Market Pipeline

What's holding back the restart of the private-label MBS market?

2011-02-17T10:00:00.000-08:00

Testimony of Michael A.J. Farrell, Chairman, Chief Executive Officer and President Annaly Capital Management, Inc. Before the U.S. House of Representatives Insurance, Housing and Community Opportunity Subcommittee of the Committee on Financial Services Hearing on “Are There Government Barriers to the Housing Market Recovery?” (February 16, 2011 in Washington, DC)

Good afternoon, Chairwoman Biggert, Ranking Member Gutierrez, and Members of the Committee. My name is Michael Farrell, and I run Annaly Capital Management, the largest residential mortgage Real Estate Investment Trust (or REIT) on the New York Stock Exchange. I also oversee the management of Chimera Investment Corporation, the second largest mortgage REIT. Annaly and our subsidiaries and affiliates together own or manage about $100 billion of primarily Agency and non‐Agency residential mortgage‐backed securities (or MBS).

I represent an important constituency in the housing market, the secondary mortgage market investors who provide the majority of the capital to finance America’s homeowners. Just for the Annaly family of companies, we estimate that through our MBS holdings our shareholders collectively help finance the homes of almost one million American households.

I’d like to begin by focusing on the fact that secondary mortgage market investors provide 75% of the capital to the US housing market. That is, of the approximately $10 trillion in outstanding home mortgage debt in the US, about $7.5 trillion is funded by investors in MBS. Of that $7.5 trillion, about $5.5 trillion is held by rate‐sensitive investors in Agency MBS, with about $2 trillion in credit‐sensitive private‐label MBS. The balance, or about $2.5 trillion, is held in raw loan form, primarily on bank balance sheets. Since our country’s banks have about $12 trillion in total assets, there is not enough money in the banking system to fund our nation’s housing stock, at least not at current levels. It is thus axiomatic that without a healthy securitization market our housing finance system would have to undergo a radical transformation.

Right now, securitization is attracting significant amounts of private capital, at least to the part of the MBS market that is government wrapped. This is to be expected, as this market always gains market share in counter‐cyclical fashion. The problem is that the credit‐sensitive, non‐Agency sector of the market, or the so‐called private‐label market, is dormant, with only one small deal done in the last 2 ½ years.

I will now discuss several reasons why the private‐label market is not restarting.

First, the economics don’t work. In order for the math to work, either primary mortgage rates have to rise, the rating agencies’ senior/subordinate splits have to come down, and/or return requirements by the secondary market have to decline. And yes, for good or for ill, the private‐label market is still critically dependent on the rating agencies as the arbiter of credit quality.

Second, there is a higher yielding alternative for investors who want to take residential mortgage credit risk—legacy private label MBS and seasoned loans that have been repriced by the market after the events of the last few years. The return to investors from re‐securitizing legacy MBS is higher than securitizing new mortgage loans. As long as this relative value disparity exists, it will impede the restart of the new‐issue private‐label market.

The third reason is the difficulty in sourcing enough newly‐originated loans. Without the outlet to sell mortgages into securitizations, banks have gotten more comfortable holding non‐conforming loans on their balance sheets, but only by tightening underwriting standards, including requiring sizable down payments. As long as underwriting standards are so stringent, I don’t see a vibrant private‐label market developing.

The fourth reason is the uncertainty over the future regulatory environment. The many different mortgage modification programs and delays in foreclosures have made it difficult for investors to analyze cash flows. The uncertainty over the capital rules related to the definition of “Qualified Residential Mortgages” and risk retention and Basel III is also putting a chill on the lending markets and concentrating origination in only the few largest banks. Will lowering the conforming loan limit, reducing FHA’s reach or raising guarantee fees help re‐start the private label market? That is unclear. These efforts are a step in the right direction toward giving lenders more options and reducing the government’s footprint, but they don’t necessarily address the issues I have discussed. Those no‐longer conforming borrowers could face much tighter underwriting standards, and higher guarantee fees for conforming mortgages will likely just show up in non‐conforming mortgage spreads.

Finally, I want to get to the heart of the current debate: Can the private label MBS market come back to fill the credit gap that is currently filled by the GSEs? The short answer is: Yes it can, but not at the same price and not in the same size. Most investors in Agency MBS won’t invest in private label MBS at any price or only in much reduced amounts, because their investment guidelines preclude taking credit risk.

These investors include money market funds, mutual funds, banks, foreign investors, and governmental agencies. Some rates investors could cross over, but we won’t know how many or at what price until we know a lot more about a lot of things. But at the end of the day I have to refer back to my two market truths: Securitization is the source of 75% of the capital to the housing market, and the private label securitization market isn’t working right now.

Following the Short Seller: Do Short Selling Bans Prevent Herding During Financial Crises?

2011-01-30T23:25:00.000-08:00

By Pierre L. Siklos, Martin T. Bohl and Arne Klein

Abstract: In the literature on short selling restrictions, their impact on pricing efficiency liquidity and trading costs is mostly investigated. Surprisingly little is known about the effects of short selling restrictions on institutional investors' herding behavior. If short selling bans hinder institutional investors from herding during stock market downturns, regulators have a successful tool to prevent further stock price declines. However, our empirical findings for six stock markets do not support this hypothesis.

Download: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1744365

Adverse Selection, Liquidity, and Market Breakdown (Bank of Canada)

2011-01-08T13:06:00.000-08:00

By Koralai Kirabaeva

Abstract: This paper studies the interaction between adverse selection, liquidity risk and beliefs about systemic risk in determining market liquidity, asset prices and welfare. Even a small amount of adverse selection in the asset market can lead to fire-sale pricing and possibly to a market breakdown if it is accompanied by a flight-to-liquidity, a misassessment of systemic risk, or uncertainty about asset values. The ability to trade based on private information improves welfare if adverse selection does not lead to a market breakdown. Informed trading allows financial institutions to reduce idiosyncratic risks, but it exacerbates their exposure to systemic risk. Further, I show that in a market equilibrium, financial institutions overinvest into risky illiquid assets (relative to the constrained efficient allocation), which creates systemic externalities. Also, I explore possible policy responses and discuss their effectiveness.

Download here: www.bankofcanada.ca/en/res/wp/2010/wp10-32.html

Systemic Risk and the U.S. Insurance Sector (SSRN)

2011-01-05T04:39:00.000-08:00

By John David Cummins and Mary A. Weiss

Abstract: This paper examines the potential for the U.S. insurance industry to cause systemic risk events that spill over to other segments of the economy. We examine primary indicators that determine whether institutions are systemically risky as well as contributing factors that exacerbate vulnerability to systemic events. Evaluation of systemic risk is based on a detailed financial analysis of the insurance industry, its role in the economy, and the interconnectedness of insurers. The primary conclusion is that the core activities of the U.S. insurers do not pose systemic risk. However, life insurers are vulnerable to intra-sector crises because of leverage and liquidity risk; and both life and property-casualty insurers are vulnerable to reinsurance crises arising from counterparty credit exposure. Non-core activities such as derivatives trading have the potential to cause systemic risk, and most global insurance organizations have exposure to derivatives markets. To reduce systemic risk from non-core activities, regulators need to develop better mechanisms for insurance group supervision.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1725512

CEBS final guidelines on Article 122a of the CRD

2011-01-03T06:00:00.000-08:00

The Committee of European Banking Supervisors (CEBS) has today published its final guidelines on the application of Article 122a of the Capital Requirements Directive (CRD).

Article 122a of the CRD provides new requirements to be fulfilled by credit institutions when acting in a particular capacity, such as originator or sponsor, and also when investing in securitisations. These include retention on an on-going basis of a material net economic interest of not less than 5% (so called “skin in the game”), due diligence and disclosure.

Following the amendments made to the CRD relating to securitisations, CEBS is required to issue guidelines ensuring convergence of supervisory practices with regard to the application of Article 122a. In particular, guidance is required on the implementation of the retention clause by the originator, the sponsor or original lender and on the due diligence and risk management practices credit institutions are asked to carry out when investing in securitisation positions.

Besides fostering a common understanding among the competent authorities across the EEA on the implementation and application of Article 122a, the current guidelines provide clarity as well as greater transparency for market participants in order to assist compliance by credit institutions with the relevant requirements of the Directive. In particular, CEBS provides an updated framework for competent authorities to apply an additional risk weight for infringements of the provisions of Article 122a.

In delivering its guidelines, CEBS has benefited from the views gathered from market participants through the responses to the public consultation (CP40) which ended on 1 October 2010, and through a public hearing held on 22 July 2010.

CEBS expects its Members to adopt the guidelines into their national supervisory framework and apply them from 1 January 2011, that is, when the new Directive provisions come into force.

Download the details here: www.eba.europa.eu/News--Communications/Latest-news/CEBS-has-today-published-its-final-guidelines-on-t.aspx

What We Don't Know We Don't Know (Gregory J. Gordon, SSRN)

2010-12-30T08:33:00.000-08:00

Abstract: Do you read everything in your field today? Do you even know what everything means any more? Readers of scholarly research are faced with an overabundance of information due to interdisciplinary subject areas, access to research at earlier and multiple stages, and simply more research from more scholars. My simple definition of innovation is the ability to create new things by being exposed to a broader and deeper set of existing things, but broader and deeper have their limits. There is no substitute for reading and truly comprehending a specific article, but there aren’t enough hours in the day to read everything. We need better tools to know what research we need to read. We need to know what we don’t know.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1710009

The dark side of financial innovation (SSRN)

2010-12-25T08:20:00.000-08:00

By Brian J. Henderson and Neil D. Pearson

Abstract: The offering prices of 64 issues of a popular retail structured equity product were, on average, almost 8% greater than estimates of the products’ fair market values obtained using option pricing methods. Under reasonable assumptions about the underlying stocks’ expected returns, the mean expected return estimate on the structured products is slightly below zero. The products do not provide tax, liquidity, or other benefits, and it is difficult to rationalize their purchase by informed rational investors. Our findings are, however, consistent with the recent hypothesis that issuing firms might shroud some aspects of innovative securities or introduce complexity to exploit uninformed investors.

Published in the Journal of Financial Economics ($$) but the working paper version is available here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1342654

Derivatives in emerging markets (BIS)

2010-12-12T19:25:00.000-08:00

by Dubravko Mihaljek and Frank Packer

Abstract: Turnover of derivatives has grown more rapidly in emerging markets than in developed countries. Foreign exchange derivatives are the most commonly traded of all risk categories, with increasingly frequent turnover in emerging market currencies and a growing share of cross-border transactions. As the global reach of the financial centres in emerging Asia has expanded, the offshore trading of many emerging market currency derivatives has risen as well. Growth in derivatives turnover is positively related to trade, financial activity and per capita income.

Download here: www.bis.org/publ/qtrpdf/r_qt1012f.htm

User's guide to the Triennial Central Bank Survey of FX market activity (BIS)

2010-12-12T19:23:00.000-08:00

by Michael R King and Carlos Mallo

Abstract: This article provides an overview of the foreign exchange components of the Triennial Central Bank Survey. It highlights key dimensions of this dataset and methodological issues that are important to interpret it correctly. It also compares the methodology of the Triennial Survey to that of more frequent surveys from regional foreign exchange committees.

Download here: www.bis.org/publ/qtrpdf/r_qt1012h.htm

Emanuel Derman on Metaphors, Models & Theories

2010-11-23T14:42:00.000-08:00

Abstract: Theories deal with the world on its own terms, absolutely. Models are metaphors, relative descriptions of the object of their attention that compare it to something similar already better understood via theories. Models are reductions in dimensionality that always simplify and sweep dirt under the rug. Theories tell you what something is. Models tell you merely what something is partially like.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1713405

FSB publishes report on improving OTC derivatives markets

2010-10-25T20:15:00.000-07:00

The Financial Stability Board (FSB) published today a report on Implementing OTC Derivatives Market Reforms. The report responds to calls by G20 Leaders at the Pittsburgh and Toronto Summits to improve the functioning, transparency and regulatory oversight of over-the-counter (OTC) derivatives markets..

The report sets out recommendations to implement the G20 commitments concerning standardisation, central clearing, organised platform trading, and reporting to trade repositories. The report represents a first step toward consistent implementation of these commitments. Authorities will need to coordinate closely to minimise the potential for regulatory arbitrage.

The report was developed by a working group comprising international standard setters and authorities with the responsibility for translating the G20 commitments into standards implementing regulations.

It can be downloaded here: www.financialstabilityboard.org/publications/r_101025.pdf

Joint Forum Report on Developments in Modelling Risk Aggregation

2010-10-21T09:51:00.000-07:00

The report suggests improvements to the current modelling techniques used by complex firms to aggregate risks. It also examines supervisory approaches to firms' use of risk aggregation models, particularly in light of the global financial crisis.

Mr Tony D'Aloisio, Chairman of the Joint Forum and Chairman of the Australian Securities and Investments Commission, said "This report is essential reading for firms considering ways to make more effective use of risk aggregation methods, and for supervisors wanting to understand firms' use of risk aggregation models to help identify shortcomings in a firm's approach."

Key Findings

Despite recent advances, models currently in use have not adapted to support all the functions and decisions for which they are now used. Firms using these models may not fully understand the risks they face, including tail events.
While some firms are addressing these issues - particularly the treatment of tail events - others are not.
Firms face a range of practical challenges when modelling risk aggregation. These include managing the volume and quality of data and communicating results in a meaningful way. Despite these challenges, the Joint Forum found that firms have little or no appetite for fundamentally reassessing or reviewing how risk aggregation processes are managed.
In carrying out their responsibilities, supervisors generally do not rely on aggregation models currently used by firms as they are generally considered a "work in progress" with best practices yet to be established. Substantial improvements and refinements in methods - particularly in aggregating across risk classes - are needed before supervisors are likely to be comfortable in placing reliance on these models for supervisory purposes.

Key Recommendations

Firms should improve their risk aggregation techniques, for example by reassessing and reorienting models according to their purpose and function. Such improvements will assist firms to better comprehend the risks they face.
Firms using models for risk identification and monitoring purposes should ensure they are sufficiently sensitive, granular, flexible and clear. Models used for capital adequacy and solvency purposes should be improved to better reflect tail events.
Supervisors should recognise the risks posed by continued use of current aggregation processes and methods. Supervisors are urged to communicate their concerns to firms while highlighting the benefits of appropriately calibrated and well-functioning aggregation models for improved decision making and risk management. Supervisors should work with firms to implement these improvements.

Full publication (PDF 113 pages, 572 kb)

Macroprudential policy, tools and systems for the future

2010-10-20T04:26:00.000-07:00

In its newest report on Macroprudential Policy, the Group of Thirty calls for urgent action to strengthen system-wide financial regulation and supervision.

The report calls on public officials to empower systemic financial regulators with new tools to enhance economic stability and potentially lessen the severity of future economic crises. These tools would address leverage, liquidity, credit and supervision. The report underscores the fact that while policy action may be difficult and controversial, robust action is necessary.

For more information on the release of the report, visit the publication's press page.

You may also download the executive summary of the report, or purchase the publication in its entirety. It is also available for free here.

A survey of current regulatory trends - report of the IBA Task Force on the Financial Crisis

2010-10-20T04:21:00.000-07:00

The International Bar Association’s Task Force on the Financial Crisis has released a new report:
A Survey of Current Regulatory Trends, dated October 2010. This report features an overview of the work of the Task Force from its Chair, Hendrik Haag, as well as updates on regulation from diverse jurisdictions: the US, the UK, Germany, Switzerland, France, Spain, Japan and Russia.

Download here: www.ibanet.org/Document/Default.aspx?DocumentUid=D36C2638-F82C-4AA4-97D7-4234C5FFBB7C

Satyajit Das on the European Financial Stability Facility (”EFSF”)

2010-09-30T04:42:00.000-07:00

In a guest post on Naked Capitalism, Satyajit Das critiques the European Financial Stability Facility (”EFSF”):

In order to finance member countries as needed, the EFSF will need to issue debt. The major rating agencies have awarded the fund the highest possible credit rating AAA.

The EFSF structure echoes the ill-fated Collateralised Debt Obligations (”CDOs”) and Structured Investment Vehicles (”SIV”). The Moody’s rating approach explicitly draws the analogy and uses CDO rating methodology in arriving at the rating.

The Euro 440 billion ($520 billion) rescue package establishes a special purpose vehicle (”SPV”), backed by individual guarantees provided by all 19-member countries. Significantly, the guarantees are not joint and several, reflecting the political necessity, especially for Germany, of avoiding joint liability. The risk that an individual guarantor fails to supply its share of funds is covered by a surplus “cushion”, requiring countries to guarantee an extra 20% beyond their shares. A cash reserve will provide additional support.

Given the well-publicised and deep financial problems of some Euro-zone members, the effectiveness of the cushion is crucial. The arrangement is similar to the over-collateralisation used in CDO’s to protect investors in higher quality AAA rated senior securities. Investors in subordinated securities, ranking below the senior investors, absorb the first losses up to a specified point (the attachment point). Losses are considered statistically unlikely to reach this attachment point, allowing the senior securities to be rated AAA. The same logic is utilised in rating EFSF bonds.

If 16.7% of guarantors (20% divided by 120%) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount. Greece whilst an Eurozone member will not participate in EFSF’s lending programs as a provider of guarantees for the obvious reason that nobody would seriously place much value on any such guarantee.

Unfortunately, the Global Financial Crisis illustrated that modelling techniques for rating such structures are imperfect. The adequacy of the cushion is unknown. If one peripheral Euro-zone members has a problem then others will have similar problems. If one country requires financing, guarantors of the EFSF will face demands at the exact time that they themselves will be financially vulnerable.

Rubbery Numbers

The rating analysis published by the Agencies highlights subtle but extremely significant features in the structure designed to ensure the desired AAA rating.

Where an Eurozone member draws on the facility, the amount of funds on lent by EFSF will be adjusted by the following deductions:

A 50 basis point service fee
A percentage equal to the net present value of EFSF’s on-lending margin. For example, the Greek financing package had a margin of 300 basis points. This would translate into a deduction of around 13-14% (depending on the discount rate applied).
[1 and 2 constitute a fungible general cash reserve ("the Reserve") which will support all EFSF debt.]
An additional reserve specific to each loan made by EFSF (”the Buffer”) will be created. The exact methodology of determining this buffer has not been disclosed but will determined by several factors. The first factor will be the borrower and it credit condition. The second will be the position EFSF itself and the level of credit support available for its existing obligations.

