Monday, November 30, 2009

Default Swap Reforms Roiled as Aiful Tests Settlement

Posted on Bloomberg by Abigail Moses and Shannon D. Harrington:

Wall Street’s system for determining payments on derivatives linked to the debt of defaulted companies is showing cracks less than a year after securities firms changed practices to avoid “Draconian” regulation.

Credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later. In Japan, owners of swaps on Aiful Corp. haven’t been compensated, though one of its banks said the consumer lender skipped loan repayments. Dealers can’t agree whether to reimburse investors in Mexican cement maker Cemex SAB’s debt swaps.

Disparities are arising in spite of practices adopted in April and July to standardize settlements and curb risk in a market that exacerbated the worst financial crisis since the 1930s by contributing to the downfall of American International Group Inc. Analysts at Bank of America-Merrill Lynch, Barclays Capital and UniCredit SpA say changes are needed as dealers examine how to interpret existing rules to maintain investor confidence.

“The first cracks are being shown in the protocols,” said Edmund Parker, head of derivatives at Chicago-based law firm Mayer Brown LLP in London.

The rules are being tested as the global default rate rises. The rate for companies ranked below investment-grade reached the highest since the Great Depression in October and will peak at 12.5 percent next month, Moody’s Investors Service said Nov. 5.

Lawmaker Ammunition

Flaws in the system may provide ammunition to President Barack Obama and lawmakers who want to rein in derivatives, including credit-default swaps, which rise in price as investor confidence decreases and pay off when a borrower fails to adhere to its debt agreements.

Regulators demanded more transparency after the meltdowns 14 months ago of Lehman Brothers Holdings Inc. and AIG, two of the largest traders, froze credit markets and worsened the first global recession since World War II.

The swaps had been the world’s fastest-growing market, with contracts protecting against defaults on as much as $62 trillion at the end of 2007, almost 10 times the amount of the U.S. government’s debt outstanding, according to the International Swaps & Derivatives Association, a trade group based in New York. The swaps totaled less than $632 billion in 2001 and the figure is $26 trillion now.

Hedge fund manager George Soros has called the market “unsafe,” and billionaire investor Warren Buffett once likened the derivatives to “financial weapons of mass destruction.”

Revenue Stream

Banks are making changes to avoid stricter rules imposed by regulators, said Atish Kakodkar, a CreditSights analyst in New York.

“The risk of over-regulation is real,” Kakodkar said in a Nov. 15 research report. “Self-regulation in the credit derivatives market seems to be driven largely by the need to pre-empt any Draconian regulation.”

Five U.S. commercial banks, including JPMorgan Chase & Co., Goldman Sachs Group Inc. and Bank of America Corp., were on track to earn more than $35 billion this year trading unregulated derivatives contracts of all types as of August, according to data compiled by Bloomberg.

Credit-default swaps are derivatives, contracts with values derived from assets or events, including stocks, bonds, commodities, currencies, interest rates or the weather. Banks, hedge funds and insurance companies use the swaps to insure bonds and loans against default or to speculate on the creditworthiness of countries and companies.

Failure to Pay

If a borrower fails to adhere to its debt commitments, bondholders who own swaps get paid the debt’s face value in exchange for the bonds. Those that don’t own the underlying bonds get the face value in cash minus the debt’s current market value as determined by industry-run auctions where holders of the securities sell them to the highest bidders.

Dealers and investors standardized the contracts this year to make them easier to trade through clearinghouses, which act as buyers to sellers and sellers to buyers, preventing a single default tripping a domino-like financial system catastrophe.

As part of that effort, ISDA formed regional committees of 15 dealers and investors in March to make binding decisions on when contracts are triggered. The committees base decisions on publicly available information such as regulatory filings, press releases and news articles. Swaps usually are triggered by one of three events in most countries: bankruptcy, failure to pay or debt restructuring, including a reduction or postponement in principal or interest. Under the new rules, traders eliminated restructuring as a credit event in the U.S.

Successful Auctions

Traders successfully auctioned debt to settle contracts linked to 41 companies and Ecuador’s government this year, with about half of those happening since ISDA created the committees.

“The determinations committee provides one place where we can resolve a lot of these issues centrally,” said Athanassios Diplas, global head of counterparty portfolio management in New York for Frankfurt-based Deutsche Bank AG and co-chair of the ISDA panel that wrote the protocols. “Imagine if we were to face all of this in the world where we had to arbitrate potential disputes bilaterally. That would be complete chaos.”

The new protocols helped eased the market’s stigma, with the net amount of protection bought and sold rising to $2.6 trillion as of Nov. 13, the highest since at least February, Depository Trust & Clearing Corp. data show.

Credit-default swaps on the Markit iTraxx Crossover Index of 50 companies with mostly high-yield credit ratings has fallen to 558 basis points, from as much as 1,100 basis points in March, according to JPMorgan Chase & Co. prices.

Thomson provided the first test of the procedures for settling contracts triggered by a restructuring in Europe when it said in August it was deferring payments on $72.5 million of 6.05 percent private notes due this year.

Multiple Auctions

The system for restructurings uses multiple auctions that set different payouts based on swap expiration dates. Dealers couldn’t settle the Thomson contracts with simpler failure-to- pay procedures that produce one recovery value because they were unable to prove the electronics company defaulted.

Asked in a July conference call with investors whether Thomson still owed the money, Chief Executive Officer Frederic Rose responded, “Since I am not a qualified lawyer, I prefer not to answer that question.” Marine Boulot, a Thomson spokeswoman in Paris, declined to comment.

To determine the size of the payouts on contracts covering $2 billion in debt, bonds and loans were split by maturity date ranges into three so-called buckets and sold at auction.

Contracts that expired on June 20, 2012 -- the first bucket’s latest date -- sold for 96.25 percent of the face amount, meaning swap holders received 3.75 percent of the amount covered. Swaps expiring a day later paid 34.875 percent because the debt in that bucket went for 65.125 percent.

Too Few Securities

Holders of June 20 swaps covering 10 million euros in debt got 375,000 euros, while those with June 21 contracts received almost 3.5 million euros. Swaps that terminated after Oct. 24, 2014, paid the most, 36.75 percent.

The disparity was a result of too few securities in the first bucket to settle swaps, according to Matthew Leeming, a London-based strategist at Barclays. “An imbalance of supply and demand for the deliverables can affect the recovery rate,” he said in a note.

Because they were part of industry indexes, swaps referencing the company “dwarfed the amount of Thomson debt,” said Teo Lasarte, an analyst at Bank of America-Merrill Lynch in London.

The more swaps there are, the more investors with stakes in the contracts need bonds to settle them. About 81 million euros- worth of debt was auctioned from the first bucket, compared with 221 million euros and 148 million euros from the second and third, according to data released by auction administrators Markit Group Ltd. and Creditex Group Inc.

Sufficient Debt

Lasarte favors changing rules governing indexes so companies in them have enough debt available to produce settlement auctions that don’t cause distortions.

“To strengthen the robustness of this product, there are some issues to be solved,” said Tim Brunne, a UniCredit strategist in Munich.

Leeming of Barclays said in a report to clients that the Thomson settlement “raises questions regarding the future of restructuring as a credit event.”

Banks that bought contracts on loans to Kyoto-based Aiful aren’t being paid because ISDA’s determinations committee ruled that there isn’t sufficient evidence to trigger swaps as the company and its lenders hold confidential restructuring talks.

Suspended Payments

Aozora Bank Ltd., one of Aiful’s creditors, said in a statement to the ISDA committee that the company “suspended scheduled payments of loan principal to all of its lenders” on Sept. 30. The committee rejected the request on Oct. 19 because the protocols only allow it to consider “publicly available information.” If the “sole source” of that evidence bought or sold swaps, it isn’t deemed publicly available. Aozora has said it owns some Aiful swaps.

Katsuyuki Komiya, a spokesman for Aiful, declined to comment.

