Tuesday, June 30, 2009

Derivative clearing efforts could face limits

Posted on Reuters by Karen Brettell:

Efforts to move the $450 trillion privately traded derivative markets to central counterparties may be limited to certain contracts as clearinghouses balk at taking on the risk of hard-to-value transactions and dealers act to protect margins.

Central counterparties are key to efforts by the Obama administration to remove the risk that the failure of a large dealer will spark a chain of defaults, or that fears of losses on the contracts sparks a run on banks as happened with Bear Stearns and Lehman Brothers.

U.S. regulators are proposing that all "standardized" contracts be centrally cleared, but so far, it's unclear how that will be defined.

Clearinghouses, which assume the risks of the contracts and determine margins posted against them, may be unwilling to clear contracts they deem risky.

"If we're going to mutualize risk in a central clearing agency or body, we don't want to tax it where it becomes the Lehman of the future, we don't want it to become the entity that the government is going to have to prop up," said Ian Cuillerier, partner at law firm White & Case in New York.

Craig Donohue, the Chief Executive of CME Group (CME.O: Quote, Profile, Research, Stock Buzz), the world's largest derivatives exchange, said this week that he wants the freedom to decline clearing contracts that don't have independent and liquid prices, even if they may be considered to have "standard" terms.

This may include some single name credit default swaps (CDSs), he said.

CDSs are used to insure against default or to speculate on an issuer's credit quality.

The contracts exploded in volumes in the credit boom from 2003 and 2007 and were used by companies including American International Group to take outsized exposure to risky assets, which led to it needing a series of government bailouts.

Proposals to mandate that all "standardized" derivatives be centrally cleared include the $400 trillion interest rate and foreign exchange markets, as well as contracts on equity and energy assets, though most attention is focused on CDSs.

InterncontinentalExchange Inc (ICE.N: Quote, Profile, Research, Stock Buzz), which operates the only clearing house yet to clear CDSs, has cleared more than $1 trillion in notional volumes in index trades, and has said it will extend clearing to single name contracts.

Many of these trade infrequently, however, which raises complications over daily price and margining requirements.

CDSs can be more volatile than other derivatives as their value can rapidly change if a borrower is suddenly deemed near default, and in some cases defaults can occur before sufficient collateral payments can be made.

Dealers may also resist pushing too many trades to clearinghouses to protect their market share.


The absence of central clearing in derivatives has enabled a small group of large banks including JPMorgan (JPM.N: Quote, Profile, Research, Stock Buzz), Goldman Sachs (GS.N: Quote, Profile, Research, Stock Buzz) to dominate as investors sought highly rated trading parties that, until mid-2007, were viewed as having negligible default risk.

Banks have been accused of benefiting from opaque, non-public prices of derivatives as it makes it harder for clients to see comparable trades and allows them to charge higher trading fees.

"Financial institutions earn extraordinary profits from the lack of transparency in the marketplace and from the privileged role they play as credit intermediaries in almost all transactions," Ken Griffin, Chief Executive at hedge fund Citadel Investment Group, told lawmakers this week in testimony on derivatives regulation.

Citadel has a joint venture with the CME to clear CDSs, while ICE has a revenue sharing agreement with major dealers.

With central clearing, trading platforms and exchanges have the potential to match trades, and book them into central clearing, taking business away from banks, said Kevin McPartland, senior analyst at TABB Group in New York.

Inter-dealer brokers may also see opportunity. "If they could move their clients from that voice business that they do so much and onto the platform, it's almost like instant liquidity," he said.

Regulators are encouraging more electronic trading, but proposals stop short of any mandates. While some banks may fight transparency to protect margins, others may see opportunity, said McPartland.

"We're getting the smart response from a lot of market participants of trying to embrace the changes and figure out how to take advantage and profit in the new world, rather than trying to fight it," he said.

Thursday, June 25, 2009

A Triple-A Punt

Posted in the Wall Street Journal:

If world-class lobbying could win a Stanley Cup, the credit-ratings caucus would be skating a victory lap this week. The Obama plan for financial re-regulation leaves unscathed this favored class of businesses whose fingerprints are all over the credit meltdown.

The government-anointed judges of risk at Standard & Poor's, Moody's and Fitch inflicted upon investors the AAA-rated subprime mortgage-backed security. They also inflicted upon the world's nest eggs the even more opaque AAA-rated collateralized debt obligation (CDO). Without the ratings agency seal of approval -- required by SEC, Federal Reserve and state regulation for many institutional investors -- it would have been nearly impossible to market the structured financial products at the heart of the crisis. Yet Team Obama suggests only that regulators reduce the agencies' favored role "wherever possible."

It's a revealing phrase, implying that there are situations when it's appropriate to rely on ratings from the big three instead of actually analyzing a potential investment. Can anyone name one? Probably not, which makes one wonder how the ratings-agency lobby could be so effective.

The truth is that the strongest defenders of this flawed system are mutual funds, state pension administrators and the federal regulators now managing the various bailout programs. Digging into the underlying assets in a pool of mortgages or judging the credit risk in a collection of auto loans is hard work. But putting taxpayer or investor money in something labeled "triple-A" is easy. Everyone is covered if the government's favorite credit raters have signed off.

The Obama plan also calls for regulators to "minimize" the ability of banks to use highly-rated securities to reduce their capital requirements when they have not actually reduced their risks. Minimize, not eliminate? Does the Treasury believe that some baseline level of fakery is acceptable in bank financial statements? To review, a critical ingredient in the meltdown was the Basel banking standards pushed by the Federal Reserve. Among other problems, Basel allowed Wall Street firms to claim that highly-rated mortgage-backed securities on their books were almost as good as cash as a capital standard.

The Obama plan does make plenty of vague suggestions, similar to those proposed by the rating agencies themselves, to improve oversight of the ratings process and better manage conflicts of interest. The Obama Treasury has even adopted the favorite public relations strategy of the ratings agency lobby: Blame the victim. "Market discipline broke down as investors relied excessively on credit rating agencies," says this week's Treasury reform white paper. After regulators spent decades explicitly demanding that banks and mutual funds hold securities rated by the big rating agencies, regulators now have the nerve to blame investors for paying attention to the ratings.

Even the Fed, which until recently would accept as collateral only securities that had been rated by S&P, Moody's or Fitch, has lately acknowledged the flaws in this approach. The New York Fed has anointed two more firms, DBRS and Realpoint, to judge the default risk of commercial mortgage-backed securities eligible for the Term Asset-Backed Securities Loan Facility (TALF). Since the passage of a 2006 law intended to promote competition, the SEC has also approved new firms to rate securities that money market funds and brokerages are required to hold.

But inviting more firms to become members of this exclusive club isn't the answer. As long as government requires investors to pay for a service, and then selects which businesses may provide it, it's unlikely investors will get their money's worth. History says it's more likely that investors who use the agencies' "investment-grade" ratings as a guide will be exposed to severe losses -- ask people who went long on Enron and WorldCom.

