Thursday, April 30, 2009

Insight: Kazakh bank falls foul of CDS

Posted in the Financial Times by Gillian Tett:

Mention the word “Kazakhstan” to a trader in New York or London, and the image of Borat is likely to spring to mind.

Right now, though, bankers have a second – more serious – reason to ponder the Central Asian country, aside from the putative mankini-wearing Kazakh traveller who featured in a comedy film.

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

For it transpires that while the US bank has a loan to BTA it also has a big CDS position on BTA, that pays out if – and only if – the Kazakh bank goes into default. Indeed, some of Morgan Stanley’s rivals suspect that notwithstanding its loan, Morgan Stanley is actually net short the Kazakh bank.

As a result speculation is rife that Morgan might have deliberately provoked the default of BTA to profit on its CDS, since a default makes the US bank a net winner, not a loser as logic might suggest.

Morgan Stanley, for its part, refuses to comment on this speculation (although its officials note that the bank does not generally take active “short” positions in its clients.) And I personally have no way of knowing whether Morgan is short or long, since Morgan refuses to disclose details of its CDS holding.

What is crystal clear is that somebody has been placing big bets on whether or not the banking equivalent of Borat will blow up. Right now more than $700bn BTA CDS contracts are registered with the Depositary Trust & Clearing Corp in New York. Last year the BTA CDS contract was so liquid that banks and hedge funds were trading it as a proxy for Kazakh governent debt.

Therein lies the crucial reason why the world outside Kazakhstan should note what has happened to BTA. In some respects, the fact that BTA has spawned so much CDS activity has been rather good for Kazakhstan. After all, if banks such as Morgan Stanley had not been able to hedge their positions in recent years, they might never have provided finance on such a scale to BTA - or any other emerging market banks.

Or, to put it another way, if CDS contracts did not exist, Western banks such as Morgan Stanley would now be nursing big losses at BTA, rather than ending up flat (or even making a profit.)

But the rub for regulators and investors is that BTA credit risk has not entirely disappeared: somebody right now is holding the other side of Morgan Stanley’s contracts and unfortunately there is little way for outsiders to know exactly who.

Worse, the presence of those CDS contracts makes it fiendishly hard to work out what the true incentives of any creditors are. In theory, lenders should have an interest in avoiding default. In practice, CDS players do not. The credit world has become a hall of mirrors, where nothing is necessarily as it seems.

At best, this makes it very difficult to tell how corporate defaults will affect banks; at worst, it creates the risk of needless value destruction as creditors tip companies into default. Either way, the key point to grasp is that this is not just a Kazakh tale.

After all, investment banks and hedge funds have written vast volumes of CDS contracts on western names too. And while the corporate default rate has been low in recent years, it is rising fast.

What is playing out at BTA, in other words, is merely a foretaste of what awaits part of the Western corporate scene too. Call it, if you like, the new face of financial globalisation, albeit one that is unlikely to look quite as funny as those Borat jokes, as companies and investors finally wake up to the implications of this deceptive new credit world.

Kazakh CDS settlement will prove test case

Posted on Reuters by Isabel Gorst, Anousha Sakoui and Gillian Tett:

A committee linked to the International Swaps and Derivatives Association on Wednesday started procedures to settle the first set of credit default swaps contracts linked to an East European credit.

The so-called determination committee of ISDA announced that the CDS contracts written on BTA, Kazakhstan’s biggest bank, will be triggered following a partial default by the group.

The move marks a potentially important test for the credit derivatives world: while CDS contracts have already been settled in relation to collapsed western companies – such as Lehman Brothers – so far, there have not been any cases involving emerging market names.

It will also be keenly watched in Kazakhstan, which is scrambling to find ways to restructure its financial sector amid a deepening credit squeeze.

The move could provoke an industry debate since ISDA’s decision to activate the CDS contracts was driven by Morgan Stanley, which is both a creditor to BTA and holds a large credit default swap position that pays out if a company defaults.

Morgan Stanley on Wednesday declined to comment on whether this meant it would benefit overall from a BTA default.

The situation highlights the complex nature of the incentives at work in the credit world, as large creditor banks increasingly conclude derivatives contracts that are designed to pay out if a company defaults.

This is the latest twist in a long-running and highly complex saga over BTA’s fate and the rest of the troubled Kazakh banking system.

Last week, Morgan Stanley and another unnamed international bank called in loans worth $550m to BTA, citing change of ownership covenants and downgrades by ratings agencies.

This prompted BTA this week to default on two loans and freeze debt repayments to avoid bankruptcy.

Anvar Saidenov, the chairman of BTA, said the bank was unable to accelerate repayment of its $15bn of debt and would present restructuring proposals to its lenders in early May.

Flawed Credit Ratings Reap Profits as Regulators Fail Investors

Posted on Bloomberg by David Evans and Caroline Salas:

Ron Grassi says he thought he had retired five years ago after a 35-year career as a trial lawyer.

Now Grassi, 68, has set up a war room in his Tahoe City, California, home to single-handedly take on Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. He’s sued the three credit rating firms for negligence, fraud and deceit.

Grassi says the companies’ faulty debt analyses have been at the core of the global financial meltdown and the firms should be held accountable. Exhibit One is his own investment. He and his wife, Sally, held $40,000 in Lehman Brothers Holdings Inc. bonds because all three credit raters gave them at least an A rating -- meaning they were a safe investment -- right until Sept. 15, the day Lehman filed for bankruptcy.

“They’re supposed to spot time bombs,” Grassi says. “The bombs exploded before the credit companies acted.”

As the U.S. and other economic powers devise ways to overhaul financial regulations, they have yet to come up with plans to address one issue at the heart of the crisis: the role of the rating firms.

That’s partly because the reach of the three big credit raters extends into virtually every corner of the financial system. Everyone from banks to the agencies that regulate them is hooked on ratings.

Debt grades are baked into hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds. U.S. Securities and Exchange Commission guidelines, for example, require money market fund managers to rely on ratings in deciding what to buy with $3.9 trillion of investors’ money.

‘Stop Our Reliance’

State regulators depend on credit grades to monitor the safety of $450 billion of bonds held by U.S. insurance companies. Even the plans crafted by Federal Reserve Chairman Ben S. Bernanke and Treasury Secretary Timothy Geithner to stimulate the economy count on rating firms to determine how the money will be spent.

“The key to policy going forward has to be to stop our reliance on these credit ratings,” says Frank Partnoy, a professor at the San Diego School of Law and a former derivatives trader who has written four books on modern finance, including Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Times Books, 2003).

“Even though few people respect the credit raters, most continue to rely on them,” Partnoy says. “We’ve become addicted to them like a drug, and we have to figure out a way to wean regulators and investors off of them.”

AIG Downgrade

Just how critical a role ratings firms play in the health and stability of the financial system became clear in the case of American International Group Inc., the New York-based insurer that’s now a ward of the U.S. government.

On Sept. 16, one day after the three credit rating firms downgraded AIG’s double-A score by two to three grades, private contract provisions that AIG had with banks around the world based on credit rating changes forced the insurer to hand over billions of dollars of collateral to its customers. The company didn’t have the cash.

