Saturday, January 30, 2010

CIBC fuels US covered bond hopes

Posted in the Financial Times by Nicole Bullock and David Oakley:

Canadian Imperial Bank of Commerce yesterday sold $2bn of covered bonds in a deal that bankers hope will lay the groundwork for a US covered bond market.

European bankers are monitoring the US for signs that covered bond issuance can take off after success in Europe with deals totalling $50bn so far this year, five times more than the same period last year.

Covered bonds are debt issued mostly by banks and secured by a pool of loans. Bankers have touted them as a way to boost mortgage lending and to provide financing for banks.

The US market has never developed, largely due to the lack of legislation codifying the treatment of covered bonds if the issuing bank were to fail.

Several non-US banks have issued covered bonds in US dollars, but CIBC is notable because it sold bonds to US investors, a rare occurrence in the last few years, bankers say.

From the Wall Street Journal:

Canadian Imperial Bank of Commerce (CM) issued $2 billion of covered bonds, maturing February 2013, according to a source familiar with the offering.

The bonds, which carry a coupon of 2%, were priced at 66 basis points over the 1.375% U.S. Treasury bond maturing January 2013, for a yield of 2.008%, according to the source.

A covered bond is a debt security backed by cash flows from mortgages. CIBC covered bonds are backed by Canada Mortgage and Housing Corp.

Bank of America Merrill Lynch, HSBC Holdings PLC, Royal Bank of Scotland Group PLC, and CIBC World Markets are acting as joint lead-managers on the transaction.

Canadian Imperial's covered bond issue is the first big dollar-denominated deal aimed at U.S. investors since the summer of 2007. Some European companies have done some small dollar-denominated covered bond deals since then, but they were targeted at non-U.S. investors.

The offering is considered "a first step on the road" to reopening the covered bond market in the U.S., said Tim Skeet, head of covered bonds at Bank of America Merrill Lynch.

U.S. investors were attracted to the offering for two reasons, Skeet said. One, they were comfortable with Canada, whose financial sector had side-stepped many of the woes seen in other countries during the financial crisis. Second, the structure was easy to understand since the underlying mortgage collateral is insured by Canada Mortgage and Housing Corp., a federal agency.

"This was the ideal issue to bring to the (U.S.) market to get people interested," Skeet said.

Friday, January 22, 2010

Japan May Push Derivatives to Overseas Clearinghouses

Posted on Bloomberg by Yusuke Miyazawa and Takako Taniguchi:

Japan’s Financial Services Agency may demand that derivatives traders process over-the-counter transactions through overseas clearinghouses as it seeks to increase transparency and reduce risk in financial markets.

“There is a possibility of centralizing in foreign clearinghouses,” FSA Deputy Minister Kouhei Ohtsuka said in Tokyo yesterday. “Developing the infrastructure of the Japanese market further is important, but we want healthy development.”

The regulator is considering whether to centralize trading of popular derivatives such as interest-rate swaps in local clearinghouses, link domestic clearinghouses with foreign ones, or move clearing entirely to overseas houses, it said in notes distributed to reporters.

U.S. and European regulators are pushing the financial industry to improve safety in the OTC derivatives market after credit-default swaps were blamed for contributing to the collapse of Lehman Brothers Holdings Inc. and American International Group Inc. Some clearinghouses act as counterparties to every buy and sell order, reducing the risk that a trader defaults on his obligation in a deal.

The $605 trillion OTC derivatives industry needs a “major transformation” to increase transparency, Federal Reserve Bank of New York President William Dudley said Jan. 14. Derivatives are securities whose value is derived from underlying assets such as stocks, bonds, commodities or currencies.

Aiful Swaps

A Japanese committee of the International Swaps & Derivatives Association ruled on Dec. 30 that Aiful Corp. had a so-called credit event triggering credit-default swaps written on its debt when the consumer lender agreed to reschedule loan repayment to avoid bankruptcy.

The committee’s ruling ended a dispute that threatened to undermine confidence in Japan’s credit swaps market. It previously rejected three requests to determine a credit event occurred, citing a lack of publicly available information on which to make a judgment.

Japan’s FSA proposed on Dec. 17 that popular deals such as the Markit iTraxx Japan index be centralized in local clearinghouses that decide when Japanese companies have had credit events instead of the ISDA-backed panel.

Local clearinghouses should “participate properly” in the ruling of credit events, “respecting convention,” it said in yesterday’s statement.

‘Long Run’

“Trading through clearinghouses is positive to the market in the long run,” Seiichiro Matsumoto, a credit analyst at Mizuho Securities Co., said in a telephone interview today. “The biggest problem is the small number of participants. I am not sure if it increases if the government participates properly.”

Regional committees of 15 dealers and investors were formed in March to make binding decisions for most of the market on when provisions in the contracts are triggered. The committees must base their decisions on publicly available information such as regulatory filings, press releases and news articles.

The committee governing Japan’s swaps market includes Goldman Sachs Group Inc., JPMorgan Chase & Co. and Barclays Plc.

“There are some arguing if it’s fair that foreign participants decide the creditworthiness of Japanese companies,” said Matsumoto.

The regulator’s proposals will be submitted to the regular session of Japan’s parliament, or Diet, in March, Ohtsuka said.

Thursday, January 21, 2010

The Time for Government Intervention in the European ABS Market Has Passed

Original posted on Structured Credit Investor:

The need for government intervention in the European ABS market has passed, according to panellists at a Fitch-hosted conference in London this week. Improving investor appetite, increasing confidence in the performance of existing European transactions and the re-emergence of a primary market were listed as positives for the sector.

"There was a time and a place for government intervention in the European ABS market, but that time has passed," said Robert Liao of Citi's European securitisation market team. "We don't want to create an artificial environment for ABS. If anything, we need constructive statements from governments and consistency between the support they provide to financial products. At the moment, governments are sending mixed messages about the implied quality of an investment by either supporting or not supporting a sector."

This view was shared by Ian Stewart, head of securitisation at Lloyds Banking Group. He commented that there was a time when more government stimuli would have been helpful, but now that investors are moving back to the market of their own accord, direct government intervention is not necessarily needed.

Graham Page, head of credit at RZB, noted that it would be good, however, to see new ABS deals properly distributed - in other words, without a US bank buying a large proportion of the notes. "If, during 2010, there were around four to five new deals issued a month, I think investor demand could easily meet supply," he said. "However, if that moved to four to five deals per week, I'm not sure that the investor base could swallow it: I'm not entirely sure of what the investor base is."

Notwithstanding the fact that many macroeconomic indicators are pointing to stabilisation in the European structured finance sector, Fitch's structured finance analysts continue to believe that the sector's recovery is fragile and vulnerable to external shocks. "Unemployment is still rising in many European countries and the risk of significant payment shock remains as interest rates begin to increase, particularly as we move into 2011," said Ian Linnel, head of EMEA structured finance at Fitch. "These factors, combined with the fact that many re-financing markets remain illiquid, mean that the scope for further deterioration in European structured finance asset performance remains."

This is reflected in the fact that outlooks for ratings in certain sectors have deteriorated as the effects of the global credit crisis continue to flow through. Fitch says rating changes are likely to still be focused on junior classes, but some criteria changes (for example, in respect of Dutch NHG-backed mortgages) and worst performing deals could mean that ratings further up the curve are affected.

"Prime European consumer ABS and RMBS has performed robustly during the credit crisis, although it is recognised that a major contributing factor to this stable performance has been the very low interest rates, so a sudden rise could have negative consequences," said Page. "Other potential brakes to a recovery in the ABS market could be declining sovereign risk, as exemplified by the recent rating actions on Greek ABS, and it remains to be seen what - if any - affect the various support measures undertaken by some governments (e.g. Italy) will have on the RMBS associated with these regions."

"Governments, regulators and central banks potentially hinder a recovery in the sector due to the lack of clarity in their views," added Liao.

The CRD's 5% ABS retention rule - which is to be applied to all new European primary ABS issuance from 2011 - was also discussed at the conference. Certain panellists expressed their scepticism over the introduction of the rule, suggesting that European regulators were introducing it as a result of European bank losses from recent vintage, 100% originate-to-distribute US subprime RMBS transactions.

Panellists also indicated that the retention rule would not necessarily affect bank business models, but expressed concern over its consequences for non-bank originators. Gerard Breen of the structured finance prudential risk division at the UK FSA argued that the ABS retention rule comes as part of a package of measures, noting that - in and of itself - it will not singlehandedly create alignment of interests between investors and originators.

