Friday, April 30, 2010

Rating Agencies in the Face of Regulation - Rating Inflation and Regulatory Arbitrage

By Christian C. Opp, Marcus M. Opp and Milton Harris

Abstract: This paper develops a rational expectations model to analyze how rating agencies alter their information acquisition and disclosure policy when ratings are used for regulatory purposes such as bank capital requirements. Although rating agencies generally publish informative ratings, sufficiently large regulatory distortions may lead to a complete break-down of delegated information acquisition - rating agencies merely facilitate regulatory arbitrage by selling inflated ratings to originators. Our model reveals that this result is more likely to occur in complex security classes and how, in general, the impact of regulation on ratings depends on the cross-sectional distribution of borrower types.

Download the paper here:

Thursday, April 29, 2010

Role of Credit Rating Agencies on the Financial Crisis

Original posted on Alston & Bird LLC's website by Melinda Calisti:

On April 23, the U.S. Senate Permanent Subcommittee on Investigations (PSI) held a hearing entitled “Wall Street and the Financial Crisis: The Role of Credit Rating Agencies.” The hearing is the third in a series of PSI hearings examining some of the causes and consequences of the recent financial crisis. On April 14, the PSI held a hearing which focused on the role of high risk mortgages in the failure of Washington Mutual Bank (WaMu). On April 16, the PSI’s hearing focused on the role of bank regulators in the failure

of WaMu. Testifying before the PSI were the following witnesses:

Panel 1

  • Frank Raiter, former Managing Director, Mortgage-Backed Securities, Standard & Poor’s
  • Richard Michalek, former Vice President and Senior Credit Officer, Structured Derivative Products Group, Moody’s Investors Service
  • Eric Kolchinsky, former Team Managing Director, Structured Derivative Products Group, Moody’s Investors Service
  • Arturo Cifuentes, former Senior Vice-President, Moody’s Investors Service and current Director, Finance Center, University of Chile

Panel 2

  • Susan Barnes, Managing Director, Mortgage-Backed Securities, and former North American Practice Leader, Residential Mortgage-Backed Securities, Standard & Poor’s
  • Yuri Yoshizawa, Group Managing Director, Structured Finance, Moody’s Investors Service
  • Peter D’erchia, Managing Director, U.S. Public Finance and former Global Practice Leader, Surveillance, Standard & Poor’s

Panel 3

In his introductory statement, Chairman Carl Levin (D-MI) presented the role that the credit agencies played in the financial crisis by stating “had credit-rating agencies been more careful in issuing rating or downgraded rating in a more responsible manner, we maybe would have averted the crisis.” According to Chairman Levin, investors’ “trust has been broken” because of the role the largest credit agencies “fueled the financial crisis.”

Chairman Levin’s conclusions were the result of an 18-month investigation, including review of millions of pages of documents, certain of which were released by the PSI, and more than 100 interviews and depositions. The investigation found that 91% of the AAA-rated, residential mortgage-backed securities issued in 2007 and 93% issued in 2006 have now been downgraded to junk status. Thus, in July 2007 when Moody’s and S&P announced mass downgrades of hundreds of subprime mortgage-backed securities, “those downgrades shocked the markets and banks, pension funds and others were held holding billions of dollars of unmarketable securities.” According to Chairman Levin, had the credit agencies taken more care in issuing rating or revised ratings more swiftly, the impact of those toxic mortgages on the financial markets would have been greatly reduced. However, the credit agencies felt pressure to provide favorable credit ratings for complex securities, amid concerns about competition and the lack of data about the mortgage securities the analysts were rating. “Credit-rating agencies allowed Wall Street to impact their analysis, their independent and their reputation for reliability,” said Chairman Levin.

In the first panel, Mr. Raiter, who was attending the hearing under subpoena, noted several factors that resulted in the major rating agencies to fail to adequately assess the risks associated with new mortgage products, including: (1) the lack of oversight of the rating agencies by the SEC and other regulatory bodies, (2) the “disconnect” between senior managers and the analytical managers responsible for assigning ratings, and (3) the separation of the initial ratings process from the subsequent surveillance of performance of the rated bonds. According to Raiter, the “disconnect” between senior manager and analytical managers helped to award high ratings to risky investments because management pressured analysts to earn fees by attracting business from banks. In addition, according to Mr. Raiter, the preferred status granted to the credit rating agencies meant that there was no regulatory overnight nor established standards to measure the quality or performance of the ratings.

According to Mr. Kolchinsky, “the cause of the financial crisis lies primarily with the misaligned incentives in the financial system. Individuals across the financial food chain, from the mortgage broker to the CDO banker were compensated based on quantity rather than quality [and] the situation was no different at the rating agencies.” Mr. Michalek stated that the independence of Moody’s Structured Derivative Products Group changed dramatically during his tenure and acknowledged that the competition amongst credit agencies meant there was constant pressure to accept deals. According to Mr. Michalek, “the unwillingness to say ‘no’ grew. The message from management was not, ‘just say no,’ but instead, ‘just say yes’.” Agreeing with the PSI’s conclusion that the credit agencies were using inaccurate rating models that were affected by competitive pressure, Mr. Cifuentes noted that a core problem was that credit rating agencies determined the basis for the ratings. He emphasized that the “raters can change what BBB means. [The basis for the ratings] is screwed up at a very fundamental level.”

Panelists who are current executives at the rating agencies were generally more reluctant to acknowledge the effects of competitive pressures and stressed the rating agencies’ efforts to improve ratings quality. Despite skepticism expressed by Sen. Edward Kaufman (D-DE), Ms. Yoshizawa claimed that she “personally [did not] feel undue pressure from the top to increase business.” Ms. Barnes claimed to have no knowledge of incentives being tied directly to the number of deals rated. Mr. McDaniel said he was unaware of terminations related to market share issues. In addition, although Mr. McDaniel testified that Moody’s was not satisfied with the performance of their ratings, he asserted that “neither [Moody’s] nor most other market participants, observers, or regulators fully anticipated the severity or speed of deterioration in the financial markets.” In addition, the current executives argued that their firms took actions they assumed appropriate at the time, such as Mr. D’Erchia who stated that S&P has “always been committed to doing the best we can to develop and maintain appropriate ratings.

TriOptima releases first public statistics for the Global OTC Derivatives Interest Rate Trade Reporting Repository

Form the TriOptima press release:

TriOptima announced that it has posted the first public reports for the OTC derivatives interest rate swap market on the Global OTC Derivatives Interest Rate Trade Reporting Repository (IR TRR) webpage The total notional amounts outstanding for all interest rate derivative transactions reported by the G-14 financial institutions was $448.7 trillion with interest rate swaps the largest component at $322.2 trillion as of March 31, 2010.

The G-14 financial institutions have been reporting market volumes for their entire OTC interest rate derivative trade portfolios to international regulators through the IR TRR since January 15th. The volumes include both cleared and non-cleared interest rate trades with G-14 institutions, buy side organizations, and other financial and non-financial institutions.

Beginning April 29th, the IR TRR is making aggregate market information available to the public summarizing the notional amounts and trade count by product type in USD; by currency in local currency and USD equivalent; and by tenor for each product type. Reports will be posted monthly on the website. Product types include caps/floors, forward rate agreements, options, swaps, swaptions, and cross currency swaps.

“This is an important step in the industry’s continued efforts to provide additional transparency in the OTC derivatives marketplace,” said David Halliden, Chairman of the IR TRR Governance Committee and Executive Director at J.P. Morgan, “Strong partnership between global regulators, major banks, buy-side firms and TriOptima has ensured we can achieve these goals quickly and efficiently.”

