Wednesday, September 30, 2009

Lehman, Metavante and the ISDA Master agreement

Posted on FT's Alphaville by

On Monday, FT Alphaville remarked upon a report by Finance Asia on a ruling in a US bankruptcy court that, as we put it, “may turn out to be something of a game-changer” as far as the world of credit derivatives was concerned.

In short, past assumptions regarding counterparties’ ongoing obligations to bankrupt swap partners appeared to have been torn up.

The report (and our coverage of it) was a bit short on detail, but here’s what we’ve learnt since. Take a deep breath…

The backstory

- The ruling on September 15, by Judge James Peck in Manhattan, centred on a dispute between Lehman Brothers and Metavante Technologies, a specialist provider of banking and payment technology, over an interest rate swap agreement.

- Metavante, relying on section 2(a)(iii) of the supposedly sacrosanct ISDA Master Agreement, had opted to cease making payments to Lehman.

- Section 2(a)(iii) permits the non-defaulting party to a swap contract governed by the Master agreement to suspend performance - in this case, to make payments due - while an event of default was continuing. Metavante argued that Lehman’s Chapter 11 filing constituted an event of default, left it without an effective counterparty, and freed it from any obligation to continuing making payments to Lehman.

- As of May 29, Metavante owed Lehman “approximately $6,640,138 representing net payments for the November 2008 and the February and May 2009 payment dates,” according to court filings. The company also owed default interest on unpaid amounts, the documents said.

- Metavante also argued that, as the non-defaulting party in the agreement, it had the option to wait to terminate the trade until market conditions moved in its favour. Lehman, somewhat unsurprisingly, disagreed with that position. The bank told the court:

In direct contravention of the specific provisions of the Bankruptcy Code, Metavante improperly is attempting to take advantage of the Debtors’ chapter 11 cases and avoid its obligations to make its payments to LBSF. The purported rationale for this failure to make payments is that the commencement of chapter 11 cases by LBSF and LBHI constituted “Events of Default” under the Agreement. The failure to make payments under the Agreement, however, ignores section 365(e)(1) of the Bankruptcy Code, which expressly prevents parties from modifying the rights of a debtor under an executory contract “at any time after the commencement of the case solely because of a provision in such contract . . . that is conditioned on . . . the commencement of a case under this title . . . .

- On September 15, Judge Peck sided with Lehman.

The back-backstory

- The ISDA Master Agreement is fundamental to, and provides a template for, the derivatives market. As one experienced industry participant put it: “The Master, after the Bible and the Koran, is probably the most scrutinised document out there.”

- When Judge Peck ruled last week that Metavante would, in fact, have to continue to perform - i.e. make payments to Lehman - unless it terminated the agreement, it “blindsided the market”, the person said. Why? For one thing, nothing like this had ever happened in the US.

- There had been a similar case in Australia in 2003. In “Enron Australia v. TXU Electricity Ltd”, the court - contra Peck - permitted TXU to withhold performance under Section 2(a)(iii) indefinitely. Crucially, the court found that Australia’s bankruptcy laws did not permit it “to deprive the counterparty of its contractual rights, such as the right not to designate an Early Termination Date . . . and the right under section 2(a)(iii) not to make a payment.”

- Still, as far as the logic of the bankruptcy court goes, Peck’s decision was not at all unreasonable. As several senior bankruptcy lawyers consulted by FT Alphaville explained (and per Lehman’s argument quoted above) insolvency law “simply does not tolerate reliance on an ipso facto provision.” That is, section 2(a)(iii) should be considered to apply in every event of default except bankruptcy.

The reaction

- ISDA, the body that is the de-facto voice of the derivatives industry, has come out on the side of the pragmatic bankruptcy lawyers. As ISDA chief executive officer David Geen told the FT:

We didn’t learn anything in Metavante we didn’t already know.

When you’re entering into these agreements, you have to make a decision regardless of the jurisdiction you deal in whether you are prepared to accept the risks involved

It’s just another reminder that their agreements are always subject to applicable bankruptcy laws…people dealing in the US would have been advised that 2(a)(iii) and the right to terminate is going to be affected by applicable law even if it’s not specified in the agreement

- Of course, the argument that people should have known better is not the same thing as saying people did know better, especially since the only other piece of case law on the matter (in Australia) came to exactly the opposite conclusion as that of Judge Peck.

Wider implications

- At the very least, the decision will make it harder for companies that have open, out-of-the-money trades with the Lehman to keep the contracts open and avoid making payments.

- Of course, the provision applies equally to any in-the-money counterparties. More broadly, the Metavante decision will make it more difficult for any counterparty to rely on 2(a)(iii ) as a walkaway clause.

- Judge Peck’s ruling also affects the safe harbour provision for swaps in the event of a bankruptcy. As Richard Schetman, partner at law firm Cadwalader, Wickersham & Taft commented (our emphasis):

The court is saying that while you don’t have to designate an early termination you then have to perform, and if you do elect to terminate under the safe harbor you have to do so within a reasonable amount of time after the bankruptcy occurs

- And, as Goodwin Proctor pointed out,

[Peck found that ]the safe harbour provisions of the Bankruptcy Code “protect a non-defaulting swap counterparty’s contractual rights solely to liquidate, terminate or accelerate” derivatives transactions upon the bankruptcy of their counterparty, or to “offset or net out any termination values or payment amounts” in connection with such a termination, liquidation or acceleration. By “simply withholding performance,” Metavante was not attempting to take any of these actions and was thus not protected by the Bankruptcy Code safe harbors. Judge Peck then found that the contract between Metavante and Lehman was a “garden variety executory contract,” subject to the general executory contract principles of the Bankruptcy Code.

- It is worth noting that until Metavante, there was no guidance on just what constitutes a “reasonable amount of time” regarding termination’ in either the ISDA Master or under existing US bankruptcy laws. The Metavante decision, which in effect said “you have a right to terminate but you can’t sit on it forever”, seemed to define “forever” as about a year.

As Clifford Chance observed in a client memo:

Although the safe harbor provisions of the Bankruptcy Code otherwise would have permitted Metavante to terminate the swap agreement on account of Lehman’s bankruptcy, the Court found that Metavante had waived its right to terminate the swap by waiting a year to do so. The Metavante swap agreement included the standard ISDA Master Agreement language that permits termination following a counterparty’s bankruptcy. The Court cited an earlier case for the view that a counterparty’s actions under the special swap protections must be made “fairly contemporaneously with the bankruptcy filing.” The Court observed that, although Metavante may not have had the obligation to terminate immediately upon filing, its failure to do so after a year constituted a waiver (notwithstanding contractual provisions in the ISDA Master Agreement that a delay in exercising a right does not constitute a waiver).

- The case has also created uncertainty over the critical issue of whether there even exists a window of time after a bankruptcy filing during which a non-defaulting party may withhold payments. Again, from Clifford Chance:

In the absence of such a window, a counterparty would need to decide by its next scheduled payment date whether it wants to terminate or pay. The import of the Metavante decision is that a swap counterparty may not reasonably anticipate a grace period from its performance in accordance with its obligations arising under the ISDA Master Agreement. Like any other “executory contract,” performance remains due on both sides notwithstanding the pendency of the bankruptcy case and until such time, if ever, that the contract has been rejected or otherwise disaffirmed by the debtor.Now, don’t even let us get started on Dante

Tuesday, September 29, 2009

Comparing Default Probabilities and Credit Default Swap Quotes: Insights from the Examples of FNMA and Citigroup

Posted on Kamakura's website by Donald van Deventer

Our blog post on September 23, 2009 was an update of a 2007 article we did in RISK on the relationship between credit default swap quotes and modern reduced form default probabilities. This post illustrates how the probability of government bailouts causes the potential losses of different liability holders to diverge sharply. A similar kind of division can be seen in the trends of default probabilities and credit default swaps. We illustrate this process using the cases of FNMA and Citigroup.

