Thursday, October 29, 2009

ISDA Announces Market Practice Changes for Asia CDS Markets

TOKYO, Thursday, October 29, 2009– The International Swaps and Derivatives Association, Inc. (ISDA) announced today at its 2009 Regional Conference in Tokyo market practice changes to the trading convention for credit default swaps (CDS) in Japan and Asia ex-Japan. These changes, which will go into effect following the December 20 roll, include the adoption of standard coupons and full first coupons in CDS transactions.

Standardization of coupons in Japan and Asia ex-Japan follows similar changes in North America, Europe, Australia/New Zealand, and Emerging markets in the Middle East and Latin America.

“ISDA and the industry have worked extensively throughout the year to achieve increased standardization, transparency and liquidity in the CDS market through the adoption of standard coupons and other market practice initiatives,” said Robert Pickel, Executive Director and Chief Executive Officer, ISDA.

Changes will include the following:

  • Firms will trade Japan CDS with standard coupons of 25bp, 100bp and 500bp and full first coupons going forward
  • Firms will trade Asia ex-Japan CDS with standard coupons of 100bp and 500bp and full first coupons going forward;

The industry successfully adopted fixed coupons in North America in April, in Europe in June and in Emerging Markets in Europe, the Middle East, Latin America and Australia/New Zealand in September.

Credit Risk Retention Act of 2009: Securitization Is Dead

Posted on The Atlantic Business Channel by Daniel Indiviglio:

Today, I resume my analysis of the Financial Stability Improvement legislation draft (.pdf) released on Tuesday. I wrapped up the "Financial Stability Improvement Act of 2009" portion of this yesterday, after considering the new oversight council, how systemically risky firms will be chosen, what heightened regulation will look like, capital requirements and a future emergency provision. Today, I'll probably just tackle two more sections -- securitization and the resolution authority. Then I'll summarize.

The securitization provision is incredible. If enacted as is it may be the beginning of the end of securitization.

Congress calls this portion the "Credit Risk Retention Act of 2009." It essentially answers the call for lenders and investment banks to have some "skin in the game" when it comes to securitization.


First, let's say you're a lender who originates mortgages. If you want to hire an investment bank to turn a pool of mortgages into bonds to sell as mortgage-backed securities, then you must now retain some portion of the risk exposure to that pool. This will have a few outcomes.

The logistics to this are somewhat problematic, because they could inhibit innovation in bond structure. I know financial innovation has become a derogatory term these days, but if securitization is done properly, then such creativity can have huge benefits. One of the great things about securitization is that you can create bonds with different risk and return characteristics for different kinds of investors who have varying risk appetites. You may still be able to still do that, but it could get logistically messy to have the bank retain some precise percentage of the risk from each of the kinds of bonds sold.

This provision also necessarily limits a lender's origination volume and makes securitization more expensive. For example, let's say you're a mortgage company with $1 billion of funding. You can use that to create mortgages, so you do. Before, you could sell that billion in loans to investors through securitization. Now you must hold 10% of the risk, which presumably means you will need capital to cushion for that potential loss. Let's say that takes $3 million -- which implies a presumed loss rate of 3%.

First, this makes securitization more expensive, as you must hold additional capital. Your return will be lower. Second, since you have hold more capital, it limits the amount you can lend each time subsequent to a securitization. Next time you will have to subtract that capital from the amount of money you have to lend. Limiting credit might not be all bad, but it is something to note.


But this can also applies to "securitizers," which I take to mean investment banks that perform the securitization. It applies to them if there is no lender to take on the risk. I suspect that Congress had more esoteric asset-backed securities like collateralized debt obligations in mind when it decided to include securitizers. In this case, the investment bank originating the bonds themselves must be exposed to some portion of the risk. This will debilitate the markets for these kinds of bonds, because investment banks hardly want to have to hold additional capital for the deals they structure. That would wipe out the some or all of the fees they get for the transaction.

5% to 10%, Or More

So how much risk will these guys have to retain? It depends on how well their underwriting methods conform to what the regulators put forth as guidelines. They must retain at least 5%, but maybe as much as 10%. Maybe even more if regulators really don't like their underwriting.

No Hedging!

Now here's the really, really interesting part: lenders and securitizers aren't allowed to hedge that risk. The document says that these new requirements:

prohibit a creditor or securitizer from directly or indirectly hedging or otherwise transferring the credit risk such creditor or securitizer is required to retain under the regulations

The clear intent here is that Congress wants lenders and securitizers to take the risk seriously. But part of being a bank is trying to hedge as much of your risk as possible. This appears to imply that banks can't buy credit default swaps or other hedges that would limit their risk. I don't see how they would not be very bothered by this provision.

The Potential Outcome

Finally, it should be noted that lenders often hold some portion of securitizations already. The really ugly, nasty part of an asset-backed deal is called the residual interest. It takes the first loss. That means losses on the underlying loans deplete that bond first, before hitting any of the more "senior" bonds. Lenders and securitizers will sometimes choose to hold onto that piece because it's hard to sell to, well, anyone. This regulation might just seek to force them to hold -- and not hedge -- it.

All in all, this provision looks like a fatal blow to securitization. If it doesn't completely destroy the market, it will almost certainly leave it in ruins. Many would applaud either result, but I think that's a short-sighted view. I've defended securitization in the past, because when done properly, it really does make for a more efficient financial market. It provides investors with better diversification and allows them to more easily meet their portfolio objectives. It provides banks and finance companies with more money to lend. While it played a part in what all went wrong, I've long maintained that securitization was more a vessel for the poison than the poison itself.

House Committee Approves Bill to Curb Rating Agencies

Posted on the Housing Wire by Diana Golobay:

The House Financial Services Committee on Wednesday passed HR 3890, the Accountability and Transparency in Rating Agencies Act, which aims to bring greater transparency to ratings firms and curb “inappropriate and irresponsible actions.”

Credit-rating agencies (CRAs) often face blame for assigning high ratings on mortgage-backed securities (MBS) related to subprime mortgages and other ultimately toxic assets that pulled down ratings when loans performed worse than expected.

The CRA accountability and transparency legislation, passed by the Committee in a 49-14 vote, was introduced by Rep. Paul Kanjorski, D-Pa., chairman of the subcommittee on capital markets, insurance and government-sponsored enterprises.

“This legislation builds on the Administration’s proposal and takes strong steps to reduce conflicts of interest, stem market reliance on credit rating agencies, and impose a liability standard on the agencies,” Kanjorski said in a statement. “As gatekeepers to our markets, credit rating agencies must be held to higher standards. We need to incentivize them to do their jobs correctly and effectively, and there must be repercussions if they fall short.”

The bill expands on the Administration’s initial proposals by enhancing the accountability of Nationally Recognized Statistical Rating Organizations (NRSROs). The changes clarify the ability of individuals to sue NRSROs. They also clarify that the limitation on the Securities and Exchange Commission (SEC) or any state against regulating the substance of credit ratings or methodologies “does not afford a defense against civil anti-fraud actions,” according to a statement by the Committee.

The legislation adds a new duty to supervise an NRSRO’s employees and authorizes the SEC to sanction supervisors for failing to do so. Changes to the Administration’s proposals also include a requirement that each NRSRO have a board with at least one-third independent directors, who sill oversee policies and procedures designed to prevent conflicts of interest.

The bill now contains requirements designed to mitigate conflicts of interest related to the issuer-pays model for compensating NRSROs. Compliance officers at NRSROs will also gain enhanced responsibilities and accountability to address these conflicts of interest.

Investors gain access to broader information about internal operations and procedures of NRSROs under the bill. The public will also be informed more about how NRSROs receive payment.

