Saturday, February 28, 2009

Expected Losses and the Assets to Capital Multiple

From a June 2008 PrefBlog post:

My introductory piece on this topic was Bank Regulation: The Assets to Capital Multiple and later noted that the RY : Assets-to-Capital Multiple of 22.05 for 1Q08 was in excess of the usual guideline and in the 20-23 range where prior permission must be sought from OSFI.

When reviewing the RY Capitalization: 2Q08 I found the following note in their Supplementary Package:

Effective Q2/08, the OSFI amended the treatment of the general allowance in the calculation of the Basel II Assets-to-capital multiple. Comparative ratios have not been revised.

… and at the OSFI website I find the following Advisory regardingTemporary Adjustments to the Assets to Capital Multiple (ACM) for IRB Institutions and an accompanying letter. The advisory states:

This Advisory, which applies to banks, federally regulated trust and loan companies and bank holding companies incorporated or formed under Part XV of the Bank Act, complements the guidance contained in the Capital Adequacy Requirements (CAR) Guideline A-1, November 2007.

The CAR Guideline A-1 sets out capital adequacy requirements, including an asset to capital multiple (ACM) test. Upon the adoption of the Basel II framework, the ACM calculation changed for institutions using an Internal Ratings Based (IRB) approach. The change in the ACM calculation is a direct consequence of changes to the treatment of eligible general allowances used to calculate regulatory capital under the IRB framework and the distinction between expected and unexpected loss. OSFI has decided to reverse this unintended change to the ACM for IRB institutions until a comprehensive review of the ACM has been completed.

Adjustments should be made to both the numerator (total assets) and denominator (total capital) of the ACM in order to reverse the Basel II inclusions in and deductions from capital related to general allowances. This will allow IRB institutions to continue with the Basel I treatment of general allowances for the purposes of calculating the ACM.

Specifically, the amounts reported as Net on- and off-balance sheet assets and Total adjusted net tier 1 and adjusted tier 2 capital on Schedule 1 of the BCAR reporting forms should be adjusted as follows:
• Any deduction related to a shortfall in allowances should be added.
• For IRB institutions that have been given prior approval to include general allowances in capital, the amount of general allowances included under Basel II should be subtracted and the amount of general allowances taken by the institution should be added, up to maximum of 0.875% of Basel I risk-weighted assets.

The OSFI Rules are available for download. Link corrected 2008-6-13. There is also a Guideline to the Capital Adequacy Requirements

The advisory is interesting, particularly in light of the fact that RY is currently in the grey zone. The effect on RY’s capital multiple from this change is approximated as:

Effect on 1Q08 RY ACM of OSFI Advisory
As Reported
Multiple22.05 21.69

It’s a significant change! But what does it mean?

As I noted in the introductory post, the variation in Assets:Risk-Weighted-Assets ratios between banks was enormous; the IMF pointed out that institutions with higher ratios appear to have been punished for this by the equity markets; I drew the conclusion that UBS had been “gaming the system” by leveraging the hell out of assets with a low regulatory risk weight … such as, f’rinstance, AAA subprime paper.

Now, the idea that the Basel II RWA calculations could possibly be gamed - or, even without conscious effort, be simply misleading - should not come as a surprise. Overall capital adequacy under preliminary guidelines was criticized in a 2005 speech by Donald E. Powell, FDIC Chair:

The magnitude of the departure from current U.S. norms of capital adequacy is illustrated by the observation that a bank operating with tier 1 capital between one and two percent of assets could face mandatory closure, and yet, according to Basel II, it has 25 percent more capital than needed to withstand a 999-year loss event.1 For 17 of the 26 organizations to be represented under Basel II as exceeding risk based minimums by 25 percent, when they would face mandatory supervisory sanctions under current U.S. rules if they were to operate at those levels of capital, is evidence that Basel II represents a far lower standard of capital adequacy than we have in the U.S. today.

Further, the FDIC argued that Basel II was incomplete without an ACM cap in its Senate Testimony:

My testimony will argue that the QIS-4 results reinforce the need to revisit Basel II calibrations before risk-based capital floors expire and to maintain the current leverage ratio standards. Leverage requirements are needed for several reasons including:
• Risks such as interest-rate risk for loans held to maturity, liquidity risk, and the potential for large accounting adjustments are not addressed by Basel II.
• The Basel II models and its risk inputs have been, and will be determined subjectively.
• No model can predict the 100 year flood for a bank’s losses with any confidence.
• Markets may allow large safety-net supported banks to operate at the low levels of capital recommended by Basel II, but the regulators have a special responsibility to protect that safety-net.

Some comment is also needed about the possibility of using the allowance for loan and lease losses (ALLL) as a benchmark for evaluating the conservatism of ELs. The aggregate allowance reported by the 26 companies in QIS-4 totaled about $55 billion, and exceeded their aggregate EL, and this comparison might suggest the ELs were not particularly conservative and could be expected to increase. We do not believe this would be a valid inference. The ALLL is determined based on a methodology that measures losses imbedded over a non-specific future time horizon. Basel II ELs, in contrast, are intended to represent expected one-year credit losses. Basel II in effect requires the allowance to exceed the EL (otherwise there is a dollar for dollar capital deduction to make up for any shortfall). More important, the Basel II framework contains no suggestion that if the EL is less than the ALLL, then the EL needs to be increased—on the contrary this situation is encouraged, up to a limit, with tier 2 capital credit.

In the view of the FDIC, the leverage ratio is an effective, straightforward, tangible measure of solvency that is a useful complement to the risk-sensitive, subjective approach of Basel II. The FDIC is pleased that the agencies are in agreement that retention of the leverage ratio as a prudential safeguard is a critical component of a safe and sound regulatory capital framework. The FDIC supports moving forward with Basel II, but only if U.S. capital regulation retains a leverage-based component.

Which is not to say that imposition of an ACM cap is universally accepted. After all, such a thing never made it into Basel II - perhaps due to this argument against leverage ratio:

As a final point, the U.S. applies an even more arbitrary “Tier 1 leverage” ratio of 5% (defined as the ratio of Tier 1 capital to total assets) in order for a bank to be deemed “well-capitalized”. As we have noted in our prior responses, the leverage requirement forces banks with the least risky portfolios (those for which best-practice Economic Capital requirements and Basel minimum Tier 1 requirements are less than 5% of un-risk-weighted assets) either to engage in costly securitization to reduce reported asset levels or give up their lowest risk business lines. These perverse effects were not envisioned by the authors of the U.S. “well-capitalized” rules, but some other Basel countries have adopted these rules and still others might be contemplating doing the same.

ALLL should continue to be included in a bank’s actual capital irrespective of EL. As we and other sourcesfootnotes 3,4,5 have noted, it is our profit margins net the cost of holding (economic) capital that must more than cover EL. As a member of the Risk Management Association’s (RMA) Capital Working Group, we refer the reader to a previously published detailed discussion of this issue that we have participated with other RMA members in developingfootnote 4. This issue is also addressed at length in RMA’s pending response to this same Oct. 11, 2003 proposal.