"We are aware of the retention rule's limitations, such as the fact that 5% retention can, under certain circumstances, be factored into the economics of a transaction by the originator. However, we are also aware of its benefits: as part of a larger package of measures, it discourages the 100% originate to distribute model, helps address the potential misalignment of incentives, and introduces some kind of balance sheet constraint."

He concluded: "The key to its success will be its implementation, and we are currently discussing the details surrounding this."

Modeling Assumptions behind the ISDA CDS Standard Model

Original posted by FinCAD:

In February 2009 the International Swaps and Derivatives Association (ISDA) released the ISDA CDS Standard Model as an open source project as part of an effort to standardize global Credit Default Swap markets. The model is intended to standardize the way in which the running spread can be converted to an upfront fee, as well as how the cash settlement amount is calculated for a CDS. Also as part of this effort, several changes were made to both North American and European CDS contract specifications.

FINCAD has independently replicated the ISDA pricing methodology, and this functionality is included in both FINCAD Analytics Suite 2010 and the new F3 product line. Through extensive testing we have observed excellent agreement between the ISDA open source code and the FINCAD implementation. There are several benefits to using the FINCAD implementation rather than calling the open source ISDA code directly; perhaps the most significant is the provision of all the risk exposures of the CDS, information which is not provided by the ISDA code. In addition, the FINCAD implementation calculates a number of other useful quantities which the open source code does not. This implementation project involved gaining a detailed understanding of roughly 30,000 lines of open source code. In this article we summarize the main modeling assumptions made in the ISDA codebase, and explain why the ISDA model will give slightly different results to other modeling approaches, without using mathematical formulae.

The Zero Curve and the Survival Curve
The most important assumption is that the discount factor curve and the survival curve are both assumed to be piecewise exponential functions. What does this mean? The discount factor curve (or "zero curve") describes how the price of risk-free zero coupon bonds, of various maturities, decrease when they are sorted by their maturity dates. The price of a zero coupon bond is 1 if the maturity date is today, and approaches 0 if the maturity date is far in the future, due to the decreasing time-value of money. These zero-coupon bonds are risk-free in the sense that the probability of default is negligible. This zero curve is implied and built from quotes for cash deposits, futures and swaps; these are financial instruments for which either the probability of default is negligible (e.g., Government Treasury bills), or their payments depend on supposedly risk-free reference rates and have mechanisms to neutralize the effects of counterparty default risk (e.g., margin accounts, or collateral agreements). The quotes for these liquid instruments, along with an interpolation rule for dates that are in between the maturities of these instruments, provide enough constraints to uniquely determine the discount factor on any arbitrary maturity date. The interpolation rule assumed in the ISDA model is that the zero curve is a series of segments, each of which joins smoothly (without jumps) with its neighbor, and whose shape is that of exponential decay. This shape of the zero curve is equivalent to saying that the instantaneous forward curve (i.e., the forward rates of infinitesimally short tenor) is a staircase of horizontal steps. The steps occur on dates that correspond to the maturities of the instruments used to build the curve.

Likewise, the survival curve shows how the probability that the reference entity (e.g, a corporation) will not have defaulted at a given point in time in the future, changes as a function of that time. This probability is 1 today, assuming that the reference entity has not already defaulted, and decreases to zero as longer and longer time horizons are considered. Typically, this survival curve is implied and built from quotes for CDS spreads for the reference entity of various maturities. The ISDA model assumes, as before, that this survival curve is a series of exponentially decaying segments. This shape is equivalent to saying that the hazard rate (i.e., the rate of expected loss divided by the expected remaining amount at risk) is a staircase of horizontal steps. The steps occur on dates that correspond to the maturities of the CDS spreads used to derive the curve.

The advantage of making these assumptions for the shapes of the curves is that it greatly simplifies, and speeds up, the calculation of the mathematical integrals that are needed for CDS pricing, as will be seen in the following discussion.

CDS Pricing Overview
Let's start with the protection leg (or "contingent", or "default" leg), which for pricing purposes can be thought of as a single payment in the event of a default. This payment is made by the protection seller as compensation for the protection buyer's net loss, and is calculated as the notional amount minus the amount that is assumed can be recovered (i.e., the recovery rate times the notional amount). In other words, the absolute payment is the product of the notional amount, and 1 minus the expected recovery rate. However, this payment is only made in the event of default, and can occur at any point in time up to the maturity date. To illustrate, imagine that default could only occur on one of two special dates with a known probabilities P and Q, otherwise the reference entity will not default before maturity. In this imaginary situation, the survival curve is 1 up to the first special date, jumps down to 1-P after it, and jumps down further to 1-P-Q after the second date. For pricing purposes the expected payment (in the statistical sense) on the first date is the absolute payment times its probability P, and the expected payment on the second date is the absolute payment times its probability Q. The value of the protection leg is the sum of the Net Present Values (NPV) of the expected payments, which means multiplying the expected payments by the discount factor on each of the two payment dates, and adding them up.
However, in reality, default could occur on any date, so it is necessary to consider every possible default date and weight each possibility according to the probability of default on that date. The value of the protection leg then becomes a sum over a continuum of possible times, rather than a sum over two dates. Computationally, it is easier to make the time increment infinitesimally small, rather than daily, and in the limit the sum becomes a mathematical integral, or an area under a curve. This function to be integrated is the probability of default (for each infinitesimally small period of time) times the discount factor that applies during that small time interval. Under the assumptions made in the ISDA model, both of these quantities are piecewise exponentially decaying functions of time, so their product is also a piecewise exponentially decaying function. The decay constant of the product of two exponentials is the sum of the decay constants of each, which in this case are the instantaneous forward rate (for the discount factor) and the hazard rate (for the default probability). Furthermore, the exponential function can be integrated using elementary calculus, and there is a simple formula for the result, which can be rapidly computed.

Let us now consider the premium leg. This is a regular series of payments, made by the protection buyer, that continues as long as the reference entity has not defaulted, or until the maturity of the CDS, whichever is the sooner. Each payment is the product of the notional amount, the premium rate (or spread), and the accrual factor for that period (e.g., around 0.25 for quarterly payments). However, this absolute payment is only made if the reference entity has not defaulted, so for pricing purposes the expected payment (in the statistical sense) is the absolute payment times the probability of survival at the end of the period. This probability

needs to be interpolated from the survival curve using the assumption of the piecewise exponential shape. The contribution of this payment to the CDS price is the NPV of the expected payment, which means multiplying further by the discount factor on the payment date. This factor needs to be interpolated from the zero curve, again using the piecewise exponential assumption. The value of the premium leg is then calculated by summing the contribution from each payment.

A major extra complication when calculating the overall price of the premium leg is caused by the payment of accrued premium upon default. This feature was prescribed as standard in the specification of the ISDA Standard North American Corporate CDS Contract (SNAC). It means that in the event of default, no further regular premium payments would be made, although the premium for the current period would be paid in proportion to the fraction of the period that elapsed before the default event. The absolute amount of the accrued premium would be the full-period premium pro-rated by the accrual fraction to the default date. So the NPV of the expected payment on each possible default date would be the product of the full-period premium, the accrual fraction to that date, the probability of default on that date, and the discount factor on that date. Adding these contributions up for each possible default date gives the contribution of this feature to the CDS price. As before, this summation is simplified in the ISDA method by summing over a continuum of infinitesimally small time periods, rather than over each possible default date. The calculation of this integral is very similar to the one for the protection leg, except that there is now an extra factor multiplying the exponential function to be integrated; this factor is the accrual fraction, which is a linear function of time, and therefore easily handled again by elementary calculus.

Other Approaches
It can be seen from the above that the assumption of exponential functions for the shape of the zero curve and of the survival curve help significantly in the calculation of the CDS price; especially in the summation over all possible default times for the protection leg and for the accrued premium. However, other modeling assumptions are also consistent with the data used to construct the two curves. For example, other ways of summing over possible default times include:
  • Sum over days: the summations are performed over each possible default date; the discount factor and survival probability on each date are interpolated from the zero curve and survival curve respectively, and the probability of default on each date is calculated as the change in survival probability from previous date to the current date.

  • Period averaging: here the integral is approximated by a series of rectangles whose width corresponds to a premium period; during each period the discount factor is taken to be a constant (equal to its average value at the start and end of the period), and the probability of default for the period equals the change in the survival probability from the start to the end of the period.

  • Trapezoid rule or Simpson's Rule: these are standard numerical methods to evaluate integrals; the time axis can be sliced into an arbitrary number of periods, and the discount factor and survival probability at the boundaries between each period are interpolated.

