Thursday, February 25, 2010

Repent! Repent! Before the Inferno Consumes You!

Original posted on the Streetwise Professor:

Yesterday I was exchanging emails with a couple of folks about CFTC Chair Gary Gensler’s increasingly apocalyptic jeremiads against OTC derivatives. (Indeed, I think I’ll start referring to him as “Jeremiah.”) I offhandedly wrote “Pretty soon he’ll be saying that OTC derivatives cause cancer.” Lo and behold, what do I read in today’s FT:

US taxpayers bailed out AIG with $180bn when that company’s ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system.

I personally find it very disturbing that I can channel Gensler’s thinking.

The substance of the oped is more Gensler same-old, same-old. Clearing is again the deus ex machina of his sermon:

Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both “too big to fail” and “too interconnected to fail”, and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Uhm, just who backs that guarantee, Jeremiah? Could it be the very same derivatives dealers? Meaning that the risk really isn’t moved off their books, and that they’re still interconnected?

Arguendo ad AIG makes its stock appearance (see the first quotation). George Stigler once wrote that data is not the plural of anecdote. What’s unbelievable is that Gensler (and Geithner and others) can’t even find multiple anecdotes, let alone anything rising close to the level of data. What’s even more unbelievable is that his use of the AIG anecdote is deeply misleading–so deeply, that Gensler is either very dishonest or very badly informed. First, although OTC derivatives deals were one source of AIG’s loss, they were not responsible for anything near the entire $180 billion bailout, but Gensler insinuates that they were. Second, since it is unlikely that the AIG deals were clearable then, or would be today, it is misleading to use them to advocate clearing. Third, Gensler doesn’t address the counterfactual question of what would have happened if AIG hadn’t written protection on mortgage CDOs; arguably, the crisis would have been worse.

Gensler also asserts that OTC derivatives were the underlying cause of the financial crisis. He provides no evidence whatsoever–other than the tired AIG trope. This is a complete misreading of the history of the crisis. If you don’t believe me, I suggest you read Rene Stulz’s piece on derivatives and the crisis in the most recent issue of the Journal of Economic Perspectives.

Gensler also makes some assertions that are categorically incorrect. For instance, he says: “The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk.” It is, in fact, well known that excessive transparency can reduce liquidity. There is NOT a monotonic relation between transparency and liquidity, as Gensler asserts.

More generally, on the transparency and exchange trading arguments, Gensler implies that market participants that willingly choose to trade on OTC markets instead of readily-available exchange alternatives don’t know their business.

I could go on and on, but I’ll let it rest here for now.

If the substance is tiresomely familiar, Gensler’s rhetoric reaches new heights. He pegs the metaphor meter with his lurid comparison of the role of OTC derivatives in the financial crisis to the Chicago Fire, and the banks to the cow in Mrs. O’Leary’s barn that kicked over the lantern that ignited the fire. (At least he spares us the apple story.) (The reference to Mrs. O’Leary’s cow is actually quite fitting here, as that poor creature is almost certainly the least plausible cause of the Chicago fire; the editor of the Chicago Republican admitted he made up the story for its entertainment value. He’d be more accurate talking about meteorites or Pegleg Sullivan–he should check out the Alkaline Trio song about old Pegleg. But accuracy is merely an obstacle, it appears, in Gensler’s shrill attacks.)

(And another parenthetical about the metaphor overload: is cancer “interconnected”? Usually cancer is used as a symbol of something maliciously that spreads, which is somewhat different from interconnection.)

Perhaps this remarkable performance is actually good news. Gensler apparently believes that he has to ramp up the rhetoric in order to achieve his (defective) policy goals; that’s usually a sign of desperation, and a lack of success in previous efforts to persuade.

And that lack of success is not surprising. Yes, it might have something to do with the fact that incumbents don’t want major changes in the ways they do business. But it’s also due to the fact that faulty analysis unsupported by reliable facts or data is usually unpersuasive.

But perhaps there’s an upside; we have a new entry in the Bulwer-Lytton fiction contest: it qualifies both because it is fiction, and because of its overwrought writing.

CDS demonization watch, Greece edition

Original posted on Reuters by Felix Salmon:

My CDS Demonization Watch has been on the back burner for a while: I thought that the caravan had moved on. But right now, the most-read story in the NYT business section, getting a lot of attention in the Twittersphere, is this one, headlined “Banks Bet Greece Defaults on Debt They Helped Hide”. It’s gaining a lot of traction: Ben Bernanke said today that he’s looking into the issue of whether the CDS market is enabling some kind of run on the Greek government. I sincerely hope he was just being polite to his Congressional overlords, rather than buying in to this theory.

It’s worth looking at the NYT story in some detail, to see just how little sense it makes.

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin.

Echoing the kind of trades that nearly toppled the American International Group, the increasingly popular insurance against the risk of a Greek default is making it harder for Athens to raise the money it needs to pay its bills, according to traders and money managers.

The first thing worth noting here is that Greece is not anywhere near the brink of financial ruin. The CDS market is actually very good at showing when a borrower is near financial ruin: when that happens, spreads gap out past 1,000bp to something closer to 2,000bp or even 3,000bp. Greece’s CDS spreads peaked at about 400bp, which is high for an EU country, but is nowhere near distressed levels. Yes, every time the CDS spread rises it gets closer to distress, but that’s just as true — and just as unhelpful — if it goes from 30bp to 40bp.

The second point to note about these opening two paragraphs is the curious presence of AIG. AIG went bust because it wrote insurance; the NYT story is here implying that there’s some relevance to what’s happening with Greece, a reference credit that people are writing insurance on. AIG had to pay out billions of dollars to make good on CDS contracts; Greece has neither bought nor sold any CDS contracts at all. No sooner are the parallels made than they break down.

That doesn’t stop the NYT, however, which then proceeds to wheel out the cliché about CDS being “like buying fire insurance on your neighbor’s house”. The problem is that the analogy just doesn’t work in this case. Much later on in the article, after most people have stopped reading it, we’re told the truth of the matter:

European banks including the Swiss giants Credit Suisse and UBS, France’s Société Générale and BNP Paribas and Deutsche Bank of Germany have been among the heaviest buyers of swaps insurance, according to traders and bankers who asked for anonymity because they were not authorized to comment publicly.

That is because those countries are the most exposed. French banks hold $75.4 billion worth of Greek debt, followed by Swiss institutions, at $64 billion, according to the Bank for International Settlements. German banks’ exposure stands at $43.2 billion.

These banks aren’t buying insurance on someone else’s house, they’re buying insurance on their own house. As the old saying goes, if you owe $75,000 to the bank, you’ve got a problem. If you owe $75 billion to the bank, the bank has a problem. And in this case, the banks are doing their best to deal with that problem and manage their risk proactively.

The question here is whether their ability to do so in the CDS market is exacerbating matters for Greece. The mechanism here is complex, if it exists at all:

As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

At the very least, this does a large disservice to bond investors. They’re not sheep who are happy to lend to any country unless or until its CDS spreads widen — in fact, at the margin, they’re more likely to lend to a country if they know that they’ll always be able to hedge that position in a liquid CDS market. Now, it’s true that as worries over Greece’s creditworthiness get more intense, Greece’s cost of funds goes up. But there’s a strong case to be made that absent the CDS market, Greece simply couldn’t borrow at all: the existence of the CDS market has made it easier (if more expensive) for Greece to borrow money, not harder.

There is a connection between the CDS market and the cash bond market, thanks to the concept of delta hedging — people who sell credit protection on Greece will often end up selling Greek bonds at some point in order to manage their exposure. But that connection is much more tenuous than the alternative, which is that of banks looking to reduce their Greece exposure all dumping their Greek bonds onto the market at the same time. The result of that kind of operation would be spreads much wider than 400bp.

The weirdest bit of all in the NYT article is the way it places the blame not on people trading Greek CDS, but rather on people trading a more general sovereign CDS index:

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations.

If you want to gamble on Greece, you can gamble on Greece: gambling on a broader Western Europe index makes little sense. What’s more, insofar as people are trading the iTraxx index, they are very unlikely to delta-hedge in the bond market — they’re just taking positions for a few hours or days, trading in and out. Blaming the iTraxx index for Greece’s problems makes no more sense than blaming the ABX index for the subprime crisis: it’s a symptom, not a cause.

But by far the worst part of the NYT piece is its headline: at no point in the article does it come close to making the case that banks in general, or Goldman Sachs in particular, are betting on a Greek default. At worst, banks are hedging their large exposure to Greece and other PIGS nations using an index they helped to create. But the fact is that Greece’s financing burden — the title of the NYT webpage is “Trades in Greek Debt Add to Country’s Financing Burden” — is entirely its own making. Blaming the banks here makes no sense at all.

Asia launches reforms for OTC derivatives

Original posted in the Financial Times by Robert Cookson:

The US and Europe may be making the most noise about the need to reduce systemic risk in the over-the-counter derivatives markets but regulators in Asia – a region not known for trading in such opaque instruments – are starting to blaze their own trails.