The Reserve and Buffer are to be invested in liquid AAA rated government, supranational, or agency securities to be available as credit support for the EFSF’s obligations.

The requirement for the Reserve and Buffer significantly reduces the amount of funds available from the EFSF. Standard & Poor’s (”S&P”) estimated that after adjusting for the guarantee overcollateralization and the exclusion of Greece from EFSF’s program, the EFSF can raise up to Euro 350 billion (20% lower than the announced amount). After adjustment for the fact that borrowing governments cannot guarantee EFSF bonds and deduction of the Reserve and Buffer the potential available EFSF lending is further reduced.

Assuming a Reserve of say 13.5% and a Buffer of 10%, this would reduce the amount available to around Euro 270 billion (39% lower than the announced amount). Assuming an equivalent reduction in the IMF component of the package, the total amount available is around Euro 460 billion. The EFSF’s ability to lend compares to the forecast budget financing need of Greece, Ireland, Portugal and Spain of over Euro 500 billion in the period 2009 to 2013.

The structure outlined also increases the cost of the funding for borrowers drawing on the EFSF facility. This additional cost is generated by the fact that the Reserve and Buffer has to be invested in securities that may earn less than the interest paid by EFSF on any issue.

In order to attain the coveted AAA rating, the EFSF structure has been “tweaked” subtly. For example, Moody’s states that “the Buffer is to be sized so that the remaining portion of the debt issue that is not fully backed by cash will be fully covered by contributions from Aaa-rated member states.” In essence this appears to confirm that the EFSF’s rating relies heavily on the support of the guarantees of AAA countries – currently Germany, France, The Netherlands, Austria, Finland, and Luxembourg. In reality this means that significant reliance is being placed on the larger parties such as Germany, France and the Netherlands.

If the EFSF is drawn upon and increasing reliance is placed on cornerstone guarantors such as Germany and France, it is not clear whether politically it will be possible for these countries to continue the facility beyond its original 3-year maturity. Interestingly, S&P state that: “… we consider it likely that its mandate would be extended if market conditions remained unsettled.”

For investors, there is a risk of rating migration, that is, a downgrade of the AAA rating. If the cushion is reduced by problems of an Euro-zone member, then there is a risk that the EFSF securities may be downgraded. Any such ratings downgrade would result in losses to investors. Recent downgrades to the credit rating of Portugal and Ireland highlight this risk.

Given the precarious position of some guarantors and their negative rating outlook, at a minimum, the risk of ratings volatility is significant. The rating agencies indicated that if a larger Euro-zone member encountered financial problems, then the rating and viability of the EFSF might be in jeopardy.

Investors may be cautious about investing in EFSF bonds and, at a minimum, may seek a significant yield premium. The ability of the EFSF to raise funds at the assumed low cost is not assured.

Ironically, the actual structure of credit enhancement encourages troubled countries to access the facility early to ensure its availability. The structure embodies an accelerating “negative feedback loop”.

As market conditions deteriorate, market access becomes limited and countries draw on the EFSF facility (eliminating them from the guaranty pool), increased financial pressure will be exerted on the AAA rated Eurozone countries. The need to maintain adequate coverage to preserve the EFSF’s AAA rating on existing debt will mean that the Buffer will increase and the capacity of the EFSF to lend may become impaired. Moody’s rating analysis indicates that in the event that a large number of countries simultaneously lose market access and draw on the facility, the current lending capacity of the EFSF would likely be overwhelmed. Moody’s believes that it would be unlikely that the EFSF would start issuing under those circumstances.

At this stage, the EFSF have indicated that they don’t plan to issue any debt, as they do not anticipate the facility being used. The facility also has a very short maturity, three years till 2013. The importance of these factors in the grant of the preliminary rating is unknown.

S&P correctly inferred that the “EFSF has been designed to bolster investor confidence and thus contain financing costs for Eurozone member states.” The agency indicated that if its establishment achieved this aim then the EFSF would not to need to issue bonds. However, if as pressures mount and market access becomes problematic for some Eurozone members, then the EFSF and it structure will be tested.

The EFSF’s structure raises significant doubts about its credit worthiness and funding arrangements. In turn, this creates uncertainty about the support for financially challenged Euro-zone members with significant implications for markets.

Financial Stability Board meets on the financial reform agenda

2010-09-28T04:45:00.001-07:00

The Financial Stability Board (FSB) met in Paris on 27 September. It reviewed risks and vulnerabilities affecting the global financial system and progress on the regulatory reform agenda under coordination by the FSB.

Vulnerabilities in the financial system

While considerable progress has been made in strengthening the resilience of the financial system worldwide, financial systems in advanced economies remain vulnerable to risks of fiscal strains in national and local governments, of renewed fragilities in bank funding markets and of weakening economic conditions. The potential for adverse feedback loops between weak economies, fragile banking systems, and fiscal strains remains significant. Further financial stability challenges arise from the continued reliance of some banks on support mechanisms, and from potential market pressures and risks of disorderly unwinding of large capital inflows to faster growing emerging markets.

The FSB emphasised the need to accelerate financial system repair by identifying and resolving weak banks in an orderly way, noting there are large benefits to a clear and systematic process which avoids forbearance. Intensified supervisory scrutiny in targeted areas is needed as well to stem undesirable side-effects of low interest rates and low market incentives for banks to adjust. Finally, authorities should continue to foster transparency through targeted consistent disclosures by financial institutions of risk factors that are most relevant to the market conditions at the time (e.g. sovereign risk during times of fiscal strains).

Progress on regulatory reforms

Basel III. FSB members welcomed the agreement reached by the Basel Committee’s governing body on the new bank capital and liquidity standards. The new standards will markedly increase the resilience of the banking system, by reducing the likelihood and severity of future financial crises and creating a less procyclical banking system that is better able to support long-term economic growth.

The FSB, with the Basel Committee, have assessed the macroeconomic impact of the transition to the stronger capital and liquidity standards. The final report of the Macroeconomic Assessment Group, taking into account the calibration and phase-in arrangements agreed in September, will be published later this year.

Addressing systemically important financial institutions. The FSB reviewed the development of policy approaches for addressing the “too big to fail” problems associated with systemically important financial institutions (SIFIs). It will make recommendations to G20 Leaders at the November Summit in Seoul covering the need for global SIFIs to have a higher loss absorption capacity; enabling the resolution of SIFIs without taxpayer solvency support; strengthening the intensity of SIFI supervision; and a peer review process to promote consistent national policies in this area.

Implementing central clearing and trade reporting of OTC derivatives. The FSB reviewed recommendations developed by an FSB Working Group to achieve the G20’s objectives to improve transparency, mitigate systemic risk and protect against market abuse in the over-the-counter (OTC) derivatives market. The draft recommendations promote consistent implementation across jurisdictions of measures to increase standardisation, central clearing and, where appropriate, exchange or electronic platform trading, and to have all OTC derivatives contracts reported to trade repositories. The report will be published at the time of the November G20 Summit in Seoul.

Reducing reliance on CRA ratings. The FSB reviewed principles being developed to reduce authorities’ and financial institutions’ reliance on credit rating agency (CRA) ratings. The goal of the principles is to reduce the cliff effects from CRA ratings that can amplify procyclicality and cause systemic disruption. The principles will call on authorities to reduce reliance on CRA ratings in rules and regulations, in order to reduce mechanistic market reliance on those ratings. The principles will be presented to G20 Finance Ministers and Central Bank Governors in October.

Regulating Systemic Risk

2010-09-12T23:34:00.000-07:00

By Steven L. Schwarcz and Iman Anabtawi

Abstract: Systemic risk management is at the forefront of financial regulatory agendas worldwide. The global financial crisis was a powerful demonstration of the inability and unwillingness of financial market participants to carry out the task of safeguarding the stability of the financial system. It also highlighted the enormous direct and indirect costs of addressing systemic crises after they have occurred, as opposed to attempting to prevent them from arising. Governments and international organizations are responding with measures intended to make the financial system more resilient to economic shocks, many of which will be implemented by regulatory bodies over time. These measures suffer, however, from the lack of a theoretical account of how systemic risk propagates within the financial system and why regulatory intervention is needed to disrupt it. In this Article, we address this deficiency by examining how systemic risk is transmitted. We then proceed to explain why, in the absence of regulation, market participants are poorly situated to disrupt the transmission of systemic risk. Finally, we advance a regulatory framework for correcting that market failure.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1670017

The payment system - payments, securities and derivatives, and the role of the Eurosystem

2010-09-09T04:28:00.000-07:00

The European Central Bank (ECB) has published a book entitled "The payment system - payments, securities and derivatives, and the role of the Eurosystem". It provides comprehensive insight into the handling of financial transactions and the functioning of the related financial market infrastructure - a core component of the financial system. It also explains the role and policies of the Eurosystem - which comprises the ECB and the 16 national central banks of the euro area - in this field. The book is in three parts.

The first provides insight into the market infrastructure of modern economies with a view to examining key concepts which have general validity and are thus applicable around the world. Emphasis is placed on the principles governing the functioning of the relevant systems and processes and the presentation of the underlying economic, business, legal, institutional, organisational and policy issues.

The second concentrates on issues concerning the market infrastructure for the handling of euro-denominated payments, securities and derivatives, as well as the most important EU legislation.

The third explains the operational, oversight and catalyst roles of the Eurosystem and the policies established by the Governing Council of the ECB in this field. It also considers the legal basis for the Eurosystem’s involvement and describes the transparent and cooperative approach adopted by the Eurosystem with a view to pursuing its public policy objectives while acting within a modern market economy environment.

Download the book here: www.eubusiness.com/topics/finance/payment-system-ecb.10

Tail VaR approach to measuring and managing systemic risk

2010-09-08T04:13:00.000-07:00

By Joseph H.T. Kim and Phelim P. Boyle, University of Waterloo

Abstract: This paper proposes a framework for measuring and managing systemic risk. Current approaches to solvency regulation have been criticized for their focus on individual firms rather than the system as a whole. Our procedure shows how an insurance program can be designed to deal with systemic risk through a risk charge on participating institutions. We use the Conditional Tail Expectation (Tail VaR) to compute the risk exposure and the premiums. One of the frequent criticisms of the current regulations is that the capital requirements have a pro-cyclical impact since they require extra capital in periods of extreme stress thus exacerbating a crisis. We show how to implement an insurance program that is counter-cyclical and we illustrate the procedure using a numerical example.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1666553

Explaining the Housing Bubble

2010-08-31T19:49:00.000-07:00

By Adam J. Levitin and Susan M. Wachter

Abstract: There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; government policies encouraging affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble, much less the parallel commercial real estate bubble.

This Article posits a new explanation for the housing bubble. It demonstrates that the bubble was a supply-side phenomenon, attributable to an excess of mispriced mortgage finance: mortgage finance spreads declined and volume increased, even as risk increased, a confluence attributable only to an oversupply of mortgage finance.

The mortgage finance supply glut occurred because markets failed to price risk correctly due to the complexity and heterogeneity of the private-label mortgage-backed securities (MBS) that began to dominate the market in 2004. The rise of private-label MBS exacerbated informational asymmetries between the financial institutions that intermediate mortgage finance and MBS investors. The result was overinvestment in MBS that boosted the financial intermediaries’ profits and enabled borrowers to bid up housing prices.

Despite mortgage securitization’s inherent informational asymmetries, it is critical for the continued availability of the long-term fixed-rate mortgage, which has been the bedrock of American homeownership since the Depression. The benefits of securitization, therefore, must be reconciled with the need for economic stability. The Article proposes the standardization of MBS to reduce complexity and heterogeneity in order to rebuild a sustainable, stable housing finance market based around the long-term fixed-rate mortgage.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1669401

Canada’s Very Own Mortgage Mess: The Laws and Programs Behind a National Dilemma

2010-08-30T04:38:00.000-07:00

By Nathan Hume, University of Toronto - Faculty of Law

Abstract: Canadian house prices require explanation. Despite a deep global recession and persistent credit crisis, they remain near record highs while prices elsewhere have plummeted. This article offers an institutional account of that anomaly. The insurance and securitization programs of the Canada Mortgage and Housing Corporation have insulated the Canadian mortgage and housing markets from recent turbulence. These large, unfamiliar programs also distort and may ultimately destabilize the Canadian economy. Arguments about asset bubbles are unproductive. This article explains these programs, their effects and their legal framework so that we can better discuss what to do with them.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1654340

FSA outlines a fundamental review of trading activity regulation

2010-08-27T05:42:00.000-07:00

The Financial Services Authority (FSA) has today published a discussion paper (DP) that considers fundamental changes to the regulation of trading activities – one of the key recommendations of the Turner Review following material trading losses incurred during the crisis.

Since the Turner Review was published, the Basel Committee on Banking Supervision (BCBS) has proposed several reforms to the prudential regime for banks and in addition has mandated a fundamental review of trading activities called for in the Turner Review.

The FSA believes that the delivery of a new, robust, long-term, approach to prudential requirements for trading activities is one of the key areas of regulatory reform that must be delivered to build a stronger financial system. The outcome of the BCBS’s fundamental review is central to achieving this objective internationally.

The DP describes the FSA’s current views and ideas in relation to major areas of reform that need to be considered to address areas of structural weakness that exacerbated the build up of risk before the financial crisis.

Paul Sharma, FSA director of prudential policy, said:

"There are clear benefits of participants in traded financial markets taking risks to facilitate a more efficient allocation of resources across the economy – where these gains in efficiency are real and the risks posed are adequately captured or controlled we are not seeking to undermine these activities.

"However, the financial crisis has highlighted that, for trading activities in particular, an over-reliance on the principles of efficient financial markets can lead to severe consequences when risks are misunderstood at a system-wide level. The balance needs to be redressed to ensure that risks posed to the system as a whole are more adequately reflected in the structure of prudential regulation."

The DP sets out a number of recommendations which are grouped into three key areas:

Valuation: We recommend an increased regulatory focus on the valuation of traded positions and think there is a need for a specific assessment of valuation uncertainty.
Coverage, coherence and the capital framework: We recommend changing the structure of the capital framework to bring greater coherence and reduce the opportunities for structural arbitrage within the banking sector and the wider financial system.
Risk management and modelling: We recommend specific measures aimed at improving firms’ risk management and modelling standards, and ensuring that these are aligned with regulatory objectives.

The closing date for responses is 26 November 2010. The FSA will issue a feedback statement in the first half of 2011.

Notes:

The Discussion Paper can be found on the FSA website.
The Turner Review can be found on the FSA website.
The FSA regulates the financial services industry and has five objectives under the Financial Services and Markets Act 2000: maintaining market confidence; promoting public understanding of the financial system; securing the appropriate degree of protection for consumers; fighting financial crime; and contributing to the protection and enhancement of the stability of the UK financial system.
See also FT Alphaville's summaries; Part 1, Part 2 and Part 3.

FHFA Releases First Conservator’s Report on the Enterprises’ Financial Condition

2010-08-27T04:36:00.000-07:00

Washington, DC - August 26, 2010 - The Federal Housing Finance Agency (FHFA) today released its first Conservator’s Report on the Enterprises’ Financial Condition. The Conservator’s Report provides an overview of key aspects of the financial condition of Fannie Mae and Freddie Mac (the Enterprises) during conservatorship. The report will be released on a quarterly basis following the filing of the Enterprises’ financial results with the Securities and Exchange Commission (SEC).

“FHFA initiated the Conservator’s Report to enhance public understanding of Fannie Mae’s and Freddie Mac’s financial performance and condition leading up to and during conservatorship,” said FHFA Acting Director Edward J. DeMarco.

The report includes information on Enterprise presence in the mortgage market; credit quality of Enterprise mortgage purchases; sources of Enterprise losses and capital reductions; and Enterprise loss mitigation activity. Information presented in the report includes:

• The key driver in the decline of the Enterprises’ capital from the end of 2007 through the second quarter of 2010 was the Single-Family Credit Guarantee business segment, which accounted for 73 percent of the capital reduction over that period. The bulk of this capital reduction was associated with losses from mortgages originated in 2006 and 2007.
• The Investments and Capital Markets business segment (which includes the retained portfolio and credit losses associated with private-label mortgage-backed securities) accounted for 9 percent of the capital reduction over the same period.
• Since the establishment of the conservatorships, the credit quality of the Enterprises’ new mortgage acquisitions has improved substantially. Single-family mortgages acquired by the Enterprises during conservatorship have, on average, higher credit scores and lower loanto- value ratios, resulting in lower early cumulative default rates.

Download the full report here: www.fhfa.gov/webfiles/16591/ConservatorsRpt82610.pdf

Structured Finance Influence on Financial Market Stability: Evaluation of current regulatory developments

2010-08-25T07:38:00.000-07:00

by Sebastian A. Schuetz of the University of Lüneburg

Abstract: In 2007 the world faced one of the biggest financial crises ever. It was the third important financial crisis in the last 12 years. Spillovers to the real economy and moral hazard behaviour of carpetbaggers resulted in enormous pressure on worldwide political institutions to approve a more rigorous regulation on financial institutions and predict financial crises via early warning systems. We analyzed the performance of structured finance ratings and structured finance issuance/outstanding to detect the main shortcomings of the subprime crisis. Afterwards we explain the behaviour of market participants with theoretical models and a survey of institutions involved in securitization. With the conclusions of this analysis we evaluate the EU regulation on credit rating agencies and current Basel II enhancements. Finally we can determine that most regulatory enhancements are in accordance with our analyzed shortcomings. Some approaches like the introduction of a leverage ratio are counterproductive and a danger for worldwide economic growth.

Download here: www.defaultrisk.com/pp_super_75.htm

Oliver Wyman: Risk Management Practices Still Inadequate

2010-08-12T04:35:00.000-07:00

The second Oliver Wyman / Financial Times Global Emerging Risks Survey of 650 senior executives at global companies with revenues of more than $1 billion finds that most executives consider their firms' risk management practices to be inadequate. Despite significant investments in improving their risk management capabilities since the financial crisis first started, over 60% of senior managers still believe their firms are "ineffective" or only "moderately effective" at incorporating emerging risks into their decision making.

"I'm surprised at how little progress has been made. So many companies have worked to improve their risk management practices since the financial crisis started," says Oliver Wyman partner Alex Wittenberg. "Yet many of the current approaches to managing emerging risks are not providing companies with the business information they need, leaving many vulnerable to a wide range of potential sudden shocks."