“We are pleased to support the important work of the Governance Committee and global regulators,” said Brian Meese, TriOptima CEO. “We look forward to further collaborative efforts that will benefit the market, improve post trade transparency and provide regulators with the information they require.”

Following a request for proposal process, representatives from sell side and buy side institutions comprising ISDA’s Rates Steering Committee selected TriOptima to provide the IR TRR in October 2009.

Betting on Future Movie Receipts: Beware the Hollywood Lemons

Original posted Knowledge@Wharton by Kent Smetters:

Wharton professor of insurance and risk management Kent Smetters looks at the pros and cons of investing in a new futures exchange -- approved last week by the U.S. Commodity Futures Trading Commission and sponsored by Cantor Fitzgerald investment bank -- that will match buyers and sellers of future movie receipts.

The movie industry fared well during the current recession, generating record receipts of more than $10 billion in 2009. In fact, demand for movies typically increases during economic downturns even while the demand for most other goods and services falls.

For investors, movies represent a potentially attractive investment. The correlation between annual box office receipts and the Standard & Poor 500 Index is slightly negative, meaning that film investments can still do well while the rest of your portfolio suffers. Moreover, a good blockbuster like Avatar might also produce revenues that are multiples of its costs. There are not many available asset classes that exhibit these sorts of tradeoffs.

So, wouldn't it be great if you could invest in a new film that you thought could be a real blockbuster?

Now maybe you can. On April 20, the U.S. Commodity Futures Trading Commission (CFTC) approved a new movies futures exchange that will match buyers and sellers of future movie receipts. The Exchange is sponsored by Cantor Fitzgerald, a New York City-based investment bank that became a household name several years ago when two-thirds of its employees were killed in the terrorist attacks of September 11, 2001. It has since rebounded with considerable success, in part due to differentiation through financial innovations like this one. Subject to final approval in June, the new Cantor Exchange will allow an investor to invest in his or her favorite movie by purchasing a share of its future revenue stream.

But not so fast. Hollywood studios are up in arms about Cantor Exchange's approval (as well a similar exchange by an Indiana-based startup Media Derivatives). The Cantor Exchange is opposed by the Motion Picture Association of America (MPAA) and the Directors Guild of America. The major studios claim that the Cantor Exchange will lead to speculative bets, insider trading, and false rumors. A rogue employee might even bet against a film's success and use his or her position to ensure its demise. Of course, such an act would be illegal, and similar concerns arise with other companies where it is possible to short the company's stock. The difference here is that an employee might have more substantial control over the success of a single movie relative to the share price of a larger firm.

Last week, Blanche Lincoln, democratic senator from Arkansas and chairman of the Senate Agriculture Committee that oversees the CFTC, agreed with the studios and placed a ban on the Exchange in the most recent version of the financial reform bill that passed her Committee. Maybe coincidentally, Lincoln is the younger sister of Hollywood director Mary Lambert who directed Stephen King's Pet Sematary and other films. The House of Representatives held hearings on April 22, 2010, where Cantor president Richard Jaycobs testified, as did MPAA president Robert Pisano.

Are the studios just looking to protect their own market power when it comes to movie financing? Are investors being cheated out of a decent way to diversify their portfolios?

Probably not. In fact, regardless of the true motivations of the studios' resistance, the Exchange itself presents a valuable warning and general lesson for investors: Taking bets on the performance of individual contracts -- in this case, specific movies -- is often subject to the curse of "adverse selection" where only the bad quality product is actually offered for sale. Nobel laureate George Akerlof refers to bazaars likes these as "markets for lemons."

Pork Bellies, Corn and Lemons

The problem is not with futures exchanges themselves. In fact, futures exchanges are a good way for counterparties to hedge their risks. For example, farmer Joe plants his wheat crops long before the price of wheat is determined at harvest time. He is worried that the price of wheat will fall during the time in between. A producer of breakfast cereals, though, is afraid of just the opposite: Prices might increase, reducing the sales of brands which breakfast cereal producers have invested heavily in. So, there are mutual gains from trade if the two parties agree to a future sale price at delivery that is close to the price today. Both parties hedge against the price moving in the direction that is harmful to their own interests.

Trillions of dollars are traded each year in contracts like these for all sorts of commodities, including pork bellies, corn, oil and exchange rates on currency.

In theory, a movie exchange should allow a studio to also diversify its future risk by effectively selling some of its unpredictable future cash flow for guaranteed money today. In a break with most other studio executives, Lionsgate's vice-chairman Michael Burns wrote to Congress that such contracts "would substantially widen the number and breadth of financing sources available to the motion picture industry by lowering the risk inherent in such financing." Outside investors might like the opportunity to bear this risk because it gives them a potentially profitable investment while allowing them to further diversify their portfolio with a unique opportunity.

But a movie exchange fails to appreciate the economics behind a market for lemons. Whenever the product being offered for sale varies in quality -- and the sellers have more information about its true value than buyers -- the low quality variation is what tends to get sold. In other words, the Cantor Exchange could end up only selling movies that studios know are real lemons based on their internal market testing.

The reason why traditional commodities exchanges, like wheat or currency, work so well is that buyers and sellers have fairly equal information about the underlying risks. Moreover, the goods being traded are somewhat standardized, so that sellers can't pick off only the low quality product to sell. In fact, marketers commonly refer to the "commoditization" of a product to suggest that it has very little quality differentiation.

But movies are not commodities. Indeed, studios have considerable private information about the quality of a movie before it is released. According to movie industry expert Tamara Rothenberg, that's the reason why "film studios often embargo reviews for bad movies until after release or offer no pre-release screenings." Wharton marketing professors Jehoshua Eliashberg and John Zhang have even developed their own sophisticated models that would help movie studios predict sales prior to release based on their internal testing. Armed with this information, studios with lemons would be incentivized to issue sell orders on the Cantor Exchange.

The nature of the flow of information is what ultimately dooms a movie exchange. The first piece of objective market-based information only becomes available once the movie is released. But by that point, it's too late for a futures exchange to add much value since most of the uncertainty has already been resolved. Indeed, movies often sink or swim based on word of mouth and online reviews during the first weekend; in addition, first-week box office sales are highly predictive of future sales. According to Wharton marketing professor Eric Bradlow, "there is a lot of recent research on the ability of user-generated content to predict movie box office performance." Twitter chats during the first weekend, he adds, appear to be more predictive than the Hollywood Stock Exchange, a fantasy movie trading game, also owned by Cantor.

Instead, the new Cantor Exchange will likely encourage studios to simply "pump and dump" their lemons. Wharton's Justin Wolfers, professor of business and public policy and an expert on prediction markets, is another skeptic of the Cantor Exchange. "Most major studios are well diversified. They make dozens of movies. The studios can also diversify and spread risk in other ways, by taking on more partners or restructuring the contracts with their stars." Indeed, private equity funds already provide capital directly to studios. They attempt to reduce the lemon problem by offering to fund a large slate of movies (pdf) rather than allowing a studio to simply pick the movies to be financed.

The market for lemons raises serious issues of transparency and is one reason why mortgage-backed securities like Collateralized Debt Obligations failed so miserably, leading to a collapse of the larger financial system in 2008. CDOs can vary substantially in the quality of the mortgages they hold. The seller -- in this case, the bank that originated the loan -- has more information about the quality of CDOs than many buyers. Not surprisingly, ample evidence exists that the mortgages that were resold to outside investors in the form of CDOs were more likely to fail (pdf) than mortgages that the originating banks simply kept on their own books.

Going to the Dogs

But suppose that you want to invest in movies while avoiding lemons. It's actually pretty hard as an individual investor. You cannot directly invest in any of the major "Big Six" studios. Each one is owned by a larger parent company. For example, Universal Studios is owned by General Electric but its impact on GE's return on equity is very small. DreamWorks, the studio behind the Shrek franchise, is an exception since it offers a more direct investment in its movies, but its price has already doubled during the past year. So unless you have access to a related private equity fund, there is only limited opportunity to directly invest in movies.