In what follows we compare 5 year composite senior debt credit default swap quotes, as reported by Markit Partners, with reduced form default probabilities The CDS quotes we report are on a “spread” basis for senior debt with “modified restructuring” documentation. The default probabilities we use are the 5 year Jarrow-Chava version 4.1 reduced form default probabilities from Kamakura Risk Information Services. These default probabilities predict the probability of failure from a combination of financial ratios, macro-economic factors, equity market returns, and company size. For more on the Kamakura Risk Information Services models see These models are benchmarked on a “failure flag” that is the earliest to occur of the following events:

• Chapter 7 or 11 bankruptcy
• Delisting for reasons of obvious financial distress, such as failing to pay fees or file financial statements
• Declaration of a D or SD rating (if the latter becomes permanent)
• A credit event under the ISDA credit default swap language (for more recent modeling)

The five year default probability is assembled from 60 different logistic regressions which predict both the spot 1 month default probability and 59 forward 1 month default probabilities. The 5 year default probability is quoted on an annualized basis comparable to the credit default swap quote.

The graph below compares the CDS quotes and 5 year default probabilities for FNMA from 2007 until it entered into conservatorship in September 2008:

The blue line is the 5 year credit default swap quote and the green bars are the five year default probabilities from KRIS. By the end of the day on September 5, 2008, the KRIS default probabilities were consistent with a 42.92% five year cumulative probability of default. Annualized default probabilities on that day were in excess of 21% for 1 year and 10.61%, shown above, for the 5 year default probability. The five year credit default swap quote, by contrast, was only 38 basis points.

Which number was the best estimate of the “failure” of FNMA, broadly defined? From a common shareholder’s perspective, clearly the default probabilities were better predictors of the almost total loss taken by common shareholders (although the stock continues to trade today at slightly in excess of $1). The 38 basis point credit default swap represents something completely different—a combination of the probability of failure, risk aversion (as discussed on September 23) and other factors, and the probability of the rescue of the senior debt holders of FNMA. The senior debt holders, but not the equity holders, were bailed out. That’s why the two time series can and do diverge so sharply.

A similar pattern can be seen in the graph of 5 year default probabilities and 5 year senior debt credit default swap quotes for Citigroup from January 1, 2007 to March 31, 2009:

The five year default probabilities peak at more than 25 percent, with the senior debt CDS quotes topping out at 6.35% on March 31, 2009. Again, the CDS spreads obscure the probability of failure, because they also include the probability, contingent on effective failure, of senior debt holders being rescued. Common shareholders, by contrast, care about the raw probability of failure because they’re unlikely to be bailed out. That’s why the default probabilities are much more important than CDS spreads to investors in common stock, preferred stock, and even subordinated debt.

Best practice risk management requires transparency with respect to both the probability of failure and the potential recovery for each class of liabilities from common stock to senior debt and insured bank deposits. That’s why both CDS quotes and modern default probabilities are essential for best practice risk management.

Incentives and tranche retention in securitisation: a screening model

BIS Working Paper No. 289 by Ingo Fender and Janet Mitchell:

Abstract: This paper examines the power of different contractual mechanisms to influence an originator’s choice of costly effort to screen borrowers when the originator plans to securitise its loans. The analysis focuses on three potential mechanisms: the originator holds a “vertical slice”, or share of the portfolio; the originator holds the equity tranche of a structured finance transaction; the originator holds the mezzanine tranche, rather than the equity tranche. These mechanisms will result in differing levels of screening, and the differences arise from varying sensitivities to a systematic risk factor. Equity tranche retention is not always the most effective mechanism, and the equity tranche can be dominated by either a vertical slice or a mezzanine tranche if the probability of a downturn is likely and if the equity tranche is likely to be depleted in a downturn. If the choice of how much and what form to retain is left up to the originator, the retention mechanism may lead to low screening effort, suggesting a potential rationale for government intervention.

The paper can be downloaded here.

Wall Street's Fraud and Solutions for Systemic Peril

Posted on Janet Tavakoli's website:

Last week I gave a presentation to members of the International Monetary Fund (IMF) explaining the corrosive atmosphere that allowed the largest Ponzi scheme in the history of the capital markets to flourish. The following is a brief summary.

Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securities (RMBS). Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But many RMBSs were backed by portfolios comprising risky fraud-riddled loans. Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless. Wall Street disguised these toxic “investments” with new value-destroying securitizations and derivatives.

Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses. This is a classic Ponzi scheme.

Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities. Underwriters are responsible for appropriate due diligence, an investigation into the risks.2 If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed. If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.

Wall Street protests that it sold toxic assets to sophisticated investors obliged to perform independent due diligence, so those investors may have trouble claiming damages. But the ballgame has changed. Massive fraud damaged the U.S. economy. (Housing prices didn’t just fall; they plummeted as the fraud unraveled.) U.S. taxpayers became unwilling unsophisticated investors funding Wall Street’s bailout.

The Fed uses tax dollars to keep some of our largest banks—weakened by reverse-Glass-Steagall mergers with troubled entities—from collapsing under heavy loan losses.

Wall Street’s huge bonus payments were based on suspect accounting. Failure should not result in fortune. Yet, Wall Street once again proposes to pay out exorbitant bonuses. Many banks’ current illusion of profitability is only made possible by taxpayers' enormous subsidies including low cost borrowing, higher interest payments on bank capital deposits, a credit line for the FDIC (to be repaid with banks' subsidized profits), and continued government debt guarantees on bank debt. A large share of certain banks’ subsidized profits is due as reparation to unsophisticated investors, the U.S. taxpayers.

Delusional Complacency
When you leverage fraud riddled fixed income securities, there is nowhere to go but down in a hurry. Confusion after the fraud falls apart leads to a vicious cycle of selling, as investors and lenders shun both good and bad assets. The deflating debt bubble is followed by a classic liquidity crunch.

By the end of 2006, public reports of implosions of large mortgage lenders eliminated CEOs’ plausible deniability. By January 2007, many (including me) publicly challenged the failure to account for losses. Instead, toxic securitization accelerated in the first half of 2007—classic malfeasance as a Ponzi scheme collapses. In August 2007, I projected hundreds of billions in principal losses for mortgage loans alone—not counting other troubled asset classes, derivative duplication, and leverage. Fed Chairman Ben Bernanke contemporaneously said mortgage loan losses would be $50-100 billion.

At a lunch following my presentation, a senior officer claimed the IMF had estimated global losses of $1 trillion in its April 2007 Global Financial Stability Report. I averred the IMF’s Report followed a growing wave of billions in write-downs; by then Bloomberg News had reported potential global losses in the high hundreds of billions of dollars (Feb 2008). (Everyone’s estimates were too low.) Not so, other senior IMF officers said; they were “early” and had great political “courage.” But their heads were up their own hindsight bias. The IMF's estimate was in the April 2008 Report, after Bear Stearns’ March 2008 implosion.3 Blind to fraud, the IMF missed the message.4

The IMF is not a financial regulator. Actual regulators did worse. The SEC dropped seminal investigations and failed to investigate ongoing securities fraud. In the spring of 2007, the Fed and the U.K.’s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. They are now repeating their mistakes. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.

Existing Solutions to Halt Growing Systemic Risk
An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse. (He was unable to attend my exposition based on Chs. 5-12 of Dear Mr. Buffett). This IMF officer isn’t just soft on crime; he’s in denial. Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:

There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient.

The IMF’s source was a 2006 speech made by Treasury Secretary Timothy Geithner, then president and CEO of the New York Fed. The IMF gets the lion’s share of its funding from the United States and the United Kingdom, its stakeholders. Geithner’s views have more influence than those of former Fed Chairman Paul Volcker, who calls for a return of Glass-Steagall, a separation of traditional commercial banking from high-risk activities.