It's time to let markets decide how to judge creditworthiness. One lesson of the crisis is that the unregulated credit default swap (CDS) market provided a more accurate measurement of the risk of financial firms than the government's chosen ratings system. Apparently even the largest provider of these government-required ratings, S&P, has taken this lesson to heart. The company recently introduced a new "Market Derived Signals" model that incorporates the prices of CDS contracts "to create a measure that facilitates the interpretation of market information."

This looks like a signal that even the prime beneficiaries of a government policy believe that the policy failed. So why won't the Obama Administration embrace real reform?

Friday, June 19, 2009

Costs set to rise amid shake-up in derivatives trading

Posted in the Financial Times by Michael Mackenzie and Aline van Duyn:

The message is clear: it is going to cost more to trade derivatives.

The plans for regulatory reform unveiled by the Obama administration this week are seeking one of two things. Either users of derivatives have to put aside capital themselves if the contracts are traded privately, or margins have to be paid to clearing houses to cover potential losses.

Regulators – particularly the Federal Reserve – are seeking the authority to raise both capital and margins if they think they need to. This will particularly apply for tailored transactions that, by their nature, are less liquid, riskier and harder to value. These have also been exceedingly profitable for banks in recent decades.

“Somewhere in the system, someone is likely to have to pay more to use over-the-counter derivatives,” said Joel Telpner, partner at Mayer Brown.

The debate about the future of financial regulation is heating up as the government seeks Congressional approval and many investors and dealers have already become more conservative on risk.

The biggest shift follows a realisation that risks resided not just with unregulated investors, such as hedge funds, but with big dealers themselves. In the decade after the collapse of Long-Term Capital Management, the highly leveraged hedge fund that collapsed in 1998, the big fear among bankers and regulators was a replay of that episode.

Hence investment banks kept hedge funds on a relatively tight leash during the credit boom. Although hedge funds operated in the unregulated over-the-counter (OTC) derivatives markets with plenty of leverage, banks required that trades were backed by collateral – assets that were held by the banks as a proportion of the positions outstanding.

This tough risk management approach to collateral was not always emulated by investment banks themselves. They also relied heavily on short-term funding through the repurchase (or repo) market. Through it, assets ranging from Treasury bonds to complex mortgage-backed securities, were lent out overnight and the cash helped finance these holdings.

At the peak last year, the Bank of International Settlements estimated the former top US investment banks funded roughly half of their assets using repo markets. That exposed banks to a classic run given their heavy reliance on short-term financing.

“The demise of Bear Stearns and Lehman Brothers has put the notion in question that hedge funds are the riskier party in a privately negotiated derivatives transaction,” say analysts at Celent in a report.

There are many lessons from this. First, the use of high-quality collateral has become widespread across privately traded markets from OTC derivatives to repo to securities lending.

Second, assumptions about pricing have become much more conservative – previously pricing did not reflect the huge discounts required to sell many assets held as collateral in a liquidation situation.

“The purpose of collateral is to protect the lender and it must be priced conservatively so as to protect their interests,” says Kelly Mathieson, managing director, clearance and collateral management at JPMorgan.

Celent said that collateral had become heavily weighted in favour of cash, and this trend would continue. “The coming years will bring tougher collateral agreements with reduced thresholds and more restrictions on eligible collateral, by excluding exotic, less liquid assets,” the report said. “Aside from tightening credit terms, OTC participants are examining the creditworthiness of their counterparties more closely.”

Greenwich Associates summed up the new risk attitudes in a report this week. A survey of 152 corporate and public pension funds, endowments and foundations in the US and Canada found that 47 per cent have cut back on their securities lending programmes – the shares or bonds lent out to banks. A further 19 per cent plan to reduce lending further.

Amid these shifts, there is a strong undercurrent of tension as dealers and investors tussle for control. The move towards greater use of electronic systems for clearing and trading means that banks are already meeting some requirements from regulators to increase transparency and reduce risks.

Lee Olesky, chief executive officer at Tradeweb, an electronic trading platform for fixed income and derivatives products, says: “The proper solution for the OTC derivatives market lies in enabling access for multiple trading systems to central counterparty clearing mechanisms.”

However, faced with lower profits as investors alter their behaviour and regulators impose tougher standards, dealers are willing to improve the derivative infrastructure up to a point. One bone of contention is a clearing house for credit derivatives. Regulators have pushed dealers to commit to including investors, but the details are still being fought over.

“I want equal access to a central clearing house as dealers,” said Michael Kastner, portfolio manager at SterlingStamos, a hedge fund. “We have seen the worst case scenario and it makes sense to put all the market on an equal footing.”

Looming over all this will be the shadow of the Federal Reserve. It wants to have the final word over whether the amounts put aside to cover risks are enough, having lost faith in its ability to rely on “moral suasion”. The government report on regulatory reform says: “Responsibility and authority for ensuring consistent oversight of all systemically important payment, clearing, and settlement systems and activities should be assigned to the Federal Reserve.

Thursday, June 18, 2009

Securitization Helps Lower Cost of Consumer Credit, Study Says

Posted on Bloomberg by Jody Shenn:

The packaging of consumer debt into securities cuts the cost of consumer credit, according to a study by National Economic Research Associates Inc.

A 10 percent increase in securitization rates lowers the cost of subprime mortgages by between 0.24 percentage point and 0.38 percentage point relative to benchmark rates, and auto loans by between 0.22 percentage point and 0.64 percentage point, according to the study, which was released today.

“When discussing the role of securitization, it is critical to keep in mind its impact on the cost of credit,” Faten Sabry and Chudozie Okongwu, the study’s authors, wrote.

The report, commissioned by the New York-based American Securitization Forum trade group, also found that securitization encouraged banks to make more loans to hold and increased the ease of getting home loans in underserved areas. The Federal Reserve this year began offering unprecedented loans to buyers of asset-backed securities in a bid to revive lending to curb the longest U.S. recession since the Great Depression.

President Barack Obama’s plan to overhaul the U.S. financial system, released today, proposes new rules of securitized debt, after the market enabled looser home lending that resulted in record foreclosures and led to bond losses that hobbled banks.

The events of recent years, when volumes plunged as home- loan debt soured, supported many of the study’s findings about the possible benefits of securitization, Sabry and Okongwu wrote. A 10 percent rise in securitization rates cuts the cost of jumbo mortgages by between 0.04 percentage point and 0.12 percentage point, and credit cards by between 0.08 percentage point and 0.54 percentage point, based on data from 1999 to 2006, according to their study.

Fed Sees Success

The Fed sees its Term Asset-Backed Securities Lending Facility as successful so far, as it has boosted creation of bonds already eligible, and driven down yields relative to benchmarks on a range of securitized debt, which had accounted for about 60 percent of lending in recent years before issuance seized late last year, Hayley Boesky, director of market analysis at the Federal Reserve Bank of New York, said May 22.

Subprime mortgages are given to borrowers with poor or limited credit records or high debt burdens. Jumbo loans are larger than government-controlled Fannie Mae and Freddie Mac can buy or guarantee, currently $417,000 in most areas and as much as $729,750.

Tuesday, June 16, 2009

Do the Treasury Proposals on Securitization Reform Go Far Enough?