Credit Ratings Now Optional, Firms Find

Posted in the Wall Street Journal by Liz Rappaport and Serena Ng:

The last few months have seen a handful of prominent companies selling bonds or structuring complex securities without credit ratings. They include money manager Highland Capital Management LP, European drinks makers Heineken NV and Gruppo Campari, and the global bank Credit Suisse Group AG.

"Two years ago, deals like this would have been inconceivable," said Peter Sack, who runs Credit Suisse's mortgage-backed securities structuring group. "Now they are a viable option."

[credit ratings]

While small in scope so far, the deals indicate that credit ratings from major firms like Moody's Investors Service and Standard & Poor's aren't a necessary ingredient for successful bond sales. The raters' alphabetical risk assessments have been ubiquitous in credit markets for decades. And, even though policy makers and regulators criticized the ratings firms for failing to foresee risks in the markets that led to trillions in losses, they have yet to propose a viable alternative to the current system.

"The ratings process is still undergoing changes, but the market needs to move forward and people are finding ways to do so," says Stephan Kuppenheimer, chief executive of FSI Capital, a New York money manager.

Dallas-based Highland Capital is putting together three collateralized-loan obligations, deals that will be at least $500 million in size and backed by corporate loans, according to a person familiar with the matter. The deals will be launched in coming months, and one will have no credit ratings at all.

The Highland deal could help resurrect a part of the credit markets that had effectively shut down -- in part because investors feared massive losses due to credit-ratings downgrades. It comes after another unrated "structured" deal this past summer, when Credit Suisse sold about $1 billion of securities backed by mortgages it had bought from a lending unit of American International Group Inc.

This week, Dubai sold $1.25 billion in U.S. dollar bonds and about $681 million in Islamic bonds without credit ratings. The Persian Gulf emirate's economy has been hard hit by downturns in real estate and the financial markets, but its unrated bonds attracted risk-taking investors looking for yield. The Dubai government sold the debt for a yield over 6%, compared with 3.85% yields on comparable debt of neighbor Abu Dhabi, which has a strong credit rating of double-A and recently provided Dubai with financial support.

Speed is driving part of the push toward offerings without ratings firms' rubber stamps. Debt issuers are paying slightly more money to sell unrated deals, but they are likely to get done more quickly. Obtaining a credit rating for a securitization, particularly one that is backed by nonstandard loans, can take several months.

Some U.S. and global-debt issuers may be taking a page out of the playbook of Europe's debt markets, where several well-known companies have for years bypassed ratings.

"Our reputation is good....I don't think a rating would have mattered that much," said Bob Kunze-Concewitz, chief executive of Italy's Gruppo Campari, which in October sold €350 million ($515 million) in seven-year bonds with a 5.375% interest rate.

Moody's and S&P said in statements that, while they encourage investors to do their own due diligence, their ratings still play an important role in the markets and investors will continue to use them. Moody's said it continues to rate more than 90% of the corporate and financial institution bonds issued globally. S&P said it continues "to work with market participants to restore confidence in the capital markets and the ratings process."

Investors buying unrated debt are doing their own analysis of the collateral and expected cash flows that back the debt. They include hedge funds and other types of institutional investors such as pensions, say people involved in the deals. More deals are in the pipeline, said bankers.

To be sure, selling unrated deals into the markets comes with its own set of potential troubles. Many investors' mandated guidelines are pegged to credit ratings, which provide a common ground when trading securities in the secondary markets. Unrated deals may be hard to sell.

In September, Bank of America Merrill Lynch offered investors the opportunity to buy $239 million of securities backed by subprime mortgages owned by Lone Star Funds without credit ratings. Since its initial offering, parties involved in the deal have sought an investment-grade credit rating in a move that may make it easier for an investor to sell the securities into the secondary market.

Wall Street isn't alone in taking steps to move away from ratings. Insurance regulators are considering an overhaul of the way they calculate insurers' capital requirements to remove ties to credit ratings for some types of securities.

The Securities and Exchange Commission last month voted to amend some securities laws to remove references to credit ratings. The Federal Reserve will soon start performing formal risk assessments on securities that may be financed by one of its key lending programs, the Term Asset Backed Securities Loan Facility.

On Wednesday, a key U.S. House panel approved a credit-ratings bill that would subject rating firms to more regulation and require federal agencies and departments to review their reliance on ratings and consider using other risk measures for debt instruments.

Broadly, the SEC's rule changes are symbolic steps, "and could send a message that investors shouldn't rely excessively on ratings agencies to define quality," says Roger Joseph, a partner at law firm Bingham McCutchen LLP.

Counterparty risk concerns set to increase the cost of securitisation

Posted on Structured Credit Investor:

Continuing Lehman Brothers-related litigation has ensured that counterparty risk has remained in focus since the bank's collapse. However, recent legal challenges to the inverted subordination clause - combined with rising rating agency scrutiny around counterparties - could increase the cost of bringing a securitisation.

Counterparty risk management continues to be in focus, confirms Navigant Capital Advisors md Pawan Malik, partly because many institutions underestimated it prior to last year's financial crisis. "In the past, pricing was the dominant factor in choosing a derivative counterparty. Since the fall of 2008, corporates are more diligent in who they trade with and under what terms. ISDA Master Agreements are being re-negotiated, large corporates now prefer to have mutual Credit Support Agreements in place and the larger treasuries are even tracking their exposures to individual counterparties," he says.

The uncertainty around counterparty risk has been heightened by the aftermath of bankruptcies such as Lehman Brothers. The bank was a counterparty to many swaps with SPVs on structured finance transactions.

In order to achieve a triple-A rating, the swap documentation stated that if the SPV owed money on the derivative at the time of default of the counterparty bank, the SPV's payment would be subordinated to the rated notes of the SPV (known as the inverted subordination clause). This clause is now being challenged in the courts (SCI passim).

The inability of the Silverstone issuer to enter into a cross-currency swap - and thereby hedge its exposure to euro-denominated notes (see last week's issue) - is a result of such concerns, for example. The cost of entering into a cross-currency swap has increased significantly due to the fear that rating agencies may insist on cash collateral to hedge the risk if a legal precedent is set on the inverted subordination issue.

Fitch last week released its revised rating criteria for counterparty risk in structured finance transactions, which includes increased collateralisation expectations as a counterparty's credit profile deteriorates or for derivatives positions that are deemed to be less liquid (see separate News story).

"It will be interesting to see where the market goes from here," observes Malik. "If legal precedent is set, securitisation documentation may have to be rewritten. Irrespective, the cost of bringing a transaction will increase significantly as the related swaps are now more expensive."

Reto Bachmann, head of European ABS research at Barclays Capital, points out in a recent report entitled 'Better Structures: Counterparty Risk' (published in European Structured Products Weekly) that eliminating counterparty risk by removing counterparties from transaction structures may not be possible in the case of operations counterparties or not in investors' interests in the case of financial counterparties. The services of operations counterparties are essential to securitisations and so the best that can be done is to reduce the risk their failure presents to the structure, he notes.

One obvious way of achieving this is via careful selection of counterparties. But hot, warm and cold back-up servicers can also be employed to mitigate the damage caused by a failure of the current servicer; while not concentrating too many services at the same servicer could be another mitigation strategy.

However, it might be possible to eliminate some financial counterparties from a structure. For example, a liquidity facility could be replaced with a larger reserve fund and deferability of non-senior coupon payments; basis swap providers could be eliminated by only securitising mortgages that match the reference rate of the issued notes or issuing notes that match the reference rate of the collateral; fixed-to-floating swap providers could be avoided if investors in a fixed rate mortgage pool are willing to accept fixed rate notes; and currency swap providers could be avoided by only issuing bonds in the currency of the collateral. But the success of any of these potential alternatives ultimately depends on investor preference.