Wall Street supplies a swinging door of jobs for its financial regulators, and—in the case of many members of Congress and our Presidents—campaign contributions. This dependence is known as “capture,” and the result is that instead of reigning in Wall Street, dependent thinking enables mayhem.

In the recent Ponzi scheme only the agents—mortgage lenders, rating agencies, fund managers, securitization professionals, CFOs, CEOs, and other fee or bonus beneficiaries—prospered. Controls and risk management were undermined. The financial institutions and their shareholders, for which these agents are failed stewards, collapsed. Investors in toxic securitizations lost money. Had regulators done their jobs, they would have shut down Wall Street’s financial meth labs, and the Ponzi scheme would have quickly choked to death from lack of monetary oxygen.

After the Savings and Loan crisis of the late 1980’s, there were more than 1,000 felony indictments of senior officers. Recent fraud is much more widespread and costly. The consequences are much greater. Congress needs to fund investigations. Regulators need to get tough on crime.

Troubled financial entities should be put into receivership and restructured. Old shareholders will be wiped out. Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity. But the job won’t be complete until we separate high risk activities from traditional banking in a return to a Glass-Steagall like structure with regulators that indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper.

The fact that many U.S. banks stuck to traditional banking and protected shareholders during this crisis is under-publicized, but their prudence worked.

We have the solutions. We need the will to implement them.

1 Collateralized Debt Obligations (CDOs and CDO-squared), Structured Investment Vehicles (SIVs), Real Estate Mortgage Investment Conduits (REMICs and Re-REMICs), Asset Backed Commercial Paper (ABCP), and related credit deriviatves.

2 Rating agencies do not buy and sell securities, but they should have their special NRSRO designations immediately revoked as a start. One former rating agency official even suggests liquidation.

3 I later sent the IMF official a link to the April 2007 Report, and he admitted he misspoke.

4 In April 2005, I gave a presentation to the IMF including a discussion of flawed ratings of “super-senior” and “AAA-rated” structured products. Thereafter, loan fraud accelerated and securitization standards deteriorated, yet the IMF’s April 2006 report stated: “As a practical matter, the investors who may be least likely to appreciate such nuances (e.g., smaller regional banks and retail investors) typically only purchase the most senior (least risky) credit products.” In reality, many “super-senior” tranches and the “AAA” tranches subordinate to them had substantial principal risk.

BIS / Joint Forum Report on Special Purpose Entities (SPEs)

Abstract: The number and complexity of special purpose entity (SPE) structures increased significantly over the prior several years through 2007 in conjunction with the growth of markets for securitisation and structured finance products, but have declined since then. It must be emphasised that the usage of SPE structures is not inherently problematic in and of itself. SPEs have been used for many years and have contributed to the efficient operation of the global financial markets by providing financing opportunities for a wide range of securities to meet investor demand. In instances where parties to an SPE possess a comprehensive understanding of the associated risks and possible structural behaviors of these entities under various scenarios, they can effectively engage in and benefit from using SPEs. The current market crisis that began in mid-2007, however, essentially “stress tested” these vehicles. As a result, serious deficiencies in the understanding and risk management of these SPEs were identified. While recent market events have resulted in a dramatic reduction in issuance of securities using SPEs, we expect that SPEs will continue to be used for financial intermediation and disintermediation going forward. These structures provide institutions and investors with a variety of uses and benefits.

We offer the observations in this document at a time when international financial sector policymakers are discussing how best to reform the regulatory and supervisory processes relating to how firms use SPEs. This paper is intended to meet two broad objectives. First, it is meant to serve an informational purpose by describing the variety of SPE structures found across the financial sectors, the motivations of market participants who rely on them, and how effectively certain structures achieve the transfer and management of risks (eg credit risk, interest rate risk, liquidity risk, market risk and event risk). A second objective is to suggest policy implications and issues for consideration by the supervisory community and market participants. Recent regulatory reform proposals under discussion (eg relating to accounting and capital adequacy frameworks) will likely affect how future SPEs are structured and used.

Full publication (PDF 115 pages, 463 kb)

Monday, September 28, 2009

Should Mortgages be Securitized?

Posted on FinReg21 by Arnold Kling:

Like Humpty-Dumpty, mortgage securitization has taken a big fall. There is a widespread presumption that government policy, if not all the king's horses and all the king's men, should be aimed at putting securitization together again. The purpose of this essay is to question that presumption.

The first section of this paper will describe how securitization worked at Freddie Mac in the late 1980s, when I worked there. This will allow me to introduce and explain the concepts of interest rate risk and credit risk in mortgage finance.

The second section of this paper will describe developments in the mortgage industry from the mid-1980s through the 1990s, when Freddie Mac and Fannie Mae took on more interest rate risk. The third section looks at what evolved over the past ten years, when the process for allocating and managing credit risk changed, with “private-label” securitization and the growth of subprime mortgages.

The fourth section of this paper describes various options for reviving mortgage securitization. The final section steps back and looks at interest rate risk and credit risk from a public policy standpoint. Government policy influences the allocation of credit risk and interest rate risk in capital markets. What are the social costs and benefits of various allocations? I suggest that policymakers might consider reverting to the housing finance system that preceded the emergence of securitization, in which depository institutions were responsible for managing both credit risk and interest rate risk for mortgages.

Freddie Mac around 1989

I joined Freddie Mac as an economist in December 1986. About eighteen months later, I was promoted to Director of Pricing/Cost Analysis, under the Vice-President for Financial Research. My job was to oversee the models used to manage interest rate risk and credit risk.

At the time, my primary focus was credit risk. Freddie Mac bundled loans into securities, and then it sold the securities. If a mortgage loan defaulted, Freddie Mac would pay the entire unpaid balance on that loan to the security holder and then try to recover as much as it could from foreclosure proceedings on the property. Thus, Freddie Mac insulated security holders from the credit risk. This was known as the guarantee business, because Freddie Mac would guarantee that investors in its mortgage securities would not have to worry about individual mortgage defaults.

A change in market interest rates could affect the value of the cash flows due to the investor in a mortgage. Because Freddie Mac packed nearly all of the mortgages it guaranteed into pass-through securities, Freddie Mac in the late 1980s had very little interest-rate risk. The interest-rate risk was borne by the investors who bought Freddie-Mac securities and relied on the cash flows that were passed through. Note that at that time there was a difference between Freddie Mac and Fannie Mae. Fannie Mae had traditionally financed most of its mortgage purchases with its own debt, rather than with pass-through securities. Thus, Fannie Mae had taken on interest-rate risk.

Interest-rate risk arises because the typical mortgage in the United States is a thirty-year fixed-rate mortgage with a prepayment option. This means that the firm receiving the cash flows of the mortgage (call this the mortgage holder) faces a difficult problem in matching funding with the cash flows from the mortgage.

Suppose that the interest rate on the mortgage is 8%, and suppose that the mortgage holder finances its position by issuing a five-year bond at 7%. If interest rates remain unchanged, then after five years the holder can issue another five-year bond at 7%. If this environment persists for thirty years, then the holder clearly makes a profit.

However, suppose that after two years, market interest rates drop by two percentage points. The borrower takes advantage of this to obtain a new mortgage at 6%, using the proceeds from this refinance to pay off the original mortgage. The holder is still stuck with having to pay interest on the five-year bond for three more years at 7%. However, the holder cannot find investments that yield more than 6 percent, so the holder takes a loss. This is known as prepayment risk, or the cost of the prepayment option.