Trying to avert a global financial cataclysm, the Federal Reserve rescued AIG with an $85 billion loan -- the first of four U.S. bailouts of the insurer.

Investors, traders and regulators have been questioning whether credit rating companies serve a good purpose ever since Enron Corp. imploded in 2001. Until four days before the Houston-based energy company filed for what was then the largest-ever U.S. bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody’s and Fitch.

In the run-up to the current financial crisis, credit companies evolved from evaluators of debt into consultants.

‘Abjectly Failed’

They helped banks create $3.2 trillion of subprime mortgage securities. Typically, the firms awarded triple-A ratings to 75 percent of those debt packages.

“Ratings agencies just abjectly failed in serving the interests of investors,” SEC Commissioner Kathleen Casey says.

S&P President Deven Sharma says he knows his firm is taking heat from all sides -- and he expects to turn that around.

“Our company has always operated by the principle that if you do the right thing by the customers and the market, ultimately you’ll succeed,” Sharma says.

Moody’s Chief Executive Officer Raymond McDaniel and Fitch CEO Stephen Joynt declined to comment for this story.

“We are firmly committed to meeting the highest standards of integrity in our ratings practice,” McDaniel said in an April 15 SEC hearing.

“We remain committed to the highest standards of integrity and objectivity in all aspects of our work,” Joynt told the SEC.

Ratings and Rescue

Notwithstanding the role the credit companies played in fomenting disaster, the U.S. government is relying on them to help fix the system they had a hand in breaking.

The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, will finance the purchase by taxpayers of as much as $1 trillion of new securities backed by consumer loans or other asset-backed debt -- on the condition they have triple-A ratings.

And the Fed has also been buying commercial paper directly from companies since October, only if the debt has at least the equivalent of an A-1 rating, the second highest for short-term credit. The three rating companies graded Lehman debt A-1 the day it filed for bankruptcy.

The Fed’s financial rescue is good for the bottom lines of the three rating firms, Connecticut Attorney General Richard Blumenthal says. They could enjoy as much as $400 million in fees that come from taxpayer money, he says.

S&P, Moody’s and Fitch, all based in New York, got their official blessing from the SEC in 1975, when the regulator named them Nationally Recognized Statistical Ratings Organizations.

Conflict of Interest

Seven companies, along with the big three, now have SEC licensing. The regulator created the NRSRO designation after deciding to set capital requirements for broker-dealers. The SEC relies on ratings from the NRSROs to evaluate the bond holdings of those firms.

At the core of the rating system is an inherent conflict of interest, says Lawrence White, the Arthur E. Imperatore Professor of Economics at New York University in Manhattan. Credit raters are paid by the companies whose debt they analyze, so the ratings might reflect a bias, he says.

“So long as you are delegating these decisions to for- profit companies, inevitably there are going to be conflicts,” he says.

In a March 25 report, policy makers from the Group of 20 nations recommended that credit rating companies be supervised to provide more transparency, improve rating quality and avoid conflicts of interest. The G-20 didn’t offer specifics.

52 Percent Profit Margin

As lawmakers scratch their heads over how to come up with an alternative approach, the rating firms continue to pull in rich profits.

Moody’s, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 percent over the past five years. It reported revenue of $1.76 billion -- earning a pretax margin of 41 percent -- even during the economic collapse in 2008.

S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says SEC Commissioner Casey, 43, appointed by President George W. Bush in July 2006 to a five-year term. S&P, a unit of McGraw-Hill Cos., has profit margins similar to those at Moody’s, she says.

“They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators,” Casey says.

Sharma, 53, says S&P has justifiably earned its income.

‘People See Value’

“Why does anybody pay $200, or whatever, for Air Jordan shoes?” he asks, sitting in a company boardroom high over the southern tip of Manhattan. “It’s the same. People see value in that. And it all boils down to the value of what people see in it.”

Blumenthal says he sees little value in credit ratings. He says raters shouldn’t be getting money from federal financial rescue efforts.

“It rewards the very incompetence of Standard & Poors, Moody’s and Fitch that helped cause our current financial crisis,” he says. “It enables those specific credit rating agencies to profit from their own self-enriching malfeasance.”

Blumenthal has subpoenaed documents from the three companies to determine if they improperly influenced the TALF rules to snatch business from smaller rivals.

S&P and Fitch deny Blumenthal’s accusations.

‘Without Merit’

“The investigation by the Connecticut attorney general is without merit,” S&P Vice President Chris Atkins says. “The attorney general fails to recognize S&P’s strong track record rating consumer asset-backed securities, the assets that will be included in the TALF program. S&P’s fees for this work are subject to fee caps.”

Fitch Managing Director David Weinfurter says the government makes all the rules -- not the rating firms.

“Fitch Ratings views Blumenthal’s investigation into credit ratings eligibility requirements under TALF and other federal lending programs as an unfortunate development stemming from incomplete or inaccurate information,” he says.

Moody’s Senior Vice President Anthony Mirenda declined to comment.

Sharma says it’s clear that his firm’s housing market assumptions were incorrect. S&P is making its methodology clearer so investors can better decide whether they agree with the ratings, he says.

‘Talk to Us’

“The thing to do is make it transparent, ‘Here are our criteria. Here are our analytics. Here are our assumptions. Here are the stress-test scenarios. And now, if you have any questions, talk to us,’” Sharma says.

The rating companies reaped a bonanza in fees earlier this decade as they worked with financial firms to manufacture collateralized debt obligations. Those creations held a mix of questionable debt, including subprime mortgages, auto loans and junk-rated assets.

S&P, Moody’s and Fitch won as much as three times more in fees for grading structured securities than they charged for rating ordinary bonds. The CDO market started to crash in mid- 2007, as investors learned the securities were jammed with bad debt.

Financial firms around the world have reported about $1.3 trillion in writedowns and losses in the past two years.

Alex Pollock, now a resident fellow at the American Enterprise Institute in Washington, says more competition among credit raters would reduce fees.

‘An SEC-Created Cartel’

“The rating agencies are an SEC-created cartel,” he says. “Usually, issuers need at least two ratings, so they don’t even have to compete.”

Pollock was president of the Federal Home Loan Bank in Chicago from 1991 to 2004. The bank was rated triple-A by both Moody’s and S&P. He says he recalls an annual ritual as he visited with representatives of each company.

“They’d say, ‘Here’s what it’s going to cost,’” he says. “I’d say, ‘That’s outrageous.’ They’d repeat, ‘This is what it’s going to cost.’ Finally, I’d say, ‘OK.’ With no ratings, you can’t sell your debt.”

Congress has held hearings on credit raters routinely this decade, first in 2002 after Enron and then again each year through 2008. In 2006, Congress passed the Credit Rating Agency Reform Act, which gave the SEC limited authority to regulate raters’ business practices.

The SEC adopted rules under the law in December 2008 banning rating firms from grading debt structures they designed themselves. The law forbids the SEC from ordering the firms to change their analytical methods.