  • Discount from end: in this approximation, it is assumed that default can only occur at the end of each period of the premium leg; the discount factor is taken as the value at the end of each period, and the probability of default for the period again equals the change in the survival probability from the start to the end of the period; the accrual factor for the accrued premium is taken on average to be one-half of the period length.
Other Details of the ISDA Model
The ISDA Model also differs from other possible approaches in the way that it handles dates, accrual fractions, the construction of payment schedules, and the bootstrapping of the zero curve. For example:
  • The "time", in years, used in the calculation of the expected accrued premium is calculated as the actual/365f accrual factor between the protection start date and the
    period end date, plus an extra 0.5/365, presumably to account for the transition from the business world of discrete dates to the mathematical universe of continuous time.

  • When bootstrapping the zero curve from swap rates, it is assumed that the floating leg (including principal payment at maturity) prices to par, thereby ignoring any known fixing of the reference rate.

  • The expected recovery rate is treated as constant for all possible times of default.
This document has shown that the ISDA CDS Standard Model incorporates certain modeling assumptions that would lead to slight pricing differences from other approaches. These other approaches would be equally consistent with the price of the liquid instruments used to build the zero curve and survival curve. However, the standardization of the methodology allows market participants to have certainty around, for example, the conversion of a running spread to an upfront fee, or upon Mark-To-Market values.

Covered bond consequences for S&P

Here’s a good illustration of the tightrope-walk often faced by the ratings agencies.

Having opted to stick with its proposed revised ratings methodology for covered bonds, first announced in February last year, S&P is now experiencing the consequences of having tougher ratings criteria.

S&P’s proposals were focused on linking the covered bond rating more closely to that of the issuer. At the moment, covered bond ratings are linked primarily to the asset quality and structure of the programme, and only tangentially to the issuer credit rating. That means that the bonds usually get higher ratings than the banks issuing them since, unlike in securitisation, the assets stay on the issuer’s balance sheet and are ring-fenced to give investors some protection in the event of issuer bankruptcy.

This was S&P’s thought process:

The proposed methodology reflects our heightened focus on the ability of covered bond structures to access liquidity to repay investors under stress scenarios where the bank becomes insolvent or halts payments on unsecured obligations. This liquidity need arises as most covered bond programs have a maturity mismatch of assets to liabilities. While the covered bond issuer is solvent, repayment of covered bonds should be addressed by the bank’s general debt service capabilities. However, if the issuer is no longer solvent, debt service and the redemption of the maturing covered bonds depends firstly on cash flow generated by the cover pool’s assets. If this cash flow from the cover assets is insufficient to service the covered bonds, the program must obtain the necessary liquidity either from third-party financing, if permitted within the program, or through the sale of assets.

Nevertheless, the proposed changes prompted plenty of howling by covered bond issuers and Pfandbrief-players — enough that some people thought S&P might opt to water down its new criteria.

But, the rating agency more or less stuck to its guns, and (albeit a belatedly) released its new methodology on December 16th, simultaneously placing 98 covered bond programmes on credit watch.

And, late on Wednesday, the agency published the following:

FRANKFURT (Standard & Poor’s) Jan. 20, 2010–Standard & Poor’s Ratings Services said today that it had affirmed its ‘A-’ long-term and ‘A-2′ short-term counterparty credit ratings on Germany-based Landesbank Baden-Wuerttemberg (LBBW). The ratings were subsequently withdrawn at the bank’s request. The outlook was negative before the withdrawal.

At the same time, various issue ratings on LBBW’s debt were affirmed and then withdrawn, including those on debt that benefit from grandfathered guarantees provided by LBBW’s owners, including its key owner, the State of Baden-Wuerttemberg (AA+/Stable/A-1+), which owns 40.5%.

Coincidence? Maybe.

But that’s not what’s implied by coverage from covered-bond specialist, The Cover:

Standard & Poor’s will no longer rate Landesbank Baden-Wurttemberg’s Pfandbriefe or other debt after the German bank ended its contract with the rating agency. The covered bond issuer is believed to be the first to have done so since S&P announced its controversial new rating methodology on December 16.

The question for S&P is — will there be more to come?

New off-balance sheet rule: Little impact on Wells

Original posted on Reuters by Rolfe Winkler:

The new accounting standard requiring banks to bring assets back on balance sheet had a negligible impact on Wells Fargo. According to slide 17 in the bank’s supplemental earnings release, Wells added just $10 billion of risk-weighted assets when the new standard took effect January 1.

wells 166 better

The idea behind the new accounting standard is to bring hidden assets back into the light of day so that regulators can insure proper levels of capital are held against them. With Wells, this appears not to be happening.

Last summer, the bank estimated the new standard would raise risk-weighted assets by $46 billion.* In its last quarterly filing, it revised the estimate down to $25 billion.** When the standard finally went into effect, the figure was just $10 billion.

Total off balance sheet assets, meanwhile, were over $2.0 trillion at the end of September. (see page 31)

One reason for the giant difference is that “conforming” mortgages comprise a bit over half of Wells’ off balance sheet assets. Because these are eligible for a government guarantee via Fannie Mae, Freddie Mac, or Ginnie Mae, Wells argues that it bears no risk. Therefore it needn’t bring the assets back on balance sheet.

Chris Whalen of Institutional Risk Analytics has argued this may be inappropriate. Some of these mortgages may be rejected by government guarantors — an even more likely prospect it would seem with FHA beefing up its lending standards. That could force Wells to take loan loss reserves against them.

A bigger question is the $900 billion worth of off-balance sheet assets that don’t qualify for a government guarantee. If indeed it’s fair for Wells to say it has so little exposure here, the bank should explain why to investors.

Ironically, the ultimate off balance sheet vehicles are the GSEs themselves: Fannie, Freddie and Ginnie Mae (which securitizes FHA loans). Though backed by taxpayers, the nearly $5.0 trillion worth of mortgages they guarantee aren’t included on Uncle Sam’s balance sheet.

With mortgage lending almost wholly dependent on GSE guarantees at this point, more of the nation’s housing stock disappears off-balance sheet every day…


*See page 13 of the Q2 10-Q.

**See page 14 of the Q3 10-Q.

Wednesday, January 20, 2010

TriOptima makes OTC rates data available

Original posted in the Financial Times by Michael MacKenzie:

Momentum to create greater transparency in the vast over-the-counter interest rate swap market gathered pace on Wednesday as TriOptima said its trade reporting repository had gone live, providing regulators with information in 15 major countries.

TriOptima, the trade processing group, said 14 financial institutions had submitted data for their non-cleared OTC interest rate derivatives trade portfolios and that these included trades with G-15 institutions, so-called buy-side organisations and other financial and non-financial institutions.

TriOptima said that while the information was available to regulators at the moment it would make it available publicly over time.

TriOptima was chosen by the International Swaps and Derivatives Association last September to set up the interest rate derivatives trade reporting repository.

The repository is designed to provide regulators with a series of monthly reports which summarise market volumes for OTC interest rate derivatives. These include derivatives that are not currently cleared, and comprise interest rate caps and floors, forward rate agreements, options, swaps, swaptions, and cross currency swaps.

The monthly reports will disclose outstanding trade volumes and gross notional volumes across different currencies and maturities.

This is seen helping regulators identify potential risks among key participants in the derivatives market and is one of a number of risk management measures that have become a priority in the wake of the financial crisis.

Jon Eilbeck, chair of the ISDA rates steering committee and chief operating officer for global rates at Deutsche Bank said: “It demonstrates the industry’s ongoing commitment to enhancing the OTC derivatives infrastructure, reducing systemic risk and improving transparency in the OTC derivatives marketplace.”

However, whether there should be just one repository for interest rate swaps covering all currencies remains a topic for debate among regulators. While some regulators desire a country-by-country approach, such a structure could run the risk of double counting OTC positions and not provide a comprehensive overview.

Monday, January 18, 2010

Slicing margins for clearing houses poses fresh peril

Posted in the Financial Times by Aline van Duyn:

Wall Street has a lot to learn from designer handbags. Once these become the latest must-have accessory, they are regarded even more desirable when their prices go up. Indeed, marking them down can be a sure way of losing customers – no one wants a bag that is so unloved that it has to be discounted. It is such a striking phenomenon that high-end items such as this actually have a name: “Veblen goods”.

The idea is hardly new. Indeed, the economist Thorstein Veblen spotted the phenomenon and wrote about it in his 1899 paper “The Theory of the Leisure Class”. Conspicuous consumption existed then, and it still continues to thrive.