Speaking in general terms, I am all in favour of a second check on the adequacy of bank capital. Looking at problems in different ways generally leads to a conclusion that is better overall than the sum of its parts. HIMIPref™, for instance, uses 23 different valuation measures and applies them in a non-linear fashion to the question of trading. No single measure has veto power; some of the valuation measures turn out to be of negligible independent importance; but the system as a whole provides answers that are better than the sum of its parts.

In this particular instance, it is not the ACM, per se, that we are examining, but the effect of deducting from capital the shortfall of provisions actually taken relative to the Expected Loss (EL) defined in the Basel II accord:

384. As specified in paragraph 43, banks using the IRB approach must compare the total amount of total eligible provisions (as defined in paragraph 380) with the total EL amount as calculated within the IRB approach (as defined in paragraph 375). In addition, paragraph 42 outlines the treatment for that portion of a bank that is subject to the standardised approach to credit risk when the bank uses both the standardised and IRB approaches.

385. Where the calculated EL amount is lower than the provisions of the bank, its supervisors must consider whether the EL fully reflects the conditions in the market in which it operates before allowing the difference to be included in Tier 2 capital. If specific provisions exceed the EL amount on defaulted assets this assessment also needs to be made before using the difference to offset the EL amount on non-defaulted assets.

386. The EL amount for equity exposures under the PD/LGD approach is deducted 50% from Tier 1 and 50% from Tier 2. Provisions or write-offs for equity exposures under the PD/LGD approach will not be used in the EL-provision calculation. The treatment of EL and provisions related to securitisation exposures is outlined in paragraph 563.

EL is calculated as:


where EAD is Exposure at Default; PD is Probability of Default; and LGD is Loss Given Default.

The FDIC provides a good explanation of the number:

A final determinant of required capital for a credit exposure or pool of exposures is the expected loss, or EL, defined as the product of EAD, PD and LGD. For example, consider a pool of subprime credit card loans with an EAD of $100. The PD is 10 percent – in other words, $10 of cards per year are expected to default, on average. The LGD is 90 percent, so that the loss on the $10 of defaults is expected to be $9. The EL is then $100 multiplied by 0.10 multiplied by 0.90, that is, $9. EL can be interpreted as the amount of credit losses the lender expects to experience in the normal course of business, year in and year out. If the total EL for the bank, on all its exposures, is less than its allowance for loan and lease losses (ALLL), the excess ALLL is included in the bank’s tier 2 capital (this credit is capped at 0.6 percent of credit risk-weighted assets). Conversely, if the total EL exceeds the ALLL, the excess EL is deducted from capital, half from tier 1 and half from tier 2. In this example, the EL that would be compared to the ALLL was a very substantial 9 percent of the exposure. The example is intended to illustrate that for subprime lenders or other lenders involved in high chargeoff, high margin businesses, the EL capital adjustment may be significant.

In the negotiations that resulted in Basel II, a major point of contention was the difference between expected losses and unexpected losses. It was agreed that unexpected losses (UL) could not really be modelled - by definition! - and that the purpose of bank capital was to guard against UL. On the other hand, EL could be calculated in accordance with credit models at any time as a routine part of the lending process, with provisions taken as necessary to reduce capital (and profit).

A major bone of contention was … what to do when a bank’s provisions were not equal to the Expected Loss as calculated? According to the BIS press release and final paper:

The Committee proposed in October 2003 that the recognition of excess provisions should be capped at 20% of Tier 2 capital components. Many commenters noted that this would provide perverse incentive to banks. The Committee accepted this point and has decided to convert the cap to a percentage (to be determined) of credit risk-weighted assets.

In order to determine provision excesses or shortfalls, banks will need to compare the IRB measurement of expected losses (EAD x PD x LGD) with the total amount of provisions that they have made, including both general, specific, portfolio-specific general provisions as well as eligible credit revaluation reserves discussed above. As previously mentioned, provisions or write-offs for equity exposures will not be included in this calculation. For any individual bank, this comparison will produce a “shortfall” if the expected loss amount exceeds the total provision amount, or an “excess” if the total provision amount exceeds the expected loss amount.

Shortfall amounts, if any, must be deducted from capital. This deduction would be taken 50% from Tier 1 capital and 50% from Tier 2 capital, in line with other deductions from capital included in the New Accord.

Excess provision amounts, if any, will be eligible as an element of Tier 2 capital. The Tier 2 eligibility of such excess amounts is subject to limitation at supervisory discretion, but in no case would be allowed to exceed a percentage (to be determined) of credit risk weighted assets of a bank.

The existing cap on Tier 2 capital will remain, Thus, the amount of Tier 2 capital, including the amount of excess provisions, must not exceed the amount of Tier 1 capital of the bank.

The basis of the difference (between EL and ALLL) is tricky to understand - possibly on purpose. Some of it may be due to correllations - as explained in a comment letter from Wachovia:

Removal of EL from required capital further highlights the problems with the retail capital functions that we and other banks have discussed in our previous letters. Assuming a 100% LGD for the “other retail” category, capital actually decreases after removing EL from the capital formula when PD increases from 2.6% to 4.6%, as shown in Figure 2 below. The correlations decline so rapidly that they more than offset the increase in PDs.

Our proposed solution is to reduce the asset value correlations at the high quality (low PD) end of the spectrum. For example, the curve smoothes out if the maximum correlation is lowered to the .08 to .10 range.

Remember correllations? That’s what makes pricing CDOs so interesting!

Another rationale (echoing that presented with WaMu’s arguments against any ACM in the first place, quoted above) was provided in a discussion by Price Waterhouse:

It is therefore clear that the calculation of expected losses is still relevant to the Basel IRB capital calculation in order to identify these shortfalls or excesses. Unless a bank has explicitly captured expected losses within its future margin income and can demonstrate this to be the case, the regulator will need to understand the amount of cushion that is in place to manage expected losses - either within capital or as part of provisions. In theory the regulator should not mind where this cushion for expected losses is positioned - future margin income, provision or capital - just as long as it is somewhere!

While this makes a certain amount of sense, it doesn’t sit well with me on a philosophical basis. All that’s happening - when expected losses are presumed to be covered by margin - is that the bank is stating that the loan is expected to be profitable. Well, holy smokes, we can assume that anyway, can’t we? Applying this rationale over a block of loans would mean that capital is equally unaffected by a stack of safe loans made at a small margin, or an equally sized stack of risky loans made at a fat margin … it makes much more sense to me to deduct the expected losses from capital (via provisioning) when the loans are made and subsequently to realize a greater proportion of the interest spread as profit as time goes on.

I’m certainly open to further discussion on this point - but that’s what it looks like from here, from the perspective of a fixed income investor to whom capitalization and loss protection is of more importance than equity stuff like income.