Role of Congress

Only Congress has the power to overhaul the rating system. So far, nobody has introduced legislation that would do that. In a hearing on April 15, the SEC heard suggestions for legislation on credit raters. Some of the loudest proponents for change are in state government and on Wall Street. But no one’s agreed on how to do it.

“We should replace ratings agencies,” says Peter Fisher, managing director and co-head of fixed income at New York-based BlackRock Inc., the largest publicly traded U.S. asset management company.

‘Flash Forward’

“Our credit rating system is anachronistic,” he says. “Eighty years ago, equities were thought to be complicated and bonds were thought to be simple, so it appeared to make sense to have a few rating agencies set up to tell us all what bonds to buy. But flash forward to the slicing and dicing of credit today, and it’s really a pretty wacky concept.”

To create competition, the U.S. should license individuals, not companies, as credit rating professionals, Fisher says. They should be more like equity analysts and would be primarily paid by institutional investors, Fisher says. Neither equity analysts nor those who work at rating companies currently need to be licensed.

Such a system wouldn’t be fair, says Daniel Fuss, vice chairman of Boston-based Loomis Sayles & Co., which manages $106 billion. An investor-pay ratings model may give the biggest money managers a huge advantage over smaller firms and individuals because they can afford to pay for the analyses, he says.

“What about individuals?” he asks.

Eric Dinallo, New York’s top insurance regulator, proposes a government takeover of the rating business.

“There’s nothing wrong with saying Moody’s or someone is going to just become a government agency,” he says. “We’ve hung the entire global economy on ratings.”

‘Like Consumer Reports’

Insurance companies are among the world’s largest bond investors. Dinallo suggests that insurers could fund a credit rating collective run by the National Association of Insurance Commissioners, a group of state regulators.

“It would be like the Consumer Reports of credit ratings,” Dinallo says, referring to the not-for-profit magazine that provides unbiased reviews of consumer products.

Turning over the credit ratings to a consortium headed by state governments could lead to lower quality because there would be even less competition, Fuss says.

“I would be strongly opposed to the government taking over the function of credit ratings,” he says. “I just don’t think it would work at all. The business creativity, the drive, would go straight out of it.”

At the April 15 SEC hearing, Joseph Grundfest, a professor at Stanford Law School in Stanford, California, suggested a variation of Dinallo’s idea. He said the SEC could authorize a new kind of rating company, owned and run by the largest debt investors.

‘Greater Discipline’

All bond issuers that pay for a traditional rating would also have to buy a credit analysis from one of these firms.

SEC Commissioner Casey has another solution. She wants to remove rating requirements from federal guidelines. She also faults investors for shirking their responsibility to do independent research, rather than simply looking to the grades produced by credit raters.

“I’d like to promote greater competition in the market and greater discipline,” she says. “Eliminating the references to ratings will play a huge role in removing the undue reliance that we’ve seen.”

Sharma, who became president of S&P in August 2007, agrees with Casey that ratings are too enmeshed in SEC rules. He wants the SEC to either get rid of references to rating companies in regulations or add other benchmarks such as current market prices, volatility and liquidity.

“Just don’t leave us the way it is today,” Sharma says. “There’s too much risk of being overused and inappropriately used.”

‘Hurt Now’

Sharma says that even with widespread regulatory reliance on ratings, his firm will lose business if investors say it doesn’t produce accurate ones.

“Our reputation is hurt now,” he says. “Let’s say it continues to be hurt; it never comes back. Three other competitors come back who do much-better-quality work. Investors will finally say, ‘I don’t want S&P ratings.’”

S&P will prove to the public that it can help companies and bondholders by updating and clarifying its rating methodology, Sharma says. The company will also add commentary on the liquidity and volatility of securities.

S&P’s New Steps

S&P has incorporated so-called credit stability into its ratings to address the risk that ratings will fall several levels under stress conditions, which is what happened to CDO grades. The company has also created an ombudsman office in an effort to resolve potential conflicts of interest.

Jerome Fons, who worked at Moody’s for 17 years and was managing director for credit policy until August 2007, says investors don’t have to wait for a change in the rating system. They can learn more about the value of debt by tracking the prices of credit-default swaps, he says.

The swaps, which are derivatives, are an unregulated type of insurance in which one side bets that a company will default and the other side, or counterparty, gambles that the firm won’t fail. The higher the price of that protection, the greater the perceived risk of default.

‘More Accurate’

“We know the spreads are more accurate than ratings,” says Fons, now principal of Fons Risk Solutions, a credit risk consulting firm in New York. Moody’s sells a service called Moody’s Implied Ratings, which is based on prices of credit swaps, debt and stock.

In July 2007, credit-default-swap traders started pricing Bear Stearns Cos. and Lehman as if they were Ba1 rated, the highest junk level. They pegged Merrill Lynch & Co. as a Ba1 credit three months later, according to the Moody’s model.

Each of those investment banks was stamped at investment grade by the top three credit raters within weeks of when the banks either failed or were rescued in 2008.

Lynn Tilton, who manages $6 billion as CEO of private equity firm Patriarch Partners in New York, says she woke up one morning in August 2007 convinced the banking system would collapse and started buying gold coins.

“I predicted the banks would be insolvent,” Tilton says. “My biggest issue was credit-default swaps. When the size of that market started to dwarf gross domestic product by six or seven times, then my understanding of what defaults would be in a down market became clear: There’s no escaping.”

‘Collective Wisdom’

Investors like Tilton watched as the financial firms tumbled while credit raters held on to investment-grade marks.

“If the ratings mandate weren’t there, we wouldn’t care because the credit-default-swap markets can tell us basically what we want to know about default probabilities,” NYU’s White says. “I’m a market-oriented guy, so I’m more inclined to be relying on the collective wisdom of the market participants.”

While credit-default-swap traders lack inside information that companies give to credit raters, swap traders move faster because they’re reacting to market changes every day.

San Diego School of Law’s Partnoy, who’s written law review articles about credit rating firms for more than a decade and has been a paid consultant to plaintiffs suing rating companies, says raters hold back from downgrading because they know the consequences can be dire.

In September, Moody’s and S&P downgraded AIG to A2 and A-, the sixth- and seventh-highest investment-grade ratings. The downgrades triggered CDS payouts and led to the U.S. lending AIG $85 billion. The government has since more than doubled AIG’s rescue funds.

‘Basically Trapped’

“When you get into a situation like we’re in right now with AIG, the rating agencies are basically trapped into maintaining high ratings because they know if they downgrade, they don’t only have this regulatory effect but they have all these effects,” Partnoy says.

“It’s all this stuff that basically turns the rating downgrade into a bullet fired at the heart of a bunch of institutions,” he says.

Sharma says S&P has never delayed a ratings change because of potential downgrade results. He says his firm tells clients not to use ratings as triggers in private contracts.

“We take action based on what we feel is right,” Sharma says.

While swap prices may be better than bond ratings at predicting a disaster, swaps can also cause a disaster.

AIG, one of the world’s biggest sellers of CDS protection, nearly collapsed -- taking the global financial system with it -- when it didn’t have enough cash to honor its swaps contracts. Loomis’s Fuss says relying on swap prices is a bad idea.