The concept applies to other situations too. If you need a defence lawyer, you are unlikely to pick the cheapest one. The problem in the financial system is that many of the shock absorbers of risk, the tools used to manage it, or even the basic loans underlying the credit markets, are priced in the same way that most goods are. The lower the price, the more people want them. Indeed, the customers for these financial instruments and loans are constantly clamouring for lower prices, and in many cases these are offered. The providers of credit and instruments such as derivatives that are used to manage credit risks are often competing for market share – creating further pressure for prices to come down.

There are plenty of examples of how this dynamic contributed to the financial crisis, and hopefully there will be much more probing of this by the Financial Crisis Inquiry Commission over the coming months.

Indeed, competition among rating agencies, bond insurers and mortgage providers is likely to have encouraged them to misprice risks. In most cases, however, complex models were rolled out that justified their approaches.

Even when the price is not lowered, the ultimate cost of the risk can fall by offering more for the same price. It is similar to the “supersize” approach that has worked so well to generate market share and profits in the fast-food industry. It is not the right business model for managing risks, however. Giving customers double the French fries for the same price might not be damaging to society as a whole – although that in itself can be debated – but when the quantities of credit exposure, default insurance or stamps of approval are pumped up, the outcome can be dangerous.

Worryingly, these dynamics are already under way among the new systemic risk shock absorber de jour – the clearing house. Regulators are pushing a growing proportion of the $600,000bn of privately traded derivatives contracts on to clearing houses, which act as a buffer if a big dealer should default. There are serious efforts under way to ensure these clearing houses can indeed handle the risks of defaults among derivatives dealers. Yet much of this is a work in progress. I’ve been told users of the clearing houses have started to ask for lower margins, on the grounds that a rival may offer a better deal. It may not be that prevalent, but such a trend could be dangerous.

Finding a way to turn clearing into a Veblen good – where pricier clearers are prized for the safety they offer – is the key to a sounder financial system. It is not easy, and the task falls to regulators, by tracking such behaviour and nipping it in the bud.

In addition, there have to be penalties for not taking the safest route – perhaps in the form of higher capital charges. It is not just about margins, but also about what is done with that money. Clearing houses investing rainy day funds in high-risk assets as a way to boost profits but may not be much use in the event of a default.

Applying the same value to managing risks as some people do to buying designer handbags and other trappings of a luxury lifestyle is the key to a safer financial system. It may increase the costs of credit, or reduce profits for Wall Street, but these trade-offs have to be analysed head-on.

That is the tough task regulators and lawmakers and the financial industry face.

OTC clearers pose fresh dilemma

Posted in the Financial Times by Aline Vanduyn and Jeremy Grant:

In the months that followed the near-implosion of financial markets, regulators scrambled to figure out how to rein in the vast over-the-counter (OTC) derivatives markets that were seen as central to the crisis.

But, as numerous high-level meetings this week by central bankers and regulators show, the hunt for solutions has thrown up a fresh dilemma: new risks posed by clearing houses.

Clearing houses have been touted as the perfect shock absorbers for risks associated with the $600,000bn, privately-traded or OTC derivatives markets, since they guarantee that trades are completed even when a party to a trade – such as a derivatives dealer – defaults.

Clearing is widely used but mostly in markets where financial contracts are traded on exchanges.

The near-collapse of the financial system after the demise of Bear Stearns, the default of Lehman Brothers and the near-collapse of AIG – never regarded as a big derivatives dealer – has changed all that.

“  ‘Clear more, and faster’ is what we are being told to do,” says an executive at a derivatives dealer. Indeed, dealers who met regulators in New York on Thursday are expected to sign up to just that. However, it is rapidly dawning on regulators that, while forcing more OTC derivatives into clearing houses removes systemic risks from one area of the financial system, it may at the same time be concentrating new risks in clearing houses themselves.

Minds are being focused in recognition that many of the OTC products that look set to be cleared have never been handled by clearing houses before.


Regulators are realising that clearers also must be robust enough to withstand a default by any of their members in this new environment. A clearing house uses funds – or margin – posted by market participants to guarantee trades are completed.

In a policy paper on OTC derivatives out last week, the Federal Reserve Bank of New York said: “If a CCP [central clearing counterparty] is successful in clearing a large quantity of derivatives trades, the CCP is itself a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses.”

That concern is mirrored in Europe. Alexander Justham, director of markets at the UK’s Financial Service Authority, says: “We should be under no illusions that clearing houses are highly systemic, therefore what goes into them and the risk standards that apply must be extremely high.”

Work is therefore starting on creating new standards to cope with a greater collapse than has been commonly assumed in such risk reduction systems.

For many years, systems used to offset and manage risks in financial markets were run on the assumption that they would have to withstand the default of their biggest participant.

Now, after the demise of big derivatives dealers and the avoidance of the collapse of others only through huge interventions by governments, that is no longer seen as enough of a test.

In Europe, clearing concerns have been magnified by reforms pushed by the European Commission that were intended – before the crisis – to encourage competition between clearers and lower post-trade costs.

They call for clearers to forge links with each other to facilitate cross-border clearing and give traders a choice over where to send their deals for clearing, rather than being tied to one monopoly clearer.

Yet regulators are now concerned that the creation of these links – a process called “interoperability” – could be the source of another systemic crisis. The worry is that the weakest in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls.

This week EuroCCP, a small European clearer, suggested that instead of clearers requiring margin deposits from each other – creating a form of financial interdependency – each clearer would instead ask its members for more margin to be ring-fenced and used in a default.

Partly as a result of concerns over interoperability, Brussels now proposes sweeping new rules for clearing houses. They go beyond US plans, encompassing not only OTC derivatives clearing but other assets such as equities.

In a discussion paper sent to EU member states by Brussels this month, Commission staff recommend tough new legislation governing clearing, including “robust regulatory requirements for CCPs”.

Rory Cunningham, public affairs head at LCH.Clearnet, Europe’s largest independent clearer, says: “It’s the biggest thing that’s hit our industry for decades and implies significant changes to all CCPs and the markets they serve.”

Yet there are many other questions that need answering even before new rules are set. The complexities are so great that a new regulatory group has been created to tackle them.

The OTC Derivatives Regulators Forum, which has about 40 members, meets today in New York.

They will discuss how much of the information gathered by trade repositories – which increasingly track all private-traded derivatives deals – should be shared among different regulators. There are also questions about how much of the data regulators can legally be entitled to see, and how much of it should be shared.

Second, regulators want to map out ways to ensure “co-operative oversight” over the trade data repositories and the central counterparties to ensure traders cannot pick and choose between the ones with the loosest oversight.

Third, is the tricky question of who regulates clearing houses. In the US, this is split between the Federal Reserve and securities and futures regulators.

In Europe, clearing houses are regulated by the national securities regulators in each country. But some say that given the systemic importance of clearers, it should be central banks that oversee clearers.

Last month Xavier Rolet, chief executive of the London Stock Exchange, warned that it was “very dangerous” for clearing houses’ capital bases and risk models to differ from country to country and called for central bank oversight over clearers.

Damian Carolan, a partner at Allen & Overy, warns: “There is a real risk that the focus on ensuring that CCPs are sufficiently robust to withstand these historically unseen risks is lagging behind the work to push derivatives through those clearing houses. The two have got to go hand in hand.”

Sunday, January 17, 2010

Sixth Industry Meeting Hosted by the Federal Reserve Bank of New York

The Federal Reserve Bank of New York hosted a meeting today of major market participants and their domestic and international supervisors to discuss efforts to improve the infrastructure supporting the over-the-counter (OTC) derivatives market. Today’s meeting is the sixth such meeting with industry participants at the New York Fed.

“The industry must undertake a major transformation to bring significantly greater levels of transparency to these markets. Increasing the amount and quality of market information available to participants, regulators and the public is critical to the work of shoring up the stability and efficiency of the financial system,” said William C. Dudley, president of the Federal Reserve Bank of New York.

Market participants provided an update on developments in the OTC derivatives market and agreed to further improvements to support the overall goals of reducing risk and increasing transparency, including:

  • Expand central clearing for interest rate and credit derivatives: Market participants agreed to increase central clearing of transactions that are currently eligible to be cleared as well as to extend the range of products that are eligible for central clearing.
  • Expand regulatory reporting on OTC derivatives transactions: Market participants will provide regulators with enhanced analysis and reporting to help identify and target opportunities for improvements to increase clearing and standardization.
  • Improve risk management for non-cleared derivatives transactions: Market participants reaffirmed their efforts to formalize best practices for managing the risks of non-cleared OTC derivatives, including collateralization practices.