The Cantor Exchange, therefore, is appealing in that it tries to "democratize" movie investments. But, as Wolfers puts it, "investors have got to be worried that studios would only want to short their dogs." Indeed, movie financing is probably best left to the pros.

The general lesson is that, as an individual investor, you should be suspicious of investing in any individual contract where the seller has a lot more information than you. Instead, simply make sure that your portfolio includes some recession-proof stocks. Companies like Wal-Mart, McDonalds, Hasbro, Yum! Brands, and Procter and Gamble often see higher (or still fairly robust) revenues during recessions. But don't overdo it: These revenue streams might also fall as the economy rebounds.

Tahawwut (hedging): A breakthrough in Islamic finance

Original posted on Arab News (McClatchy-Tribune Information Services via COMTEX):

The launch of the Tahawwut (Hedging) Master Agreement (TMA) earlier in March 2010 by the Bahrain-based International Islamic Financial Market (IIFM) in cooperation with the International Swaps and Derivatives Association, Inc. (ISDA) gives the global Islamic financial industry the ability to trade Shariah-compliant hedging transactions such as profit-rate and currency swaps, which are estimated to represent most of today's Islamic hedging transactions.

While Ijlal Ahmed Alvi, the CEO of IIFM, hails the TMA as "a breakthrough in Islamic finance and risk management, and marks the introduction of the first globally standardized documentation for privately negotiated Islamic hedging products," it may be wise to remember that it remains a financial industry framework document that may be used on a voluntary adoption basis, as almost all standards issued by various relevant international bodies such as IIFM, AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions) and the IFSB (Islamic Financial Services Board) in the Islamic finance space.

As such, it is premature to suggest that the Tahawwut Master Agreement "is applicable across all jurisdictions where Islamic finance is practiced" because it would be subject to the vagaries of the legal and political governance process in various jurisdiction.

Voluntary adoption of standards in the financial sector by Muslims countries is very underdeveloped and very often national practice takes precedence over the less well-established international organizations especially in the nascent Islamic finance space. In addition, in markets such as Malaysia, they have developed local Shariah-compliant hedging techniques including profit-rate and currency swaps quite some time ago.

As such, as Dean Naumowicz of the London-based international law firm Norton Rose points out, "parties wishing to transact under the (Tahawwut) Master Agreement will still be required to develop confirmations to document transactions. In addition, where parties intend to enter into designated future transactions, documents (each a DFT Terms Agreement) will need to be developed in order to bind the parties to enter into, and to give a value to, designated future transactions."

Under Shariah principles, the Tahawwut or hedge must be strictly linked to underlying transactions and cannot be a transaction that has the sole purpose of making money from money.

From a Shariah structure point of view, in entering into the Tahawwut Agreement, each party issues an undertaking to enter into a contract in the future for the sale of assets following the designation of an early termination date. The party to whom the relevant index amount is due may exercise the wad (promise) given in its favor and sell pre-agreed assets in exchange for the cost price of such assets and the relevant index amount. If, in breach of the wad it has issued, a party fails to purchase the assets under a Musawama, liquidated damages are determined and payable.

The Tahawwut Master Agreement is also similar in some respects to the 2002 or 1992 ISDA Master Agreement, a conventional hedging framework agreement governing the contractual relationship between the parties, with transactions documented by way of confirmations.

But while ISDA represents participants in the privately negotiated global derivatives industry, with members including most of the world's major institutions that deal in privately negotiated derivatives, as well as many corporates, governmental entities and other end-users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities, IIFM is an organization steeped in the politics of Islamic finance, especially between Bahrain and Malaysia, arguably the two most developed Islamic finance markets in the world.

After two false starts in which the very ethos of the organization was confused and questioned, IIFM under the stewardship of Alvi, reinvented itself emerging with a primary focus on the standardization of Islamic products, documentation and related processes, and better resourced than previously.

The lack of hedging products for managing risks has put many investors and institutions involved in Islamic finance at a disadvantage. The global financial crisis has underscored the importance of sound risk management, primarily related to hedging transactions. Similarly, the lack of standardized documentation has often meant that transactions in the Islamic finance industry were faced with delays in their execution.

The Tahawwut Master Agreement has other potentially wide-reaching implications. According to Azizan Abdul Rahman, director general, Labuan Financial Services Authority (Labuan FSA), the Malaysian offshore regulator, the Tahawwut Master Agreement provides the needed consistency and predictability to ensure deep and liquid international Islamic financial markets and is a testament to the greater convergence in Shariah interpretations in the global industry.

Similarly, industry players such as Afaq Khan, CEO, Standard Chartered Saadiq, stress that the TMA will allow Islamic banks to offer end-to-end solutions to their customers and will allow better treasury risk management tools for Islamic financial institutions

to competitively manage market risks.

According to Norton Rose, the Tahawwut Master Agreement permits "parties to enter into transactions which may be documented immediately (each a transaction) as well as transactions due to occur in the future (designated future transactions). Using transactions and designated future transactions, parties are able to create cash flows similar to the cash flows created in conventional derivatives products."

There are also a number of similarities between the Tahawwut Master Agreement and the 2002 and 1992 ISDA Master Agreements. In fact, some of the provisions in the original Tahawwut Master Agreement had to be amended to bring them more in line with the 2002 and 1992 ISDA Master Agreements.

According to Norton Rose, these include: i) condition precedent -- where the Tahawwut Master Agreement retains the right of a party to withhold payments and deliveries if an event of default or a potential event of default has occurred with respect to the other party; ii) payments in the same currency, due on the same date in respect of the same transaction will automatically be netted with the ability to opt for multiple transaction payment netting; iii) The scope of the set-off provisions in the Tahawwut Master Agreement were amended to allow such amounts to be capable of being set off in a similar way as under the 2002 or 1992 ISDA Master Agreement; iv) the events set out in the Tahawwut Master Agreement are very similar to those contained in the ISDA 2002 Master Agreement, but have been extended to apply to designated future transactions.

IIFM stresses that though the structure of the Tahawwut Master Agreement document is similar to the conventional ISDA Master Agreements, the key mechanisms and provisioning such as early termination events, closeout and netting are developed based on Shariah principles. It is designed to be used between two principal counterparties as a master agreement. Parties understand that no interest shall be payable or receivable and no settlement based on valuation or without tangible assets is allowed. Moreover, the counterparties to the Tahawwut Master Agreement make representations as to the fact that they enter into Shariah-compliant transactions only.

Indeed, according to Alvi, "a record 24 drafts were developed during the industry consultation and Shariah guidance process before ultimately reaching the final version, which is comprehensive as well as practical in terms of usage with no compromise to Shariah principles."

However, another London-based international law firm, K & L Gates, while stressing the Tahawwut Master Agreement as "a step forward in demystifying the Islamic finance and investment market by using an accepted market document as the basis for a new standard," agrees that the agreement's use will need to be monitored on an ongoing basis, and predicts that issues will arise in its application which will need to be carefully considered.

Indeed, Jonathan Lawrence and his colleagues Stephen H. Moller and Anthony R.G. Nolan at K & L Gates stress that a number of clarifications are needed regarding the Tahawwut Master Agreement especially with reference to the caveats as to the Shariah compliance of the agreement, especially in the case of a non-Muslim party in a transaction which may wish to exclude the representation that a party is only obliged to confirm that the transaction is Shariah-compliant as far as it wishes or is required to do so.

