Thursday, December 31, 2009

Credit models and the crisis, or how I learned to stop worrying and love the CDOs

Abstract originally posted on Moneyscience by Damiano Brigo, Andrea Pallavicini, Roberto Torresetti:

We follow a long path for Credit Derivatives and Collateralized Debt Obligations (CDOs) in particular, from the introduction of the Gaussian copula model and the related implied correlations to the introduction of arbitrage-free dynamic loss models capable of calibrating all the tranches for all the maturities at the same time. En passant, we also illustrate the implied copula, a method that can consistently account for CDOs with different attachment and detachment points but not for different maturities. The discussion is abundantly supported by market examples through history. The dangers and critics we present to the use of the Gaussian copula and of implied correlation had all been published by us, among others, in 2006, showing that the quantitative community was aware of the model limitations before the crisis. We also explain why the Gaussian copula model is still used in its base correlation formulation, although under some possible extensions such as random recovery. Overall we conclude that the modeling effort in this area of the derivatives market is unfinished, partly for the lack of an operationally attractive single-name consistent dynamic loss model, and partly because of the diminished investment in this research area.

Get the paper from arXiv or here.

Monday, December 28, 2009

It’s impossible to price a CDO

Posted on Reuters by Felix Salmon:

The discussion about Goldman’s synthetic CDOs just happens to coincide with a separate thread about a working paper by four researchers at Princeton, who seem to have a solid mathematical demonstration that CDOs simply can’t be priced: the amount of computing power necessary to do so just doesn’t exist.

Robert Oak has a good English-language explanation of the implications of the article: it boils down to the idea that if Goldman was loading up its synthetic CDOs with nuclear waste, there’s a good chance that its clients couldn’t have worked that out. Not because they were insufficiently sophisticated, but just because there aren’t enough computers in the world to do so.

It’s possible to overstate the connection between the paper and the events that happened at the height of the credit bubble. There’s a hidden implication in the paper that maybe with better models or faster computers we might have avoided some of this mess — but the solution to model risk isn’t more complex models, its less reliance on models altogether. And anybody who applied a simple smell test to the mortgages underlying the CDOs in question — rather than deciding instead to trust various quants both in-house and at the ratings agencies — would have come to the right conclusion without any computing power at all.

That said, there’s a case to be made that Goldman — along with much of the rest of Wall Street — was indeed arbitraging the models that investors and ratings agencies were using to price CDOs in general and synthetic CDOs in particular. The latter were particularly toxic, because synthetic CDOs are zero-sum, meaning that Goldman stood to gain in precise proportion to the degree to which the buyers of the paper were underestimating the risk involved.

The result was that Goldman had every incentive to structure CDOs which would blow up spectacularly, leaving investors with massive losses and Goldman with equal and opposite gains. The investors, meanwhile, might not have trusted Goldman (after all, they understood the zero-sum nature of these instruments), but did trust — far too much — mathematical models which turned out to be deeply flawed. And which, now, seem to be far too complex to get a grip on in any case, given the limitations of today’s computers.

In the final analysis, much of the problem here was a function of banks waving the magic letters “AAA” in front of the eyes of lazy institutional investors who thought they were getting free money by buying risk-free debt at hefty spreads over Treasuries. Some banks, like Merrill Lynch, did that and still contrived to lose billions; Goldman, by contrast, did that and managed to make a profit on the deals.

The whole sorry episode I think was fairly summed up by Goldman CEO Lloyd Blankfein when he said that “we participated in things that were clearly wrong and have reason to regret”. At the same time, however, Goldman wasn’t particularly evil or cunning here. It was simply acting like everybody else in the finance world, trying to take as much advantage of the credit boom as it possibly could. The main difference was that it had a bit more control over its own balance sheet than most of its rivals.

SIFMA's position on US OTC derivative market reform

OTC derivatives are important risk management tools for companies across the country and throughout the world. Companies use OTC derivatives to manage exposures to interest rate, currency exchange rate, commodity price, and other risks inherent in their businesses. Because commercial and industrial companies use derivatives in this manner, they can devote their time and attention to what they do best: producing and providing medical equipment, clothing, floor coverings, airplanes, and other goods and services.

Many financial firms use credit default swaps to manage their exposure to credit risk in an efficient and cost-effective manner, which makes loans more available and less expensive to businesses and consumers. Because credit default swaps played a role in the problems encountered by a small number of insurance companies, including American International Group (AIG), policymakers at the federal and state levels are considering what steps can be taken to reduce the risk of similar problems arising in the future.

SIFMA supports the creation of a single financial stability supervisor, a central authority with oversight in all markets and of all systemically important market participants – regardless of charter, function or unregulated status. In conjunction with the appropriate prudential regulator(s), the systemic risk regulator should be responsible for participant and product regulation and therefore have broad authority to ensure that these market participants manage their derivatives businesses in a prudent manner. SIFMA supports the use of clearing organizations for standardized transactions and reporting through data repositories for all other OTC derivative transactions. SIFMA believes that every OTC derivatives clearing organization and data repository should be subject to federal regulatory oversight, thereby ensuring that the systemic risk regulator and other federal financial regulators have access to all of the information needed to monitor OTC derivatives markets. It is important for the federal government to create a single set of regulations in order to promote clarity and accountability.

House of Representatives
During 2009, legislation has been introduced in the House of Representatives and the U.S. Senate to enhance regulation of OTC derivatives. In the House, Agriculture Committee Chairman Collin Peterson (D-MN) introduced H.R. 977 which would enact mandatory central clearing of OTC derivatives and suspend "naked" CDS trading. The Agriculture Committee marked up and reported H.R. 977 on February 12, 2009. Legislation introduced by Energy and Commerce Committee Chairman Henry Waxman (D-CA) and Rep. Ed Markey (D-MA), the American Clean Energy and Security Act, H.R. 2454, includes several provisions concerning the regulation of OTC derivatives. That legislation was marked up and reported by the committee on May 21, 2009 and approved by the House of Representatives on June 26, 2009.

In October, both the House Financial Services Committee and the Agriculture Committee produced derivatives legislation. House Financial Services Committee Chairman Barney Frank (D-MA) and House Agriculture Committee Chairman Collin Peterson (D-MN) drafted and marked up two distinct versions of H.R. 3795. Both bills require clearing of eligible transactions and that those transactions originate on regulated exchanges. The bills differ on key definitions and other provisions, including exemptive authority granted to primary regulators.

In the Senate, Agriculture Committee Chairman Tom Harkin (D-IA) introduced S. 272, which would move most OTC derivatives onto CFTC-regulated exchanges. The Agriculture Committee’s new Chairman Blanche Lincoln (D-AR) is expected to introduce new legislation in mid-December. Other bills concerned with derivatives regulation have been introduced by Senators Carl Levin (D-MI) and Susan Collins (R-ME), S. 961; and by Senator Ben Nelson (D-NE), S. 807.

In September, Senator Jack Reed (D-RI) introduced the Comprehensive Derivatives Regulation Act, S. 1691, which requires standardized derivatives transactions to be cleared, but does not mandate exchange trading for cleared transactions. S. 1691 requires all OTC transactions to be reported to trade repositories, and it does not call for shared regulatory jurisdiction (SEC and CFTC). In November, Senate Banking Committee Chairman Chris Dodd released a comprehensive financial regulatory reform bill, the Restoring American Financial Stability Act, which establishes a presumption of clearing for derivatives transactions. The bill also mandates exchange trading for cleared transactions. It grants the SEC and CFTC limited authority to exempt transactions from clearing requirements.

Executive Branch
On June 17, 2009, the Treasury Department released a White Paper entitled Financial Regulatory Reform, which prescribed mandatory clearing for all standardized OTC derivatives and more stringent capital and margin requirements for market participants. In the paper, Treasury supports the Federal Reserve as regulator of “systemically important payment, clearing, and settlement systems, and activities of financial firms;” as well as the harmonization of futures and securities regulations of the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC). In August, the Treasury Department released draft legislation that recommends mandatory exchange trading and attempts to clarify regulatory jurisdiction over derivatives by assigning swaps and securities-based swaps to the CFTC and SEC, respectively.

At the state level, the National Conference of Insurance Legislators (NCOIL) has adopted model legislation that would subject credit default swaps to regulation as insurance and prohibit such transactions that are not undertaken for hedging purposes.

CDS market is far less opaque than presumed

Letter to the Financial Times posted by Stewart Macbeth, Managing Director and General Manager, Trade Information Warehouse, DTCC:

Sir, Your article on sovereign credit default swaps, “CDS market needs reform if more drama is to be avoided” (December 18) erred when it said “nobody really knows exactly how low volumes are (or not) since this is an over-the-counter market, conducted away from any exchange”.

In fact, The Depository Trust & Clearing Corporation (DTCC) has brought an unparalleled level of transparency to the OTC derivatives market through its trade repository, the Trade Information Warehouse, which holds the underlying position data on virtually all credit default swap contracts traded globally. These data include figures on sovereign CDS contracts such as the Hellenic Republic that was referenced in your article.