Whatever that preference may be, once a counterparty no longer satisfies its eligibility requirements, remedies have to be put in place. Bachmann notes that the classic three remedies remain: counterparty replacement by an eligible counterparty; a guarantee of the counterparty exposure by another eligible counterparty; and posting of collateral.

Meanwhile, an area of continuing debate among swap professionals is the S 2a) iii) clause in the ISDA Master Agreement, according to Malik. This clause allows the non-defaulting party to terminate a derivative contract at a time of their choosing. Furthermore, they can stop payments on the derivative.

Unsurprisingly, this clause is only exercised when the non-defaulting party is out of the money on the swap. Recent rulings in New York have challenged the ability of a non-defaulting party to indefinitely keep a contract open without making any payments (SCI passim).

The intention of S 2 a) iii) was probably to allow non-defaulted counterparties to keep a contract open for a short time to avoid systemic risk and give them some time to pay. According to the recent rulings, courts appear to have taken the view that some counterparties have misused this clause so they can avoid paying altogether - they claim it's only fair that they either pay up or terminate the contract.

"From the bankruptcy estate's perspective, it's also difficult to know how much is available to pay its unsecured creditors without some clarity on what is owed to the estate," Malik adds.

Finally, one issue that has caused much pain to counterparties but now appears to be being resolved is re-hypothecation of client assets by broker-dealers. This process enables a reduction in funding costs that dealers can give to counterparties and was considered to be routine before the crisis erupted in September 2008.

The experience has emphasised the fact that in a default scenario there is considerable uncertainty as to who the money 'belongs' to (especially if collateral is held in a general pool) - the defaulted bank or the client who deposited the security. "At the peak of the crisis, many hedge funds rushed to get their security out of broker-dealer accounts, which served to amplify the turmoil in the financial markets. Interestingly, after a period of extreme reluctance to allow re-hypothecation, many hedge funds are now happy to allow dealers to on-lend their securities to bring their funding costs down materially," Malik concludes.

Tuesday, October 27, 2009

FDIC to launch the mother of all bank securitisations?

It could be on its way from the Federal Deposit Insurance Corp — the body responsible for insuring US bank deposits.

Avid readers of FT Alphaville will know that FDIC, headed by Sheila Blair, took over its 100th failed bank this week.

The plethora of bank failures since the start of the financial crisis means the organisation now has control of billions of failed bank assets.

What to do with them all?

Apparently, securitisation is an option. From Structured Finance News:

The Federal Deposit Insurance Corporation (FDIC) has seen a growing volume of assets acquired from failed banks in its role as receiver of these institutions.

Michael Krimminger, special advisor for policy, office of chairman at FDIC and speaking at Information Management Network’s 15th annual ABS East conference in Miami said that FDIC has acquired more that [sic] 100 failed banks and it is likely that they may seek to do a securitization

And that’s the article in its entirety — so far.

What sort of securitisation might the FDIC be thinking of?

Your guess is as good as ours, but the alphabet soup that could emerge — FDIC CDO/ABS/CLO etc. — doesn’t exactly fill us with confidence.

Moody's announces plans for structured ratings indicator

London, 27 October 2009 -- Moody's Investors Service has announced preliminary plans to add an indicator to its ratings of structured finance securities as early as the second quarter of 2010 in order to comply with anticipated regulatory requirements in the European Union (EU). Moody's plans to add the indicator to all outstanding structured finance securities it rates globally, as well as to new structured ratings as they are assigned, although the rating agency may phase-in implementation beginning with European-rated securities. The indicator, if applied, would only denote that the rating is on a structured finance security; it would not otherwise change the meaning of the rating.

The EU has passed regulation for credit rating agencies which includes a requirement that ratings assigned to structured instruments be differentiated from those assigned to other types of securities. Other regulatory bodies globally have likewise raised the possibility of requiring such a differentiation. The EU regulation is expected to enter into force in the fourth quarter of this year, after which the rating agencies are expected to have six to nine months to comply.

Moody's expects the indicator will take the form of an "(sf)" which would appear following the rating in all of Moody's press releases and research reports -- e.g. "Aa3 (sf)". It would also appear in a separate rating indicator field on and in the rating agency's data products.

The indicator would apply to all structured finance securities, including asset-backed securities (ABS), asset-backed commercial paper (ABCP), residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and derivatives such as collateralized debt obligations (CDOs). Prior to implementation of the indicator, Moody's plans to publish a full list of the types of securities it considers to be structured finance instruments.

More information about the EU regulation is available at

Moody's also said that additional modifications to its ratings may be required as a result of changing regulation in a number of jurisdictions, including the EU, and that it plans to notify the market of any such changes prior to their implementation.

Rehypothecation "driver of contagion" during crisis

Posted on by Peter Madigan:

Rehypothecation of client assets was one of the “dominant drivers of contagion” during the financial crisis, amplifying the market turmoil in the wake of the Lehman Brothers collapse, the Senior Supervisors' Group (SSG) has concluded.

The body, consisting of financial regulators from the US, Japan, Germany, France, the UK, Canada and Switzerland, made the assertion in its Risk Management Lessons from the Global Banking Crisis of 2008 report, issued as a follow-up to its first survey published in March 2008. It noted that “many of the weaknesses highlighted in our first report continue to contribute to financial strains. Despite the passage of many months since our first survey, we found that a large number of firms had not fully addressed the issues raised at that time”.

The authors noted that, following the bankruptcy of Lehman Brothers International Europe (LBIE), clients that had elected to allow the dealer to rehypothecate their assets – the process by which a dealer lends out collateral posted by a client to another counterparty - found themselves caught in the bankruptcy as mere unsecured creditors to the estate, rather than having their assets preserved in segregated customer accounts.

As a result, counterparties that should not have been significantly affected by the collapse of the dealer found their assets trapped in the insolvency, shrinking their funding base and dragging a host of additional institutions into a precarious fiscal position, further deepening the crisis. LBIE’s administrators PricewaterhouseCoopers confirmed that more than $40 billion in hedge fund collateral had been swallowed in the collapse.

“Custody of assets and rehypothecation practices were dominant drivers of contagion, transmitting liquidity risks to other firms. The loss of rehypothecated assets and the “freezing" of custody assets created alarm in the hedge fund community and led to an outflow of positions from similar accounts at other firms. Some firms’ use of liquidity from rehypothecated assets to finance proprietary positions also exacerbated funding stresses,” the authors concluded.

The report focuses heavily on liquidity risk and capital management processes at institutions in seven of the world’s largest economies, and determined that firms continue to exhibit weaknesses more than 18 months after concerns were first raised by the SSG.

Paying particular attention to liquidity risk, the report notes that the institutions found to be most vulnerable during the crisis depended heavily on uninterrupted access to secured financing markets, and relied on excessive short-term and often overnight wholesale financing of long-term illiquid assets, a practice that made it difficult for the firms to withstand market turmoil without a deposit base to draw upon and central bank support.

Conversely, the institutions that weathered the storm much better were those that resisted taking advantage of short-term credit and were able to draw on other sources such as deposits, liquidity pools consisting of government bonds and central bank lending facilities.

The SSG also concluded that “considerable work” remains to be done in the areas of governance and internal controls. It blamed senior managers and directors for being unwilling or unable “to articulate, measure, and adhere to a level of risk acceptable to the firm,” and added that existing compensation plans often conflicted with the control objectives of the firm and favoured risk-takers at the expense of independent risk managers and control personnel.

The full report is available at:

ISDA Writes Global Standards for Islamic Derivatives

Posted on Bloomberg by Katrina Nicholas:

Global standards for Islamic derivatives contracts may be published as soon as December, helping companies and investors manage risk more effectively, according to the International Swaps and Derivatives Association.