Having witnessed the turmoil that gripped OTC derivatives markets in the west during the financial crisis, Asian regulators are keen to prevent the same problems from appearing on their own turf.

But there is also a concern that Asia does not get left behind in the race to reform the vast OTC derivatives markets as the US and Europe co-ordinate on reforms of their own.

The concern, say industry experts, is that as the big exchanges and clearers in the west start to gain traction with their new OTC clearing businesses, their momentum could crowd out Asian players from what is rapidly emerging as a ground-breaking business opportunity in global financial markets .

Japan, India, China, Hong Kong, Singapore, Korea and Taiwan have all created task forces to study setting up clearing operations for the opaque OTC markets, either by using existing clearing houses or by setting up clearers specifically for OTC derivatives.

Japan’s Financial Services Agency, the markets regulator, last month published the results of a consultation on the issue in which it recommended that more OTC derivatives be cleared and that improvements be made to clearing houses.

The moves are the latest phase of reforming zeal that has affected markets since last summer, when the Obama administration first insisted on sweeping reforms that aimed to bring greater transparency and safety to OTC derivatives .

So far US and European policymakers have agreed on a need to move as many OTC derivatives that are deemed eligible for clearing through clearing houses after they have been traded. A clearer stands between two parties to a trade, guaranteeing that a trade goes ahead even if one party defaults.

The aim is to prevent the default of one market participant from spreading “counterparty risk” throughout the financial system. A lack of such safeguards in OTC markets led to a dangerous ripple effect in 2008 when the Lehman Brothers default triggered widespread counterparty risk fears.

While Asia constitutes a small part of the global OTC markets – where notional outstanding volumes total $600,000bn, according to the Bank for International Settlements – trading volumes are rising fast and most international dealers have established footholds across in the region.

In Japan – the biggest market in the region – the notional outstanding amount of interest-rate swaps expanded by 47 per cent between June 2007 and June 2009, according to the Bank of Japan, reaching $27,100bn, or about 6 per cent of the global interest-rate swap market.

Yet some western policymakers believe that without a consistent global approach, market participants will pick and choose where to conduct their business – known as “regulatory arbitrage”.

In recognition of this, South Korea plans to follow the guidelines agreed by Group of 20 officials at their Pittsburgh summit in September.

Under the Pittsburgh agreement, all “standardised” OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through clearing houses, or “CCPs”, by the end of 2012 at the latest.

Although Singapore is not in the G20, it has endorsed its process. The local exchange, SGX, aims to become a regional hub for OTC clearing and is exploring the idea of joining forces with other clearers such as the UK-based LCH.Clearnet, already the world’s largest clearer of OTC interest rate swaps.

SGX already clears OTC oil, freight, and other commodity derivatives through its Asiaclear unit and plans to expand into OTC foreign exchange and interest rate products.

But as the push for OTC clearing gains momentum, there is some concern among the big OTC dealers at banks that a proliferation of CCPs could add to costs for some amid a proliferation of CCPs, forcing dealers to post margin in multiple places.

Keith Noyes, Asia head of the International Swaps and Derivatives Association, which represents the dealers, says: “There is a lot of potential risk that we get lots of ‘national champion’ CCPs that are very inefficient. From a practitioner’s standpoint, costs would go up dramatically.”

For its part, China launched the Shanghai Clearing House three months ago, although the country has not revealed what products would be included and when clearing would start.

The Clearing Corporation of India, which was established in 2002, has started clearing rupee foreign exchange derivatives and is moving towards the clearing of local interest rate swaps.

Japanese trading volumesIn Japan, the FSA has concluded that at least one CCP will be necessary for the clearing of straightforward interest rate swaps and credit default swaps of a certain turnover, such as iTraxx Japan index transactions.

For interest rate swaps, Japan’s FSA has said that, ideally, domestic CCPs should be used to reduce settlement risk swiftly and effectively.

But not all Asian countries are quite so gung-ho. While Taiwan is also considering setting up a national CCP, a central bank official says there is no urgency to do so because its OTC derivative market is relatively small.

For similar reasons, Australia says it is unlikely to build a domestic OTC clearer.

But there is another reason why some countries are hesitant about the idea of building their own clearing houses: the risk of getting it wrong.

“A CCP is the ultimate too-big-to-fail institution,” says one regulatory expert. “If a CCP goes down, you really are looking at financial armageddon.

Tuesday, February 23, 2010

ECB to start lending covered bonds?

Original posted in FT Alphaville by Izabella Kaminska:

Here’s an interesting story from this week’s issue of The Cover, a trade publication focused on the covered bond market.

According to the weekly title, the European Central Bank may soon begin lending out the covered bonds it purchased under its €60bn programme to help secondary market liquidity.

The Cover article says that the industry is particularly keen on this because, while the ECB’s programme may have helped kick start issuance in the primary market, it didn’t necessarily improve secondary market activity at all. In fact, according to the author of the report, it may even have hampered liquidity.

The problem being that a general lack of bonds in the market was heightened by the ECB purchases. Without supply freely available, market makers became reluctant to go short. Bid-offer spreads inevitably widened, and liquidity suffered more.

Dealers made their feelings known in a letter to the director general of market operations at the ECB Francesco Papadia, dispatched via the AFME/European Covered Bond Dealers Association (ECBDA) back in October.

As The Cover highlights, here’s how they suggested at the time that lending of purchased bonds by the ECB could alleviate the situation (our emphasis):

The ECB and the NCBs “buy-and-hold” strategy has taken an enormous amount of Covered Bonds out of circulation. Covered Bonds are also being posted as collateral with the ECB in enormous quantities. The ECB and NCBs opening up and lending out purchased bonds would help to alleviate the situation on the repo side which could lead to more mixed flows and therefore improvements in liquidity.

Which sounds to us like much of the new supply the ECB’s purchase programme generated simply went straight for use to the ECB’s liquidity window.

In that case it’s probably worth remembering what’s been happening to respective country bond-spreads since then. Because as the dealers themselves noted back in October:

October has proven to be much slower in terms of new issuance and some recent deals may have struggled with oversupply in the market. Dealers also witnessed certain new issues particularly from Spanish
jurisdictions now trading wider in the secondary market.

Which perhaps sheds some light on the following statement from the ECB’s head of market operation analysis Michel Stubbe back on February 17?

As Reuters reported:

While issuance resumed quite well after the ECB announced last summer it would buy 60 billion euros ($82 billion) worth of covered bonds, the central bank sees possible trouble ahead in the sector, the ECB’s head of market operations analysis division told an IFR covered bond conference. “We are not so sure everything is going better,” Michel Stubbe said. “Further homework is needed in order to maintain the momentum.”

Monday, February 22, 2010

Financial Crisis Inquiry Committee holds hearings

Originally posted on Lexology:

On January 13th and 14th, the Financial Crisis Inquiry Committee held its first public hearings. The prepared statements of the Committee's commissioners and witnesses are available on the Committee's website, Witnesses included SEC Chairman Mary L. Schapiro, who stated that the SEC staff is broadly reviewing the regulation of asset-backed securities including disclosures, offering process, and reporting of asset-backed issuers. The staff is also considering several proposed changes designed to enhance investor protection. Schapiro Testimony. The Committee will seek testimony from Federal Reserve Board Chairman Ben Bernanke, as well as former regulators including Alan Greenspan and Christopher Cox. Future Witnesses. Lanny A. Breuer, assistant attorney general in the Justice Department's criminal division, testified that the division is investigating the underwriters of subprime mortgages as well as those who securitized and sold them. Criminal Investigations.

Friday, February 19, 2010

American Bar Association on Securitization Risk Retention Proposals

Following the Obama Administration's announcement of its proposed legislative reforms aimed at securitization and recognizing securitization's critical role both to the availability of consumer credit and to corporate liquidity, the Securitization and Structured Finance and Banking Law Committees formed a drafting committee of lawyers with broad experience in the asset securitization and banking arenas.

The Committees believed that a "white paper" describing securitization's history, structures, economics and role in the economic crisis, and discussing some of the possible effects of the proposed reforms, could educate readers and assist policymakers in formulating a targeted approach to securitization reform that would avoid unintended consequences.

The drafting committee, chaired by Ellen Marks (Latham & Watkins LLP), recently completed the paper, entitled "Securitization in the Post-Crisis Economy: An ABA Business Law Section White Paper." The White Paper was presented by the Committees to the ABA Task Force on Financial Markets Regulatory Reform, and with its encouragement, the Business Law Section furnished copies of the White Paper to Senator Dodd, Congressman Frank and other key members of Congress on January 25, 2010.

Trade Receivable Securitizations Make a Comeback

Original posted on the International Securitization Review:

Trade receivables have re-emerged as a favoured asset class among securitisation market players, Dechert lawyers said in a report. This is due to their short maturities, traditionally straightforward deal structures and a historic ability to provide companies that have less than top-grade credit with access to the capital markets.

"The costs of rapid expansion and globalisation have led to an increased need for working capital on both sides of the Atlantic, and some global companies have begun to finance their European subsidiaries using methods more traditionally utilised in the United States (i.e., trade receivables securitisation)," Dechert said.