Posted on Naked Capitalism:

The Treasury Department's plans for securitization reform are being bandied about in the press. A key question is whether it can or will fix the now-broken private securitization process.

Credit became more dependent on securitization than many realize. By pretty much any metric, the role of banks relative to other players has declined since 1980, by some measures as much as a 50% drop in market share. Securitization, which is the process of putting loans into pools and often slicing and dicing the cash flows to create instruments that are more appealing to investors, has been the big culprit.

In case you missed it, securitization has slowed down to a trickle. In the US, non-agency securitization was $900 billion in 2007, $150 billion in 2007, and a mere $16 billion through April. Now some of that was dodgy CDOs and other subprime spawn that is better off not coming back. However, if the securitization machine remains impaired, the alternative is on-balance sheet bank lending, and the authorities do not appear interested to going back to banking circa 1980. As the Financial Times notes today:
Securitised markets – which financed more than half of all credit in the US in the years immediately preceeding the crisis – are essential for the US economy. Without a recovery in these markets, the flow of credit will not return to more normal levels, even if US banks overcome their problems.

The reason securitization became so widespread is that it is cheaper than on-balance-sheet bank lending. Traditional lending requires banks to recoup their cost of equity and FDIC insurance premiums. For assets that can be packaged, securitization is more attractive.

From a policy standpoint, therefore, the desire to restart securitization is two-fold. First, it in theory produces more abundant and cheaper credit (although any reduction in yield depends on whether the banks and other participants keep all the cost savings in the form of increased profit or pass some of them on to borrowers). Second, going back to old-fashioned lending wold require banks to have much larger balance sheets, hence more equity. The banks are having enough trouble coming up with enough capital to support their current footings that raising even more equity would seem to be a non-starter.

However, it is not clear that the ideas floated by the Treasury will do the trick. It has two components: the first is requiring that the party that originates the loans to be securitized retain 5% of the deal. The second is to eliminate gain-on-sale accounting, which increased the attractiveness of securitization considerably. Again, from the FT:
The authorities plan to force lenders to retain part of the credit risk of the loans that are bundled into securities and to end the gain-on-sale accounting rules that helped spur the boom of the markets at the heart of the financial crisis...

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared. The proposed elimination of “gain on sale accounting” is to prevent financial companies from booking paper profits on loans – packaged into securities – as soon as they were sold to investors.

Banks would only be able to record income from securitisation over time as payments are received. Brokers’ fees and commissions would also be disbursed over time rather than up front, and would be reduced if an asset performed badly due to bad underwriting.

The US authorities also plan to stop credit rating agencies from assigning the same types of ratings to structured credit products that are assigned to corporate and sovereign

The proposal to change accounting and allow for clawing back of profits if a deal goes bad is probably far more meaningful than having banks retain 5%. 5% is simply not significant enough, in and of itself, to change behavior much.

However, there is an unrecognized contradiction here. The reason securitization became pervasive was both a real improvement in economics (bona fide cost savings per above) which were then compounded by efforts of banks to streamline costs further by scrimping on vetting loans (why bother if all you needed to on-sell the stuff was FICO scores and other simple metrics?). And the favorable accounting also was a considerable impetus.

Thus any activity that changes the incentives meaningfully will also reduce the attractiveness of the economics to banks. Some of this is salutary and necessary. The point is to discourage banks from selling dreck. But effective measures may reduce the size of the securitization market more than the powers that be anticipate. There may be no free, or even cheap lunches here. For instance, it might take a more meaningful retention (20%? 30%) to change originator incentives, but a proportion that lare would make securitiation a far more marginal activity and might require the move the powers that be are hoping to avoid, namely considerably more on-balance sheet lending.

Personally, I'd stick with the changes in accounting treatment proposed, but would increase liability considerably in the event of deficient due diligence and mis-selling (ie, burned investors could go after banks and rating agencies tooth and nail). However, it would take some effort and thought to come up with the right framework.

Sadly, the US seemed able to do that in the Great Depression. The provision of the securities laws of 1933 and 1934 were astute and durable. I wonder why devising good regulatory regimes has become a lost art.

Monday, June 15, 2009

Joint Forum stocktaking on the use of credit ratings

In its report to the G7 titled Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, the Financial Stability Forum (FSF) requested the Joint Forum to conduct a stocktaking of the uses of external credit ratings by its member authorities in the banking, securities and insurance sectors. The request also suggested that authorities review whether their regulations and/or supervisory policies unintentionally give credit ratings an official seal of approval that discourages investors from performing their own due diligence.

To implement the FSF request, the Joint Forum Working Group on Risk Assessment and Capital (JFRAC) prepared and circulated to member authorities a questionnaire on the use of credit ratings in their jurisdictions. The questionnaire was designed to elicit information regarding member authorities' use of credit ratings in legislation (statutes), regulations (rules), and/or supervisory policies (guidance) affecting, or generated by, such authorities (collectively, LRSPs).

The questionnaire requested information on the definitions (either internal or via cross-reference to an external source) of "credit ratings," "credit rating agencies," or any related terms as well as any references to specific credit rating agencies in LRSPs. Member authorities were also asked questions regarding the usage of credit ratings and/or references to credit rating agencies (or, in either case, related terms) in their LRSPs, including an explanation of what each LRSP was designed to accomplish and the purpose of using credit ratings in the LRSP. Finally, the questionnaire asked member authorities to describe their assessments, if any, of unintended implications of such uses, in particular, whether the use of credit ratings has had the effect of implying an endorsement of such ratings and/or rating agencies or discouraging investors from performing their own due diligence.

The report can be downloaded here.

Constant Proportion Debt Obligations (CPDO): Modeling and Risk Analysis

Abstract posted on SSRN.com by Rama Cont and Cathrine Jessen:

Constant Proportion Debt Obligations (CPDOs) are structured credit derivatives indexed on a portfolio of investment grade debt, which generate high coupon payments by dynamically leveraging a position in an underlying portfolio of index default swaps. CPDO coupons and principal notes received high initial credit ratings from the major rating agencies, based on complex models for the joint transition of ratings and spreads for all names in the underlying portfolio.

We propose a parsimonious model for analyzing the performance of CPDO strategies using a top-down approach which captures the essential risk factors of the CPDO. Our analysis allows to compute default probabilities, loss distributions and other tail risk measures for the CPDO strategy and to analyze the dependence of these risk measures on various parameters describing the risk factors. Though the probability of the CPDO defaulting on its coupon payments is found to be small, the ratings obtained strongly depend on the credit environment -- high spread or low spread.

More importantly, CPDO loss distributions are found to be bimodal and our results also point to a heterogeneous range of tail risk measures inside a given rating category, suggesting that credit ratings for such complex leveraged strategies should be suitably complemented by other risk measures for the purpose of performance analysis.

A worst-case scenario analysis indicates that CPDO strategies have a high exposure to persistent spread-widening scenarios. By calculating rating transition probabilities we find that CPDO ratings can be quite unstable during the lifetime of the strategy.