The results clearly show that even with their renewed focus on managing risk, most companies still fail to take information about emerging risks into account. Emerging risks are defined as both new risks, such as this year's eruption of volcanic ash in Iceland, and familiar risks in unfamiliar conditions, as when volatile commodity prices suddenly become some of the largest costs for businesses such as airlines and consumer products manufacturers. That general lack of progress is especially troubling given that 71% of respondents view global recession as the greatest risk to their business.

This report makes recommendations for how risk management programs should address not only traditional risks but also new risks that threaten to change the rules of the game.

Reasons for the serious disconnect between companies' approaches to assessing risks and effectively using the information to make better decisions highlighted in the report include:

Many boards of directors receive emerging risk information only infrequently.

Many executives rely on basic, "static" risk analytics and tools rather than multidimensional approaches that take advantage of a wide range of outside data.

Immediate and pressing financial events have pushed risks not directly related to their business, such as climate change or pandemics, off most executives' radar screens.

Only half of executives surveyed integrate emerging risk information into their strategic planning process.

For more information about this report, please visit www.oliverwyman.com/ow/risk_survey_2010.htm

Into the Abyss: What If Nothing is Risk Free? (SSRN)

2010-08-02T04:28:00.000-07:00

By Aswath Damodaran, New York University - Stern School of Business

Abstract: In corporate finance and investment analysis, we assume that there is an investment with a guaranteed return that offers both firms and investors a “risk free” choice. This assumption, innocuous though it may seem, is a critical component of both risk and return models and corporate financial theory. But what if there is no risk free investment? During the banking crisis of 2008, this question came to the fore, as investors began questioning the credit worthiness of US treasuries, UK gilts and German bonds. In effect, the fear that governments can default, hitherto restricted to risky, emerging markets, had seeped into developed markets as well. In this paper, we examine why governments may default, even on local currency bonds, and the consequences. We also look at how best to estimate a risk free rate, when no default free entity exists, and the effects on both investors and firms. In particular, we argue that the absence of a risk free investment will make investors collectively more risk averse, thus reducing the prices of all risky assets, and induce firms to borrow less money and pay out lower dividends.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1648164

Funding liquidity risk: definition and measurement (BIS)

2010-07-20T10:57:00.000-07:00

by Mathias Drehmann and Kleopatra Nikolaou

Abstract: Funding liquidity risk has played a key role in all historical banking crises. Nevertheless, a measure based on publicly available data remains so far elusive. We address this gap by showing that aggressive bidding at central bank auctions reveals funding liquidity risk. We can extract an insurance premium from banks' bids which we propose as measure of funding liquidity risk. Using a unique data set consisting of all bids in the main refinancing operation auctions conducted at the ECB between June 2005 and October 2008 we find that funding liquidity risk is typically stable and low, with occasional spikes, especially around key events during the recent crisis. We also document downward spirals between funding liquidity risk and market liquidity. As measurement without clear definitions is impossible, we initially provide definitions of funding liquidity and funding liquidity risk.

Download here: www.bis.org/publ/work316.htm

European Repo Market White Paper Emphasises Importance Of Repo And Urges Reform Of Market Infrastructure

2010-07-14T05:40:00.000-07:00

(Press Release) ICMA’s European Repo Council (ERC) has today published a White Paper on the European repo market, including the role of short-selling, the problem of settlement failures and the need for reform of the market infrastructure. It emphasises the importance of the repo market for the efficiency and stability of the financial system.

The White Paper was commissioned by ICMA’s ERC in response to current regulatory considerations which will impact the repo market. There is concern that regulatory initiatives should not constrain the capacity of the repo market in Europe at a time when increasing demands are being made on it, both by the regulators themselves in terms of proposals for enhanced collateral management to reduce risk and by governments in terms of increased debt issuance.

Proposals relating to the restriction of short-selling would have unintended consequences for the securities market, which will increase costs and risks for issuers and investors.

There is also an urgent need for action to remove the barriers to the efficient cross-border transfer of securities posed by the settlement infrastructure. The paper highlights infrastructure problems which have caused fails in the system in recent difficult market conditions and suggests solutions.

The White Paper was written by Richard Comotto of the ICMA Centre drawing on extensive interviews with market participants, regulators and clearing systems.

Godfried De Vidts, Chairman of the ERC commented: “The White Paper will make an important contribution to the debate that is needed amongst policy makers, assisting them to make informed decisions. The support from the market, in the form of the ERC Committee and the ERC Operations Committee, allowed the author to produce this comprehensive document in a comparatively short time, demonstrating the commitment of the repo community of the ERC to continue working on a meaningful debate to solve repo related issues. We welcome more in-depth, constructive discussions with all concerned and trust they will lead to a well-functioning secured funding market that will continue to be an important brick in the building of a more robust financial market environment.”

The main issues which the ERC White Paper addresses are:

Role and functioning of the repo market: The White Paper emphasises the important role played by the repo market in providing secure and efficient cash funding, and as a means of borrowing securities, which underpins bond market liquidity. Repo is also a key tool for central bank operations. At a time when governments are depending on markets to distribute large quantities of debt, regulation which affects the repo market could have serious consequences for sovereign debt issuance. It also explains how some of the more arcane features of that market (ie negative repo rates) form a normal part of market operation.

Short selling: In response to the Greek crisis regulators are discussing how to control short-selling and in particular naked short-selling. The repo market provides the borrowing facilities that support short-selling. The paper describes the essential role of short-selling, and outlines the likely costs and risks of regulatory restrictions. The argument is made that short-selling is not a problem but a necessary and desirable market activity for a well-functioning and liquid securities market, and that “abusive” short-selling is rare and should be tackled through existing market abuse regulations. The paper supports reporting of short positions to regulators to assist them in monitoring short-selling and identifying potential abusive behaviour. The cost of suppressing a normal market activity would be serious unintended consequences for market efficiency and liquidity at a time when governments are seeking to use those markets to issue large amounts of debt. The damage to the repo market would also derail the regulators’ proposals to encourage increased collateral management as a means of containing credit risk.

Clearing and settlement: The White Paper proposes that official action is needed by regulators to remove barriers to clearing and settlement in Europe, which may have contributed to problems experienced during recent market turbulence; and suggests reforms. It details interconnectivity barriers between national Clearing and Settlement Depositories in various Eurozone countries and the International Clearing and Settlement Depositories (ICSDs) used by international investors.

The European repo market White Paper is available from ICMA’s website

NY Fed Working Paper on the Shadow Banking System

2010-07-08T20:54:00.000-07:00

By Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky

Abstract: The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo. This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance. The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks. Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

Download here: www.newyorkfed.org/research/staff_reports/sr458.html

S&P places Moody's on CreditWatch

2010-06-29T15:23:00.000-07:00

June 29 (Bloomberg) -- Moody’s Corp.’s short-term debt ranking of A-1 was placed on CreditWatch with negative implications by rival credit rating company Standard & Poor’s.

“We believe there may be added risk to U.S.-based credit rating agency Moody’s business profile following recent U.S. legislation that may lower margins and increase litigation related costs for credit rating agencies,” S&P, a unit of McGraw-Hill Cos., said in a today statement.

Moody’s and S&P, both based in New York, along with Fitch Ratings, owned by Paris-based Financiere Marc de Lacharriere SA, have drawn criticism from officials, including Financial Crisis Inquiry Chairman Phil Angelides, and from investors after assigning top ratings to securities that collapsed in value.

Collapsed debt market poses dilemma for G20

2010-06-24T04:51:00.000-07:00

Some pithy commentary from Gillian Tett:

At the height of the credit bubble in June 2007, European bankers working in the world of complex credit were so optimistic about the future that they held their annual meeting in swanky Barcelona and threw parties flowing with champagne.
No longer: last week the European Securitisation Forum – the body that represents bankers slicing and dicing debt – held its annual meeting in Edgware Road, a scruffy quarter of London. As attendees sipped their coffee, the group creating a buzz were not hedge funds but government officials, particularly those from the European Central Bank...
Unsurprisingly, all western central banks are deeply uncomfortable about the fact that they, in effect, have replaced, or become, the securitisation sphere. They are thus looking for exit strategies and urging the banking industry to restart the securitisation machine...
While such reforms are laudable, unfortunately they are unlikely to be enough. In 2007, when bankers were guzzling champagne, a large source of the demand for securitised bonds came from quasi “invented” buyers – that is, banks and bank-funded vehicles that were developing investment strategies to take advantage of regulatory and rating agency loopholes, fuelled by artificially cheap loans.
Cheap funding has since vanished and governments are determined to close all those loopholes. As a result, those invented buyers have disappeared.
That need not spell the end of securitisation, per se. After all, there are still real money investors out there, such as pension funds, which could buy securitised bonds. But if these real investors reappear, they will demand much better returns. That means the market will be smaller in future, and funding costs will rise.

Swaps Push-Out to Have Major Impact on U.S. Dealers

2010-06-23T05:36:00.000-07:00

According to a Moody's report published on June 21:

If enacted into law, the “swaps push-out” will make it impossible for major U.S. dealers to conduct market-making of OTC derivatives -- a major franchise and a large earnings contributor -- within their U.S. bank subsidiaries. Housing OTC derivatives within the lead bank offers dealers funding and capital efficiencies, and makes them more desirable counterparties from a credit risk standpoint. Losing these advantages and moving positions to a different subsidiary can have material franchise, operational and, possibly, capital implications for U.S. dealers…

Deriviatives and the New Financial Legislation

2010-06-16T05:17:00.000-07:00

SEC's Rick Bookstaber on the OTC derivatives portion of the Senate bill, S. 3217 and "the potential for that legislation to allow regulatory arbitrage and reduce transparency to the regulators."

The bill divides the regulation of OTC derivatives between the SEC and the CFTC, assigning the SEC regulatory authority over some – but not all – securities-related derivatives and the CFTC authority for others, such as indexes of those securities. In a world where financial engineering can create an asset in any number of ways, this is an approach that is just asking to be gamed.

Let me illustrate this with a simple example. When I ran a long-short equity hedge fund a few years ago, I traded in the U.K. equity market. However, I never bought or sold a U.K. stock. I only traded total return swaps on U.K. equities. The reason I took this circuitous route is that by using a total return swap, I avoided the tax that the U.K. puts on stock transactions. My broker bought the stock I wanted and kept it on its books (apparently the transaction tax did not apply to the broker) and then the broker executed a swap with me. The swap gave me a payment equal to the return from the stock in exchange for a payment from me to the broker. Of course, this payment to my broker was identical to the cost of funding the stock.

As far as I was concerned, I owned the stock: I treated the swap transaction in my trading and risk management systems as if I held the stock, and my portfolio return was the same as if I held the stock.

If regulation allows equity index swaps to be under the CFTC’s regime and the stocks to be under the SEC regime, there will be the same potential for regulatory arbitrage. I can already envision a thriving new market developing for what might be called Index Spread Total Return Swaps. A fund that wants to hold a long equity position in IBM and P&G, but wants to do it under the CFTC regime, will have a broker give them a total return swap that pays the difference between a position in an index that holds the S&P 500 and another index that holds all the stocks in the S&P 500 except for IBM and P&G. This is a swap on indexes, and so will be under the aegis of the CFTC. Whatever equity positions the fund wants to hold, a swap can be created to fulfill its needs. With the push of a button, voila, the fund is effectively trading stocks – securities – under the CFTC rather than SEC umbrella.

This is a simple example of a broader point: a financial engineer could just as easily construct a position drawn from the equity market that behaves like a commodity, or create a currency swap that looks like a bond. In other words, under the proposed OTC derivatives regime, traders will be permitted to choose their regulators. In my view, these provisions should seek to eliminate regulatory arbitrage, not create it.

Another weakness of the bill is what it affords regulators in terms of transparency. As I stated in my 2007 testimony before your subcommittee, I believe that regulators should know the positions, leverage and web of counterparty connections across firms. I do not think regulators can fulfill their mission of protecting investors, the market or the economy at large without this information. The bill enhances the transparency of OTC derivatives both by improving price discovery and by pushing for greater simplicity and standardization, a critical step. However, the division of OTC derivatives oversight between the SEC and the CFTC moves us away from this objective. There is no ready mechanism envisioned within the bill to allow unfettered sharing of these data. This not only will create routes to hide abuse, but also, because what is essentially the same asset will end up in different buckets based on how it is constructed, neither agency will be able to readily amass this position and exposure information.

One last thought, based on my experience in risk management. Risk managers have the unfortunate tendency of fighting last year’s war, of developing tools and reports to prevent the crises that just occurred from happening again. Of course, the next crisis almost always comes from a different direction. To some extent, the financial legislation has a similar tendency. For example, much thought has been given to credit default swaps. It is likely, however, that the next major issue will spring from a new financial innovation. The nature of the markets is to exploit weaknesses and to find ways to work around regulation and other constraints. Because legislation can only address what has happened in the past and what is currently expected to occur in the future, the legislation must give the regulators the flexibility to address the unanticipated.

CVA desks and sovereign CDS spreads

2010-06-15T08:50:00.000-07:00

The Bank of England's most recent Quarterly Bulletin has a nice little box on the impact of dealer CVA (counterparty valuation adjustment) desks influence the spreads on sovereign credit default swaps (CDSs):

Increased use of derivatives by financial institutions during the past couple of decades, together with a general consolidation of the international banking system has led to a structural reorganisation in the way large banks manage counterparty risk. Specifically, many banks have set up specialist trading units to measure and hedge counterparty credit risk, known as counterparty valuation adjustment (CVA) desks. This box explains the activities of CVA desks and how they may influence financial markets; particularly the market for credit default swaps (CDS).

A commercial bank’s CVA desk centralises the institution’s control of counterparty risks by managing counterparty exposures incurred by other parts of the bank. For example, a CVA desk typically manages the counterparty risk resulting from a derivative transaction with another financial institution (such as entering an interest rate swap agreement).

CVA desks’ hedging of derivatives exposures In a derivative transaction, a bank may incur a loss if its counterparty defaults. Specifically, if the bank’s derivative position has a positive marked-to-market (MTM) value (calculated for the remaining life of the trade) when the counterparty defaults this is the bank’s ‘expected positive exposure’. These potential losses are asymmetric. If the value of a bank’s derivative position increases (ie the bank is likely to be owed money by its counterparty), the potential loss in the event of default of the counterparty will rise. In contrast, if the value of the bank’s derivative position falls such that it is more likely to owe its counterparty when the contract matures then the potential loss on the transaction is zero.

Having aggregated the risks, CVA desks often buy CDS contracts to gain protection against counterparty default. If liquid CDS contracts are not available for a particular counterparty, the desk may enter into an approximate hedge by purchasing credit protection via a CDS index and increase the fee charged to the trading desk to reflect the imperfect nature of the hedge. On occasion, when CDS contracts do not exist, CVA desks may try to short sell securities issued by the counterparty (ie borrow and then sell the securities) but this is rare.

Another way to mitigate counterparty risk is for parties to a derivative trade to exchange collateral when there are changes in the MTM value of the derivative contract. The terms of the collateral agreements between the counterparties (detailed in the credit support annex in the derivative documentation) include details such as frequency of remargining. Since MTM exposure for the bank is greatest if counterparties do not post collateral, CVA desks have reportedly been influential in promoting better risk management via tighter collateral agreements in order to reduce the CVA charge.

CVA activity and the sovereign CDS market

Against the background of heightened investor awareness of sovereign risk, the cost to insure against default on government bonds through CDS has risen recently. According to contacts, increased hedging by CVA desks has been an influential factor behind these moves.

Specifically, CVA desks of banks with large uncollateralised foreign exchange and interest rate swap positions with supranational or sovereign counterparties have reportedly been actively hedging those positions in sovereign CDS markets. For example, for dealers that have agreed to pay euros to counterparties and receive dollars, a depreciation in the euro will result in a MTM profit and hence a counterparty exposure that needs to be managed.

Given the relative illiquidity of sovereign CDS markets a sharp increase in demand from active investors can bid up the cost of sovereign CDS protection. CVA desks have come to account for a large proportion of trading in the sovereign CDS market and so their hedging activity has reportedly been a factor pushing prices away from levels solely reflecting the underlying probability of sovereign default.

SIFMA Offers Guidance to Enhance Regulators’ Ability to Protect Against Systemic Risk

2010-06-14T12:07:00.001-07:00

New York, NY, June 14, 2010—The Securities Industry and Financial Markets Association (SIFMA) today released the results of a study intended to assist regulators and policymakers in preparing for expanded systemic risk oversight and enhance their ability to respond to potential future systemic risk events. The guidance is aimed at supporting the financial industry's efforts to foster financial stability and accommodate the information needs of a systemic risk regulator. SIFMA believes developing the right information structure for tracking systemic risk can play a major role in the ability of the firms and regulators to identify and address potential problems before they escalate.

“SIFMA strongly supports the creation of a tough, competent systemic risk regulator to oversee systemically important firms so that the activities of one or a few firms will not threaten the stability of the entire financial system,” said Tim Ryan, SIFMA president and CEO. “With this study, we offer important insights into the development of a systemic risk regulation regime, which we hope will be useful to the regulatory community as it works to expand its monitoring of systemic risk and better understand the inter-connected risks between systemically important institutions.”

Produced together with Deloitte & Touche, the Systemic Risk Information Study is based on interviews with 22 organizations, including regulators, commercial and investment banks, insurers, hedge funds, exchanges, and industry utilities. The interviews focused on how the interviewees defined and/or viewed systemic risk, then specifically identified what type of information and data regulators would require from large, interconnected financial institutions to effectively monitor systemic risks. Systemic risks are developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions.

Among the study’s major findings:

The study highlights eight different potential systemic risk information approaches which a regulator could use in to monitor and understand potential systemic risks.
There is not a single ideal approach, and the various approaches may work best in concert, complementing their different strengths and weaknesses. Some are better at understanding certain drivers of systemic risks, while others are easier to aggregate across firms and products.
The information approaches vary considerably in their structure and the granularity of information which is provided to the regulator. Some take a top down approach, while others are bottoms up. There were varied opinions as to which would be the most effective. They also vary in the resources necessary, including personnel and technology to provide and analyze data that a regulator would require.
Where possible, systemic risk regulation can be more effective by drawing on resources which already exist in the system, either in current regulatory filings or in firms’ own risk and information systems and leveraging infrastructure and repositories of data.
Significant concerns were expressed that a focus on granular position level data may cause the systemic risk regulator to be looking at the wrong “altitude” of information, which may hinder the ability of the systemic risk regulator to focus on the relevant build-up of systemic risks.
Reporting structures should reflect the difference between normal times when periodic reporting can provide information about latent problems, and periods of market stress when frequent reporting is valuable in understanding an unfolding shock.
Systemic risk regulation should recognize the importance of capturing information on macroprudential risks which threaten the stability of the system as a whole; current regulation has a microprudential focus looking mainly at the stability of individual firms.