In addition, some lenders have turned to Europe in search of short-term assets because of perceived saturation within the US trade receivables market and the appearance of room for growth on the continent.

The majority of Europe's trade receivables are produced in England, France, Germany, Italy, Spain and the Netherlands.

"Whereas many United States trade receivables opportunities may have already been absorbed by the market (or simply moved from one conduit to another), new opportunities are still available within Europe, particularly with respect to cross-border transactions," Dechert noted.

South Korea OTC Law Approved

Original posted on International Financial Law Review by Tim Young:

South Korea’s New Product Approval (NPA) bill that will force banks to seek approval before selling new types of over-the-counter (OTC) derivatives has passed through the legislation and judiciary committee.

The bill received initial approval on February 16. It is expected to be passed on February 26 in the assembly plenary session.

If passed, the law will have a dramatic effect on institutions selling derivatives in the country. Any new credit derivatives will have to be reviewed by the newly established Korea Financial Investment Association (Kofia), regardless of the counterparty. And any new derivatives sold to general investors will also have to be approved, regardless of the underlying.

The NPA will affect all licensed investment brokers or dealers. These include a number of foreign banks, which have been fiercely contesting the licences and the right to trade derivatives in the country for years.

Despite political pressure to pass the bill, opposition remains. “It will seriously restrict the derivatives market,” said an in-house counsel at a Korean bank.

The counsel believes the pre-approval committee – made up of professors, accountants and private practice lawyers – won’t be knowledgeable or confident enough to approve many of the products.

“These so-called experts will be conservative in their approvals. Many are still aware of the litigation surrounding last year’s currency options and won’t want to be seen approving a product that could lead to further litigation,” he added.

The proposals are unique. “We have conducted a wide range of research into OTC regulation and have found nothing like this anywhere in the world,” said Hyun Joo Oh, derivatives partner at Lee & Ko in Seoul.

In December 2009, when the law was first proposed, The International Swaps and Derivatives Association (Isda) also publically criticised the plans.

Banks will have time to adjust though: the bill contains a grace period of three months, which is expected to remain in the final law if it is passed.

Some fear the law slowing down new products. “In OTC, timing is very important. If it takes two or three months for the banks to obtain approval it will be incredibly hard to launch products,” said Hyun Joo.

In informal conversations with the regulator, Hyun Joo was told that that the approvals will take between one and two weeks. “They have promised to expedite the process, but we’ll have to see.”

She does think that products will still be approved though. “Rather than a straight ‘no’, it’s more likely Kofia will ask to add some risk disclosure to the counterparty,” she added.

See also:

To hear a presentation by Isda outlining the problems with the bill, click here

Isda’s criticism of the proposals from December last year

An in-depth analysis of the law and its effects by Yoon Yang Kim Shin & Yu

Thursday, February 18, 2010

Italy loves currency swaps too

Original posted on FT Alphaville by Izabella Kaminska:

Turns out, sovereigns are not the only public bodies with a love of currency swaps.

Bloomberg reported on Wednesday that Italian municipalities are increasingly under domestic pressure over their prevalent use of derivatives in the last few years.

According to the chairman of the state audit court, Tullio Lazzaro — as quoted by Bloomberg:

“Many local authorities used such instruments to get immediate liquidity for current expenditure,” Tullio Lazzaro, chairman of the Court of Accounts, said in a speech in Rome today. “This will leave them and the future generations with forms of increasingly onerous debt.”

The Bloomberg report stated more than 519 Italian municipalities now face an estimated €990m in losses from such derivative contracts, according to to data from the Bank of Italy.

And it’s not something the Italian authorities are taking lightly. As Bloomberg continued:

Police are investigating losses on derivatives linked to 870 million euros of bonds sold by the Apulia regional government in 2003 and 2004, the prosecutor’s office in Bari said on Feb. 3.

In a separate investigation in Milan, prosecutors seized assets from four banks including JPMorgan Chase & Co. and UBS AG in April and requested they stand trial for alleged fraud in derivative contracts bought by the City of Milan.

Hearings started this month. “The distorted use of derivatives was aimed at goals unrelated to risk coverage,” Mario Ristuccia, the court’s general prosecutor, said today. This practice “extended sometimes even to local authorities of modest size and lacking the needed structures and expertise to make a financial and economic assessment.”

Jane Foley, research director over at, meanwhile noted how the matter could complicate things for Europe:

Complicating matters further have been fears that Italian municipalities may have significant derivatives exposure which has dragged Italy’s government budget under the spotlight. While Italy appeared to be running a healthy primary surplus in the years ahead of EMU its huge public debt points to years of poor fiscal management. Whether or not its budget was enhanced by the use of derivative operations does need to be clarified.

It also turns out that Italy has been a dab hand at currency swaps for some time.

In a separate but not un-related story, the ECB put out a denial on Wednesday that Bank of Italy governor Mario Draghi had played any role in arranging the now infamous Greek sovereign ‘deficit smoothing’ currency swap while employed at Goldman Sachs. As Bloomberg reported:

“Swap deals involving Goldman Sachs and the Greek government were made previously to Mario Draghi’s appointment at Goldman Sachs” in 2002, the Bank of Italy in Rome said in a statement today. Draghi had “nothing to do with those transactions,” nor with any subsequent swaps, a spokeswoman said by phone. She declined to be named in line with the central bank’s policy.

According to Bloomberg, Italian authorities developed somewhat of an expertise in this area back in the 1990s, when Italy first used derivatives to lower its deficit to qualify for membership of the euro. As the wire stated: “The swaps allowed it to temporarily cut the amount of interest paid and to trim the 1997 deficit. The European Commission reviewed the operation and approved the transaction.”

There was nothing wrong with this at the time because the country’s official currency was still the lira, Italian Finance Minister Guilio Tremonti told reports in Brussels on Wednesday.

We, meanwhile, would remind that currency derivatives were also aggressively marketed by western and err Italian banks in areas like Eastern Europe in the last few years. Polish media estimated back in February 2009 that derivative-related losses in forex the previous year may have amounted to as much as 20-30bn zlotys for Polish firms.

In which case, are derivative losses stemming from such transactions in more established markets really such a surprise then?

Gaming the PPIP?

Original posted on the Baseline Scenario by James Kwak:

A couple of weeks ago, Yves Smith picked up on the story that the TARP Special Inspector General is investigating suspicious trades in connection with the Public-Private Investment Program. When PPIP was announced almost a year ago, there was widespread speculation about how banks and other private investors could take advantage of the program to unload toxic securities onto taxpayers (technically speaking, onto investment funds containing some private money, some public money, and a lot of non-recourse financing from the government). That story more or less faded away because PPIP never really amounted to much; banks apparently decided they were better off sitting on their toxic assets, counting on favorable accounting rules and regulatory forbearance, instead of selling them.

Here’s the relevant section from the SIG-TARP report (p. 141):

“The PPIF management company in question operates both a PPIF and one or more non-PPIF funds that invest in similar securities (i.e., mortgage-backed securities (‘MBS’)). In the case of this fund management company, the same person is the portfolio manager for both the PPIF and the non-PPIF fund. In late October, the portfolio manager directed that a particular MBS from the non-PPIF fund be sold after the security — in this case a residential MBS — had been downgraded by a rating agency. According to the company, multiple bids were received, and a quantity of the security was sold to a dealer. Within minutes of the sale, however, the same portfolio manager purchased, for the PPIF, the same amount of the same security from the dealer at a slightly higher price. Later in the day, the portfolio manager bought more of the security for the PPIF from the dealer at the original price.

“The management company involved (the identity of which is not being disclosed at this time pending SIGTARP’s investigation) asserts that there was nothing inappropriate about these trades, and Treasury has concluded that the trades did not violate PPIF rules. The facts, however, give rise to difficult questions. Was the initial purchase really arm’s length, or was the dealer aware that the portfolio manager was prepared to repurchase the securities immediately? How can a manager conclude that it is wise to sell a security at one price but then almost simultaneously repurchase the same securities at a higher price? Were these trades designed to push the risk of this downgraded security from the private, non-PPIF fund onto the taxpayer-supported PPIF?”

I wouldn’t necessarily assume wrongdoing. For one thing, the fund manager is just a fund manager, meaning he makes fees (based on assets under management and performance) from both the PPIF and the private fund. So arguably, shifting losses from one fund to another doesn’t help him that much. Of course, there are various scenarios under which it would benefit him: the fees from the private fund could be higher; one fund could have profits from which he gets a cut while the other may not; he could have his money in the private fund but not in the PPIF; he could have a nudge-nudge wink-wink agreement with the private investors; and so on.

Stripping away the disguise of derivatives

Posted in the Financial Times by Satyajit Das:

Reaction to revelations that Greece used derivatives to disguise its true level of borrowing is reminiscent of Captain Renault (played by Claude Rains) in Casablanca: “I am shocked, shocked to find that gambling is going on in here.”