Mapping Credit Models to Actual Defaults, Key Issues and Implications

Posted on RiskCenter.com by Donald R. van Deventer:

Credit models fall into two broad classes. In the first class of models, a statistical technique like logistic regression is used to fit explanatory variables to a “default flag” that is 1 if the counterparty defaults in that period, and 0 if there is no default. In the second class of models, there is a two stage process one goes through. In stage 1, a theory of credit risk is used to come up with a default probability for each counterparty. In stage 2, this theoretical default probability is benchmarked to actual default rates, which may be substantially different from what is implied by the theory. The first class of models doesn’t require benchmarking to actual defaults because that’s accomplished by the statistical technique automatically. In this blog post, we talk about key issues and implications of benchmarking the second class of models to actual default experience.

There are a number of model types that require mapping to actual default experience:

  • The Merton model of risky debt, typically used for public firms
  • Internal and third party ratings
  • Retail credit scores

In the case of ratings (either internal or external) and credit scores, the rater or model builder may cite historical default rates associated with each rating or credit score level. Benchmarking allows a mapping from the rating or credit score to actual default experience over a time period that may be different from the time period over which the ratings methodology or credit scoring technique was developed. Benchmarking is also essential due diligence, required by Basel II guidelines, that ensures that the ratings or credit scores work with the accuracy asserted by those doing the ratings or model construction.

Most analysts do the mapping in such a way that the ordinal ranking of companies or individuals by riskiness is not changed. The default probabilities are simply adjusted up or down to better fit history. If A is rated more risky than B before the mapping to actual experience, after the mapping, this is still true. A monotonic mapping of theoretical to actual default experience leaves unchanged the accuracy measures like the Receiver Operating Characteristics (ROC) accuracy ratio or Jorge Sobehart’s cumulative accuracy profile concept. Since these accuracy measures are a function only of the order in which counterparties are ranked, they are not changed by the mapping to actual default rates as long as this mapping is monotonic. Many credit market participants erroneously believe that the mapping process changes these accuracy measures. What the mapping does change is accuracy in another sense—the consistency of actual defaults with expected defaults both over time and by default probability level.

Another nuance in mapping the theoretical default rate to the actual default rate is very important. If the underlying theoretical model is highly accurate, as the theoretical default probability rises the mapped default probability will rise sharply toward 100%. If the underlying theoretical model is very inaccurate, as the theoretical default probability rises, the mapped default probability will either rise very modestly or remain flat, and the highest level it will achieve will be very low.

We illustrate this phenomenon with a silly model that postulates that the default probability of a public firm is lowest for CEOs with very gray hair and highest for firms whose CEOs do not have any gray hair. The model builder assets that default is highly correlated with the degree of grayness, as shown in the following chart where 10 indicates hair that is completely gray and 1 indicates hair that is not gray at all:

Case I: No Accuracy

Grayness Scale

Model Default Rate

Actual Default Rate































In case 1, the actual default rate for each of the ten “gray scales” is 1% everywhere, in spite of the analyst’s assertions that the model works. The correct mapping to actual defaults is f(gray scale)=1.00%. Instead of inserting the gray scale into this mapping function, we could have input the theoretical default probability. In actual practice Kamakura Risk Information Services mapping is done at the individual observation level (such as the 1.4 million observations in the KRIS version 4.1 Merton model) using logistic regression. For exposition purposes, we assume that the mapping is a linear function of the gray scale. The implications of this mapping are very strong—as the risk index (gray scale or the theoretical default probability) increases, the default probability stays constant and never rises above 1%. This is not indicative of bad mapping—it’s indicative of a model with zero accuracy.

Consider Case 2, where the gray scale is more consistent with the probability of default:

Case 2: Moderate Correlation

Grayness Scale

Model Default Rate

Actual Default Rate































In this case, the mapping function that most accurately converts the gray scale to the actual default rates is f(gray scale)=11%-0.01(gray scale). The mapping function using the “model” default rates as input (instead of the gray scale) is not linear but it produces the same mapped default rates. Note something very important in this example: as the theoretical default rates approach 99%, the mapped or expected default rates never exceed 10%! This is because of the fundamental lack of accuracy of the gray scale model—even at the riskiest default probability or gray scale level, the actual default rate never exceeds 10%. The mapping process should preserve this implication. Mapping the theoretical default rate of 99% or the gray scale of 1 to any default probability higher than 10% is a serious modeling error that is in violation of the requirements of good corporate governance and the Basel II guidelines.

Let’s look at one more case, Case 3 where the gray scale model is much more consistent with actual default rates:

Case 3: High Correlation

Grayness Scale

Model Default Rate

Actual Default Rate































On the Case 3 data set, the gray scale model works much better. The mapping function is f(gray scale)=41%-0.04(gray scale). The mapped gray scale model will show no default probability less than 1% nor more than 37%, but it does increase by 36% as the gray scale goes to 10.

These implications are very important for model building and for drawing implications from a theoretical model that has been properly benchmarked. If a mapped model shows a very gentle rise to a low level of default probabilities at the highest risk grade, what that means is that the underlying theoretical model is not very accurate. It does not mean that there is anything wrong with the mapping procedures. It’s the statistical equivalent of trying to make a silk purse out of a sow’s ear.

As Xiaoming Wang, Li Li, and I reported in “Advanced Credit Model Testing to Meet Basel II Requirements: How Things Have Changed,” (The Basel Handbook, second edition, RISK Publications, 2007, Michael Ong editor), the relative inaccuracy of the theoretical Merton model produces this kind of gently sloping “mapped model.” Even at the 99% theoretical Merton default probability level, the actual default rate is well under 10%. Doing the mapping of theoretical to actual default probabilities accurately is essential to best practice risk management. One must take great care not to overstate the accuracy of a model by mapping the theoretical default probabilities to a higher level than the empirical evidence indicates.

Friday, June 12, 2009

Credit derivatives on countries are behaving oddly

Posted in the Economist:

GOVERNMENTS in the rich world are announcing record-breaking deficits and their credit ratings are under threat. Yet the market that should be most worried is not. An index of credit-default-swap (CDS) spreads on the seven biggest rich economies maintained by Credit Derivatives Research (CDR), a research outfit, has widened in recent weeks, but still signals half the risk it did in February, before the full scale of the damage to public finances became clear (see chart). The trend holds true even for Britain, which is threatened with a credit-rating downgrade, and Ireland, which on June 8th suffered its second sovereign downgrade in three months.

Dave Klein at CDR admits to being puzzled by the trend. He reckons that investors associate sovereign-default risk with overall financial risk because governments now backstop so much of the system. When America bailed out Fannie Mae and Freddie Mac, the country’s two big mortgage agencies, its CDS spreads widened sharply. Conversely, a recovering economy means fewer bank failures, so government balance-sheets are less likely to be strained by bail-outs.

Sovereign CDSs are in any case harder to interpret than corporate CDSs. Rich-country defaults are extremely rare (emerging markets, less so) which makes it difficult for investors to estimate how much they would recover in bankruptcy, a key determinant in CDS pricing. Moreover, payouts on the swaps are triggered in different ways. A corporation generally has a grace period on its debt payments before a credit event is declared and protection is paid off. Governments have no such grace period. If America is 30 seconds late, a credit event is declared, says Mr Klein. Sovereign CDSs also tend be priced in dollars—except for swaps on America’s debt, which are priced in euros—so currency risk blurs things too.