‘Not Always Right’

“The market is not always right,” he says. “An unregulated market isn’t always a fair appraisal of value.”

Moody’s was the first credit rating firm in the U.S. It started grading railroad bonds in 1909. Standard Statistics, a precursor of S&P, began rating securities seven years later.

After the 1929 stock market crash, the government decided it wasn’t able to determine the quality of the assets held by banks on its own, Partnoy says. In 1931, the U.S. Treasury started using bond ratings to analyze banks’ holdings.

James O’Connor, then comptroller of the currency, issued a regulation in 1936 restricting banks to buying only securities that were deemed high quality by at least two credit raters.

“One of the major responses was to try to find a way -- just as we are now with the stress tests and the examination of the banks -- to figure out how to get the bad assets off the banks’ books,” Partnoy says.

Since then, regulators have increasingly leaned on ratings to police debt investing. In 1991, the SEC ruled that money market mutual fund managers must put 95 percent of their investments into highly rated commercial paper.

Avoiding Liability

Like auditors, lawyers and investment bankers, rating firms serve as gatekeepers to the financial markets. They provide assurances to bond investors. Unlike the others, ratings companies have generally avoided liability for errors.

Grassi, the retired California lawyer, wants to change that. He filed his lawsuit against the rating companies on Jan. 26 in state superior court in Placer County.

The white-haired lawyer discusses his case seated at a tiny wooden desk in his small guest bedroom, with files spread over both levels of a bunk bed. Grassi says in his complaint that the raters were negligent for failing to downgrade Lehman Brothers debt as the bank’s finances were deteriorating.

The day Lehman filed for bankruptcy, S&P rated the investment bank’s debt as A, which according to S&P’s definition means a “strong” capacity to meet financial commitments. Moody’s rated Lehman A2 that day, which Moody’s defines as a “low credit risk.” Fitch gave Lehman a grade of A+, which it describes as “high credit quality.”

‘Without Merit’

“We’d like to have a jury hear this,” Grassi says. “This wouldn’t be six economists, just six normal people. That would scare the rating agencies to death.”

The rating companies haven’t yet filed responses. They’ve asked the federal court in Sacramento to take jurisdiction from the state court.

S&P and Fitch say they dispute Grassi’s allegations. “We believe the complaint is without merit and intend to defend against it vigorously,” S&P’s Atkins says.

Fitch’s Weinfurter says, “The lawsuit is fully without merit and we will vigorously defend it.”

Mirenda at Moody’s declined to comment.

S&P included a standard disclaimer with Lehman’s ratings: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

‘On Your Own’

Grassi isn’t deterred.

“They’re saying we know you’re going to rely on us and if you get screwed, you’re on your own because our lawyers have told us to put this paragraph in here,” he says.

The companies have defended their ratings from lawsuits, arguing that they were just opinions, protected by the free speech guarantees of the First Amendment to the U.S. Constitution.

McGraw-Hill used the First Amendment defense in 1996 after its subsidiary S&P was sued for professional negligence by Orange County, California. S&P had given the county an AA- rating before the county filed for the largest-ever municipal bankruptcy.

Orange County alleged in its lawsuit that S&P had failed to warn the government that its treasurer, Robert Citron, had made risky investments with county cash.

Not Liable

The U.S. District Court in Santa Ana, California, ruled that the county would have needed to prove the rating company’s “knowledge of falsity or reckless disregard for the truth” to win damages.

The court found that the credit rater couldn’t be held liable for mere negligence, agreeing with S&P that it was shielded by the First Amendment.

Sharma says rating companies shouldn’t be responsible when investors misuse ratings.

“Hold us accountable for what you can,” he says. He compares the rating companies to carmakers. “Look, if you drove the car wrong, the manufacturer can’t be held negligent. But if you designed the car wrong, then of course the manufacturer should be held negligent.”

The bigger issue is whether the credit rating system should be changed or even abolished. From California to New York to Washington, investors and regulators are saying it doesn’t work. No one has been able to fix it.

‘Like a Cancer’

The federal government created the rating cartel, and the U.S. is as dependent on it as everyone else. So far, the legislative branch hasn’t cleaned up the ratings mess.

“This problem really is like a cancer that has spread throughout the entire investment system,” Partnoy says. “You’ve got a body filled with little tumors, and you’ve got to go through and find them and cut them out.”

As the U.S. has spent, lent or pledged about $12.8 trillion in efforts to revive the slumping economy, and as President Barack Obama and Congress have worked overtime to find a way out of the deepest recession in 70 years, no one has taken steps that would substantially fix a broken ratings system.

If the government doesn’t head in that direction, all of its efforts at financial reform may be put in jeopardy by the one piece of this puzzle that nobody has yet figured out how to solve.

Wednesday, April 29, 2009

Morgan Stanley Said to Join ICAP-Led Group Bidding for LCH

Posted on Bloomberg by Nandini Sukumar:

Morgan Stanley will join a group of brokers and banks led by ICAP Plc that may bid for LCH.Clearnet Group Ltd., according to three people familiar with the situation.

The move comes as Depository Trust & Clearing Corp. today abandoned plans to merge with London’s LCH.Clearnet, the biggest European securities clearinghouse.

Barclays Plc, Credit Suisse Group AG and Nomura Holdings Inc. also may join the ICAP-led alliance planning to bid for LCH.Clearnet by May 29, two people familiar with the situation said yesterday.

DTCC, LCH Merger Collapses

Depository Trust & Clearing Corp. abandoned plans to merge with London’s LCH.Clearnet Group Ltd., the biggest European securities clearinghouse, after brokers and banks led by ICAP Plc said they may bid for the U.K. company.

DTCC said it will pursue “strategic alternatives” in Europe. The ICAP-led alliance told LCH.Clearnet on April 27 it may make a bid by May 29, people familiar with the matter said.

New York-based DTCC first agreed to buy LCH.Clearnet in October for 739 million euros ($979 million) to form the world’s biggest processor of trades in stocks, bonds, currencies and derivatives. The closure of the deal had already been delayed twice. LCH.Clearnet is 73.3 percent owned by banks and brokers that use its service.

“The banks don’t want LCH.Clearnet in American hands and there’s a lot to lose from not owning your clearinghouse,” said Mamoun Tazi, Geneva-based exchange analyst at MF Global Securities Ltd. “There are now two options for LCH.Clearnet. One, they stay as they are, and two, that the consortium will buy out the other shareholders.”

LCH.Clearnet provides guarantees for about half of Wall Street’s interest-rate swap transactions, the $458 trillion market where companies hedge the risk of borrowing costs moving against them. The company also plans to offer clearing for credit derivatives as regulators seek control over the $28 trillion market after the collapse of New York-based Lehman Brothers Holdings Inc. and American International Group Inc.

‘Tipping Point’

The ICAP alliance already includes Deutsche Bank AG of Frankfurt and New York-based JPMorgan Chase & Co. London-based Barclays Plc, Credit Suisse Group AG of Zurich and Tokyo-based Nomura Holdings Inc. may join the group, two people familiar with the situation said yesterday.