“This is a real innovation in what could potentially be a huge growth area,” ISDA Chairman Eraj Shirvani said in an interview in Singapore yesterday. “Establishing market standards with the input of the scholars’ opinions, combined with the expertise and benefits of the ISDA framework, potentially opens up a significant array of new hedging possibilities for issuers and investors.”

The New York-based ISDA, which represents more than 830 organizations active in the $592 trillion derivatives market, started working on its Shariah-compliant master agreement with the Bahrain-based International Islamic Financial Market in 2006. The first version of their framework will focus on swaps for profit-rate and currency transactions, Shirvani said.

Islamic finance is the fastest-growing segment of the global financial system with $919 billion of assets under management, including $114 billion of Shariah-compliant bonds, known as sukuk, Prudential Financial Inc. said on Oct. 7. Assets will grow to as much as $1.1 trillion this year, Kuwait Finance House KSC forecast in July, as the world emerges from recession and a recovery in oil prices boosts Arab wealth.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Bond Trading

“Investors will have the ability to trade in sukuk they perhaps wouldn’t have been able to before without a hedging tool available to them,” Angus Amran, treasury and capital markets head for Cagamas Bhd., Malaysia’s biggest buyer of home loans, said in a phone interview from Kuala Lumpur. The standards will “promote homogeneity and acceptance of Islamic financial products,” he said.

Because Muslim Shariah law prohibits payment or receipt of interest, speculation and uncertainty, many Islamic investors avoid derivatives. To ensure compliance with Shariah, new Islamic financial products must be vetted and approved by recognized scholars who are versed in its principles.

Standardized terms in derivatives agreements may help market participants focus on “developing a more innovative and diverse range of Shariah-compliant derivative tools and products instead of channeling resources to reduce documentation risks,” said Mark Toh, who helps manage about $525 million in Islamic funds at Prudential Corp. Asia in Kuala Lumpur.

Oil Prices

Created in the 1970s after an almost 20-fold jump in oil prices over 10 years, the Shariah finance industry caters to the world’s 1.57 billion Muslims. From being almost non-existent a decade ago, the Islamic bond market has grown to $130 billion, according to Moody’s Investors Service.

Sukuk have returned 27 percent this year, an HSBC Holdings Plc index shows, after the market fell four times as much as conventional investment-grade corporate debt last year. The Dubai government set up a $2.5 billion Islamic bond program on Oct. 25 as the emirate seeks to sell international bonds for the first time in more than a year.

Malaysia, which has 14 Islamic banks and the biggest sukuk market, said in July that it would introduce a trading platform to make it easier for companies to buy and sell commodities like palm oil and rice that are used to back Islamic securities. Sukuk are asset-based bonds that pay a profit rate to investors to avoid interest.

Government Efforts

South Korea said on Aug. 26 that it plans to exempt sukuk from tax on distributions, joining countries including Singapore, Hong Kong, the U.K. and France that are modifying regulations to help attract Islamic investments.

Islamic financial institutions have been more resilient to the global financial crisis than their conventional counterparts because direct investment in subprime assets and derivatives is prohibited to them, Moody’s said in February.

“We have had many enquiries regarding derivatives and some people say this is important for the industry and some people have done without them,” Mohamad Alchaar, secretary-general of the Accounting & Auditing Organization for Islamic Financial Institutions, said in a phone interview today.

The Bahrain-based AAOIFI, which promotes industry standards, is not part of the ISDA’s project with the IIFM, Alchaar said.

Market Contagion

U.S. and European regulators have called for the adoption of central clearinghouses to reduce risk in derivatives after President Barack Obama’s administration described the contracts as a “major source of contagion” in the credit crunch.

The derivatives market relies on counterparties negotiating their own buy and sell orders, with no guarantees either will complete the trade.

“In Islamic finance gambling is prohibited, but running a big un-hedged open position is gambling in my way of thinking, so I’m pleased to hear there will now be more alternatives available for reducing risk,” Deborah Schuler, Moody’s group credit officer for Asia, the Middle East and Africa, said in a phone interview from Singapore.

Monday, October 26, 2009

Securitisation datapoint du jour, Nationwide edition

Posted on FT's Alphaville by

You have to love this headline from the Guardian on Sunday, even if you disagree with the premise: “Nationwide revives bond market that caused crunch”.

Beyond specious headlines, the Guardian reported that UK mortgage lender Nationwide intends to issue a £3.3bn prime residential mortgage backed security - Silverstone 2009-1 - in what would be only the second such deal this year. HBOS reopened the European RMBS market with its £4bn Permanent 2009-1 deal in September.

Reuters, which reported on upcoming Nationwide deal earlier in October, had more detail on the banks involved:

Barclays Capital, Citi and JP Morgan are joint-lead managers on the sterling-denominated residential mortgage-backed securitisation (RMBS), the manager at one of the banks in charge of the planned sale said.

Separately, Reuters’ International Financing Review publication analysed the mortgage lender’s decision to opt for an RMBS issue rather than a covered bond “given that the latter would be likely to offer much cheaper funding”. Emphasis FT Alphaville’s:

In the secondary market, Nationwide’s three-year covered bonds trade around the mid-swaps plus 80bp to 90bp region, whereas most UK prime RMBS trades in the Libor plus 130bp area. The choice of funding tool demonstrates that spreads are not the only consideration and that Nationwide knows the importance of maintaining funding diversity.

In the recent third-quarter ABS confidence survey from JP Morgan the same point was made. A “significant proportion of originators [83%], do not see covered bonds as a substitute for RMBS issuance”, the report said. Nevertheless, nearly three-quarters of those originators felt RMBS spreads would need to tighten (39% by up to 50bp and 44% by 50bp-100bp) before they would return to the primary market.

Another factor affecting the choice that prospective issuers have to make is that covered bonds may soon become less efficient as a funding tool, relative to RMBS.

The rating agencies are increasingly concerned about the ability of issuers to meet bullet repayments when covered bonds mature and it seems likely that S&P will be the first agency to insist that issuing banks put more collateral into their covered deals in order to maintain a Triple A rating, especially those banks with subordinate debt ratings below Double A.

According to Barclays Capital analyst Fritz Engelhard, at least 60% of covered bonds rated by S&P would be subject to a downgrade without extra assets being added to pools. As Nationwide has subordinated debt ratings of BBB+ (S&P), Baa3 (Moody’s) and A+ (Fitch), its covered bonds may well be one of the 60% at risk.

Moreover, as IFR pointed out, the lack of a euro-denominated tranche could be a stumbling block:

This exclusion met a lukewarm response from a major European investor, who argued that the absence of euro-denominated notes made the deal a “non-event” for Continental buyers.

The absence of a euro piece underscores what is widely considered a major stumbling block in the way of a recovery in the European securitisation market. Of the few remaining eligible counterparties that have the capacity to write swaps, even fewer actually want the risk, even though 35bp fees can now be earned, versus 2bp-3bp in pre-crisis times.

The change in perceived risk assessment followed the collapse of Lehman Brothers, in which it became clear that providers would need to post collateral at the point when they were least able to do so. This “cliff risk” is so-called because liabilities can step-jump, creating a negative feedback loop, where the stressed swap counterparty must post ever-increasing amounts of collateral - with fatal consequences.

UK securitisations have been creeping back

Posted in the Guardian by Elena Moya:

Nationwide is set to become the second UK mortgage lender to publicly sell residential mortgage-backed securities – bonds that use homeowner's mortgages as collateral – since the financial crisis last summer.