I am not particularly impressed by the explanation given in the TD Bank Guide to Basel II:

Referring to page 24 lines 14 and 21 of the Supp-pack, how is the “50% shortfall in allowance” derived?

The shortfall under Basel II is a regulatory calculation. The methodology is prescriptive and builds in possible, but not necessarily probable, assumptions. Examples could include downturns in the economy, sectors that experience particular challenges, among other items. Our current general allowance methodologies are in accordance with GAAP and approved by OSFI. We believe the existing allowance reported on the Balance sheet is adequate and we are comfortable with our current allocation.

This doesn’t make a lot of sense to me. TD’s EL is entirely under their control; they, not the regulators, determine the EAD, PD and LGD for each loan (subject to approval of methodology by the regulator). I will write them for more information on this matter.

Remember the OSFI advisory? The thing that this post is (allegedly) about? I’m deeply suspicious of the sentence OSFI has decided to reverse this unintended change to the ACM for IRB institutions until a comprehensive review of the ACM has been completed. They’re saying they want to do this now, and that the change was unintended? Not only have they spent the last yearbragging about how hard they worked, but

  • The Expected/Unexpected losses thing was a major issue, that actually held up the signing of the Basel II accord. I would have expected anything to do with these effects to have be subject to more scrutiny than other elements, not less.
  • The ACM cap is exclusive to North America (as far as I know). Again, surely all elements of this measure must have been scrutinized with more care than others.

I will certainly be following their “comprehensive review of the ACM” with great interest - and, for what my two cents are worth, lobbying for the divisor to be Tier 1 Capital, as it is in the States, not Total Capital.

Here’s a summary of the differences as of the end of the second quarter. Kudos to BMO, who seem (seem!) to have bitten a bullet that has frightened off the competition.

Provisions vs. Expections & Total Capital
*BNS, CM, NA - deduction may include securitization deductions, etc.; the figure is not adequately disclosed.

Update: The following eMail has been sent to BMO Investor Relations:

I note from page 19 of your 2Q08 Supplementary Package that “Expected loss in excess of allowance - AIRB approach” is zero, implying that your provisions for expected loan losses (ALLL) is equal to your Basel II EL = EAD * PD * LGD.

(i) Is this equality deliberate? Is there a policy at BMO that states a desired relationship between ALLL and EL?

(ii) Do you have any discussion papers or written policies available that will explain BMO’s policy in computing ALLL and/or EL?

(iii) Has the bank determined a position regarding the “comprehensive review of the [Assets to Capital Multiple]” announced by OSFI in their advisory of April, 2008?

Update, 2008-6-5: The following eMail has been sent to TD’s Investor Relations Department:

I note that in your discussion of Basel II at you state: “The shortfall under Basel II is a regulatory calculation. The methodology is prescriptive and builds in possible, but not necessarily probable, assumptions. Examples could include downturns in the economy, sectors that experience particular challenges, among other items.”

However, I also note that in testimony to the US Senate Donald Powell stated that ALLL should normally be - and should be encouraged to be - greater than EL due largely to a shorter time horizon for the latter measure of credit risk. It is also my understanding that the factors of EL (EAD, PD and LGD) are entirely within your control.

What specific differences in assumptions are applied by TD when computing ALLL as opposed to EL? Do you have a reconciliation between the two figures that shows the effect of these assumptions? Do you have any policies in place that would have the effect of targetting a relationship between the two measures?

Update, 2008-6-5: The following eMail has been sent to OSFI:

I have read your April Advisory on the captioned matter (
advisories/Advisory_Temp_Adjust_ACM_e.pdf) with great interest. I have a number of questions:

(i) Why does OSFI enforce the ACM using total capital instead of solely Tier 1 Capital, the latter being the practice in the United States?

(ii) Was testing of the ACM incorporated in any run-throughs and pro-forma financial tests performed by OSFI prior to implementation of the Basel II accord? Were the effects of provision shortfalls simply missed or have they changed significantly in the interim?

(iii) It is my understanding (from Donald Powell’s 2005 Senate testimony, published at that in the States it is expected that ALLL will normally exceed EL, due to differences in the desired effects of these two measures. Are you aware of any methodological or philosophical differences that have led to this situation being reversed in Canada for five of the Big-6 banks as of 2Q08?

(iv) I also understand that ACM is normally regarded as being a more stringent constraint on bank policies that Tier 1 Capital and Total Capital Ratios. Is this the view of OFSI?

(v) I understand that some justification for ALLL being lower than EL is that some proportion of EL is expected to be made up as a component of gross loan margin. Is this rationale accepted by OSFI?

(vi) Should the answer to (v) be affirmative, it seems to me that two similar banks could each make a basket of loans having the same value, with Bank A’s basket being lower-margin, lower-risk than Bank B’s basket. The EL for Bank B would be higher, but ALLL for both banks could be the same if Bank B determined that their higher margin justified a shortfall of ALLL relative to EL. Under the rules effective 1Q08, the effect of the ACM cap would be more constraining than they currently are after giving effect to the advisory; that there is currently no effect of risk on the ACM cap (although there is an effect on the Capital Ratios). Is this the intent of the advisory?

(vii) Will OSFI be dedicating a section of its website to the “comprehensive review of the ACM”? Will draft papers, requests for comments and responses from interested parties be made public in this manner? Have the terms of the comprehensive review yet been set?

Friday, February 27, 2009

CDS auctions reach record high in February

By Laura Mandaro (MarketWatch):

A wave of corporate bankruptcies triggered by the credit crunch and deepening global recession has pushed the number of credit-defaults swaps auctions to record highs, testing the system as it faces increased pressure to establish structures similar to other trading markets.

Banks and institutional investors in February participated in 13 credit-default swap auctions on the defaulted debt of eight companies, including bankrupt telecom gear maker Nortel Networks Corp., chemical maker Lyondell Chemical Co. and packaging maker Smurfit-Stone Containers.

That was a monthly record since Markit and partner Creditex started holding auctions to match buyers and sellers of credit-default swaps in 2005, said Markit, which supplied the data.

The number of auctions surpassed the October high of seven, when CDS contracts settled on the September credit events of failed banks Washington Mutual and Lehman Bros, and Fannie Mae and Freddie Mac .

For this growing but controversial market, the fact that it's been able to handle so many auctions without any blow-ups is a good sign, said one analyst.

"The number of auctions and relative success and cleanness of them shows that the single-name and index CDS market is an operationally sound market," said Tim Backshall, chief credit strategist at Credit Derivatives Research, an independent research provider based in Walnut Creek, Calif.

Credit-default swaps are a type of derivative that provides protection on a company or country defaulting on its bonds or loans. Trading of these privately negotiated contracts grew rapidly over the past few years as financial institutions looked for new ways to hedge their debt exposure - and also target new trading opportunities.