There are also disclaimers throughout the Tahawwut Master Agreement that there is no guarantee of Shariah compliance for any amendments or additions to the agreement or related underlying transaction documents.

Another area for potential concern is the election of New York law or English law as the governing secular law for the Tahawwut Master Agreement. Under English law, as several of the cases involving Islamic financial institutions and their clients have shown, it is for each party to satisfy themselves that the substantive terms of the underlying contract comply with Shariah principles. This English court approach prevents parties introducing Shariah principles to avoid the contract they observe.

The Tahawwut Master Agreement also rigorously eliminates provisions for payment of interest. However, according to K & L Gates, it is not clear how the time value of money is addressed in situations contemplated by the agreement where amounts may be deferred. These issues related to the removal of interest will need further examination by parties and in-house counsel to determine whether the economics of a transaction will be distorted on early termination or otherwise.

They also raise points of ambiguity including relating to netting of transactions and Relevant Index Amounts under DFT, since the netting of future transactions is not covered (except in a footnote that contemplates that parties may provide for similar netting in those agreements); the replacement of "transfer" with "redesignation" in the Tahawwut Master Agreement may create ambiguity as to whether "redesignation of rights and obligations" implies the ability of the affected party to change substantive rights in connection with changing the obligor office; the replacement of the definition of close out amount that appears in the 2002 Master Agreement with a very brief definition; the removal of credit-worthiness in determining quotations, which could distort the economics of a transaction on early termination or otherwise; the lack of Shariah board approval for transactions; and basis risk concerns, because it may remain to be seen how the Tahawwut Master Agreement will coexist with other forms to the extent that counterparties may hedge exposure there under by entering into master agreements with differing terms.

TriOptima makes interest rate swap data public

Original posted in the FT by Jeremy Grant:

TriOptima, a European securities post-trade company, has made data showing details of interest rate swaps contracts publicly available for the first time.

The move, announced on Wednesday, is a sign that regulators’ demands for more transparency in the over-the-counter derivatives markets are being met by industry participants even before legislation designed to reform OTC market structures has been finalised.

TriOptima is one of a handful of companies in the world that operate “trade repositories”, which store electronic records of thousands of OTC trades previously logged manually.

It and other trade repositories have already provided details of OTC trades to regulators. But the latest move is the first time such data have been made available to the public.

The company, controlled by Icap, the interdealer broker, said it had “posted the first public reports for the OTC derivatives interest rate swap market” on its website.

David Halliden, chairman of the interest rate trade reporting repository, a service run by TriOptima, and an executive director at JPMorgan, said: “This is an important step in the industry’s continued efforts to provide additional transparency in the OTC derivatives marketplace.”

Time to rein in the ratings agencies (FT)

Original posted in the FT by John Gapper:

Goldman Sachs executives suffered a marathon grilling in front of the Senate investigations subcommittee on Tuesday. But just as important a hearing of the body – arguably more important – occurred last week.

The organisations on political trial last Friday were the ratings agencies Moody’s and Standard & Poor’s, which played a more central role than any investment bank in the failure of so many investment-grade securities. If all the subprime mortgage securities they rated triple A had not turned to junk, no bail-outs would have been required.

The stories that former Moody’s and S&P employees told at that hearing – of the agencies trying to please investment banks that were paying big fees to get high ratings – cast doubt on a central plank of how the fixed-income markets are supposed to work. Why should investors place faith in these over-rated bond market guardians again?

Ratings agencies have been criticised in past crises – most recently in the aftermath of Enron’s collapse – for lending their approval to dubious bonds and issuers. Their failings in the housing bubble were much greater. Yet, despite shareholder lawsuits against the agencies and some political heat, there is little sign that their quasi-official status – or their business models – will be substantially changed. The financial reform bill that is still blocked on Capitol Hill has placed other priorities, such as derivatives regulation, above them.

That is unfortunate. If the crisis proves anything, it is that the agencies enjoy too much authority among investors and regulators. Any reform that would loosen their grip on bond markets deserves a shot.

This was a triple-A crisis. The banks and insurance companies that came close to failure believed so implicitly in the safety of “super-senior” mortgage debt that they were willing to stuff their balance sheets with it. They would never have taken such a punt on high-yield securities or equity tranches of collateralised debt obligations (CDOs).

In the case of Goldman, it managed to get the Abacus 2007 deal, over which it is accused of securities fraud, rated as investment grade by the agencies. That sufficiently reassured IKB, the German bank with a long position on the deal, and the bond insurer ACA, that they took on the risk that Abacus’s senior tranches would fail – as they did.

The ratings failures went beyond synthetic mortgage CDOs. James Robinson, a non-executive director of the pharmaceuticals company Bristol-Myers Squibb, recounted at the Milken Global Conference in Beverly Hills this week how BMS’s audit committee had questioned its treasury staff about whether they were making any risky investments.

“They said everything was in treasuries and nothing more than 90 days [maturity], triple A. What were they in to the tune of $800m? Auction rate notes, triple-A rated by the agencies,” he said. Mr Robinson said that this cost BMS $600m when the auction rate note market collapsed in February 2008.

It is not only investors and companies that have placed too much reliance on bond ratings. The ratings agencies were first given official status by the Securities and Exchange Commission in 1975 as a means for regulators to assess capital charges for broker-dealers.

Since then, their influence has spread into unexpected quarters. American International Group’s financial products unit, which used its triple-A rating to insure CDOs for banks, offered them a regulatory arbitrage based on ratings. The banks that wrapped senior debt tranches with AIG did not have to set aside so much regulatory capital.

In all kinds of ways, ratings agencies have extended their grip and lulled investors and institutions into a false sense of security. “Throughout the world, the ratings agencies were instrumental in building up a house of cards. They were behind the scenes everywhere you looked,” says James Barth, a senior fellow at the Milken Institute.

What should be done about it? A place to start would be to remove their “regulatory licences” – the status of Nationally Recognised Statistical Rating Organisation – or at least to open the status up more broadly. That might worry regulators who like some official seal of approval, but it would also reduce the halo effect.

Frank Partnoy, a law professor at San Diego University, argues that there is an alternative market mechanism for judging risky investments in credit default swap spreads (which have proved better predictors of forthcoming defaults than ratings). Instead of being told to invest in only triple-A securities, investors could buy bonds with low swap spreads. He also argues in favour of removing the protection that ratings agencies enjoy under US securities law from investor lawsuits relating to securities they rate before they are underwritten. At the moment, they are far more protected than banks or accountants.

Last, politicians and regulators must take a long, hard look at the conflict of interest in agencies being paid by issuers, and so having an incentive to boost ratings. The subcommittee heard stories of analysts being placed under strong pressure to “maintain market share”.

None of these reforms would be easy to implement. Some have been mooted in previous crises without any big changes to the status quo. But this crisis was of a severity beyond others in the past, and triple-A securities were at its heart. It is time to curb the power and influence of the agencies behind them.

Wednesday, April 28, 2010

Why you should take Warren Buffet's derivative assertions with a grain of salt

Originally posted in the Wall Street Journal by Matt Phillips:

Warren Buffett’s assertion that derivatives are “financial weapons of mass destruction” is probably the best known association between the Berkshire Hathaway chief and the financial instruments of the moment....

But... Buffett’s relationship with derivatives is more complicated than it first seems. Barclays Capital analysts wrote back in early April:

“Berkshire Hathaway attracted attention in 2008 and early 2009 due to its growing derivatives exposure. The company increased its exposure to fluctuating investment valuations by selling long-dated put options on equity indexes and high yield indexes as well as credit default protection for states/municipalities and individual corporations with a total notional value of $63 billion.”