The technique of selling bonds backed by mortgages or other loans such as for cars or credit card balances, known as securitisation, was widely used during the years before the onset of credit crunch, giving banks a tool to lend more than they could afford and ultimately pushing many to the brink of collapse.

Securitisations have been creeping back as investors seek higher returns at a time when interest rates are at record lows. Tesco, Lloyds, Volkswagen and Ford have carried out securitisation deals over the past four weeks, reviving a market that had barely witnessed any transactions in the first nine months of the year.

"Investors are looking to reinvest in relatively simple asset classes, and for the most recognised names," said Rick Watson, managing director of the European Securitisation Forum. "So we're seeing the beginning of the reopening of the market."

The return of securitisation is seen by analysts as a way to kickstart bank lending, although banks, battling to shore up their books, are likely to remain cautious.

Nationwide's £3.3bn issue will come from Silverstone, a vehicle set up by the mortgage lender, which "has comparatively few problem loans such as interest-only loans and high loan-to-value loans," according to CreditSights, a research firm. The first mortgage-backed deal came from HBOS, owned by Lloyds, which issued a £4bn bond in September.

The issue comes as the UK economy is still shrinking and unemployment rising, traditional signs of rising defaults.

"We remain negative on UK house prices and believe that UK [residential mortgage backed securities] still face risks from low mortgage repayment rates and the risk of rising arrears when interest rates are finally once again increased," Credit Sights said. "That said, Silverstone's pool of mortgages … appears to have fewer loans that could cause problems in the future."

JPMorgan, one of the international banks least affected by the credit crunch, has been one of the top buyers of notes backed by UK residential mortgages.

Friday, October 23, 2009

Thomson CDS auction a good deal for some

Posted on by Jane Merriman and Jane Baird:

The outcome of an auction on Thursday to settle credit default swaps on Thomson after a debt restructuring at the French electronics firm could leave some investors dissatisfied with the process.

he auction produced a surprisingly high recovery rate for debt with short maturities, according to analysts.

The auction set the cash payout on debt maturing up to 2.5 years at 3.75 pct of the amount sellers of protection agreed to cover.

'The outcome for the 2.5 year maturity bucket looks beneficial to sellers of protection if their contracts were triggered against them, as it costs them only 3.75 percent,' said Matthew Leeming, part of Barclays Capital's credit derivatives quantitative strategy team.

The auction was the first of its kind under a new system known as 'Small Bang' to try to smooth settlement of credit default swap (CDS) contracts on a company after a debt restructuring rather than a default

'The main point is still that the mechanism of the auction does not make sure that the final recoveries are not driven by market technicals,' said Tim Brunne, credit analyst at Unicredit.

'Some investors will look at the auction and not be very satisfied,' he said. 'You need a robust auction process and their might be the necessity for improvements.'

The Thomson ( TOC - news - people ) auction had attracted a lot of attention because of a drive by politicians and regulators to standardise credit derivatives markets and make them more transparent.

It took weeks to organise, following Thomson's July debt restructuring, partly because of the complexity of the process and because of a relatively small number of Thomson bonds to deliver against a much bigger number of CDS contracts.

'Thomson was a great example because all of the debt was private, so it wasn't clear what was going to be deliverable and what the debt maturity profile was like,' Leeming said.

'So it was a fairly special case.'


The final value of CDS contracts was set at 96.25 percent on debt up to 2.5 years, 65.125 percent up to five years and 63.25 percent up to 7.5 years, according to results published by auction administrators Creditex and Markit.

The price of the 2.5 year bucket came in far above the 75 percent overall recovery rate estimated by dealers on Oct. 13, the deadline for triggering payment under CDS contracts.

The settlement for bonds with up to five and seven year maturities was priced at a much lower recovery value than some had expected.

The 96.25 percent recovery rate for the 2.5 year bucket was higher than the recovery swaps market had indicated, said Tobias Sproehnle, Markit's director of indices.

'The process went smoothly and worked the way we normally do it,' with the one difference being that three auctions were held at once, said Charles Longden, managing director of fixed income for Markit.

A credit default swap is effectively an insurance contract on a company's debts that can pay out if it defaults or restructures.

An auction following default is much more straightforward since all CDS contracts are automatically triggered.

A restructuring improves a company's prospects of staying in business, particularly in the short term. Its recovery value should be higher and its CDS spreads tighter for two years than for seven years.

Data from the Depository Trust and Clearing Corp showed that the net notional value of all Thomson CDS contracts amounted to nearly $2.1 billion as of Oct. 9, ranking it among the world's top 1,000 referenced names.

International Swaps and Derivatives Association (ISDA) data showed that a total of 7,496 contracts were triggered, which is likely to amount to a sizeable chunk of the net notional value of the Thomson CDS contracts.

ISDA would not provide data on the overall value of triggered contracts.

Thursday, October 22, 2009

Push for compromise on derivatives reform

Posted in the FT by Jeremy Grant:

Regulators on both sides of the Atlantic have agreed to study whether greater use of bilateral collateralisation could be expanded in over-the-counter derivatives markets as an alternative to sweeping imposition of greater capital charges.

The move will be greeted with relief by financial and corporate users of OTC derivatives. They have argued that reforms of the OTC derivatives markets risk going too far in mandating that banks and other intermediaries set aside extra cash on their balance sheets against the perceived risks of using many OTC derivatives.

The Obama administration and European Commission have thrown their weight behind greater use of capital requirements as one way to reduce risks in the financial system. Some OTC derivatives have been blamed for exacerbating last year’s financial crisis.

Another key part of the reforms is mandating greater use of clearing houses for OTC derivatives.

Paul Myners, financial services secretary to the UK Treasury, on Thursday said the UK and other jurisdictions had “secured the agreement of global over-the-counter derivatives supervisors for a major overhaul of bilateral collateralisation”.

Bilateral collateralisation is a process by which a trader post funds with an opposite party in a trade. In case of default by the opposite party, the trader keeps the collateral funds posted by its counterparty.

In clearing, such collateral is paid to the clearing house, which goes further by guaranteeing that the deal is completed in case of default by either party.

Collateralisation is already used in about 70 per cent of OTC derivative transactions.

But financial markets regulators in the US, UK and continental Europe will meet next week with participants in the industry to discuss ways to encourage greater use of the process. The meetings will involve the US Commodity Futures Trading Commission, the UK’s Financial Services Authority, as well as German and French authorities.

Lord Myners said: “At the global level, we are leading work to strengthen bilateral collateralisation. We have secured the agreement of global over-the-counter derivatives supervisors for a major overhaul of bilateral collateralisation and anticipate formal approval from industry next week.”

One person familiar with the plans said the aim was to see if it would be possible to “standardise” the use of bilateral collateralisation. A formal agreement on a way forward would be agreed in January.

Last month, Deutsche Börse, the German exchange and operator of a clearing house published a study saying that complex OTC derivatives trades that can not be processed through clearing houses should be collateralised as a matter of standard procedure to help safeguard the financial system.

Tony Freeman, director of industry relations at Omgeo, a post-trade service provider, said: “If the regulators have come to some conclusion that they are going to mandate bilateral collateralisation they have found a solution that is an extension of an existing solution and can be implemented really very quickly.”

Borrowers step up their fight against OTC derivatives regulation

Posted in Euroweek by Brendan Daly:

Tougher regulation is coming to the derivatives market — that is inevitable after the credit crisis wreaked its havoc ­— but a growing number of MTN issuers and intermediaries are becoming increasingly vocal in rejecting moves to impose blanket standardisation across the market.

Regulators on both sides of the Atlantic have been calling for tougher regulation on financial markets since the crisis struck, including the idea that all derivatives should be standardised and traded on exchanges.

Opposing this are increasing numbers of market participants and commentators who fear the threat such moves could pose.