Trading values, or spreads, of these contracts can provide investors with an early indication that the company is running into trouble. If they do, holders of CDS have a contract to receive a payout from the CDS seller to recover their losses on the debt investment.

Mortgage financing giants Fannie Mae and Freddie Mac, for instance, did not declare bankruptcy. But their takeover by the U.S. government was considered a credit event by CDS buyers and sellers, triggering payouts in protection.

Domino effect worries
These derivatives have also been criticized for their ability to wreak havoc on the financial system, largely due to volumes outstanding and opaqueness of the over-the-counter market.

Worries that the collapse of a big CDS player could trigger a domino effect of losses at its counterparties - and their CDS counterparties - pushed the U.S. government to bail out CDS-seller American International Group last year.

The failure of Lehman Bros. last September set off a bout of investor panic on concerns that banks that had sold protection on a default by Lehman, once considered a stalwart financial institution, would fail to come up with the funds to meet their CDS contracts. That didn't happen.

With Lehman in mind, however, U.S. regulators have been pressuring the industry to establish a central clearing house for derivatives, similar to what futures traders have.

Marc Barrachin, director of credit products at Markit, says the number of auctions held and settled smoothly has put to rest some fears about whether the system can handle the growth in CDS contracts.

"The process for the auction has worked so well that auction process is being hard-wired into CDS contract," he said.

Thursday, February 26, 2009


NEW YORK, Thursday, February 26, 2009 –The International Swaps and Derivatives Association, Inc. (ISDA) today announced the launch of the ISDA CDS Standard ModelTM as an open source project. The model has its basis in J.P. Morgan’s CDS Analytical Engine, which was transferred to ISDA on January 29, 2009. The code underlying the model is widely used in the industry to price CDS contracts. Making the code available as open source increases availability and transparency of CDS pricing. Markit, as administrator, will provide support and maintenance for the project.

The code is available through an open source license at Along with the code, standard inputs to the model, such as recovery value and yield curve, will be described and made available in due course, together with an online discussion forum, which will allow for community input.

Markit, in its role as administrator, will provide support for the maintenance and further development of the code, following open source principles and under the direction of ISDA.

“ISDA's primary goal in making the code available is to enhance transparency and to optimize use of standard technology for CDS pricing, thereby helping promote the development of the credit derivatives industry as a whole,” said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. “We are very pleased to be able to provide this service freely to the entire industry.”

Armins Rusis, Executive Vice President and Global Co-Head of Fixed Income at Markit, said, "The standard model provides a critical piece of fixed-coupon CDS trading infrastructure, ensuring that counterparties calculate upfront fees in a consistent manner. A market standard valuation model that is freely available to all will enhance trade accuracy and help ensure continued operational improvements in the CDS business. Markit appreciates the opportunity to assist ISDA and the industry in this important undertaking for the CDS market."

Thursday, February 19, 2009

U.S., Europe May Jointly Regulate Credit Derivatives

By Matthew Leising (Bloomberg):

U.S., U.K., and European regulators are in talks to jointly regulate the $28 trillion credit-default swap market, the Federal Reserve said today.

Regulators including the Fed, U.K.’s Financial Services Authority, German Federal Financial Services Authority and European Central Bank met today to discuss a possible information sharing agreement, the Fed said in a statement on its Web site. The goal would be to apply consistent standards to the market and provide support across jurisdictions, the Fed said.

Dealers are under pressure to process credit-default swaps trades through a clearinghouse in the U.S. or Europe after last year’s failure of Lehman Brothers Holdings Inc., which was among the largest traders of the contracts. Earlier today, nine banks and brokers including Deutsche Bank AG, JPMorgan Chase & Co. and Barclays Plc committed to start using one or more clearinghouses within the 27-nation European region by the end of July.

“Central clearing of CDS is particularly urgent to restore market confidence,” European Union Financial Services Commissioner Charlie McCreevy said. “Given the size of derivatives markets I am looking whether other measures might be necessary to make sure they are adequately supervised and do not pose unnecessary risks to financial markets.”

Prices and Positions

Clearinghouses, capitalized by their members, add stability to markets by pooling the collateral of traders to share the risk of default. The practice also gives regulators access to prices and positions.

Other regulators in the international group include the U.S. Commodity Futures Trading Commission, the Securities and Exchange Commission, Deutsche Bundsbank and the New York State Banking Department. The group plans a meeting “in the near future” to discuss what is needed to share regulation activities over the market, according to the Fed.

The group had an initial meeting on Jan. 12 in New York, the Fed said in the statement. Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent if the borrower defaults.

Atlanta-based Intercontinental Exchange Inc., which has the support of nine dealers including Goldman Sachs Group Inc. and Morgan Stanley, said today that it will offer European-based clearing through its existing London clearinghouse.

“We’re working with all the appropriate European-based financial institutions to address their clearing needs,” said Sunil Hirani, chief operating officer of Creditex Inc., which Intercontinental bought last year. He declined to identify which banks the company is working with.

Intercontinental’s London operations, including the planned credit swap clearing, are regulated by the Financial Services Authority.

Intercontinental is competing with Chicago-based CME Group Inc., Eurex AG and NYSE Euronext’s Liffe derivatives market to clear credit-default swaps. LCH.Clearnet Ltd., Europe’s largest securities clearinghouse, said last week it will start offering clearing through a Paris-based unit to meet European regulators’ demands.

ISDA: Major Firms Commit to EU Central Counterparty for CDS

The International Swaps and Derivatives Association, Inc. (ISDA) today announced that major industry participants have committed to the use of central counterparty clearing for CDS in the European Union (EU).

Nine of the leading dealer firms in the CDS industry have signed a letter to European Commissioner, Charlie McCreevy, confirming their engagement to use EU-based central clearing for eligible EU CDS contracts by end-July, 2009. These efforts mirror the engagement the industry has made in other jurisdictions in the interests of a globally cohesive regulatory framework for clearing.

The letter also commits the signatories to work closely with infrastructure providers, regulators and the European Commission in resolving outstanding technical, regulatory, legal and practical issues. Each firm will make an individual choice on which central clearing house or houses might best meet its risk management objectives, subject to regulatory approval of any such clearing house in Europe.

"This commitment provides the basis for constructive dialogue with the European Commission, both on arrangements for central clearing and on related regulatory matters,” said Eraj Shirvani, ISDA Chairman and Head of Fixed Income for EMEA, Credit Suisse. "ISDA and its member firms will continue to work closely with the European Commission, national and international regulators and infrastructure providers to ensure a sound and efficient regulatory framework for central clearing of the CDS market. "

"ISDA has always supported the development of options for market participants to manage the risks they encounter in the course of their businesses," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The introduction of a standard coupon for CDS as well as the so-called 'hardwiring' of the auction settlement process, two of ISDA’s most significant current initiatives, are among several important steps necessary to facilitate the clearing of eligible trades."

The co-signatories of the letter are: Barclays Capital, Citigroup Global Markets, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, J.P. Morgan, Morgan Stanley and UBS.

