Friday, May 28, 2010

No One Said Re-Creating Securitization Standards Would Be Easy

Originally published on the Housing Wire:

The recently released Mortgage Banker’s Association report, “Anatomy of Risk Management Practices in the Mortgage Industry,” is the latest sign that the industry is connecting some of the dots between what has been done already and what still needs to be done for a sustainable investor base to return in earnest.

(Download here:

Until now the most prevalent stories in the press have rightly highlighted the important work being done to bring underwriting and issuance standards onto a more level playing field. Attention now though is shifting to the challenges investors face in making use of increasingly commoditized information as disclosure in all its new ‘standard’ forms becomes the norm.

The report highlights much of what we know already about risk taking in the mortgage industry of old and in the structuring and ongoing analysis of the risks in mortgage backed securities. It mentions how, “data and analytical limitations and blind spots led risk managers to grossly underestimate credit losses.”

Nothing new there.

And it calls for a more comprehensive focus on the development of industry-wide data and techniques for measuring risk in mortgage backed securities. Well, we can see that there has been an overwhelming commitment to do that from industry bodies and working groups over the last 18 months.

Achieving a one-size-fits securitization standard is a big thing to ask for but with continued international coordination, a solid platform for a prudent securitization industry can be established. Governments are committed to adopting standards in spirit but the secret to success in the long term will be how the industry translates more openly available data, into more standardized and useful forms that genuinely add value to investors.

More information is one thing, but a sound footing requires a level playing field. Industry bodies such as the ASF and AFME/ESF are doing much to provide a foundation for the most prominent asset classes. The European Central Bank, Bank of England and SEC have all stated the need for standard data points for loan level, pool level descriptors and information in deal documentation, with variations for each asset class.

But they have not yet come to a consensus as to what those should be.

The extension of these efforts into other aspects of disclosure will be critical if investors are able to truly capitalize on the work done so far.

The SEC’s proposals that issuers must provide and publicly disclose a computer program of the securitization’s waterfall could help bridge the gap between loan level data and an investor’s actual investment. Standardizing the way cashflow waterfalls are defined and scripted and trying to implement a common language when non-standardization is the prevailing characteristic, may be nigh on impossible though. There is an opportunity to create a basis from which models’ input assumptions and output cashflow calculations can be standardized across issuers and asset classes. Finding this happy medium, without oversimplifying the modeling that must be provided to investors, will be a sizeable but important barrier to overcome.

Take international accounting standards and securities law as examples of standardization in action. They provide a framework for comparability. In securitization, the equivalent was never going to be created easily such are the inherent complexities of the business. The MBA report describes how consolidation in the industry leading up to the crisis significantly challenged organizations’ IT systems.

It identifies failures in managing complex data in all its various forms and in being able to merge asset performance data with other data across the company so it can be aggregated and reported on in a consistent manner. It’s up to each region to come to a level of agreement on the implementation of standards and to compel issuers and investors to adopt best practices. Once data is disclosed, market participants can find the tools, models and mechanisms to understand it. But if a lack of comparability remains part of the equation then we lose the whole point of having all this readily available information and many of the same challenges will remain.

In the future, turning more commoditized, voluminous data into a value add for investors has to be the desired end game. Investors should be able to focus on their core business rather than spending a disproportionate amount of time collecting data or reverse engineering loan level information and waterfall structures (although more independent analysis is a given in the new environment). Wider adoption of standards by issuers and investors alike can deliver the ammunition to understand investment performance and the fundamental differences between transactions.

Alongside investors building the operational capabilities to merge and analyze all the necessary data, the commoditization and transparency of information will truly be able to play its part in steadying securitization’s footing. Then organizations will be locked and loaded to move from relying on quantitative methods of assessing performance attributes such as delinquency and default risk, and embrace more qualitative assessments of deal, tranche and collateral performance.