Market participants agreed to detail their next steps and commitments for addressing these priorities in a letter to regulators by March 1.

The New York Fed will continue to work with domestic and international regulators to encourage further improvements and transparency in the OTC derivatives infrastructure and market.

List of attending institutions

Comments by ISDA:

The International Swaps and Derivatives Association, Inc. (ISDA) today commented on the continuing progress of major member firms in their initiatives addressing further improvements to the privately negotiated derivatives industry infrastructure.

ISDA and its members continue to be committed to the delivery against industry goals in three key areas:

-- Strengthening and diversifying counterparty risk management through increased use of clearinghouses by extending their use to a greater number of individual market participants and product types;

-- Improving transparency by building and using trade repositories for interest rate, CDS and equity derivative transactions; and

-- Further strengthening the operational infrastructure of the privately negotiated derivatives business.

"With the direct input of the supervisory community, we have made significant progress in each of these areas and are determined to make more in the near future in line with ongoing commitments," said Eraj Shirvani, Chairman of ISDA and Head of Fixed Income EMEA at Credit Suisse. "We look forward to working constructively with the New York Fed and other policymakers on these initiatives."

In a January 14 meeting with supervisors, the industry outlined its accomplishments in the following areas:

-- Meeting clearing targets in respect of new and pre-existing eligible trades;

-- Achieving buy-side clearing;

-- Delivering on a range of collateral management targets, including portfolio reconciliation and dispute resolution procedures;

-- Establishment and go-live of trade repositories -- the industry interest rate trade repository has recently gone live and an equity derivatives repository is in build-out phase; and

-- Radically reducing, and in some product areas eliminating, confirmation backlogs.

ISDA and the industry have undertaken to deliver a further commitment letter to supervisors on March 1, 2010, extending and building upon prior commitments.

John Hull Supports Tranche Retention, Bonus Deferral

Original posted on PrefBlog:

John Hull has published an essay titled The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?:

This paper explains the events leading to the credit crisis that began in 2007 and the products that were created from residential mortgages. It explains the multiple levels of securitization that were involved. It argues that the inappropriate incentives led to a short‐term focus in the decision making of traders and a failure to evaluate the risks being taken. The products that were created lacked transparency with the payoffs from one product depending on the performance of many other products. Market participants relied on the AAA ratings assigned to products without evaluating the models used by rating agencies. The paper considers the steps that can be taken by financial institutions and their regulators to avoid similar crises in the future. It suggests that companies should be required to retain some of the risk in each instrument that is created when credit risk is transferred. The compensation plans within financial institutions should be changed so that they have a longer term focus. Collateralization through either clearinghouses or two‐way collateralization agreements should become mandatory. Risk management should involve more managerial judgment and rely less on the mechanistic application of value‐at‐risk models.

With respect to tranche retention, Dr. Hull argues:

The present crisis might have been less severe if the originators of mortgages (and other assets where credit risk is transferred) were required by regulators to keep, say, 20% of each tranche created. This would have better aligned the interests of originators with the interests of the investors who bought the tranches.

The most important reason why originators should have a stake in all the tranches created is that this encourages the originators to make the same lending decisions that the investors would make. Another reason is that the originators often end up as administrators of the mortgages (collecting interest, making foreclosure decisions, etc). It is important that their decisions as administrators are made in the best interests of investors.

This idea might have reduced the market excesses during the period leading up to the credit crunch of 2007. However, it should be acknowledged that one of the ironies of the credit crunch is that securitization did not in many instances get the mortgages off the books of originating banks. Often AAA-rated senior tranches created by one part of a bank were bought by other parts of the bank. Because banks were both investors in and originators of mortgages, one might expect a reasonable alignment of the interests of investors and originators. But the part of the bank investing in the mortgages was usually far removed from the part of the bank originating the mortgages and there appears to have been little information flow from one to the other.

Assiduous Readers will not be surprised to learn that I don’t like this idea. In my role as bond trader I have never bought a securitization … I would if the spreads were high enough, but generally spreads are compressed by other buyers.

When I buy a bond, I want to know somebody’s on the hook for it. I like the idea that if the borrower is a day late or a dollar short, I can force an operating company into bankruptcy and cause great anguish and financial ill effects on the deadbeats. Securitizations tend to be highly correllated; while this is claimed to be counterbalanced by the overcollateralization (or tranche subordination, which is simply a formalization of the process) I confess I have a great preference for keeping actual bonds in my bond portfolios.

Tranche retention is simply a methodology whereby securitizations become more bond-like. I object to such blurring of the lines, especially when enforced by governmental regulatory fiat. What I am being told, in a world where such retention is mandated, is that if something has been issued that I - for good reasons or bad - wish to buy and that the security originator wishes to sell, we’ll both go to jail if we consummate the transaction.

I will also point out the logical implications of tranche retention: when I sell 100 shares of SLF.PR.A, I should be forced to retain 20 of them, so that the buyer will know they’re OK. That’s crazy. The buyer should do his own damn homework and make up his own mind.

The world has learned over and over that while regulation is very nice, the only thing that works really well is caveat emptor. I do not want some 20-year old regulator with a college certificate in boxtickingology telling me what I may and may not buy.

Dr. Hull has underemphasized the heart of the matter: one of the ironies of the credit crunch is that securitization did not in many instances get the mortgages off the books of originating banks. Often AAA-rated senior tranches created by one part of a bank were bought by other parts of the bank..

In this context, I will repeat some of Sheila Bair’s testimony to the Crisis Committee:

In the mid-1990s, bank regulators working with the Basel Committee on Banking Supervision (Basel Committee) introduced a new set of capital requirements for trading activities. The new requirements were generally much lower than the requirements for traditional lending under the theory that banks’ trading-book exposures were liquid, marked-to-market, mostly hedged, and could be liquidated at close to their market values within a short interval—for example 10 days.

The market risk rule presented a ripe opportunity for capital arbitrage, as institutions began to hold growing amounts of assets in trading accounts that were not marked-to-market but “marked-to-model.” These assets benefitted from the low capital requirements of the market risk rule, even though they were in some cases so highly complex, opaque and illiquid that they could not be sold quickly without loss. Indeed, in late 2007 and through 2008, large write-downs of assets held in trading accounts weakened the capital positions of some large commercial and investment banks and fueled market fears.

I see the basic problem as one that happens when traders try to be investors. Traders do not typically know a lot about the market - although they can talk a good game - and when they try their hand at actual investing, bad things will happen more often than not. It’s a totally different mindset.

I didn’t make a penny during the tech bubble - never bought any of it. I have numerous friends, however, who made out like bandits and set themselves up for life during those years. The difference between us was not the knowledge that that stuff was garbage … we all knew it was garbage. But I could not sleep at night knowing I had garbage in my portfolio; they were fine with the idea, so long as there was lots of positive chatter and prices kept going up.

A long, long time ago - so long I can’t remember the reference - I read an interview with a big wheel (perhaps the proprietor) of a small NASDAQ trading firm. The interview was interupted when one of his staff burst in with the news that another brokerage (XYZ brokers) wanted to sell a large block of stock (45,000 shares, if I remember correctly) in ABC Company and was willing to do so at a discount to market. So they look at the recent price/volume history, check the news and the deal gets done. When the interview resumed, the interviewer asked “So … what’s ABC Company?”. The trader replied, patienty and wearily: “Its something XYZ wanted to sell 45,000 shares of.”

Now that’s trading!

Despite constant interviews by the media, there is not really much correlation between trading ability and investing ability.

So anyway, I will suggest that when considering a regulatory response to the Credit Crunch, a clearer distinction between trading and investing activities is what’s required. As I have previously suggested, there should be no bright-line between investment banks and vanilla banks; but the difference should be recognized in the capital rules. Investment banks should have low capital requirements for trading inventory and higher ones for investment positions; the reverse for vanilla banks. And for heaven’s sake, make sure that there’s no jiggery-pokery with aging positions on the trading books! Hold it for thirty days, and the capital charge goes up progressively! Start trading too many “investment” positions and you’ll find your investment portfolio reclassified.

As far as bonus deferral is concerned … it’s suitable for investors, not so much for traders. Bonus deferral requires a lot of trust by the employee, trust that is all too often unjustified as exemplified by the Citigroup case discussed January 7 and, here in Canada, by the case of David Berry. The major effect of bonus deferral, I believe, will be to spawn a migration of talent to hedge funds and boutiques.