Contracts protecting a net $1.36 billion of Aiful’s debt were outstanding as of Nov. 6, more than any other Japanese company, according to New York-based DTCC. As much as $238 million more of Aiful’s debt is protected through credit swaps based on indexes in which the company is a member. Aiful is meanwhile seeking to secure a credit line from Sumitomo Trust & Banking Co., its main bank, two people familiar with the matter said.

Aiful Swaps

The value of Aiful credit-default swaps that mature in December plunged on speculation they may expire without being triggered. Contracts protecting 100 million yen ($1.2 million) of Aiful debt from default through Dec. 20 dropped to 10 million yen upfront, from 55 million yen on Oct. 15, according to a trader who asked not to be identified because the prices are private.

The Japanese Association of Turnaround Professionals, which is mediating Aiful’s so-called alternative dispute resolution process, is forming a group of bankers, lawyers and government officials to study whether talks between companies and creditors on rescheduling debt payments should trigger swap payouts, said Miyako Hara, an executive secretary for the trade group.

The ISDA determination committee was asked on Oct. 9 to rule that swaps linked to Monterrey, Mexico-based Cemex should be paid out after the company agreed with lenders to extend the maturity on about $15 billion of debt for five years.

After four weeks of deliberations, the committee was deadlocked, and the issue will now be decided by an arbitration panel set up by ISDA. The panel will rule in December.

Struggling With Debt

The biggest cement maker in the Americas has struggled to repay debt since shipments started dropping in the second- quarter of 2006, before it paid $14.2 billion in July 2007 for Australian rival Rinker Group Ltd. Cemex has $19.67 billion of debt, according to data compiled by Bloomberg, and is rated B by Standard & Poor’s, five steps below investment grade.

Cemex spokesman Jorge Perez declined to comment.

The cost of credit-default swaps on Cemex surged as high as 1,500 basis points in March, or $1.5 million a year to protect $10 million of debt for five years, according to CMA DataVision, as the price of its 900 million euros of 4.75 percent bonds due 2014 dropped to 38 cents on the euro.

Credit-default swaps are “not a perfect product,” said J. Paul Forrester, a Mayer Brown partner and co-head of its derivatives and structured products practice. “These are difficult questions, and unfortunately as we continue to use this product and explore it we’re going to find that it has these sorts of issues,” he said.

The issue of shariah compliance and the Nakheel sukuk

Posted on FT Alphaville by Izabella Kaminska:

When is a sukuk not a sukuk?

When it fails to be shariah compliant, of course.

And the key issues, it seems, that may or may not make a sukuk shariah-compliant relate to principal protection and the bondholder’s unsecured status.

After all, if there’s one tenet that applies to sukuk bonds more than any other it’s the concept of “no risk, no reward”. The idea of principal protection in that case goes completely against the ethos of Islamic finance.

In the years leading up to the financial crisis, however, sukuk structures became increasingly dependent on mirroring traditional structures in a bid to attract western investors. Clauses, trusts and guarantees were all built in to make them more conventional — especially when it came to protecting the par value of bondholders’ investments and making the certificates unsecured in nature.

Fast forward to 2008, and the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) — the body which maintains and promotes shariah standards for Islamic financial institutions — began to take issue with these quasi-Islamic quasi-Western looking structures.

As the Middle East North Africa Financial Network (MENAFN) reported in April 2008:

The global Islamic capital market, of which the Sukuk sector is the most important, is still reverberating from the recommendations of the Shariah Committee of the Bahrain-based Accounting and Auditing Organization for Islamic Institutions (AAOIFI) relating to current Sukuk structures and their issuance. One scholar reportedly said that 80 percent of current Sukuk structures are not Islamic, a statement which has unfortunately made the headlines the world over.

The developments stem from a meeting of the Shariah Committee of AAOIFI held in Bahrain in February 2008 which issued new recommendations regarding Sukuk structures and issuance especially relating to the ownership of underlying assets in a sukuk transaction and the guarantee of the principle investment to Sukuk certificate holders. The immediate reaction of some bankers has been that the recommendations may put a dampener on the issuance of future sukuk because of these extra ‘constraints’ and thus affect their future tradability.
In April 2009, meanwhile, Sukuk.me — a global provider of sukuk information – reported:
April 2009 Up to US$15 billion (Dh55.09bn) of sukuk, or Islamic bonds, have been shelved since the onset of the financial crisis because the specialised debt instruments became indistinguishablee from conventional bonds, an Islamic banking expert says. New issuance of sukuk had completely dried up because Islamic banks were structuring them incorrectly from the start, said Sohail Zubairi, the chief executive of the Dubai Islamic Bank Dubai Islamic Bank unit Dar al-Sharia, which advises on how to structure Islamic financial products. “We lost at least $10bn to $15bn since the onset of the crisis - I’m talking about the second half of 2008,” Mr Zubairi told Reuters.

Which shows that even a year ago there was already a question mark over the valuation of such pseudo-sukuk products. In fact, Moody’s flagged up the risk in January 2009, attributing the decline in sukuk issuance since the Lehman crisis to this very issue of uncertatinty over compliance. As the ratings agency stated at the time:

“Early in 2008, the Accounting Auditing Organisation for Islamic Financial Institutions (AAOIFI) recommended that Islamic finance market participants should refrain from issuing Sukuk structures that have a purchase undertaking or a guarantee from the Sukuk issuer to repurchase at a specific price at a future date.

This is because AAOIFI believed that this structural mechanism is not compliant with a fundamental principle of Shari’ah, namely profit and risk-sharing,” Mr. Hijazi explains. At the same time, Sukuk issued through securitisation became a mainstream financial vehicle. One of the key fundamental objectives of Shari’ah is asset ownership and the sharing of profit and losses, which are features of many asset-backed Sukuk structures, including Mudarabah, Musharaka and Investment partnership. AAOIFI standards are widely followed (without obligation) across many countries, but are only adopted by Bahrain, Dubai International Financial Centre in the UAE, Jordan, Lebanon, Qatar, Sudan and Syria.

It’s probably worth nothing therefore that Dubai World’s Nakheel sukuk — being both unsecured and principal protected — would in the eyes of the AAOIFI fall under the non-compliant umbrella. (You can read the full terms and conditions underpinning the certificates in the prospectus, which can be found here.)

Indeed, as Maverecon blogger Willem Buiter, an advocate of a ‘true’ Islamic-finance solution to the global crisis, noted back in July:

What we need is the application of Islamic finance principles, in particular a strong preference for profit-, loss- and risk-sharing arrangements and a rejection of ‘riba’ or interest-bearing debt instruments. I am not talking here about the sham sharia-compliant instruments that flooded the market in the decade before the crisis; these were window-dressing pseudo-Islamic financial instruments that were mathematically equivalent to conventional debt and mortgage contracts, but met the letter if not the spirit of sharia law, in the view of some tame, pliable and quite possibly corrupt sharia scholar. I am talking about financial innovations that replace debt-type instruments with true profit-, loss- and risk-sharing arrangements.

Which, of course, echoes the quest we’ve seen from the European Union to impose some burden sharing on bondholders in the crisis too.

In that case, is it really that surprising that Dubai — perhaps under pressure from Abu Dhabi — is keen on a little burden-sharing of its own? This is especially so if one assumes legal proceedings held in the UAE would likely side with the views of the AAOIFI, potentially rendering Nakheel’s certificates unlawful and unenforceable.

What’s more, Nakheel’s own prospectus says that it’s only because the issuer waives his immunity from UAE law that the bond guarantees par value at all.

Yet as the prospectus also warns:

The Declaration of Trust is governed by English law and is subject to the non-exclusive jurisdiction of the English courts. The laws of the Emirate of Dubai and (to the extent applicable in the Emirate of Dubai) the federation of the UAE (UAE law) do not recognise the concept of trust or beneficial interests and, accordingly, there is no certainty that the terms of the Declaration of Trust would be enforced by the courts of Dubai. The concept of agency is, however, recognised under UAE law.

Which leaves us to wonder whether this whole Dubai World standstill is actually the beginning of a much wider pseudo-sukuk related case?

The Nakheel sukuk, after all, is just the the tip of the iceberg when it comes “out of the money” sukuks currently in the market place.