Wednesday, February 18, 2009

France calls for eurozone CDS clearing house

By Jeremy Grant (Financial Times):

The French central bank has called on eurozone countries to rally to create a clearing house for the credit default swaps (CDS) market to “face down” the risk of the business going to London or the US, raising alarm bells over financial protectionism.

In the war for control of the $28,000bn market, the confidential report prepared by the Banque de France looks at establishing a clearing mechanism for over-the-counter CDS.

It is likely to trigger a reaction from the UK Treasury and Bank of England, already concerned at the damage done to the City of London’s future prospects by the financial crisis.

Credit default swaps offer a form of insurance against corporate defaults. They are the focus of a push by regulators on both sides of the Atlantic for wider use of safeguards such as clearing in the use of lightly regulated, off-exchange products.

Efforts to come up with a clearing house for the CDS market are advanced in the US, where four exchange-led groups have proposed solutions.

The European Commission and European Central Bank insist that Europe have a clearer based in the region as well. But matters became complicated after suggestions last month by French finance minister, Christine Lagarde, that such a solution should apply to the eurozone.

The only clearer to offer CDS clearing in Europe is LCH.Clearnet, which is based outside the eurozone in London. It is in talks about a possible takeover by The Depository Trust & Clearing Corporation, the large US clearer.

In the 26-page report, obtained by the Financial Times, the Banque de France warned that LCH.Clearnet’s “decision-making structure” was based in London and that this could lead to “an increase in the weight of the London financial market or the relocation of governance to the US, if the Paris financial markets do not recommend a solution”.

“The strategic nature of this business sector means that it is important to create a pan-European clearing house for the eurozone with sufficient critical size to face down these challenges,” the report said.

Banque de France called for the creation of a “consortium of eurozone banks and shareholders of major infrastructures with the objective of developing a common strategy for the integration of several of the eurozone’s principle clearing houses”.

Tuesday, February 17, 2009

Fitch Decision on Proposed Additional Structured Finance Rating Scales

Fitch Ratings launched its new Loss Severity Ratings for global structured finance [on February 17, 2009]. The latest in a series of steps by Fitch to enhance the quality and transparency of its credit ratings, Loss Severity (LS) ratings are designed to complement traditional debt ratings.

LS Ratings were first proposed by Fitch on 1 July 2008 as part of a wider consultation on three potential supplementary rating scales and indicators for structured finance. The other scales considered addressed rating transition probability and volatility, and collateral quality assessment.

In the case of a volatility or transition risk rating applied to structured finance securities, it remains Fitch's view that the analytical drivers to such a rating would overlap significantly with those already addressed by 'Rating Outlooks'.

"Rating Outlooks are intended to give a forward-looking opinion about the prospective direction of a tranche's rating over the next 12-24 months," says Stuart Jennings, structured finance risk officer for the EMEA region at Fitch Ratings. "Fitch believes that they give the market greater information about prospective future individual tranche performance than any potential explicit rating volatility indicator."

In addition, factors that would result in a security being assigned a high volatility rating would also typically be captured by the underlying credit rating. For example, assigning a high investment-grade rating, e.g. 'AAA', would in many cases be incompatible with the type of factors that might lead to a high volatility rating.

This would serve as a limit on any potential scale's application. Fitch's decision, therefore, was not to assign volatility ratings but instead to roll-out 'Rating Outlooks' globally across structured finance. The majority of market feedback supported Fitch's position on this point. Fitch remains the only agency to assign rating Outlooks to structured finance securities.

Fitch's third proposal concerned an explicit assessment/rating of underlying collateral quality. Feedback on this was mixed as to the value of supplementary information that would be provided. In addition, Fitch believes two new scales within a short space of time could create a degree of excess information. Instead, Fitch will enhance the transparency of its credit opinion in this respect through the provision of explicit commentary on collateral quality in its pre-sale and research reports.

The new Loss Severity rating methodology is detailed in a criteria paper published today, entitled "Criteria for Structured Finance Loss Severity Ratings". The original exposure draft for the three proposed ratings scales and indicators, "Fitch Proposals for Complementary Ratings and Indicators to Structured Finance Ratings", was published on 1 July 2008. Both reports are available on the agency's public website,

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.

Measuring the Credit Risk of Synthetic CDOs with CDS-Implied Ratings

By David T. Hamilton

Abstract: In this paper, we demonstrate how CDS-implied ratings for corporate reference names, together with an analytic CDO ratings model, can be used to derive CDS-implied tranche ratings for corporate synthetic CDOs (CSOs). It is an experiment in which we change one key variable, the ratings of the portfolio of reference entities, while holding other data and model assumptions constant and measure how tranche ratings perform. We find that CDS-implied tranche ratings lead changes in Moody's ratings, more accurately rank order default losses by rating, and exhibit higher loss prediction accuracy ratios for the riskiest tranches.

ICE plans European CDS clearer

By Jeremy Grant (Financial Times):

IntercontinentalExchange, the operator of futures exchanges and over-the-counter trading platforms, plans to set up a European clearer for credit default swaps in an effort to establish the first transatlantic clearing mechanism for such products.

The move is aimed at offering the industry a simple solution for clearing of CDSs on both sides of the Atlantic at a time of increasing confusion over European efforts to establish a Europe-based clearing mechanism to complement one already planned for the US.

US authorities have already persuaded exchanges and the industry to come up with a central counterparty clearer (CCP) for the $28,000bn CDS market, with ICE one of four groups vying to become the preferred industry solution.

But matters have been complicated by the insistence by the European Commission and European Central Bank that there also be a CCP in Europe.

The development is opposed by many industry participants, including the Futures and Options Association, which says having two clearers would be costly and cumbersome – especially if each were owned and operated by different exchange-led groups.

Participants are also alarmed about calls from some quarters for the creation of a “eurozone” clearer, when others appear to be calling for a wider “European” solution.

The FOA has written to the UK Treasury alerting it to a danger of “triggering a move to a create two European financial markets – an inner eurozone market and an outer, marginalised non-eurozone market”, according to one FOA source.

ICE is already well-advanced with plans to launch CDS clearing in the US, and recently received approval for a New York-state regulated banking entity, ICE Trust, to carry it out.

So far two clearing providers have said they are working on a European CCP: Eurex Clearing, a unit of Deutsche Börse and and LCH.Clearnet.

ICE’s plans for Europe would use its existing London-based clearer, ICE Clear Europe. The exchange group is in talks with the Financial Services Authority, the UK regulator, about expanding ICE Clear’s remit to CDSs.

The exchange operator believes that offering an integrated transatlantic CDS clearing solution would neutralise many of the concerns that dealer banks have, since such an arrangement would offer cross-netting and other market efficiencies.

Sunil Hirani, chief executive of Creditex, a unit of ICE which offers trading of CDS contracts, told the Financial Times: ”We have been working extensively with the credit derivatives market and much of the work that we’ve done to create our US solution is already being leveraged with our plans in Europe.