In fact, in his most recent letter to shareholders, Buffett relayed that derivatives were a boon to the company in 2009. The Journal’s Scott Patterson reported back in March:

The company also benefitted from several derivatives contracts it entered into in recent years. The contracts are insurance policies against long-term declines in U.S. and foreign stocks and expire during the next two decades. Berkshire will have to pay money if the indexes are below where they were when it entered the contracts. Berkshire posted an after-tax gain in derivative contracts of $486 million in 2009, compared with a loss of $4.6 billion the previous year.

So exactly where does Buffett stand on derivatives? It’s simple, he stands — as most business people do — where he thinks he has to in order to get the most out of his portfolio.

Here’s how he put his thoughts — and the thoughts of his longtime partner Charlie Munger — in his most recent letter to shareholders:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

Monday, April 26, 2010

The mysterious “Fed staffers” document

Courtesy of the Financial Times, here are four pages of "Fed staff" comments on the Dodd financial reform bill:

According to the Times:
It details seven areas where derivatives-related reform needs a comprehensive re-draft — a re-draft that might have the handy side-effect of helping Wall St banks avoid having to spin off their derivatives operations.

IFSL Annual Report on Global Securitization

Abstract: Global securitisation markets in 2009 were dominated for the second successive year by funding operations of central banks. These operations kept gross issuance at $2,860bn in 2009, up 3% on the previous year. Excluding central bank funding operations, net issuance sold into the market remained depressed at $548bn in 2009, only a quarter of the $2.1 trillion total in 2007. Globally securitisation has fallen away since the autumn of 2007, due to turbulence in credit markets, a lack of liquidity and a reduction in investors’ tolerance of risk.

The report can be downloaded on the International Financial Services London website here.

Gillian Tett and Paul Krugman on the "murky world" of credit ratings

The FT's Gillian Tett welcomes last week's publication of the rating agency emails:

Another week, another bout of e-mail embarrassment. Goldman Sachs shot into the spotlight 10 days ago, after the Securities and Exchange Commission accused the bank of fraud and released e-mails written by Fabrice Tourre, a trader, describing the financial products he created as useless “monstruosities” (sic).

A senate committee released a fresh batch of documents at the weekend, including e-mails from senior Goldman officials crowing that the bank could make “serious money” from America’s mortgage disaster. These will be debated in Washington on Tuesday.

But these have not been the only electronic howlers. A senate committee last week released e-mails from Standard & Poor’s and Moody’s which revealed something long suspected but never proven: that from 2005 the rating agencies faced growing pressure to cut corners in how they rated complex credit instruments in order to win lucrative business from banks....

It is fascinating, almost touching, stuff. Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working. But by 2007 they, like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also in a strange, geeky silo, into which few non-bankers ever peered...

There are two important lessons. One is that what went wrong in finance was fundamentally structural, as an entire system spun out of control It might seem tempting to lash out at a few colourful traders but that is a sideshow: what is needed is systemic reform that removes conflicts of interest.

The second lesson is that the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.

And in the NY Times, Paul Krugman:

What those [rating agency] e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

The rating agencies began as market researchers, selling assessments of corporate debt to people considering whether to buy that debt. Eventually, however, they morphed into something quite different: companies that were hired by the people selling debt to give that debt a seal of approval.

Those seals of approval came to play a central role in our whole financial system, especially for institutional investors like pension funds, which would buy your bonds if and only if they received that coveted AAA rating.

It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job. It’s all too obvious, in retrospect, how this could have corrupted the process.

And it did. The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” Clearly, the rating agencies skewed their assessments to please their clients.

These skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle. Paul McCulley of Pimco, the bond investor (who coined the term “shadow banks” for the unregulated institutions at the heart of the crisis), recently described it this way: “explosive growth of shadow banking was about the invisible hand having a party, a non-regulated drinking party, with rating agencies handing out fake IDs.”

So what can be done to keep it from happening again?

The bill now before the Senate tries to do something about the rating agencies, but all in all it’s pretty weak on the subject. The only provision that might have teeth is one that would make it easier to sue rating agencies if they engaged in “knowing or reckless failure” to do the right thing. But that surely isn’t enough, given the money at stake — and the fact that Wall Street can afford to hire very, very good lawyers.

What we really need is a fundamental change in the raters’ incentives. We can’t go back to the days when rating agencies made their money by selling big books of statistics; information flows too freely in the Internet age, so nobody would buy the books. Yet something must be done to end the fundamentally corrupt nature of the the issuer-pays system.

An example of what might work is a proposal by Matthew Richardson and Lawrence White of New York University. They suggest a system in which firms issuing bonds continue paying rating agencies to assess those bonds — but in which the Securities and Exchange Commission, not the issuing firm, determines which rating agency gets the business.

I’m not wedded to that particular proposal. But doing nothing isn’t an option. It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

Saturday, April 24, 2010

The Catch-22 of Credit Rating Model Transparency

As reported in the New York Times...

One of the mysteries of the financial crisis is how mortgage investments that turned out to be so bad earned credit ratings that made them look so good.

One answer is that Wall Street was given access to the formulas behind those magic ratings — and hired away some of the very people who had devised them. In essence, banks started with the answers and worked backward, reverse-engineering top-flight ratings for investments that were, in some cases, riskier than ratings suggested, according to former agency employees...

The rating agencies made public computer models that were used to devise ratings to make the process less secretive. That way, banks and others issuing bonds — companies and states, for instance — wouldn’t be surprised by a weak rating that could make it harder to sell the bonds or that would require them to offer a higher interest rate.

But by routinely sharing their models, the agencies in effect gave bankers the tools to tinker with their complicated mortgage deals until the models produced the desired ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.” ...David Weinfurter, a spokesman for Fitch, said via e-mail that rating agencies had once been criticized as opaque, and that Fitch responded by making its models public...

Read the rest of the article at

Friday, April 23, 2010

Securitization: Don’t Make Transparency the New Opaque

Original posted on the Housing Wire by Linda Lowell:

If the Federal Deposit Insurance Corp. (FDIC), currently digesting comments to its proposed securitization safe harbor rules, and the Securities and Exchange Commission (SEC), now posting comments on its proposed revisions to REG AB, are to be believed, transparency is the critical ingredient to “restarting” asset securitization markets. Transparency is promoted in a couple of guises: simpler deals (fewer tranches etc.) and loan level information at issue and thereafter.

The call for loan level information strikes me as exceptionally misleading. It makes the regulators look like activists, when in fact they are either ignorant of the market they would regulate or they are cynically making an empty display of regulatory zeal.

Loan level performance data is already available on the great majority of non-agency deals. In fact, the degree of disclosure provided on non-agency MBS was envied by Ginnie Mae/GSE analysts and investors who understood that the credit characteristics of underlying loans (LTV, loan purpose, credit score, etc.) influenced the prepayment experience, and hence the interest rate sensitivity, of the bonds.

In August 2002, staff from the SEC, the GSE regulator (then OFHEO, now Federal Housing Finance Agency (FHFA)) and Treasury Department conducted a study of MBS disclosures to determent whether enhancements were desirable. The results of that study were published January 2003 in “Enhancing Disclosure in the Mortgage-Backed Securities Market”.

The study concluded that “the significant evolution of disclosure standards in the offer and sale of MBS – whether of GSEs, Ginnie Mae or private-label MBS – in the past has been nearly entirely market driven. Furthermore regarding loan size, geographic distribution, property type, occupancy, LTV, credit scores, degree of documentation and loan purpose, private issuers provided detailed statistical information on pool loans while the GSEs did not. Missing from all MBS offering disclosures was information on debt-to-income ratios of underlying borrowers.”