Trades are currently fed into the Warehouse on a real-time basis by MarkitSERV, a joint servicing offering of DTCC and Markit Group Limited, which is used to confirm electronically more than 95 per cent of credit defaults traded globally, thus permitting the Warehouse to maintain real time position and turnover information for the entire market. Currently this information is published weekly on In addition, Warehouse information is provided separately to regulators worldwide, including the Financial Services Authority, the European Central Bank and the Federal Reserve. Our goal is to release publicly even more data and initiate daily reporting in 2010.

The value of the Warehouse was highlighted, following the Lehman bankruptcy in 2008, when rumours of $400bn in CDS exposure amplified stress in the financial markets. From our unique vantage point we were able to disclose that the market's exposure to Lehman would be closer to $6bn on a net basis. Ultimately, the trades were closed out at $5.2bn. We regret that the FT did not contact us or refer to our data tables prior to publishing their story, since we could have provided data addressing questions about the level of trading activity in sovereign CDS. The CDS market is far less opaque than the FT presumes, because there is a global trade repository supporting this asset class. If CDS trades were moved on to exchanges or CCPs and they did not report their data to a trade repository, the transparency that exists today would be lost.

As policymakers on both sides of the Atlantic take steps to increase regulatory oversight of the over-the-counter derivatives market, we urge them to consider the proven value of a single, central trade repository for each asset class, where both cleared and uncleared trades across the globe are registered.

How Overhauling Derivatives Died

Original posted in the New York Times by Randall Smith and Sarah N. Lynch:

Lobbying by Wall Street has blunted efforts to step up regulation on derivatives trading by carving out exceptions or leaving the status quo in place.

Derivatives took blame for some of the worst debacles of the financial crisis. But a year after regulators and critics began calling for an overhaul in the way they are traded, some efforts have been shelved and others have been watered down.

The two main issues concerning regulators were trading and clearing of swaps, which allow investors to bet on or hedge movements in currencies, interest rates and many other things. Swaps generally trade privately, leaving competitors and regulators in the dark about the scope of their risks. In November 2008, the chairman of the Senate Agriculture Committee proposed forcing all derivatives trading onto exchanges, where their prices could be publicly disclosed and margin requirements imposed to insure that participants could make good on their market bets.

But a financial-overhaul bill passed by the House of Representatives on Dec. 11 watered down or eliminated these requirements. The measure still allows for voice brokering and allows dealers to use alternatives to public exchanges.

A lawyer for one big Wall Street dealer said in an interview that the rollback from the first proposals in Congress was the result of an "educational" process by dealers and customers that resulted in "a grudging recognition" that many uses of derivatives didn't fit such a strict approach. At one point, House agriculture chairman Collin Peterson (D., Minn.) said he suspected dealers had dispatched their customers to lobby Capital Hill.

For Wall Street, switching to exchanges would have cut their profits in a lucrative business. "Exchanges are anathema to the dealers," because the resulting added price disclosure "would lower the profits on each trade they handle, and they would handle many fewer trades," said Darrell Duffie, a finance professor at Stanford business school.

Clearing is considered important by regulators because it requires parties to a trade to post margin or collateral meant to ensure that each side can absorb losses if the trade moves against them. With derivatives, often little margin was required, allowing risks to pile up. Another issue that emerged with the failure of Lehman Brothers was whether such margin should be held in central clearinghouses. Exchange trading usually involves clearing with margin.

Dealers persuaded lawmakers to make exemptions to the clearing rules for some customers, including those covering foreign-exchange contracts, hedging by "end users" such as energy firms and airlines, and activities to offset "balance sheet risk," said Adam White, derivatives analyst at White Knight Research & Trading in Atlanta.

Mr. White says the Dec. 11 financial-reform bill will exempt nearly half of the $600 trillion in outstanding derivatives transactions from clearing requirements. Ohio Democrat Dennis Kucinich said in a statement he voted against the bill because it "contains a number of loopholes that sophisticated industry insiders will exploit with ease."

In an interview, House Financial Services Committee Chairman Barney Frank, who led efforts to craft the bill, defended the legislation, saying it is tougher than critics say. He said its clearing and trading provisions would require greater disclosure of trades and resulting risks, and give regulators more power to monitor and manage such risks.

The Massachusetts Democrat disputed Mr. Kucinich's implication that Wall Street dealers will be able to exploit the bill's exceptions, but said House Republicans had blocked some of his own efforts to make the bill tougher.

Wall Street executives say requiring end users to post additional margin could boost costs. An executive from Chicago utility Exelon Corp. told the Senate in September that requiring it to execute its electricity hedges on exchanges could require billions in additional cash outlays for margin that could boost prices to consumers. 3M Co. and Boeing Co. also warned of costs.

The Obama regulatory reform plan unveiled in June envisioned imposing higher capital requirements on dealers for customized, nonstandard derivatives that aren't cleared—to encourage dealers to send more to clearinghouses. But the House bill said only that capital and margin standards for off-exchange trades should be appropriate "for the risk associated with the noncleared swap," leaving specifics to regulators.

Some credit-default swaps clearing has already begun this year at the IntercontinentalExchange Inc., known as ICE, and CME Group Inc. The biggest derivative clearing operation, LCH Clearnet Group Inc. in London, already clears about one-third of roughly $200 trillion in interdealer interest-rate swaps.

A report Dec. 17 by Morgan Stanley analysts estimated that the volume of derivatives cleared could increase from a current 20% of the total to as much as 60% by 2012—a backdoor confirmation of critics' charge that 40% of the universe won't be covered.

“Is Blaming AAA Investors Wall-Street Serving PR?”

Original posted on Naked Capitalism by Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC:

In my view, Goldman, and a host of other clever bankers, are deliberately obscuring one of the most important points about modeling, CDOs and sophisticated investors. One of their defenses against the tremendous losses these products delivered amounts to “caveat emptor”: everyone is a grown up and should have known what he was buying.

But that conveniently obscures a critically important fact: for so-called ABS CDOs (the kind made from asset backed securities, meaning tranches of either residential or commercial mortgage bonds), 75% to 90% of the deal was rated AAA. And these ratings did not depend on the insurance provided by AIG or monolines; those ratings were issued on the CDO as concocted by the packager/underwriter.

The argument that the CDO market blew up because it was so complex and speculative is fundamentally flawed. Believe it or not, the bonds that caused the damage to AIG, the bond insurers, and banks were not highly speculative, high risk bonds. They were AAA securities and were supposed to be virtually free of credit risk. In many cases, they were “super senior” bonds – meaning they had another layer of protection above the AAA level to make them even safer than regular AAA bonds. In return for this high level of safety and large levels of protection, the investors or insurers received a very low AAA level yield. In addition, because the bonds were heavily protected, AAA rated and presumably safe, the investors and insurers did not (and were not required to) allocate very much capital to them. The bonds were not considered risky, so there was little need to reserve capital against them. In contrast, the investors and insurers held much more capital against the BBB bonds in their portfolio. This was fundamental to their business model.

Historically, investors viewed super-safe, high quality investments, such as Treasury securities, as simple, non-sophisticated investments where their money could be placed safely without worry about complex models and detailed review. In most institutions, a novice portfolio manager starts out by investing in AAA bonds, and works his way up the sophistication curve over time. Over the past few years, many investors seem to have forgotten this. But anyone who thought they needed to be super-smart, sophisticated and using “cutting edge” models (the phrase my old boss used) in order to invest in AAA bonds was either a fool or a fraud. In retrospect, there were plenty of both types.

In other words, these highly complex products were targeted to buyers who in many cases were the very least sophisticated institutional investors. And fund managers, both freestanding ones, and ones within larger organizations (think portfolio managers at insurance companies) are subject to competitive pressures. If industry benchmarks for AAA returns start to include complex, manufactured AAA paper, these investors would damage their careers by sticking to what they were sure they understood and shunning the more complex instruments that offer a bit of a yield pickup. As Keynes observed,

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

The whole notion that an investor must do complex, detailed, sophisticated analysis of AAA bonds in order to understand them and not get ripped off is, as a result, completely upside down. A high yield or a distressed bond requires a lot of analysis to determine if it is safe. This may involve elaborate models and multiple scenarios. Investors who pursue these types of risky bonds believe they have the tools to understand all of the considerations that go into the decision to purchase it or not. This type of investor is sophisticated and is aware that he is either taking risk or making a speculative bet. To compensate this investor for such a bet, the bonds pay a high yield and, if the bet is right, produce a high return. Even if the bet eventually goes bad, the yield may be enough to pay the investor so that the loss is offset. Often, investors in these bonds employ teams of quants and Phd’s to help them understand their bets.

Investments in AAA bonds are supposed the opposite of this type of high yield investment. It makes absolutely no sense that a AAA investor should need the same high tech models to make his investments or that if he fails to properly use his models he will be completely blown up and his investment will be worthless.