Dr. Hull suggests:

One idea is the following. At the end of each year a financial institution awards a “bonus accrual” (positive or negative) to each employee reflecting the employee’s contribution to the business. The actual cash bonus received by an employee at the end of a year would be the average bonus accrual over the previous five years or zero, whichever is higher. For the purpose of this calculation, bonus accruals would be set equal to zero for years prior to the employee joining the financial institution (unless the employee manages to negotiate otherwise) and bonuses would not be paid after an employee leaves it. Although not perfect, this type of plan would motivate employees to use a multi-year time horizon when making decisions.

One problem I have with that is vesting. Is the vesting of this bonus iron-clad or not? Is it held by a mutually agreed-upon third party in treasury bills? And what happens if the employee leaves the firm and somebody else starts trading his book? Who takes any future losses then?

Another problem, of course, is trust (assuming the vesting is not iron-clad). When a relationship turns sour - or somebody gets greedy - things can turn nasty in a hurry. It should always be remembered that the purpose of regulation is not to protect anybody. The purpose of regulation is to ensure that everybody is guilty of something.

I have twice been offered jobs with the stupidest incentive scheme in the world. Not only would my bonus be determined by how well the firm did - putting me on the hook for decisions made by people I didn’t even know - but because of deferral, up-front transfers and discretion, I could have worked there for five years and paid them for the privilege. Those negotiations didn’t take long!

Friday, January 15, 2010

Asset-Backed Debt Revival in Europe Led by Ford, BMW

Original posted on Bloomberg by Esteban Duarte and Jody Shenn:

Europe’s asset-backed bond market, dormant for a year, is coming back to life as Bayerische Motoren Werke AG and Ford Motor Co. sell more than 1 billion euros ($1.45 billion) of debt backed by automobile loans and leases.

BMW, the world’s biggest luxury car maker, is selling 742 million euros of bonds backed by German auto leases, said a banker with direct knowledge of the deal. Dearborn, Michigan- based Ford sold 300 million euros of debt tied to car loans on Jan. 8.

The revival in debt backed by consumer and business payments in the auto industry shows improving investor sentiment as Europe emerges from the recession. Yields on company bonds averaged 4.13 percent yesterday in New York, down from 4.37 percent at the start of the year, according to the Bank of America Merrill Lynch Global Broad Market Corporate Index.

“If BMW is successful, it would be a really good indicator for other issuers now monitoring the market,” said Markus Ernst, a credit analyst at UniCredit SpA in Munich. Borrowers testing the waters is “definitely a good sign as it underlines that the market is not drying up,” he said.

Sales of asset-backed bonds in Europe may rise to 50 billion euros this year, from 8 billion euros in 2009, according to Gareth Davies, a debt analyst at JPMorgan Chase & Co. in London. The region’s securitized credit market has been slower to recover than in the U.S. because there’s no equivalent to the Federal Reserve’s Term Asset-Backed Securities Loan Facility, which provides low cost loans to investors buying the bonds.

Yield Spreads

Elsewhere in credit markets, global corporate bond yields remained 1.61 percentage points higher than Treasuries, unchanged from Jan. 12, according the Bank of America index, which tracks almost 8,500 bonds around the world.

Premiums on bonds in developing countries narrowed to 2.67 percentage points from 2.70 percentage points yesterday, approaching the 19-month low of 2.64 points reached on Jan. 11, according to the JPMorgan Emerging Markets Bond Index Plus.

U.K. pay-television company Virgin Media Inc. sold $2.4 billion of first-lien bonds in dollars and pounds at its lowest rates ever after tripling the size of the deal.

Freddie Mac is offering securities in the U.S. derived from loans on apartments as it gains a larger role in financing multi-family properties.

BMW Bonds

BMW’s asset-backed deal is its first in Europe since before credit markets seized up in mid-2007. The offering is made up of notes rated AAA with an average life of 1.88 years, according to the banker who declined to be identified because the terms haven’t been set.

Officials from Munich-based BMW will meet with investors in cities including London and Paris between Jan. 15 and 22. Societe Generale SA and WestLB are managing the transaction and the notes will be issued through Bavarian Sky SA, Compartment 2, said the banker.

Ford, the only major U.S. automaker to avoid filing for bankruptcy last year, issued AAA rated securities last week in Europe in a deal managed by HSBC Holdings Plc. The notes, sold through Ford’s Globaldrive Auto Receivables 2008-B B.V. unit, yielded 165 basis points, or 1.65 percentage points, more than swap rates.

Assets Shunned

The market for bonds backed by real estate, consumer debt and corporate loans slammed shut in 2007 as the worst credit crisis for decades caused investors to shun hard-to-value assets. About the only sales have been of mortgage securities that can be used as collateral for European Central Bank loans.

The yield over benchmark rates that investors demand to hold top-rated U.K. five-year mortgage-backed securities surged as high as 4.25 percentage points a year ago, JPMorgan data show. The spread on the securities, which are the most easy asset-backed notes to buy and sell in Europe, has now dropped to 1.1 percentage point.

Now, signs that growth in the global economy is gathering pace also helped push the extra yield, or spread, that investors demand to buy senior two-year bonds backed by European car loans down to 1.1 percentage points more than benchmark rates, the narrowest spread since August 2008, according to JPMorgan.

Confidence in the world economy rose as an acceleration in manufacturing and service industries signaled a sustained recovery from last year’s recession, according to a Bloomberg survey of users on six continents. The Bloomberg Professional Global Confidence Index gained to 66.6 this month from 58.9 in December, reaching the highest level since the series began two years ago. The index exceeded 50 for a sixth month, which means there were more optimists than pessimists.

Consumer Debt

Sales of asset-backed securities from consumer debt in Europe last year compare with about $178 billion in the U.S., according to Bank of America. Most of the offerings in America, or $105 billion, were facilitated by the Fed’s TALF program.

Ford took advantage of that program last week to sell $1.25 billion of bonds backed by loans that finance cars on dealer lots. The top-rated bonds were priced to yield 165 basis points more than the one-month London interbank offered rate.

Virgin Media’s bond sale was split between dollar- denominated debt that priced to yield 6.75 percent and pound notes yielding 7.25 percent, the lowest rates Virgin has paid on corporate securities, Bloomberg data show. The 875 million-pound portion is the biggest-ever issue of high-yield, high-risk debt in U.K. currency.

Financing ‘Tight’

“With bank financing likely to remain tight throughout 2010, more and more new issuers will no doubt try their luck in the high-yield bond market,” CreditSights Inc. analyst David Watts in London said yesterday in a report to clients.

Virgin Media’s $1 billion of 8-year, 6.5 percent dollar debt were priced to yield 3.25 percentage points more than Treasuries. The 8-year, 7 percent notes in pounds paid a spread of 3.4 percentage points over gilts. The company last sold bonds in sterling in November, issuing 350 million pounds of unsecured 8.875 percent notes due in 2019 that paid a spread of 5.35 percentage points, Bloomberg data show.

Freddie Mac, the mortgage-finance company with U.S. government support, is marketing about $1.1 billion of bonds backed by loans on multi-family properties.

The debt, one of at least six such issues planned this year, is likely to price around Jan. 27, the McLean, Virginia- based company said yesterday. Investors will be shielded against defaults on the underlying mortgages by both a Freddie Mac guarantee and credit protection created by the deal’s structure, the company said.

Mortgage Securities

Freddie Mac and Fannie Mae, which is also under government control, gained larger roles in the market for financing apartments after demand for private commercial-mortgage-backed securities collapsed as property prices fell. Sales of private U.S. commercial-mortgage bonds totaled $1.4 billion last year, compared with the record of $237 billion in 2007, Bloomberg data show. In 2009 Freddie Mac sold $2.1 billion of similar securities.

“Given our pipeline we expect to come to market every other month throughout 2010 with new deals, and thereby continue to provide greater liquidity to the multi-family housing market,” David Brickman, Freddie Mac’s vice president of multi- family and CMBS capital markets, said in a statement.

Fannie Mae plans to sell three-year benchmark notes today, the Washington-based company said yesterday in an e-mailed statement. The size of the offering, its first since the Treasury Department’s Dec. 24 announcement of an expansion of its capital backstops and portfolio limits for Fannie Mae and Freddie Mac, wasn’t disclosed.