China Creates Derivatives Clearinghouse

Posted in the Wall Street Journal by Denis McMahon:

China launched a new body to centralize settlement and clearing of financial products traded among the country's banks, in a move that could bolster confidence in China's derivatives markets and open the way for the regulators to approve new products.

The move, announced by the central bank over the weekend, comes as the U.S. and the European Union have also been trying to centralize trading of some derivatives in their markets, to prevent markets seizing up if a key player defaults as they did when Lehman Brothers filed for bankruptcy last year. A central clearing body removes some of the risk that counterparties won't deliver and makes the overall market situation more transparent to regulators.

China's strict capital controls meant its markets weren't directly affected by last year's financial turmoil. But the financial crisis greatly shook the trust that Chinese banks had in their foreign counterparts, and China's largest lenders even now decline to trade key products with the local units of most foreign banks.

That has increased the expense and reduced the liquidity in China's interest-rate and foreign-exchange swaps markets. Those are the country's two main financial derivative products and key tools for companies trying to manage their foreign-exchange and credit risks.

By inserting itself between counterparties trading those products, a central clearinghouse would assume the risk that either party might default, and take insurance against that happening by collecting collateral from each party.

There are few details as to how the new clearinghouse will actually work. In a statement posted on its Web site Saturday, the People's Bank of China said the Shanghai-based clearinghouse will clear local- and foreign-currency financial markets, but didn't specify which markets it will start with or when.

The clearinghouse will "raise the transparency of the interbank market...better guard against systemic risk, and maintain the stability of the financial system," People's Bank of China Governor Zhou Xiaochuan said in a separate statement. Mr. Zhou said it also will reduce settlement costs and "provide the necessary technical support for financial products innovation."

That may signal that regulators feel the new clearinghouse will give them better ability to handle more volatile and heavily traded markets. So far China has been slow to introduce new financial products, with their reservations about derivatives reinforced by the financial crisis.

One possible concern is the lack of experience any Chinese government institution has in calculating risk and assessing appropriate levels of collateral to collect, given the huge amount of risk clearing centralizes in one organization.

The PBOC statement said the clearinghouse has signed a cooperation agreement with Deutsche Börse, which owns the Eurex derivatives trading platform and operates clearinghouses for exchange and over-the-counter products..

In June, China's foreign-exchange trading platform, the China Foreign Exchange Trade System & National Interbank Funding Center, launched central counterparty clearing for the foreign-exchange spot market. The move was somewhat unusual by global standards, because the two-day settlement period for foreign-exchange deals in China diminishes the risk of default. Market watchers said the move was likely to build experience to help guard against default in markets with longer maturities.

The foreign-exchange trading center is one of the six government agencies, also including the central bank and the Ministry of Finance, backing the new clearinghouse. It will have 300 million yuan ($43.9 million) of registered capital, the central bank said.

Sunday, November 29, 2009

LCH.Clearnet needs clear path to Washington

Posted in the Financial Times by Jeremy Grant:

In recent weeks an executive at LCH.Clearnet has been shuttling back and forth from the clearing house’s headquarters in a drab London office block to Washington DC.

For a business that has its roots acting as a clearer for the London coffee markets of the 19th century, this may seem like a distraction.

But as the business of clearing moves centre stage while regulators move to clean up the financial system, having an ear on the ground in the US capital is crucial. US politicians are busy making laws that will reshape the structure of the global over-the-counter derivatives markets – and clearing is central to that.

A clearing house stands between two parties to a trade, guaranteeing that a transaction is completed even if one party defaults. The lack of such a mechanism in most of the OTC markets prior to the Lehman Brothers default was one reason why shockwaves were sent through the financial system.

The big idea that has gripped the imagination of politicians is to insist on more clearing, so that if there are future shocks, the systemic ripple effects can be limited.

But the sometimes tortuous process of producing legislation in the US Congress has reached a crucial stage, with final legislation possible early next year.

That makes it critical that LCH.Clearnet, Europe’s largest independent clearing house and already a big clearer of OTC derivatives, has a voice in the corridors of power. And the air miles being clocked up by its executive show how the big players, from exchanges to clearers to the big banks active on the OTC markets, are muscling in on the process.

For Roger Liddell, the clearer’s chief executive, the machinations of US politicians have already caused relief and anguish in equal measure.

He is “delighted” that Barney Frank, powerful chairman of the House of Representatives’ financial services committee, changed his mind last week on whether OTC foreign exchange contracts should be exempted from clearing. Mr Frank now believes they should be cleared, altering a key bill accordingly.

Mr Liddell sees this as an opportunity. His focus is now on expanding further into OTC derivatives clearing – with FX clearing a top priority, and plans for OTC equity derivatives next on the list.

Key developments

1888: The London Clearing House is established to clear commodities contracts in London

1980: Ownership of LCH passes to a consortium of six British banks

1987: LCH starts clearing for the London Metal Exchange

1996: Introduction of clearing for cash equities

1999: LCH subsidiary SwapClear clears the first OTC interest rate swaps. RepoClear, an OTC fixed income clearing service, is launched

2003: LCH.Clearnet Group is formed following the merger of the London Clearing House and Clearnet SA

2006: Roger Liddell becomes chief executive

2009: LCH.Clearnet streamlines shareholder base

“We are very keen to develop foreign exchange clearing – options and forwards. So that’s a big initiative for 2010,” says Mr Liddell, a former Goldman Sachs head of global operations who spent half his career immersed in the unglamorous post-trade services that underpin much of the world’s trading.

Mr Frank’s change of mind alarmed the FX community, some of which believes that the FX derivatives market is so big that clearing it would concentrate too much risk in clearing houses.

But as much as Mr Frank’s change of mind on FX was a gift for LCH.Clearnet, another issue on his desk could prove a nightmare.

One idea being bandied around Congress is that banks should not be allowed collectively to own more than 20 per cent of a clearing house.

Its backers argue that if banks could control a clearer, they might be able to design OTC contracts in such a way that they dodge legal requirements that they be cleared. The non-cleared OTC markets have hitherto been lucrative for dealers at the banks and there are concerns that clearing could crimp those profits.

For LCH.Clearnet, the inclusion of any such threshold in US legislation would be a disaster. Under its new shareholder structure, it is owned 83 per cent by banks active in the OTC markets – in effect disqualifying it from operating in the US.

Yet Mr Liddell has plans to expand in the US. Industry observers suspect that rival clearing businesses are lobbying Washington lawmakers in favour of the threshold. Nasdaq OMX is building an interest rate swaps clearing business that would compete with LCH.Clearnet’s SwapClear swaps clearing business.

Mr Liddell admits that any proposal to limit bank ownership of a clearer “could be a problem for us, and we are obviously hoping that it won’t get through to the legislation”.

He also dismisses the idea that banks in the OTC markets would be reluctant converts to clearing in any case.

“The strange thing is it seems there are people who believe that there is some reluctance on behalf of some of the banks to have this stuff cleared. We just don’t see that.

“The fact of the matter is we want to clear more types of activity, our customers want to clear more types of activity, the regulators and politicians want us to clear more OTC derivatives. So I am not sure who’s resisting it.”

LCH.Clearnet’s need to focus on Washington has come just in time. For the past year it has been distracted by uncertainty over its future ownership.

Last week the clearer drew a line under this by re-organising its shareholder base, and seeing off a potentially hostile bid from a consortium of banks active in the OTC markets, together with Icap, the inter-dealer broker. A bid from The Depository Trust & Clearing Corporation, the nearest, and much larger, equivalent to LCH.Clearnet in the US, has also come and gone.

But Mr Liddell, who spent 10 years in the British coal industry – even running a coal mine during the country’s famous miners’ strike of the 1980s – says: “Because of where we sit, because of what we’re involved in we’re always going to be involved in different conflicts, different tugs of war, things like that. It sort of comes with the territory.”

Friday, November 27, 2009

Keeping Derivatives in the Dark

Posted in the New York Times by Floyd Norris:

Opaque markets breed insider profits and abuse of investors. Sunshine can bring competition and lower costs even if regulators do little beyond letting the sunlight shine.