This “highly sophisticated investor” argument has been used by Goldman, other banks and a remarkably high number of journalists (in my opinion just repeating the crap they have been fed by their sources) as a way of getting the banks off the hook. But it is a fundamentally flawed argument. The CDO bonds that AIG insured were rated AAA. If you have to be a rocket scientist to understand the investment and if anything short of perfect analysis of the bonds means you will be blown up – then by definition the bonds are not AAA.

AAA = easy and low yield. BBB = complex, high yield. This is a pretty simple and bright light distinction. And yet it has been blurred and ignored throughout the discussion of this asset, as recently as two days ago by Goldman.

A “super senior” investment in any asset should, by definition, not require sophisticated analysis. it should be as safe as, or safer than, Treasury securities from a CREDIT perspective (ratings do not address market value or interest rate risk – which could be more complex).

Neither investors in, nor insurers of, AAA or super senior bonds were compensated with high yields – they were not yield hogs, as suggested by one comment on NC the other day. If they were getting huge yields they would have been on notice that their risk was high.

I don’t want excuse the insurers or investors of all of their responsibility. I was one of them. We got sucked into the game of “complex” AAA bonds and believed that we were sophisticated. It was part of the cultural experience of the era – even boring old muni people wanted to believe that they were “special” and “sophisticated”.

An investment that purports to be AAA or super AAA should be obviously of high quality. There should be “no ifs ands or buts” about it. The investment should not be binary, such that if you are “right” it is AAA and if you are wrong it is worthless. Model sophistication, extreme diligence, the need to have skepticism about potential lies or misrepresentations from sellers and issuers – all of this is completely incompatible with a AAA bond.

Goldman Sachs and dozens of other banks and captured journalists want the story to be about the failure of the investors who were sophisticated and assumed the risk. They ignore the crucial fact that the bonds that blew up were AAA and were sold as virtually risk free. The entire environment created by the banks, managers and rating agencies for the AAA CDO market was false and contrary to the definition of what was being sold.

The reason that is most frequently cited as why AAA CDO bonds collapsed in value is that they had extreme cliff risk, or tail risk. However, the notion of “cliff risk” should be incompatible with a AAA bond – by definition. Any model that obscures or ignores or adjusts this issue away, is a form of sophisticated lying, as it relates to AAA bonds.

The problem with the CDO market, and a good chunk of the financial crisis, is that the participants took complex, highly volatile, highly risky and highly leveraged assets and passed a magic wand over them to turn them into AAA. Unfortunately, this process did nothing to remove the volatility, risk, complexity or leverage (in fact, the CDO made all of these worse). From the very start, the market for AAA CDO bonds backed by ABS collateral was a fraud; the advocates of these bonds used fancy models, flashy Powerpoint presentations, expensive meals and a whole lot of flattery to convince people it wasn’t a fraud, but that didn’t change the truth.

The essence of the issue is that these AAAs that blew up and went to zero (and this is no exaggeration, many former AAA-rated CDOS are utterly worthless) were hopelessly badly designed and/or fraudulently sold. As Yves and I will be discussing in upcoming posts (and Yves covers at some length in her book), there is ample reason to believe a lot of the CDO packagers and underwriters knew exactly what they were doing

The rating agencies should have known that this degree of complexity and an AAA rating were fundamentally incompatible, but they were financially incented to ignore it (they got paid much more money for rating CDOs). The investors and insurers should have known it too. But I am pretty confident that the biggest responsibility lies with the sellers and the creators of the bonds – they were selling something that was supposed to be super safe but turned out to be worthless – and they knew this to be the case, one way or the other.

Thursday, December 24, 2009

Financial instruments could be spiked with unfindable risks

Posted on by Rong Ge, based on a paper he wrote with Sanjeev Arora, Boaz Barak, and Markus Brunnermeier:

In a result that may have implications for financial regulation, researchers from computer science and economics have revealed potentially impenetrable problems with the pricing of financial derivatives. They show that sellers of these investments could purposefully include pieces of bad risk that no buyer could detect even with the most powerful computers.

The research focused on collateralized debt obligations, or CDOs, an investment tool that combines many mortgages with the promise of spreading out and lowering the risk of default. The team examined what would happen if a seller knew that some mortgages were "lemons" and structured a package of CDOs to benefit himself. They found that the manipulation may be impossible for buyers to detect either at time of sale or later when the derivative loses money.

The team consists of Sanjeev Arora, director of Princeton's Center for Computational Intractability, his colleague Boaz Barak, economics professor Markus Brunnermeier, and computer science graduate student Rong Ge.

It is now standard wisdom that a major culprit in the 2008 financial meltdown was use of simplistic mathematical models of risk at financial firms. This paper, released as a working draft Oct. 15, suggests that the problems may go deeper.

"We are cautioning that even if you have the right model it's not easy to price derivatives," Arora said. "Making the models more complicated will not make these effects go away, even for computationally sophisticated."

Arora noted that the problem arises from asymmetric information between buyers and sellers, and goes against conventional wisdom in economic theory, which holds that derivatives reduce the negative effects of such unequal information.

"Standard economics emphasizes that securitization can mitigate the cost of asymmetric information," Brunnermeier said. "We stress that certain derivative securities introduce additional complexity and thus a new layer of asymmetric information that can be so severe it overturns the initial advantage."

Brunnermeier noted that the finding came from combining computer science and finance, which has not been done before but has the potential for further insights. “I anticipate that both fields can enrich each other,” he said.

The paper can be downloaded here.

CME Launches The Clearance And Settlement Of Credit Default Swaps

Originally published by Fried, Frank, Harris, Shriver & Jacobson LLP:

On December 15, 2009, the CME Group Inc. (the "CME") commenced the clearance and settlement of certain types of credit default swaps ("CDS"), including a number of Markit CDX indices and liquid single-name CDS. The CME clearing initiative is designed to meet industry commitments to provide access to central clearing for CDS transactions for both buy-side and sell-side participants and to address systemic issues relating to enhancing risk management, trade processing and transparency in the CDS market.

Fried, Frank, Harris, Shriver & Jacobson LLP served as counsel to a working group comprised of the CME and leading market participants from both the managed fund and dealer communities (the "Working Group") to develop the form of legal documentation to be used in connection with clearing CDS transactions on the CME.

The CME's approach to clearing CDS transactions, including the applicable CME Rules, leverages relevant over-the-counter market conventions, such as the 2003 ISDA Credit Derivatives Definitions and the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement, each as published by ISDA, and applies certain key features of the regulatory framework for the listed derivatives (futures and options on futures) market, such as intermediation by CME clearing member firms who are registered futures commission merchants subject to net capital and liquidity requirements, segregation of customer margin funds, and the portability of customer transactions.

Buy-side customers may document CME-cleared CDS transactions through utilizing their existing Futures Customer Agreement with a CME clearing member firm by executing an addendum to such agreement developed by the Working Group, referred to as the CME-Cleared Over-the-Counter Derivatives Addendum (the "Addendum"). Among other things, the Addendum includes representations and warranties by both parties applicable to CME-cleared CDS transactions, as well as detailed mechanics relating to trade portability and valuation in the event of a termination initiated by either a customer or a CME clearing member. CME clearing members and buy-side customers may also negotiate bilateral terms applicable to cleared CDS transactions and confirm such terms in the agreed form of Addendum. Please click here ( for a copy of the published Addendum.

In addition to the Addendum, the Working Group prepared a form of give-up agreement, referred to as the CME-Cleared Over-the-Counter Derivatives Give-Up Agreement (the "Give-Up Agreement"). The Give-Up Agreement is a triparty agreement among the CME clearing member, the customer and the executing party (i.e., the swap dealer counterparty), and addresses mechanics involving the agreement by a customer and the executing party on the relevant terms for give-up to, and clearance and settlement by, the CME through the customer's account with the CME clearing member.

The Give-Up Agreement leverages the Recommended Common Principles for Relationships Between Customer and Executing Broker and CME Clearing Member, as published by ISDA, but also contains certain timelines for each party's performance which may be amended through bilateral negotiation. The Give-Up Agreement addresses, among other things, the circumstances in which a trade may be accepted or rejected for clearing, as well as in which a trade may constitute a bilateral non-cleared transaction between the customer and the executing party.

Please click here ( for a copy of the published Give-Up Agreement and please click here ( for a summary of the timelines.

ECB calls for more clarity in bond market

Posted in the Financial Times by Jennifer Hughes:

Developers of securitised bonds could have to produce far more information about their underlying loans, according to proposals from the European Central Bank.

Asset-backed securitisations, where vast pools of loans are bundled together into new bonds, were a key form of finance for consumer loans from credit cards to mortgages in the years before the financial crisis. But the market froze as the credit crunch began.

The plans, released on Wednesday, are part of the ECB’s efforts to restart the market, considered crucial to the strength of the longer-term economic recovery.

The move also reflects the fact that the ECB has been accepting increasing amounts of securitisations from eurozone banks as collateral and is keen to have more data on the bonds it now holds.

