. Upon final adoption by the SEC of the disclosure requirements in the new Regulation AB, the FDIC anticipates that compliance with those requirements will satisfy the disclosure requirements in the FDIC's proposed rule. The FDIC will continue to work closely with the SEC on these issues.

FDIC Chairman Bair said, "The market is clearly trying to find a new securitization model, with investors placing a premium on transparency throughout the process. With the system awash in cash, investor appetite is coming back. Now is the time to act to put prudent controls in place before the significant issues we saw during the crisis return."

"We must acknowledge the role that the "originate to distribute" model played during the crisis. Insured institutions and our economy have lost many billions because our mortgage finance system broke down."

"The proposed rule compliments other regulatory and legislative efforts to correct the weaknesses in securitization that contributed to the crisis. The proposed NPR will help support stronger, sustainable securitizations – that are consistent with securitization's role as a source of funding and risk management tool for insured banks."

The NPR will be open to public comment for 45 days following publication in the Federal Register.

Download the complete document here:

Darrell Duffie on Banning Naked CDS Transactions

Posted on Grasping Reality With Both Hands:

Among other things, [the amendment to the Senate financial reform bill that would ban naked CDS transactions] means a big limitation on the entire securitization market, since in many cases the loan default risk is transferred into the structured credit product through a CDS. (This is not to be confused with a synthetic CDO, which is much different, and not such a big loss in my view.) So, lots of loans to ordinary individual Americans (their credit card loans, home equity loans, mortgages, and so on) and American operating companies will get somewhat more expensive. (This effect is not huge. Credit card or home equity interest rates will not go up 4%, say, but they would be higher because of this, other things equal.) [Disclosure: I am a director of Moody's Corporation since late 2008. Moody's makes money rating these products. There would be fewer of them to rate if this passes.]

There seems to be a presumption that buying CDS protection is fine as long as you have lent money to the borrower. That's a bad presumption. Example: I lend you money. There are covenants on the loan that protect me by requiring you to run your business prudently, and to not borrow too much. Then I ask a CDS protection seller, X, to sell me protection on you. Now I don't care if you default or not, so I won't worry about monitoring or enforcing those covenants, because X will pay me if you go under. Bad news. Even worse, where it might be efficient to help you avoid default, so that I can eventually get my money back, I will pull the rug from under you by calling in the loan. You won't be able to pay me back, but I am covered by X. Bad news. CDS can be misused more easily by those buying protection when having lent to the borrower ("legitimate CDS" in this amendment), than by those who have not lent, and have no ability to affect the borrower.

Lost ability of Americans to reduce their risk. Another Example: This one was part of testimony to the House Financial Services last week, on the panel on which I sat. A congressman (Rep. Manzullo, I think) asked how John Deere, a tractor manufacturer in his district, could use derivatives in its business. I gave an example in which John Deere sells 1000 tractors to a Greek company. Another panelist, Bob Pickel, explained that the Greek buyer of tractors would probably not be available as a referenced name in the CDS market, but that John Deere could get a reasonable hedge against the default risk of Greek firms by buying CDS protection referencing Greek sovereign bonds. That is true. But, this amendment would rule that out. John Deere would be unable to hedge the default risk on the receivables of its tractor sales. This is just one of many examples in which CDS protection buyers who reference a proxy name to get a hedge would no longer be able to hedge. Also, the definition of a "valid credit instrument" will probably be too narrow to allow people to hedge against losses when a borrower defaults that are not losses on a valid credit instrument. For example, if Company X defaults, I will lose the opportunity to collect money owed to me on the foreign exchange derivatives I have with X. If Country Y defaults, the market value of my factories in Country Y would decline precipitously. I could no longer hedge that. Why would anyone want to prevent an American company from protecting itself from losses this way?

The reporting requirement is redundant. All CDS and all other OTC derivatives in the SEC's regulatory domain will be required to be reported to the SEC already under the "data repositories" provision of the bill.

The restriction of a maximum of 60 days for a dealer to be "short" without owning a credit instrument is not very elegant, to say the least.

If it passes, it will not be the end of the world, but it is a step backward. The cost-benefit analysis: Cost: moderate. Benefit: none that I can see...

CPSS and IOSCO consult on policy guidance for central counterparties and trade repositories in the OTC derivatives market

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have today issued two consultative reports containing proposals aimed at strengthening the OTC derivatives market.

The first report, Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties (RCCP) to OTC derivatives CCPs, presents guidance for central counterparties (CCPs) that clear over-the-counter (OTC) derivatives products.