You might think that as Congress considers just how much regulation is needed for the shadow financial system — the one that largely escaped regulation in the past — letting in such light would be an easy and uncontroversial move.

But it is not proving to be easy at all, and is one part of the Obama administration’s financial reform package that is most in jeopardy.

Timothy Geithner, the secretary of the Treasury, will testify before the Senate Agriculture Committee next week in an effort to hold on to important provisions of the proposal that have come under attack by banks fearful of losing one of their most profitable franchises — the selling of customized derivatives to corporate customers. Remarkably, the banks have persuaded customers that keeping the market for those products secret is in their interest.

Last week, Gary Gensler, the chairman of the Commodities Futures Trading Commission, faced the same panel, and ran into questions that indicated at least some senators were sympathetic to efforts to keep large parts of the derivatives market in the dark.

Those markets allow companies to bet on — or, if you prefer, hedge themselves against losses from — changing interest rates and commodity prices. They also allow investors to use credit-default swaps to bet on whether a company will go broke. The administration wants to standardize those products when possible, and force the trading of them onto exchanges when possible.

Banks want to whittle away the reforms if they can, and to minimize the roles of the C.F.T.C. and the Securities and Exchange Commission, experienced market regulators who have been generally kept away from over-the-counter derivatives in the past. Instead, the banks would like to leave it to banking regulators to oversee the dealers, something regulators totally failed to do in the past. Unless Mr. Geithner can persuade legislators otherwise, one of the great bank lobbying campaigns will have succeeded, in large part because some companies that buy derivatives from banks have been persuaded that their costs will rise if needed reforms were made.

The opposite is probably true. The history of nearly all markets is that customers suffer if dealers are able to keep them ignorant of what is actually going on.

Until the beginning of this decade, that was true in the corporate bond market, where actual trades were kept confidential. That made it easy for bond dealers to charge big markups when they sold bonds to customers.

After regulators forced timely disclosures, the bid-ask spreads — the difference between what customers paid when they bought bonds and what they could get when selling them — declined significantly. The result was smaller profits for bond dealers, and better returns for bond investors.

“It is now time,” Mr. Gensler testified, “to promote similar transparency in the relatively new marketplace” for derivatives traded over the counter.

“Lack of regulation in these markets,” he added, “has created significant information deficits.”

He listed “information deficits for market participants who cannot observe transactions as they occur and, thus, cannot benefit from the transparent price discovery function of the marketplace; information deficits for the public who cannot see the aggregate scope and scale of the markets; and information deficits for regulators who cannot see and police the markets.”

In the listed markets for derivative securities, like futures, there are margins that must be posted every day if markets move against the buyer of the derivative. Corporate customers of over-the-counter derivatives fear that they might face similar margin requirements if their contracts were to be traded on exchanges, and have persuaded some legislators that would be horrible.

Of course, because prices aren’t made public, we can only hope that the banks currently are pricing the credit at reasonable levels. The banks say they are. Robert Pickel, the chief executive of the International Swaps and Derivatives Association, an industry group, assured me this week that “the cost of credit is taken into account in the collateral relationship and in the bid-ask spread.”

In layman’s terms, that means that customers with worse credit would face different prices than customers with excellent credit, which Mr. Pickel argued would make price disclosure of limited value.

Mr. Gensler, the C.F.T.C. chairman, argues that customers would be better off if the two markets — for the derivatives and for the credit — were separated and had clear pricing. “How else,” he asked in an interview, “can customers know if they are getting fair prices?”

Remarkably, big corporations like Boeing, Caterpillar and many others that use derivatives to hedge risk have been persuaded by bankers that they should not worry about that.

If over-the-counter derivatives were to be traded on exchanges, or centrally cleared, or subject to margin requirements, a host of corporate trade associations and companies said in a recent letter to legislators, such reforms “would inhibit companies from using these important risk management tools in the course of everyday business operations. These proposals, which would increase business risk and raise costs, are at cross purposes with the goals of lowering systemic risk and promoting economic recovery.”

Reflected in that letter is a belief that the banks, in designing and selling derivatives to customers, are acting as trusted advisers, looking out for the best interests of their customers. Every so often, one of these deals blows up and winds up in court. Then the banks argue that they were simply counterparties, with no responsibility for the wisdom, or lack of same, shown by the customers.

If, as seems likely, Congress chooses to eliminate or minimize the disclosure of customer trades, and if it allows custom derivatives to remain almost completely opaque and without visible pricing of credit, that will encourage some corporate customers to prefer customized contracts. Such contracts will probably cost them more, but the cost of credit will be hidden, and they may not have to post collateral immediately if they are losing money.

For Mr. Geithner, this legislative battle may indicate whether he still has the ability to persuade legislators, or whether he has become the political liability that at least some Republicans think he is. When he ventured to Capitol Hill earlier this month, one congressman suggested he should resign.

If Mr. Geithner is vulnerable, it is because the efforts of the administration and the Federal Reserve to save the banking system worked too well. The fears of collapse that were present early this year have faded away, and been replaced by a general feeling of resentment.

The banks seem to be on the verge of harnessing that feeling of resentment to preserve a major profit center. In terms of lobbying, it will be a remarkable achievement.

Financial crisis could be positive for securitisation in Asia

Posted on FinanceAsia.com by Fabienne Michaux:

The availability of cheaper and easier financing alternatives and the diverse market environment are impeding the growth of securitisation markets in the region, but there are signs of change, argues Standard & Poor's.

From Shanghai to Sydney, the Asia-Pacific region contains a rich tapestry of diverse cultures and economies. The spectrum is also broad in terms of each country's sovereign creditworthiness, economic development, and market sophistication.

While some countries possess legal and regulatory structures to support domestic and cross-border securitisation markets, relatively few have well-developed capital markets by international standards, and fewer still have the legal framework, stability, scale, and operational infrastructure to support vibrant and stable securitisation sectors.

Although data on the aggregate size of the securitisation markets in Asia-Pacific is not readily available, in the below table we estimate the current securitisation outstandings by country.


Despite a strong history of trade cooperation and agreements within the region and beyond, Asia-Pacific's domestic capital markets are fragmented. Consequently, Asia-Pacific investors have tended to look to the US and European markets for investment opportunities rather than to their own region. Standard & Poor's Ratings Services believes these factors impede the growth and recovery of individual securitisation markets, as well as efforts to foster greater regional cohesion.

However, we also believe the global financial crisis, a growing sense of independence and confidence in the region, increasing wealth, and a desire by several policy-makers to foster greater regional cohesion may spur changes that will improve the region's long-term prospects for greater integration of capital markets and the ongoing development of securitisation markets around the region.

The impact of the global financial crisis

The impact of the global financial crisis on individual countries has underscored the diversity of Asia-Pacific's securitisation markets. The effects vary both by nature and degree among the individual markets, with the most pronounced occurring in securitisation markets with the following characteristics:

  • Markets with heavy reliance on cross-border investors and, in particular, structured investment vehicles (SIV)/conduit investors -- for example, Korean cross-border transactions and Australian residential mortgage-backed securities (RMBS);
  • Sectors where foreign banks dominate securitisation activity. After the crisis, a few of these banks have scaled back or exited noncore markets -- for example, the Japanese conduit commercial mortgage-backed securities (CMBS) sector;
  • Sectors where securitisation was the predominant source of funds -- for example, the Australian non-bank RMBS sector and Japanese conduit CMBS sector; and
  • Jurisdictions where government interventions to protect and stabilise the banking systems had broader unintended consequences for securitisation. This was most pronounced in Australia.

And yet, the credit performance of most Asia-Pacific securitisation transactions remains sound. In our opinion this reflects several factors:

The relative strength of banking systems and asset quality in the region leading into the global financial crisis

The Asia-Pacific countries have endured and recovered from several shocks to their financial systems in the past few decades, leading to significant structural reforms in many of the region's financial markets. These events include Australia's recession in the early 1990s, which revealed significant credit quality issues in several banks; the 1997/1998 Asian financial crisis; Korea's credit card crisis in 2003; and Japan's decade of restructuring following the bursting of the 1990s asset price bubble.