On the other hand, suppose that after two years market interest rates rise by two percentage points and that this rise is permanent. Now, the mortgage borrower will try to retain the loan as long as possible, while the mortgage holder's financing will run out after five years. At the end of the fifth year, the holder is going to have to obtain new funding, which will cost 9%, so that the holder is going to be suffering a loss. This might be called duration risk, because the cash flows from the mortgage have a longer duration (the last payment will not be received until thirty years from the date of origination) than the holder's liability (a five-year bond in our example).

When I joined Freddie Mac, its major competitors had recently been stung by duration risk. In the late 1960s and early 1970s, mortgage interest rates were around 6%. By the early 1980s, market interest rates had more than doubled. Fannie Mae, which at that time relied on medium-term debt to finance its mortgage holdings, was losing $1 million a day in 1982. More importantly the savings and loan industry, which financed its mortgage holdings with short-term deposits, was bankrupt.

Thus, by the early 1980s, the approach of funding mortgages with short-term deposits was discredited. Securitization, which allowed the interest-rate risk to be transferred to institutions such as pension funds and insurance companies, seemed to be a superior financing method.

The big challenge with securitization was managing credit risk. This required pricing policies, capital policies, and risk management policies.

For pricing, we wanted to price mortgages according to risk. We specified a probability distribution for house prices, and we assumed that losses from mortgage defaults would take place when individual house prices fell below the outstanding mortgage balance. Because of this, the guarantee fee charged on a loan that was for 80% of the purchase price would be higher than the fee charged on a loan that was for 60% of the purchase price.

Our capital policy was tied to something that we called “the Moody's scenario,” since it was suggested to us by that credit rating agency, based on what happened in the Great Depression. Under this scenario, the average house price would fall by 10% per year for four years, and then remain flat thereafter. Although this was the average price path under the Moody's scenario, we simulated a distribution of house prices, in which some fell by more and some fell by less. We then measured the total losses under this scenario, and we assumed that we would need enough capital to cover those losses. The cost of this capital was then priced into the guarantee fee. This capital charge did even more to penalize the relatively high-risk loans, such as loans backed by rental properties or loans with a high loan-to-value ratio.

Pricing for risk is fine, assuming that the loan origination process is standardized. However, because loan origination was not under the control of Freddie Mac, we faced principal-agent problems. The incentive of the originators was to aim for volume, regardless of quality. To appreciate the challenge that we faced, consider that we might encounter a shady mortgage originator, whose intent is to create fraudulent mortgages and then abscond with the origination fees—or even the entire proceeds of the loan. Freddie Mac might revoke the eligibility of the shady operator, only to find that the operator moves to another location and does business under a different name.

To manage this principal-agent problem, Freddie Mac had a number of devices (and Fannie Mae had very similar measures):

--a qualification system for sellers. To sell loans to Freddie Mac, you had to prove that your staff had experience and you had to show sufficient capital that you could buy back loans that had been improperly originated.

--a seller-servicer guide. This spelled out exactly the procedures and rules that we wanted originators to follow when approving or rejecting loan applications.

--contractual obligations. Sellers were providing contractual representations and warranties to us that they were following our guide.

--quality control. We inspected the loan files of a sample of loans from each originator. Loans that were found to violate the “reps and warrants” were put back to the seller to be repurchased.

All of these risk management processes were costly, and all were imperfect. The principal-agent problems in securitization were difficult, and we were constantly tinkering with our systems to try to improve them.

Freddie Mac and Fannie Mae Achieve Domination

In the mid-1980s, inflation and interest rates began trending down. This made it profitable to finance mortgages with medium-term debt. Indeed, the downward movements in interest rates served to highlight prepayment risk. Mortgage holders had difficulty protecting themselves against sharp declines in interest rates, which caused borrowers to refinance while the holders were still paying interest on medium-term debt.

Fannie Mae found a solution to the prepayment problem by issuing callable debt. For example, it might issue a ten-year bond that it could extinguish at par after five years, if interest rates had fallen. This effectively transferred prepayment risk from Fannie Mae to its debt investors, in return for which Fannie paid a slightly higher interest rate.

The innovation of callable debt ultimately produced a dramatic change in the mortgage market. It undermined the Freddie Mac model of issuing pass-through securities. Investors were more comfortable with the relative simplicity and transparency of callable debt. In the 1990s, Freddie Mac jointed Fannie Mae as a “portfolio lender,” meaning that it held its own mortgage securities and funded them with callable debt.

Funding mortgages with callable debt was so efficient that by 2003 Freddie Mac and Fannie Mae together held half of the mortgage debt outstanding in the United States. This dominant position was undermined by other innovations, discussed below.

Securitization Goes Private-Label

The benefits of securitization come from the fact that investors do not have to go to the trouble and expense of examining the underlying mortgages. Investors know the types of mortgages and the interest rates on the mortgages in the pool, which is the information that they need to manage interest-rate risk. However, investors assume that they are entirely insulated from credit risk, because of the guarantee provided by Freddie Mac or Fannie Mae.

The guarantees from Freddie Mac and Fannie Mae were credible because of the capital and historical record of those firms. Most of all, however, the guarantees were credible because of the perception that it would be politically unacceptable to allow those firms to fail.

There are mortgages that Freddie and Fannie could not guarantee, because of legislated limits on the size of loan eligible for those agencies. Moreover, ten years ago there were loans that the agencies would not guarantee, because low downpayments or weak borrower credit history made the loans high risk for default.

About ten years ago, a number of innovations emerged that substituted for an agency guarantee, allowing “private-label” securities to compete with those of the agencies. Borrower credit scores provided a simple, quantitative measure of the borrower's credit. Structured securities allowed credit risk to be reallocated, with subordinated holders taking most of the risk and senior holders only taking what was left over. The various tranches were evaluated by credit rating agencies, so that investors could treat AAA private-label securities as equivalent to agency securities (a practice which was formally ratified by bank regulators in a policy that took effect on January 1, 2002). For extra comfort, the holder of a security could purchase a credit default swap, which would pay off in the event that the security's principal repayment was jeopardized.

With all of these layers or protection, holders did not have to examine the underlying mortgages. In fact, it is not clear where that responsibility lay. With agency securitization, it was clearly the responsibility of Freddie Mac and Fannie Mae for managing, measuring, and bearing credit risk. However, with private-label securitization, those functions were diffused. The Wall Street firms that packaged securities had no experience with the risk management functions needed to ensure quality standards in mortgage origination. The credit rating agencies had most of the responsibility for credit risk measurement, but they bore none of the risk. In retrospect, the incentive to be overly generous in rating securities was far too high.

Toward the latter part of the housing boom, the risk management process also broke down at Freddie Mac and Fannie Mae. Private-label securitization and the growth of subprime mortgages were leading to a sharp fall in the market share at the two agencies. In retrospect, the agencies should simply have held on to their capital standards and risk-management controls. However, at the time, they suffered from doubts about whether their traditional approach was still valid. They began to loosen standards for mortgage quality, to maintain insufficient capital relative to credit risk, and to purchase subprime mortgage securities based on agency ratings rather than on an assessment of the risks of the underlying loans. As a result, when the crisis hit, the agencies were not in a position to survive the losses that they incurred.

Fix Securitization?

On April 30, 2009, Gillian Tett lectured at the London School of Economics.[1] Tett, the author of perhaps the best book published so far on the origins of the financial crisis,[2] was asked a question about the impact of the failure of Lehman Brothers. In her response, she said that having the securities market break down was the equivalent of waking up one morning and finding that the Internet and cell phones had broken down.

The consensus in the financial community is that securitization simply must be fixed. The question is how this can be done.

Securitization worked because the holders of securities assumed that they were not bearing any credit risk. Securitization broke down when mortgage defaults reached a level where holders of securities were no longer confident that they were insulated from credit risk. For mortgage securitization to work again, the credit risk will have to be absorbed in a credible way by someone other than the holder of the securities.