“Our plan is to utilise ICE Clear Europe, which is already FSA approved to clear ICE’s energy OTC and futures contracts, to also clear CDS. We are working with the FSA as well as other UK and European regulators on this effort,” Mr Hirani said.

Meanwhile, user-banks who met in Frankfurt on Friday to discuss their requirements for a CCP with the European Central Bank say that the talks went smoothly and that consensus quickly emerged.

One item they are seeking is connectivity between the CCP and a central bank, which could be valuable in the event of a liquidity squeeze. In effect, this would probably mean either the UK’s Bank of England (in the event of a City-based CCP) or the ECB within the eurozone.

A much larger meeting, involving regulators, banks, central bankers and fund managers, is scheduled for February 24 at which the European banks, ISDA and fund management representatives are all expected to present their separate wish-lists.

Among those present will be Pervenche Beres, chair of the European parliament’s economic and monetary affairs committee. Ms Beres, a socialist MEP, has tabled some last-minute amendments to an existing legislative initiative which could force banks that do not clear CDS in Europe to set aside extra capital.

Her proposals could come to parliamentary vote in April. But banks are hopeful that, if talks on an industry-led solution are going well, some of her more punitive amendments might be dropped. That, however, does not appear to enthuse European regulators; having finally galvanised the industry into action over CDS clearing, they may be far more reluctant to see the legislative stick thrown away.

Monday, February 16, 2009

Rollover Risk and Market Freezes

By Viral V. Acharya, Douglas M. Gale and Tanju Yorulmazer:

Abstract: The sub-prime crisis of 2007 and 2008 has been characterized by a sudden freeze in the market for short-term, secured borrowing. We present a model that can explain a sudden collapse in the amount that can be borrowed against assets with little credit risk. The borrowing in this model takes the form of asset-backed commercial paper that has to be rolled over several times before the underlying assets mature and their true value is revealed. In the event of default, the creditors (holders of commercial paper) can seize the collateral. We assume that there is a small cost of liquidating the assets. The debt capacity of the assets (the maximum amount that can be borrowed using the assets as collateral) depends on how information about the quality of the asset is revealed. In one scenario, there is a constant probability that "bad news" is revealed each period and, in the absence of bad news, the value of the assets is high. We call this the "optimistic" scenario because, in the absence of bad news, the expected value of the assets is increasing over time. By contrast, in another scenario, there is a constant probability that "good news" is revealed each period and, in the absence of good news, the value of the assets is low. We call this the "pessimistic" scenario because, in the absence of good news, the expected value of the assets is decreasing over time. In the optimistic scenario, the debt capacity of the assets is equal to the fundamental value (the expected NPV), whereas in the pessimistic scenario, the debt capacity is below the fundamental value and is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.

Friday, February 13, 2009

Dresdner Kleinwort CDO and Longevity Swap Models

by Domenico Picone and colleagues posted on

Infinitely large homogeneous portfolio CDO model:

  • In the first part of our series we release the Large Homogenous Pool Model in the standard version as well as a version using the Gauss-Hermite Integration technique.
  • This publication has been structured as a user guide to be used in conjunction with the excel-based model. Whilst we do briefly touch upon the main theoretical concepts, we do not go into detailed explanations and proofs, as this information has been widely discussed and is readily available. Instead, we focus on how to implement the theory and apply the models.
  • Given the simplified assumptions behind this model, it is not a pricing tool for CDO tranches but instead is the first step to allow the user to appreciate the impact of key parameters such as correlation, recovery and spread on the value of a specific tranche.
  • Additionally, as the pool is considered to have an infinite and identical number of obligors, aspects such as idiosyncratic risk are not specifically treated. We will relax and analyse these points in the upcoming models.

Download spreadsheet : here. Download manual (700K PDF) 19 pages

With Gauss-Hermite integration : here. Download manual (631K PDF) 13 pages

Finite, homogeneous pool model:

  • After having released the Large Homogenous Pool Model in the first part of our series, we now move towards the Finite Homogenous Pool model.
  • Given the simplified assumptions behind this model, it is not a pricing tool for CDO tranches but instead is the first step to allow the user to appreciate the impact of key parameters such as correlation, recovery and spread on the value of a specific tranche.
  • Additionally, as the pool is considered to have a finite and identical number of obligors, aspects such as idiosyncratic risk are not specifically treated. We will relax and analyse these points in the upcoming models.

Download spreadsheet : here.

Analysing default risk of credit portfolios and CDOs:

  • In our CDO model series we have so far released various models with increasing flexibility and sophistication.
  • While they all have the advantage of being analytical / closed form solution models, they require simplifying assumptions with respect to the way credits may default together.
  • Most importantly, they all use a factor model to generate joint default events.
  • If the way credits default together is introduced without a factor model:
    • We can't apply the recursive algorithm anymore (as it depends on conditioning on a common factor).
    • However, Monte Carlo (MC) techniques can be used to simulate joint default events.
  • Within a MC approach, copulas allow for a very general and flexible way to directly model the dependency within the portfolio.
  • The current credit crisis has highlighted the importance of tail events in risk management. This model gives credit investors the tool to analyse the behaviour of their credit portfolio under stressed market conditions.

Download spreadsheet : here. Download manual (631K PDF) 13 pages

European RMBS: Cashflow dynamics and key assumptions:
  • Forced sales, lack of liquidity and of investor demand have pushed European Prime RMBS spreads to unprecedented levels. Currently AAA European RMBS are offering secondary spreads between 450-600bp. Launch spreads (pre-crisis) were in the range of 10-25bp.
  • Several distressed funds, and some real money investors, are increasingly looking at this sector with the aim of identifying good quality paper trading below fundamental value with the aim of monetising on the current dislocation and thereby capturing the large liquidity premium that markets are presently pricing in. We expect this theme to emerge strongly in the first half of 2009.
  • However, unlike standard corporate bonds, the increased cashflow complexity of RMBS means that it is important to understand the underlying model framework and the impact of key assumptions on future returns. In our view, ratings are just a starting point.
  • With this in mind, we have build an excel-based European RMBS model, incorporating all the key features of a typical cashflow model used to structure deals. In addition to showing how S&P and Fitch model the key assumptions, we have also provided the flexibility for user specific assumptions to understand sensitivities of different tranches.
  • With this model, after having recently published a series of CDO models, we continue our effort to increase transparency in the market. Going forward we also plan to release CLO, CMBS and Longevity Risk models.
  • In this presentation we initially look at some specific building blocks for a cashflow model before turning to our spreadsheet.