However, following deal closing, servicers transmitted very detailed information on each loan at issue which includes debt-to-income ratios and all terms necessary to calculate scheduled P&I. Monthly updates track loan balances, delinquency status, coupon changes and payment recasts (if applicable), and so on. About the only items missing are updated credit scores or appraisals, names and addresses.

(It is possible to map loan data to public credit histories stripped of names and addresses to deal data by zipcode and original lien amount. Analysts who do this can estimate with considerable accuracy changes in credit scores, how related non-mortgage debt is being serviced, whether second-lien mortgages exist and who holds them, and so on. Using home price data at the zip code level – a variety of vendors can provide this – it is also possible to estimate current LTVs. HousingWire coverage of research reports is replete with examples of analysts’ findings using such techniques with loan level data. I participated in such analysis as far back as the early 90s, but I’ve seen the work since the late 80s.)

Needless to say, Ginnie and the GSEs responded to the 2002 findings (and the market that called for the study) by expanding the items included in at-issue and monthly pool updates. Now, however, the regulators have apparently forgotten that private-label MBS were the template for improved disclosure in government guaranteed and sponsored MBS.

If you read the regulators, policy geeks and bloggers, MBS investors have forgotten as well. It’s hearsay, but apparently they are telling the regulators they would never have made such bad investments if they’d known what was inside. I believe this is called passing the buck or shifting the blame. If they had read the prospectus and looked at the loan level data for other deals by the same issuer, or similar issuers (they needed to do that to make basic relative value decisions), they would have known what was inside the MBS. If they couldn’t make sense of the prospectus, they should have realized they were in over their heads. If they didn’t subscribe to the data themselves, they could ask the dealer (who had a small army analyzing this to support sales and trading) – and if the dealer stonewalled, they should know to step away. If a particular issuer wasn’t providing this data, they should know to step away or lower the bid significantly.

Only if the loans turned out to be other than as represented in the prospectus, prospectus supplement and term sheet, do they have a complaint about inadequate loan level data. In fact, they and the SEC have a lawsuit.

The fact is, everyone but the regulators knows that no one reads the prospectus. And I know from experience how few investors demanded loan level analysis of subprime issuers before they bought into the dream. The dream of the fattest yields for a given rating available in the bond market. Well, except for CDOs made of MBS, but that is a different story. (CDO were black boxes. I say buyer beware. This market blew itself up before – as recently as the late ‘90s – and apparently too few investors learned any lesson from the debacle.)

Conspiracists to the Rescue
It’s not bad enough that regulators and their cronies have concealed the existence of loan level data. There is a band of righteous crusaders in the weeds of this debate calling for these “new” disclosures to be made on a daily basis.

I wouldn’t be bothering you, patient readers, about this, if I were sure no one is listening. Alas, proponents of this scheme attract listeners because they are convinced Wall Street firms broke down the chinese walls, acquired up-to-the minute daily performance data from their conduit and subprime lender subsidiaries, and used it to short the market with credit default swaps (CDS).

That’s right, they are playing the Wall-Street-bet-against-its-own-securities card. It’s the kind of argument many people, incensed as they now are with Wall Street, don’t stop to question. So let us now, if only in the spirit of devil’s advocacy, dispute it.

The Drummer Boy
Leading the charge is Richard Field, Managing Director of TYI, LLC, a boutique portfolio strategy firm (Bloomberg calls him a day trader). I first noticed Richard via his comment on the FDICs proposed securitization rule but he’s gotten the attention of reporters at Bloomberg, CNBC, the New York Times, the Chicago Tribune, and Fortune Magazine, among others. The Financial Times has run an Insight piece from Field, and he garnered a speaker slot at ABS East 2009. (Links to all are available on the TYI website.)

Last week, my favorite banking industry analyst, Chris Whalen brought Field on as a guest writing about “Covered Bonds and the Reform of Structured Finance” in the April 12, 2010 Institutional Risk Analyst (IRA). (Unfortunately it’s rolled into archive, but the IRA archives are well worth the annual subscription fee.)

The occasion for writing about covered bonds was the recent covered bond legislation introduced in the House, but the legislation simply provides a fresh segue to Field’s thesis that daily data is necessary to level the playing field between investors and the big Wall Street banks. His comments in IRA are addressed to the SEC, which has not specifically addressed the timing of the “new” data disclosure. Field explains why it should:

“In the ABS market, a select few have access to loan-level performance information on a daily basis. Firms such as Goldman Sachs and Morgan Stanley have subsidiaries involved in originating, billing and collecting loans backing ABS. They receive “fresh” loan-level performance data on a daily basis that they can use for trading days, even weeks, before most other market participants receive the information.”

By contrast, other participants have to wait to receive the “stale” data distributed monthly or, he asserts, less frequently. “It has been reported” says Field, that players like Goldman Sachs and Morgan Stanley who had the data on a daily basis “recognized that risk was mis-priced, stopped buying new securities by late 2006 and in fact went further and shorted the subprime market.” Yet another $1.75trn in non-agency mortgage backed securities, home equity loan backed securities and CDO were issued between Goldman and Morgan stepped back and the market collapsed in 2007.

Think about it. Even if it is true that these banks used their originators like stethoscopes, they were only ahead of the rest of the market by maybe a month (reporting is done as of the 25th of the month). In other words, whatever Goldman and Morgan might have learned from insider channels at the end of 2006, investors saw in the first month or two of 2007 when the loan level data was processed.

As a matter of fact, what everyone saw — coming through every orifice, in loan level data, research reports and conferences, remittance reports — drove spreads wider and prices down (which everyone investor would see in month-end dealer marks). Falling prices pushed the collateral calls and rising haircuts on repos, killed the Bear Stearns funds, forced the raters to begin — late, as was their wont — mass downgrades in second quarter 2007. The accumulating troubles in subprime were media events as well — the first subprime mortgage banking companies started dying in 2006. Wasn’t that information?

As a great poet of American popular music observed, it is not necessary to have a weatherman on staff to know which direction the wind is blowing.

Inside Information Through a Pinhole
Those big dealer’s purported stethoscopes were pretty dinky too. Let’s take the case of Goldman, which owned a small subprime lender, Senderra. (I have to admit that, having heard in my first days on Wall Street that Goldman, above and beyond the usual drug test, required a lie detector test of prospective employees, I have been unenthusiastic about the firm, regardless whether it was true or not. And Goldman does not publish MBS research, though I believe they have “desk” analysts who could talk to investors with questions. Why this did not discourage investors from buying their MBS issues, I do not know. Given my wall of indifference to daily doings at Goldman, I was ignorant of the firm’s acquisition of Senderra and only learned of it when Richard Field kindly provided me with one of the Wall Street Journal articles on which he bases his claims.)

Anyway, Goldman invested in Senderra at startup, in late 2005 and bought it outright in early 2007. In an April 13, 2007 article in the Charlotte Business Journal, staff writer Will Boye quotes Tony Plath, finance professor at UNC Charlotte, who opined that Goldman, like others, was bottom fishing in hopes that the subprime market would come back. (Read on — better scoop on Goldman’s motives below.)

The news on subprime was already very bad and very public. Writes Boye, “The U.S. subprime-mortgage market has fallen on hard times, with rising loan defaults leading to problems for some lenders. New Century Financial Corp., one of the largest subprime lenders, has filed for bankruptcy. Locally, Wells Fargo Home Mortgage, the mortgage unit of Wells Fargo & Co. (WFC: 33.39 -0.57%), is eliminating 250 jobs at its Fort Mill facility because it is cutting back on its subprime lending.”

Wouldn’t an investor think that, if rising loan defaults could sink and shrink lenders, they could mess up your portfolio real bad? I mean, wasn’t the media busily providing the daily updates already?