The study also looks at current reporting metrics and compares what is currently reported with the data firms and regulators thought would be needed to better understand and monitor systemic risks, thus identifying key gaps in current reporting systems. Current reporting metrics focus on the soundness of individual firms and do not effectively capture all of the drivers of broader sources of risk, but they do capture parts of the information needed to monitor systemic risk.

The study reports that systemic risk builds up over time, influenced by drivers which are distinct from factors which create risk in individual firms. Interview subjects discussed the drivers of systemic risk, as understanding these drivers is critical to designing ways to track and monitor risk. Major drivers which were identified include: firm size, interconnectedness, liquidity, concentration, correlation, tight coupling, herding behavior, crowded trades, and leverage.

The full study is available on SIFMA’s website at http://www.sifma.org/regulatory/pdf/SIFMA_Systemic_Risk_Information_Study_June_2010.pdf

EC Publishes Recommendations on Derivatives and Market Infrastructure

2010-06-14T04:31:00.001-07:00

The purpose of the document (which can be downloaded here: http://ec.europa.eu/internal_market/consultations/2010/derivatives_en.htm) is to obtain information from Member States, market participants and other stakeholders on the measures aimed at enhancing the resilience of derivatives markets and market infrastructures.

The European Commission adopted a Communication on "Ensuring efficient, safe and sound derivatives markets – future policy actions", on 20th October 2009 after a full consultation on a previous Communication of July 2009 (COM(2009)332) and accompanying Staff Working Paper and Consultation Paper (see IP/09/1546). In this Communication, the Commission outlined the policy actions it intended to take to address the problems of OTC (over-the-counter) derivatives markets.

Since then, the Internal Market and Services Directorate General of the European Commission has been developing more detailed measures in this respect. Following better regulation principles and considering the significant impact that the announced policy actions are likely to have on the markets, the Internal Market DG would now like to consult all interested stakeholders on these detailed measures. This consultation, which is open until 10 July 2010, is the final step before the Commission proposes legislative proposals in September.

What is the status of this consultation? Is this a legislative blue-print?

This document is a working document of the Internal Market DG for discussion and consultation purposes. It does not purport to represent or pre-judge the formal proposal of the Commission. However, it does give an overview of the Internal Market DG's current thinking on how to practically implement some of the actions outlined in October 2009.

How does the consultation fit with other Commission initiatives in response to the financial crisis?

In its 2009 October Communication, the Commission announced a series of policy actions to respond to the issues raised by OTC derivatives. The aim of these actions is to reduce systemic risk and increase transparency. These initiatives are in line with the agreement signed by the G20 leaders in Pittsburgh on 25th September 2009, which stipulates that "all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements".

What is the objective of the measures put out for consultation?

The consultation document outlines the Internal Market DG's current thinking on how to implement four of the policy actions that were announced in October 2009, notably:

Mandatory clearing of all "standardised" OTC derivatives;
Mandatory reporting of all OTC derivatives to trade repositories;
Common rules for Central Counterparties (CCPs) and for trade repositories; and
More transparency through reporting to trade repositories.

Other measures are foreseen later in 2010 or beginning of 2011, notably the revision of the Capital Requirements Directive, MiFID (Market in Financial Instruments Directive) and the Market Abuse Directive.

On substance, the Commission's future proposal will focus on four points:

Reducing counterparty credit risk by mandating CCP-clearing where possible

Increasing transparency by mandatory reporting to trade repositories

Ensuring safe and sound CCPs through stringent and harmonised organisational, conduct of business and prudential requirements.

Improving efficiency in the EU post-trading market by removing barriers preventing interoperability between CCPs while preserving the safety of them.

What are the main issues you are consulting on?

Central clearing requirements: All eligible derivate contracts should be cleared through a CCP. A process needs to be developed for the determination of the eligibility of contracts. There are also questions relating to the scope of exemptions for non-financial corporate end-users.

- Requirements on CCPs: the consultation asks what rules are necessary to ensure that CCPs contain risk in the market instead of becoming a potential source of risk concentration themselves.

- Relationship with third countries: the consultation asks how to ensure that CCPs and trade repositories in third countries can continue to provide services in the EU and what is the right approach for a sector, which is by nature, a global one.

- Interoperability: the consultation asks how best to achieve interoperability between CCPs.

- Requirements on trade repositories: the consultation asks amongst other things how to ensure access to data and make sure that trade repositories are adequately organised to receive, process and store that data. And the consultation asks about reporting requirements for market participants to trade repositories..

Why are you considering introducing requirements on interoperability even if those were not announced in the October Communication?

The Commission services have in recent years repeatedly highlighted that Europe's post-trading sector (i.e. clearing and settlement) ) remains fragmented along national lines (see e.g. European Commission (2006) Draft Working Document on post-trading activities and Commission Staff Working Document (2009), The Code of Conduct on clearing and settlement: three years of experience). This undermines the efficiency of each national system and increases the costs of cross-border transactions. Interoperability (please explain in one sentence what interoperability is) was, and still is, considered as one possible way of solving these problems. However, the experience with the Code of Conduct has demonstrated that industry action alone is not sufficient to attain this goal.

Furthermore, the European Council in its December 2008 and 2009 Conclusions stressed the need for further progress on access and interoperability while ensuring the safety of these arrangements and the high prudential standards CCPs need to comply with.

The consultation contains no reference to authorisation and supervision of CCPs. Why? Will this be addressed in forthcoming legislation?

Authorisation to provide CCP services and supervision (ongoing monitoring of CCP activities) are of paramount importance. But these issues are not technical details which the Commission needs stakeholder input on, but a key political choice. To enable the Commission to take an informed decision on those matters, the Commission services are discussing these institutional arrangements in other, more appropriate fora (e.g. working groups with Member States).

If adopted, how would CCPs, trade repositories and users benefit from the technical measures under consideration?

The measures, if adopted, would establish a level playing field between market infrastructures, which would also benefit users . In particular, users would benefit from high prudential standards imposed on CCPs that will help ensure the safety and soundness of the wider system, and thus greater protection for users. CCPs will benefit from fair competition as common requirements will avoid competition on the margins. Trade repositories will be subject to common requirements: this will add clarity to what they should collect as data and how they should maintain the information recorded.

You are considering a comprehensive solution for all derivatives markets. How are you taking into account important differences between asset segments, e.g. in terms of risk?

Various segments of the OTC derivatives market differ in their characteristics, namely in terms of risk, operational arrangements and market participants. Therefore, at first sight, a specific regulatory approach for each market segment could seem warranted. However, the financial crisis has shown that problems such as lack of transparency and excessive counterparty credit risk are common to all segments. That is why a common policy approach is preferable. Such an approach is also justified by the fact that the boundaries between market segments are blurred, as any derivative contract can be partitioned and reconstructed into different but economically equivalent contracts. A segmented policy approach would enable market participants to exploit differences in rules to their advantage. Moreover, the approaches to some of the key obligations under consideration (e.g. mandatory clearing), contains a number of safeguards that, if adopted, would take into account differences between asset segments.

You are considering giving ESMA significant powers, notably as regards the clearing obligation. Isn't that too much for an Authority that does not yet exist?

The European Securities and Markets Authority (ESMA) needs sufficient powers to be effective. These powers will be set out in the supervision package, currently in the final stages of negotiation between the European Parliament and finance Ministers. We are considering entrusting ESMA with determining the contracts subject to the clearing obligation. This is important, as we need a single list of eligible contracts in Europe. A national approach whereby each Member State would decide in isolation could lead to 27 different clearing obligations for market participants. This would not reduce systemic risk and would only create legal uncertainty across the Single Market.

We are also considering endowing ESMA with responsibility for setting the thresholds above which non-financial institutions should be subject to the clearing obligation. Such thresholds need to take into account the technical and evolving characteristics of the market place; therefore, it is appropriate to give regulators a predominant role in setting them. Moreover, the data necessary for setting the thresholds will only be available after the implementation of the future legislation.

You are considering stringent requirements for CCPs. Should you not limit the future legislation to high level principles to leave room for the implementation of internationally agreed standards?

We need to find the right balance. We are responsible for ensuring that European CCPs are safe and sound institutions, and meet robust and harmonised binding prudential requirements that are the same across all 27 EU-Member States. They should not be allowed to compete on risk grounds. This requires stringent requirements for CCPs setting out the key prudential requirements they have to respect.

International consistency is desirable. We therefore strongly support the work done by central banks and financial market regulators working together in CPSS-IOSCO (Committee on Payment and Settlement Systems - International Organisation of Securities Commissions) ) to review the global non-binding recommendations for CCPs. The future legislation under consideration would leave room for technical details to be developed at a later stage. Accordingly, it would be possible to further integrate aspects of the CPSS-IOSCO review potentially not covered by the legislation.

Why are you considering different options for trade repositories? Would it not be preferable to have one global repository per asset class?

Market participants will be required to report their trades to a repository. Trade repositories will maintain this information, which is of key importance to regulators. It is therefore essential that regulators have access to the relevant information stored in those repositories. This needs to be taken into account when considering the trade repository market structure. All options - i.e. requiring location in the EU only if access to information is not guaranteed, requiring location as in the form of a subsidiary as a condition for registration, or requiring a self-standing EU trade repository, under consideration have pros and cons. We therefore believe it is important to seek the views of stakeholders on these different options so as to eventually have a proposal that would represent the best option.

How do the actions under consideration relate to Credit Default Swaps (CDS)?

If adopted in the forthcoming Commission's proposal, the actions under consideration would have two effects on CDS:

First, it would further increase transparency of CDS transactions by requiring all trades to be reported to trade repositories to which regulators would have full access.

Second, two of the requirements under consideration - the obligation to clear most derivatives with CCPs and the requirement to strengthen the risk management of non-cleared OTC derivatives – would, if adopted, increase the cost of engaging in OTC derivatives deals. Therefore, while the primary aim of these actions is to reduce the systemic risk, they would also increase the upfront cost of engaging in speculative derivatives deals.

The Commission is also considering an initiative on short-selling this autumn where measures on CDS are considered.

Annex – Glossary of key terms

For information purposes … not legally binding:

'Derivatives' means financial instruments as defined by Annex I Section C numbers (4) to (10) of Directive 2004/39/EC. In simple terms, a derivative is a financial instrument - a contract between two people or two parties - that has a value determined by the price of something else, the underlying. The "underlying" can be any kind of asset, for example a share, a currency, a commodity. There are many kinds of derivatives, the most notable being swaps, futures, and options. However, since a derivative can be placed on any sort of security, the scope is endless.

'Over the counter (OTC) derivatives' means derivative contracts whose execution does not take place on a Regulated Market as defined by Article 4(14) of Directive 2004/39/EC.

'Central counterparty (CCP)' means an entity that interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer and which is responsible for the operation of a clearing system.

'Trade repository' means an entity that centrally collects and maintains the records of OTC derivatives.

'Market infrastructure' means either a CCP or a trade repository.

'Clearing' means the process of establishing settlement positions, including the calculation of net positions, and the process of checking that financial instruments, cash or both are available to secure the exposures arising from a transaction.

'Interoperability' means two or more CCPs entering into an arrangement with one another that involves cross-system execution of transactions.

MPAA, myriad interest groups lobby on financial regulation bill

2010-06-10T04:18:00.000-07:00

The Washington Post reports on the diverse lobby groups lining up to influence the financial regulation bill moving through Congress:

The Motion Picture Association of America, the trade group for the six big Hollywood studios, has been working to insert a provision banning a futures market for box office returns.

Two financial companies are trying to establish such futures markets, but studios are concerned that the exchanges could create negative publicity for films.

"Box office futures are not a commodity," said Howard Gantman, a spokesman for the association. "Especially if the industry is not allowed to invest in it, this just becomes a form of pure gambling..."

"The bill is so broad and goes into so many segments of the economy, it was bound to touch agriculture somewhere," said Adam Nielsen of the Illinois Farm Bureau. "We're looking at the bill and hoping there aren't any negative consequences. I think that would probably be the sentiment of a lot of people."

Nielsen said the bureau had concerns about whether, under the bill, farmers would be able to manage risk using options and futures, although the measure is not one of its top priorities.

U.S. Telecom, the trade association for broadband companies, is concerned about pieces of the Senate bill that could affect prepaid phone cards and a broad definition of "financial data processing" in the measure, which could regulate Internet companies with customers who bank online.

Several large utility companies, including Southern Co. and Florida Power & Light, have registered to lobby on provisions of the bill banning derivatives sold in private or "over the counter." Those financial instruments help even non-financial companies hedge against market forces changing prices for commodities or interest rates that affect their business, and many companies are seeking an exemption for end-users that depend on them.

The publishing company Argus Media, which provides energy news and business intelligence, also listed derivatives as one of the issues on which it would lobby. A company official declined to comment. Competitor McGraw-Hill also targeted the bill

Rick Bookstaber on Common Sense Crisis Risk Management

2010-06-09T05:01:00.000-07:00

The catch is that "what protects you in a crisis is also what leaves money on the table pre-crisis... [and] the best trades... in the pre-crisis regime are the ones that cause the greatest losses in the crisis."

All days in a normal market seem the same, but when a crisis occurs, it seems as if we have never seen the likes of it before. But of course, we have seen it before, or at least some aspects of it. The cause might be different, the initial market from which it propagates might take us by surprise. But the path a crisis takes, at least in broad strokes, hardly differs from one case to the other.

We all know the limitations of standard risk management methods in dealing with times of market crisis. And we are starting to get a sense of what is needed beyond these methods in order to see a market crisis coming, things like understanding who is under pressure, what sorts of positions they hold (and thus might be forced to liquidate) and who else is holding those positions (and thus who might get caught up in the propagation of the forced selling).

Common Sense about Market Crisis
Unfortunately, although we can hope that this sort of information will end up with those regulating the markets, it is beyond the realm of anyone in the private sector. But here are a few common sense things we know about the way markets behave during a crisis:
Equities drop
Volatility goes up
Credit spreads widen
Correlations rise
Areas of low liquidity decline more than similar areas with high liquidity
The yield curve flattens
Volatility goes up because everyone is jumpy, so any new piece of information leads to a big reaction, and also because there are fewer people willing to step up as liquidity providers, so prices have to move more to elicit the other side of the trade.

Correlations rise because people don’t care much about the subtle characteristics of one instrument versus another. Everything is either high risk or low risk, high liquidity or low liquidity. I think of the market during a crisis like in high energy physics, where matter melds into a homogeneous plasma when the heat gets turned up.

Because liquidity becomes critical, the less liquid markets – emerging markets, low cap stocks and the like – take it on the chin more than their more liquid cousins.

(Oh, and what about gold? Sometimes it responds, sometimes it doesn't. There is nothing intrinsic about gold that makes it part of the crisis/no-crisis equation. If it is a flavor-of-the-month market, it will respond positively, otherwise, it will simply act like a commodity, responding to economics).

Knowing this, it is not hard to take steps to protect against a crisis. Just move away from equities, avoid being short volatility, stay away from credit-laden debt, focus on the liquid markets, and watch those carry trades. Also, don’t trust diversification, because those low correlations you are depending on will not be there when it matters.

Or, if you want to be more sophisticated about it, create a variance-covariance matrix predicated on these sorts of relationships, and be sure to add a constraint to your portfolio optimization so that you will not breach a specified risk level under this crisis-based matrix. For example, if your usual risk constraint is to keep you portfolio volatiliy below twelve percent, perhaps you also make sure it won’t be higher than thirty percent in the case of crisis. Or, because we know the direction of these market effects, to make life simpler you can add a simple scenario test, and not allow the portfolio to lose more than, say, ten percent in that scenario. Doing this will guard against the tendency to over-rely on diversification, over-lever or put too much exposure into the markets that are particularly sensitive to a crisis.

The problem with this advice is that it is exactly the opposite of what will make sense when the crisis has yet to emerge. More to the point, it is exactly the opposite of what makes money as the market is building into a crisis.

Before a crisis (I won’t say “during a bubble”):
Equities are rising
Volatility is low
Credit spreads are narrow
Correlations are low
The opportunities are in the hinterland markets of low liquidity
The yield curve is steep
Volatility is low because everything is so rosy. Any new piece of information is No Big Deal, and liquidity is swarming around the market, so prices barely have to move to get an order filled.

Correlations are low because, in an attempt to find value in when every portfolio manager, trader and dentist is spending his time combing the hills for value, the slightest difference between otherwise similar instruments is worth mining. And with the languid pace set by the low volatility and money sloshing over the sides, people have the luxury of spending time in fine-tuning.

With so much money flooding into the market (and so much money means so much leverage), people start to scan the landscape for the less known – and less liquid – markets to find value.

Regime-switching models of market crisis
People sometimes look at periods of market crisis in the context of a regime switching model. There are the normal times and then there are the crisis times. But what I am suggesting above is that there are (at least) three regimes. There are the crisis times, the normal times, and the pre-crisis times. The transition generally is not from normal to crisis, but rather from pre-crisis to crisis. And the move from the pre-crisis to the crisis regime is more gut-wrenching because in almost every dimension things are moving from one extreme to another.

The killer is that what protects you in a crisis is also what leaves money on the table pre-crisis. The best trades and market positions in the pre-crisis regime are the ones that cause the greatest losses in the crisis.

Pay the rating agencies according to results

2010-06-04T08:00:00.000-07:00

A new idea from Larry Harris (former SEC chief economist) in an article posted in the Financial Times:

The best solution must address the fundamental problem with ratings: we do not know how good ratings are on average until bonds mature or default. The solution thus must depend on future performance.

An effective solution to the ratings problem would make the profits that rating agencies earn depend on how the bonds they rate perform. Credit agency profits should rise if bonds they rate as investment grade perform well and fall if such bonds default more often than expected.

Credit rating agencies could create this contingent compensation scheme by putting a meaningful portion of their fees into escrow. The custodian of these funds eventually would return them to the agencies if their ratings performed well.

To fund their operations, the rating agencies could borrow against these escrowed funds, using their future contingent payments as collateral. The lenders then would rate the raters instead of the government. The SEC could create this system simply by requiring that rating agencies opt in if they want the NRSRO designation. The SEC would then only need to determine whether the deferred contingent compensation schemes used by each credit agency provided meaningful incentives to produce well-researched and unbiased ratings.