“This could be the tipping point with those three jumping in,” said Mark Williams, a finance professor at Boston University School of Management, said yesterday. “That’s a really strong group. Those are significant players with significant volume so their getting in is important to those competing against them.”

The European clearinghouse is also 15.8 percent owned by Brussels-based Euroclear, the region’s largest settlement agency, and 10.9 percent by exchanges.

‘The Solution’

“LCH has several options under consideration and all of them need to be looked at,” Pierre Francotte, the chief executive officer of Euroclear, said in an interview in London yesterday. “We have seen the DTCC proposal and I would like to see the consortium’s. No matter what the solution is, it should address the issue of equity-clearing fees.”

DTCC operates a European unit which clears trades for London-based alternative stock trading systems, including Turquoise, NYSE Euronext’s SmartPool block trading system and its NYSE Arca Europe alternative market.

“We will compete with LCH.Clearnet,” said Stuart Goldstein, a New York-based spokesman for DTCC. “In addition we are pursuing other strategic alternatives. We are well positioned to grow in Europe. Everyone who has chosen us has done so because of our pricing and the reliability and certainty of our technology.”

New York-based Citigroup Inc. and Zurich-based UBS AG are also part of the ICAP alliance, along with Paris-based BNP Paribas SA and Societe Generale SA, London-based HSBC Holdings Plc, and Royal Bank of Scotland Group Plc in Edinburgh, according to people familiar with the plan.

Some clearinghouses operate central counterparties to every buy and sell order executed on an exchange, reducing the risk that a trader defaults on his obligation in a deal. Customers pay fees for clearing, or post-trade processing services, which include verifying that a buyer has the funds to execute a trade.

Credit Default Swaps and Control Rights, Redux

Posted on Derivative Dribble by Charles Davi:

Felix Salmon and I are usually on the same side of the jury box when it comes to the trial of credit default swaps. However, it appears we have reached an impasse concerning creditor control rights in the context of restructurings and bankruptcies. While that sounds like an awfully narrow issue to quibble about, the policy implications of this seemingly obscure issue are far reaching and call into question both the orderly functioning of the debt markets and the soundness of the current bankruptcy regime.

Let’s begin by outlining the issue at hand. In my previous article, I wrote:

Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC’s bankruptcy. The problem seems obvious: B either doesn’t care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.

In fairness to Felix, here’s his added qualification of the issue from his response to my article:

The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.

The key to understanding why we shouldn’t expect this change in incentives to lead to any material change in the restructuring process is rooted in the distinction between incentive to act and power to act. Clearly, anyone who expects to profit more from option A than B will choose A given the chance. And so, a bondholder who expects to receive a larger payout from CDS than from a restructuring will choose the CDS payout given the chance. But does that bondholder have any power to bring this result about? As a general matter, probably not.

One Is the Loneliest Number

Restructurings generally take place across the entire capital structure of firm. A firm could have multiple issuances of bonds, loans, and may even have other hybrid debt-equity financing. Each class of creditors has holders with certain control rights. While this complicates the restructuring efforts for the firm, since the firm will have to coordinate with various classes of creditors which may have competing incentives, it also mitigates the influence that any individual creditor/creditor-class can exert on the restructuring process. In addition, it usually means that the firm will require different thresholds of creditor approval from each class. For example, ABC concludes for a given restructuring plan that it needs the approval of 75% of class A holders, 60% of class B holders, etc. The actual threshold will be determined in large part by two main drivers: (i) the agreements that determine the rights of each creditor class (ii) and the number of on-board creditors needed to make the deal economically feasible.

So, even acknowledging the clear incentive on the part of those who stand to gain more from a bankruptcy than a restructuring, their impact on the success of the restructuring will be determined by their ability to affect the firm’s ability to achieve the required thresholds. Thus, their impact will be determined by their ownership stake in the debt. And so, in order for Felix’s argument to be taken as a serious point of concern, we must posit the existence of a class of hedged creditors who stand to gain more in bankruptcy than restructuring that is so large and well coordinated that it is able to obstruct the restructuring efforts of the firm and those creditors that stand to gain more from restructuring than bankruptcy. While not impossible in a nominal sense, this strikes me as a rather fortuitous state of affairs.

Bankruptcy Is Not A Sure Bet

In analyzing the incentives of the participants, Felix assumes that bankruptcy is certain in the case that a restructuring fails. This is not necessarily the case. He wrote:

I might end up with just 45 cents on the dollar — $450,000 — if I agree to the company’s [restructuring] plan. If I just let it go bust, on the other hand, I get $600,000 [from CDS]. And so I have an incentive to opt for the more economically-destructive option.

Every filing for involuntary bankruptcy is reviewed by a judge and can be contested by the debtor. And CDS don’t payout until judgment is entered against the debtor. That means payout under a CDS as it relates to bankruptcy is an uncertain event. That means that your expected payout should be discounted by the probability that the event will occur. So in the example above, the expected payout should be some fraction of $600,000, which could easily bring it below the $450,000 indifference point. What’s worse, that probability might be impossible to calculate for your average bondholder, which holds its bonds passively and is not likely to have access to up to the minute progress reports on the firm’s financial condition or the restructuring process.

Review by a judge also means that only meritorious claims for bankruptcy will survive. And so, again, we run into the distinction between the incentive to act and the power to act. That is, whether or not someone would like a firm to go into bankruptcy, its ability to cause that to occur is restricted to only those circumstances where it would have been permissible anyway.

Covenant Thy Lender

In the previous article, I suggested that if companies were truly concerned about their creditors stocking up on CDS and fouling up restructurings, they could require the bondholders to promise to not hedge beyond a certain threshold. Felix responded with the following:

And Charles Davi’s idea that companies could somehow constrain their creditors from buying credit protection is even sillier — and probably illegal. The whole point of issuing bonds is that they’re tradable, fungible, and anonymously held. You can’t covenant up bondholders in the same way you can with bank lenders.

First, loans are covenant-heavy for the borrower, not the lender. That’s why companies like issuing bonds in the capital markets, as opposed to taking on loans. Second, without commenting directly on the legality of the scheme (though I’ll note that Felix cites no authority for his claim), it is common place in the MBS market for large, wrapped deals to condition voting rights on bona fide economic exposure. In a wrapped deal, there’s an insurer that guarantees payment on the bonds. If the bonds don’t pay, the insurer does. In these types of deals, the insurer controls all of the bondholders’ voting rights, unless the insurer defaults or goes belly up. So, what bondholders have in these deals are bonds whose voting rights are contingent upon their exposure to risk.

If CDS were truly a problem in the context of restructuring, I would expect companies to issue bonds with voting rights contingent upon maintaining bona fide economic exposure, in a manner analogous to what is done in the MBS market. That said, I wouldn’t expect them to be very popular with bondholders.

Note that this voting restriction would not affect tradability or fungibility at all. The bonds would still be identical and therefore completely fungible.

The “Restructuring” Credit Event

Finally, Felix misstates the requirements for recovering under a restructuring. He wrote:

[A]ny restructuring as drastic as the one I described would count as an event of default — so owners of credit protection would get paid out either way.