The Association of Corporate Treasurers has been outspoken on its position on standardisation proposals. It sent a letter last Friday to Baroness Ashton, European trade commissioner, expressing its concerns about a commission staff consultation on over the counter (OTC) derivatives issued in July that is expected to be brought forward to the commission later this month.

John Grout, policy and technical director at the ACT, explains how regulation could harm companies.

"There are regulations that might increase the cost for corporations dealing in derivatives and also regulations that might induce cashflow volatility into corporations dealing in derivatives," he said. "Increasing costs are never welcome for any company and while it’s very easy for regulators to say ‘oh well it’s only a small increase in costs,’ it can add up. But issue that I think is more serious is the one that generates cashflow volatility. If a company needs to use a lot of derivatives, if margin is required, variation margin paid or received can be very large."

Market participants accept that there are advantages in some standardisation, as well as the use of trade repositories and exchanges.

"In the capital markets there is an evolution that we think is good and is already taking place in derivatives markets, which is a streamlining of processes and the implementation of useful platforms," said Ivan Zelenko, head of derivatives and structured finance at the World Bank. "This saves netting and counterparty risks for products and the market is making it happen spontaneously, so it would be good to anchor and push such evolutions to cover a broader range of products."

But blanket standardisation is seen as a cause for concern.

"What we see as a potential danger is the idea that there should be a very strict and extreme standardisation of derivatives products, meaning that those products which are not standardised will be penalised in many ways," says Zelenko. "We see that as a danger for the market and for end users, because in reality innovation and customisation are good things for the market, and if it’s penalised I think we are all going to lose."

Experimental phase

Any such blanket regulation is likely to stymie the creation of new structures in the MTN market.

"Customisation is the essence of the MTN market," said Zelenko. "If you want to create a new structure that is going to become the callable bond of tomorrow, a structure that will be used by investors and issuers, you must let people experiment. So there is a sterilising effect of standardising everything."

Grout agreed market solutions are often best, and that the products that should be standardised either have been or will be.

"There are some commodities which you deal on exchanges because that’s the only place you can deal them, and there are some things you only do with banks because there are no exchanges," he says. "In most things, the market decides for itself whether to use exchanges or OTC and, for OTC, whether to post variation margin mutually between the bank and the client. Mostly they don’t require margin."

One way to avoid adverse consequences from planned regulation may be to specifically target the financial sector and exempt non-bank issuers from standardisation.

"I think authorities quite rightly see an objective of trying to limit systemic risk in the financial sector," said Grout. "They should widely define the financial services sector, because the wider the definition the less regulatory arbitrage becomes possible. But I think they can exclude non-financial companies. Some have asked what would happen if an oil company bought a dealer broker, as has just happened with Occidental and Phibro. If you’ve defined the financial sector as offering a service to the public, the fact that Occidental owns Phibro shouldn’t change regulation for its own activities, so that’s not an issue. Non-financial issuers are a small part of the market and they are not building up large speculative positions. They are hedging underlying business."

A new hope for non-financials

A draft bill in the US two weeks ago offers hope that such an exemption is likely. The bill, introduced by Barney Frank, chairman of the Financial Services Committee, would be less stringent on non-financial end-users than the Treasury Bill proposed by the Obama administration in August.

The new bill suggests that corporate end-users of derivatives be allowed to continue trading OTC derivatives for hedging.

"It’s positive that they’re nodding in that direction, though the lawmaking process in the United States is complex," says Grout. "The fact that people are beginning to include it in drafts is encouraging. It is likely to be refined and changed, but the fact they are trying is good. I hope the commission in Europe will be able to come forward with proposals that equally try to achieve the results."

But the draft bill has far from quashed all concerns, as a statement from swap dealer Reval on Thursday indicated.

According to Jiro Okochi, CEO and co-founder of Reval, unless swap dealers have the same margin and capital posting exemption for hedges sold to corporate end-users, they will either increase prices to make it worthwhile to enter into customised swaps with corporations or may simply refrain from dealing with the hassle and costs of supporting the market.

"Some regulators have indicated that they believe all OTC derivatives should be cleared or be on an exchange, so not specifically exempting corporate end-users in the legislation is risky," Okochi said."Even if the current commissions would give corporate end-users a pass today, what happens when a new commissioner with a different view is named?"

Not all speculation

Regulation of derivatives may also inhibit the ability of some bodies to meet their mandates.

The World Bank uses derivatives to help countries achieve aims such as managing risks and meeting environmental targets.

"For the World Bank financial innovation is a way to manage risk for countries," said Zelenko. "the kind of derivatives and markets that are not the core of the MTN market, but that are very important for our member countries, things like Cat bonds or carbon finance. These are not standardised products, but they have a lot of value in terms of development and public finances for developing countries."

The EIB may also be inhibited from assisting the development of domestic markets in its member countries.

Isabelle Laurent, head of funding at the European Bank for Reconstruction and Development, said excess capital requirements on non-standardised derivatives could make it difficult for the EBRD to develop domestic capital markets in its member countries.

Many believe that there is a misconception of the threats posed by OTC transactions.

"The OTC model works very well," says Richard Metcalfe global head of public policy at the International Swaps and Derivatives Association. "It delivers, which is why it has grown to such a size. It does not make sense to say that it’s all speculative. By definition each derivative contract allows two parties to express equal and opposite views, so they can’t speculate in the same direction. It’s perfectly obvious that a very large chunk of net risk transfer through derivatives is driven by hedging."

There seems to be widespread agreement among issuers on the potential risk of overregulation and excessive standardisation.

"All issuers I know that are active in the MTN market are really on the same page when it comes to the dangers of standardisation and penalising innovation in structures and derivatives," said Zelenko. "And then there is the whole spectrum of positions regarding how to encourage streamlining and how far we should go."

Despite the calls for reason and an avoidance of blanket standardisation, many expect drives for improvements in procedures.

"While all this is happening, quietly in the background we continue to work hard on broadening the scope of central clearing, improving back office operations more generally, and tightening up procedures around the use of collateral," says Metcalfe. "There’s a lot going on behind the scenes, which we hope and believe will ultimately get factored into the regulatory approach."

CESR Consults On Details For Proposed Registration And Supervision Of CRAs

Posted on Mondovisione:

CESR published today a feedback statement on its consultation for a central repository for credit rating agencies (CRAs) and issued a consultation paper detailing the proposed registration and supervision process for CRA in Europe.

The feedback statement provides a summary of the main suggestions received by CESR regarding the setting of common standards for presentation of historical and performance information and the potential output design of the repository along with an explanation of CESR’s decision on some of the most significant issues raised.

The purpose of the consultation document is to seek comments on the conclusions CESR has drawn for setting guidelines for the registration process, the functioning of colleges, the mediation protocol, the common standards on presentation of information for registration and endorsement (Annex II) and the information for the application of certification and for the assessment for CRAs systemic importance.

The consultation is open for comments until Friday, 30 November 2009.

Both the consultation paper and the feedback statement are available on CESR's website.

EC threatens higher capital charges for bilaterally cleared trades

Posted on by Joel Clark and Matt Cameron:

Higher capital charges and increased collateral requirements for bilaterally cleared trades could lie at the heart of new legislation of the over-the-counter derivatives markets in Europe to be drafted by the European Commission (EC) in 2010.

In a communication released yesterday, Ensuring efficient, safe and sound derivatives markets: Future policy actions, the EC said it would propose legislation to require financial institutions to post more collateral and hold higher capital against any contracts that cannot be centrally cleared.