Finally, the SEC should require disclosure of these deferred contingent compensation schemes, so that investors can decide for themselves which schemes provide adequate incentives to rate securities well. The proposal outlined here allows the power, creativity and wisdom of the free market to produce the best solution.

Commission proposes improved EU supervision of Credit Rating Agencies

2010-06-02T09:07:00.000-07:00

As part of its work on preventing a future financial crisis and strengthening the financial system, the European Commission has today put forward amendments to the EU rules on Credit Rating Agencies (CRAs). Furthermore, in order to advance swiftly in completing the necessary reforms... the Commission has adopted a more general Communication where it commits itself to table the remaining financial reform proposals in the next six to nine months from now. Following discussion and hopefully strong support from all heads of State and government at the forthcoming European Council, the Commission will present all these proposals – together with its recent ideas on bank resolution funds (see IP/10/610) – at the G-20 Summit in Toronto on 26-27 June 2010. On CRAs, the Commission has two main objectives: ensuring efficient and centralised supervision at European level, and increased transparency on the entities requesting the ratings so that all agencies have access to the same information. These changes would improve supervision, increase competition in the CRA market and improve investor protection.

Internal Market and Services Commissioner Michel Barnier said: "The changes to rules on Credit Rating Agencies will mean better supervision and increased transparency in this crucial sector. But they are only a first step. We are looking at this market in more detail."

As rating services are not linked to a particular territory and the ratings issued by a CRA can be used by financial institutions all around Europe, the Commission is proposing a more centralised system for supervision of Credit Rating Agencies at EU level. Heads of State and government had called the Commission to come forward with proposals on this in June 2009.

Under the proposed changes, the new European supervisory authority – the European Securities and Markets Authority (ESMA, see IP/09/1347) – would be entrusted with exclusive supervision powers over CRAs registered in the EU. This would include also the European subsidiaries of well-known CRAs such as Fitch, Moody's and Standard & Poor's.

It would have powers to request information, to launch investigations, and to perform on-site inspections. Issuers of structured finance instruments such as credit institutions, banks and investment firms will also have to provide all other interested CRAs with access to the information they give to their own CRA, in order to enable them to issue unsolicited ratings.

These changes mean that CRAs would operate in a much simpler supervisory environment than the existing varied national environments and would have easier access to the information they need. Users of ratings would also be better protected as a result of centralised EU supervision of all CRAs and increased competition among CRAs.

The Commission's proposal, which amends Regulation 1060/2009, will now pass to the EU Council of Ministers and the European Parliament for consideration. If adopted, the new rules would be expected to come into force during 2011.

Background: CRAs issue opinions on the creditworthiness of companies, governments and sophisticated financial products. They contributed to the financial crisis by underestimating the risk that the issuers of certain more complicated financial instruments might not repay their debts. In response to the need to restore market confidence and increase investor protection, the Commission put forward new EU-wide rules that put in place a common regulatory regime for the issuance of credit ratings. Under these rules, which will become fully applicable in December 2010 (see IP/09/629), all CRAs that would like their credit ratings to be used in the EU now need to apply for registration. Registrations open this month. The risks of conflicts of interest affecting ratings are also addressed (for example, a CRA cannot also offer consultancy services) CRAs will need to be more transparent as they will need to disclose the methodology and internal models and key rating assumptions they use to make their ratings. This should allow investors to perform better their due diligence.

The Canadian ‘good banks’ myth

2010-05-31T06:14:00.000-07:00

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.

Bankers’ ‘doomsday scenarios’ under fire

2010-05-30T19:56:00.000-07:00

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.”

How Wall Street Gamed Derivatives Reform

2010-05-28T12:13:00.000-07:00

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.

Inching closer to the derivatives end-game?

2010-05-27T05:37:00.000-07:00

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

2010-05-27T05:11:00.000-07:00

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: www.newyorkfed.org/research/staff_reports/sr449.html

Extend and Pretend Reaches A New Level

2010-05-25T05:09:00.000-07:00

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.

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

2010-05-24T13:46:00.000-07:00

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).

Naked Credit Default Swaps--the Role of Dealers

2010-05-23T09:07:00.000-07:00

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: www.isda.org/c_and_a/pdf/BaFin-decree-Summary-of-key-issues.pdf

Barnier press conference on financial regulatory reform

2010-05-19T08:46:00.000-07:00

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

2010-05-19T04:45:00.000-07:00

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

2010-05-19T04:28:00.000-07:00

Original posted on EurActive.com:

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.

Links
European Union
European Commission: Summary of regulation
European Commission: Proposal to regulate credit rating agencies [FR] [DE]

Background

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

Analysis:Europe needs a European Public Rating Agency
News:EU says will probe rating agencies

Conspiracy of Banks Rigging States Came With Crash

2010-05-19T04:24:00.000-07:00

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: www.bloomberg.com/apps/news?pid=20601109&sid=axH24KWxjVDE

NY Fed Releases White Paper on Tri-Party Repo Reform

2010-05-18T08:13:00.000-07:00

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
For the New York Fed white paper and task force report, visit: http://www.newyorkfed.org/banking/tpr_infr_reform.html
For the Tri-Party Repo Infrastructure Reform Task Force final report, visit: http://www.newyorkfed.org/prc

EU to deal severely with CDS; leaders seek ban

2010-05-18T04:39:00.000-07:00

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.
NOT EVIL SPECULATORS
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."

BIS Working Paper: Attributing systemic risk to individual institutions

2010-05-17T10:07:00.000-07:00

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: www.bis.org/publ/work308.htm

Rating Agencies May Squeak Through

2010-05-17T08:14:00.000-07:00

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.

How to implement the Franken & LeMieux NRSRO Amendments?

2010-05-15T08:36:00.000-07:00

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

2010-05-15T08:05:00.000-07:00

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 ($$).

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

2010-05-14T19:18:00.000-07:00

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

2010-05-14T09:32:00.000-07:00

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

2010-05-14T04:44:00.000-07:00

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.

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

2010-05-13T05:09:00.000-07:00

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

2010-05-13T04:33:00.000-07:00

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: ftalphaville.ft.com/blog/2010/05/13/230081/cuomo-targets-beyond-the-ratings-agencies/ See also Yves Smith's post at Naked Capitalism: www.nakedcapitalism.com/2010/05/were-the-ratings-agencies-duped-rather-than-dumb.html

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: blogs.reuters.com/felix-salmon/2010/05/13/the-cdo-prosecution-bandwagon-gathers-more-steam/. Also Tracy Alloway at FT Alphaville is providing more detail on the Morgan Stanley "Dead Presidents" deals here: ftalphaville.ft.com/blog/2010/05/13/229771/dead-presidents-in-detail/

FDIC Board Approves NPR Regarding Safe Harbor Protection for Securitizations

2010-05-11T13:56:00.001-07:00

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: www.fdic.gov/news/news/press/2010/pr10112a.pdf

Darrell Duffie on Banning Naked CDS Transactions

2010-05-11T12:39:00.000-07:00

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

2010-05-11T12:25:00.000-07:00

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.

Notes

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 (cpss@bis.org) and the IOSCO secretariat (CCP-OTC-Recommendations@iosco.org).
Comments on Considerations for trade repositories in OTC derivatives markets should be sent to both the CPSS Secretariat (cpss@bis.org) and the IOSCO secretariat (OTC-Trade-Repositories@iosco.org).
The comments will be published on the websites of the Bank for International Settlements and IOSCO unless commentators have requested otherwise.
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).
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.
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 www.bis.org/cpss.
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.
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.

Al Franken's plan to end the credit rating conflicts

2010-05-11T04:38:00.000-07:00

Posted in the Washington Post by Senator Al Franken:

I was heartened to read the May 5 editorial "A standard and poor remedy," highlighting the disturbing conflicts of interest in Wall Street's credit rating system. For the past two weeks, I've been working with Professor Matthew Richardson of New York University's Stern School of Business, mentioned in the editorial, to craft an amendment that would fundamentally change the incentives driving the rating industry.

As the editorial pointed out, the market is plagued by conflicts of interest and doesn't reward ratings for their accuracy: The current system allows investment banks to shop around to get the most favorable bond rating.

My amendment would create an independent board to assign a rating agency to each newly issued bond, taking into consideration the capacity and expertise of each agency. It would monitor their performance over time and reward the best actors with more assignments. This would eliminate conflicts of interest and make the system more accurate, fair and transparent. It would increase competition by giving smaller rating agencies an opportunity to compete against the largest three agencies, which have abused the current model.

We must take action that would change the way the system works by putting accuracy ahead of profits.

And here's a Q&A from Ezra Klein's blog on the Washington Post:

Why did you decide to focus on the rating agencies?

The agencies were an enormous part of the problem. They were giving AAA ratings to products that didn't deserve them. There's this inherent conflict of interest where the issuers of these financial products were shopping for raters. It's become very clear that what's going on was they had an incentive to inflate the ratings to get more business. In some cases the agencies were just stupid, but there was also a reason to be stupid. They had motive.

How does your amendment fix the problem?

Instead of the issuer shopping for ratings, we'd form a board under the SEC that would decide which rating agency rates each instrument. I don't mandate how they do it. But it wouldn't have to be totally random. The board would be comprised mainly of investors and people who manage pensions and university endowments. One of the advantages of this is that it'd inject more competitions into the business. Right now, we have Moody's and Standard & Poor's and Fitch doing 94 percent of the ratings. This board could give business to smaller agencies. You'd be rewarded on accuracy and so the incentive would be to be more accurate.

And that, you hope, takes care of the problem wherein the rating agencies actually do a worse job because they're now guaranteed to get business?

Right. Depending on the nature of the product, you'd be able to judge the accuracy over some period of time. Developing a track record of accuracy would be in your interest as opposed to rewarding the exact thing we don't want, which is inflating ratings on behalf of the banks.

Another criticism people have raised about this approach is that giving the government more power over the agencies will leave them more beholden to the government. Right now, the agencies have been criticized for downgrading Greece, and in the future, with our deficit, you could imagine them downgrading America. But not if they rely on the federal government for work.

Well, maybe there'd be part of this where they're not rating government securities. I'm not sure how that would work. But this is about the securities that got us into trouble. So it might not be how we'd do a Treasury bond.

Rather than bringing them further into the government's embrace, why not just kick the rating agencies out altogether? Right now, the government credentials them, uses their "AAA" rating in certain laws and generally makes sure they're central to the system. Why not let them rise or fall on their own?

I think that would be a problem. You could say let's just not have any rating agencies. But we'd have a problem if we didn't have rating agencies at all. I think what you want are rating agencies that do a good job.

To press you on that, though, you'd still have rating agencies. It just wouldn't be the government saying you have to listen to them. And that seems like a good thing to me. Even if you get rid of the conflict-of-interest problem, it still seems to me that these players exist to tell Wall Street that it doesn't really need to know what it's doing. You can be an English literature major who's only been on Wall Street for five months and as long as you know it's "AAA" or "BBB," you're good to go.

I think the government sanction in this amendment would incentivize accuracy and mean that these agencies would do their due diligence and compete and be a bit smarter than the ones in Michael Lewis's book, who seemed particularly easy to fool.

It has occasionally seemed to me that the best reform would be to tax the banks and use the money to make the people at the rating agencies the highest-paid folks on Wall Street.

Well, there might be something to that. I don't prescribe how much they'll get paid but if you are rewarded by your track record, people who do a better job will be paid more.

Do you know if your amendment will get a vote?

I'm not certain. But probably next week sometime. We've been talking to the banking committee staff and I hope that it does come up next week, either as is or in some form. We're very prescriptive in this for how the board will look and there are other ways to skin this cat.

OTC Derivatives Market in India

2010-05-11T04:32:00.001-07:00

By Dayanand Arora and Francis Xavier Rathinam:

Abstract: The OTC derivative market in India, though in its infancy, is an interesting case, because it came out unscathed in the present global crisis. The paper seeks to prove the point that this is because of India’s cautious regulatory framework and support institutions such as a centralised counter party (CCP). This case study about the Indian OTC derivativesmarkets can serve as a model for other developing countries.

The paper analyses the regulatory structure of the Indian OTC derivatives market, particularly the role of OTC-traded versus exchange-traded derivatives, the role of reporting platforms and the role of a centralized counterparty (CCP) for the transparent functioning of the market. It further explores some of the open issues, such as competition in reporting platforms and counterparty services and supervision of the off-balance sheet business of financial institutions, to ensure stable growth of OTC derivatives markets.

Read the Vox column here, and download the whole paper here: www.esocialsciences.com/data/articles/Document1352010140.3762781.pdf

BIS announces modest increase in OTC derivatives

2010-05-10T14:09:00.000-07:00

From the BIS website... Key developments in the second half of 2009:

Notional amounts of all types of OTC derivatives contracts outstanding increased by 2% during the second half of 2009, rising to $615 trillion at the year-end. Interest rate and foreign exchange derivatives accounted for most of this increase. By contrast, overall gross market values decreased by 15%, following a contraction of 22% in the previous six-month period. Gross credit exposures fell by 6%, following an 18% decline in the previous period.
Notional amounts outstanding of CDS contracts continued to decline (-9%), albeit at a slower pace than in the first half of 2009 (-14%), while positions on commodities also receded, by 21%. CDS gross market values shrank by 40%, a similar rate of decline to that seen in the first half of the year (-42%). This brought the market value of the CDS contracts down to 35% of its end-2008 peak.

Download full report here: www.bis.org/publ/otc_hy1005.pdf

Q&A: Evolution of the OTC Derivatives Markets

2010-05-10T09:03:00.000-07:00

Posted on DerivAlert.org by John Avery, Partner at SunGard Consulting Services:

Q: Are the OTC derivatives proposals currently being considered the right move for the industry?

A: To paraphrase Darwin, "evolution happens". I think "some sections" of the current proposals are simply natural evolution for the unregulated, bi-lateral OTC derivatives market. It's more than just coincidence that the same Timothy Geithner was an active advocate five years ago for reducing systemic risk in bi-lateral post-trade operations when he was running the New York Fed.

I also think the movement to regulate this market is well outside the hands of the industry itself at this point, so it might be better to ask if the industry has had enough of the "right" objective input into the current proposals for reform. ISDA and SIFMA have been evolving the industry in parallel with reform and have advocated very well, accurately representing the industry and doing their best to contain the "witch hunt", so I think that in general, the industry has indeed defended itself well against most of the regulatory response.

OTC derivatives markets have served and will continue to serve an important function in the market, with nimble, tailored products that permit the dissection and dispersion of a number of key business risks throughout a broader range of market participants. Once the political dust settles, balanced regulation will ultimately do well to increase transparency to a point where enough of the right eyeballs can ensure that fundamental principles for OTC derivatives remain sound, which was not the case leading up to the credit crisis.

Q: What are some benefits/negative effects to the derivatives space from the proposed regulation?

A: Reduced systemic risk and reduced counterparty credit risk will increase awareness and use of OTC derivatives for portfolio managers and end-users who can leverage the behavior they offer.

Immediate negatives for the big dealers are reduced margins, increased capital requirements, client collateral re-hypothecation constraints, and increased house funding constraints that, when combined together, can have dramatic economic consequences. Uncertainty for all other market participants on exemptions, margining, and capital treatment across the gamut of products they use will also have economic consequences that have yet to be fully explored.

An obvious other impact for participants will come in the form of significant capital expenditures in operations, technology and compliance, however the long term benefits of these investments will ultimately yield a more scalable, risk managed infrastructure to serve the industry for years to come.

Q: In your opinion, will the proposed bill pass with the current OTC mandates intact?

A: I think Clearing, Transparency and Swap Execution Facilities have quite a bit of support and will likely make their way into the final legislation, as will some set of End-User exemption behavior. The Volcker Rule is quite contentious - and one that could have dramatic disruptive economic consequences if immediately forced upon the industry - so it's likely that cooler heads will prevail and a more balanced, bi-partisan bill will find its way to Obama's pen.

Q: Do you think OTC derivatives are being vilified by Washington?

A: I think they're an easy target and it's unfortunate that the entire apple cart of OTC derivative instruments has been upset by a few bad apples that contributed to the credit crisis.

Q: What will derivatives traders and other market participants have to do to be compliant with the pending regulation?

A: This is a great question that very few are asking right now and will ultimately catch most of the industry off-guard. We've been looking at this for quite some time within SunGard, because we have a responsibility to our clients to help them with answers and solutions.

At face value, the move from an unregulated to a regulated market is not one that can be taken lightly. Clearing, Swap Execution Facilities and Trade Repositories are the obvious immediate operational compliance requirements, but it's the non-obvious hints we glean from other markets that we must be cognizant of.

Game over for Moody's?

2010-05-09T05:27:00.001-07:00

Some potentially catastrophic news in the Moody's 10Q statement about an SEC Wells Notice:

From time to time, Moody’s is involved in legal and tax proceedings, governmental investigations, claims and litigation that are incidental to the Company’s business, including claims based on ratings assigned by MIS. Moody’s is also subject to ongoing tax audits in the normal course of business. Management periodically assesses the Company’s liabilities and contingencies in connection with these matters based upon the latest information available. Moody’s discloses material pending legal proceedings pursuant to SEC rules and other pending matters as it may determine to be appropriate.

Following the events in the U.S. subprime residential mortgage sector and the credit markets more broadly over the last two years, MIS and other credit rating agencies are the subject of intense scrutiny, increased regulation, ongoing investigation, and civil litigation. Legislative, regulatory and enforcement entities around the world are considering additional legislation, regulation and enforcement actions, including with respect to MIS’s compliance with newly imposed regulatory standards. Moody’s has received subpoenas and inquiries from states attorneys general and other governmental authorities and is responding to such investigations and inquiries. Moody’s Wall Street Analytics unit is cooperating with an investigation by the SEC and the Department of Justice concerning services provided by that unit to certain financial institutions in connection with the valuations used by those institutions with respect to certain financial instruments held by such institutions.

On July 1, 2008, Moody’s publicly announced the results of the Company’s investigation into the issues raised in a May 21, 2008 newspaper report concerning a coding error in a model used in the rating process for certain constant-proportion debt obligations. The Company’s investigation determined that, in April 2007, members of a European rating surveillance committee engaged in conduct contrary to Moody’s Code of Professional Conduct. On March 18, 2010, MIS received a “Wells Notice” from the Staff of the SEC stating that the Staff is considering recommending that the Commission institute administrative and cease-and-desist proceedings against MIS in connection with MIS’s initial June 2007 application on SEC Form NRSRO to register as a nationally recognized statistical rating organization under the Credit Rating Agency Reform Act of 2006. That application, which is publicly available on the Regulatory Affairs page of http://www.moodys.com, included a description of MIS’s procedures and principles for determining credit ratings. The Staff has informed Moody’s that the recommendation it is considering is based on the theory that MIS’s description of its procedures and principles were rendered false and misleading as of the time the application was filed with the SEC in light of the Company’s finding that a rating committee policy had been violated. MIS disagrees with the Staff that the violation of a company policy by a company employee renders the policy itself false and misleading and has submitted a response to the Wells Notice explaining why its initial application was accurate and why it believes an enforcement action is unwarranted.