ECB officials believe a large part of the collapse of the ABS markets was because investors lacked enough data to understand the loans underlying their bonds. The market simply froze amid fears their bonds exposed them to the collapse of the US subprime market – though they were unable to verify this.

“As the recent crisis demonstrated, investors did not correctly assess the risks of the underlying asset pools of ABSs and relied too heavily on third-party assessments,” the ECB said on Wednesday. “More transparent and timely information on the underlying loans and their performance, in a standardised format, would help rating agencies and investors.”

ECB officials have been consulting market participants led by José Manuel González-Páramo, a member of its executive board and governing council.

Wednesday’s proposals outlined a system of standardised templates for all deals and a “data-handling infrastructure” through which data would be made available to investors.

Several deals in recent months have signalled a tentative reopening of the market, but its future is far from assured and it is not expected to recover to pre-crisis levels. Before it seized up, investors were split almost equally between long-term fund managers, off-balance sheet vehicles and banks’ treasury operations. Of those, the off-balance sheet sector is considered dead and banks are shrinking their balance sheets, meaning they will have less appetite to invest.

Retained ABS Start To Hit The Market, Outlook Unclear

Original posted in the Wall Street Journal by Mark Brown:

The market for European asset-backed securities--bonds backed by repayments on consumer loans, mortgages, credit cards and the like--has taken another step towards normalization in December, but the outlook for 2010 remains uncertain thanks to an unclear economic outlook and a shrunken investor base.

Earlier this month, Friesland Bank NV of the Netherlands sold EUR560 million of triple A-rated securities backed by residential mortgages to investors in a deal from its Eleven Cities program. These bonds had originally been put together by the bank, but weren't sold, in May 2008.

One recent estimate suggests that European banks have held back, or retained, almost EUR300 billion of ABS in 2009 alone, to be used as collateral in the event the banks needed to borrow cash from the European Central Bank.

One key to reviving the market, and unlocking bank lending to shoppers, home buyers and businesses thereby supporting the nascent economic recovery, analysts said, would be to wean banks off that ECB liquidity by putting those retained ABS into circulation among investors.

The disappearance of demand for asset-backed bonds was one of the first warning signs of the coming global economic crisis. As the U.S. market for subprime mortgage began collapsing in 2007, investors lost confidence in such deals, whatever their rating.

But demand has started to return in 2009. The Friesland deal could represent another milestone on the path to recovery.

"The interesting thing about the [Eleven Cities] deal was that it had already been structured and retained," said Tim Michael, syndicate banker at Royal Bank of Scotland Group PLC, sole bookrunner on the transaction. "To our knowledge, it's the first retained deal to be syndicated, and it showed that investors are comfortable buying bonds on that basis."

In November, the ECB said it would tighten standards for accepting certain ABS as collateral for its refinancing tenders, requiring them to have two separate credit ratings to be eligible from March 2011.

ABS analysts at Deutsche Bank said that Friesland Bank's move to sell the bonds was "possibly aided by recent pronouncements from the ECB," suggesting that the central bank is starting to achieve its stated aim of helping the recovery of the European ABS market.

Selling more retained deals to investors could be the next step in that recovery, but it isn't always a straightforward process. Because so many bonds were created with no real prospect of being sold to investors, the coupons--the interest payments made to investors--on many retained deals are unrealistically low.

This may necessitate "a wave of deal restructuring" before retained deals "start flowing into the market," Bank of America Merrill Lynch analysts said recently.

RBS's Michael said it was hard to estimate how many retained deals could be sold straight into the market, because some would have to price significantly below par to give investors realistic returns given the low coupons in place.

He said the Eleven Cities deal had "quite a high running coupon" and also offered investors a "significant" increase in interest payments if the bonds are not bought back, or called, when the issuer has the option to do so.

"A deal that pays a materially lower coupon could still be sold, albeit at a significant discount," he said. "However, investors will be very focused on how much the coupon steps up if the bonds are not redeemed on the call date."

Still, the deal is an encouraging sign, and may have started a trend. Spain's Banco Bilbao Vizcaya Argentaria SA (BBV) has also been seeking to sell debt backed by loans to small and mid-sized businesses that was originally retained by the bank nearly a year and a half ago.

If more of these deals are executed successfully, European ABS issuance volumes can increase in 2010. Since the market reopened in September, just over EUR7.3 billion worth of bonds backed by U.K. and Dutch mortgages, German auto loans and loans to small and mid-sized Spanish companies have been sold publicly.

That's a start, although it is tiny compared to the boom years of 2006-2007, and the outlook for 2010 issuance volumes is unclear. One problem is that the hedge funds and specialist investment vehicles that fueled Europe's 2006-2007 ABS boom have exited the market, which has "dented significantly the available investor base," said BofA Merrill Lynch.

But some of the other traditional buyers of European ABS, such as banks and insurers, could return to the market as they seek to diversify their investments either to receive higher yields or for regulatory reasons.

BofA Merrill Lynch bank also pointed out that so far in 2009, investors have only bought the least risky, top rated tranches of European ABS, not the lower-rated tranches exposed to the earlier losses in the underlying loan pools.

So overall, the outlook for European ABS in 2010 remains uncertain, so much so that BofA Merrill Lynch said new issuance next year could be anywhere between EUR50-EUR150 billion.

Still, if ABS volumes hit the upper end of that estimate, they will be back at 2001-2002 levels. These should be more sustainable than the huge issuance of 2006-2007, which arguably encouraged imprudent lending and left some banks over-reliant on asset-backed securities.

"We are seeing some signs of life, but I am not too excited. Yet," said a second syndicate banker.

Wednesday, December 23, 2009

On The Use Of Models By Standard & Poor's

Original posted on the Standard & Poor's website:

Standard & Poor's Ratings Services' ratings are opinions of creditworthiness based on our analysis. Ratings are not precise probabilities of default but rather a relative ranking of creditworthiness. One important tool we use in assigning ratings, but by no means the only one, is quantitative modeling. This report summarizes our definition of models, briefly describes what Standard & Poor's models are and are not used for, and discusses in general terms our view on methods of combining qualitative and quantitative considerations in the ratings process. The paper concludes with a discussion of our views on some distinctions we see between models suitable for ratings analysis and models more suitable for use in valuation, portfolio optimization, and risk measurement.

What Is A Quantitative Financial Model?

A quantitative model is a controlled view of certain real world dynamics that is used to infer the likely consequences of some pre-specified assumptions under various circumstances. However, in the process of moving from inputs to outputs, a model may not capture all the nuances of the real world. The distinctive feature of a quantitative financial model is that it is a quantitative calculation based on one or more assumptions. Models are not black boxes of revealed truth but merely numerical expressions of some view of how the world would be likely to behave. The models used in finance rely on assumptions about the behavior of people, organizations, acts of the natural world, and the use of other models by market participants. Quantitative financial models embody a mixture of behavioral psychology, statistics, numerical methods, and subjective opinions.

The physical sciences have laws of nature called "theories," that observation or experiments can verify or disprove. In finance, however, there are merely statistically significant tendencies and patterns, and there are always exceptions that do not fit these patterns. These exceptions do not mean that a given model is not useful. Rather, all quantitative financial models are necessarily generalizations that events in the real world will sometimes contradict. Because mathematicians, scientists, and engineers have developed powerful techniques for solving certain types of equations, quantitative financial analysts tend to express the underlying financial dynamics and assumptions as the same type of mathematical equations, and employ analogies to physical laws. This enables the financial models to use the same techniques from the physical sciences to compute the numerical solutions to these financial equations.

Different assumptions and different intended uses will in general lead to different models, and those intended for one use may not be suitable for other, unintended uses. Weaker performance under such circumstances does not necessarily indicate defects in a model but rather that the model is being used outside the realm for which it was optimized. In our view, the test of a financial model is how suitable it is for its intended use, which involves a simultaneous test of assumptions, inputs, implementation, and usage.

We believe that quantitative financial models can be very useful tools for analyzing credit risk.

The Use Of Quantitative Models By Standard & Poor's Ratings Services

The ratings process at Standard & Poor's can involve use of quantitative (models) in addition to qualitative (analytical judgment) considerations. The applicable published Standard & Poor's criteria will, in general, outline the nature of those considerations. The importance of models in the rating process varies. Analysis of more complicated debt often calls for more elaborate tools. Conversely, analysis of an unsecured senior bond might be, in effect, as simple as that the firm will pay interest unless it defaults. In this case, an analyst familiar with the issuer might not need models to form a credit opinion. On the other hand, when analyzing certain structured finance products, for example, model results could be of greater importance in a rating committee's decision. In between these two cases, such as when the issuer has a complicated portfolio of risks or has significant asset holdings in structured products, the debt we rate might have some risks we evaluate quantitatively and others qualitatively.

An essential part of any financial model is the set of assumptions on which the model is based. In some cases, the analysis of assumptions may call for a quantitative model. In other instances, models may not be necessary. Indeed, ratings determinations where no formal model is involved are common.