Use of derivatives to disguise debt and arbitrage regulations and accounting rules is not new. In the 1990s Japanese companies and investors pioneered the use of derivatives to hide losses – a practice called “tobashi” – “to make fly away”.

Derivatives, such as interest rate and currency swaps, are used to alter the interest rates and currency of the cash flows on existing assets or liabilities. Transactions entail exchanges of one stream of payments for another. At the commencement of the transaction, if the contract is priced at current market rates, then the current (present) value of the two sets of cash flows should be equal (ignoring any profit). The contract has “zero” value – in effect, no payment is required between the parties.

Using artificial “off-market” interest or currency rates, it is possible to create differences in value between payments and receipts. If the value of future payments is higher than future receipts, then one party receives an upfront payment reflecting the now positive value of the contract. In effect, the participant receives a payment today that is repaid by the higher-than-market payments in the future. Any number of strategies involving combinations of different derivatives can achieve this effect.

Greece may be merely following the precedent of another Club Med member. In 2001 academic Gustavo Piga identified Italy’s use of derivatives to provide window dressing to meet its obligations under the European Union’s Maastricht treaty.

In December 1996 Italy used a currency swap against an existing Y200bn bond to lock in profits from the depreciation of the yen. Italy set the exchange rate for the swap at off-market rates – at the May 1995 level rather than the current rate.

Under the swap, Italy paid a rate of dollar Libor minus 16.77 per cent reflecting the large foreign exchange gain for the counterparty. Given Libor rates of 5 per cent, the interest rate paid by Italy was negative. The swap was really a loan where Italy had accepted an unfavourable exchange rate and received cash in return. The payments were used to reduce Italy’s deficit, helping it meet the budget deficit targets of less than 3 per cent of GDP.

The Greek transactions are believed to be similar cross-currency swaps linked to the country’s foreign currency debt, structured with off-market rates. Analysts suggest that the cash received from the transactions may have reduced Greece’s debt/GDP ratio from 107 per cent in 2001 to 104.9 per cent in 2002 and lowered interest payments from 7.4 per cent in 2001 to 6.4 per cent in 2002.

Securitisation, non-consolidated borrowers, private-public financing arrangements supported indirectly by the state and leasing of assets can also be used to disguise levels of debt.

Although no illegality is involved, the arrangements raise important questions about public finances and financial products.

The episodes also raise questions of the skills of regulators and reporting agencies in understanding and dealing with complex financial structures. They highlight inadequacies of public accounting.

Reported debt statistics fail to provide adequate information of the level of borrowing, the real cost of debt and future repayment commitments. Under international standards applicable to corporations, such an off-market swap would have had to be accounted for on a mark-to-market requiring greater disclosure, especially the large negative market value (representing future payment obligations) as a future liability.

Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. The true cost to the borrower and profit to the counterparty is also not known, because of the absence of any requirement for detailed disclosure in derivative transactions.

Derivative professionals argue that the instruments are used to hedge and manage risk. While they do play this role, derivatives are now used extensively to circumvent investment restrictions, accounting rules, securities and tax legislation.

Current proposals to regulate derivatives do not focus on this issue. The policy case for permitting such applications is not clear.

As the so-called Greek Job highlights, simple borrowing and lending can be readily disguised using derivatives, exacerbating risks and reducing market transparency.

Regulators need to heed the warning of the 17th-century French author Francois de La Rochefoucauld: “We are so accustomed to disguise ourselves to others that in the end we become disguised to ourselves.”

Satyajit Das is the author of the recently released “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives”

Wednesday, February 17, 2010

Bank funding: taxpayers have done enough

Original posted in Euroweek:

UK mortgage lenders and rating agencies have woken up to the threat of £319bn of state-supported borrowing that will need refinancing in the three years from 2011. But pleas for further state aid will likely go unheeded: the securitisation industry has already had two years to put its house in order while the government has its own fiscal problems to worry about.

The Bank of England dashed the hopes of mortgage lenders last week when it firmly closed the door on an extension of its Special Liquidity Scheme through which it provided term funding for mortgage bonds.

Some £287bn of collateral was posted with the Bank during the SLS’s brief life in exchange for £185bn of funding with a term of up to three years. The vast majority of this is believed to comprise mortgage backed securities and covered bonds — some £242bn of which was issued but not placed with investors while the SLS window was open.

So it is understandable that the Council of Mortgage Lenders would respond to the closure with warnings of a huge funding gap, backed up this week by Moody’s. Between the SLS and the Credit Guarantee Scheme, which provided government backing to banks’ senior unsecured debt, lenders will have to refinance over £319bn of debt over three years, said the CML, in addition to financing new lending.

According to Deutsche Bank analysis published by this week, SLS swaps will begin coming due in earnest in June 2011, with between £10bn and £25bn of maturities each month until January, 2012. Meanwhile, two thirds of the CGS bonds are due to mature in 2012 with the remainder due by 2014.

In light of this, the CML’s calls for further government support are understandable, as are Moody’s warnings that the funding gap will put pressure on UK lenders, especially building societies. There is no doubt that the UK government was too slow to act to restart private markets in mortgage bonds — unlike its prompt liquidity support, concrete programmes for funding support only emerged late last year and have so far proved unworkable.

Since September last year, originators have issued just a trickle of mortgage bonds from the UK in the absence of explicit government support. The issuance has been encouraging, but also limited to a handful of issuers and in many cases underpinned by large orders from a single investor. This week Co-operative Bank is marketing a £2.5bn RMBS, but only £350m of this is being sold publicly.

By contrast, the Term Asset Backed Securities Loan Facility in the US has had a dramatic impact on investor demand for consumer ABS, to the extent that most market participants feel that a vibrant market will survive the withdrawal of support. It has even begun to spur new issuance of CMBS, even as the sector enters a fraught period from a credit perspective. In Australia, A$8bn of government participation in new RMBS issues alongside investors has kept the domestic market ticking along, albeit at much reduced volumes.

Time to reprice

Calls for further government support, however, seem strangely out of touch at a time when jittery markets are scrutinising sovereign borrowers intensely. The UK’s long term fiscal position is not that much better than some of the southern European governments about which IMF bailouts are being discussed, and an election is just around the corner.

An unsteady government is hardly likely to commit to adding yet more billions to its borrowing requirement at such a time, and besides a possible weakening of the UK’s credit rating might hurt the wholesale funding markets more than a guarantee would benefit individual issuers.

The securitisation industry has already had two years to put its house in order, re-engage investors and reprice underlying assets to support higher funding costs. Politicians would be justified in wondering why the taxpayer should extend its considerable exposure even further if wholesale markets are still not viable five years after the peak of the crisis.

Regardless, the circle must be squared. If the funding markets do not significantly improve, the cost of credit will increase and loan origination will decrease. The government must bear that in mind as well.

Tuesday, February 16, 2010

S&P To Add Symbol To Global Structured Finance Ratings (Press release)

As market participants will be aware, under the European Regulation on Credit Rating Agencies (Regulation (EC) No 1060/2009) in force from December 2009 (the "Regulation"), credit rating agencies regulated within the European Union will be required to add a symbol to ratings on structured finance instruments.

Standard & Poor's Ratings Services will apply for registration under the Regulation. It is our intention that, on or before Sept. 7, 2010, we will give all ratings on structured finance instruments such an additional symbol. Having carefully considered various options, we believe that operationally it is most practical to have a global application of this rule and accordingly determined that our attribution of a symbol to structured finance instruments will be global.

The symbol that we will use is "(SF)". We will add this symbol as a subscript to the existing ratings symbology (see "Standard & Poor's Ratings Definitions," published Feb. 15, 2010). No other changes are intended to the rating categories applied to structured finance instruments.

We will designate structured finance instruments with a subscript irrespective of where they are issued, the location of the issuer, originator, or assets, or the subject of the instrument.

The Regulation provides a definition of "structured finance instrument," which cites the definition in the Capital Requirements Directive (Directive 2006/48/EC). In the coming months we will be considering which instruments will require the application of the subscript based on this definition. If any market participant wishes to provide us with their feedback on this point, we invite them to communicate with us through the following address: We would be grateful if all such feedback could reach us on or before March 5.

Related Research: Standard & Poor's Ratings Definitions, Feb. 15, 2010

Islamic derivatives standard to launch soon

Original posted on Reuters by Frederik Richter, Dinesh Nair and Raissa Kasolowsky:

The launch of the first template for an over-the-counter Islamic derivative contract is "imminent" and will encourage more companies to hedge their risks, an executive at a bank involved in its creation said on Tuesday.

The contract, which is expected to pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions, was initially due to be launched a year ago.

"It will be launched imminently," Simon Eedle, Managing Director of Islamic Banking at Credit Agricole CIB (CAGR.PA), told the Reuters Islamic Banking and Finance Summit on Tuesday.

The bank, as well as the IIFM, an industry body backed by the central banks of several Muslim countries, has been working with the International Swaps and Derivatives Association (ISDA) on the contract.