"Current collateral levels are too low and do not reflect the risk that bilaterally cleared derivatives pose to the financial system when they reach a certain critical mass. Financial firms need to hold a larger amount of collateral to cover their credit exposure," the EC said, adding it would also widen the difference between capital charges for centrally cleared and bilaterally cleared contracts in the capital requirements directive (CRD), making non-standardised contracts more costly.

The communication makes a clear effort to pacify the concerns of corporate end-users, which have expressed fears any new rules could make non-standardised, bespoke derivatives less appealing if capital and collateral requirements increase.

"While most hedging should, in principle, be achieved through non-customised/standard derivatives, tailor-made derivatives will still be necessary. Accordingly, the commission does not want to limit the economic terms of derivative contracts, neither to prohibit the use of customised contracts nor to make them excessively costly for non-financial institutions," the EC insisted, but warned that corporate users would face an increased cost for the trading of OTC derivatives.

In a response to the communication, the International Swaps and Derivatives Association emphasised the need to ensure OTC derivatives remain viable hedging tools for corporates. "Companies ranging from auto makers to airlines rely on derivatives to manage an array of risks, including interest rate and currency changes. Isda strongly believes increasing collateral requirements for non-financial institutions could be excessively burdensome," the association said.

The communication also pledges to make mandatory the central clearing of all standardised derivatives through central counterparties (CCPs), but said it will draft legislation to govern the activities of CCPs, abolish inconsistencies between national legislation on clearing and ensure CCPs abide by a minimum level of risk management.

"Currently, CCPs provide services on a European basis but remain regulated at national level, as there is no community legislation covering CCPs... the commission intends to propose legislation governing their activities so as to eliminate any discrepancies among national legislations and ensure safety, soundness and proper governance," the EC said.

On the issue of trade repositories, the communication left open the possibility of establishing separate trade repositories in Europe. Some European regulators have argued against having a single global trade repository for each asset class, and have said a separate trade repository should be established in Europe for each asset class. Market participants cited data protection issues, data access and the prospect of being unable to provide support should a repository be in danger of collapse.

The communication states: "The European Securities and Markets Authority (Esma) should ensure that European regulators have unfettered access to complete global information. In the absence of such access, the commission would encourage the creation and operation of European-based trade repositories." It goes on to explain that Esma should be responsible for authorising and supervising trade repositories, as repositories provide services on a European, if not global basis.

The communication also requires that it be mandatory to report all transactions to trade repositories, but does not distinguish between cleared and non-cleared trades. However, it did state that information on trades made on-exchange or cleared through a CCP can be provided to regulators directly through these entities.

The commission will propose legislation that will provide a common legal framework for the operation of repositories and is intended to cover issues including authorisation/registration requirements, access and participation to a repository, disclosure of data, data quality, access to data, safeguarding of data, legal certainty of registered contracts and operational reliability. These issues are currently being discussed at an international level by the OTC Derivatives Regulators Forum, a medium through which international securities regulators and central banks, cooperate, exchange views and share information related to OTC derivatives, CCPs and trade repositories.

Although the EC has undertaken an industry consultation on the package of reforms after it outlined the initial proposals in a July 3 communication, it will not be responsible for drafting the formal legislation as its mandate is due to end on October 31, after which it will undertake a caretaker role until the next commission starts work in early 2010.

But yesterday's paper suggests draft legislation on the governance of CCPs and the regulation of trade repositories will be produced by mid-2010, while amendments to the CRD to include higher collateral and capital requirements for bilaterally cleared contracts should be made by the end of 2010.

Wednesday, October 21, 2009

Scope remains to circumvent derivatives bill

Posted in the FT by Robert Engle:

The House financial services committee in the US last week approved a bill to deliver sweeping changes to the structure and regulation of the massive over-the-counter derivatives business.

This bill goes far in reducing counterparty risk in the OTC derivatives market and the systemic costs of bankruptcy of a large sector participant. The process of closing positions and managing exposures will be much easier. The proposal also should reduce transaction costs in swap markets and improve price discovery. Furthermore, participants will save the cost of credit insurance which is typically taken out against counterparty defaults.

The bill requires that most standardised swaps will be traded on a swaps exchange facility or an electronic exchange. Once a large swap participant accepts the standardised contract offered, it will be executed against a central counterparty. The participant will be required to post a margin to ensure the central counterparty is able to meet its commitments to all of its counterparties. The margin required will vary as the position gains or loses money. If some participants become insolvent, then they will forfeit their margin balance which should be sufficient to avoid substantial losses to the system. The data from these transactions will be reported to a registry and aggregated versions made public.

Contracts without an electronic market will be traded bilaterally. But in contrast to current practice, regulators will set margins at least for large swap participants and dealers. All such non-cleared contracts will be reported to the registry which will be visible by the regulators so they can see interconnections. Capital requirements against these non-cleared positions will be set at a higher level than for cleared transactions reflecting increased risks.

The bill also exempts end-users who are not large swap participants from the requirement to post margins or clear standardised products. But it empowers regulators – the Security and Exchange Commission and the Commodity Futures Trading Commission – to designate market players as major swap participants if they take big and systemically risky positions. Thus excluded end-users can be brought under the regulatory umbrella.

Yet some exceptions in the bill deserve more careful examination. Slightly non-standard contracts can be traded bilaterally and only reported to the repository. This structure may encourage financial innovation designed only to keep products from central clearing. Regulators will be obliged to set margins and capital requirements for these new and potentially complex products but they may be unable to keep up with the flood of variations.

An alternative and much simpler solution is available: transparency. If such transactions were required to be posted on a public site with information on counterparties and, importantly, their margining arrangement, the risk of a bilateral deal with any counterparty could be more accurately assessed. The market would price the counterparty risk and this would provide a far more powerful disincentive to excessive risk taking than the threat of regulatory capital requirements. Third parties would assemble this data and sell credit information to market participants. A swap participant that does not want its transaction made public would have an incentive to move to a cleared product.

Several other extensions should be pursued. Margins should be netted across clearing structures. That is, if a position in interest rate swaps is positive and in credit default swaps is negative, the margin to be posted should be the difference between these. Similarly, international co-ordination should allow for margins across geographical areas to be netted. Finally, the accounting treatment of hedge positions may require further flexibility.

This bill has the potential to reduce the likelihood and severity of future financial crises. But in its current form, it leaves loopholes that a healthy financial sector will find all too easy to arbitrage round.

Robert Engle teaches at the Stern School of Business at the University of New York and is the 2003 winner of the Nobel Prize in Economics. This article was co-written by Viral V. Acharya, who also teaches at the Stern School

Tuesday, October 20, 2009

Credit Scores by Email Domain

Posted on Credit Karma:

Our lives are full of numbers: Phone numbers, social security numbers, birthday dates, lottery numbers, lucky numbers... the list goes on. But, no number says more about us than our old favorite, the credit score.

Our credit scores speaks of our creditworthiness, gives potential lenders a peek into our credit history and even predicts our financial future. However, recent correlations have been drawn between credit scores and other factors... saying more about us than we'd ever imagined. Here are a few examples:

According to the Insurance Information Institute, drivers with lower credit scores file 40% more claims than drivers at the higher end of the credit scale.

Forget "red" state, "blue" state... certain states also have higher credit scores than others. The Dakotas and Wisconsin lead the country while Texas and Nevada have the lowest average credit scores.

We found another intriguing credit score correlation, email address domains. Based on a sample of 20,000 credit scores, our data shows that there is a difference of average scores based on what email service users prefer (see map at Interestingly, Gmail and Comcast users came out the top with a higher average, while AOL and Yahoo users had the lowest average credit scores.

What does it all mean? Not much. Certainly switching email providers will not increase or decrease your credit score. It's more the case that people with a certain score have a greater likeliness to use a particular email provider. Why this happens is probably due to some demographic skew which then carries to the email domain. But that's not the point, we just thought it was interesting.