The Wells Notice apparently relates to the Moody's admission back in July 2008 that:

...members of a European CPDO monitoring committee engaged in conduct contrary to Moody’s Code of Professional Conduct. Specifically, some committee members considered factors inappropriate to the rating process when reviewing CPDO ratings following the discovery of the model error. According to Moody’s Code of Professional Conduct, a committee may consider only credit factors relevant to the credit assessment and may not consider the potential impact on Moody’s, or on an issuer, an investor or other market participant.

Translation: "Moody’s had wrongly bestowed triple-A ratings on billions of dollars of so-called constant proportion debt obligations." (Stacy-Marie Ishmael in FT Alphaville)

According to Henry Blodget:

Wells Notices are usually precursors to full SEC complaints (and most of them result in the agency going forward with charges). The SEC is preparing to file a "cease and desist". It's not clear how broad the threat is here. It might just require Moody's to re-file its application. If the action could be a "cease-and-desist from being a ratings agency," however, Moody's is potentially screwed.

'Sophistication’ debate heats up

2010-05-06T11:44:00.000-07:00

Original posted in the FT by Gillian Tett:

T

his year I wrote a column that argued it was time to start a debate about the definition of “sophisticated” investor. That was sparked by a saga bubbling in Italy, where investment banks have flogged numerous derivatives trades to local governments, and other entities (including convents) – and some of the deals are now turning sour, sparking law suits.
Now, however, this issue of investor “sophistication” is become doubly fraught, for reasons that have nothing to do with Italian nuns. Earlier this week, two Democratic senators filed an amendment to the US financial reform bill, that seeks to impose a fiduciary duty on all registered broker-dealers, when they deal with investors.
That would mean that a Wall Street broker would have to protect clients at all times, instead of the bank, even when acting as a counterparty. Or, as Arlen Specter, Democratic senator co-sponsoring the bill, said. “This is a commonsense amendment that seeks to close a gaping loophole in federal law where brokers and dealers can avoid putting their clients’ interest first.”
It is unclear whether that proposal will fly. The banking industry loathes it, and there are several versions of this “fiduciary” idea now floating around. The Specter bill, for example, wants to impose fiduciary duty for all investors. Other proposals “only” demand this in relation to municipalities or pension funds.
Nevertheless, the central theme that underpins this Washington fight – although it is rarely articulated – is that thorny matter of “sophistication”. Until now, the financial world has assumed that investors could be divided neatly into two mental camps: “unsophisticated” retail investors and everyone else. While the first group needed to be protected, the second group did not. If you were “sophisticated”, in other words, you were supposed to live by the principle of buyer beware.
But if US lawmakers now want to expand the fiduciary net, this definition of “sophisticated” players will shrink too. And that could overturn the entire business model of Wall Street, not least because it will mean that banks will no longer be able to suck fat fees from supposedly sophisticated clients.
Is this a good idea? Unsurprisingly, bankers insist not. More specifically, bank lobbyists argue that if the fiduciary net is expanded to cover municipalities and pension funds, this will stop them offering swaps contracts, or force them to impose dramatically higher fees. That would make it much harder for municipalities and pension funds to hedge risk, or so the argument goes.
But while there may be a grain of truth to this argument, in practice the banks are on very weak political ground. The recent Goldman Sachs hearings have shown on prime time television just how cavalier – and unscrupulous – Wall Street traders can be when they deal with clients. More important still, it seems likely that a wave of American municipalities will go bust this year, sometimes due to poorly constructed derivatives deals.
So, for my money, this suggests that the most sensible way forward would be for both bankers and politicians to look for some middle ground – in the most literal sense – by redefining this “sophistication” idea. Some bank clients, such as retail investors, clearly do need full protection. At the other end of the spectrum, however, there are other investors who are probably as sophisticated and savvy as the banks, and thus probably do not require or deserve such protection. The critical issue is the group that lies between those extremes, such as municipalities and pension funds, which are not “retail” (since they are run by professionals), but not as “sophisticated” as the banks. Personally, I think it would be an overreaction to treat that middle group in exactly the same way as retail investors. It would also be a pity if banks stopped offering swaps trades to that middle group. They can be beneficial, if handled sensibly.
Even if municipalities were not given as much protection as retail investors, there is a case to impose milder fiduciary standards. Banks could, for example, be forced to be completely transparent about the costs of products to this middle group. They could also be forced to reveal any conflicts of interest (say if their own proprietary traders were betting against the deal). Local governments could also be forced to engage a “swap transaction adviser”, to act on their behalf as their fiduciary in transactions with swap dealers.
But most important of all, US lawmakers could state emphatically that municipalities and pension funds are not “sophisticated” (nor retail) – but form a third, intermediary category. That three-tiered approach would force banks to amend their internal processes. It might also prompt Europe to follow suit. If so, this would be a thoroughly good thing – not just for American municipalities (or Italian convents) but the battered reputation of the financial industry too.

Bill Gross: I come not to bury the rating services, but to dismiss them

2010-05-05T15:29:00.000-07:00

Pimco's Bill Gross on the rating agency follies:

In all of the hullabaloo over Goldman Sachs, a CQ analysis of the rating services – Moody’s, Standard & Poor’s and Fitch – has escaped front-page headlines. Not that a number of observers haven’t been on to them for a few years now, including yours truly. Back in July of 2007 some of you will remember my description of their role in the subprime crisis. “Many of these good-looking girls are not high-class assets worth 100 cents on the dollar. You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’” Now, it seems, I was a little long on humor and a little short on the reality. Tramp stamp and hooker heels do not begin to describe the sordid, nonsensical role that the rating services performed in perpetrating and perpetuating the subprime craze, as well as reflecting the general deterioration of investment common sense during the past several decades. Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbors. The result has been the foisting of AAA ratings on an unsuspecting (and ignorant) investment public who bought the rating service Kool-Aid that housing prices could never really go down or that countries don’t go bankrupt. Their quantitative models appeared to have a Mensa-like IQ of at least 160, but their common sense rating was closer to 60, resembling an idiot savant with a full command of the mathematics, but no idea of how to apply them.

For more lively prose, read his latest Investment Outlook. However, for a more thoughtful and self serving commentary, read Josh Rosner's Taming the Wild West:

While full elimination of the rating agencies may or may not be necessary or realistic, in my opinion we must reduce reliance on ratings and support a narrowing spread between price and value in the secondary market. To that end, the SEC should require that after the deal is sold, all data fields in the pre-issuance disclosures and material information about the loan level collateral in the pool should be updated and be similarly disclosed on a daily, or at least monthly, basis in an electronically manageable and standardized format. Regardless of the nature of the deal (private placement or registered) the data should be publicly disclosed to the loan level and all servicer advances to the pool shall be disclosed as such on a timely basis. Any subsequent repayments of servicer advances should also be reported in a clear manner.

And here's ex-Moody's guru Jerome Fons being interviewed on Rortybomb:

Imagine a central repository of ratings methods and data, accessible to all. Imagine a world of transparent data for all transactions and all securities. What we could then do is empower users, train them in the use of the methods. And evolve methods as needed. You could broadly democratized the process.

In this world you would do your own work, and it isn’t outsourced to clearly conflicted people. I think that’s where we’ll evolve to, but it’ll take a huge shift in our thinking and infrastructure.

The major ratings firms could improve transparency today by simply refusing to rate an obligation unless all relevant data is made public. I think that would be an important first step.

Pershing Square Capital Management chief William Ackman would like to see the Securities and Exchange Commission set up a research database, modeled on its EDGAR system for corporate filings.According to the story posted on FinAlternatives:

Ackman said he would also allow investors to post research on the database—with the caveats of full disclosure and no libel, those posts would be protected from liability.

“If we had a mechanism like that, where there’s a much freer exchange of ideas, it would lead to more accurate security prices,” he said. “It would be a great forum for the SEC to comb through to find companies they should focus their investigations on.”

Roger Ehrenberg on Information Arbitrage would go even further:

One of the unique aspects of the debt market is its mind-numbing diversity and dimensionality: maturity, amortization, optionality, collateral, seniority, etc. A "one size fits all" approach simply does not work for the bond market, and it is questionable as to whether a single entity has the intellectual horsepower and access to the resources necessary to effectively and efficiently analyze its range of securities. Large, seemingly intractable software problems have benefited from the massive collaboration available through the open source movement. This has been an effective method for not only addressing a core problem, but for keeping up-to-date and relevant as technology evolves. It has also been a vehicle for value-added service providers to build on top of these solutions (e.g. Red Hat/Linux, Lucid Imagination/Lucene, etc.) for specific use cases, providing needed service levels and documentation, etc. While not a panacea, the open source movement has effectively harnessed the world's intellectual capital and applied it to big problems relevant to a broad array of constituencies.

If an open source approach has worked so well in software, why not apply it to the ratings problem? Whether or not ratings should be required for institutional investors to buy certain securities is not the issue; the essential point is getting better transparency into and analysis of instruments constituting the investable universe. Imagine a university or a large institutional investor seeding the open source initiative by putting their own debt ratings models into the public domain and allowing others to contribute to its development. I can see a suite of open source libraries by type of instrument, with a new industry emerging to deliver additional analytics, data and recommendations on top of these libraries. There would need to be a Wikipedia-type board of curators, ensuring that additions to the libraries are sensible and increase the stock of intellectual capital. But I can't see why such an approach wouldn't address the biggest problems facing the ratings industry today.

Combining bond analysis and the open source movement could deliver:

Transparency;
Unbiased input;
Access to a global talent pool;
Opportunities for specialized applications to be delivered in tandem; and
Institutional-grade analytics and research available to all.

I haven't seen or heard of a better solution to the problem, and the problem certainly isn't going away. If we as a financial community are committed to such an approach, it is bound to be successful. Let's give it a shot.

A Short History of Derivative Security Markets

2010-04-27T05:37:00.000-07:00

By Ernst Juerg Weber, University of Western Australia - UWA Business School

Abstract: Contracts for future delivery of commodities spread from Mesopotamia to Hellenistic Egypt and the Roman world. After the collapse of the Roman Empire, contracts for future delivery continued to be used in the Byzantine Empire in the eastern Mediterranean and they survived in canon law in western Europe. It is likely that Sephardic Jews carried derivative trading from Mesopotamia to Spain during Roman times and the first millennium AD, and, after being expelled from Spain, to the Low Countries in the sixteenth century. The first derivatives on securities were written in the Low Countries in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the turn of the seventeenth to the eighteenth century, and from France to Germany in the early nineteenth century. Circumstantial evidence indicates that bankers and banks were at the forefront of derivative trading during the eighteenth and nineteenth centuries.

Download paper here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1141689

The Mysterious "Fed Staffers" document that stalled the Dodd bill

2010-04-26T19:09:00.000-07:00

Courtesy of the Financial Times here are four pages of "Fed staff" comments on the Dodd financial reform bill: av.r.ftdata.co.uk/files/2010/04/Senate-Ag-bill-comments-april-24-2010-FED.pdf.

According to the Times:

It details seven areas where derivatives-related reform needs a comprehensive re-draft — a re-draft that might have the handy side-effect of helping Wall St banks avoid having to spin off their derivatives operations.

Gillian Tett and Paul Krugman on the "murky world" of credit ratings

2010-04-26T06:15:00.000-07:00

The FT's Gillian Tett welcomes last week's publication of the rating agency emails:

Another week, another bout of e-mail embarrassment. Goldman Sachs shot into the spotlight 10 days ago, after the Securities and Exchange Commission accused the bank of fraud and released e-mails written by Fabrice Tourre, a trader, describing the financial products he created as useless “monstruosities” (sic).
A senate committee released a fresh batch of documents at the weekend, including e-mails from senior Goldman officials crowing that the bank could make “serious money” from America’s mortgage disaster. These will be debated in Washington on Tuesday.
But these have not been the only electronic howlers. A senate committee last week released e-mails from Standard & Poor’s and Moody’s which revealed something long suspected but never proven: that from 2005 the rating agencies faced growing pressure to cut corners in how they rated complex credit instruments in order to win lucrative business from banks....
It is fascinating, almost touching, stuff. Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working. But by 2007 they, like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also in a strange, geeky silo, into which few non-bankers ever peered...
There are two important lessons. One is that what went wrong in finance was fundamentally structural, as an entire system spun out of control It might seem tempting to lash out at a few colourful traders but that is a sideshow: what is needed is systemic reform that removes conflicts of interest.
The second lesson is that the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.

And in the NY Times, Paul Krugman:

What those [rating agency] e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.
The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.
Those seals of approval came to play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.
It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.
And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.
These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”
So what can be done to keep it from happening again?
The bill now before the Senate tries to do something about the rating agencies, but all in all it’s pretty weak on the subject. The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough, given the money at stake — and the fact that Wall Street can afford to hire very, very good lawyers.
What we really need is a fundamental change in the raters’ incentives. We can’t go back to the days when rating agencies made their money by selling big books of statistics; information flows too freely in the Internet age, so nobody would buy the books. Yet something must be done to end the fundamentally corrupt nature of the the issuer-pays system.
An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.
I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

E-Mails Show Goldman Boasting as Meltdown Unfolds

2010-04-24T08:52:00.000-07:00

Original posted on U.S. Senator Carl Levin's website:

“Investment banks such as Goldman Sachs were not simply market-makers, they were self-interested promoters of risky and complicated financial schemes that helped trigger the crisis,” said Sen. Levin. “They bundled toxic mortgages into complex financial instruments, got the credit rating agencies to label them as AAA securities, and sold them to investors, magnifying and spreading risk throughout the financial system, and all too often betting against the instruments they sold and profiting at the expense of their clients.” The 2009 Goldman Sachs annual report stated that the firm “did not generate enormous net revenues by betting against residential related products.” Levin said, “These e-mails show that, in fact, Goldman made a lot of money by betting against the mortgage market.”
The four exhibits released today are Goldman Sachs internal e-mails that address practices involving residential mortgage-backed securities and collateralized debt obligations (CDOs), financial instruments that were key in the financial crisis.
In one of the e-mails released today, Mr. Blankfein stated that the firm came out ahead in the mortgage crisis by taking short positions. In an e-mail exchange with other top Goldman Sachs executives, Mr. Blankfein wrote: “Of course we didn't dodge the mortgage mess. We lost money, then made more than we lost because of shorts.”
In a second e-mail, Goldman Sachs Chief Financial Officer David Viniar, who also will testify on Tuesday, responded to a report on the firm's trading activities, showing that – in one day - the firm netted over $50 million by taking short positions that increased in valued as the mortgage market cratered. Mr. Viniar wrote: “Tells you what might be happening to people who don't have the big short.” Levin said: “There it is, in their own words: Goldman Sachs taking ‘the big short’ against the mortgage market.”
In a third e-mail, Goldman employees discussed the ups and downs of securities that were underwritten and sold by Goldman and tied to mortgages issued by Washington Mutual Bank's subprime lender, Long Beach Mortgage Company. Reporting the “wipeout” of one Long Beach security and the “imminent” collapse of another as “bad news” that would cost the firm $2.5 million, a Goldman Sachs employee then reported the “good news” – that the failure would bring the firm $5 million from a bet it had placed against the very securities it had assembled and sold.
In a fourth e-mail, a Goldman Sachs manager reacted to news that the credit rating agencies had downgraded $32 billion in mortgage related securities – causing losses for many investors – by noting that Goldman had bet against them: “Sounds like we will make some serious money.” His colleague responded: “Yes we are well positioned.”

Go here for the actual emails: http://levin.senate.gov/newsroom/release.cfm?id=324169

The Catch-22 of Credit Rating Model Transparency

2010-04-24T07:11:00.001-07:00

As reported in the New York Times...

One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.
One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them. In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees...

The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.

But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...David Weinfurter, a spokesman for Fitch, said via e-mail that rating agencies had once been criticized as opaque, and that Fitch responded by making its models public...

Read the rest of the article at www.nytimes.com/2010/04/24/business/24rating.html

Goldman’s biggest lie

2010-04-23T12:29:00.000-07:00

Original posted on Reuters by Felix Salmon:

Alea has given us Abacus for Dummies: a very useful quick overview of the structure of the deal. And in doing so, he helps to reveal Goldman’s biggest lie.

Simplifying Alea even further, we have five steps here:

The reference portfolio is put together.
Goldman sells super-senior protection, Paulson buys it.
IKB and ACA sell senior protection, Goldman buys it.
Goldman takes the senior protection that it bought from IKB and ACA, and sells it on to Paulson.
Goldman buys super-senior protection from ACA, through ABN Amro.

From Goldman’s point of view, steps 3 and 4 cancel each other out as a perfect hedge, and it can walk home happily with its fee income. And steps 2 and 5 should do the same thing, but they don’t: in step 2, Goldman sold super-senior protection on the top 50% of the deal, while in step 5 it bought super-senior protection only on the top 45% of the deal. So the hedge was imperfect, Goldman ended up long 5% of the deal, and, in the end, it lost lots of money.

But the fact is that there are two big-picture deals here, not one — and yet they’re very intimately connected.

In the first deal, the super-senior deal, Goldman acts as an intermediary, first selling protection to Paulson, and then buying it from ACA via ABN.

In the second deal, the actual Abacus deal, Goldman creates the Abacus vehicle, which issues securities to IKB and ACA, which are ultimately funded by Paulson taking the other side of the trade.

Now, let’s look at a page from the pitchbook:

The Super Senior tranche here is the one in the first deal; Class A is the notes which were sold to IKB; Classes B, C, and D were sold to ACA; and the First Loss equity tranche at the bottom is the bit of the deal which never existed since, as Alea says, “the deal doesn’t need an equity investor (and doesn’t have one)”. The fact of its nonexistence is conspicuous by its absence: “Not Offered” is by no means the same thing as “Does Not Exist”.

The fact is that the Abacus deal itself didn’t need a super senior investor, either, and didn’t have one. It just needed classes A through D, which were sold to ACA and IKB. The super-senior deal was entirely separate, and had nothing to do with Abacus, although it used the same portfolio of reference securities.