The contract -- to be known as Ta'Hawwut or hedging -- would create a standard legal framework for OTC derivatives in the Islamic market, whereas currently contracts are arranged on an ad hoc basis.

"It will save time," Eedle said, adding that it will also help the industry in managing its asset liabilities.

The Islamic finance industry is governed by a patchwork of national banking regulations, its own standard-setting bodies and scholars interpreting Islamic laws, making contracts much more complicated.

Designing a two-party derivatives contract could previously take six to nine months, which will be considerably reduced by this master agreement, Eedle added.

OTC derivatives, or swaps, are privately negotiated deals between investors and counterparties and are commonly used to hedge against interest rate risk and default risk.

Islamic institutions have limited access to derivative products mainly because Islamic law requires the underlying assets in any transaction to be tangible, virtually excluding most of the mainstream derivatives instruments.


Eedle said the agreement might persuade institutions with doubts over the legitimacy of using these instruments to hedge their risks more easily.

"You will see more hedging on the corporate products because there is a standard there," he said.

On Monday, Munir Khan, head of Islamic finance department at law firm Simmons and Simmons in Dubai, said there is growing demand for hedging and Sharia-compliant derivatives product, such as profit rate swaps, which would be used solely for hedging and not speculation.

"Clients are starting to look at hedging their risks more," he said. "The whole industry is developing very rapidly ... and we're seeing a huge amount of work in that area."

In addition, ISDA's endorsement of the template will mean it will be quickly be accepted by banks and institutions, Eedle said.

"The fact that it is endorsed by ISDA will force the Western banks on to the standard very quickly, because the risk culture in conventional banks is to adopt market standards," he said.

Islamic scholars are split on the legitimacy of derivatives; some see them as permissible instruments to hedge risks but others as speculative transactions, which Islam forbids.

Some Islamic operators have used a contract known as Arbun to replicate call options.

"Of course on the balance of it, we don't want the agreement to encourage speculation. This documentation is not produced to encourage a replication of conventional banking," Eedle said.

Monday, February 15, 2010

Sovereign CDS: Cat or Canary?

Right, time for a little bit of perspective on the sovereign CDS are good/evil (delete as appropriate) debate, courtesy of BarCap.

The above charts show the relative size of the CDS market in the eurozone periphery as proportion of outstanding government debt.

As you can see they range from a few percentage points to 10 per cent in Portugal. For other developed countries (Germany, Frank, UK and the US) the proportion is even smaller, according to BarCap. A maximum of 1.5 per cent and even lower for the UK and US.

Now, here are some more charts, which show how spreads move relative to market activity.

What this shows, BarCap says, is two things:

Spread widening, triggered by real issues, was exacerbated by the sovereign CDS market, where the price discovery process is more skewed towards ‘shorts’ than in the cash markets.

The ensuing widening of spreads, and as importantly, volatility of these spreads, then caused cash market participants to adjust their positions (reducing longs or going underweight), with the move feeding on itself, and leading to a deterioration in the liquidity of the cash markets. Essentially, an initial CDS-driven move would thus have been followed by a generalised risk reduction and loss of liquidity. This is somewhat supported as well by the evolution of the cash-CDS basis.

And on that final point, BarCap makes the following observation:

These charts show clearly that the CDS market has been much more active when spreads are volatile and widening. On the one hand, this is not unexpected; market volatility tends to generate activity. The charts do not establish that activity in the CDS market leads the widening of spreads as such; the moves seem to be contemporaneous (similarly, an analysis of the evolution of cash and CDS sovereign spreads points to no particular lead or lags between them).

On the other hand, both charts show that CDS activity drops quite a bit when spreads tighten. This would suggest that the CDS market tends to be dominated by players who are looking to buy protection (ie, be short in cash terms). This may be particularly the case in markets where it is more difficult to be short.

For example, the Greek repo market is not centrally cleared, which limits the appetite of dealers and investors to be short in specific bonds (there are only around €5bn of shorts currently – much the same as in Portugal, which is a 50% smaller government bond market, but is LCH cleared). We suspect as well that the mark-to-market sensitivity of a number of these players might be higher than the one of those active in the cash markets (which would tend to be dominated by longer-term, more passive types of investor) – a factor that could generate more volatility.

Bringing it altogether and considering the relative sizes and liquidity of the markets, BarCap reckons investors should be looking to government bond markets (and in particular to measures of government swap spreads versus OIS curves) rather than the CDS market for an accurate gauge of sovereign default risk.

Sovereign CDS, it says, are neither the ‘canary in the coalmine’ or the ‘cat among the pigeons’.

Europe’s ABS currency-swap exposure

Original posted on FT Alphaville by Izabella Kaminska:

Back in January, a US court rather controversially decided that claims of a Lehman Brothers special purpose vehicle — to which the bank was a counterparty — should not be subordinated to other creditors.

As the FT commented at the time:

It is a controversial ruling which will be closely scrutinised for its implications for the structured products and derivatives markets.

Judge Peck decided on Monday that a provision that would normally subordinate Lehman’s claims is unenforceable under US bankruptcy law. The decision goes against a ruling by the English courts last summer which determined that a group of investors in the vehicle should be paid ahead of the failed bank in its unwinding.

While the above decision was always going to have far-reaching implications for structured product and derivative markets, a recent note from BarCap draws attention to the implications for Europe’s ABS market.

One concern, it turns out, is Europe’s beloved use of embedded swaps in ABS deals for the purpose of hedging out interest-rate, basis and currency risk. These, it seems, are hedged out in exchange for credit risk.

Usually this is considered acceptable because even though the swaps undergo mark-to-market gains and losses over the life of an ABS transaction, the fact that the notes are supposed to be hedged over the life of the transaction means gains and losses have no discernible “real-world consequence” for noteholders.

In the event of early termination, however, payments are positioned senior to those noteholders. As BarCap explain:

…should a swap be terminated early, mark-to- market gains and losses can indeed play an important role: a termination payment equal to the mark-to-market amount may be due to be paid by the swap counterparty suffering a mark-to-market loss to the counterparty enjoying a mark-to-market gain. These termination payments are often senior to the notes in European ABS cashflow waterfalls, just as is typically the case with regular swap payments.

However, there is one important exception — a swap provider bankruptcy. In this scenario payouts are subordinated to those of noteholders:

If the swap provider enjoys a mark-to-market gain, the transaction is obligated to make a corresponding payment; to ensure that making such a payment does not result in payment shortfalls to noteholders in the transaction upon its due date (and possibly an event of default under the notes), said swap termination payment is commonly subordinated to note payments if the termination payment results from the bankruptcy of the swap counterparty.

Except, as Barclays Capital points out, due to the US Lehman SPV ruling this scenario has potentially been flipped around for US swap providers. As BarCap explain:

Given the prevalence of swaps in European ABS structures, the risk that US law could apply to securitisations governed by UK law is a considerable concern.

The good news, according to the analysts, is that interest-rate or basis swaps would only ever expose noteholders to losses on the interest component of total payments — a substantially smaller sum than the principal component. What’s more, there’s less chance of a US swap provider going bankrupt in the first place because the crisis is waning.

The bad news, however, is that currency swaps reflect a much bigger concern. As BarCap note:

By contrast, currency swaps apply to the interest and the principal components of the swapped notes’ total payments and are therefore of greater concern.

Although, even here there is an upside:

…in many European ABS transactions that use currency swaps, only some notes are swapped into a currency different from the currency of the collateral – the smaller the proportion of total note notional swapped into a different currency, the smaller the transactions’ overall exposure. In addition, European ABS structures may have multiple currency swap providers, reducing the exposure to any one counterparty.

That said, despite the immediate risk to European ABS being reasonably contained, BarCap say there is still the chance of extensive ratings actions to come. They cite Fitch as follows:

“Following the completion of analysis of any securities placed on RWN, the ratings of these securitized notes could become credit-linked and downgraded to the level of the counterparty. Specifically, if a downgrade is warranted, higher-rated tranches would likely be downgraded to the counterparty rating, which is between ‘AA’ and ‘A’ in most SF transactions”.

Related links:

Ghost of Lehman hits ABS
– FT Alphaville
Lehman SPV ruling sparks controversy
– FT Alphaville

Saturday, February 13, 2010

Covered bond bailouts

Last week FT Alphaville mused on whether covered bonds — darlings of the European debt universe — could make it through a sovereign crisis unscathed.

Here’s a quick Friday follow-up.

From Deutsche Bank’s excellent fixed income team:

Covered bonds trading though sovereign bonds are typically a sell . . . With the recent tightening of Italian sovereign bonds, this has changed and confirms our view that covered bonds trading though sovereign credit, despite potentially having a higher rating, is typically unsustainable, particularly in the primary market. Given the ongoing pressure on public sector credit quality which is likely to worsen further, this point (i.e. the question if covered bonds can trade through sovereigns) is likely to be an ongoing topic. Moody’s mentioned in its 2010 outlook that the ongoing worsening sovereign credit quality is a burden for covered bond ratings.