Testing the limits of Islamic debt

Posted in the FT by Robin Wigglesworth:

The default of two prominent Middle Eastern investment companies is shaping up to be a test case for the $1,000bn Islamic finance industry on how Islamic bonds, or sukuk, are settled.

Until recently, the market for bonds that comply with Islamic law, or sharia,, was one of the fastest growing niches of the international financial industry, with issuance soaring from virtually nothing less than a decade ago to about $100bn of sukuk bonds outstanding this year.

However, like many of the complex financial products conjured up during the past decade, Islamic bonds are facing their sternest test yet.

The defaults of Kuwait’s Investment Dar and Saudi Arabia’s Saad Group earlier this year have raised uncertainty on how sukuk-holders will be treated compared with more conventional creditors.

“It’s a real legal battleground,” says Mohieddine Kronfol, managing director of Algebra Capital, a Dubai-based asset manager that has invested in Saad’s sukuk. “It will set an important precedent.”

Sukuk skirt round Islam’s ban on interest by allowing investors to profit from the income of an underlying asset, such as rental income on land or real estate placed in a special purpose vehicle for the duration of the bond, rather than receive a fixed interest rate.

Lawyers and bankers are now poring over the legal documentation of Investment Dar’s $100m sukuk, which defaulted in May, and Saad’s $650m “Golden Belt” Islamic bond to find out whether sukuk-holders have recourse to the assets.

Saad’s Golden Belt sukuk is secured by land in Saudi Arabia – valued at about 40 per cent of the bond’s principal, according to Mr Kronfol – and some investors are trying to get the sukuk dissolved so they can gain recourse to the property. A ruling is expected later this month.

islamic-debtHowever, experts say that the issue may not be clear-cut. Lawyers say confusion has arisen on the difference between “asset-based” and “asset-backed”, and they stress that not all Islamic bonds are secured by an underlying asset.

Moreover, sukuk are usually structured according to UK law to adhere to Islamic principles, raising concern over how courts will rule in a liquidation.

Even the Muslim clerics that have to approve all Islamic financial products often disagree on how closely Islamic bonds can mimic conventional paper and what happens in the case of a default.

“The sharia view is that they [sukuk-holders] are the owners [of the assets], but it depends on how [the sukuk] is structured. If someone has purchased a sukuk assuming that they automatically have recourse to the assets, they might be unpleasantly surprised,” says Muddassir Siddiqui, a former sharia scholar and head of Islamic finance at DentonWildeSapte.

While received wisdom holds that sukuk-holders would be better protected than conventional bond-holders in the case of liquidation, assets are primarily put in place to facilitate the Islamic structure rather than protect creditors, according to Raphael de Ricaud, head of Islamic finance at Rothschild.

“At the core of this confusion lies the subtle – some would say ‘fictitious’ – distinction between ‘beneficial right’ and ‘legal right’ to the asset,” he says.

“In a liquidation case, the court is very likely to look only at with whom the legal title of the asset resides to sanction who owns the particular asset.”

The future of the Islamic debt markets could be at stake on what eventually happens in the restructurings, some bankers say.

“Sukuk have never been tested like this,” says Nish Popat, head of fixed income at ING Investment Management in Dubai.

“This will be an important test case to see if the market continues to evolve and improve or if the market starts to splutter.”

Total global issuance of Islamic debt has reached almost $18bn so far this year, according to Zawya, a data provider, with much of this issuance by sovereign or quasi-sovereign entities. Abu Dhabi’s Tourism Development & Investment Company recently sold a $1bn sukuk that was seven times subscribed.

Among private sector issuers, the Islamic debt market is still difficult and bankers warn that investors are likely to be sceptical of any sukuk sales until the Investment Dar and Golden Belt sukuk issues are settled.

“Sukuk are no different from any new financial product that hasn’t been tested in stress situations before,” says an Islamic lawyer.

“It’s a young market, and this is its first major test; lessons will be learnt, and practitioners will hope that investors and regulators learn from the outcomes.”

Commission sets out future actions to strengthen the safety of derivatives markets

The European Commission has adopted a Communication for ensuring efficient, safe and sound derivatives markets. The Communication sets out future policy actions to increase transparency of the derivatives market, reduce counterparty and operational risk in trading and enhance market integrity and oversight. They follow the stakeholder consultation launched with the Communication in July ( IP/09/1083 ) and the public hearing in September. The Commission will come forward with legislative proposals in 2010. These proposals will be in line with the G20 Pittsburgh statement and will be accompanied by a thorough impact assessment. In order to avoid any risk of regulatory arbitrage and to ensure a global consistency of policy approaches, the Commission stands ready to work with authorities around the world when finalising the proposals.

Internal Market and Services Commissioner Charlie McCreevy said: "This Communication marks a paradigm shift away from the traditional view that derivatives are financial instruments for professional use and thus require only light-handed regulation. The Commission proposes a comprehensive approach that will ultimately enable markets to price risks properly. We cannot afford another situation where the risks of the financial sector are ultimately borne by the taxpayer."

This Communication lays out the Commission's future policy actions. It builds on the Commission's July Communication 1 ( IP/09/1083 ) and the subsequent stakeholder consultation and high-level conference.

The future policy actions will:

  • Reduce counterparty risk by (i) proposing legislation to establish common safety, regulatory and operational standards for central counterparties (CCPs), (ii) improving collateralisation of bilaterally-cleared contracts, (iii) substantially raising capital charges for bilaterally-cleared as compared with CCP-cleared transactions, and on top of this (iv) mandate CCP-clearing for standardised contracts;

  • Reduce operational risk by promoting standardisation of the legal terms of contracts and of contract-processing;

  • Increase transparency by (i) mandating market participants to record positions and all transactions not cleared by a CCP in trade repositories, (ii) regulating and supervising trade repositories, (iii) mandating trading of standardised derivatives on exchanges and other organised trading venues, and (iv) increase transparency of trading as part of the review of the Markets in Financial Instruments Directive (MiFID) for all derivatives markets including for commodity derivatives;

  • Enhance market integrity and oversight by clarifying and extending the scope of market manipulation as set out in the Market Abuse Directive (MAD) to derivatives and by giving regulators the possibility to set position limits.

The Commission will now start the process of drafting legislation, notably by launching impact assessments, in order to come forward with ambitious legislation to regulate derivatives in 2010.

The market for derivatives is global. To ensure an ambitious and convergent international regulatory outcome, the proposals are in line with the objectives agreed at the G20 meeting of 25 September 2009. The Commission intends to further develop the technical details in cooperation with its G20 partners in order to ensure a coherent implementation of these policies across the globe and thus avoid regulatory arbitrage. Such cooperation is particularly important with the US, which is also in the process of designing a new approach to derivatives markets.


Derivatives play an important role in the economy but are associated with certain risks. The financial crisis – notably the events surrounding Bear Sterns, Lehman Brothers and AIG – has highlighted that these risks are not sufficiently mitigated in the OTC part of the market. In view of the central role played by derivatives markets in the financial crisis, on 3 July 2009 the Commission published a Communication on ensuring the efficiency, safety and soundness of derivatives markets, accompanied by a Commission Staff Working Paper and a Consultation Paper. The consultation resulted in over 100 replies, and 450 participants attended a high-level conference on 25 September in Brussels. The July Communication announced operational conclusions for the end of October, which is the subject matter of the present communication.

More information is available at:

1 Commission Communication "Ensuring efficient, safe and sound derivatives markets" - COM(2009) 332, Staff Working Paper SEC(2009) 905, and Consultation document SEC(2009) 914. See press release IP/09/1083 .