As a result of these events, the region's banks recapitalised, improved risk management and credit systems, and maintained higher credit quality through the most recent credit boom relative to their US and European counterparts. In particular, subprime lending comprised a negligible proportion of regional banking assets.

The performance of Asia-Pacific's economies relative to other regions

The economic deterioration started later in Asia-Pacific than in the rest of the world, providing a strong performance buffer for a large proportion of the region's amortising transactions, which have relatively short weighted-average lives and sequential payment structures. In addition, the slowdown was shallower and the recovery started earlier than in the US and Europe.

Further, lower interest rates resulting from looser monetary policies have, to a certain extent, alleviated the financial stress among borrowers and offset the impact of modest rises in unemployment on delinquencies and default rates of consumer portfolios.

The nascent state of Asia-Pacific's securitisation markets

Asia-Pacific's securitisation markets are relatively less mature and lack the depth and scale of markets in the US and Europe. Further, the Asian cultures are far more traditional in their use of credit, demonstrated by their very high savings rates. As a consequence, only a small proportion of securitisation transactions in Asia-Pacific comprise highly leveraged loans, or loans to lower credit-quality borrowers, who are most vulnerable to performance issues when economic conditions deteriorate.

Further, reflecting the lack of market depth, scale, and maturity, transaction structures remained quite straightforward. For instance, very few transactions relied on the ability to resell assets in a liquid market to repay noteholders.

The path to recovery and growth may not be easy

Each market within the Asia-Pacific region may have to forge its own path to recovery and growth, depending on local conditions. In our opinion, this process may not be easy, due to the region's longstanding challenges to the development of securitisation. In addition, the extent and timing of global and local regulatory and market developments in response to the global financial crisis will likely play a part, as uncertainty around the scope and timing of these developments and their impact on securitisation markets may stall recovery efforts.

Asia-Pacific's domestic banking systems are highly competitive, with a strong emphasis on relationship banking. Further, high savings rates in most markets (except in Australia and New Zealand) provide banks with a low cost, stable base from which to fund lending, as the savings comprise predominantly bank deposits. This reduces the impetus of the banks to use securitisation to diversify and/or increase their funding bases.

Indeed, for many potential issuers of securitised products in Asia-Pacific, securitisation is not a necessity. For instance, Hong Kong, which has one of the most developed and international capital markets in the world, has had only a nascent securitisation market for years due to easy availability of competitive bank financing. For individual securitisation markets to grow and prosper, in our opinion, securitisation would need to provide a compelling value proposition relative to other funding sources.

The region comprises countries with distinctive and diverse cultures, different stages of economic development, sovereign credit quality, currencies (several of which are not widely traded in foreign exchange and swap markets), regulatory environments, and legal systems. Legal precedent is scarce for securitisation issues, and without the ability to write legislation to facilitate securitisation, these obstacles add layers of complexity for issuers and transaction participants, and increases time and costs of execution. For investors considering some of these newer markets, it may be too demanding to invest the time and effort to understand the complexities of an individual market if they aren't certain they'll be rewarded with a flow of ongoing opportunities in the future.

With the exception of Australia and New Zealand, historically Asia-Pacific's securitisation markets have been opaque. However, a growing global emphasis on market transparency, led by the International Organisation of Securities Commissions (IOSCO), may help to change this. Initiatives are underway in the US (Project Restart) and in parts of Asia-Pacific. For instance, Japan's Securities Dealer Association introduced the SIRP, or Standardised Information Reporting Package, on June 1, 2009, to help improve transparency and comparability among transactions.

While global and local policy-makers are developing and implementing various reforms, the ultimate impact of specific changes, as well as the combined effect of the myriad of local and global reforms, remains uncertain. We believe it will likely take well into 2010 for the implications of many of these significant changes on the design of, and future demand for, securitisation products to become more apparent.

Nevertheless, it's likely that for as many doors that close, others will open. We believe securitisation can and will continue to provide valuable contributions to the credit creation process, risk management, and funding diversification needs and imperatives of issuers, investors, and policy-makers.

Catalysts of change may drive greater regionalisation

Despite these challenges to recovery and growth, changes seem to be emerging across the region. A noteworthy one is the rise of Asia-Pacific as an economic power. The region has become a significant global force in terms of the world's investable funds, and it's home to two of the world's economic growth engines, China and India. This has fueled a growing sense of independence and confidence.

Asia-Pacific investors are also significant holders of US securitisation in particular and as a result of the crisis some of these investors are beginning to rethink their strategies to include a more regional focus. In our opinion, this might be evidence of a positive effect from the global financial crisis on Asia-Pacific, especially when it comes to the future development of its domestic capital markets, securitisation capability, and greater regional integration of its financial markets.

With increasing intra-regional trade and investment flows, and the push by regional policy-makers toward closer integration of business and capital markets, over time, regional investors are likely to encounter a broader cross-section of asset classes and currency opportunities for investment. These options may become an attractive alternative or a complement to investments in their own markets, and the larger US and European markets. In the long term, regional investors may be able to construct diverse regional fixed-income portfolios, which may lead to shifts in investment styles.

In our opinion, Asia-Pacific's more established securitisation markets will likely recover, reinvent themselves, and find new ways to bring value and opportunity to investors, issuers, markets, and economies in the region. For instance, this year brought the first covered bond issue in Asia by Korea's Kookmin Bank. For the less developed emerging markets, continued efforts of policy-makers and a compelling value proposition emerging for securitisation in those markets will, in our opinion, be needed to underpin development and growth of those markets.

Commitment and collaboration are key

Restoration of investor confidence in securitisation markets is at the core of recovery and future growth in the sector. While time is a healer, the region also needs to take tangible steps to help boost investors' confidence in securitisation and to foster increased regional collaboration to develop Asia-Pacific's securitisation markets. In our opinion, such steps need to focus on:

  • Improved transparency, standardisation, and access to documentation, data, tools and models to help investors make more informed investment decisions with less reliance on rating agencies;
  • Clarity, harmonisation, and/or mutual recognition between global securities regulators, bank regulators, and accounting standard setters;
  • Increased education about securitisation products to better inform potential investors of their relative strengths and risks;
  • Increased coordination between industry bodies to understand local and regional investor preferences and needs in terms of transparency as well as asset and structural preferences;
  • Ensuring that securitisation markets in Asia-Pacific are up-to-date with global regulatory and industry standards and developments, so as to keep the door open to global markets and investors when the markets pick up, which we believe will inevitably occur;
  • Ensuring the simplicity, quality, and performance of new issues, because, in the long run, performance will speak for itself; and
  • Ultimately striving for an ideal state where regulatory safeguards provide protection without stifling innovation, and the short-term benefits of leverage and cheap funding are balanced against longer-term stability and sustainability.

The broader market fundamentals and drivers in each country, as well as policy-makers' aspirations, may provide clues as to how and where securitisation may emerge more strongly. They may also identify areas where the financial industry and policy-makers can work together to innovate and address market gaps. If they sustain a commitment to change, we believe greater collaboration will draw countries toward each other, and attract regional investors to new opportunities.

In our opinion, securitisation will be a viable funding, risk-management, and debt-structuring technique for Asia-Pacific companies and financial institutions, while at the same time providing more fixed-income investment opportunities to regional investors.

The author of this article, Fabienne Michaux, is a managing director of structured finance for Asia-Pacific at Standard & Poor's.

CDS changes considered in wake of Thomson restructuring

Posted on Risk.net by Mark Pengelly:

After a series of difficulties hit auctions to cash-settle credit derivatives referencing French media firm Thomson last month, dealers are considering making further changes to the European credit default swap (CDS) market.

Any alterations would follow the small bang protocol earlier this year, which changed the mechanism for dealing with restructuring credit events to make them compatible with central clearing. Thomson is the first restructuring to have occurred under the small bang protocol and was billed as the first real test of the new rules. But aspects of the auction didn’t work as smoothly as dealers had hoped.