You can see some of the sovereign stress in the below chart, showing spreads for European countries’ covered bonds. While Italian and British covereds have tightened somewhat in recent weeks, Spanish cedulas, Irish covered bonds, and those of `other’ countries are widening:

What of German pfandbriefe — the safest of the `safe’ bonds? They’ve been flatlining so far, but could eurozone sovereign stress begin feeding into the Deutsche market as well?

Deutsche Bank (perhaps unsurprisingly) thinks not:

The current outstanding volume of German Pfandbriefe amounts to around EUR 720 bn and hence is more than twice the size of Cédulas (which rank second and amount to around EUR 352 bn in total). Hence, the German government has a very strong interest to support Pfandbriefe if the need arise (arguably stronger than the need to support Greek government bonds).

Bundesbank seems to continue supporting Pfandbriefe and seems to have . . . the most ammunition regarding the ECB buying scheme. The interest of the German government in the German market can also be seen in the high covered bond exposure of German insurance companies. The exposure of German insurance companies amounts to around 35% of their assets under management, which are very likely predominantly Pfandbriefe.

Overall, while being short Pfandbriefe versus peripheral covered bonds looks attractive, given the mentioned supportive facts, the performance potential is likely far less that indicated by historical spread charts.

LCH.Clearnet Hopes To Offer Swap Clearing To Japanese Banks

Original posted in the Wall Street Journal by Sarah N. Lynch:

London-based LCH.Clearnet, a major global over-the-counter derivatives clearinghouse, hopes to soon start offering Japanese banks access to its interest-rate swap clearing service, LCH.Clearnet Chief Executive Roger Liddell said Monday.

In an interview with Dow Jones Newswires, Liddell said LCH.Clearnet is currently negotiating with banks and regulators in Japan, and may be close to an agreement. If the plan eventually comes to fruition, Liddell said he envisions that the member Japanese banks would then be able to offer their clients access to the clearing platform as well.

"We have been spending quite a bit of time in Japan with some of the larger banks there, but also with the regulators and the central bank trying to agree on an access model that would allow the large Japanese banks to become members of our SwapClear service," Liddell said. "We haven't gotten there yet, but we think we are getting close."

LCH.Clearnet's efforts to push its business into the Asian swaps market comes as regulators in the U.S. and Europe are seeking to enact new rules of the road for derivatives following the global financial crisis. U.S. and European officials hope that by requiring some market participants to have their swaps cleared--a process by which a clearinghouse guarantees a trade to protect against default--the risk to the broader marketplace will be greatly diminished.

The U.S. House passed a bill last month that would require big banks to clear some of their swaps, and the Senate is expected to take up legislation with a similar provision in the coming weeks and months. The European Commission, meanwhile, is working on a similar proposal.

Asia has been much slower to push for the central clearing of swap products, in part Liddell said because there hasn't been as much political interest there as in Europe and the U.S. But banks and Asian regulators are starting to show more interest in the idea lately. In the fall, for instance, China announced it was launching a clearinghouse for interbank financial markets.

LCH.Clearnet is currently the leading clearer of interest-rate swaps, but it is looking to expand to other asset classes of derivatives. In March, it plans to become the third European platform to compete by offering clearing for credit-default swaps--a swap often blamed for its role in nearly collapsing American International Group (AIG) in 2008.

Once that is completed, LCH.Clearnet expects to turn its attention next to foreign exchange derivatives--a class of derivatives U.S. officials appear much less poised to regulate than some of their European counterparts.

The U.S. House bill that passed last month excluded certain foreign currency products from the clearing requirements. Liddell, who was visiting Washington, D.C., this week to track the development of derivatives regulations in the U.S. Senate, said he thinks it's a mistake to single them out from new clearing regulations.

"They are an asset class with risk attached to them. They are clearable," Liddell said.

Liddell said LCH.Clearnet is close to reaching a conclusion with major global banks "in the next few weeks" for the development of a foreign currency clearing platform. The European clearing company aims to first start clearing foreign currency options, and then branch out to other foreign exchange products based on market demand. He hopes to develop and test a platform this year in time to launch by early 2011.

As for LCH.Clearnet's plans to offer clearing to Japanese banks through its SwapClear service, Liddell hopes to have something finalized by the end of the year. Before that can happen, however, Japanese banks, regulators and the company still need to clarify if a Japanese legal entity can clear products through a foreign clearinghouse and if it would require a change in the law first.

Europe Regulators Give Info On Clearing Links

Posted in the Wall Street Journal by Adam Bradbery:

The U.K., Swiss and Dutch financial regulators wrote to several European clearinghouses Friday to tell them they believe the risks created by interoperable links between them will be manageable but will require increased use of collateral, according to a person familiar with the matter.

The letter, which follows requests for regulatory clearance of links between clearinghouses in those countries, suggests that delays in achieving interoperability between European clearinghouses in a bid to reduce trading costs will be overcome, albeit in time.

Clearinghouses stand between counterparties to a trade, guaranteeing trades in the event one party goes into default.

The U.K.'s Financial Services Authority, the Netherlands' Autoriteit Financiele Markten, and the Swiss Financial Market Supervisory Authority, or Finma, wrote the letter, in which they made it clear they don't reject the idea of interoperability and that the risks involved can be managed, the person said.

The regulators also said the creation of links between clearinghouses will increase credit exposures between those companies, which will need to be managed by holding adequate collateral to compensate one company if another they are linked to goes bust. This means there will be an increase in the collateral used by companies.

The supervisors also said they won't determine which models clearinghouses must use to calculate collateral levels but they will need to show they adequately cover the risks they face. They also said that clearinghouses may need to take into account other risks to manage, including operational, legal and technical risks.

The letter from the regulators was triggered by an application made by European Multilateral Clearing Facility, a Dutch clearing house, to the Dutch regulator in the last week of December for approval of a link with LCH.Clearnet (LCHC.YY), the European clearing house company, which would allow EMCF to handle U.K. and Swiss equity trades.

LCH.Clearnet, which clears trades in the U.K., already has a link with SIX x-clear Ltd., the Swiss clearing company, which has operated since 2003.

The Dutch regulator put the approval process on hold until it had conferred with the FSA and Finma on how to manage the risk that the collapse of one clearing house could knock on to other clearing houses due to these links.

EMCF said in a statement it welcomed the guidance from regulators, which it is now studying ahead of making further comment next week.

"EMCF is happy that there is now clarity about the direction regulators are going with regard to interoperability," the company said in the statement.

LCH.Clearnet and SIX x-clear declined to comment on the matter.

The European Commission, the European Union's executive body, forced national exchanges and trade processing companies in 2006 to agree to creating links between each other as part of a code of conduct designed to reduce trading costs. The agreements would allow an investor in one country to more cheaply process stock trades executed on overseas markets by using one clearing or settlements house.

Currently, the cost of cross-border trading in the EU is higher than domestic trading and much more costly than clearing in the U.S. because trades in each country are channeled through domestic clearing and settlement systems, which means market users have to pay agent banks to get access to each of them.

More than 80 requests for links were lodged by trade-processing companies. However, the overwhelming majority never progressed because some companies wanted to protect their captive trade processing businesses or because national regulators failed to give them the green light due to concerns the links could spread problems across borders if one company went bust.

LCH.Clearnet on central bank support and interoperability

I can't access the Wall Street Letter, but this came across the tape: "European clearing houses may need access to central banks funds in order to avoid major defaults, said Roger Liddell, ceo of LCH.Clearnet, in a hearing held ..."

Also interesting is this story from the Financial Times on links between LCH.Clearnet and X-Clear:

LCH.Clearnet, Europe’s largest independent clearing house, and X-clear, a Swiss clearer, revealed on Monday details of the framework they use to link to each other as part of “interoperability”, a process used by clearers that is designed to allow traders a choice of where their trades are cleared.

The move comes as European regulators prepare to publish guidance on interoperability in the next few weeks after they called a halt to the set-up of new interoperability links late last year.

It was aimed at increasing transparency over the two clearers’ arrangements, an LCH.Clearnet spokeswoman said.

The European Commission pushed interoperability before the financial crisis as a way of spurring clearing choice and lowering post-trade costs across the region. But it has run into trouble as clearers have disagreed over issues such as risk management, and how to treat margin, or collateral, posted by one clearer to another.

Progress on interoperability ground to a halt late last year after regulators called into question a three-way arrangement between LCH.Clearnet, X-clear and EMCF, the Dutch clearer. Regulators in the UK, the Netherlands and Switzerland are expected to decide soon how such inter-clearing house links could work without posing risks to the wider financial system if one clearer were to default.

The LCH.Clearnet and X-clear interoperability arrangement, which was set up in 2003, differs from the EMCF approach – and that proposed by EuroCCP, a fourth clearer – in its treatment of margin collateral.

The EMCF/EuroCCP approach, known as a “survivor pays” model, envisages that clearers do not exchange margin collateral but increase their own default funds instead by calling on greater contributions from their members. Here, the burden of a default by an interoperating clearing house is shared by the surviving ones.

Under the LCH.Clearnet and X-clear model, both exchange margin collateral with each other in the same way their clearing members exchange margin collateral with them.