But I’m digressing. I was going to show you how narrow a look into the world of subprime Senderra might have afforded Goldman. Inside Mortgage Finance estimated total 2007 subprime origination at $192.5bn and The Mortgage Lender Implodometer indicates that Senderra averaged about $30.8m originations a month in 2007. That works out to about 0.19% of 2007 subprime originations.

Analyzing monthly loan level data across the subprime universe would provide a vastly more detailed and comprehensive picture of subprime’s unraveling, and would pinpoint performance by geographical location, loan product, layered risk combinations. In particular, it would put specific issuers, vintages and bonds under the microscope.

Extrapolating from the experience of one small operation in the Carolinas would not indicate which bonds to buy credit default swaps on (the technique dealers, hedge funds and others used to short the subprime market). Even if you used the ABX index to short the market, it would still be far more effective to track the underlying deals to determine which contracts to buy.

More to the point, having an originator in pocket would not tell bond investors which bonds to sell or how soft the bid would be for specific bonds when they offered them for sale. For that, they could look at monthly performance on a loan level basis (including the rates at which loans go from one delinquency bucket to a worse one, how long foreclosure takes by state, how long liquidation takes by zip code, what kind of loss severities are being experienced, etc.). For that they would have to compare their bonds to other bonds that had recently traded.

Misrepresenting the Press
I can sympathize if the media misunderstands how MBS are constructed, perform, trade, are tracked, analyzed, etc., etc. Even the big names in financial reporting are under deadlines, have editors who want it slicked up and dumbed down and were clueless about the complexities of mortgage and other asset-backed securities until the crisis struck. If they had been able to do a better job, I wouldn’t have neglected consulting opportunities and started writing columns.

But I am not sympathetic with people who treat items in the press as the truth. Even the best is “infotainment” and needs to be read carefully. I am even less sympathetic with folks who, in the service of their agenda, rewrite what they find in the press and present it as evidence.

This is something I believe Richard Field does. In his response to the FDIC’s ANPR and his March 30, 2010 response to the Bank of England’s request for comments regarding its Consultative Paper on Extending Eligible Collateral in the Discount Window and Information Transparency for Asset-backed Securitizations, Field states:

“On January 21, 2010, the Wall Street Journal discussed Goldman Sachs’ acquisition of a subprime mortgage lender. Goldman invested in the subprime lender when it was launched in 2005 and bought the firm in 2007. According to the article, ‘mortgage experts say the acquisition likely gave Goldman a clearer view of the market as other parts of the company made bets on home loans.’ These bets generated nearly $4bn in profits for Goldman.”

First of all, the article wasn’t about the acquisition, it was about layoffs at Senderra and its impact on Ft. Mill, South Carolina, where Senderra and other subprime mortgage units were located. The stuff about Goldman is buried half-way down.

Second, the 2007 acquisition came late in the unravelling of the subprime market, so I would argue scoop reaching Goldman from Senderra is stinking old news and, had they been real experts, the WSJ’s sources would have known that. (I don’t blame the WSJ reporter, his editor expected precisely such expert color.)

Third, it appears Bloomberg’s reporters penetrated considerably deeper into Goldman’s motives for buying Senderra outright. Citing a November 19, 2008 Bloomberg article, Implode-o-meter notes that Goldman converted its acquisition into an FHA shop to refinance their portfolio of subprime loans. If so, that was a boon for investors!

He Said WHAT?
Here’s another of Field’s assertions that had me stumped. In his comment on the FDIC’s ANPR, he repeats a quote he found in Total Securitization, taken from a Global ABS Researcher Panel Discussion on June 3, 2009. Apparently a J.P. Morgan (JPM: 44.83 +0.20%) vice president said “in an investor survey just carried out by the bank asking what would bring them back to the market, 60% said a greater level of deal information was their number one requirement.” This was offered after another panelist was said to observe: “We don’t have all the information we need. The loan-level data is not available. We can’t rely on the rating agencies, so we need data that allows us to make our own educated forecasts. The more information we get … the better.”

I could not believe any of the wonderful analysts I know at J.P. Morgan could have said such a thing, as I am a great admirer of their analysis of loan level deal data. So I emailed the quote to them. They were mystified. They said, we don’t even use the title of vice president. It took a day to track it down to a gentleman in the UK who said the dates matched the European ABS conference, it was his survey, which anyone on the team might have quoted at the meeting. And he explained, “This is being taken totally out of context if applied to the US – in Europe we don’t have any loan level data reporting and have quarterly reporting in the majority of jurisdictions.” (The emphasis is his.)

Enhance the Monthly Data, Spare Us the Daily
Afflicted as I was with insatiable data greed throughout my career as an analyst, I could never object to enhancing loan level data, by expanding coverage to, for instance, provide more detail on the range of potential loss mitigation and modification actions a servicer might take, standardizing the formats and definitions, putting it in easily accessed public locations and so forth. And please make it mandatory. For the investors sake and because I am a completist.

But doing so won’t change the facts — that diligent investors will use it, read the prospectus, familiarize themselves with the originators underwriting criteria and business model, and the un-diligent will not.

This will make it marginally easier to look at a single deal, but it will not change the fact that an institutional investor — a professional investor — does not own just one, but many, perhaps hundreds of these MBS. Moreover, professional investors do not assess a bond in a vacuum, but relative to many similar bonds. This means data bases, and data bases either require full time staff to build and feed them, or the services of vendors who, at a minimum, aggregate all the deal data or build reporting systems and analytic user interfaces for the data. So cheaper it will not be (though the SEC thinks it will be).

But please, no daily data. Having poured over monthly reports and diced and sliced monthly data, the thought exhausts me. It’s not just that I am lazy. I’m not too lazy to read a prospectus. But I know in my gut it is extravagantly impractical.

It’s also intellectually unappealing. Monthly data is fully intuitive. It reflects the loan accounting cycle. Mortgage payments are made 30 days in arrears. (By convention a month is considered to be 30 days long.) That means the January payment is due on February 1. Most lenders allow a 15-day grace period. From the 16th day to the end of the month is a penalty period. Borrowers are charged a penalty fee if they pay during this period, but the loan is not counted as delinquent until the 1st day of the next month, when the next payment is due. This event is reported to the credit bureau and may incur yet more penalty fees. (I’m skipping the technical difference between the Office of Thrift Supervision (OTS) and the Mortgage Bankers Association (MBA) method of determining delinquency. It matters, but not for this discussion.) Subsequent delinquencies are reported at 30-day intervals.

Watching the Paint Dry
The milestones on the delinquency path are 30, 60 and 90 days. Current thinking is that if a loan reaches 60 days, it has a convincing likelihood of default (and if strategic default becomes a greater fad, 30 days might raise the alarm), but in the old days 90 or more days was as far out as credit analysts toted them up. Watching loans move from current to late to delinquent on a daily basis will be like watching paint dry. Necessary if you have are managing servicing interventions designed to keep borrowers current and cure them if they aren’t, but a monumental analytic problem and time drain for someone trying to manage a portfolio that is also subject to a host of market forces. Simply put, senior, triple-A bond holders won’t do it. They’ll say, just show me the 30, 60, 90 buckets please, I don’t want all this paper on my desk.

The investors who might care are the ones holding unrated or residual pieces and rated credit tranches taking losses or about to. But it will still be like watching paint dry, waiting for loans 90+ to roll to foreclosure, from there to modification, short sale or REO, waiting for the REO to be liquidated.

I do not believe the market will price differential delinquency or daily changes in the number of loans 90+ of in foreclosure. Too much can change in either direction.

Its the discrete events that people will study: how many loans went into foreclosure later to be modified, how many loans were modified only to re-default (and of course, how many loans going 30-days delinquent ultimately default, etc.).