That is simply incorrect. First, an “Event of Default” is distinct from a “Credit Event.” A Credit Event is caused by the issuer referenced in the CDS. An Event of Default is caused by one of the two parties to the CDS. The former triggers a payout under the CDS. The latter triggers a payout for damages, in essence for breach of contract. For example, if X and Y enter into a CDS naming ABC Co. as the reference entity, any failure by ABC to make a payment on its bonds would be a “Credit Event” and would trigger a payout, let’s say from X to Y. Any failure by X or Y to make a payment required under their CDS would be an “Event of Default.” The two concepts are completely distinct.

More importantly, Felix misstates the circumstances under which payout occurs. At the outset of a CDS trade, the parties will agree which Credit Events will cause a payout. And indeed, Restructuring is one type of Credit Event. However, only those parties who specifically elect Restructuring as a Credit Event will be entitled to payout upon the occurrence of a restructuring. As such, his analysis of the incentives of participants, which assumes that all trades include Restructuring as a Credit Event, is flawed.

Most importantly, if someone is using CDS to truly hedge against credit risk, they will elect to have Restructuring as a Credit Event. Assuming that this is the case, Felix’s entire argument is out the window, since in that case, the hedged creditor is either indifferent towards or, in the case he’s over-hedged, has an incentive to see the Restructuring succeed.

Tuesday, April 28, 2009

Record-keeping in Financial Markets to Soar

Posted by Benjamin Wright on Electronic Data Records Law:

New financial regulations, when coupled with advancing technology, will force the retention of massive electronic commerce records.

Famed economist Hernando de Soto says poor documentation for $1 quadrillion worth of financial derivatives is wreaking havoc on the world economy. "Toxic Assets Were Hidden Assets," Wall Street Journal, 3/25/09, pA13. Former SEC Chairman Harvey Pitt calls for much new record-keeping and reporting by entities like hedge funds that have not previously been regulated. “Former SEC chief says gather, share more data,” USA Today, 3/27/09 p3B.

To prevent more of the “toxic” assets poisoning today’s financial system, Treasury Secretary Geithner says, “We will require that all non-standardized derivatives contracts be reported to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices.”

What’s a “non-standardized derivatives contract?”. . .

It’s really just a negotiated contract that allocates risk between two or more parties. It can cover most any kind of risk or possibility, from the risk of a lawsuit to the potential for rain in the Australian Outback. (A derivative can be "embedded" in an ordinary commercial contract, such as a sale agreement or a mining agreement.) The scope of this field is breathtaking. Non-standardized derivatives contracts have become a very large, thinly-monitored part of our financial world.

So what’s a complete record of one of these derivatives contracts look like? Would it be a stack of paper, stapled together, with signatures at the end? It could indeed be such a stack of paper.

But . . . let’s think deeper about how contracts are documented these days. As the methods for written business communication – letter, telex, fax, e-mail, instant message and so on -- have grown progressively more cheap and easy, the challenges for documenting complex contracts have risen.

If the derivatives contract were entered in the 1970s, using the practices of the day, a stack of paper, stapled together, would most likely be the form it would have taken. It might have been supplemented with a few paper letters and, once-in-a-blue-moon, a telex or two.

Then in the 1980s faxes became popular, and the contract might have been a stack of stapled paper, supplemented or amended by several faxes. (We learned years ago that faxes can be legally-binding records, just like paper-written letters.)

Next, in the 1990s e-mail started to become a common form of business communication. Numerous judicial decisions have held e-mail to be legally-binding “signed writings” essentially equivalent to paper letters.

See JSO Associates, Inc. v Price (informal e-mails can constitute signed writings agreeing to hire a broker to sell securities and pay a commission) and Cloud Corp. v. Hasbro (formal paper contract that says it can be amended only by a signed writing is amended by informal e-mails).

The e-mails in a contractual relationship can be very numerous. And they often are not as clearly written as old-fashioned, formal paper contracts were.

Today non-standard derivatives contracts can be negotiated, documented, amended, supplemented and interpreted by a dizzying array of electronic communications. Fax and e-mail are probably most common, but instant messages, phone text messages, chat rooms, message boards, social networking channels and voicemail-converted-to-text are rising in usage among busy traders. (Dedicated online marketplaces like Agora-X provide organized electronic environments for communication and negotiation of over-the-counter derivatives.) All this stuff can be very relevant to full documentation for a modern financial contract. In the Lehman Brothers bankruptcy, for example, the administrator digs through mountains of e-mail to figure out what the firm’s rights and obligations were in the over-the-counter derivatives market.

So what will it mean for bankers, investment mangers and hedge fund representatives to document their derivatives contracts? These guys will come (soon if not already) to be working in environments that look like “lifestreaming” on Facebook, Twitter and other advanced Web 2.0 systems. Their firms will have to record (and comprehend) their every-move – e-mail, text message, voice mail, Twitter tweet, blog entry, collaborative contribution, social network wall-posting and more. Anticipate the numbers of records being of a Biblical order of magnitude.

Smart players in the financial markets will recognize today that this future will arrive quickly.

Musings on Credit Default Swaps

Posted on Naked Capitalism:

As readers may know, I view the credit default swaps market with more than a bit of skepticism. I can point to cases where it has caused harm:

1. Bagholders. Dealers claim that CDS are really not bad at all because they haven't been taking risk, oh no, they hedge their position with offsetting swaps.

So let's assume they are right. The dealer community is a closed system with no net exposure. But you have the buyers of contracts (hedgers and punters). Someone somewhere has to be assuming the risk.

We used to know who that someone was: AIG, and on CDOs, Ambac and MBIA (their policies were structured more like traditional insurance but was also sometimes called credit default swaps). But other bagholders have included public investors who bought products with enhanced yields (typically synthetic CDOs) but where they'd actually lose money if defaults on the referenced bonds went above a trigger level. And guess what? Those products typically contained names of real turkeys like AIG, the auto companies, Lehman. They were also peddled heavily overseas to chumps that would only know these were famous American companies.

2. Distortions in cash bond pricing. The theory is that CDS make markets more efficient, but in reality, they can distort the price of new issues. That means they are damaging the real economy by making costs higher than they "ought" to be. From March 2008:
The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company's ability to repay debt.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.

The Financial Times reported that this was continuing in May.

3. Incentives to push companies into bankruptcy. One worry, that seems to be coming to pass, is that CDS are leading investors to be indifferent to a bankruptcy, and in cases to push for it. Since they own a CDS, they'll get their payoff, while negotiating a restructuring takes time and money. Why bother? But negotiations can keep companies out of BK, and are also necessary for Chapter 11 to succeed. And if a restructurings fail, more job losses result. This too is a toll on the real economy.

I have a fourth concern, which is harder to prove, and I'd welcome reader feedback. CDS also create an incentive for lenders and investors to skip or do a cursory job on credit research. Why bother if the market give you a price? The reason that this is particularly bad is that it is the lender that can do the best examination, by virtue of direct interaction with the borrower and being able to obtain non-public information. Having the original lender be able to lay off risk presumably had lead them to cut back on their credit function. Is this correct? If so, what evidence can you point to? When did this start and how pronounced has it become?