Mortgage credit risk includes both systemic risk and idiosyncratic risk. Systemic risk is the risk that conditions in the overall housing market will take a sharp turn for the worse. Idiosyncratic risk is the risk that mortgage originators will deliver faulty or fraudulent loans into the securitization process.

The private-label securities operations did not seem to have strong mechanisms for dealing with idiosyncratic risk. Recently, the U.S. Treasury published recommendations for financial reform that included requiring mortgage originators to retain a 5% interest in the mortgage loans that they deliver for securitization. This strikes me as a crude approach. Five percent is too high for an honest but capital-strapped mortgage broker. At the same time, it is too low to deter serious fraud: retaining a 5% interest is no penalty at all if your intent all along is to abscond with 100% of the funds.

A basic problem in private-label securitization is that the functions for managing idiosyncratic risk (procedures for qualifying sellers, establishing and enforcing guidelines, and so forth) are no one's responsibility. Some party must take on those functions in order to address idiosyncratic risk.

Another problem with all forms of mortgage securitization is that of systemic risk. At this point, there is no private-sector firm that can credibly insulate security holders from systemic risk. If Freddie Mac, Fannie Mae, and AIG all are unable to proceed without government backing, then there is no way that securitization can come back without the government acting as a guarantor of last resort.

One suggestion that I have heard is that government should provide support along the lines of “the GNMA model.” This strikes me as nonsense. GNMA packages loans that are guaranteed by FHA and VA. GNMA is not taking any credit risk. Instead, losses are absorbed by the agencies from which it obtains the loans.

The only way that the “GNMA model” could be used for the entire mortgage market would be if the FHA were to guarantee every mortgage. However, the FHA is not even capable of properly pricing the credit risk within its own niche. The FHA currently is suffering significant losses, creating large liabilities for taxpayers.

Another proposal is what I refer to as “Wall Street's Wet Dream.”[3] The idea is that a government agency would behave like a late-1980s Freddie Mac. This agency would take all of the credit risk in the securitization process, but it would not hold any securities in portfolio. This would be ideal from Wall Street's point of view, because it would maximize the circulation of mortgage securities, rather than keep them stuck inside Freddie Mac or Fannie Mae in their own portfolios. The result would be an agency that bears no interest rate risk (which Freddie and Fannie were able to manage successfully), but which bears all of the credit risk (which brought them down).

The “Wall Street Wet Dream” model would ensure that mortgage securities can be traded safely and profitably. The government agency would be responsible for managing the idiosyncratic risk of dealing with mortgage originators. It also would have to price for the systemic risk that arises from fluctuations in regional and national housing markets. Ultimately, this systematic risk would be borne by the taxpayers. Thus, the profits of the securities business would be fully privatized, and the credit risk would be fully socialized. Given the way Washington and Wall Street relate to one another in our society, it is a good bet that this is the model that will gain the most political support.

Returning to the Savings and Loan Model

Policymakers should consider returning to the mortgage finance system that we had forty years ago. Mortgages were originated and held by firms that financed their mortgage holdings with deposits. These were the savings and loans.

The savings and loans did not suffer from the principal-agent problems that plague securitization. The loan originator is controlled by the institution that is going to hold the mortgage. The management of idiosyncratic risk is internalized.

To manage systemic risk, regulators could subject depository institutions to capital regulations and stress tests. Mortgage holders that benefit from deposit insurance would have to hold enough capital to withstand a severe drop in house prices.

The biggest flaw with the savings and loan model was that the savings and loans could not manage interest rate risk. When inflation and interest rates leaped higher in the 1970s, the savings and loans were stuck holding mortgages with interest rates that were well below the new prevailing market rates.

There are various ways to make the S&L model work better than it did in the past. One is to conduct monetary policy in a way that stabilizes the inflation rate. In fact, since the early 1980s the Fed has been able to do that.

Another approach would be to encourage variable-rate mortgages. These do not have to be the sort of high-risk, “teaser” loans that became notorious in recent years. Instead, they could work more like Canadian rollover mortgages, in which the interest rate is renegotiated every five years. The loans would be on a thirty-year amortization schedule, and they would start out at a market interest rate, rather than an artificially low rate. If interest rates were to rise sharply over any given five-year period, we would expect that the borrower's income would have risen as well, so that the burden of the loan would not be significantly larger.

Defenders of securitization will argue that it is more efficient to fund mortgages in the capital market. I would make two counter-arguments. The first counter-argument I would make[AN1] is that the alleged efficiency of securitization has not been demonstrated in the market. Mortgage securities are the artificial creation of government, starting with GNMA and Freddie Mac. The second-counter-argument is that adding efficiency to mortgage securitization serves to divert capital from other uses, and it is not necessarily the case that this capital diversion is best for society. More recently, bank capital regulations severely distorted the cost of holding mortgages relative to holding securities, strongly favoring the latter. In a completely free market, it is doubtful that securitization would emerge, particularly in light of recent experience.

At its best, securitization appeared to lower mortgage rates about about one quarter of one percentage point relative to loans that could not be placed into securities. Suppose that government-backed securitization could be put in place to achieve a comparable reduction in mortgage interest rates. Is that an outcome for which we should aim?

Compared with the risks that the government must assume in order to make securitization work, it seems to me that lowering mortgage interest rates by one quarter of one percent is not a commensurate benefit. This is particularly so given the alternative uses of capital. If mortgage rates are a bit higher than they could be under the most efficient system, then some capital will go toward other uses—interest rates charged to businesses or to consumers for other loans will be slightly lower. It is not clear that mortgage loans are better for society than other uses of capital. If it turns out that the “originate and hold” model is not as efficient as securitization for delivering low mortgage interest rates, that would not be a tragedy.

In order to revive securitization, taxpayers would have to absorb large risk. The social gains would be small, or perhaps even nonexistent. The best thing to do with the shattered Humpty-Dumpty of mortgage securitization would be to toss the broken pieces into the garbage.

Arnold Kling is an economist and member of the Financial Markets Working Group of the Mercatus Center at George Mason University. In the 1980's and 1990's he was an economist with the Federal Reserve Board and then with Freddie Mac. He blogs at

[1] A recording of the lecture is available at or

[2] Gillian Tett, Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe (Free Press, 2009).

[3] For an example of the type of proposal I am describing, see Harley S. Bassman, “GSE's: The Denouement,” available at

Industrial groups warn on OTC rules

Posted in the Financial Times by Jeremy Grant:

Some of Europe’s largest industrial companies have warned they could shift their financial hedging away from Europe if proposed reforms of the vast over-the-counter (OTC) derivatives markets go ahead as proposed by the European Commission.

Executives from Lufthansa, the German airline, and Rolls-Royce, the UK engineering group, told a conference in Brussels on Friday that the Commission’s proposals for OTC derivatives reforms would hit companies that routinely use such products to manage business risks.

“The whole concept of the proposed regulation would result in a penalisation of those market participants which have true justification to be in the market,” Lufthansa said. “In contrast, financial intermediaries and speculators would not be affected. It should be the other way around.”

The comments show that opposition to a key part of US and European proposals for reform of the financial system is gathering from an unexpected quarter: industrial companies.

Many companies use OTC derivatives, such as interest rate and currency swaps, to hedge routine business risks like fuel purchases and future pension liabilities.

Lufthansa said a $1 fluctuation in the price of crude oil “has a $60m impact on our cost base”, which it tackles through hedging in the OTC markets.

The US has proposed ways to tighten regulation of OTC derivatives, which are bilaterally negotiated between two parties and not traded on exchanges. Some OTC derivatives were blamed for worsening the financial crisis.

The proposals call for swathes of “standardised”, or less complex, OTC derivatives to be shifted to clearing houses to remove risks from the system. A clearing house guarantees that a trade is completed even if parties default.

European companies say that if regulators force greater standardisation of OTC derivatives and more clearing this would cause a huge drain on cash as companies would be forced to post margin collateral to help guarantee such trades, something they currently do not have to do.