So the question arises: why on earth is the super senior tranche (and the equity tranche, for that matter) even listed in the pitchbook in the first place?

When Goldman refers to ACA as “the overwhelmingly largest investor in the transaction”, it’s clearly referring to the transaction as a whole, including the super-senior deal, rather than just the Abacus part of it. And what’s more, there’s something clean and elegant about the way in which the structure of the deal, as outlined in the pitchbook, goes smoothly all the way from First Loss all the way to 100%.

In theory, as far as I can tell, there’s no reason why the 45-50% tranche — the one that Goldman ended up holding onto and losing $90 million on — should ever have existed either: it, like the equity tranche, could simply never have been offered to anyone. Why didn’t Goldman just move the attachment point for the super senior tranche up from 45% to 50%, so as to match the hedge it bought from ACA via ABN?

After all, Paulson was not buying credit protection on the reference securities as a whole. But that’s how it looks, in the pitchbook. Here’s the pretty picture of the structure, in the same book:

If you’re ACA, looking at this structure, you know that as the deal is being put together, you’re negotiating to insure the Super Senior Amount which exists in this picture as a semi-fictional entity outside the structure and inside a grey dotted box. In other words, while you know it’s not a formal part of the Abacus structure, you also know that it exists.

And in this picture, the First Loss Amount has the same ontological status as the Super Senior Amount: it exists, but only outside the formal confines of the Abacus deal. Since ACA knew full well that the super-senior tranche existed — after all, it was negotiating to insure it — there’s no reason why it should have doubted that the equity tranche existed as well, just like it did in Magnetar trades with which it was familiar.

Here’s Goldman Sachs, in its letter to the SEC:

The fact that ACA may have perceived Paulson to be an equity investor is of no moment. As a threshold matter, the interests of an equity investor would not necessarily be aligned with those of ACA or other noteholders, and holders of equity may also hold other long or short positions that offset or exceed their equity exposure. Indeed, Laura Schwartz of ACA understood this from her work on a transaction that closed in December 2006 in which Magnetar, a hedge fund that bought equity and took short positions in mezzanine-level debt, participated. (See GS MBS-E-007992234 (“Magnetar-like equity investor”).)

This is, I think, inadvertently damning to Goldman’s case. It’s true that in the Magnetar deals the entity which was long the equity tranche was also short the debt. But at the same time, it’s also true that in the Magnetar deals there was no question that the equity tranche existed. So if ACA’s Schwartz was thinking in terms of the Magnetar deal which closed just before the Abacus deal started being negotiated, then it’s quite understandable that she believed in the existence of an equity tranche in this deal, too. And Goldman never did anything to disabuse her of that belief.

The clear message of the pitchbook is that this synthetic CDO was put together to mimic a cash CDO, which has to have all of its tranches spoken and accounted for. You can’t have a cash CDO without an equity tranche. Remember that if the only point of the Abacus deal was to create the Abacus securities, then there wouldn’t have been a super-senior tranche at all, and ACA would not have been the largest investor in the transaction.

Here, then, is arguably Goldman’s biggest lie of omission: it never told ACA that the equity tranche didn’t exist. If it was being a true and honest broker, it should have done. End of story.

How important is IKB’s sophistication?

2010-04-23T12:27:00.000-07:00

Original posted on Reuters by Felix Salmon:

John Carney has a defense of Goldman Sachs up at the Daily Beast, based on the not-novel-at-all idea that the investors in the Abacus deal were sophisticated.

A document exclusively obtained by the Daily Beast demonstrates (view them here) that just a few months before it invested in the derivatives at the center of the SEC’s case, the German bank was touting its prowess as a sophisticated investor in those derivatives.

But no one is asserting that IKB, or any other party to this transaction, wasn’t sophisticated. The word never appears in the SEC’s complaint against Goldman, for instance, and I have yet to see a Goldman critic latch onto the idea that IKB was some kind of naive widow or orphan, who was bamboozled by all these CDOs and CDSs and whatnot.

On the other hand, Goldman itself loves hammering home the idea that the investors in the deal were sophisticated. Its first big public statement on the deal uses the word twice, its second uses the word three times, and its two letters to the SEC use the word no fewer than twenty-three times between them.

Here, for example, is a chunk of the first letter:

The problem with all of this banging away about IKB’s sophistication is that it looks very much like protesting far too much. The SEC doesn’t need to show that IKB was unsophisticated, it just needs to show that Goldman didn’t make the disclosures required by the law.

Carney, a lawyer by training, tries to explain why he thinks this is such a big issue, but he’s far from convincing:

The sophistication of IKB will be an important issue in the Goldman case. In general, the securities laws of the United States assume that sophisticated investors can fend for themselves. That’s exactly why hedge funds—which only accept money from so-called “accredited investors”—are largely free from regulation. The focus of our securities laws is the protection of ordinary investors and market integrity.

I’m sure that a class on the history of US securities laws would be fascinated by their treatment “in general” of sophisticated investors, and by their overall focus in terms of investor protection. But the point at question here is whether Goldman failed to make necessary disclosures, simple as that. To be sure, the level of disclosure necessary changes according to the sophistication of the investor in question, and qualified institutional investors in the 144a market are much more sophisticated than ordinary individual investors. But the level of disclosure never goes away entirely, and in fact the statute in question is drawn very broadly:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

There’s nothing there about “any unsophisticated person”: if Goldman’s omission of Paulson’s role in its statements made what it was saying misleading, or if it was deceitful, then that’s it, case closed. IKB may or may not have been a sophisticated investor, but I don’t think that status matters nearly as much as Goldman and Carney think and/or hope that it does.

CDO Market – Rife With Collusion and Manipulation?

2010-04-23T05:11:00.000-07:00

Original posted on Naked Capitalism by Tom Adams and Yves Smith:

Despite extensive credit crisis post mortems, many of the widely accepted explanations of what happened are at odds with facts on the ground. These superficial explanations are hard to dislodge because they tally with widely held beliefs about how the real estate and securitization market operate. The waters have been muddied even more by self-serving PR from various market participants.

The consensus reality of the credit crisis appears to be: it was the result of a complex combination of factors, no one can be blamed all that much (save maybe greedy borrowers and complicit rating agencies) and almost no one saw it coming.

We’ve argued that many of the arguments that support that view are myths. In particular, the more we have dug into the CDO market, the more we are convinced that it was central to the crisis. Furthermore, we believe that this market did not operate on an arm’s length basis, that many of the practices that were widespread in the industry amounted to collusion.

Collusion and resulting price distortions serve as the most likely explanations for behaviors that are consistently glossed over in the consensus accounts of the crisis. By early 2006, many mortgage market participants felt that the housing market was overheated and unsustainable. Many felt that mortgage rates should be higher, but despite interest rate tightening by the Fed, mortgage rates were not increasing. Even more distressing, credit spreads remained narrow despite widespread concerns that mortgage risk was increasing and deals were weakening.

Many economists and academics described this as a conundrum at the time and tried to come up with theories to explain it, none of which were terribly satisfying. None of them looked at a more likely culprit – the securitization market and, specifically, the CDO market.

CDOs distorted the mortgage market because they undermined the normal processes for pricing risky assets. For subprime debt, demand for the lower rated tranches had served to constrain market growth. If investors started to shun the BBB to AA rated tranches of subprime mortgage bonds, dealers were not willing to retain them, no new deals would be sold, and the market would need to find better quality mortgages or grind to a halt. But CDOs were the dumping ground for these tranches. A 1990s version of mortgage-related CDOs proved ultimately to be a Ponzi scheme (unsold risky CDO tranches were rolled into new CDOs), but even then, that CDO market imploded early enough that the damage was comparatively minor.

This time, the CDO market distortions were more significant and wide-ranging. In particular:

1. Demand for CDOs came not from long investors, who would be concerned about credit losses, but primarily from (a) short investors who wanted to bet aggressively against the housing market and needed a tool to allow them to do so without disclosing their real intentions (b) investment banks who created the CDOs so they could generate fees and bonuses by putting the CDO bonds in their trading portfolios (negative basis trades) and off balance sheet vehicles (SIVs) without regard to risk and (c) correlation traders who were indifferent to credit risk

2. The normal mechanisms for pricing risk were upended because of manipulation of the demand for mortgage and CDO bonds by a consortium of banks and CDO managers who masked the real appetite for the bonds and fabricated pricing for the bonds

3. By creating the illusion of demand for the mortgage and CDO bonds, the CDO managers and arranging banks operated under a well disguised conspiracy that allowed a massive housing bubble to be created which only exploded when the shorts became impatient for realizing their gains.

If traditional cash investors and insurers were avoiding the mortgage securities market, who was driving the yields and spreads lower? Many industry participants agreed that the “CDO bid” was distorting the market.

The mechanism was the CDO managers, who assembled the assets for cash or hybrid deals (ones like Magnetar’s that used a combination of mortgage bond tranches and credit default swaps). They were effectively extensions of investment banks, dependent on substantial credit lines from them. Perhaps more important, it appears that many of the larger CDO managers bought much, perhaps all, of the AA to BBB tranches of entire subprime mortgage bond issues to be placed into CDOs. Having a single affiliated party take down the riskiest layers of subprime deals means that normal arm’s length pricing was not operating, and the profit potential of CDO issuance, rather than investor demand, was driving the market.

Consider this series of interconnected transactions:

A “sponsor” indicates an interest in creating a CDO to an investment bank. In combination, the sponsor and the bank would select the CDO manager who would buy the mortgage bonds for the CDO at start up and oversee the portfolio after closing. The sponsor would typically provide the CDO manager with an investment objective and find a manager that could achieve these aims.

Since the CDO deals were typically over a billion dollars, the CDO manager didn’t usually have the capital to purchase the mortgage bonds. As a result, the investment bank for the deal would offer the manager a line of credit to use to purchase the bonds that the manager selected. When the CDO closed, the CDO would repay the line of credit.

The bank for the CDO would not offer the line of credit to a thinly capitalized CDO manager casually. They were sure to get an attractive rate of interest plus a security interest in the bonds being financed to protect them in case the CDO manager ran into trouble. In addition, the CDO manager would work hard to find investors in the CDO to pay of the loan from the investment bank.

Many CDO managers were repeat issuers and many had a fairly systematic approach to how they covered the market. For instance, in a particular period, a CDO manager might be responsible for a mezzanine deal and a high grade deal or two. This would mean that the CDO manager had multiple lines of credit active

This execution strategy meant that the CDO manager had significant capital at its disposal for the purpose of buying mortgage bonds. Normally, the process of bidding on newly issued mortgage bonds while trying to meet the eligibility criteria of the proposed CDO transaction can be timing consuming and arduous for the CDO manager. The clever ones with more influence and access to generously termed lines of credit, could use their capital to tremendous advantage. Rather than face the competition of multiple bidders on a particular bond of a new mortgage deal, the CDO manager, armed with multiple upcoming deals and lines of credit, could offer to buy the entire stack of subordinated bonds that the issuer was bringing to market: BB all the way up to AA. This would be very attractive to the issuer, since it made it easier to get his deal sold. It was attractive to the CDO manager, since they could slot the bonds into both their mezzanine deal and their high grade deal at the same time, saving them a considerable amount of work. In addition, it could be very attractive for the bank on the mortgage transaction, particularly if they were the same bank that was issuing the CDO. A bank that knew it would be able to sell its mortgage deal and supply bonds to its CDO deal at the same time would take comfort that it was not terribly exposed to market risk.

One additional feature that some CDO managers might employ is to have a line of credit established for an upcoming CDO squared. A CDO-squared is made up of other CDO bonds, rather than MBS bonds. Putting aside how ridiculous the concept sounds now, this type of deal served a tremendous importance at back in 2006 and 2007. Since the riskier tranches of a CDO were more expensive to the issuers and harder to place, a CDO manager who knew that he had a home for these slices of his upcoming mezzanine or high grade CDO could certainly sleep easier. If managed properly, a CDO manager working with a friendly bank could pre-place the all of the sub bonds for a number of mortgage deals into their mezzanine and high grade deals and also pre-place all of the sub bonds from their mezzanine and high grade deals into a CDO squared transaction.

This example illustrates that pricing was often not based on market demand. Is there any real price discovery if one buyer (the CDO manager) is snapping up all of the risky tranches from a mortgage deal, and the bank on the mortgage deal is the same bank on the CDOs where the bonds will end up? Similarly, if all the risky tranches of a CDO were all pre-placed into another CDO, did anyone even bid on them? And since all of these pieces fit so nicely together, wouldn’t getting competitive bids really have been rather inconvenient?

Consider the role that a company like TCW played in the market. TCW was the biggest CDO manager in the ABS CDO market. In 2006, TCW acted as manager on about $9.5 billion worth of CDOs over 7 transactions.

The deals have an interesting pattern – alternating between high grade ($5.5 billion) and mezzanine ($3.4 billion) and across four banks, Goldman, Merrill, Wachovia and Morgan Stanley. The high grade deals included not just A and AA MBS bonds but also similarly rated bonds from other CDOs, including potential the mezzanine and high grade deals managed by TCW during this period.

During this same time 2006, those four bankers owned or acquired subprime lenders who typically securitized most of their originated loans. By rotating among the lenders owned by these banks, TCW could achieve decent diversity in their CDOs without ever having to pursue other lenders for their bonds. While they certainly mixed the bonds of other lenders into the mix to achieve better diversity scores from Moody’s (and lower rating agency cost of issuance, TCW may have offered to take all, or nearly all, of the mortgage bonds issued by the acquired lenders of Merrill Lynch, Wachovia, Morgan Stanley and Citigroup when they brought a subprime or Alt A mortgage deal or perhaps even the occasional deals where the banks had offered the bonds of third party mortgage lenders. If so, it’s likely the offer was received well.

Consider the systemic impact. Lower costs on for the CDO translated into lower, more aggressive bids for the mortgage bonds, which translated into lower mortgage rates – all of which were potentially being set between just 4 or 5 traders

But the risky tranches represented only a relatively small portion of the mortgage or CDO transactions. What happened to the biggest portion of the transactions – the senior (AAA) bonds? The bond insurers insured a decent amount of the market in 2006 (about a third), but even the many of the insured bonds needed a buyer and the uninsured senior bonds still needed a home. As we learned last week when Citigroup testified at the FCIC, Citigroup were big buyers of their own CDOs. Just like with the mezzanine and high mortgage deal, it was probably much more convenient for bank who was selling the senior CDO bonds, to convince management to acquire the bonds themselves rather than try to sell them in a messy, time consuming bid process. Similarly, Yves discussed in ECONNED that Eurobanks frequently retained AAA tranches because Basel II rules gave them considerable latitude in how much (as in how little) capital to charge against them.

As a result, from the top of the structure – the senior bonds of a high grade or mezzanine CDO, all the way down through the mortgage bonds and into the price of the mortgage loans – third party assessments of the risk and rewards of the loan appear to have been limited to non-existent.

The result was that riskier and riskier loans were being originated at effectively lower costs for issuers with little outside feedback. In one big happy family among the mortgage issuers, CDO managers and CDO investors, there would have been little motivation to worry about increasing risk or wider spreads. They were all keen to keep the great fee machine rolling.

Finally, if you throw the shorts into the equation, you complete the picture. Hedge funds who wanted to short subprime were pushing for more and more CDS on MBS, which led to the creation of more CDOs, which in turn, bought more cash and synthetic MBS bonds, helping to keep spreads low. The tight spreads on the mortgage deals created a great buying opportunity for the shorts, who were getting to bid on what we now know were extremely risky loans at bargain basement prices. Once the risks in the mortgage loans began to emerge, spreads on the bonds finally started to widen, sometime in mid 2007. By then it was too late – the deals were already created. Since the bonds had never really been distributed very widely and sat with highly leveraged firms that could not take much in the way of losses, the result was systemic risk and financial crisis.

Abacus for Dummies

2010-04-23T05:09:00.000-07:00

Original posted on Alea:

First, a reference portfolio is constructed

Second, Paulson buys protection on the 45%/100% tranche (super senior) from Goldman Sachs, this is a bilateral trade with nothing to do with the Abacus SPV other than using the same reference portfolio.
This leaves Goldman Sachs short protection on the 45%/100% tranche.

Third, Goldman Sachs sells notes to IKB ($192 milion) and ACA ($42 million) => this leaves Goldman Sachs long protection (via purchase from the Abacus SPV) on the notes notional and short protection on the 45%/100% tranche.
Notes sold are well below what was expected in the “flipbook”.

Fourth, post-deal closing Goldman Sachs sells its long protection on the notes (acquired from the Abacus SPV) to Paulson => this puts back Goldman Sachs as short protection on the 45%/100% tranche

Fifth, more than a month after the deal closing, Goldman Sachs buys protection from ACA (through ABN/AMRO) on the 50%/100% tranche, this a bilateral trade with nothing to do with the Abacus SPV other than using the same reference portfolio => this leaves Goldman Sachs short protection on the 45%/50% tranche (5% of total notional).
The ACA deal (50% to 100% = 50%) is for $909 million notional, which implies a total notional of $1.8 billion for the deal, also below the level announced in the “flipbook”.

The deal goes sour and Goldman Sachs exposure is wiped out => $1.8 billion * 0.05 = $90 million

This a synthetic CDO referencing a static portfolio and protection was bought/sold NOT on the entire portfolio notional but only on the super senior tranche and the notes sold to qualified investors.

It is completely irrelevant whether Paulson was or wasn’t an equity investor as the deal doesn’t need an equity investor (and doesn’t have one).

Seize the yachts! The best financial reform? Let the bankers fail

2010-04-23T04:31:00.000-07:00

Original posted in the Washington Post by James Grant:

The trouble with Wall Street isn't that too many bankers get rich in the booms. The trouble, rather, is that too few get poor -- really, suitably poor -- in the busts. To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.

Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors.

Of course, there are only so many mansions, Bugattis and Matisses to go around. And many, many such treasures would be needed to make the taxpayers whole for the serial failures of 2007-09. Then again, under my proposed reform not more than a few high-end sheriff's auctions would probably ever take place. The plausible threat of personal bankruptcy would suffice to focus the minds of American financiers on safety and soundness as they have not been focused for years.

"The fear of God," replied George Gilbert Williams, president of the Chemical Bank of New York around the turn of the 20th century, when asked the secret of his success. "Old Bullion," they called Chemical for its ability to pay out gold to its depositors even at the height of a financial panic. Safety was Chemical's stock in trade. Nowadays, safety is nobody's franchise except Washington's. Gradually and by degree, starting in the 1930s -- and then, in a great rush, in 2008 -- the government has nationalized it.