Yet another argument when the bank stocks were taking a beating was that speculators pushing up CDS spreads were much bigger culprits than short sellers, but I am not clear as to the mechanism.

I am also wondering if the same thing has happened on the investor side, that credit research isn't what it used to be.

I am similarly skeptical of the purported benefits. More liquidity does not appear to have produced less volatility, which is the theoretical reason why liquidity is a boon. I also don't buy the price discovery argument. In the Volcker era, when bond trading was under stress, I cannot once recall anyone complaining about price "discovery" being a problem in corporate bonds. Please. Even then, there were enough liquid issues to easily grid prices for those that didn't trade much (bonds trade by attribute, duration, rating/credit quality, presence or absence of call features, etc,).

Another bone of contention (although this is a more specific complaint) is that when the industry argues against moving to exchanges, they argue that they need to do OTC trades so they can "customize". Yet I have never read a single example of why they need customization (as in when and how it serves investor needs, with specific examples) and how much the investor would lose by buying off the rack products. The lack of specificity in any of these claims makes me believe the main reason is to create complex products to hive risk off onto bagholders, or to charge extra for an added feature that really does not do the investor a meaningful amount of extra good.

Monday, April 27, 2009

Chicago Missing Swaps Swagger, Melamed Vows Comeback

Posted on Bloomberg by Matthew Leising:

Leo Melamed helped create the first contracts almost 40 years ago in what would become the $20 trillion financial futures market. In the 1980s he pushed for electronic trading, propelling his Chicago-based CME Group Inc. to dominate U.S. futures exchanges.

“We think we’re better than everybody else,” said Melamed, CME Group’s Chairman Emeritus.

In the $28 trillion world of the credit-default swap market, though, the Chicago swagger is less certain. Six months after announcing its plan to back credit-default swaps with its clearinghouse, and six weeks after gaining regulatory approval, CME Group hasn’t processed a single dollar of the contracts. It’s losing to the 9-year-old Intercontinental Exchange Inc., which is about to hit the $100 billion mark.

CME Group’s stumble in this new market has forced the world’s largest futures exchange to admit mistakes and change course. Melamed, 77, and his colleagues got fresh evidence of the need to do so last week when the company reported a 30 percent drop in first-quarter profit because trading in its largest contract, interest-rate futures, fell 53 percent.

“We started a little wrong,” Melamed said in an April 22 interview in his office, where photographs of him with Federal Reserve Chairman Ben S. Bernanke and every president back to Gerald Ford hang on the wall. “We said you had to trade with us to go to our clearinghouse. That was wrong. We’ve now adjusted that, and that was a big difference.”

Lehman Fallout

CME Group is battling to penetrate the credit-default swap market where regulators are demanding more transparency after Lehman Brothers Holdings Inc., one of the largest swaps dealers, filed the biggest bankruptcy in U.S. history last September with $613 billion of debt. American International Group Inc.’s bad bets using the contracts led to four attempts by the U.S. to salvage the insurer in a rescue package valued at $182.5 billion.

A clearinghouse that backs the contracts spreads the counterparty default risk among the members that capitalize it by becoming the buyer to every seller and seller to every buyer. It also creates one location for regulators to see prices and positions in the market.

Credit-default swaps are derivatives used to hedge against losses or speculate on companies’ ability to repay their debt. The swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.

110-year History

While clearing credit-default swap trades is a goal of CME Group, the exchange has its eye on the broader over-the-counter business, which is the world’s largest derivative market with a notional value of $684 trillion.

“We think that’s the next frontier,” Melamed said, adding that the CME Group eventually would prevail in attracting customers to its clearinghouse. “If one were to choose where one wants to go with credit-default swaps, how about the place that has a 110-year history without default?”

Intercontinental Exchange, based in Atlanta, is an upstart compared with that pedigree, having begun in 2000 with a system to guarantee over-the-counter energy transactions. The company has since grown to the second-largest U.S. futures market, owning exchanges in New York, London and Winnipeg.

CME Group fell $5, or 2.1 percent, to $234.80 at 12:21 p.m. New York time in Nasdaq stock market trading. Intercontinental Exchange gained $4.02, or 4.8 percent, to $88.41 in New York Stock Exchange composite trading. CME had risen 15 percent his year before today while ICE was up 2.4 percent.

Wall Street ‘Threat’

CME Group has fallen behind its competitor not only because of the initial decision to make clearing customers also trade with the exchange. The Wall Street banks that account for the majority of over-the-counter trading don’t want to give away the lucrative business, said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York.

“They don’t have customers because the street views CME as a threat, not because the CME product is in any way flawed,” said Hintz, who was rated the top analyst covering brokerages in a survey by Institutional Investor magazine last year. JPMorgan Chase & Co. earned $5 billion last year from its fixed-income OTC trading, people familiar with the earnings said last month.

Melamed agreed that banks are wary of shifting over-the- counter business to CME Group. “The majors make a lot of money by not bringing it to us,” he said, referring to the banks.

Fix Needed

Intercontinental’s clearinghouse, known as ICE Trust, has the backing of nine banks including Goldman Sachs Group Inc., JPMorgan, Citigroup Inc. and UBS AG that Intercontinental obtained through its acquisition last year of the Clearing Corp., which the banks owned. The banks receive half the profit from clearing trades on ICE Trust.

Melamed said CME Group’s bank customers told it that the initial proposal to offer credit-default swaps for clearing only through its CMDX platform wasn’t how they wanted to use the system. The banks wanted to trade the contracts among themselves or with clients and then bring them to CME Group to be cleared, he said.

“They were very frank about it,” Melamed said, adding that the Chicago exchange changed CMDX several months ago to allow that outside trading of credit-default swaps. “We saw it as a legitimate problem that we ought to fix.”

Melamed declined to comment on which banks CME Group is in talks with about joining CMDX, which is a joint venture with Citadel Investment Group LLC, the $13 billion hedge fund based in Chicago.

Olive Branch

ICE Trust has cleared 875 credit-default swap transactions in Markit CDX North American indexes, guaranteeing $98 billion of the contracts, according to its Web site.

“I have to give ICE a lot of credit,” Melamed said. “They came in strong. They are a serious competitor.”

Craig Donohue, CME Group’s chief executive officer, said in an April 22 interview that the evolution of the credit-default swap market will take time. The exchange is working to build trust with the major banks involved in over-the-counter markets, Donohue, 47, said the next day in response to a question on a conference call with analysts.

“We’re modifying our approach to extend the olive branch,” he said.

ICE Trust’s share of credit-swap clearing was minimal, Donohue said in the April 22 interview. “The amounts that have migrated to the clearinghouse are very, very small,” he said.

Financial Futures Founder

The total in credit swaps cleared by ICE Trust comprises 1.5 percent of the investment grade and high volatility CDX indexes, which total $6.4 trillion, according to the New York- based Depository Trust & Clearing Corp., which runs a central registry that captures most trading. Revenue from the business could reach $50 million a year, according to Goldman Sachs. That would boost revenue 6.2 percent at ICE or 2 percent at CME Group based on 2008 sales.

Intercontinental spokeswoman Kelly Loeffler declined to comment.