Sovereign CDS volumes have held up better than other parts of the market. According to figures from the Depository Trust & Clearing Corporation (DTCC) the number of contracts and the notional value of derivatives on some 60 sovereign borrowers have generally held steady or grown a bit faster than the overall CDS market.

But most of this activity remains concentrated on emerging markets like Turkey, Brazil, Russia and Mexico. For rich countries, the amounts at stake are minuscule. DTCC puts the notional value of CDS contracts on American debt at $9 billion, barely 0.1% of the total amount of publicly held debt. The value of sovereign CDSs is just 6% of all CDSs, according to the Bank for International Settlements. Clues to the rickety state of public finances are better found elsewhere.

Wednesday, June 10, 2009

Fair Deals and Bad Dealers: CDS, Regulatory Reform and Other Tales from Washington

Posted on the Institutional Risk Analyst:

During our regular New York lunch meeting last week with The Gang - Josh Rosner, Barry Ritholtz and the former emergency room physician, recovering hedge fund trader known as "Tyler Durden" - we heard some interesting chatter about stress tests, executive changes and rate hikes. One question: Is there some reason why we are not having further bank stress tests in Q3 and Q4?

We also heard some gripping from members of the dealer community, who also get a seat at the table. They accuse us of having a "chip on our shoulders" when it comes to the debate over reforming the market for over-the counter derivatives and particularly credit default swaps ("CDS"). By way of summarizing our remarks for today's conference in Washington sponsored by Professional Risk Managers International Association, "Regulation of Credit Default Swaps & Collateralized Debt Obligations," some thoughts follow below.

Excuse us for not liking a market that is rigged in favor of the sellers, the monopoly dealers, who even today refuse to allow open price discovery in CDS among and between the other dealers. We hear about this issue constantly, from clients large and small, from hedge funds to huge pension managers. If the range of end-users from whom we hear are at all representative of Buy Side views of the CDS market, change will be welcomed.

And yes please pardon us for not putting our stamp of approval on a market structure that creates more risk in financial institutions and their clients. Every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity.

Simply stated, the supra-normal returns paid to the dealers in the CDS market is a tax. Like most state lotteries, the deliberate inefficiency of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pay the CDS tax via wider spreads and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. And for every large, overt failure like AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets.

What offends us about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks.

No, what bothers us about the CDS market is that is violates the basic American principal of fair dealing. Jefferson said that "commerce between master and slave is barbarism." All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets, how can we expect our financial institutions and markets to be safe and sound?

Equal representation under the law went hand in hand with proportional requital, meaning that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain. A situation in which one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans. Whether through laws requiring disclosure of material facts to investors, anti-trust laws or the laws and regulations that once required virtually all securities transactions to be conducted across open, public markets, not within the private confines of a dealer-controlled monopoly, Americans have historically stood against efforts to reduce transparency and make markets less efficient - but that is precisely how we view the proposals before the Congress to "reform" the OTC derivatives markets.

To that point, look at Benjamin M. Friedman writing in The New York Review of Books on May 28, 2009, "The Failure of the Economy & the Economists." He describes the CDS market in a very concise way and in layman's terms. We reprint his comments with the permission of NYRB:

"The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

"But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.

"This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention."

When we see too many people in "agreement" on a given issue, like the rebound of equity market valuations for the largest zombie banks or the growing chorus of economists that the "recession" is ending, we usually lean the opposite way instinctively, just to keep the rowboat from capsizing. Fact is, the professional investment crowd is mad to see financials recover and is getting even madder over the prospect of any sort of reform of OTC markets, restructuring of financial regulation or links between risk taking and executive compensation.

Here's our bottom line on CDS reform, banks repaying TARP and the growing crowd at the zombie dance party:

First, the pressure bearing down on the Congress not to touch the OTC derivatives markets is enormous and stems from the fact that banks like JPMorganChase (NYSE:JPM) cannot survive without the supra-normal returns from these dealing activities. But at the same time, the risk from these activities is arguably going to destroy JPM and the other dealers unless changes are made to reduce aggregate risk-taking. See our comments yesterday on Tech|Ticker about JPM and the other money center banks by clicking here.

Perhaps the fact of this huge, unmanageable risk embedded in the OTC model explains why none of the major partnership exchanges have been willing to propose themselves as alternatives for the OTC derivatives model. As one Chicago insider told The IRA: "None of our members are comfortable with the economics of CDS contracts nor would they be willing to backstop settlement of these instruments as they exist today."

Second, the decision to allow the larger banks to repay their TARP money is a mistake of the first order, in our view, and illustrates the degree to which Washington is letting the large dealers call the shots on regulatory strategy. If our estimates for loss rates by US banks prove correct, many of the TARP banks repaying capital now may be forced to come back to Washington seeking more help in Q4 2009 or in 2010. And the large banks not repaying the TARP money bear a stigma that may cause regulators and bankers serious problems as the year wears on.

Whereas the regulators had rebuilt some credibility with the public as a result of the stress test exercise, allowing the largest US banks to exist the TARP before we transit the most serious part of the financial storm strikes us as very reckless. If the Fed and Treasury want US banks to be seen by the public as safe and sound, then allowing them to reduce their capital - before ending dependence on FDIC debt guarantees and Fed repurchase agreements for toxic waste - seems contrary to the public interest.

Third, the repayment of the TARP capital by some banks does not end the GSE status of all of the major banks, Chrysler, GMAC, AIG and GM. While the White House is talking about "exit strategies" for some of these zombies, the reality is that the US government could end up as the long-term owner of both automakers, Citigroup (NYSE:C), GMAC and AIG. The cost of keeping the doors of these zombies - plus the housing GSEs -- open will consume all of the discretionary cash flow that Washington thinks is available for other pressing needs. Waive "bye bye" to health care reform, Mr. President, if we are going to feed all of these zombies in 2010.

We are told by one of our favorite Democratic economists that the Obama White House is beginning to understand the concept of resource constraints when it comes to federal spending and obtaining the dollars to spend via Treasury borrowing operations. Until and unless the Obama team accepts that keeping the zombies alive will mean putting aside plans for health care and other political priorities, there is not likely to be any action to resolve any of the GSEs.

But we do see signs of change within the White House. Just as Secretary Geithner was finishing his high profile but low substance visit to China, former Federal Reserve Board Chairman Paul Volcker was observed quietly arriving in Beijing for talks with the senior Chinese political leadership. The Chinese have made it clear, we are told, that the opinions of Chairman Volcker are more reliable than the at times sophmoric statements of Secretary Geithner.

The Treasury Secretary, do not forget, is seen in China, Europe and elsewhere as a representative of the largest US banks. The Chinese and Europeans have an intense distrust of the US dealer community for causing the financial crisis, thus Geithner's ties to Wall Street work against the interests of the US, both in Europe and in many conservative investor communities throughout Asia.