When we use a model, our ratings determination can follow one of several different paths, depending on the nature of the information and the circumstances. A path could involve qualitative assessments, quantitative models, or both, and it could have any number of steps. Models can fit into this analytical process either before or after qualitative judgments. For a front-end process, the analysts use the model output as one of the pieces of information on which to base their qualitative opinion. In a back-end process, analysts render a set of subjective opinions, which are the inputs to a model, and the model combines these and generates output. The model output could be a preliminary ratings indication, a numerical estimate such as a projected probability of default (PD), or the input to some other process.

One-step processes

Ratings determinations that employ only fundamental analysis without relying on formalized models emphasize qualitative factors, even when they are difficult to quantify. Such a process may include both qualitative and quantitative considerations without using a model. It may also include stress testing and scenario analysis.

Conversely, the financial analysis some market participants perform for certain types of instruments, such as collateralized debt obligations (CDOs), could largely or solely result from automated systems. Such systems might use a purely quantitative process in which the design of the model can potentially reflect certain qualitative considerations participants identify that the analysis of individual deals doesn't reconsider. And new information can immediately produce new results. On the other hand, this approach might fail to capture the impact of rapidly changing market conditions. Key relationships among variables in the model could suddenly change, diminishing the model's ability to produce useful and meaningful results. Accordingly, even a one-step-model-driven process requires close oversight from analysts to assess when the model's underlying assumptions begin to break down. Standard & Poor's generally uses an approach that incorporates additional assessments made outside of a formal quantitative model framework.

Multi-step processes

In contrast, many types of rating analysis involve a multi-step process in which models may play a role in one or more steps. For example, the analysis of residential mortgage-backed securities (MBS) involves a quantitative model (LEVELS) in the first step of the process to estimate tentative credit enhancement levels consistent with our criteria at the applicable rating levels for the liability side of a transaction. After the initial step, pursuant to our criteria, analytic adjustments could be made to reflect Standard & Poor's view regarding originator quality, the quality of due diligence, and the quality of a transaction's representations and warranties. After that, we may use a different quantitative model (SPIRE RMBS) to test the cash flow structure of an MBS transaction. We could also make qualitative analytic adjustments to the SPIRE output.

In other settings, qualitative analytic judgments could become inputs to a quantitative model. An example is the set of analytic adjustments made to financial ratios used in ratings analysis, based on a rating committee's views of potential sources of distortion and future volatility in the unadjusted ratios.

Multiple-model processes

In many cases, Standard & Poor's uses more than one model to help analyze whether the assets supporting a transaction are sufficient to fund the liabilities involved at the applicable rating stress level. It is quite common for the model used for the analysis of the assets to be distinct from the "waterfall" model of payment priorities used for the liability side. In most of these cases, we run both models under a prespecified set of stress scenarios. Either or both models could have separate qualitative adjustments applied.

Some ratings rely on models for certain components of analysis but not others. As an example, in insurance analysis, we use quantitative models to effectively analyze certain risk factors, such as property catastrophe risk or financial market risks. Other areas may not be amenable to quantitative modeling, such as management actions or regulatory risk. In these situations, the rating committee will determine the rating based on both quantitative and qualitative approaches, using its judgment about the significance of each risk and the appropriate weight to apply to each of those approaches.


A more subtle subjective judgment lies in calibrating the model. In calibrating models, analysts should be careful to choose relevant data on which to base assumptions, including data from analogous areas. Standard & Poor's has taken steps toward the implementation of processes whereby models are independently reviewed, tested for parameter sensitivity, and recalibrated at regular intervals -- as and when more data become available or as market conditions change. We have recently published a list of stressful historical examples (see Appendix V of "Understanding Standard & Poor's Rating Definitions," June 3, 2009) as an aid in calibration. This list is merely suggestive and is not a definitive guide to calibrating any particular model or any particular asset class.

Quantitative Models For Credit Risk In Contrast To Other Financial Models

The intended uses of quantitative financial models include valuation, portfolio selection and optimization, risk measurement, and stress testing. Some features of any one model type might be incompatible with other model types.

For instance, some risk-measurement models, such as the Basel-mandated 10-day 99% Value-at-Risk (VaR) model, assume the probabilities of certain hypothetical future events and infer the likely consequences if these events occur. The VaR model is calibrated based on the assumption that market behavior in the near future will usually be similar to the recent past. Other risk-measurement models, collectively called stress tests, infer the likely consequences in assumed severe but plausible scenarios, without necessarily assigning any numerical probability to the scenarios. These stresses are calibrated based on the assumption that the market may occasionally behave very differently than it has in the recent past. An important distinction, in our view, between these two models is that, broadly speaking, the former addresses a bad day in a normal market, whereas the latter addresses an abnormal market.

Models used for different purposes could call for different assumptions. For example, because our assessment of creditworthiness is not a unique number but rather a band of expected performance, a credit rating model might calculate a modest range of values consistent with a specified stress assumption, whereas a valuation model would in general produce a much tighter range of values consistent with the current market with no extra assumed stresses. Also, the number of assumptions needed can depend on the characteristics of the intended use. As an example, consider a complex interest rate option. A stand-alone valuation model for the option is based on the assumed dynamics of the yield curve. If that same option is embedded in a high-yield corporate structured note, a model for valuing the incremental change in the note's price due to the embedded option must make additional assumptions about the relationship between interest rates and the issuer's credit spread, and about the likelihood of sub-optimal option exercise in different hypothetical yield curve scenarios. A model for estimating the incremental change in creditworthiness of that same structured note due to the same embedded option must make additional assumptions about both the likely option exercise behavior of the issuer in different hypothetical credit stress scenarios and the likely relationships between credit scenarios and interest-rate scenarios.

Financial risk consists of various components such as credit risk, franchise risk, liquidity risk, market risk, operational risk, and political risk. Most of the models Standard & Poor's uses are intended for our analysis of credit risk -- the likelihood and probable magnitude of credit events under different economic conditions. These models can concern many aspects of credit risk, including:

  • Expected cash flows under assumed stress scenarios,
  • Expected and unexpected losses from a financial instrument,
  • The correlation between debtors,
  • Contagion from the distress of one debtor to others,
  • Use of various indicators to infer the magnitude of credit risk, and
  • Use of various indicators and market observations to derive signals.

It's important to note that rating committees assign ratings based on qualitative and quantitative assessments. Where applicable, model outputs can provide relevant, useful information for purposes of a committee's analysis.

Many quantitative tools can be classified as either true models or rule-based calculations. True models (such as Standard & Poor's CDO Evaluator and LEVELS) make assumptions about possible future scenarios, while rule-based calculations (such as cashflow "waterfall" computations) compute the consequences of a given set of inputs without making any assumptions. For example, suppose that, in one particular scenario of a model, a CDO would collect $100. A rule-based cashflow tool could calculate how that hypothetical $100 would be paid out to the various tranches and accounts through the waterfall spelled out in the contract.

For a model intended for stress tests, some important features, in our view, may include:

  • Providing a meaningful answer over the widest possible range of circumstances;
  • No underlying implicit assumptions that certain inputs will remain small even in a stressed environment;
  • The ability to handle extraordinary relationships, such as when a bad asset affects previously unrelated assets. This is called contagion;
  • Features that are important only in extreme conditions;
  • Precision of results that was necessary in normal circumstances is not as important in a stress situation; and
  • Model calibration that combines extrapolation from past experience with expert judgment because of unprecedented stresses.

For models intended for risk measurement in less-extreme conditions, such as VaR, some important features, in our view, may include:

  • Giving meaningful answers in unremarkable circumstances;
  • Eliminating some less significant, or unobservable, inputs;
  • Hypothetical relationships not seen in the model calibration period might not be as important to model as carefully as those actually observed;
  • A business decision regarding which features can be eliminated;
  • Results in normal circumstances that are expressed in the same units as those in more extreme conditions to facilitate numerical comparisons; and
  • Model calibration that combines historical experience, current market expectations, and smaller amounts of judgment than for stress models.

Valuation models assume some relationships between some observed "calibrating" prices for liquidly traded instruments and the theoretical price of a less-liquid instrument, and they infer this unobserved price. Here, the analogous important features, in our view, may include:

  • Valuations for calibrating instruments that match the observed prices for all model inputs while using the same model for the calibrating instruments and the illiquid one;
  • A minimal number of unobservable inputs;
  • The need to incorporate relationships seen during the model calibration period into the model;
  • The importance of comparing results to the market consensus;
  • Quality of results in more extreme conditions is not as important; and
  • Calibration is based only on current market expectations and on historical relationships, with little or no judgment.