The second report, Considerations for trade repositories in OTC derivatives markets, presents a set of considerations for trade repositories (TRs) in OTC derivatives markets and for relevant authorities over TRs.

"These two complementary sets of high-level guidance constitute an important response of the CPSS and IOSCO to the recent financial crisis. They also reflect the G20's recommendations for the strengthening of the OTC derivatives market," said William C Dudley, CPSS Chairman, and Kathleen Casey, Chairman of the Technical Committee of IOSCO.

Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs

In response to the recent financial crisis, authorities in many jurisdictions have set out important policy initiatives encouraging greater use of CCPs for OTC derivatives markets. Recently, several CCPs have begun to provide clearing and settlement services for OTC credit default swaps. A CCP interposes itself between counterparties to financial transactions, acting as the buyer to every seller and the seller to every buyer.

Mr Dudley and Ms Casey said: "This is a positive development because a well designed CCP can reduce the risks and uncertainties faced by market participants and contribute to financial stability. As the greater use of CCPs for OTC derivatives will increase their systemic importance, it is critical that their risk management should be robust and comprehensive. Moreover, because of the complex risk characteristics and market design of OTC derivatives products, clearing them safely and efficiently through a CCP raises more complex issues than the clearing of exchange-traded or cash products does."

These issues were not fully discussed in the 2004 report of the existing RCCP. Consequently, the CPSS and the Technical Committee of IOSCO have identified such issues and developed international guidance tailored to the unique characteristics of OTC derivatives products and markets. The aim is to promote consistent interpretation, understanding and implementation of the RCCP across CCPs that handle OTC derivatives.

Considerations for trade repositories in OTC derivatives markets

The financial crisis highlighted a severe lack of market transparency in OTC derivatives markets. As an important step in addressing this issue, OTC derivatives market participants, with the support of the regulatory community, are committed to establishing and making use of trade repositories. A TR in OTC derivatives markets is a centralised registry that maintains an electronic database of open OTC derivative transaction records.

Mr Dudley and Ms Casey said: "The CPSS and the Technical Committee of IOSCO welcome various ongoing industry initiatives and associated close regulatory cooperation in this relatively new area of the financial market infrastructure, which will play a key role in identifying signs of systemic risk and threats to market integrity in the future financial system".

Recognising the growing importance of TRs in enhancing market transparency and supporting clearing and settlement arrangements for OTC derivatives transactions, the CPSS and the Technical Committee of IOSCO have developed a set of factors that should be considered by TRs in designing and operating their services and by relevant authorities in regulating and overseeing TRs.

Consultation process

The two reports are being issued as consultation documents. Comments are invited from any interested parties by 25 June 2010 (for contact details, see Note 1). There will be an outreach event with the industry as part of the consultation process.

The CPSS and the Technical Committee of IOSCO do not plan to issue finalised reports after the consultation period. Instead, the guidance presented in the reports, as well as the feedback received in the consultation process, will be incorporated in the general review of the international standards for financial market infrastructures that was launched by the CPSS and the Technical Committee of IOSCO in February this year.


  1. Comments on Guidance on the application of 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs should be sent to both the CPSS Secretariat ( and the IOSCO secretariat (
    Comments on Considerations for trade repositories in OTC derivatives markets should be sent to both the CPSS Secretariat ( and the IOSCO secretariat (
    The comments will be published on the websites of the Bank for International Settlements and IOSCO unless commentators have requested otherwise.
  2. The start of the general review of the international standards for financial market infrastructures was announced by the CPSS and the Technical Committee of IOSCO in their press release of 2 February 2010 (available on the websites of the BIS and IOSCO).
  3. The reports have been prepared for the CPSS and the Technical Committee of IOSCO by a joint CPSS-IOSCO working group co-chaired by Daniela Russo at the European Central Bank and Jeffrey Mooney at the US Securities and Exchange Commission.
  4. The Committee on Payment and Settlement Systems (CPSS) serves as a forum for central banks to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The chairman of the CPSS is William C Dudley, President of the Federal Reserve Bank of New York. The CPSS secretariat is hosted by the BIS. More information about the CPSS and all its publications can be found on the BIS website at
  5. IOSCO is recognised as the leading international policy forum for securities regulators. The organisation's membership regulates more than 95% of the world's securities markets in over 100 jurisdictions, and its membership is steadily growing.
  6. The Technical Committee, a specialised working group established by IOSCO's Executive Committee, is made up of 18 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms Kathleen Casey, a Commissioner of the US Securities and Exchange Commission, is the Chairman of the Technical Committee. The members of the Technical Committee are Australia, Brazil, China, France, Germany, Hong Kong SAR, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, the United Kingdom and the United States.