Richard Raeburn, chairman of the European Association of Corporate Treasurers, said: “Derivative contracts between non-financial companies and the financial sector should be exempt from any requirements for mandatory margining or for use of [clearing houses] with margin requirements, as non-financial companies pose no systemic risks in their use of derivatives.”

David Wright, deputy director-general of the Commission’s internal market and services unit, said: “We can’t design a system where the cost [of using OTC derivatives] is so high that it takes out derivatives that can be used to hedge. On the other hand, if we have a system with loopholes the system could be gamed. It’s a balance.”

Modeling Correlated Default in a Reduced Form Model: A Worked Example

Posted on Kamakura's website by Donald van Deventer:

Our April 19, 2009 blog post “Modeling Default for Credit Portfolio Management and CDO Valuation: A Menu of Alternatives” outlined a number of different ways in which one can model default among many counterparties, from retail to corporate to sovereigns, in a correlated way. The most modern technology for doing this is the reduced form modeling technique first introduced by Robert Jarrow and Stuart Turnbull in 1995. This blog provides a simple worked example of how to simulate default probabilities forward in a correlated way using two counterparties and three macro factors.

Kamakura Risk Manager and Kamakura Risk Information Services both offer a multiple models approach to simulating default in a realistic way on a multiperiod basis. Common practice for many years was the copula approach, which has been blamed by publications from Mother Jones to Wired for the current credit crisis. We discussed the problems with the copula approach in our April 9, 2009 post “The Copula Approach to CDO Valuation: A Post Mortem (Updated April 27, 2009).”

In this post we discuss two hypothetical corporations, ABC Company and XYZ Company, but the same example with different explanatory variables would apply equally well to retail or sovereign counterparties. We assume that we are a close relative of God and we are told that ABC Company’s 1 year default probability is sensitive to the 2 year change in home prices and the real growth rate in gross domestic product, as shown in the following chart:

XYZ Company is sensitive to a separate set of macroeconomic factors and through divine intervention we are told that its one year default probability has the following sensitivity to the 2 year change in home prices and the 10 year yield on government bonds:

In a reduced form modeling context, theoretical default probabilities are usually modeled in continuous time, and the instantaneous default rate is normally given as a linear function of macroeconomic factors which move randomly. For simulation purposes, these instantaneous default probabilities are normally generated as default probabilities that apply for discrete monthly, quarterly or annual time periods. They can be derived either from historical default data bases, like that for Kamakura Risk Information Services, or they can be derived from observable risky securities prices. For simulation purposes, the logistic formula is an attractive choice for modeling because:

  • It is the maximum likelihood estimator for 0/1 problems like default/no default
  • It will never produce simulated default probabilities outside of the range from 0 to 100%

The logistic function takes the form:

where P[t] is the default probability over some discrete interval. The variables Xi are the explanatory variables and the alphas and the betas are the “best fitting” coefficients that produce the maximum likelihood estimates of default probabilities.

For ABC Company, the coefficients which produce the table of default probabilities above are consistent with this logistic function for one year time intervals:

X1 is the annual growth rate in real gross domestic product and X2 is the 2 year change in home prices, both expressed as a decimal.

For XYZ Company, the coefficients which produce the default probabilities above as a function of 10 year government yields and the two year change in home prices are given here:

X2, as before, is the 2 year change in home prices and X3 is the 10 year government yield, both expressed as a decimal.

We can simulate these default probabilities forward for M scenarios in N annual time steps by generating M scenarios for the three macro factors that drive defaults for these two firms:

  • The growth in real gross domestic product
  • The 2 year change in home prices
  • The level of 10 year government yields

ABC Company and XYZ Company have default probabilities which we know are correlated because they have a common dependence on the 2 year change in home prices as given by the tables above. Assuming the current real GDP growth is 0% and that 10 year government yields are 5.00%, a stress test of default probabilities for both firms with respect to the 2 year change in home prices is as follows:

ABC Company and XYZ Company may also have other sources of implicit correlation if the growth in real domestic product (which directly affects only ABC Company) and the 10 year government yield (which directly affects only XYZ Company) are correlated.

Simulating these macro factors forward in an accurate way requires a careful analyst to specify:

  • The probability distribution for each factor’s random movements. Often these distributions are not normally distributed, although that assumption is common.
  • Whether or not the distribution of the factor in period N is in fact independent of its value in period N-1. Often, they are NOT independent, although that independence assumption is common.
  • The correlations between the random factors themselves

In our N period simulations over M periods, we can value a portfolio of securities for ABC Company and XYZ Company if we know how spreads move, conditional on the level of default probabilities for each firm and the three macro factors above. That was the subject of our September 23, 2009 blog post.

This simple example shows that using reduced form default models as part of a comprehensive enterprise wide risk management simulation is powerful and straightforward. It allows the analyst to produce U.S. government mandated stress tests with respect to each macro factor that is important in driving defaults. The macro factor links are explicitly and derived from either historical data or current market prices and their history. Any simulation approach that uses ratings as part of the simulation will not have the same degree of accuracy or transparency with respect to the macro factors which drive risk. The reason is that the rating agencies have been unable to articulate even the time horizon over which ratings apply, let alone the exact formulas by which macro factors affect ratings.

With the reduced form approach, the linkages are clear and based on best practice econometric methodology.

CDS curves are moving to pre-crisis "normal"

Posted on Soberlook by Walter Kurtz:

As the corporate bond market opened for business this year, it slowly became clear that many corporations, even ones with poor business models, may be able to refinance their debt. The market just has that much appetite for paper. The number of expected defaults in the near-term has dropped off significantly (thanks in large part to all the liquidity chasing yield).

That means that the high front-loaded default probabilities of corporate debt in the CDS markets are shifting further out in time and falling overall. The CDS curves that have been highly inverted for some vulnerable names are starting to flatten or even become normalized (spreads increasing with term).

As an example consider what happened to Ford CDS in just a month:

Nobody thinks Ford is out of the woods on a long-term basis, but it took mostly just a reduction in the front-end default risk to change the shape that much. To get a feel of how a drop in near-term default probability drives the shape of the CDS curve, here is a simple illustration. The chart below shows a hypothetical default probability curve (probabilities for each year).

With only the front-end probability of default dropping, the resulting change in the shape of the CDS curve is as follows:

This effect is now seen across the corporate credit markets, with CDS curves changing shape this way. A spectacular example of that is seen in the financials. Consider the Goldman 1-year CDS spread. It is now at pre-crisis levels. According to the market, the government has succeeded in taking out the risk of a major financial institution failure.

And here is what the Goldman CDS curve looks like now, a month ago, and a quarter ago.

These moves in CDS curves are unprecedented. The markets are saying that in the corporate sector we are close to being back to the pre-crisis "normal". The question of course remains as to whether this is justified by the fundamentals or sustainable.

Saturday, September 26, 2009

UK RMBS relaunch

Posted in the Financial Times:

It’s the credit crunch circle of life. The residential mortgage-backed securities market that pushed the world into a financial hole is set to reopen. Lloyds Banking Group is betting on renewed confidence in UK house prices as it brings £2.8bn of AAA-rated RMBSs to market. Although these are not subprime packages, no chances are being taken with the sale.

The safety checklist is almost as thorough as for a space launch. Already lined up are “real money” investors, including pension and managed funds; no exotic highly leveraged vehicles here. And the pricing – one tranche at 170 basis points over Euribor and the rest at 180bp over Libor – is swoonworthy. Investors are set to receive about 20 times the return they could have expected before the crisis. This, though, is still about half the levels at which similar securities traded at the height of the crisis. A successful issue should see market spreads tighten further.