“It was a lot of work. I can assure you people around here were glad to see the back of it,” remarks one senior London-based credit derivatives banker.

Thomson was a widely traded CDS reference entity and featured in many of the off-the-run Markit iTraxx credit derivatives indexes – including series 1-7 of the iTraxx Europe credit derivatives index, series 4-7 of the iTraxx Europe HiVol index and series 8-11 of the iTraxx Europe Crossover index. It was also heavily referenced in the structured credit market, ranking as the fourth most popular component of corporate synthetic CDOs in the US, according to a study by New York-based Standard & Poor’s in December 2008.

However, €1.1 billion of the company’s €2.839 billion in debt was privately placed, leading to confusion among trading desks and the organisers of the cash-settlement auction. A final list of deliverable obligations for the auctions was not published until almost eight weeks after a credit event was announced at the firm. Meanwhile, with no idea of where the company’s bonds were trading, market participants were unable to determine potential recovery rates.

In line with market changes brought in by the small bang, three separate auctions were held on October 22 for contracts of varying maturities: a two-and-a-half-year bucket, a five-year bucket and a seven-and-a-half-year bucket.

Prices of 65.125 and 63.25 were set for the five-year and seven-and-a-half year auctions, respectively. But the low volume of deliverable debt at shorter maturities skewed the outcome of the two-and-a-half-year bucket, which settled at 96.25. The result surprised market participants, and has caused some to call for the removal of restructuring as a credit event altogether.

“It does raise questions about the future of restructuring as a credit event in Europe. My guess is that banks will try to make restructuring a hard credit event in future,” says a London-based credit derivatives head at a large European dealer.

At the moment, restructuring does not automatically trigger most European CDSs, instead giving buyers and sellers of protection the option to trigger their contracts. Furthermore, the maturity of bonds that can be delivered into the CDS varies depending on which side triggers the CDS – something that further complicated the Thomson credit event.

Other market participants have proposed removing limits on the maturity of debt that can be delivered into CDS contracts, which would mean having a single auction for a wide variety of maturities. This would simplify the process and reduce the possibility of a squeeze in shorter-maturity buckets, as happened with Thomson. But dealers believe it would leave the process open to abuse, allowing protection buyers to deliver cheap long-dated debt – as occurred with Indiana-based life insurer Conseco in 2000.

Sellers of CDS protection have two days to trigger contracts after the final list of deliverables is published, while buyers of protection have five days. In the run-up to the final deadlines, dealers say they tried to trigger contracts as quickly as possible to ensure the process went smoothly. Nonetheless, last-minute triggering still posed a problem as dealers attempted to ensure they kept hedged books, says Guy America, London-based head of European credit trading at JP Morgan. “People smartly started triggering early, so a lot of that rush was avoided. But you did see people triggering at the last minute, often reacting to triggers they received themselves.”

As a result, dealers are keen to implement conditional triggers. This would mean nominating certain CDSs that banks would like to automatically trigger if other CDSs are triggered against the bank. A similar method was used to tear up offsetting trades on Thomson prior to the auctions. Run by Stockholm-based technology vendor TriOptima, the portfolio compression cycle eliminated $19.6 billion in single-name CDS notional. If conditional triggers were used more broadly, dealers believe this would eliminate a much greater volume of trades and help resolve the problem of last-minute triggers.

Other suggestions made in response to Thomson include preventing reference entities with thinly traded debt from being included in the major credit derivatives indexes.

Dealers caution that any discussions about market changes are unlikely to happen until at least the first quarter of 2010. An International Swaps and Derivatives Association working group is already looking into improvements for the treatment of index tranches – another issue that proved particularly problematic for Thomson due to its heavy inclusion in the indexes.

Providers group to form official UK structured products body

Posted on Risk.net by Sylvia Morrell:

A total of eight structured products providers have signed up to create the UK Structured Products Association (UK SPA), a formal trade association for the industry. The group counts six major providers among its members: Royal Bank of Scotland, Citi, Santander, Credit Suisse, Morgan Stanley, Skandia, Legal & General and Prudential.

The confirmation of the line-up comes after weeks of speculation over which institutions would be included, and months of behind-the-scenes negotiations among providers.

"The creation of the UK SPA is a unified response from the members who believe that whilst structured products form an increasingly integral part of financial planning for investors, they are sometimes misunderstood and misrepresented, and that any lack of understanding can and should be addressed," says the SPA. It underlines that its role is not to promote individual firms or products, and says it will provide independent comment to media organisations. Spokespeople will be anonymous.

Third-party plan managers have their own advisory committee within the body, which includes Gilliat Financial Solutions, Jubilee Financial Products, Meteor Asset Management and Walker Crips Structured Investments.

Additionally, the organisation is working with the Association of Independent Financial Advisers (AIFA), which endorsed the new body today. "AIFA supports the launch of this initiative, which will help ensure all participants in this market are continually better informed," says Robert Sinclair, AIFA director.

The inclusion of third-party providers and the AIFA has invalidated initial accusations from some industry participants that the organisation was too exclusive because it would only include banks and insurers. "In this set-up we feel we have most of the significant parties who have some interest in structured products represented in some way," says its spokesperson.

The new association will also be working in co-operation with the European Structured Investment Products Association (Eusipa), says a spokesperson for the SPA, but it will not be joining as a full member of Eusipa for the time being.

The news comes a day after the US Structured Products Association announced it would be opening a London branch, after reaching 1,000 UK members.

"Post-Lehman, we received a significant spike in interest in building out our UK chapter from independent financial advisers, distributors and personnel at the issuing firms," says Keith Styrcula, the New York-based chairman of the US Structured Products Association (also known as the SPA). "Over the last six months, we discussed having a physical presence in London, and several key people in the UK agreed. We decided we could open an office only if we had critical mass of 1,000 members in the UK, a goal we reached last month."

Styrcula adds that he is looking forward to working with the new association in the same way it works with other trade organisations in the US.

The body was the subject of debate at yesterday's Structured Products Europe Conference.

Speaking at the event in London, Colin Dickie, a director of Barclays Capital Investor Solutions said he was "sceptical" about the rumoured association. "The ability to form ourselves into an organisation that is able to fight our corner and have the time to do our day jobs, I am sceptical about," said Dickie. "It's a fragmented market and I need to be convinced it's something we can devote time to," he later added. However, Dickie also said he was open-minded.

Other delegates said a trade association was a positive development that would help the industry tackle negative perceptions about structured products in the financial press.

Monday, November 23, 2009

SEC to Focus on Derivatives as Insider Probes Expand

Posted on Bloomberg by David Scheer and Joshua Gallu:

The U.S. Securities and Exchange Commission will focus on financial instruments such as derivatives as it broadens a crackdown on insider trading by hedge funds, enforcement director Robert Khuzami said.

“The days of insider-trading scrutiny being focused almost solely on the equity markets are now gone,” Khuzami said today at a New York legal conference on hedge-fund regulation. After bringing its first insider trading case tied to credit default swaps in May, the SEC will “roll back the curtain on those markets and look at patterns across all markets,” he said.

Insider trading has become “systemic” behavior in the hedge-fund industry and the SEC is working with criminal authorities to ferret out misconduct, Khuzami said this month. Billionaire Raj Rajaratnam and his New York-based Galleon Group are among more than 20 people and firms the agency has sued since Oct. 16 in its probe of hedge funds.

The SEC brought its first insider-trading case tied to credit-defaults swaps in May, when it sued a Deutsche Bank AG salesman on claims he illegally fed information on a bond sale to a hedge-fund money manager. Prices on credit-default swaps, which insure investors against bond defaults, have surged before corporate takeovers in recent years, fueling speculation that traders are abusing inside information. The SEC has said since at least 2007 that it’s examining the trades.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. The contracts, typically expiring after five years, pay if a borrower fails to meet obligations.

Khuzami, in an interview today, declined to say whether the SEC has any current insider-trading investigations involving derivatives.