Melamed is often called the “father of financial futures” for his role in creating the first currency futures contracts in the early 1970s. Along with Richard Sandor, who helped invent interest-rate futures at the Chicago Board of Trade at the same time, Melamed transformed a futures world that had been based on agricultural products such as corn.

Chicago’s financial identity for generations was defined by traders in colorful jackets shouting buy and sell orders at each other in the pits at the CME and Board of Trade.

Culture Challenge

In the 1980s, Melamed challenged that open-outcry culture by spearheading the development of the Chicago Mercantile Exchange’s Globex electronic trading platform against opposition from the city’s floor traders.

Globex now accounts for more than 80 percent of CME Group’s total volume, up from less than 15 percent in 2000. From 2000 to 2007, the number of contracts traded annually rose to 2.8 billion from about 200 million. That growth boosted CME Group’s shares more than 14-fold from 2003 to 2007, allowing it to buy the Board of Trade and another competitor, the New York Mercantile Exchange. CME Group now controls 98 percent of U.S. futures trading.

The $684 trillion notional value of the over-the-counter derivatives market dwarfs the $20 trillion exchange-traded futures market, which doesn’t include commodities, according to the Bank for International Settlements in Basel, Switzerland.

The lack of transparency in the OTC derivatives market allowed banks to make billions in profits from the spreads between offers to buy and sell.

Day to Remember

In foreign exchange markets in the 1970s, Melamed said, the Chicago Mercantile Exchange’s futures contracts reduced spreads to as little as 2 basis points from 20 basis points when the banks traded in the OTC market. A basis point is 0.01 percentage point.

From those days more than 30 years ago, Melamed still trades foreign currency contracts. At one point during the interview in his office, an announcement about a trade in yen crackled over a squawk box.

“I trade, which makes me live,” Melamed said. “I know what’s going on because it’s my money.”

He shows off Chinese, Japanese and Korean translations of his 1996 book “Escape to the Futures” with Bob Tamarkin. On a shelf, a crumpled calendar page from Thursday Nov. 13, 1969, sits in a frame.

Melamed commemorated the date because it was the day he did well enough in the pits to get himself out of debt from trading egg futures. He’d gone broke as a trader twice already, and he promised himself never to do so again.

With that perspective, he said he isn’t overly concerned about ICE Trust taking the lead in clearing credit-default swaps.

“I learned that, yes, there probably is a timeline,” he said, “but it’s much longer than we all intuitively think.”

ICE Begins Clearing Live Credit Derivatives Trades

Posted on

IntercontinentalExchange Inc. (ICE) this week began clearing live credit default swap transactions, a key step toward mitigating systemic risk in the $28 trillion market.

The move comes as ICE Trust, the credit derivatives clearinghouse launched by the Atlanta-based exchange in early March, crossed the $100 billion threshold in notional value of trades cleared.

ICE Trust remains the only clearinghouse for credit derivatives in the U.S. and the only such platform to do any business on either side of the Atlantic.

Chicago-based CME Group Inc. (CME) is readying its own CDS clearing and trading solution, a joint venture with the hedge-fund firm Citadel Investment Group, though no launch date has been set.

NYSE Euronext (NYX) rolled out its own clearing platform for credit derivatives in London last December, but, as of this month, that service had yet to handle any trades.

Up until this week, ICE Trust had been clearing pre-existing trades, as dealer banks backloaded positions into the clearinghouse.

Credit default swap indexes remain the only sort of credit derivatives clearable through ICE Trust, though ICE plans to eventually expand clearing capabilities to single-name instruments.

Authorities in the United States and Europe have pushed CDS dealers to clear credit derivatives trades, in a bid to improve efficiency and reduce the systemic risks exposed by the near-collapse of American International Group Inc. (AIG) last fall.

Facts belie the diagnosis on credit derivatives

Posted in the Financial Times by Terry Smith (CEO of Tullett Prebon):

The report* that has just been published by the City of London on over-the-counter (OTC) derivatives makes for alarming reading if, like me, you believe that politicians and regulators should approach the financial crisis as the medical profession would approach a sick patient: by diagnosing the illness and then prescribing treatment.

There are a couple of characteristics of the OTC markets that are important to recognise.

First, they are much bigger than the markets that are conducted on exchanges. The report shows that the market value of OTC derivatives contracts is eight times larger than exchange-listed derivatives, and that turnover in exchange-listed derivatives is in turn 25 times the turnover in traded cash equities, This gives some sense of the relative size and importance of these markets.

Second, London is the most important centre for the OTC markets. It is estimated that 43 per cent of worldwide derivatives trading in 2007 was conducted in London, whereas 24 per cent was conducted in New York, and less than 15 per cent in France, Germany and Japan combined. OTC markets are important to the City of London in its widest sense, including the offshoots in Canary Wharf and Mayfair.

This makes it all the more worrying that the prescriptions put forward for the OTC markets show a blatant disregard for the facts, and the cultivation of self-interest by politicians and some operators.

Let’s start with the simple proposition, which seems to be almost universally accepted, that the OTC markets in credit derivatives were one of the main causes of the crisis. The City of London report utterly refutes this claim. There have been no significant problems caused by the markets in credit default swaps. In fact, the market survived a severe test with the failure of Lehman Brothers without any ill effect.

Despite this absence of any evidence that the OTC markets in credit default swaps have caused any problem, there is a clamour for a central counterparty to guarantee trades in the CDS market and even for CDS trading to be conducted on exchanges. We have seen Tim Geithner (when he was president of the New York Federal Reserve) indicate that the OTC CDS market should be regulated by the US, which is amazing since three-quarters of the world’s CDS trading takes place outside the US.

Not to be outdone, the European Commission has threatened legislation imposing stringent new controls unless the banks that are the main dealers in CDS establish the use of an EU-based central counterparty for CDS by the middle of the year. The practicality of achieving this has, of course, not been considered, let alone the desirability.

Last but by no means least, the Banque de France has proposed that a central counterparty needs to be established for the eurozone – in other words, one that is not located in London, since the UK is not in the euro.

Added to this mêlée is the suggestion, for example in a submission from the Federation of European Securities Exchanges, that CDS (and other OTC) trading can be transparent, liquid and well regulated only if it is conducted on exchanges. This assertion, which is equally unsupported by any evidence, is promoted by those exchanges that are seeking legislative or regulatory help to drive OTC business on to their platforms.

Their action is not surprising since they have almost universally failed to make any inroads into the OTC markets. There are many reasons they have failed, but the largest one is that OTC market products are of necessity bespoke instruments and contracts, traded in large amounts between professional participants; and as such, they are the antithesis of an exchange-traded product. If OTC business is driven to these unsuitable venues, markets will become less efficient, which is an outcome we should seek to avoid.

Given the importance of OTC markets to London and to the health of the financial markets in general, the British government should surely be lobbying to support the City of London report’s conclusions. But as we saw last week, its priorities would seem to lie elsewhere.

* Current Issues Affecting the OTC Derivatives Market and its Importance to London by Lynton Jones of Bourse Consult

The writer is chief executive of Tullett Prebon