The slow return to life of the European asset-backed market is welcome; the International Monetary Fund has called its revival critical for wider economic recovery. Specialised issues from Tesco and Land Securities in June and July were followed by a €500m vehicle lease-backed issue from Volkswagen. The Lloyds issue, at six times the size of VW’s, represents an attempt at mainstream resuscitation.

Some self-regulation is ensured by the need for reputational security. Although broader initiatives seeking originators to take the first slice of losses remain just talk, 8 per cent of this issue will be held in cash; Lloyds will use it to absorb any losses. One ghost of the past does remain, though. Investment bankers will take their fees from the transaction’s completion, not the bonds’ subsequent performance. With gold on the table, a glint is back in their eyes.

Friday, September 25, 2009

Goldman to benefit from new OTC derivatives rules: Citi

Posted on Reuters by Tenzin Pema:

Goldman Sachs Group Inc expects to benefit from the new over-the-counter derivatives and commodity trading rules owing to its strong technology position, said a Citigroup analyst, who met with Goldman management, and raised his earnings outlook for the bank.

"Standardized central clearing of OTC derivatives are likely to force a major electronification of derivatives trading, which may play to Goldman's advantage given their existing technology platform and expertise in high volume electronic trading," Citigroup analyst Keith Horowitz said.

Taming the over-the-counter (OTC) derivatives market -- a "shadow banking system" of enormous size now largely beyond government reach -- is a key part of a push for tighter government oversight of banks and capital markets under way now for six months.

"Standardized" OTC derivatives would go through clearinghouses at regulated exchanges to reduce the risk of default. OTC derivatives are complex instruments whose value is based on an underlying asset.

Horowitz, who recently met with Goldman's Chief Financial Officer David Viniar, said the new rules, which could set mandatory minimum collateral and margin requirements, if enacted are expected to benefit the bank relative to its peers.

Goldman has historically had among the most stringent collateral and margin terms versus more generous peers, who too often cut deals with easy credit terms to win business, said Horowitz, who also met Goldman's Chief Operating Officer Gary Cohn and investment banking head David Solomon.

"We are more optimistic on Goldman's long-term prospects and gained comfort that worst-case outcomes from regulatory reform are unlikely to materialize and structurally impair returns," Horowitz wrote in a note to clients.

Global policymakers agree that the OTC derivatives market should be regulated after a type of derivative, credit default swaps, led to insurer American International Group's (NYSE:AIG - News) near collapse and $180 billion government bailout.

ISDA Highlights Derivatives Industry Progress; Remains Committed to Further Improvements

LONDON, Thursday, September 24, 2009 – Amidst the economic and financial markets instability of the past two years, the International Swaps and Derivatives Association, Inc. (ISDA) and the privately negotiated derivatives industry have made significant progress in improving and standardizing the CDS business, with further improvements underway. These include: strengthening and diversifying counterparty risk management mechanisms, reinforcing the industry’s infrastructure, assessing the appropriate approach to capital and accounting, and enhancing operational efficiencies and transparency.

“The privately negotiated derivatives industry clearly recognizes its responsibility to help strengthen the global financial markets, as evidenced by the scope and scale of our collective efforts to identify and reduce the sources of risk in our business,” said Eraj Shirvani, ISDA Chairman and Head of Fixed Income EMEA at Credit Suisse. “This in fact is why ISDA was founded and it is a mission to which we remain deeply committed. Since the credit crisis began, no other area of the financial markets has worked as strenuously or effectively to enhance financial stability as the privately negotiated derivatives business.”

“Today there is a broad consensus for a comprehensive plan to modernize and protect the integrity of the financial system,” said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. “ISDA supports the key concepts underlying reform efforts, including appropriate regulation for all systemically important financial institutions, stronger counterparty risk management, increased transparency, and a more resilient and efficient infrastructure.” The industry’s ongoing initiatives are a key focus of ISDA’s 2009 Regional Conference in London today.

"ISDA will continue to lead and participate in these initiatives in a constructive way," Mr Pickel continued. "The Association and the industry will not wait for legislation or additional regulation to demonstrate their commitment to these principles."

Key accomplishments and initiatives include:

· Stronger and more diverse counterparty risk management, including increased use of clearinghouses: More than $2 trillion of credit default swaps contracts have been cleared in North America and Europe since March. Earlier this month, ISDA and 15 large derivatives dealers publicly committed in a letter to the Federal Reserve Bank of New York that the firms would submit 95% of new eligible credit default swap trades for clearing within 60 days by October 2009, and 90% of new eligible interest rate swap trades beginning December 2009.

· Improved transparency: ISDA is working to enhance market transparency in several important ways. The Association appointed buy-side participants to join with the dealer community on the ISDA Board and on many industry initiatives, such as the Credit Derivatives Determinations Committee.

In addition, ISDA is working to increase the flow of information on the derivatives business to the regulatory community as well as to the general public. More information on exposures and activity is available through DTCC’s trade information warehouse. ISDA has made available to all participants a CDS standard model that improves consistency and reduces operational differences regarding the calculation of CDS prices. And the ISDA CDS MarketplaceSM website brings together information, data and statistics on the CDS business. ISDA and industry participants have also developed a request for proposals from vendors interested in helping to construct a trade information warehouse for interest rate swaps, similar to that which currently exists for credit default swaps.

· A resilient operational infrastructure: In April, ISDA successfully launched the Big Bang Protocol, which incorporated auction settlement terms into standard CDS documentation. It also incorporated Determinations Committee resolutions into the terms of standard CDS contracts. The Committees are comprised of dealer and buy-side representatives to determine whether credit events have taken place and what obligations can be delivered. The Big Bang Protocol is important as more than 40 credit events have been processed globally since October 2008.

ISDA also increased operational efficiency through industry-wide compression or 'tear-up' efforts that helped to significantly reduce the notional amount of CDS outstanding. The industry continues to improve in other key areas, such as electronic processing, collateralized portfolio reconciliation and reduction in outstanding confirmations. Electronic matching rates of eligible confirmation events increased from 69 percent in 2007 to 85 percent in 2008 for equity derivatives, 70 percent to 78 percent for interest rate derivatives and 96 percent to 98 percent in CDS. The level of aged confirmations continues to steadily decline, with equity derivatives at 1.3 business days’ worth of outstanding confirmations in 2008, compared with 2.4 days for 2007; interest rate derivatives at 1.3 days vs. 0.7 days and CDS at 0.3 days compared to 0.1 days.

Looking forward, ISDA will remain proactive in identifying and reducing the sources of risk in the industry. ISDA remains committed to working on a broad number of fronts – risk management, operations, trading practices, legal, technology – to further strengthen the robust and resilient infrastructure it has developed since its inception.

U.K. Says It Will Consider Derivatives Reporting Requirements

Posted on Bloomberg by Caroline Binham:

The U.K. will consider introducing reporting requirements for derivatives trades if European Union efforts to improve transparency and cut risk don’t work.

The U.K. Treasury and the Financial Services Authority gave qualified support to EU proposals to oversee derivatives in a report published today. The U.K. doesn’t support the forced use of standardized contracts for all trades, or using demands for extra capital as a punishment rather than as a weight against perceived risk, according to the document.

U.K. “measures could include imposing minimum risk management standards, transparency and reporting requirements, and complementary legislative changes that can support broad market functioning” if EU measures don’t work, the report said.

EU proposals in July were an attempt to cut risk in the $592 trillion over-the-counter derivatives market after the collapse of banks such as Lehman Brothers Holdings Inc. last year. U.S. President Barack Obama released a similar plan in June that would require standardized over-the-counter derivatives to be guaranteed by clearinghouses. The U.K. today stressed the necessity for international coordination.

Derivatives are financial instruments used to hedge risks or for speculation. They’re derived from stocks, bonds, loans and commodities, or linked to specific events like changes in interest rates. Options and futures are the most common types of derivatives.