Predictive models, such as those used for investment and portfolio optimization, attempt to strike a balance between some measure of risk and a prediction of future reward. In general, these do not target market mispricing. Rather, they attempt to evaluate the market price of risk. They can address the entire market or a particular segment, or they can aim at a particular risk profile. Some key features, in our view, may include:

  • Giving a meaningful estimate, averaged over a range of expected future circumstances, including the likely error of the estimate;
  • Inputs include investor preferences, and different investors using the same model could get different answers;
  • Relationships expected for the future, up to the investment horizon, need not depend on what was seen during the model calibration period;
  • Features included in the model may depend on investor preferences;
  • The degree of applicability may also depend on investor preferences; and
  • Judgmental decisions and model calibration may, in many cases, disagree with the market consensus.

Statistical arbitrage models attempt to find and exploit perceived errors in the market consensus. In some sense, this is the opposite of a valuation model. The goal is, in CAPM (capital assets pricing model) jargon, to enhance alpha, either with a single security or on the portfolio level. In our view, key features may include:

  • Meaningful prediction of returns over a range of future circumstances;
  • Input could include proprietary views, and different arbitrageurs using the same model may get different answers;
  • Relationships expected for the future, up to the investment horizon, could be inputs and need not depend on what was seen during the model-calibration period;
  • The importance of modeling features not priced by the broader market, because an arbitrage model attempts to predict market mispricing;
  • A degree of model applicability that depends on investor expectations; and
  • Calibration that combines historical experience, current market expectations, and proprietary views.


For certain securities, the use of quantitative financial models can be an important tool in the rating process. The models Standard & Poor's uses are built to embody our assumptions and are specifically designed for use in our ratings process. These models can differ from those intended for other purposes and from those embodying different assumptions. We may use these models earlier in the ratings process than qualitative analysis, or later, or simultaneously, depending on our view on how best to analyze a particular aspect of credit risk.

Monday, December 21, 2009

ISDA: Derivatives trade matching faces challenges

Original posted on Reuters by Karen Brettel:

Frequent trade matching is touted as one initiative that can help reduce risk in the $450 trillion, privately traded derivatives markets, though a number of challenges may complicate its wider practice, according to an industry study released on Monday.

Concerns about derivatives exposures, and whether collateral posted against the trades would be sufficient to cover losses if a dealer failed, added to stresses in the financial system last year and helped spark runs on banks including Lehman Brothers.

Differences in the way that derivatives trading partners record trades, which may include whether or not a trade was entered into or variations in a trade's size, terms or value, can be risky as they can leave parties with exposures that they are unaware of.

Disputes over trades can also hold up the exchange of an estimated $4 trillion in collateral that is used to back derivatives and mitigate losses in the event of a counterparty failure.

Large derivatives dealers in June adopted daily trade matching of exposures with each other, known as portfolio reconciliation, a practice which now accounts for around 60 percent of derivatives volumes, the study, conducted by trade association the International Swaps and Derivatives Association, found.

ISDA plans to publish documents detailing best practices and minimum market standards by the end of the year to encourage more of the market to undertake the procedure.

Variations in technology used to compare trades portfolios, and concerns over the quality of data used in the systems, however, pose challenges for expanding the practice to the other 40 percent of the market, ISDA said.

To ensure greater use of the practice, a solution is needed to overcome differences in technology and reticence among some participants to make results from reconciliation transparent to their counterparty.

ISDA Portfolio Reconciliation Feasibility Study

Advances Understanding and Promotes Better Collateral Management Practices

NEW YORK, Monday, December 21, 2009 – The International Swaps and Derivatives Association, Inc. (ISDA) today announced the publication of its “Feasibility Study: Extending Collateralized Portfolio Reconciliations”. This publication is intended to enhance understanding of the achievability for wider adoption of portfolio reconciliation discipline across the industry.

“While portfolio reconciliation is clearly a subject of interest in the privately negotiated derivatives industry, actual take-up across the broader community is still relatively nascent,” said Julian Day, Head of Trading Infrastructure, ISDA. “The level of engagement on this topic has been encouraging and productive. To this end, buy-side and sell-side firms will work collaboratively and with vendors to identify solutions to support a wider rollout of portfolio reconciliation during 2010.”

The Study discusses the considerations that exist for expansion of a frequent reconciliation for collateral portfolios beyond the group of 15 major dealers that regularly report progress and commitments relating to industry infrastructure projects ('Fed 15'). The Study has been undertaken by representatives of dealer and buy-side firms under the guidance of the ISDA Collateral Committee.

In July 2008, ISDA and derivatives industry participants made the first of a series of commitments to regulators regarding collateral management, including portfolio reconciliation. These commitments led to significant improvements in market practice towards the goals set by the Counterparty Risk Management Group III (CRMPGIII). Amongst these improvements was the adoption by June 30, 2009 of a daily portfolio reconciliation standard between the Fed 15 dealer firms.

Daily reconciliation between Fed 15 dealers covers an estimated 60% of the global privately negotiated derivatives industry, across all asset classes.

While this is a significant accomplishment in less than a year from the first formal industry commitment, participants are committed to addressing expansion to a broader constituency.

The study can be downloaded here.

Securitization Systematic Risk to be Much Lower in 2010

Original posted on the Housing Wire by Jacob Gaffney:

Due to the “herculean” and “unprecedented” efforts of myriad Fed bailouts, Barclays Capital is reporting that, going into the New Year, the systemic risk posed by the securitized markets will be much lower, although the agency mortgage-backed securities (MBS) market remains a concern.

Further, increased investor due diligence, the implementation of stress testing and the realization of losses on these investments by banks, will all help create a much less risky securitization market, from a systemic point of view.

“2010 promises to be an exciting year,” they write. “It will just not be the heart-pounding, spine-chilling excitement that we saw in early 2009; and for that, we should be thankful.” With all of this taken into consideration, the analysts are predicting the 2010 rate of growth, above Fed predictions, at 3.5% to 4%.

There are some down sides to the report: “For example, while mortgage rates are near all-time lows, mortgage credit has tightened in the past year, blunting the benefits of record low rates,” write the analysts in their outlook for the secondary market. “Losses in non-agency loans are set to be a drag on bank balance sheets for the next few years, and we expect commercial mortgage losses to pick up steam from 2010.”

They add that the expect rates to begin to climb, and the Fed to begin to walk away from asset purchases come March. They also expect rising demand from banks to help offset the resulting $1.7trn in duration demand.

This creates a picture of stability as long as inflation can be kept in check, according to economist who contributed to the report.

“That is why we are calling for a relatively mild sell-off; the forecast shows the 10-year Treasury rising only to 4.5% – a 100bp move over 12 months,” they write. “This kind of rate move should not unduly distress securitized investors.”

New CDS system to help volumes,liquidity in Asia-ISDA

Original posted on Reuters by Umesh Desai:

Credit default swaps in Asia will now follow a standardised trading format designed to facilitate centralised clearing, improve transparency and in the long-run raise transaction volumes, a trade body said on Monday.

From Monday on, CDS or insurance-like contracts that protect against defaults and restructuring, will adopt standard coupon sizes and the payment of full first coupons, the International Swaps and Derivatives Association said in a statement.

following similar changes in Europe and North America

Entities in Japan will now trade CDS with standard coupons of 25 basis points (bps), 100 bps and 500 bps and full first coupons going forward.

In the rest of Asia CDS will adopt standard coupons of 100 bps and 500 bps and full first coupons going forward, said ISDA, which represents participants in the privately negotiated derivatives industry.

The move follows similar changes in Europe and North America earlier this year.

"The purpose of creating standardised contracts is it concentrates liquidity and that should facilitate the move to central clearing," said Keith Noyes, ISDA Regional Director, Asia Pacific.

"Pricing will become more transparent and liquidity may increase as everyone is quoting the same thing," he told Reuters.

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

The new convention will instead fix a coupon at the outset of a contract.

For example, a CDS now quoted at 150 basis points would be quoted with a coupon of 100 basis points plus an additional upfront payment equal to the 50 basis points.

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

"We have not seen any notable impact from the changes themselves but over the longer term this will help liquidity and trade volumes," said Richard Cohen, Head of Credit Trading Asia Pacific for Credit Suisse.

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

Europe followed in June with four coupons for new trades and two other coupon options to remake existing trades. The two other coupons are 300 and 750 bps.

"The ISDA changes do make clearing easier as they standardise contracts. They would definitely make exchange-based trading a lot easier as well," Cohen said.

Markit, a data provider and index administrator, said the spread widening on many sovereigns makes the move a timely one as standardisation reduces risk.

"The trading of CDS contracts is a global phenomenon and greater standardisation promotes greater operational efficiency and reduced systemic risk," it said in a note.