Each clearing house has “the authority to determine the eligibility of trades for clearing”, LCH.Clearnet and X-clear said. The margining process, where the clearing houses calculate how much margin they require from a counterparty to clear trades “preserves the integrity and safeguards of each clearing house”.

It also provides for distinct default funds with the aim of minimising fall-out in the event of a clearing house defaulting, the two clearers said.

Wayne Eagle, director of equity services at LCH.Clearnet said: “LCH.Clearnet and Six x-clear have a proven model that has withstood the largest default in history [Lehman Brothers].”

“It demonstrates that interoperability can be safe and secure so long as the structure preserves the integrity of the CCPs and minimises contagion in the event of a default through securely ring-fencing the surviving CCP and its members.”

Friday, February 12, 2010

S&P's On The Impact Of The U.S. Bankruptcy Court Decision On Swap Termination Payments

NEW YORK (Standard & Poor's) Feb. 9, 2010--After reviewing a recent U.S. court decision that casts doubt on the enforceability of payment modification provisions involving U.S. swap counterparties, Standard & Poor's Ratings
Services believes that the ratings impact will likely be limited to certain structured finance transactions. In our view, the ruling will most likely affect structured finance transactions that rely on the upfront payment of collateral and the subordination of termination payments (terminating structures). We are currently reviewing our ratings on these transactions.

On Jan. 25, 2010, Judge James M. Peck of the U.S. Bankruptcy Court for the Southern District of New York ruled on the enforceability of a payment modification provision in a case concerning Lehman Bros. Special Financing Inc. (Lehman) as a swap counterparty. In the issuances from the Dante Finance Public Ltd. Co. (Dante) program, the payment modification provision in the trust deed would subordinate Lehman's otherwise senior claims to payments from trust collateral proceeds whenever a swap termination resulted from a default of Lehman under the swap agreement. Lehman sought a determination that the payment modification provision was unenforceable under U.S. bankruptcy law in an effort to compel the collateral trustee for Dante (BNY Mellon) to dispose of the collateral and distribute the proceeds to Lehman before making any payments to the noteholders.

The court ruled that the payment modification provision in Dante was unenforceable because subordination of the termination payment was triggered, ipso facto, by Lehman's bankruptcy filing or that of its swap guarantor (Lehman Bros. Holdings Inc.; LBHI). The court also held, among other things, that the payment modification provision would not fall under the protections of the safe harbor provisions of the U.S. Bankruptcy Code.

In a Nov. 6, 2009, decision, a U.K. court reached a different conclusion under U.K. law in a parallel case brought by a representative of noteholders to compel BNY Mellon to dispose of the collateral and distribute the proceeds to the noteholders before making any payments to Lehman. The U.K court held that the payment modification provision was triggered by the bankruptcy filing of LBHI, which occurred before Lehman filed for bankruptcy and did not violate the "anti-deprivation" principle of U.K. law. On Feb. 2, 2010, BNY Mellon announced that it will appeal the U.S. Bankruptcy Court's decision.

In our view, the U.S. court's ruling could have the greatest rating implications for existing transactions where arrangers have attempted to mitigate credit default swap counterparty risk by structuring deals to provide for posting collateral, redeeming the notes following counterparty default, and subordinating the termination payments to the counterparty to the noteholders' rights when the counterparty is the defaulting party. Under this approach, the counterparty remains in the transaction and posts additional collateral, even as its rating deteriorates. In these types of transactions, the documents typically provide that, if the counterparty defaults, termination payments would not be owed to the counterparty ahead of noteholders. Most synthetic collateralized debt obligation (SCDO) transactions used this approach to mitigate counterparty risk. Because we believe it is likely that many existing SCDO transactions have not been structured to absorb the potential additional costs of paying termination amounts to defaulting counterparties, absent other relevant considerations, it is possible that we may rate the notes no higher than the rating of the counterparty.

Our current view is that the U.S. Bankruptcy Court's ruling would be generally unlikely to affect our ratings on existing transactions structured with replacement provisions. In those transactions, counterparties agree to provide collateral and replace themselves within specified timeframes when their ratings are no longer viewed as sufficient under our criteria to support the ratings on the notes.

In light of the U.S. Bankruptcy Court decision, we are reviewing existing SCDO transactions (and certain other transactions) to assess, on a case-by-case basis, whether the risk to the special purpose vehicle associated with counterparty default is consistent, pursuant to our criteria, with the current applicable rating level.

Standard & Poor's will continue to monitor developments pertaining to Dante. We also continue to review our counterparty risk methodology.

Thursday, February 11, 2010

Derivatives, bankruptcy and Lehman

Original posted on Lexology by Barbara Rachel Parlin:

During the past 18 months, the world has felt the impact of derivatives on financial markets. Many businesses have for years used derivative contracts such as currency or interest rate swaps or forward contracts for the purchase of oil, gold, natural gas, wheat or other commodities to hedge their exposure to an unexpected rise or fall in values, interest rates or prices. However, the scope and extent of trading in derivative instruments exploded during the past 10 years, causing profound effects on the world’s financial markets.

In fact, the Bank for International Settlements, the central bankers’ bank located in Basel, Switzerland, estimated that the total notional value of global derivative contracts had risen to $516 trillion as of June 2007, just before the failure of two Bear Stearns hedge funds signaled the beginning of the current financial crisis.

Many derivatives were, and continue to be, traded on public exchanges such as the New York Mercantile Exchange (NYMEX), but the overwhelming majority of these transactions are “over the counter” (OTC) trades negotiated directly between private parties that are exempt from regulation by the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC) or other governmental regulatory bodies.

In some cases, interest rate swaps or other derivative transactions are included within complicated structured finance transactions involving special purpose vehicles that were sold to investors as “safe” and given triple A ratings by one or more ratings agencies.

The September 2008 collapse of Lehman Brothers Inc. and its affiliates “opened the kimono” to the nature and extent of global derivative trading and the use of such transactions in other structured finance deals, and heightened awareness of the tremendous impact that the collapse of a significant player in the derivatives market can and did have on worldwide financial markets.

Today, 15 months after the first Lehman bankruptcy case was filed, Lehman is still affecting the derivatives markets, albeit in a very different fashion. Through bankruptcy court adversary proceedings and motion practice, Lehman and its former trading partners (counterparties) are creating precedent that may change the way future derivative contracts are negotiated and the way other investments are structured.

In addition, these proceedings and motions will provide some guidance to litigants navigating the murky waters at the edges of the Bankruptcy Code’s securities and derivative “safe harbors.” This article will discuss the Code’s safe harbors and some of these ongoing proceedings.

The Safe Harbors

To understand the Bankruptcy Code safe harbors, it is useful to understand the effect that a bankruptcy case typically has upon persons or entities engaged in transactions with a debtor.

The filing of a bankruptcy petition is a watershed event that creates an estate consisting of all of the debtor’s rights and interests in property, including contract rights. With some notable exceptions, the Code prohibits a non-debtor counterparty from exercising any rights and remedies against the debtor or its property or from continuing litigation against the debtor.

The debtor in possession or the bankruptcy trustee also is vested with certain rights and powers, such as a qualified right to assume, reject, or assume and assign unexpired leases and other types of contracts to which the debtor is a party where some performance by both parties remains due (executory contracts).

To facilitate a debtor’s ability to retain and/or realize value from its pre-petition contracts, the Bankruptcy Code renders certain types of contract provisions unenforceable, such as anti-assignment clauses and clauses that permit a party to terminate a contract based on a debtor’s insolvency or the filing of a bankruptcy case (so called “ipso facto clauses”).

These provisions, and many others like them in the Code, are purposefully designed to provide the debtor:

  • breathing room to assess its situation;
  • a means to delay or prevent the forfeiture of valuable property and contract rights;
  • a way to collect and sell its assets;
  • the opportunity to take the steps necessary to reorganize;
  • the ability to obtain performance from its counterparties in spite of existing defaults;
  • the ability to undo or avoid certain transactions that benefitted one subset of creditors to the detriment of others.

As a necessary corollary, some non-debtor counterparties may find themselves stuck in limbo for months, and even years, waiting for the debtor to determine whether to assume, reject or assume and assign their contracts, negotiate and confirm a plan, and pay claims.

This delay and uncertainty is difficult for any business but can be particularly problematic for financial markets, which require parties to be able to timely close existing trades in order to engage in new ones. Indeed, many market players engage in back-to-back trading, so the bankruptcy of one market player could result in a cascade of defaults and insolvencies.

To prevent the policies underlying the Bankruptcy Code from disrupting financial markets, the Code has been amended numerous times since it was first enacted in 1978 to include the so-called safe harbor provisions. These provisions are designed to neutralize the impact of a bankruptcy filing upon counterparties. Among other things, the safe harbors:

  • permit certain categories of counterparties to terminate existing securities, commodities, forward, repurchase, and swap agreements and master netting agreements relating to these types of instruments (collectively “securities and derivative contracts”);
  • exercise contractual, exchange-specific or other rights to accelerate, liquidate, terminate or set-off under the parties’ securities and derivatives contracts;
  • exempt certain prepetition settlement payments, margin payments and other transfers made in connection with securities and derivative contracts from avoidance as a preference or a constructive fraudulent conveyance when such payments are made to or through certain categories of persons.