Download spreadsheet : here. Download manual (556K PDF) 16 pages

A Model for longevity swaps: Pricing life expectancy

  • In addition to the obvious exposure each and everyone of us has to mortality, economic agents such as pension funds, insurers and governments are exposed to mortality and to its flip-side longevity risk.
  • OECD pension funds had about USD 18tr of assets under management in 2007, and through their defined benefit pension schemes are massively exposed to longevity risk, as increases in life expectancy create additional costs. They are "short longevity".
  • In Europe, the UK and the Netherlands, because of the size of their pension fund markets, would be the greatest beneficiaries of a liquid longevity market.
  • Life settlements and mortality cat bonds have been used in the past to transfer very specific forms of longevity risk. Annuity buyouts have also been offered some form of risk relief for UK DB pension funds.
  • With regulators also forcing pension funds and life insurers to take a more active stance in managing longevity risk, longevity derivatives are likely to become the instrument of choice to manage this risk.
  • The longevity swap offers the simplest and easiest way to standardise the transfer of longevity risk between pension funds, insurers and new longevity investors looking at this market for diversification benefits.
  • With the attached spreadsheet to price the longevity swap, we distribute our implementation of the Lee Carter ‘92 model, which we used to forecast future German mortality rates, the main input for pricing.

Download spreadsheet : here. Download manual (589K PDF) 12 pages

Thursday, February 12, 2009

Fitch Launches Enhanced Presale Reports for Structured Finance

Fitch Ratings today announced the launch of enhanced presale and new issue reports for global structured finance transactions. The principal aim of the revised reports is to increase their focus on Fitch's opinions with respect to key rating drivers. They will include new content which will provide greater transparency regarding how a rating opinion was formed and the impact on such opinion of any changes in key assumptions.

The reports also aim to create one consistent template framework across structured finance asset classes which will aid comparison of risk characteristics across countries and sectors. These changes also reflect widespread industry and regulator comments regarding the need for greater transparency in structured finance transactions.

The revised reports will be adopted throughout the course of 2009, as individual asset class groups finalise the specific content for their area. The first asset groups will start to use new templates for all new transactions as from 16 February 2009.

"Fitch's overriding aim for the revised reports is to enhance transparency of the rating opinion. Fitch's view of key rating drivers will be described more succinctly with a greater focus on key areas of discussion during the rating committee. Reports will also describe the data requested and received from originators and how this was used in the analysis," said Andreas Wilgen, Senior Director in Fitch's EMEA Structured Finance team, who co-ordinated the project to revise the reports. "With increased focus upon model risk in structured finance generally, the reports will describe which models have been used in the analysis, the models' main drivers and any 'out-of-model' adjustments that might have been applied by rating committee."

A new aspect to the reports will be an analysis of the sensitivity of ratings to changes in key rating assumptions. The final form of such analysis will be specified throughout the course of 2009 for the different asset classes. Example enhancements include an analysis of changes to key assumptions which could result in rating migration from the current note rating.

Additionally, a breakeven point analysis will be introduced to identify the maximum stress to a key rating factor (for example mortgage foreclosures for RMBS) a given tranche can withstand without experiencing a default.

Fitch will value any feedback from report users as to the changes made to the reports following their launch.

Wednesday, February 11, 2009

Credit Swaps Clearing Stalls on Pricing, ICE Says

By Matthew Leising on Bloomberg:

Intercontinental Exchange Inc.’s planned clearinghouse for the $28 trillion credit-default swap market is stalled over pricing on less frequently traded contracts, Chief Executive Officer Jeff Sprecher said.

U.S. regulators and industry representatives are working with Intercontinental to create a system to determine prices for credit-default swaps that differ from the standard five-year contract, Sprecher said today on a conference call with analysts. Federal officials had hoped the clearing plans would be approved by the end of 2008, they said last year.

“There’s an interactive discussion” going on about how to price contracts that don’t trade often, Sprecher said. “That’s why the clearinghouse has not been approved. We’re working with the market on this.” Chief Financial Officer Scott Hill said regulatory approval may come “in the very near term.”

U.S. regulators and other government officials are pushing the creation of a clearinghouse for credit-default swaps after Lehman Brothers Inc., one of the largest dealers in the market, filed for bankruptcy in September. A clearinghouse reduces the risk that a counterparty such as Lehman will default on a trade and also creates prices for the contracts that are now privately traded in the bi-lateral over-the-counter market.

Intercontinental, the second-largest U.S. futures market, is competing with NYSE Euronext, Eurex AG and CME Group Inc. to provide guarantees to credit-default swap trades by processing them with a clearinghouse. Intercontinental has agreed to buy the Clearing Corp., a clearinghouse owned by nine major dealers including JPMorgan and Goldman Sachs Group Inc., to get the banks to commit to its service.

Understanding Risks

Pricing contracts that don’t trade often could be accomplished through an auction at the end of the trading day, Sprecher said.

Intercontinental’s credit-default swap clearinghouse would have the ability to mark prices during the trading day in case contracts move sharply higher or lower, said Hill, the finance chief.

“There’s clearly the ability to do intraday margin calls if spreads blow out,” Hill said in an interview. “We are developing the capacity to understand intraday risks.” The process has been complicated, he said.

“It’s an additional complication we’ve had to work through,” Hill said.

Intercontinental also needs federal approval for the credit- default swap clearinghouse in order to close its purchase of Clearing Corp., Sprecher said.

‘Tail End’

Atlanta-based Intercontinental is awaiting regulatory approval from the Federal Reserve and the U.S. Securities and Exchange Commission.

“We’re at the tail end of that” regulatory process, he said. “A lot of decisions have been made, especially in January.”

Getting the contract-pricing process correct is important because investors will be using those prices to determine profit and loss on their positions, he said.

“Our clearinghouse will only be as good as the marks we put in,” Sprecher said.

Sunday, February 8, 2009

Fix Housing, Fix the Banks and the Securitization Markets Both

From the Institutional Risk Analyst:

As this issue of The IRA goes out, in Washington the Obama Administration is wrestling with three basic issues: dealing with troubled banks, restoring illiquid securities markets and restarting economic growth - though not necessarily in that order of priority. The political issue of "helping homeowners" is significant as well. But perhaps it is time to consider whether the Wall Street-centric priority of restoring function to the existing securities markets for "toxic assets" is not independent of these other very real priorities. Reports that Treasury Secretary Geithner is focusing additional spending on spurring new market activity and not remediation of existing securities is, to us, good news.

This does not mean that private label securitization is dead or that the toxic cannot be cleansed. Indeed, we've heard from a number of practitioners in the channel on the state of the securitization markets in recent weeks, partly as we have been working to organize an all-day event in Washington on May 4, 2009 sponsored by PRMIA, "Market & Liquidity Risk Management In Post-Bubble Markets."

One confirmed participant in that event, Sylvain Raynes of RR Consulting, told The IRA last week:

"The securitization market will come back because the next generation will not remember what happened here, in the same way this one forgot the depression, the 1929 Crash, and even the S&L crisis. Is that ancient history? As far as how this "come back" will emerge, that's easy. What we will see is an accelerated version of the first cycle, i.e. the one that took 25 years to unfold first time around. First, prime RMBS will start-up again with simpler and more meaningful underwriting criteria (that's already happening) then the prime credit card and auto sectors will be brought back to life. Maybe US medical receivables will be the next big, 'exotic' asset class to take off."