The EU proposed the use of clearinghouses for some over- the-counter derivatives trades and said it would study shifting more trades to exchanges. It also said it would consider the creation of a data warehouse to boost the transparency of trades and promote standardized contracts.

‘Stricter and Closer’

While the U.K. supports moves for greater standardization, it said today that there should be flexibility. It also approved of clearinghouses and said that the progress in using them for credit-default swaps should be extended to other types of derivatives. CDS let buyers guard against a borrower’s missed payments.

A conference starts tomorrow in Brussels to examine the EU’s derivatives proposals.

The FSA’s response to the European Commission’s communication “quite rightly prioritizes the need for stricter and closer oversight of the OTC markets,” said Futures and Options Association Chief Executive Officer Anthony Belchambers. “It does recognize the growing calls from the ‘buy-side’ to avoid impairing the capacity of markets to facilitate risk management or, through punitive regulation, exacerbating its cost to the point where it becomes uneconomic.”

Thursday, September 24, 2009

The ghosts of AIG prosper

Posted in the Financial Times by Gillian Tett:

Could another AIG-style disaster shake the financial markets again? It is not an entirely idle question. This month, there has been plenty of hand-wringing about the anniversary of the Lehman Brothers collapse. But behind the scenes the issue of AIG – and its links to the credit derivatives market – is currently provoking even more debate among some finance officials.

After all, when AIG imploded in September 2008, the potential losses on its credit derivatives contracts were so devastating for the system, because they were so concentrated, that the US government used tens of billions of dollars to honour the deals, benefiting groups such as Goldman Sachs, Société Générale and Barclays. And that money, remember, will not return to the Treasury’s purse (unlike the sums invested to boost bank capital, say).

Yet if that is startling, what is more striking is that a well-respected Fitch survey before the collapse of the credit bubble suggested that AIG was just the 20th largest credit default swap player in the sector, based on gross notional outstanding volumes. No wonder those billions of lossmaking contracts subsequently came as such a shock.

So have the lessons from that episode been learnt, and implemented? Regulators and bankers will mull this over today in Brussels, as part of the European Commission’s efforts to garner feedback on forthcoming financial reforms (initiatives which echo the ongoing debates in Washington).

No doubt many participants will be at pains to stress how much progress has been made over the past year in response to the AIG shock. There is, for example, a push to put part of the CDS market onto centralised clearing platforms, to reduce the counterparty risk that proved so deadly with AIG. The sector has streamlined itself by tearing up – or cancelling – redundant contracts, halving the outstanding notional size of the CDS market.

A mechanism to settle CDS contracts after a default is functioning well. Some of the opacity in the sector is clearing. The reason why AIG ranked 20th in the industry tables three years ago, for example, was because most official data tracked gross CDS positions (ie all outstanding contracts added together), rather than the type of net risk, which AIG had in spades. Now – belatedly – regulators and banks are watching net data instead.

Yet, welcome as such progress is, the grim fact remains that the CDS sector still faces a peculiar contradiction. When credit derivatives were first developed 15 years ago, they were presented as products which would encourage the dispersion of credit risk, among banks, hedge funds, asset managers and companies. In practice, many corporate users have never really adopted the instruments on any scale. That is in stark contrast to the world of interest or currency swaps, where such instruments are very widely used.

That pattern has left the CDS market marked by striking levels of circularity, since a limited pool of large financial players dominate much activity. In some respects, this sense of concentration has actually risen – not fallen – in the last year, because hedge funds and other players (including AIG) have been forced out of the sector. The Banque de France, for example, calculates that the 10 largest dealers now account for 90 per cent of trading volume (it was below 75 per cent in 2004). In the US, JPMorgan Chase alone now apparently represents 30 per cent of the US market. This is similar – ironically – to its share a decade ago when it first pioneered the CDS world.

Now, if all these dealers are handling these risks sensibly, and trades are centrally cleared, there may be no reason to worry. But, as the European Central Bank recently observed in a fascinating report, regulators are finding it tough to assess whether the net risks are being handled sensibly, since there is a paucity of detailed counterparty data.* Every bank likes to say it has programmes to monitor net risks. That is probably true: AIG, after all, was a terrible shock.

Irrespective of that, the fact is that not everything in the market today looks rational. (The ECB notes, as one example, that European banks have recently become net sellers of credit protection on their sovereign debt. That, it points out, is tantamount to “wrong way risk” – or plain nuts – given that those banks are implicitly government-backed.) And while regulators keep prodding banks to become more transparent in relation to counterparty risks, many are still dragging their feet on data provision – and the question of how many deals are actually placed on clearing platforms. No wonder western finance leaders keep muttering that the “too big to fail” problem remains; one year on, the ghost of AIG refuses to die away.

* Credit Default Swaps and Counterparty Risk; August 2009, ECB working paper

The Treasury Department's Proposed Regulation of OTC Derivatives Clearing & Settlement

By Christopher Culp, University of Chicago - Booth School of Business; Compass Lexecon

Abstract: In the wake of the ongoing credit crisis, policy makers are considering whether the regulation of over-the-counter (OTC) derivatives could help avert another such crisis and taxpayer-financed bailout. In particular, the Treasury Department has proposed to subject OTC derivatives to comprehensive regulation and to mandate the exchange trading and central counterparty clearing and settlement of standardized OTC derivatives. This paper explores the regulatory, operational, and economic aspects of the clearing and settlement of OTC derivatives and the likely consequences of the Treasury Plan. I contend that the proposal to mandate central counterparty OTC clearing for standardized products will not likely avert another potential crisis or failure of a large financial institution, but will likely engender significant legal and regulatory uncertainty, impede financial innovation, raise market participants’ costs, and adversely impact the competitiveness of U.S. derivatives participants. To address systemic and payment system concerns, improvements in the consolidated enterprise-wide supervision and regulation of certain financial institutions (across all of their risk-taking activities) will likely prove more effective and less disruptive than new product-based regulations.

Paper can be downloaded here.

A Global Framework for Regulatory Cooperation on OTC Derivative CCPs and Trade Repositories

International regulators announced today the establishment of the OTC Derivatives Regulators’ Forum. Since January 2009, international regulators have been meeting periodically to exchange views and share information on developments related to central counterparties (CCPs) for over-the-counter (OTC) credit derivatives (CDS).1 Based on the success of this cooperation, the OTC Derivatives Regulators’ Forum has been formed to provide regulators with a means to cooperate, exchange views and share information related to OTC derivatives CCPs and trade repositories.
The objectives of the Forum are to:

  • Provide mutual assistance among the regulators in carrying out their respective authorities and responsibilities with respect to OTC derivatives CCPs and trade repositories, and with respect to the broader roles and implications of these infrastructures in the financial system;

  • Promote consistent public policy objectives and oversight approaches for OTC derivatives CCPs and trade repositories, including the development of international cooperative oversight arrangements that may be applied to individual systems;

  • Adopt, promote, and implement consistent standards, such as the CPSS-IOSCO Recommendations for Central Counterparties (RCCPs), in setting oversight and supervisory expectations;

  • Coordinate the sharing of information routinely made available to regulators or to the public by OTC derivatives CCPs and trade repositories;

  • Effectively deal with common issues collectively and consistently; and

  • Encourage strong and open communication within the regulatory community and with the industry.

The OTC Derivatives Regulators’ Forum is comprised of international financial regulators including central banks, banking supervisors, and market regulators, and other governmental authorities that have direct authority over OTC derivatives market infrastructure providers or major OTC derivatives market participants, or consider OTC derivative market matters more broadly. See appendix 1 for a list of regulators and authorities currently involved in the Forum.

Appendix 1 – Authorities Currently Involved in the OTC Derivatives Regulators’ Forum pdf

1See A Global Framework for Cooperation Among CDS CCP Regulators