Tuesday, June 9, 2009

New European CDS pricing to start on June 22

Posted on Reuters by Jane Baird:

New trading conventions on European credit default swaps will come into action on June 22, traders and Markit officials said on Monday, in further efforts to standardise contracts and prepare for a central clearing house.

The new convention will mean that CDS on individual corporate borrowers will be priced based on fixed coupons, similar to the way that the Markit iTraxx European indexes already trade.

There will be a choice of four fixed coupons for new trades -- 25 basis points, 100 basis points, 500 basis points and 1,000 basis points, Markit officials said at an industry conference. The latter is not expected to be traded heavily.

The changes are aimed at standardising credit derivatives contracts to help dealers net their positions and cut the number of outstanding contracts in a process known as compression, and also to help a central clearing house balance its different positions to reduce risk.

Under the current system, single-name CDS contracts trade at a par spread -- the level that makes the contract's value at the outset equal to zero for both the buyer and seller of protection.

The new convention will instead fix a coupon at the outset of a contract. For example, a CDS now quoted at 150 basis points would be quoted with a coupon of 100 basis points plus an additional upfront payment equal to the 50 basis points.

The fixed coupon and variable price makes it easier for the dealer or central counterparty to match trades on the same underlying name, even though they are executed at different times and at different spreads.


The U.S. market took the lead in adopting the new trading conventions in early April but with only two available coupon options at 100 and 500 basis points.

The European approach will offer four coupons for new trades and two other coupon options to remake existing trades, traders said. The two other coupons are 300 and 750 basis points, they said.

The greater the number of coupon options, the less potential for standardisation, however.

Traders said that they expect dealers will quickly settle on one preferred coupon level for each corporate name to head off the potential for arbitrage between different coupon types.

The new trading regime officially becomes effective when single-name contracts are scheduled to roll over on June 20, a Saturday, and will start to impact trading two days later.

In the United States, the new pricing was introduced at the same time as a move to standardise the auction process for defaults and include it in the wording of CDS contracts, known as the "Big Bang."

Europe has not yet come up with its equivalent changes to the settlement process for defaults.

One big difference is that while the U.S. CDS contracts eliminated restructuring as a potential credit event, Europe's standardised settlement process will continue to include restructuring as a potential trigger for payment under CDS contracts.

The International Swaps and Derivatives Association is due to publish the new European protocol, being called the "Small Bang," next week, with the aim to have it adopted by the industry by end-July, Markit officials said.

That would be just in time to meet the industry commitment to European regulators to begin using central clearing houses by July 31.

Monday, June 8, 2009

Fed’s TALF Fuels Rating ‘Shopping,’ Moody’s Says

Posted on Bloomberg by Caroline Salas:

The Federal Reserve’s Term Asset- Backed Securities Loan Facility is causing issuers to “shop” for credit-ratings, or seek the highest ratings with the lowest standards, according to Moody’s Corp.

The need to have a [single] AAA rating to be eligible “for government programs raises the specter of rating shopping,” Andrew Kimball, head of the global structured finance business at Moody’s Investors Service, said during the company’s investor day today. “Those programs don’t differentiate on the quality of the rating. Rating shopping becomes a problem.”

As a result, New York-based Moody’s hasn’t been included in some recent transactions, Kimball said on a conference call broadcast from the event. Under TALF, the Fed provides low-cost loans to investors to buy AAA rated securities backed by auto, credit card, equipment, education and other kinds of loans. Companies sold about $15 billion of eligible asset-backed debt ahead of the fourth deadline for the Fed’s TALF on June 2, up from about $13.5 billion in May, according to Bloomberg data.

Members of the U.S. Congress and regulators have criticized Moody’s, whose founder John Moody created credit ratings in 1909, along with rivals Standard & Poor’s and Fitch Ratings for ignoring conflicts of interest and risks that helped fuel the worst financial crisis since the Great Depression. The U.S. Securities and Exchange Commission is considering how to improve its oversight of the raters.

‘Creates a Market’

“We are looking in particular at the rating-shopping phenomenon,” SEC Chairman Mary Schapiro said this week before a U.S. Senate appropriations subcommittee. The SEC is considering removing “references to ratings in SEC rules, which creates a market for rating agencies and gives a certain amount of credibility that perhaps they don’t always deserve,” she said.

Credit-ratings companies have changed some business practices in an attempt to eliminate shopping for top ratings, such as agreeing to charge debt underwriters for their preliminary work reviewing the structure of asset-backed securities even if they aren’t selected to grade the bonds.

The Fed mandated that securities must be rated by two or more “major” nationally recognized statistical ratings organizations, or NRSROs, to be eligible for TALF to minimize risk. The Fed may revise how it uses ratings, Chairman Ben S. Bernanke said in an April 13 letter in response to a complaint from Connecticut Attorney General Richard Blumenthal that the central bank’s rules unfairly favor the companies that helped cause the financial crisis.

‘Improved Conditions’

The Obama administration and Bernanke are counting on the TALF as a cornerstone of plans to revive credit and end the recession. While the program is on pace to fall short of its $1 trillion official ceiling, Bernanke said in a letter to a lawmaker last month that the TALF has helped create “improved conditions” in the asset-backed securities market.

Cabela’s Inc., a Sidney, Nebraska-based chain that specializes in hunting and fishing gear, sold about $425 million in bonds backed by payments on its store card for TALF in April. The securities had AAA ratings from S&P, Fitch, and Toronto- based Dominion Bond Rating Service Ltd. Moody’s doesn’t grade the debt.

“The most conservative rating agency usually has the lowest market share, and in the case of TALF-eligible ABS, that would be Fitch,” said Kevin Duignan, spokesman for Fitch in New York.

‘Fact of Life’

“It is the internal mandate to maintain market share that leads an analyst to compromise credit quality,” said Jack Toliver, managing director of global commercial mortgage-backed securities at Dominion.

“More players increase the opportunity for the issuers to play each agency against the others,” he said. “This is a fact of life and prevalent whether there are three or five or 10. Where this becomes a problem is when the major market share leaders build their business plans around maintaining an 80 percent or 90 percent market share.”

“In structured finance we have a very concentrated investor base, my colleagues characterize it as a single investor base in the form of the government,” Moody’s Chief Executive Officer Raymond McDaniel said at the company’s event. “To the extent they are not making active choices on a transaction-by-transaction basis, but are simply saying a AAA is a qualification standard for participation in the program that does encourage rating shopping.”

Friday, June 5, 2009

CDSs and Too Big to Fail or Unwind: Interview With Ed Kane

Posted on the Institutional Risk Analyst:

To continue the discussion on OTC derivatives and zombie banks, we next feature an interview with Professor Ed Kane, James F. Cleary Professor in Finance, Boston College. Ed is a member of the Shadow Financial Regulatory Committee and one of the leaders of the US academic community when it comes to financial regulation. We spoke to him from his office in Boston.

The IRA: So we understand from Josh Rosner that you had some very good comments about the proposals to reform the market for credit default swaps (click here to download Dr. Kane's presentation).