In other words, when they apply, the safe harbor provisions protect counterparties to securities and derivative contracts from being subject to the automatic stay, the prohibition against the enforcement of ipso facto clauses, avoidance claims and many of the other special protections afforded to debtors.

In the Lehman case, tens of thousands of non-debtor counterparties took advantage of the Bankruptcy Code safe harbors to terminate their ongoing securities and derivative contracts with Lehman during the days and weeks after the bankruptcy filing. Many other such transactions appear to have terminated automatically, in accordance with their terms, when the particular Lehman counterparty or credit support provider filed its petition.

Less Routine Issues

Certain counterparties, however, did not terminate their securities and derivative contracts with Lehman. In at least some of these cases, it appears that termination would have resulted in a net payment to Lehman, i.e., Lehman was “in the money” on those trades. So those counterparties may have waited to see what happened in the market before incurring a present liability.

Others have terminated, but not made payments to Lehman based on “walkaway” clauses in their agreements, the default resulting from Lehman’s filing or because Lehman itself failed to perform post-petition.

There is no question that the safe harbors do not apply in every case. The counterparty seeking to exercise rights under one of the safe harbors must qualify under one or more of the definitions set out in the Bankruptcy Code, the transaction itself must qualify for such treatment, and the right exercised must be of a type protected by the safe harbors.

Although the facts are different in every case, certain of these issues have been litigated before and thus there are decisions that provide some guidance to parties in determining how to act when their counterparties become debtors. However, until now, there have been very few decisions directly dealing with the effect of time, i.e., does there come a time when a party can be deemed to have waived its right to terminate so that the safe harbors are no longer safe?

And, assuming that waiting is an option, can the counterparty rely on the bankruptcy as a default that excuses ongoing performance due to the debtor?

Likewise, the enforceability of walkaway clauses or other provision that have the effect of subordinating the debtor’s right to payment in the context of securities and derivative contracts has been and remains an open question.

The following discusses some of the recent rulings, motions and proceedings pending in the Lehman case that bear on these open issues.

Waiting Does Not Always Pay

In spring 2009, Lehman Special Financing Inc. (LBSF) filed a motion to compel one of its counterparties, Metavante Corporation, to perform under an interest rate swap that the parties had entered into pre-petition.

The contract contained a quarterly net payment schedule, by which only the net obligor was required to make a payment in any given month. Lehman Brothers Holdings Inc. (LBHI) was the credit support provider.

Apparently, the parties did not dispute that, but for the default resulting from Lehman’s bankruptcy, Metavante would have owed Lehman quarterly net interest payments as it was the net-obligor for each post-petition quarter.

After the bankruptcy cases were filed, Metavante did not terminate the swap. It also did not make the quarterly payments, claiming that the LBHI Chapter 11 filing was a default that excused its obligation to make payments under the terms of the 1992 ISDA Master Agreement that governed the transaction. Metavante also argued that the Bankruptcy Code’s safe harbors permitted it to wait to terminate, and in the meantime, to withhold performance.

The bankruptcy court disagreed, and in so doing made several important holdings:

  • First, it held that even though the swap at issue qualifies under the Bankruptcy Code safe harbors, it is an executory contract.
  • Second, while the safe harbors protect a counterparty’s right to terminate, liquidate, accelerate and set-off amounts due under its securities and derivative contracts with a debtor, the safe harbors do not permit such a party to withhold performance while the transaction is ongoing even if the debtor is in default, and the Bankruptcy Code trumps any state law that might otherwise permit such a result.

As such, since Metavante didn’t terminate the swap, it had to perform post-petition despite the fact that the Lehman bankruptcy filings constituted a default under the agreement.

  • Third, the bankruptcy court found that while the safe harbors don’t require the counterparty to terminate, Metavante’s failure to do so a year after the filing constituted a waiver of its rights to do so in the future. The bankruptcy court did not indicate a specific time by which termination must occur, but read the applicable Bankruptcy Code sections and legislative history to require the counterparty to take action “fairly contemporaneously with the bankruptcy filing.”
  • Finally, the bankruptcy court held that Metavante’s failure to perform (i.e., pay amounts due) under the swap was a violation of the automatic stay, and directed Metavante to perform while Lehman determined whether to assume or reject the parties’ swap agreement. Id. In subsequent rulings, the bankruptcy court denied Metavante’s motions to alter or amend its ruling and to stay the effect of the ruling while Metavante’s pending appeal is decided.

A copy of the transcript of the Metavante ruling is available at

Walkaway Provisions

In another series of pending motions and adversary proceedings, Lehman has challenged the enforceability of contract provisions that eliminate termination payments (a “walkaway”) or otherwise change the priority of payments that might otherwise be due to Lehman when the securities or derivative contract was terminated as a result of a Lehman bankruptcy or certain other events of default.

These types of provisions typically were included in structured swap/credit derivatives and other types of transactions between institutional counterparties and special purpose entities set up by Lehman; they may have been included to satisfy certain rating agency requirements.

While the facts and terms of each transaction are different, in each of these cases Lehman has argued that the walkaway clauses are unenforceable ipso facto clauses not encompassed by the safe harbor right to terminate, accelerate, liquidate and set-off under a securities and derivative contract. The counterparties generally have argued that walkaway and subordination clauses are part and parcel of the liquidation provisions under these securities and derivative contracts and thus are enforceable under the Bankruptcy Code safe harbors.

By contrast, Lehman has taken the position that the safe harbors protect only a limited right to liquidate, i.e., calculate the amount due, but not to actually give effect to the payment structures set out in the contracts. These issues are complicated by the fact that in many cases, the direct counterparty to the transaction is a special purpose vehicle that may or may not have assigned its rights to a trustee acting on behalf of the underlying investors who are the real parties in interest.

The bankruptcy court has not ruled as to whether walkaway or subordination provisions in securities and derivative contracts are protected by the safe harbors, but a ruling on this issue may result from one of the pending summary judgment motions in these cases.

Reverse Pay to Play

Since the Metavante motion was filed, Lehman has sought to apply the same arguments to compel performance by counterparties to other non-terminated securities and derivative contracts.

In response, some of these counterparties have argued that, unlike the situation in Metavante, where the default resulted solely from the bankruptcy filing and the parties’ contract only required payment by the net obligor, they were not obligated to perform because Lehman is in default post-petition for failure to make its required payments post-petition.

In effect, these counterparties have sought to stand Lehman’s Metavante argument on its head, claiming that Lehman must likewise “pay to play” where the parties’ agreement does not provide solely for a net obligor payment as was the case with Metavante, and thus should not be permitted to ride the market until conditions turn in its favor. At a minimum, the counterparties claim that Lehman must pay outstanding sums due post-petition and the counterparty should be granted adequate assurance that Lehman likewise will perform (i.e., pay) its obligations on outstanding swaps in the event of a credit event that would result in a payment to the counterparty in the future.

In another variation, the counterparty argued that while a debtor is not required to perform its duties under an executory contract post-petition, the debtor also cannot compel a counterparty’s performance without paying for such performance. Since Lehman had not made any payments to that counterparty since it filed for bankruptcy protection, the counterparty asserts that the motion to compel should be denied.

At a recent argument dealing with one of these motions to compel and Lehman’s companion motion to dismiss the counterparty’s adversary proceeding, the bankruptcy court noted that the cost to Lehman of performing was very low, and suggested that a settlement could be worked out on that basis. The implications of such an agreement may be problematic for Lehman, however, particularly if other counterparties demand the same type of post-petition performance.


If upheld on appeal, the Lehman court’s Metavante decision is likely to have a significant impact on a counterparty’s decision whether and when to terminate outstanding securities and derivative contracts at the outset of a bankruptcy case.

At a minimum, an “out of the money” counterparty will be faced with a difficult choice: terminate immediately but possibly have to make a significant termination payment to the debtor, or let the contract ride in the hope that the market turns quickly, but have to perform post-petition in the meantime.

Indeed, this choice is very much “heads I win, tails you lose” for the debtor, because even if the market does turn in favor of the counterparty, the debtor likely will reject the contract, leaving the counterparty with nothing more than a large, pre-petition rejection damages claim.

Nevertheless, the impact of the Metavante decision may be tempered if the court agrees that the debtor must “pay to play” post-petition, particularly where the debtor and the counterparty have many outstanding transactions and performance by both parties is required.

So too, the bankruptcy court’s construction of the “walkaway” clause (present in many negotiated securities and derivative contracts) may influence parties in future negotiations, particularly if the court holds that such clauses are not enforceable when one side is in bankruptcy.

As more of these issues are litigated, the Lehman bankruptcy case likely will provide at least one court’s answer to some of the many open questions regarding the extent and reach of the Bankruptcy Code’s derivative safe harbors.