So the good news seems to be that the private securitization markets are beginning to fix themselves, albeit without a vital federal leadership role in terms of setting standards for the future. Raynes lists three areas where such leadership and perhaps legislation is needed:

* First, define a meaningful template for data disclosure regarding all securitizations and OTC contracts, and enforce it. This is already largely done in the form of Regulation AB for securitizations. Enforce it.

* Second, mandate monthly valuation-feedback via a monitoring system that uses remittance reports and publicly published models from the rating agencies. That's much harder to do, but will soon happen.

* Third, mandate educational standards in the area of structuring and primary market valuation for securitizations and OTC contracts.

With those positive thoughts on the private securitization market in mind, we come back to the central task facing the Obama Administration, namely to help the banks, help homeowners and also the broad economy. One interesting idea we heard from a veteran banker in South Texas might provide food for thought in terms of how to deal with the existing body of toxic assets on the balance sheets on banks, the key issue that must be resolved if banks are to start lending again.

As part of the Obama Administration's efforts to support the primary market for new mortgage securitizations and also provide new capital to banks, below we describe an approach that harkens back to the market maker model The IRA described last year when we first started talking about the need for more bank capital ("More Bank, Less Bucks: A Four Point Plan for the Rescue," October 6, 2008).

Here's the basic approach:

* The US Treasury would tender for all of the private label CDO/MBS extending between a range of dates, say 2004 forward to year-end 2007, representing trillions of dollars in assets held by investors and banks globally. The pricing on this paper will reflect current market prices, but say the average price was 50% of face value. Only issues that actually have an enforcable legal claim to collateral will be eligible. Derivative structures without collateral will not be eligible.

* Treasury then transfers all of the purchased toxic paper to the FDIC Deposit Insurance Fund, which acting as receiver under 12 USC restructures the trusts that are the legal issuers of the bonds and recovers legal ownership of the underlying collateral. The FDIC arguably has the power to call in all bonds and related investment contracts, and extinguish the claims of those parties which do not respond to the Treasury tender. The legal finality of an FDIC-managed receivership under 12 USC is what is required to end the toxic asset issue once and for all. The bankruptcy courts could be used in a similar fashion, but the unique legal authority of the FDIC suggests to us that this agency should run the process as part of its larger asset sale operations.

* This now "clean" whole loan collateral will then be re-sold to solvent banks in the localities where the property is located, using zip codes and other means to identify eligible buyers, priced at say 90 cents on the dollar, with a full recourse guarantee from the FDIC and financing from the Federal Reserve Bank in the relevant district. The banks will initially be guaranteed a minimum net interest margin and servicing income, and immediately begin to service the loan and manage the credit locally. Indeed, the participating bank must agree to retain and service the loan so long as government financing is used. The bank has the option to repay the financing from Treasury and take full, non-recourse possession of the loan.

We don't pretend that this simple outline is sufficient treatment of this proposal, but we have heard several permutations of this approach from veteran bankers in the loan origination channel all over the US. We see several advantages to this "community bank" approach to the crisis, which might be combined with modest additional capital infusions to solvent community and regional banks like WABC, if they even need it.

* First, it puts the trillions of dollars in now illiquid mortgage loan collateral trapped inside thousands of securitization deals back into strong local hands, who are responsible and incentivized to both manage and service the loan.

* Second, it re-liquefies the balance sheets of the US banking industry and it will vastly improve the prospects for home owners and housing markets around the country. If we are going to further lever the balance sheets of the Treasury and Fed, let's do it for a real reason and with a clear purpose.

* Third, the approach outlined above provides the Obama Administration and the US Treasury with maximum bang for the buck in terms of both addressing the solvency problems facing the banks and also helping the economy and the housing industry.

One downside: This new market paradigm suggests that loan servicing as a standalone business may be at risk. Once community banks begin to accumulate significant local servicing portfolios, they may rediscover the benefits of keeping the credits that they originate. Sorry Wilbur!

And what about valuation? Well, as our friend Kyle Bass of Hayman Capital likes to remind us, all of these assets are valued and traded every day. It's just a matter of organizing the purchase process in a transparent and competent fashion. Starting with our friends at shops like Hayman, Black Rock and RW Pressprich, we know people who know how to trade illiquid assets.

Of interest, securitization experts like Raynes believe that servicing will remain a viable business model, but only time will tell. We notice that nobody seems to want the Lehman Brothers servicing portfolio that is still sitting in the NY bankruptcy of the parent. We'll be exploring these and related issues regarding securitization at the May 4 PRMIA event in DC.

Friday, February 6, 2009

Credit Default Swaps: So Dear to Us, So Dangerous

By Eric Dickinson (Fordham University - School of Law)

Abstract: Credit-default swaps (CDS) are a valuable financial tool that has created system-wide benefits. At the same time, however, these derivative contracts have also created the potential for relatively few market participants to destabilize the entire economic system. This Paper will explore (1) how CDS could hypothetically create systemic risk, (2) how CDS have recently exacerbated the current financial crisis, and (3) how the U.S. legislature could best regulate CDS to minimize systemic risk in the future.

In theory, CDS could foster systemic crisis by means of (1) encouraging the growth of dangerous asset bubbles, (2) causing the collapse or failure of an institution that is systemically significant, and (3) creating perverse incentives that subvert policies underpinning business law on a system-wide scale. This paper will question whether CDS helped support the growth of the sub-prime mortgaged-backed securities asset bubble that has been blamed for igniting the current financial crisis. Ultimately, there is evidence cutting both ways, thereby encouraging further research into the issue. The second of these theoretical risks has certainly come into realization within the last few months when the trillion-dollar company, AIG, destroyed itself by blundering in the CDS market and causing system-wide instability. As for the third theoretical risk, there is currently no empirical evidence that CDS has created perverse incentives on a system-wide scale.

How should the government regulate CDS to minimize systemic risk? After examining seven distinct proposals, this paper recommends that legislators require CDS market participants to (1) maintain increased capital reserve requirements when involved in the purchase or sale of CDS tied to highly speculative debt; and (2) confidentially disclose their CDS positions to the Federal Reserve. Increasing the capital reserve requirements for companies that trade in junk-grade CDS is essential for two reasons. First, higher capital reserve requirements protect the solvency of systemically significant institutions that attempt to profit from the riskiest CDS. Second, specifically targeting CDS that are associated with the junk lending business will discourage banks from extending cheap credit to unworthy borrowers, thereby reducing the potential for markets to generate precarious asset bubbles. As a second regulatory measure, confidential disclosure of CDS positions to the Federal Reserve is an efficient but relatively non- intrusive way to greatly facilitate the monitoring of systemic risk going forward.