Kane: You folks at IRA have distinguished yourselves by your comments on this subject. I've been hearing a lot from Walker Todd about your work.

The IRA: Thank you. We'll be joining Walker and his colleagues at American Institute for Economic Research on June 25, 2009, for an event to discuss reform of the CDS markets. Of note, IRA is expanding into foreclosed asset management, recovery and disposition. In the months ahead, we hope to become an even larger part of the solution to the current crisis. You mentioned that you are going to be visiting Turin as part of your upcoming trip. No doubt you savor the irony of the two weak men of the auto industry, Chrysler and Fiat, being pushed together by the politicians in the respective countries.

Kane: Well, it makes sense. That is what governments typically do, put weak firms together and then do that again and again until the whole thing crashes.

The IRA: Let's start at the beginning with a discussion of the banking industry a year into the crisis and your presentation at the FRB Atlanta. The list of troubled institutions in The IRA Bank Monitor is now over 1,000 banks as of Q1 2009. What is your take as to the roots of this mess?

Kane: I focus on the role of safety net subsidies. The large firms understand this and have deliberately made themselves too difficult to unwind. The term "too big to fail" or TBTF misses the point. It is the difficulty of unwinding that is critical. There is a lot of discussion about the politics of TBTF, but it is also a cost-benefit analysis within the regulatory agencies that drives the decision. Look at how difficult it was for the FDIC to take over and unwind IndyMac Bank.

The IRA: A relatively small institution.

Kane: Yes, but the biggest that the FDIC had taken over and run to date. That is important. The FDIC saw that they could unwind a complex institution. They put one of their top people, John Bovenzi, and several other senior people in charge of the bank.

The IRA: For our readers, John F. Bovenzi was Deputy to the Chairman and Chief Operating Officer of the FDIC. When the Corporation takes over a bank, the COO becomes the chief executive. We suspect his colleagues will be running a few more banks before long.

Kane: Agreed. But to the point about politics, I believe it is a mistake to blame the reluctance to resolve complex banks only on political pressure. The other mistake that I constantly hear people make is that the industry puts pressure on the agencies, but the Congress stands up for the taxpayers. Actually the pressure goes through the Congress onto the agencies and nobody protects the taxpayer.

The IRA: Our nation's Founders worried about the development of factionalism based on geography, but instead we now have industry factions, the triumph of the corporate state. Members of Congress are bought and sold the way they have always been, just today it is corporations calling the shots instead of the Robber Barons.

Kane: No, they are rented.

The IRA: Speaking of rented representatives, we hear that many of the members of SIFMA cut their dues due to the economic meltdown, but JPMorgan (NYSE:JPM) reportedly doubled their annual contribution to $4 million and as a result Jaime Dimon got to pick the top two officials. This goes along with the massive lobbying firepower amassed by JPM is the past few months, including many of the lobbyists formerly employed by Fannie Mae and Freddie Mac. Since JPM is now a GSE, that seems appropriate.

Kane: JPM is the clear survivor and the vacuum cleaner that can pick up the pieces that have to be taken over.

The IRA: Indeed. Many of our clients believe that JPM is the last redoubt for both cash and collateral. We remind them, however, that all of the bailouts to date engineered by Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke, including the merger of Bear Stearns, the acquisition of WaMu and the rescue of American International Group (NYSE:AIG) were designed to prevent the trigger of CDS and the resultant evaporation of JPM. The bank is an afterthought compared to the OTC derivatives exchange that JPM has become. That is why JPM must ensure that any true reform of CDS is strangled with the proverbial umbilical cord.

Kane: Well sure, that was the point of my presentation last week at the Atlanta Fed. The way in which the CDS market has developed is a function of the dealers being "Too Difficult to Fail and Unwind" or TDFU institutions. Safety net subsidies keep other firms from gaining much market share.

The IRA: Precisely. So what is your take on the likelihood of reform in terms of CDS? We are participating in a panel discussion on June 10, 2009 sponsored by Professional Risk Managers International Association on June 10th in Washington to examine this very point. We have an excellent panel, including a late addition of former JPM official Tim Ryan, now President of SIFMA. He was registered as an attendee, so the moderator Gary Kopff of Everest Management invited him to join the fun.

Kane: The discussion seems to be coalescing around not a clearing house arrangement but a clearing platform. Such a platform provides some standardization and makes it easier to exit particular swaps positions instead of having to settle them with the original counterparty. This may, for example, give parties the ability to net-out opposing contracts that are bought and sold via different counterparties. I think this is something that people are willing to work towards. But the big dealer banks that enjoy safety net subsidies do not want to see this market migrate to an exchange. And ICE Trust -- the CDS clearinghouse that the dealer banks are backing - is a limited liability corporation. Unless we put the dealers on a partnership exchange, we won't really get the kind of tough monitoring and discipline of brokers and traders we could get with a partnership exchange.

The IRA: Yes. In an exchange model, the dealers are all joint and severally liable for all trades, so they must work to limit risk. In the OTC model, the incentives are just the opposite. The dealer banks still hold all of the collateral and, as we wrote in our comment two weeks ago under the Geithner plan the non-bank players, no matter how large or substantial they may be, are made second class citizens in a market they helped to create! Firms like Exxon-Mobil (NYSE:XON) and Royal Dutch Shell are far more sound financially than dealers like JPM, yet they must subordinate their interests to those of the dealer banks in order to participate in the OTC markets. In an exchange, all participants would be equal and the impartial third party - the exchange -- holds the money.

Kane: Yes, but remember that the exchange itself then becomes TDFU. An LLC uses only a dedicated and finite fund to bond traders against failures to deliver. Once that fund is exhausted, authorities will be under pressure to come up with a rescue plan. What benchmark do they have to step in and limit losses in such a scenario? The AIG case tells us that the plan will be to throw taxpayer money into the pot.

The IRA: Indeed. So throw money is the default plan in the event of a systemic failure. But we keep wondering what happens when we find the next dumbest guy in the room after AIG, to paraphrase Martin Mayer, and the system requires yet another mega bailout. If there is another default event of the magnitude of AIG, would this provide the political catalyst for more change, perhaps all the way to an exchange model? As we already noted, the Geithner plan marginalizes all of the non-banks corporates, funds and other players in the OTC derivatives markets in favor of the banks. There is a growing awareness of this fact and it may just take another default event to swing the political equation against JPM and the other dealers, who keep claiming that there is nothing wrong with the current OTC model.

Kane: It tells you where Geithner sees the benefits to his policy making.

The IRA: At the top of this issue of The IRA, we feature a comment from a read named Bruce Rating, who makes the point that the banks base reported earnings and executive compensation on the assumed profits of structured finance and OTC derivative deals that pay over a period of years, thus the bank has to borrow money today to pay dividends and compensation that is not yet supported with cash received.

Kane: One of the things I have suggested in some of my writing is that we should pay executive compensation in the same instrument that generates the banks income. That way the executive is taking the same risk as the organization and its clients. Society must find ways to lengthen the horizon of organizations and managers, if we are to fix the unhealthy incentives at work in financial institutions today.