Confidential Tips

Rajaratnam and his accomplices were part of a network that shared confidential tips on at least 10 companies, including Google Inc., Hilton Hotels Corp. and Intel Corp., investigators said last month. Rajaratnam and other defendants have denied wrongdoing.

The lawsuits, based in part on wiretaps and years of data- mining, allege that hedge-fund managers and traders obtained tips, sometimes in exchange for payment, on corporate deals and earnings that generated as much as $53 million in illegal profits.

Khuzami, a former federal prosecutor who joined the SEC in March, is adding front-line investigators, speeding inquiries and creating specialized units after the agency was faulted for missing Bernard L. Madoff’s Ponzi scheme. He’s also seeking to bolster his attorneys’ powers by gaining greater access to grand-jury evidence and expanding deal-making and cooperation with informants.

Chinese regulators clamp down on derivatives

Posted in the Financial Times by Robert Cookson, Patti Waldmeir and Jamil Anderlini

When, at the beginning of 2008, Antoine Castel took control of the fixed-income unit in Beijing of Calyon, the investment banking arm of Crédit Agricole, the world’s biggest banks were making fat profits in China’s nascent derivatives markets.

But just weeks into his new job at the French bank, Mr Castel watched in horror as Chinese companies began to lose billions of dollars on the bespoke trades they had struck with western dealers. It was the start of a chain reaction that this summer unleashed a fierce backlash from regulators and local banks.

In stark contrast to the slow pace of reform in derivatives markets in the US and Europe, China’s regulators have in recent months shut down the main route by which foreign banks sold derivatives from offshore operations and have banished speculative deals – moves that have important implications not only for Chinese companies and foreign banks, but also for the evolution of China’s capital markets and the internationalisation of the renminbi.

As a result of the sweeping regulatory overhaul, trading volumes have plunged and foreign banks are scrambling to adapt to doing business in the new environment. “If you compare the business we are doing today with the business we were doing two years ago, it’s completely different,” says Mr Castel. “You have to forget about [the old] market. It’s gone.”

Previously, dozens of western banks such as Goldman Sachs and Morgan Stanley were striking huge deals with mainland companies that wanted to manage their exposure to swings in commodity prices, interest rates and currencies.

In two cases where trades went spectacularly wrong, Citic Pacific, the Hong Kong-listed arm of China’s largest investment conglomerate, lost $1.9bn last year on bets against the Australian dollar, while Air China, the country’s flag carrier, lost $1.1bn on oil derivatives.

They were just two of hundreds of companies that entered trades that were wildly mismatched with their hedging requirements, market participants say.

Chinese regulators suspect that in some instances companies used derivatives as a way to speculate, rather than hedge, while banks frequently sold overly complex products – the most profitable – without fully explaining the potential downside.

Products with names such as “snowballs” and “snowblades” proliferated, many with so-called “zero cost” structures that failed to live up to their name. Dealers say billions of dollars of trades are being renegotiated in private, some under pressure from Sasac, the shareholder and regulator of hundreds of state companies.

Total trade volumes have more than halved since a year ago, say market participants. Complex trades have vanished from the market.

“We are selling plain vanilla business in China, that is it,” says Mr Castel.

Deals that banks were once able to complete in five minutes over the phone now take an hour as the risks are explained in detail, says Mark Wightman of Super Derivatives, a data provider. The biggest shock to the established order came this summer when the China Banking Regulatory Commission banned most of the trades that can be originated offshore.

Until recently, almost all derivatives deals between foreign banks and China’s industrial and commercial companies were struck overseas, typically in Hong Kong. To surmount obstacles including foreign exchange controls that made it difficult to trade with Chinese companies directly, overseas groups would typically get mainland banks to stand in the middle of each deal for a fee. These “intermediary trades” also allowed those overseas groups to minimise their credit risks by dealing with a small number of big banks rather than dozens of more risky companies.

For the Chinese banks, however, acting as middlemen proved less advantageous. When the crisis struck in 2008, they were forced to provide their foreign trading partners with vast amounts of collateral, but were unable to recover nearly as much money from the local companies on the other side of each trade.

Regulators are said to be furious that local banks got into such a vulnerable position and enabled offshore groups to use “suitcase salesmen” to do business on mainland soil.

As well as banning the practice of intermediary trades, the CBRC now requires that banks ensure clients only buy derivatives that are appropriate for their hedging needs. The rules make it “virtually impossible to do some of the hairier trades and will really chill the market for anything but vanilla trades in future”, says Fred Chang, an industry veteran who now works for the law firm Lovells in Beijing.

In spite of grumbling among some bankers, most market participants believe that the regulations, while a stumbling block for the time being, are necessary foundations for the growth of a market that traders expect to be enormous within a decade.

David Liao, head of global markets at HSBC China, says the rules would be “a short-term sting in terms of revenue” but would be helpful over the longer term.

But regulation is only the start of the problems for many western groups. The Chinese banks that dominate onshore trading have grown more assertive and are demanding that foreign banks play by their rules.

The big four state-owned commercial banks are refusing to deal with the local operations of foreign banks unless they provide contractual guarantees on the trades from their global headquarters.

Foreign banks are reluctant to provide these guarantees or other concessions being demanded because it would lead to higher capital charges, and they fear it would trigger a cascade of similar demands from banks across the world.

As a result of the stalemate, a two-tier system has emerged, with foreign banks trading almost exclusively among themselves, while local banks do the same. Most market participants expect a solution to the deadlock to emerge in time, most likely with foreign banks backing down on their positions. More­over, at some point the trading books of the Chinese banks will reach bursting point and they will need to offload their risks to their western peers.

What is clear is that foreign banks, while bruised, are unwilling to let either regulatory clampdown or local competition drive them out of the market. As one western banker in China says: “You have to be in this market. You can’t afford to stay out of it.”

Friday, November 20, 2009

IMF Paper on Credit Derivatives: Systemic Risks and Policy Options

By John Kiff, Jennifer Elliott, Elias Kazarian, Jodi Scarlata and Carolyne Spackman:

Abstract: Credit derivative markets are largely unregulated, but calls are increasingly being made for changes to this "hands off" stance, amidst concerns that they helped to fuel the current financial crisis, or that they could be a cause of the next one. The purpose of this paper is to address two basic questions: (i) do credit derivative markets increase systemic risk; and (ii) should they be regulated more closely, and if so, how and to what extent? The paper begins with a basic description of credit derivative markets and recent events, followed by an assessment of their recent association with systemic risk. It then reviews and evaluates some of the authorities' proposed initiatives, and discusses some alternative directions that could be taken.

Download the paper here.

The insecurity of the unsecured creditor

How do you solve the problem of excessive risk-taking and systemic risk?

FDIC chairman Sheila Bair had an idea back in October:

ISTANBUL (Reuters) - Ensuring secured creditors face losses when a financial institution fails could help rein in excessive risk-taking and strengthen the financial system, a top U.S. banking regulator said.

Federal Deposit Insurance Corp Chairman Sheila Bair told a group of international bankers on Sunday that officials might want to consider “the very strong medicine” of limiting secured claims to 80 percent, although she said such a proposal would need to be carefully weighed.

Which means that if a bank failed share- and bondholders would only get 80 per cent of their investment back.

There’s a bit of federal jaw-boning taking place here. At the moment when a bank fails the Federal Home Loan Banks (FHLBs) have priority over other creditors, including FDIC, which is responsible for insuring US bank deposits. FDIC, according to some sources, has long sought to overturn the FHLBs priority status.

But the basic idea is that secured creditors would more closely monitor the risks the bank is taking if they knew they stood to suffer a 20 per cent haircut on their investment should it fail.

And fast forward a month or so and it looks like Bair’s unsecured idea is gaining traction.

The House Financial Services Committee on Thursday passed an amendment, offered by Democratic representatives Miller and Moore, that included the haircut proposal. (For a round-up of the other amendments, see here).

And the amendment is already generating criticism.