Spreads Narrow

The sale comes as spreads on bonds of the mortgage companies narrows. Freddie Mac sold $4 billion of five-year reference notes that mature Feb. 9, 2015, at a price to yield 2.88 percent, or 27.5 basis points more than Treasuries. In June, the company sold five-year notes at 3.054 percent, a spread of 41.3 basis points.

Average premiums on so-called agency debt -- mostly from Fannie Mae and Freddie Mac, government-chartered Federal Home Loan Bank system, and banks that sold Federal Deposit Insurance Corp.-guaranteed bonds -- have narrowed 4 basis points since Dec. 24 to 27 basis points yesterday, according to Barclays Capital Inc. index data. That compares with the record high of 180 basis points reached on Nov. 20, 2008.

Thursday, January 14, 2010

TriOptima terminates $14.5 trillion notional CDS

TriOptima announced that its triReduce multilateral termination service significantly reduced outstanding notionals between dealers in credit default swap (CDS) and interest rate swap (IRS) outstandings during 2009.

With 68 CDS portfolio compression cycles globally, triReduce eliminated $14.5 trillion in CDS notionals, $12 trillion in credit index transactions with an additional $2.5 trillion in European, Asian and Japanese single name and credit tranche transactions. This also included the Thomson index and single name portfolio compression cycles which were the first to be initiated after implementation of the ISDA “Small Bang” protocol.

Multilateral terminations in interest swap transactions virtually doubled in 2009 to $25.8 trillion from $13.6 trillion in 2008. The largest reductions in interdealer notional outstandings were in interest rate swaps in USD ($11.2 trillion), EUR ($8.8 trillion) and JPY ($1.8 trillion). TriOptima offers triReduce termination cycles in 22 currencies globally including AUD, CAD, CHF, CNY, CZX, DKK, EUR, GBP, HKD, HUF, INR, JPY, KRW, MXN, NOK, NZD, PLN, SEK, SGD, TWD, USD, and ZAR.

“We are pleased that we were able to support the industry in its ongoing efforts to reduce OTC derivative notional outstandings,” said Ulf Andersson, triReduce global business manager. “CDS portfolio compression continues strong despite the dramatic reductions through compression in 2008 and the introduction of clearing; while the heightened focus on interest rate swaps is achieving significant results that should continue in 2010.”

European Derivatives Companies Form Regulatory Lobby Group

Original posted in the Wall Street Journal:

European derivatives exchanges, clearing houses and dealers have set up a lobby group to represent their interests at a time when European policy-makers are drawing up rules set to change the face of trading in this market.

The European Industry Council, which has been formed under the auspices of the London-based Futures and Options Association, will represent these companies' interests in debates on recent regulatory proposals such as a financial transactions tax and limitations in the ownership of clearing houses.

The European Commission is already drawing up rules to encourage banks and their customers to trade standardized over-the-counter derivatives on exchanges and to clear them through clearing houses to reduce the impact of a default by one of their counterparties and to improve transparency in the market.

The commission, for example, plans to increase costs for banks that don't clear derivatives through central clearing houses, by requiring these banks to hold larger amounts of capital against potential losses.

U.S. regulators also plan to encourage more trading and clearing of OTC derivatives but many lobbyists say they aren't taking as hard a line on the issue as European supervisors.

"The current pace of regulatory change is significant," said Anthony Belchambers, chief executive of the FOA. "Many of the recently proposed regulatory developments...will have widespread implications for exchanges and their members alike."

The EIC will initially comprise representatives from exchanges ICE Futures Europe, the London Metal Exchange and NYSE Euronext; European clearing house company LCH.Clearnet; banks Deutsche Bank AG and Morgan Stanley; and brokerage Marex.

Tuesday, January 12, 2010

5% retention Rule, A Small Positive Step – Fitch

Original posted on the International Securitization Report:

The EU retention rule that will from next year force European banks to retain 5% of securitisations that they originate and place with investors is a "small" but "positive step", Fitch said in a report.

The rating agency believes that on balance, the new rule will help better align the economic interests of originators with those of investors. But the effects are likely to be muted for typical securitisations from established bank balance sheets. The changes may, however, reduce the attractiveness of the originate-to-distribute model, especially for lightly capitalised originators, due to the requirement for ongoing originator "skin in the game", which may help avoid some of the worst excesses of the sub-prime crisis, Fitch noted.

Fitch warned that in "some cases, the option under the retention rule that best achieves the stated objective of aligning originator and investor incentives may also remove the economic incentive to securitise, undermining broader regulatory and policy efforts to restore effective securitisation markets."

Moreover, this rule does not deal with the key problem of "asymmetric information" -- originators will continue to have more information than investors regarding their underwriting and servicing standards and are free to choose the retention option that suits the originator best, Fitch explained.

Finally, the retention rule may also come into conflict with accounting rules and is open to interpretation; raising the potential that application of the rule could be inconsistent across jurisdictions and result in regulatory arbitrage, Fitch pointed out.

Monday, January 11, 2010

Rating agency reform efforts have achieved little, says PF2

Original posted on Creditflux:

PF2 Securities Evaluations has kicked off a series of papers, entitled “In Search of the Missing Pedestal”, on rating agency reform. In the first instalment, Gene Phillips argues that after two years of concentrated effort there has been little progress.

No measures have been implemented to stop a rating agency from rating a product it does not understand or believe in, or a product for which it has insufficient data to support its assumptions, he says. The influences that encouraged the decline in ratings standards have not been removed. Nor, claims Phillips, has the market’s self-imposed government mandate for the dependence on rating agencies.

According to the piece, rating agencies continue to earn significant fees rating and monitoring complex securities for which their models and methodologies have proven grossly inadequate – such as CPDOs and resecuritisations including RMBS CDOs. The market has in fact increased ratings pressure and competition by adding several new rating agencies, with recent regulatory constructs continuing to be based on ratings as the sole metric against which risk capital provisions are applied.

Basel could force OTC derivatives onto exchanges

Posted on the International Financial Law Review by Elizabeth Fournier:

New Basel proposals apply large haircuts to securitisations exposures used as collateral to hedge counterparty risk. They could ramp up charges and force derivatives trades based on that risk onto exchanges

The haircuts would be applied to the collateral that counterparties give to each other to secure obligations. Under the existing Basel II rules, all similarly rated instruments are given the same haircut. But under new rules a distinction would be made between government, corporate and asset-backed bonds.

“The Basel committee wants banks to have an economic incentive to trade derivatives through regulated exchanges, so is increasing the counterparty risk charges for one-to-one deals,” said Mark Nicolaides, partner at Latham & Watkins in London.

The new rules would double the haircut as the perceived risk involved increased, with AAA-rated government bonds subject to a 0.5% haircut, corporate bonds incurring 1% and securitisation exposures 2%.

“For a one-year instrument that might not seem like much,” said Nicolaides, “but when you consider that for instruments with more than five year residual maturity that goes up to 4%, 8% and 16% respectively, it’s a dramatic difference.”

With a consultation period on the proposals open until April 16, this point will be hotly contested by banks.

But with the additional regulatory benefit of encouraging regulated trades it’s likely to remain, particularly in the light of Wednesday’s move by the Bank of International Settlements to call central bankers and the heads of large financial institutions to a meeting in Basel to express concerns about renewed risk-taking.

The latest set of Basel proposals has also reassessed how interconnected banks are, and added a 25% premium on counterparty risk charges for large financial institutions.

The rules mean that a bank and its special purpose vehicles (SPVs) will be considered 100% interconnected, so if a bank fails its SPVs will also automatically fail.

Due to the level of detail in the proposals, banks are expected to take their time planning responses, with meetings over the next four to six weeks, and draft consultations after that.

“The committee isn’t tinkering around the edges anymore,” said Nicolaides. “This is a comprehensive modification of the rules involving some very complicated calculations.”

Thursday, January 7, 2010

Good Idea Coming

Original posted on the Baseline Scenario by Simon Johnson:

One striking aspect of the public debate about the future of derivatives – and how best to regulate them – is that almost all the available experts work for one of the major broker-dealers.

There are a couple of prominent and credible voices among people who used to work in the industry, including Frank Partnoy and Satyajit Das. And there are a number of top academics, but if they help run trading operations they are often unwilling to go on-the-record and if they don’t trade, they lack legitimacy on Capitol Hill and in the media.

The Obama administration is criticized from various angles – including by me and, even more pointedly, by Matt Taibbi – for employing so many people from the finance sector in prominent policy positions. But, the administration pushes back: Where else can we find people with sufficient expertise?