Securitization: BIS Examines New Century Capital

Original posted on Prefbog:

The Bank for International Settlements has released a working paper by Allen B Frankel titled The risk of relying on reputational capital: a case study of the 2007 failure of New Century Financial:
The quality of newly originated subprime mortgages had been visibly deteriorating for some time before the window for such loans was shut in 2007. Nevertheless, a bankruptcy court’s directed ex post examination of New Century Financial, one of the largest originators of subprime mortgages, discovered no change, over time, in how that firm went about its business. This paper employs the court examiner’s findings in a critical review of the procedures used by various agents involved in the origination and securitisation of subprime mortgages. A contribution of this paper is its elaboration of the choices and incentives faced by the various types of institutions involved in those linked processes of origination and securitisation. It highlights the limited roles played by the originators of subprime loans in screening borrowers and in bearing losses on defective loans that had been sold to securitisers of pooled loan packages (ie, mortgage-backed securities). It also illustrates the willingness of the management of those institutions that became key players in that market to put their reputations with fixed-income investor clients in jeopardy. What is perplexing is that such risk exposures were accepted by investing firms that had the wherewithal and knowledge to appreciate the overall paucity of due diligence in the loan origination processes. This observation, in turn, points to the conclusion that the subprime episode is a case in which reputational capital, a presumptively effective motivator of market discipline, was not an effective incentive device.

The end of the road for New Century came when:

Purchasers of New Century’s loan production normally conducted a due diligence examination after a sales agreement had been reached. The investor, or a due diligence firm hired by the investor, would review loan files to determine whether the loan was underwritten according to the pool’s guidelines. Loans not meeting guidelines could be excluded from the loan bundle (kicked out) and returned to the originator.

Once kicked out, the mortgages were known as a “scratch and dent” (S&D) loans, which were purchased by specialised investors at a large discount to their principal balance. Consequently, one measure of the deterioration of the quality of New Century’s loan production is the percentage of S&D loan sales. In 2004 and 2005, such sales amounted to less than 0.5% of New Century’s secondary market transactions. By contrast, in the first three quarters of 2006, S&D loan sales accounted for 2.1% of such transactions (Missal (2008, p. 68)).

The upsurge in loan repurchase requests to New Century coincided with a change in the methodology employed to estimate its allowance for loan repurchase losses. New Century’s board learned of the change after a considerable delay. This discovery was followed, after a few days, by a public announcement on 7 February 2007 that New Century’s results for the three quarters of 2006 needed to be restated. It also noted an expectation that losses would continue due to heightened early payment default (EPD) rates.

New Century’s announcement prompted margin calls by many of its warehouse lenders and requests for accelerated loan repurchases. Soon, all of New Century’s warehouse lenders ceased providing new funding. Because simultaneous margin calls by its warehouse lenders could not be met, New Century filed for bankruptcy on April 2, 2007. It ceased to originate mortgages and entered into an agreement to sell off its loan servicing businesses.

Amusingly, in the light of the current bonus hysteria:

The examiner’s access to internal New Century documents provided valuable insights into how the appearance of the warning flags influenced, or did not influence, management. For example, the examiner could find no reference to loan quality in the internal documents that described New Century’s bonus compensation system for regional managers for 2005 and 2006 (Missal (2008, p. 147)). The examiner says that the compensation of New Century’s loan production executives was directly and solely related to the amount of mortgage loans originated, loans that, in turn, were subsequently sold or securitised.32 Likewise, the examiner found no mention of penalties (reduced commission payments to loan production staff) that would be assessed against defective loans that required price discounts for secondary market sale.

Heightened investor concerns about the performance of subprime loans were reflected in changes in their due diligence processes (Missal (2008, p. 165)). Historically, investors would ask due diligence firms to examine, on their behalf, only a small sample of loans in a particular pool. The character of the process first changed in 2006 when most investors began to look at the appraisal documents in all loan files in a loan pool. Investors then increased the share of loan files examined. This intensification of due diligence efforts was responsible for a sharp increase in New Century’s kickout rate from 6.9% in January 2006 to 14.95% in December 2006 (Missal (2008, p. 161)).

The author concludes:

The examiner’s report suggests that some of the actions undertaken to improve loan quality in late 2006 and early 2007 were designed to anticipate new credit risk concerns among New Century’s counterparties. Nonetheless, when New Century announced a need to recast its financial reports, there had not yet been a defection by any of its largest counterparties. Not surprisingly, defections ensued immediately after the announcement. In those circumstances, the bunching of defections probably signalled an absence of attention on the part of counterparties to the mounting risks of ongoing transactions with New Century. In turn, the evidence of ineffective counterparty risk management has led to concerns about the effectiveness of existing governance structures (corporate and regulatory) and, in particular, reputational capital as an incentive device. Can those structures now be relied on to discipline the risk-taking incentives of those involved in underwriting securities backed by subprime (and other risky) assets?

Rating re-Remics

Original p

Re-Remics, those recooked RMBSs, made headlines this year, as financial players rushed to solve the securitisation crisis by err, engaging in more securitisation.

In fact, according to research by Amherst Securities, about $43bn worth of re-Remics were created between January and November this year; Most of those made after investors found themselves holding onto RMBS securitisations with “cashflows that do not fit their needs” — which is a nice way of saying the securities had been downgraded.

Here’s a bit more detail from Amherst’s mortgage team, led by Laurie Goodman:

. . . the less than investment grade securities are, in some cases, no longer eligible investments for the institutions that purchased them. In other cases, they occupy the very limited “less than investment grade” allocation. For regulated institutions, the downgraded securities often require “other than temporary impairment” charges to be taken, and require higher capital charges. Re-REMICs allow for the transformation of cash flows on a downgraded bond into cash flows which better meet the needs of investors; the original security is re-tranched into: (1) a new, properly enhanced AAA security + (2) a junior bond

. . .

Most of this year’s $43 billion has been arbitrage re-REMICs; deals in which a dealer buys the bonds, carves them up, then sells all the pieces. These deals have been very dependent on the front bond obtaining a AAA rating. Exhibit 2 shows that over 95% of the re-REMIC transactions have been backed by prime and Alt-A collateral. Option ARM and subprime deals are quite rare (on those deals, it can be difficult to create enough AAA bonds to make the transaction economically advantageous).

One of the really interesting things then, is how ratings agencies are rating these relatively new securitisation structures, bearing in mind that one of the reasons the things were created in the first place was to bypass those ratings downgrades.

The below table from Amherst is instructive:

Rating agency activity - Amherst

The vast majority of re-Remics are coming to market with a single rating by a single agency. Much of that is due to individual quirks between the agencies’ criteria for rating the securitisations.

Fitch, for instance, no longer rates deals backed by Alt-A collateral (something Amherst finds perplexing, but could well turn out to be a prudent move). S&P will only rate re-Remics in which it can also rate the underlying bonds, while Moody’s won’t rate re-Remics where it’s in the process of re-rating the underlying bonds.

With the vast majority of re-Remics carrying only one rating, then, the issue of rating consistency becomes much more important. Back to Amherst:

The fact that most re-REMICs are getting done with only one rating produces ratings between AAA re-REMIC tranches that are inconsistent; i.e., not all AAA ratings are created equal. With S&P making it difficult to obtain a rating on a deal where they did not underwrite the underlying bond, Fitch unwilling to rate Alt-A deals, and Moody’s in and out of the market—some deals may have 4 firms willing to rate the securities, while other deals may have only one willing rating agency. And if only one rating agency is willing to rate a security, that remaining agency may be very conservative. As a result of the ratings patchwork, some of the ratings look too aggressive to us, while others too conservative.

Which basically translates into one big caveat emptor for would-be re-Remic investors.

But if you want to see just how the ratings can vary, while getting a good granular look at two re-Remic deals, click here to read the tale of WFMBS 2007-8 2A 11 and RAMP 2004-RS6 AI6, and much more, in the full Amherst note.

Related links:
All roads lead to retranching in CRE crunch – FT Alphaville
Re-mimicking the crisis – FT Alphaville
Amherst sees `inconsistent’ triple-A re-Remic ratings – HousingWire
The role of ratings in structured finance – BIS paper

ECB moves towards forcing more ABS transparency

Original posted on Reuters by Krista Hughes:

At its mid-month meeting, the ECB's policymaking Governing Council decided to call for comments on banks' reporting of information about the securitised assets they then swap for ECB liquidity.

"The Governing Council, having assessed the need for surveillance of loan-level data, decided to launch a public consultation on the reporting of loan-level information for asset-backed securities (ABSs) in the context of the Eurosystem collateral framework," the ECB said.

The ECB recently tightened its rules for accepting ABS as security in its liquidity operations, but has also said more transparency about the way such assets are put together would help revive public confidence and trade.

Better information about individual loans, such as the value of the property backing a mortgage and whether borrowers have kept up repayments, could give the ECB and others valuing the loans a true value.

The ECB said in its monthly bulletin in May it was working with ratings agencies on plans to introduce loan-by-loan information in the ongoing surveillance process for ABS.

"These efforts will improve the quality of the surveillance process by allowing rating agencies to identify early any possible problems with the underlying assets backing the transactions," the May bulletin said.

"It is hoped that by improving transparency in the surveillance process, market participants can regain confidence in the work performed by rating agencies in the securitisation markets, thereby allowing their reactivation."