Happily, these are the kinds of events that are presently being analyzed under microscopes in dealer research departments, at the big money management firms, by hedge funds and private equity firms. Using monthly loan level data.

More Details Emerge on $222m Redwood RMBS

Original posted on the Housing Wire by Diana Golobay:

Redwood Trust filed a prospectus on the first residential mortgage-backed security (RMBS) since 2008 — the forthcoming Sequoia Mortgage Trust 2010-H1.

Redwood Trust is named as the seller and sponsor, while Sequoia Residential Funding is the depositor in the filing with the Securities and Exchange Commission (SEC) Thursday. CitiMortgage acts as the originator and servicer, while Wells Fargo Bank is listed as the trustee on the deal.

The issuer is planning to issue four classes of senior certificates, including one class of interest-only certificates and two classes of residual certificates, according to the prospectus. The issuer also plans four classes of subordinate securities.

The deal is expected to close on or about April 28, and consists of 225 first lien mortgages secured by single-family residential properties, according to a preliminary term sheet filed on Wednesday with the SEC.

The filings show 76.5% of the loans are rate and term refinancings, 19.4% are purchase loans and 4.1% are cash-out refinancings. They also illustrate that 73% of the loans are secured by properties with no second liens, while 27% have “silent seconds.”

The loans bear approximately $222.38m of principal balance, with an average $932,700 principal balance per loan. The loans bear a weighted average seasoning of eight months, and a weighted average original loan-to-value ratio of 56.57%. The weighted average original credit score for the borrowers is 768.

There is no loan level data available in the filing, though the deal is set to be publicly-placed and closed by April 28, and more information may be available then, sources tell HousingWire.

Treasury won't seek customized derivatives ban

Original posted on Reuters:

The U.S. Treasury is not proposing a ban on customized derivatives, nor is the U.S. Senate considering one, the Treasury's number two official said on Thursday.

Deputy Treasury Secretary Neil Wolin told an International Swaps and Derivatives Association meeting there was a valuable role for customized contracts traded on over-the-counter markets.

"Where managing a particular risk requires the use of a customized contract, we do not object to customization," Wolin said. "But to ensure that the market in customized products does not give rise to unmanaged risk, dealers and other major swap market participants must be subject to much higher prudential standards than they are today."

Wolin's remarks come against a controversy over a proposal to sell derivatives contracts based on Hollywood box office receipts, which would let investors bet on movie ticket sales.

U.S. Treasury Secretary Timothy Geithner told ABC Television's "Good Morning America" program he did not think the movie futures were a good idea. But he said he was not inclined to ban specific products and would instead work to make derivatives markets safer.

Wolin scolded ISDA for taking only tepid initial steps toward transparency, standardization of contracts and more effective collateral requirements.

"We welcome those commitments. But make no mistake: they are not enough. There can be no substitute for effective regulation and oversight of a market so large, so important and -- still today -- so unsupervised."

Wolin said that by imposing conservative capital and margin requirements on derivative dealers and major market participants, "we will help ensure that no firm is able to take large, highly leveraged risks in the derivatives markets, without holding adequate capital."

The deputy Treasury chief also said the department will work with Senate Agriculture Committee Chairman Blanche Lincoln and Senate Finance Committee Chairman Christopher Dodd, and Senate leadership to "make sure that the final derivatives provisions remain strong."

On Wednesday, the Agriculture Committee approved a derivatives bill that would require banks to get out of the swaps markets if they want to keep their federal deposit insurance. Wolin made no mention of this provision in his remarks and declined to comment on specifics of the Senate bills to reporters after his speech.

In addition to laying out the Treasury's arguments for central clearing and standardized contracts and higher capital requirements, he also said any exemptions from such clearing requirements for non-dealers or major swap participants must be kept narrowly focused.

The purpose of this exemption is for firms that are hedging real risks and are predominantly engaged in nonfinancial activities, he said.

"Any exemption must be drawn narrowly. We cannot allow a reasonable exception to become an expansive loophole," Wolin added.

Derivatives industry opposes Lincoln reform bill

Original posted on Reuters by Karen Brettell:

Representatives for the $460 trillion, privately traded derivatives industry on Thursday fought back against growing momentum for reforms that would require contracts to be traded on exchanges, calling it unnecessary and likely harmful to industrial companies.

Calls for wider reforms of the unregulated derivatives industry have intensified in recent weeks as credit default swaps came back into the spotlight for their role in spreading the risk of mortgages that caused the global financial crisis.

Senator Blanche Lincoln, who chairs the agriculture committee, last week unveiled an aggressive draft bill to regulate privately traded derivatives, which would require that banks spin off swaps desks if they are protected by federal deposit insurance or access the Federal Reserve discount window.

The bill would also require most swaps to trade on regulated exchanges and pass through clearinghouses. For more, see: [ID:nN16137927]

Conrad Voldstad, chief executive officer at derivatives trade group the International Swaps and Derivatives Association and former head of JPMorgan's first swap unit, said Lincoln's bill is likely politically motivated and overrides prior, more "sensible" efforts made by the committee.

The bill is "driven by politics - the administration wanted to have a victory and the victory was to beat up the banks and do something they dislike," Voldstad said at a meeting with reporters at ISDA's annual meeting here.

Mandating contracts to be traded on exchanges would damage the ability of industrial companies to hedge their business risks, he said.

"Mandating that all swaps be exchange-traded will increase costs and risks for the manufacturers, technology firms, retailers, energy producers, utilities, service companies and others who use over-the-counter derivatives," Voldstad said. "That's because the risk-hedging products that they want and need will no longer be available."

A key debate in derivatives reform is how many trades are ultimately put into central clearinghouses, which may then be subject to electronic trading. This has the potential to narrow trade margins and shift market share away from dealers to newer players, including exchanges.

ISDA Chairman Eraj Shirvani, who also heads fixed income for Europe, the Middle East and Asia at Credit Suisse, said that not all derivatives are appropriate for central clearing, wherein a central counterparty stands between two trading parties and assumes the risks of the contract.

Deputy Treasury Secretary Neal Wolin, however, said dealers should make greater efforts to clear more contracts.

"Not every derivative contact can be cleared. But many can," Wolin said at the ISDA conference. "The large OTC dealers do not have a sufficient incentive to speed up the process of standardization. Large dealers profit too handsomely from the current system in which they have far more information and far more leverage than other market participants."

Revenue lost by dealers could be significant in the event trading moves toward exchanges. Research and advisory firm TABB Group estimates the top 20 dealers generate around $40 billion annually from privately traded derivatives, excluding credit default swaps.

Jamie Dimon, chief executive of JPMorgan Chase & Co (JPM.N), told bank analysts earlier this month that forcing dealers to trade derivatives on exchanges could cost his firm up to a couple of billion dollars in revenue annually.

Theo Lubke, senior vice president at the Federal Reserve Bank of New York, said clearing needs to be expanded to more contracts, but warned that only contracts with liquid pricing should be routed through central counterparties.

Buy-side participants have been slow to adopt central clearing of contracts including credit default swaps. Ted MacDonald, treasurer at hedge fund DE Shaw Group, said a key reason for this is the limited number of contracts on offer, though he added that expects this range to broaden over the coming year.

Companies that use derivatives to hedge against interest rate, currency, commodity and other risks are likely to win exemptions from clearing because they say that margin requirements would be too costly.

The Commodity Futures Trading Commission and Securities and Exchange Commission, which will enforce the rules, may push for few exemptions.

CFTC Chairman Gary Gensler has said exemptions should be narrowly applied, and that all financial companies, including insurance companies and hedge funds, should be required to centrally clear eligible positions.

Gensler has further said that contracts that are not cleared should still be traded on electronic trading platforms to promote transparency and reduce trading costs.