The defense sector faced a similar problem after World War II. The rising importance of technology in combat meant that the military needed specialized suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, and other types of equipment. But there was – and still is – a real danger that these companies would capture the Defense Department and push it to buy overly expensive and ineffective technologies (or worse).

President Eisenhower famously warned in 1960, as he was leaving office, about the military-industrial complex. His concise remarks were brilliant – look at the text or YouTube versions. And C. Wright Mills’ influential The Power Elite, published in 1956, put weapons suppliers at the center of our national power structure. (link: ; but this may be copyright violation.)

Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan.

But, at least in terms of weapons design and procurement, we have made some progress in developing a set of highly skilled independent engineers – as argued by Larry Candell in the latest issue of Harvard Business Review (now on-line, but there’s an awkward page break; here’s an alternative link – look for idea #3).

Larry is an interested party – from a leadership role at Lincoln Labs, he explains that this organization provides an independent design and evaluation capability that is not government bureaucracy and definitely not a profit-oriented defense contractor. (Disclosure: Lincoln is part of MIT, where I work.)

Irrespective of what you think about the defense business, Larry’s proposal vis-à-vis finance is intriguing. He thinks the government should set up its own arms-length labs (or sponsor nonprofit research organizations to do the same) that would concentrate on testing financial derivative products in test bed-type settings.

This would not, of course, be the same as trading in real markets. But with today’s computer resources and plenty of unemployed finance talent at hand, it should be possible to develop individual people and a broader organizational capacity able to test the effects of various kinds of derivatives on customers, as well as on overall financial system stability.

The proposed National Institute of Finance (NIF) would have similar broad goals – and the National Institutes of Health is an appealing model – but as NIF is currently proceeding with industry-backing (e.g., Morgan Stanley, Bank of America), we should be skeptical.

We definitely need independent derivatives experts who can be called to testify before Congress or work in an administration. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to our economic health.

It would be great if people from hedge funds or other financial institutions were willing to step forward and play this role – many of our best experts don’t actually work for the big banks. But while these independent people criticize eloquently the major broker-dealers in private, very few of them are willing to step forward in public.

Initial responses (e.g., by Stefan Stern, writing in the Financial Times) suggest that Larry’s idea may get some traction.

LSE chief urges safeguards on clearing houses

Original posted in the Financial Times by Jeremy Grant:

Clearing houses in Europe should be regulated by central banks to guard against the risk of a catastrophic failure by one of them, the London Stock Exchange‘s chief executive said.

Xavier Rolet, a former Lehman Brothers and Goldman Sachs banker, said that it was “very dangerous” for clearing houses’ capital bases and risk models to differ from country to country.

His comments come amid growing concerns that the insistence by policymakers that more financial instruments – such as over-the-counter derivatives – should be processed through clearing houses could overwhelm a clearer and spark a new crisis.

A clearing house stands between buyer and seller in a trade, using funds – or margin – deposited by its members to guarantee deals are completed even in the event of a default.

Efforts are under way on both sides of the Atlantic to force more OTC derivatives through clearing houses to guard against the ripple effects of a default such as the collapse of Lehman.

The Financial Services Authority, which regulates clearing houses in the UK, said last week: “The drive to have a significantly greater proportion of OTC derivatives markets centrally cleared will further increase the systemic importance of [clearing houses].”

Mr Rolet said it was possible that a clearing house could be overwhelmed if in the case of a default the clearing house members were unable to cover the margin calls that the clearer would make to cover the losses.

Margin is the funding posted by market participants that are members of a clearer as a form of insurance against default.

He said that clearing houses should have access to the funding provided by central banks through their discount window in the case of an emergency.

“This is not about fear-mongering, but where a clearing house has a substantial amount of ‘binary risk’ products that require a potentially huge collateral [margin] call which the [members of the clearing house] are not able to supply then the question is: who funds it?” said Mr Rolet.

“It seems sensible to us that the central banks should have at least a funding relationship to clearing houses.”

He said Europe needed a “harmonised, integrated clearing industry with standardised regulation” and “lending arrangements” with central banks.

In the US, the Federal Reserve does not regulate clearing houses.

But the Obama administration has proposed giving the Fed oversight of “systemically important clearing houses”.

Mr Rolet’s comments come as the European Commission is to address the issue of clearing in a directive early next year.

This is expected for the first time to define what a clearing house is, establish rules under which clearers should be managed and possibly stipulate what capital requirements should apply.

A draft of the directive is expected to be finalised this week.

Asked if Brussels should also address the issue of regulation by central banks, Mr Rolet said: “I think it certainly would be good if it did.”

CFTC head blames OTC derivatives for crisis

Original posted in the Financial Times by Gregory Meyer:

A top US regulator on Wednesday stepped up rhetoric calling for regulation of over-the-counter derivatives, saying they were at the heart and not a side effect of the financial crisis.

Gary Gensler, chairman of the Commodity Futures Trading Commission, said Wall Street dealers need to be “explicitly” regulated for derivatives transactions, in addition to existing government oversight, as the risks of unregulated derivatives could bring down the financial system.

“Some opponents of reform - some I would say in this room - would say this really wasn’t at the centre of the crisis, the crisis was about mortgage underwriting practices, the crisis was about not enough capital in the banks and so forth,” Mr Gensler said in a speech to the Council on Foreign Relations in New York.

“But I believe that the over-the-counter derivatives marketplace was in fact part and parcel to this crisis.”

Participants listed in the event programme included nine names from Goldman Sachs, where Mr Gensler worked for 18 years, along with several others from banks including Barclays Capital, Credit Suisse, JP Morgan and Morgan Stanley.

Asked who opposes derivatives reform, Mr Gensler said, apparently half-jokingly: “Many people in this room. You can look at the programme in the back.” He later called opponents “primarily the five or six largest Wall Street firms. They have a fiduciary duty to shareholders to maximise profits. The information advantage is theirs right now.”

Mr Gensler has called repeatedly for a centralised market where prices are more transparent to traders and regulators. In the seven months since the Obama administration kicked off sweeping reforms of the OTC derivatives markets, lobbying from banks, companies and others has intensified. They argue that all OTC derivatives are being unfairly targeted for reform because it was only part of the markets - credit derivatives - that was at fault during the crisis.

Mr Gensler has repeatedly said that reforms must encompass all OTC derivatives because they are opaque, lightly regulated and could pose risks to the financial system. The European Commission has taken a broadly similar approach.

Mr Gensler spoke as the US Senate takes up a bill to regulate OTC derivatives, which were central to the collapse of Lehman Brothers and AIG’s brush with extinction before its taxpayer bailout. A bill regulating such derivatives passed the US House of Representatives last month.

Mr Gensler downplayed risks of regulatory arbitrage, as some industry participants fear may be possible, if the US and Europe end up diverging in their approach to OTC derivatives reform.

He said a European Commission proposal on reform was consistent with US efforts to the extent that it would require all standardised derivatives to be cleared and centrally traded. Mr Gensler estimated that 80-85 per cent of the OTC derivatives market is located in Europe or the US.

Japan, China and Canada were co-operative, he said, although “Hong Kong is not as engaged right now”.

Some have been concerned that capital charges for derivatives contracts that are not cleared in clearing houses could differ across jurisdictions, creating an incentive for traders to flock to a low-cost, potentially higher-risk, location.

Mr Gensler said: “The large financial intermediaries are global in nature. If there’s comparable and consistent regulation overseas, we should be allowed as regulators here to recognise that.”

He said he was optimistic international regulators would co-operate to create consistent capital charges.

ICE clears its first 100 European credit default swaps

(ICE Press Release) Through December 31, ICE's CDS clearing houses have cleared $4.6 trillion in notional value across 56,259 transactions.

Since its inception in March 2009, ICE Trust has cleared $3.3 trillion of notional value, resulting in $232 billion of open interest.

ICE Clear Europe has cleared euro 885 billion ($1.3 trillion) of notional value since its July 2009 launch, resulting in euro 75 billion ($107 billion) of open interest.

On December 14, ICE Clear Europe launched clearing services for European single-name CDS contracts. Through December 31, ICE Clear Europe cleared 100 single- name transactions totaling euro 566 million ($829 million) of gross notional value, with open interest of euro 184 million ($265 million). ICE Clear Europe also announced that BNP Paribas and Nomura were approved as CDS clearing members and began clearing transactions.

On December 21, ICE Trust began clearing North American single-name CDS contracts. Through December 31, ICE Trust cleared 150 single-name transactions totaling $1.3 billion of gross notional value, with open interest of $500 million. ICE Trust is the only clearing house processing single-name CDS in North America.