For the bulletin article, please see the ECB's Web site:


Sunday, December 20, 2009

Summary of CDS Clearing Initiatives

From B&B Structured Finance:

  • The first initiatives to set up a central clearing counterparty for CDS originated in the US
  • There were four main initiatives to clear CDS in the US, all of which developed at around the same time in 3Q2008
  • The initiatives for a European clearing counterparty followed US efforts given pressure from the European Commission and the ECB for a European-based clearing mechanism that could be locally regulated
  • Ten banks committed to start using one or more clearing houses in the Eurozone by the end of July 2009
  • The most recent initiatives have been from Asia, with Japan Securities Clearing Corporation (JSCC) and Tokyo Financial Exchange (TFX) working out details on how to clear CDS
  • However, it is unlikely that participants would want or use two Japanese clearing institutions for OTC products, as the Japanese CDS market is a small proportion of global volumes. Currently, Japan accounts for 0.6 per cent of global CDS volumes outstanding
  • Overall, given recent regulatory focus on counterparty risk across derivatives, exchanges and clearing houses are looking to offer centralized clearing services across more derivative products or expand their existing clearing services to include buyside investors where such services were only available to large dealers
  • As of mid-Sep 2009, 15 banks (which include Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase and Morgan Stanley) have made a pledge to the Fed to clear the majority of credit and interest rate derivatives through central counterparties by the end of the year
  • The banks have pledged to clear 95 per cent of all eligible credit default swaps and 80 per cent of all credit default swaps through a central clearing party. They have further pledged to submit 90 per cent of eligible interest rate derivatives, 70 per cent of new trades, and 60 per cent of all existing interest rate derivatives to be cleared centrally

What’s common among the initiatives

  • All the US based initiatives are from exchanges – CME, Euronext Liffe, Eurex (part of the Deutsche Borse) and Intercontinental Exchange (ICE)
  • The European based initiatives are from clearing providers – Eurex Clearing and LCH.Clearnet – who have been involved in the US effort, Eurex Clearing being the clearing provider for Eurex and LCH.Clearnet being the clearing provider for Euronext Liffe
  • In addition, ICE has set up a European clearing provider so that they can provide a transatlantic solution
  • The Japanese initiatives are from clearing providers - JSCC is 86.3% owned by the Tokyo Stock Exchange and is the clearing house for all Japanese cash equities and derivatives on the Tokyo Stock Exchange; and TFX is owned by its members and specializes in trading and clearing derivatives
  • All the initiatives are focused on applying the central counterparty solution to current CDS contracts rather than creating exchange traded instruments such as futures
  • The plan is for trades to be done under standard ISDAs and linked to the current ISDA auction process for settlement
  • CDS trades will be agreed bilaterally as they are today, but each leg of the trade will be transacted with the central counterparty
  • The central clearing counterparty will then determine a margin amount for each of its counterparties

What’s different among the initiatives

  • Their state of readiness
  • The products they cover
  • Their margin calculations
  • The institutions that are eligible to become clearing members
  • Interestingly some exchanges may only be willing to face the large institutions that meet their criteria for capital and reporting, and crucially, are able to contribute to the fund that guarantees against default by one of the members
  • As a result only the dealers and biggest buy-side firms would qualify as members to such central counterparties
  • It is not clear what criteria each the exchanges will apply, but it is possible that many of the smaller institutions may have to still face a dealer who then trades with a central counterparty, which means that the small institutions may still have counterparty risk to dealers

Where we are now and what’s remaining

  • It seems that the market supports the existence of more than one central counterparty
  • While this is a healthy sign, it is likely that market participants will choose to trade with the counterparty that asks for the smallest margins
  • At the same time, if certain exchanges are only willing to face the largest counterparties, the smaller institutions will be limited to dealing with the central counterparties that are willing to face them – these may be the central counterparties that ask for higher margins
  • The exchanges haven’t gone into much detail yet about how they will calculate margins. This aspect is crucial for the successful implementation of the central counterparty initiative, especially for those exchanges that will trade less standardized CDS contracts where calculating margin is less straightforward.


  • Received regulatory approval to clear CDS in mid-March 2009
  • Has restructured its clearing initiative to focus on clearing-only services and not exchange trading of the contracts
  • Plans to announch the launch of its pilot programme shortly
  • Entered into a joint venture called CMDX with hedge fund Citadel Investment Group to clear CDS
  • Has recently had fund managers AllianceBernstein, BlackRock, BlueMountain Capital Management, the D. E. Shaw group and PIMCO join as founding members, and is in the process of signing on a number of sell-side participants as founding members
  • Will use its existing central counterparty, CME Clearing, to clear CDS in its joint venture with Citadel
  • CME’s execution platform will be regulated by the CFTC as a derivatives clearing organization
  • Expects to trade indices (US and European investment grade, high yield and crossover) and single name CDS (components of indices plus other liquid names)
  • Has the benefit of allowing all counterparties to face it rather than only the largest financial institutions

Euronext Liffe

  • The first to launch their CDS clearing service in December 2008, they placed their CDS clearing intiative under review at the end of June 2009 after failing to clear a single contract
  • Plans to use LCH.Clearnet, an independent clearing house in London, to clear CDS as part of its Bclear service which already clears OTC equity derivatives
  • The primary regulator for LCH.Clearnet is the UK Financial Services Authority (FSA)
  • Initially expects to trade the iTraxx Europe, Crossover and Hi-Vol indices
  • Not known whether all counterparties can face it


  • Off to a slower start than the other initiatives, but is one of the two clearing solutions in Europe
  • Uses Eurex Clearing, its existing clearing provider in Europe to clear CDS in Europe
  • Expects to trade the iTraxx Europe indices, sub-indices and their constituents first (and further European single names subject to eligibility criteria), followed by the CDX index in North America and its constituents
  • Any entity meeting its requirements can face it as a counterparty, the main requirement being EUR 1bn in equity capital, which can substituted in part by a third party bank guarantee, cash or collateral securities
  • Started clearing the iTraxx index and 17 single name contracts at the end of July 2009, and had cleared one iTraxx index trade worth EUR 25mm as of 31 July 2009


  • Started by transfering existing bilateral CDS contracts on the Markit CDX indices to its clearing house in the US as of 9 March 2009 following SEC approval for ICE Trust to clear credit default swaps
  • Existing Markit CDX index contracts are being transferred by way of novation to ICE Trust, which will process and clear the contracts going forward
  • In its first month of operation, ICE Trust in the US cleared approximately $70bn notional of CDS contracts
  • Started clearing new CDS contracts in the US in late April 2009
  • Has the greatest support from dealers (potentially because of their association with The Clearing Corp)
  • Acquired The Clearing Corporation (TCC) in Oct 2008 and has set up ICE US Trust along with TCC and ten major dealers (BofA, Barclays, Citi, CS, DB, Goldman, JPM, Morgan Stanley and UBS) to clear CDS in the US
  • There are currently thirteen clearing members of ICE Trust, the three most recent members being BNP Paribas (Sep 2009), HSBC (May 2009) and RBS (May 2009)
  • ICE US Trust is a limited purpose trust bank that is regulated by the Federal Reserve and the New York State Banking Department
  • ICE has set up ICE Trust Europe to clear CDS. ICE Trust Europe will function within ICE Clear Europe, its existing FSA-approved London-based clearing provider that clears OTC energy futures. ICE is in conversations with the FSA to expand ICE Clear Europe’s remit to clear CDS
  • Started with clearing North American and European indices and plans to add liquid single name CDS clearing in November 2009
  • Any entity meeting its requirements can face it as a counterparty, the main requirement being EUR 5mm in capital
  • Looking to adapt ICE Trust to allow buyside members to access CDS clearing by December 2009. This would be done by getting derivatives "clearing merchants" who would be members of ICE Trust to provide clearing services to the buyside
  • On the 10th of March 2009, ICE US Trust started clearing CDX contracts, following ICE's acquisition of the Clearing Corporation and SEC approval for ICE Trust to clear credit default swaps
  • The European platform, launched in July 2009, cleared 840 contracts worth EUR 37.8bn in its first two weeks, far ahead of its competitors both in terms of contracts and notional volumes
  • As of November 2009, ICE has cleared more than 43,000 CDS index trades in the US and Europe with a notional value of more than $3.5 trillion


  • Initially teamed up its London-based operation with Euronext Liffe to clear CDS in December 2008, but stepped away from the venture after limited business
  • Instead it plans to launch its own CDS clearing platform in the Eurozone by mid-December 2009
  • The Eurozone service will be managed by Paris-based LCH.Clearnet SA, which is a Eurozone bank and regulated by Banque de France, though there have been many discussions around LCH.Clearnet providing a Europe-wide solution
  • The clearing service will initially cover the iTraxx indices
  • Banks rated single A or higher with EUR 3 billion of capital can become clearing members, and the service may later include buyside members
  • LCH.Clearnet has no US CDS clearer but opened an office in New York in mid-March 2009 to pursue opportunities
  • LCH.Clearnet is also preparing to offer centralized interest rate swap clearing services to corporations, governments and investment funds. LCH.Clearnet's SwapClear service currently clears around $85 trillion in interest rate swaps that are transacted between large dealers.