The IRA: To shift to the condition of the large banks as we go through 2009 and into next year, the changing investor tone in the bond market seems to suggest that it is going to be very hard for the banks and even the US Treasury to support a large portion of liabilities via the issuance of long maturity debt. Asian investors are turning up their noses at Treasury debt with maturities longer than five years and this change will also impact the funding costs for the zombie banks, which now depend upon government guarantees to issue debt. What happens to the large banks and the subsidy arrangement you've described if they are all forced down the curve in a rising rate environment. The assumption inside Treasury and the Fed of New York is that the dealers will be able to rebuild their market access with non-guaranteed debt at gradually falling spreads, but long-dated Treasury paper may widen so much that any improvements in the investor acceptance of bank paper is muted. How do you see the banks operating in an environment where global investors are backing away from sovereign risk?

Kane: There are so many things to say about this. As long as the authorities are willing to pump money into zombie firms, they are making bad bets. The incentives of the zombie firms, especially those with stock-based formulas for executive compensation, is to take longshot gambles even if the investments have negative present value. So-called toxic assets are precisely the type of exposures managers want to keep when their enterprise has no economic net worth and all of their resources are coming from the public safety net. Once the economy gets better, some of these assets will gain value sharply. Putting money into the zombie institutions is likely to make things worse in the long run unless the country is very, very lucky. It is not a good bet. One can win some bad bets, but in the long run the strategy is a loser. A bad bet makes sense for zombie managers, but not good bets for the country. The whole basis of policy making in Washington today is that the taxpayer is a sucker who does not know how to defend him or her self against this kind of regulatory gambling. The sucker never gets an even break.

The IRA: Well you saw that the FDIC is imposing limits on the interest rates that troubled banks may offer on deposits. Wonder if they will apply those rules to Ally (f/n/a GMAC Bank)?

Kane: Well, again, one of the problems is that the authority to regulate bank holding companies resides with the Fed. The Fed has been captured by the financial sector. As I see it, the central bank is destroying its credibility. Many Reserve Bank presidents understand this and have been fighting for better policy within the FOMC, but that isn't where supervisory decisions are made. The result is that some Reserve Bank presidents are very frustrated.

The IRA: Well, the talk in town is that there is open warfare between the Fed Board in Washington and the Federal Reserve Bank of New York, due partly to the latter's alignment with the Geithner Treasury. We have a former economist from Goldman Sachs (NYSE:GS) in Bill Dudley running the FRBNY and so that "capture" by GS, JPM, etc. is complete. And it looks like the Board is now regaining courage, refusing to allow the TBFU banks repay their TARP funds unless they raise a certain about of equity. The FRBNY is entirely captive of JPM and GS, in our view.

Kane: Well, the way I look at it is that the Board and the Reserve Bank presidents have a long-run interest in maintaining their credibility and independence. Treasury Secretaries come and go every few years, but the Fed's leaders have much longer tenures. They are supposed to use the protection of their tenure to ensure independence in decision making. Federal Reserve Bank presidents should be concerned with the impact their policies have on "the firm." To greatly simplify the example, the Fed is going to face scathing criticism going forward. It is going to be blamed for many of the failings of current policy long after Secretary Geithner is gone. I have written a lot about this over the years. I see the role of the Fed is to be the scapegoat for the bad decisions made during this period. The Federal Reserve is purported to be an agency that can and will take a longer view.

The IRA: Well, a case in point is the approval of the bank holding company application by GMAC. That approval is an outrage, but neither the Reserve Bank nor Bernanke and the rest of the Board had the courage to say no to the White House. Now we have a bank holding company that is insolvent and is literally being kept afloat with subsidies from Washington while its bank unit, Ally, advertises for deposits on national TV, radio and other media in competition with solvent banks. In our view, the right thing for Bernanke to have done was to say no to the application and force the Treasury, which was then under former GS CEO Hank Paulson, to seek legislation to bail out the non-bank financing arm of GM. But neither Bernanke nor the other governors seem to have any spine whatsoever. That was a terrible day for the Fed as an institution. And the Board continues to approve applications that slam zombie banks together, even though these combinations are never successful. The banks get bigger and require bigger implicit and/or explicit subsidies.

Kane: In my view, the Board does not adequately understand the incentives of zombie banks. If the Fed and the Congress appreciated the incentives of zombie firms, they would not be playing around the margins with executive compensation. They would be actively limiting risk taking by these firms. That is why we had a deepening crisis, at least until the results of the stress tests began to be leaked. It looked as if the authorities did not have a clue. The first crisis managers must do is triage. By doing that - or at least appearing to do that - authorities temporarily stabilized expectations. Now they've got to follow that triage up with appropriate action, but proposals like PPIP are just terrible.

The IRA: Only the zombies want to attend the party. None of our clients are participating. The chief reason is fear of sovereign risk in terms of dealing with the US Treasury. They look at the Congress and the Geithner Treasury. Investors see the instability and inconsistency of the thinking in these captive institutions and the reaction is negative. Then investors look at the behavior of the Obama Administration vis-à-vis private investors in the Chrysler and GM situations and that ends the discussion. By crudely threatening investors in Chrysler and GM, President Obama and aides like Steve Rattner are burning bridges with investors that we as a nation will need later this year and beyond. Only players who are already in bed with Treasury could find "opportunities" such as PPIP and TALF attractive. To get back to the zombie issue, is there any hope that we will see meaningful restructuring of the larger banks?

Kane: Oh yes, eventually. You can't run this game forever. The credit rating organizations - I refuse to call them "agencies" - came close to lowering the rating on New Zealand the other day…

The IRA: The UK is also now on a "credit watch" by one of the ratings monopolies. Incidentally, we understand that the Obama Department of Justice is considering anti-trust action against several of the ratings monopolies as part of the Obama witch hunt against corporate America. This sort of behavior explains why few investors want to do business with the US government when it comes to toxic assets or anything else.

Kane: Well, once the credit ratings are lowered on a few sovereign names, then the question of the condition of Treasury and Fed balance sheets will come under analysis. There is going to be pressure on Treasury yields as you mentioned. We will see competition from other sources.

The IRA: So perhaps the view of the late Milton Friedman that we could exchange pieces of paper for real goods with our trading partners indefinitely was a little too glib?

Kane: It is. It has always been glib to say that Treasury debt is risk free. It has always carried inflation risk. A country can inflate its way out of debt, but it is effectively a partial default on the debt holders.

The IRA: We've actually heard some members of the far-left wing of the Obama Nation advocating the idea of calling in all outstanding Treasury debt and issuing enough fiat paper dollars to redeem it all at par. That is the kind of thinking that was seen in Weimar Germany and also in Latin America during the debt crisis. They seem to think that dollars and US Treasury debt are interchangeable.

Kane: What has been most distressing about this episode of crisis management is that our country has done precisely what we have always told other nations not to do. I hope that President Obama understands that following these short-sighted polices at the beginning of his term is going to result in some very serious problems next year in the mid-term election and in 2012 when he stands for re-election.

The IRA: If President Obama stands for re-election. Thanks Ed.