To wit, John Jansen of Across the Curve has picked up a bit of comment from Barclays Capital:

The House of Representatives is working on a draft bill that would more closely regulate large financial institutions in an effort to reduce the systemic risk that pushed the economy deep into recession. The nearly 300-page bill deals with a number of tough issues, including the role of the Federal Reserve in providing credit to non-banks (the “exigent circumstances” clause of the Federal Reserve Act), and, most significantly, establishing rules for the unwinding of a large, systemically important institution. The definition of systemically important institution, however, is subject to a number of interpretations, some of which are outlined in another amendment. But it is generally assumed that any bank or financial institution with more than $10bn in assets would qualify. While no doubt well intentioned, an amendment passed yesterday has significant implications for secured funding markets. Proposed by Reps. Miller (D) and Moore (D), it would effectively replace existing repo and secured funding with unsecured borrowing subject to a margin, or haircut, of up to 20%. Specifically, in the case that a large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%. This discount is meant to raise enough funds to offset any taxpayer losses. In the language of the bill, it establishes a “polluter pays” structure for unwinding a financial institution: the cost of a (hopefully) orderly unwind is fully absorbed by the firm’s shareholders and unsecured creditors — not the taxpayer.

Implications We believe the Miller and Moore amendment would have significant implications for the repo market. It would likely make secured funding to large institutions much more “flighty” — that it, much more volatile and prone to leave quickly. In any situation where it appears that a large firm is about to fail, secured lenders will rapidly head for the exit and terminate as many of their repo transactions as possible. No secured lender will want to be left in a trade with a bank in receivership where the regulators have converted the transaction into an unsecured loan at 80% of the original amount (net of the original haircut). We believe the proposed legislation will also make secured lending far more pro- cyclical — with lenders stepping away from a systemically important institution immediately upon hearing anything that might raise the odds of a FDIC takeover. In our opinion, the combination of flight-prone money and pro-cyclicality would ultimately defeat the intent of this legislation, which is to reduce systemic risk. Instead, large systemically important firms would become more vulnerable to liquidity runs — of the sort seen last fall. In addition, the Miller and Moore amendment would raise funding costs for large institutions, pushing them into the unsecured market and removing an important source of liquidity to the repo market — at precisely when unsecured money is not available.

In a broader sense, the amendment calls into question the legal underpinnings of secured funding. After all, if the repo and other secured funding contracts can be reversed (no pun intended) when a systemically important institution is taken over by the FDIC, might there be other situations in which repo trades would be demoted in a bankruptcy? Obviously, it is too early to forecast the fate of this bill, much less those of the dozen or so attendant amendments. However, like other regulatory efforts — from reforming tri-party repo to recasting how money market funds operate — the Miller-Moore proposal exemplifies the new shift toward heavier regulation in Washington. Striking a happy medium between ensuring financial stability and overly aggressive regulation will prove very difficult next year. As a result, 2010 could be a very bumpy year.

Which is a very interesting point, given that, historically it’s been sophisticated creditors — not retail depositors — who have a tendency to very quickly withdraw their funding when a bank shows signs of being in trouble, thus crippling its operations, and possibly sending it into bankruptcy. Putting those creditors on more uncertain footing could well exacerbate that problem, as Barclays notes.

Of course, if the basic idea of the proposal works — that creditors, knowing they’re in line for a 20 per cent haircut will monitor the risks to the banks they invest in — then in theory banks should never get to that (troubled) point. But that’s a very big if.

Either way — it’s food for thought, and a great illustration of the immense reformatory challenge facing regulators.

Related links:
Ten propositions about liquidity crises - BIS, (H/T Alea)
House amendment poses threat to lending liquidity - The Voice of Housing
Imposing a haircut on unsecured bank creditors - Felix Salmon
Repo-ssessed: Lehman RMBS goes on sale - FT Alphaville

FDIC May Tie Asset-Backed Performance to Rater Pay

Posted on Bloomberg by Jody Shenn:

The Federal Deposit Insurance Corp. may force underwriters and credit raters of asset-backed debt to tie their compensation to the performance of the securities, as it seeks to create better lending practices.

The requirement may be part of new rules for bank securitizations to be proposed by FDIC staff at an agency board meeting next month, Michael Krimminger, special adviser for policy to FDIC Chairman Sheila Bair, said in an interview yesterday. The FDIC will host a meeting today on the topic with other regulatory bodies, said people familiar with the matter who declined to be identified because the talks will be private.

The FDIC, whose power to influence practices probably would be limited to deals sponsored by banks and not the securities arms of their parents, is working on a package of new policies for securitizations after the business helped create a “crisis that rocked the foundations of our financial system,” Krimminger said. The meltdown, fueled by demand for “unsound” mortgages, offers lessons in what needs to change, he said.

“The underwriters get all their cash upfront, the ratings agencies get all their cash upfront, and nobody really has a strong incentive to make sure the loan performs in the long term,” Krimminger said.

Lender Compensation

Lenders should have their compensation tied to how well they meet the contractual promises they make over the quality of loans that back bonds, Krimminger said in an e-mail. Such representations and warranties can require originators to repurchase ineligible debt.

FDIC proposals will likely include requirements for greater disclosure on assets backing securities, limits to how much of the underlying debt lenders can buy from others to put deals together and a demand that issuers retain a certain amount of the credit risk from the underlying loans, Krimminger said in the interview.

Asset-backed bonds are securities derived from receivables such as mortgage interest, auto-loan payments, credit-card payments and royalties. They are typically sliced into classes, or tranches, with varying ratings and risk. The bonds contributed to about $1.7 trillion in write downs and losses at the world’s biggest financial institutions since the start of 2007, according to data compiled by Bloomberg.

The FDIC may seek to limit the number of classes allowed in a securitization, strengthen rules directing the firms that service the debt to act in the best interest of all tranches and prevent the bonds from being turned into even more securities unless issuers offer information on all underlying loans, Krimminger said.

Safe Harbor

The FDIC wants the conditions as part of any extension of a so-called safe harbor that prevents assets in securitizations from being available to the agency when it winds down failed institutions, Bair said last week.

Barbara Hagenbaugh, a spokeswoman for the Federal Reserve Board, William Ruberry, a spokesman for the U.S. Office of Thrift Supervision, and Kevin Mukri, a spokesman for the Office of the Comptroller of the Currency, declined to comment.

Ed Sweeney, a spokesman for Standard & Poor’s, and Sandro Scenga, a spokesman for Fitch Ratings, declined to immediately comment. Thomas Lemmon, a spokesman for Moody’s Investors Service, didn’t return a message.

Regulators should establish minimum underwriting standards for all mortgages made in their countries, Comptroller of the Currency John C. Dugan, who oversees U.S. commercial banks, said in a Nov. 18 speech in Tokyo.

‘Widespread Damage’

“Sometimes, when underwriting standards get so out of balance that they cause widespread damage to borrowers and lenders alike, it becomes necessary for regulators to act more prescriptively,” he said, according to a copy of his remarks on the agency’s Web site. “If ever there was a demonstrated need for such intervention, the searing U.S. mortgage market experience of the last several years fits the bill.”

Chris Flanagan, an analyst covering asset-backed securities in New York at JPMorgan Chase & Co., said in a Nov. 13 report that part of the reason for the drop in prices of securitized debt this month is “regulatory overshoot concerns.”

Financial-overhaul bills unveiled over the past month by Senate Banking Committee Chairman Christopher Dodd and House Financial Services Committee Chairman Barney Frank would force asset-backed issuers or loan originators to retain 10 percent of the credit risk of debt and offer greater disclosures.

Accounting Rules

Last week, the FDIC acted to extend its “safe harbor” for securitized debt through March after new accounting rules sparked concern it would be able to tap the pools underlying credit-card securities to protect its deposit insurance fund after banks fail.

The Financial Accounting Standards Board rules take effect for fiscal years starting after Nov. 15, and require issuers to include assets and liabilities of securitized debt on their balance sheets.

Attaching conditions on practices to a longer-lasting FDIC safe harbor won’t make credit harder to get or more expensive for consumers and companies, as the rules will help revive the market, Krimminger said.

“I view this as not putting in conditions that will impair in any way securitization, but actually creating the kind of transparency” and other protections that “the investor community wants to have,” he said.