No surprise, then, the perversity of Wall Street's incentives. For rolling the dice, the payoff is potentially immense. For failure, the personal cost -- while regrettable -- is manageable. Senior executives at Lehman Brothers, Citi, AIG and Merrill Lynch, among other stricken institutions, did indeed lose their savings. What they did not necessarily lose is the rest of their net worth. In Brazil -- which learned a thing or two about frenzied finance during its many bouts with hyperinflation -- bank directors, senior bank officers and controlling bank stockholders know that they are personally responsible for the solvency of the institution with which they are associated. Let it fail, and their net worths are frozen for the duration of often-lengthy court proceedings. If worse comes to worse, the responsible and accountable parties can lose their all.

The substitution of collective responsibility for individual responsibility is the fatal story line of modern American finance. Bank shareholders used to bear the cost of failure, even as they enjoyed the fruits of success. If the bank in which shareholders invested went broke, a court-appointed receiver dunned them for money with which to compensate the depositors, among other creditors. This system was in place for 75 years, until the Federal Deposit Insurance Corp. pushed it aside in the early 1930s. One can imagine just how welcome was a receiver's demand for a check from a shareholder who by then ardently wished that he or she had never heard of the bank in which it was his or her misfortune to invest.

Nevertheless, conclude a pair of academics who gave the "double liability system" serious study (Jonathan R. Macey, now of Yale Law School and its School of Management, and Geoffrey P. Miller, now of the New York University School of Law), the system worked reasonably well. "The sums recovered from shareholders under the double-liability system," they wrote in a 1992 Wake Forest Law Review essay, "significantly benefited depositors and other bank creditors, and undoubtedly did much to enhance public confidence in the banking system despite the fact that almost all bank deposits were uninsured."

Like one of those notorious exploding collateralized debt obligations, the American financial system is built as if to break down. The combination of socialized risk and privatized profit all but guarantees it. And when the inevitable happens? Congress and the regulators dream up yet more ways to try to outsmart the people who have made it their business in life not to be outsmarted. And so it is again in today's debate over financial reform. From the administration and from both sides of the congressional aisle come proposals to micromanage the business of lending, borrowing and market-making: new accounting rules (foolproof this time, they say), higher capital standards, more onerous taxes. If piling on new federal rules was the answer, we'd long ago have been in the promised land.

Until 1999, Goldman Sachs was a partnership, with the general partners bearing general and unlimited liability for the firm's debts. Today, Goldman -- like the vast majority of American financial institutions -- is a corporation. Its stockholders are liable only for what they invested, no more. And while there are plenty of sleepless nights, the constructive fear of financial oblivion is, for the senior executives, an all-too-distant nightmare.

The job before Congress is to bring the fear of God back to Wall Street. Not to stifle enterprise but quite the opposite: to restore real capitalism. By all means, let the bankers savor the sweets of their success. But let them, and their stockholders, pay dearly for their failures. Fair's fair.

Goldman's Dirty Customers

2010-04-22T10:07:00.000-07:00

Original posted on The Daily Beast by John Carney:

While Goldman and hedge-fund king John Paulson garner all the scrutiny, John Carney reveals how the shadiest player in the saga might be the alleged victim.

In Michael Lewis’ bestseller The Big Short, when Greg Lippman, one of the top traders dealing with the kind of derivatives that helped implode the world’s economy, was asked who was selling insurance on all the lousy subprime loans, he answered concisely: Dusseldorf. “Stupid Germans,” Lippman purportedly told wary hedge-fund investors, despite the fact that he worked at a Deutsche Bank. “They take the ratings agencies seriously. They believe in the rules.”

But the Germans selling the credit default swaps to Goldman Sachs—the very swaps at the heart of the SEC’s case against Goldman Sachs—weren’t stupid. In fact, they were wily and wealthy financial players. Nor did they necessarily play by the rules: Their dealings with Goldman seemed designed to evade regulatory and auditor supervision—something the SEC conveniently shoved down the memory hole in order to paint the Germans as just another victim of Goldman fraud.

In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman.

Rather than suckers, a thorough study of the case indicates that Dusseldorf-based IKB Deutsche Industriebank—which seems to eerily resemble the “stupid Germans” Lippman was referring to when seeking buyers for his eventually toxic collateralized debt obligations—was playing the same game that Goldman was.

In a nutshell, the SEC is alleging that hedge-fund titan John Paulson approached Goldman with a list of mortgage-backed securities he wanted to bet against and, since it's generally not possible to bet directly against a mortgage-backed security, Goldman agreed to provide credit protection, before pawning off the mirror image of Paulson’s basket, named Abacus, to unsuspecting customers, while pocketing a profit on both sides of the transaction.

Enter Dusseldorf’s IKB. Beginning in 2001, CEO Stefan Ortseifen pursued a strategy to turn his modest operation that specialized in lending to small and midsize companies into an aggressive global player dealing in risky assets while, as detailed by financial reporter Nick Dunbar, getting around the prying eyes of his largest shareholder, a conservative, government-owned development bank. Specifically, he set up off-balance-sheet, offshore company called Rhineland Funding, The Wall Street Journal reported, that would buy risky securities, while escaping direct regulatory or auditor scrutiny. Since IKB controlled Rhineland, which was listed on the Irish stock exchange, and lent it money, it could siphon profits out via hefty management fees. Meanwhile, IKB remained at arm’s length, reducing its exposure by pawning off a portion of its dicey Rhineland loans to others.

It was a piece of regulatory arbitrage: In essence, IKB was investing in complex mortgage bonds without having to set aside regulatory capital or report the increase in risky assets to its regulators or auditors.

In short order, Rhineland became one of the biggest buyers of the complex investment products puked out by the likes of Lippman at Deutsche Bank, JP Morgan Chase—and Goldman. One banker told Euroweek that IKB—through Rhineland and similar tactics—had become one of the five or six largest investors in Europe. Thus, Goldman found them a willing buyer for the junk piled into Abacus.

The crucial question in the SEC’s case against Goldman is whether Rhineland should have been told that Paulson was ultimately the short-seller in this deal or that he had played an important role in selecting the securities that went into Abacus. While it’s not clear that in 2007 anyone would have been worried about a little-known hedge fund being short a deal if they weren’t already worried about Goldman being short, Rhineland certainly should have asked how the portfolio was constructed.

So why didn’t Rhineland—or the managers who controlled it from Dusseldorf—make these inquiries? Most likely, because IKB was playing the game even more aggressively.

Because Rhineland was an off-balance-sheet entity, IKB’s exposure to Rhineland was limited by the size of its guarantees and credit lines. If a particular transaction lost money, the conduit, Rhineland, was on the hook, but the bank, IKB, was not. If Rhineland made money, on the other hand, the bank took a big share of the gains. In short, the profits were the bank’s and the losses were someone else’s problem. Financial engineering at its best—and worst.

Simultaneous with the Abacus deal, IKB executives were busy with another piece of financial chicanery, insulating their bank from losses at Rhineland courtesy of a French bank, Calyon, which agreed that, if requested, it would pay $2.5 billion for assets held by Rhineland. In exchange, the value of those assets would be guaranteed by IKB and a bond insurer named FGIC. The deal was known as Havenrock II.

But Abacus and similar deals were already sucking money out of Rhineland, according to a person familiar with the matter. The ratings agencies were threatening to downgrade a host of subprime bonds, scaring off other lenders. Deutsche Bank, which had bought a piece of the liquidity facility IKB provided Rhineland, alerted German authorities, according to Dunbar.

A closing dinner for Havenrock II was held in Dusseldorf in July 2007, according to Bloomberg News. Just three days later, IKB announced that it was failing and had to be rescued by the German government. Calyon was out $2.5 billion. IKB paid $625 million to Calyon. But FGIC refused to pay the remaining $1.875 billion. Calyon sued FGIC, FGIC sued IKB. FGIC wound up paying Calyon just $200 million in a settlement, according to reports.

When Calyon asked IKB to pay for the shortfall, IKB said that Calyon “failed to conduct any, or any adequate, appraisal of the risks,” according to a report from Bloomberg. Calyon wasn’t cheated or duped, IKB said. Rather, the bank entered into the agreement to “fulfill its ambitions to develop and diversify significantly its activities in securitization and structured credit,” IKB said in court filings quoted by Bloomberg.

In other words, IKB’s defense against Calyon anticipated in an eerily precise way Goldman’s defense: Everyone involved were big boys who knew—or should have known—what they were getting into.

IKB has taken a deserved pounding in Germany. Four members of the board of managing directors were forced to step down. The CFO was ousted, along with Ortseifen, who was charged with stock-market manipulation and embezzlement. (The charges were later dropped when investigators concluded they couldn’t establish an intent to harm the bank.) The assets—and losses—from Rhineland were brought onto IKB’s balance sheet.

The SEC omitted these facts from its complaint. It’s hard to make a case, after all, when the victim acts even more capriciously that than alleged wrongdoer.

Are Interest Rate Derivatives a Ticking Time Bomb?

2010-04-22T04:21:00.000-07:00

Original posted on Washington's Blog:

Derivatives are the world's largest market, dwarfing the size of the bond market and world's real economy.

The derivatives market is currently at around $600 trillion or so (in nominal value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows.

So interest rate derivatives are the world's largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were "only" $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where's the Danger?

In 2003, John Hussman wrote:

What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.
In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) ...

***
According Bank for International Settlements, the U.S. interest rate swap market [has] nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.

***

In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt – effectively “buying dollars.” ... A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.
But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.
***

Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in derivatives may end up bankrupting a wide range of institutions, including municipalities, state governments, major insurance companies
, top investment houses, commercial banks and universities.
Defaults now beginning to occur in a number of European cities prefigure what may end up being the largest financial bubble ever to burst – a bubble that today amounts to more than $600 trillion.
***
A popular form of derivative contracts was developed to permit one money manager to "swap" a stream of variable interest payments with another money manager for a stream of fixed interest payments.
The idea was to use derivative bets on interest rates to "hedge" or balance off the risks taken on interest-rate investments owned in the underlying portfolio.
If an institutional investment manager held $100 million in fixed-rate bonds, for example, to hedge the risk, should interest rates rise or fall in a manner different than projections, a purchase of a $100 million variable interest rate derivative could be constructed to cover the risk.
Whichever way interest rates went, one side to the swap might win and the other might lose.
The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.
In the strong stock and mortgage markets experienced beginning in the historically low 1-percent interest rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article about the woes of little towns and counties in Tennessee that bought interest-rate derivatives sold by Morgan Keegan, an investment bank based in Memphis.

It turns out that these municipalities did not understand the risks they were taking. The derivatives have now blown up, and the officials are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million. They ended up spending about $3 billion on this. And they ended up owing about $5 billion in the end, after you look at all the refinancing and the interest rate swaps and everything.

As the Bloomberg, Times and Taibbi stories hint, many unsophisticated schools, cities, states and universities were played by the big interest rate derivatives sellers, just as many people were played by the CDS sellers. So the fallout will likely be substantial.

But Aren't Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a much more straightforward, legitimate business purpose than credit default swaps.

Yes, maybe. But the people thought the credit default swap salespeople and their bosses didn't really didn't understand them.

And as George Soros pointed out in 1994, the excessive use of dynamic hedging can and often does backfire:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called 'circuit breakers', which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take ....

Doug Noland wrote an intriguing article in 2001 - based on the research of Bruce Jacobs (doctorate in finance from Wharton, co-founder of Jacobs and Levy Equity Management) on portfolio insurance - arguing that interest rate derivatives were widely being used without understanding the risks they create for the system (warning: this is long ... go get some caffeine, sugar, nicotine or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs' excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: "Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as 'portfolio insurance.' In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses 'sons of portfolio insurance," and procedures with similar objectives and possibly similar effects on markets, in existence today."
From Dr. Jacobs' introduction: "This book ... examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.
***

"In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts - survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors."
***
I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: "Option replication requires trend-following behavior - selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors."

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. "Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, 'insured' portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against - volatility and instability in underlying equity markets.And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy's dynamic hedging spelled its end."

***
"In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit." ...
Dr. Jacobs' wonderful effort explains ... the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today's complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants."

Unfortunately, this language seems at least as applicable to today's interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don't seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification - anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.

***
Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than "self insurance" - "The Son of Portfolio Insurance." I have written repeatedly that markets cannot hedge themselves, and that derivative "insurance" is different in several critical respects from traditional insurance. From Dr. Jacobs: "Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves." Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, "it doesn't matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost."
Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts ...experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found - so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive "insurance" heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.

***
There is another key factor that greatly accentuates today's risk of a serous market dislocation, that was actually noted by the BIS: "Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps."

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that "liquidity" and the "effectiveness of traditional hedging vehicles" have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today's bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The "answer" to this dilemma, apparently, has been an explosion of "more effective hedging instruments, such as interest rate swaps (from the BIS)." We very much question the use of the adjective "effective." ...

All the same, the interest rate swaps market remains Wall Street's favorite "Son of Portfolio Insurance." A similar pre-'87 Crash perception of a "free lunch" conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There's no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this "loser" will certainly plan to dynamically hedge escalating exposure. If you are on the "winning" side, you had better accept the fact that the greater your "win," the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative "insurance" in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses [what a quaint notion], and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.
***
At some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. ...
The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into "safe" securities and "money." The credit system's newfound and virtually unlimited capability of fabricating "safe" securities and instruments is the mechanism providing unbounded availability of credit - the hallmark of "New Age Finance." It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against - volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.
***

The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history's most crowded trade."

Conclusion

Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as portfolio insurance previously did. As Nassim Taleb has shown, behavior which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle...

Given that the market for interest rate derivatives is orders of magnitude larger than credit default swap market - let alone portfolio insurance - the risks of a "black swan" event based on interest rate derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy could be risky - one unforeseen event and things could destabilize very quickly. Too much of anything can be dangerous. Water is essential for life ... but too much and you drown.

But I am confident that no one - even the people that design, sell or write about the various interest rate derivatives - really know how much of a danger they do or don't pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented. Independent risk analysts would do a great service if they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives does not harm the economy as a whole, it will certainly harm the cities, states and other governmental and quasi-governmental entities which are on the wrong side of the trade. My hunch is that - just as the fraud in the CDO and CDS markets was exposed when the "water level" of the economy fell, exposing the rocks underneath - rising interest rates will reveal massive fraud in the interest rate derivative market.

Goldman Sachs: Too Big To Obey The Law (TBTOTL)?

2010-04-19T04:38:00.000-07:00

Original posted on the Baseline Scenario by Simon Johnson:

On a short-term tactical basis, Goldman Sachs clearly has little to fear. It has relatively deep pockets and will fight the securities “Fab” allegations tooth and nail; resolving that case, through all the appeals stages, will take many years. Friday’s announcement had a significant negative impact on the market perception of Goldman’s franchise value – partly because what they are accused of doing to unsuspecting customers is so disgusting. But, as a Bank of America analyst (Guy Mozkowski) points out this morning, the dollar amount of this specific allegation is small relative to Goldman’s overall business and – frankly – Goldman’s market position is so strong that most customers feel a lack of plausible alternatives.

The main action, obviously, is in the potential widening of the investigation (good articles in the WSJ today, but behind their paywall). This is likely to include more Goldman deals as well as other major banks, most of which are generally presumed to have engaged in at least roughly parallel activities – although the precise degree of nondisclosure for adverse material information presumably varied. Two congressmen have reasonably already drawn the link to the AIG bailout (how much of that was made necessary by fundamentally fraudulent transactions?), Gordon Brown is piling on (a regulatory sheep trying to squeeze into wolf’s clothing for election day on May 6), and the German government would dearly love to blame the governance problems in its own banks (e.g., IKB) on someone else.

But as the White House surveys the battlefield this morning and considers how best to press home the advantage, one major fact dominates. Any pursuit of Goldman and others through our legal system increases uncertainty and could even cause a political run on the bank – through politicians and class action lawsuits piling on.

And, as no doubt Jamie Dimon (the articulate and very well connected head of JP Morgan Chase) already told Treasury Secretary Tim Geithner over the weekend, if we “demonize” our big banks in this fashion, it will undermine our economic recovery and could weaken financial stability around the world.

Dimon’s points are valid, given our financial structure – this is exactly what makes him so very dangerous. Our biggest banks, in effect, have become too big to be held accountable before the law.

On a more positive note, the administration continues to wake from its deep slumber on banking matters, at least at some level. As Michael Barr said recently to the New York Times,

“The intensity, ferocity and the ugliness of the lobbying in the financial sector — it’s gotten worse. It’s more intense.”

This is exactly in line with what we say in 13 Bankers – just take a look at the introduction (free), and you’ll see why our concerns about “The Wall Street Takeover and the Next Financial Meltdown” have grabbed attention in Mr. Barr’s part of official Washington.

But at the very top of the White House there is still a remaining illusion – or there was in the middle of last week – that big banks are not overly powerful politically. “Savvy businessmen” is President Obama’s most unfortunate recent phrase – he was talking about Dimon and Lloyd Blankfein (head of Goldman). After all, some reason, auto dealers are at least as powerful as auto makers – so if we break up our largest banks, the resulting financial lobby could be even stronger.

But this misses the key point, which Senator Kaufman will no doubt be hammering home this week: There is fraud at the heart of Wall Street.

And we can only hold firms accountable, in both political and legal terms, if they are not too big.

It is much harder to sue a big bank and win; ask your favorite lawyer about this. Big banks can more easily hold onto their customers despite so obviously treating them as cannon fodder (take this up with the people who manage your retirement funds). Big banks spend crazy amounts on political lobbying – even right after being saved by the government (chapter and verse on this in 13 Bankers.)

When you really do want to take on megabanks through the courts – and have found the right legal theory and compelling lines of enquiry – they will threaten to collapse or just contract credit.

No auto dealer has this power. No Savings and Loan could ultimately stand against the force of law – roughly 2,000 S&Ls went out of business and around 1,000 people ended up in jail after the rampant financial fraud of the 1980s.

We should not exaggerate the extent to which we really have equality before the law in the United States. Still, the behavior and de facto immunity of the biggest banks is out of control.

These huge banks will behave better only when and if their executives face credible criminal penalties. This simply cannot happen while these banks are anywhere near their current size.

Fortunately there is precisely zero evidence that we need banks anywhere near their current size – we document this at length in 13 Bankers (in fact, this was a major motivation for writing the book).

Break up the big banks before they do even more damage.