Thursday, May 27, 2010

Covered Bonds May Play Role In Mortgage-Financing Fix

Update posted on the CNBC website:

A little-noticed bill introduced in the House last March may be the first step in connecting financial reform efforts with the eventual attempt to restructure the nation's housing financial system and the deeply troubled Fannie Mae and Freddie Mac.

The U.S. Covered Bonds Act, introduced by Scott Garrett (R-NJ) and co-sponsored by Spencer Bachus (R-Ala.) and Paul Kanjorski (D-Pa.) and others, would add liquidity to the still sluggish credit markets and offer a private-market mortgage lending alternative to the government loans and guarantees of the two firms, which were taken over by the Treasury in September 2008 as the financial crisis was about to explode.

Garrett failed to get the measure included in the either the House or Senate versions of the financial reform bill, but there's some speculation it could wind up in the compromise bill that will will be crafted in the coming weeks by a House-Senate conference committee, of which Garrett could be a member.

"We're certainly going to certainly push it," Garrett told in an interview Tuesday. "We always saw it as a slice of the reform process. It's one of the few pieces that will do what the markets' need--provide certainty. It's not a total solution, but a piece of the puzzle."

The proposal is also likely to come up when the House subcommittee on capital markets—whose senior members are Kanjorski and Garrett—takes up the issue of the government-supported housing market with Edward J. DeMarco, acting director of the Federal Housing Finance Agency, at a hearing Wednesday.

The proposal hopes to free up mortgage lending through the use of so-called covered bonds—debt securities that are backed by the cash flow of a loan such as a mortgage. The loan is secured—or covered—by a pool of assets that investors can claim rights to if the issuer, or originator, becomes insolvent.

Though covered bonds are common in European countries, they are relatively rare in the U.S. Bank of Americaand the old Washington Mutual, now a unit of JPMorgan Chase, have issued them and firms like BlackRock and Pimco invested in them. But proponents in the US argue that covered bonds need a solid legal framework with clear rights of onwership to create and drive a healthy, dynamic marketplace.

The push for covered bonds is not new, but the timing is probably better.

In mid 2008, with Fannie and Freddie clearly in trouble, Treasury Secretary Henry Paulson lined up four large US banks to kick-start a covered-bond market, largely as an alternative to mortgage-backed securities. The mortgage market meltdown and broader financial crisis snuffed out the effort.

Today, it's exactly that MBS alternative that's makes covered bonds so relevant, especially since the Obama administraion and Congress opted to keep any overhaul of the two mortgage giants and the mortgage finance system out of the regulatory reform bill. Legislation won't happen until 2011 at the earliest.

"There's not a lot of certaintly about how the GSE debate will evolve and play out," says one market player, referring to Fannie and Freddie's special status as government sponsored enterprises. "The securitization business is obviously still struggling. You need more tools, It's better you have the options."

Proponents point to the dark early days of the financial criss when the government's plan to buy toxic assets from a market with little or transparency was dropped.

"It's a very feasible financing option," said Alex Pollock, a former CEO of the Federal Home Loan Bank of Chicago and now a resident fellow at the American Enterprise Institure. "The loan stays on the balance sheet. You get skin in the game with the retention of credit risk. The bank issuing the bond mantains 100 percent of the credit risk."

Covered bonds do not have the complex and sometimes vague ownership structure of the securitization market that made dealing with mortgage-backed securities a legal and logistic nightmare.

"There's no 127 holders and knowing what they want to do," said Lawrence White, a former regular and White House economist now with NYU's Strern School of Business. "Those poblems go away."

Just how much of an impact covered bonds would have is a matter of some debate.

Some proponents go so far as to say that the MBS market could eventually be replaced entirely by covered bonds, assuming the right transition leading up to the eventual dissolution of Fannie and Freddie.

"I see no reason why you need to have a government securitizer," says independent bank analyst Bert Ely, who argues that the current model emphasizes an originate-to-sell rather than the originate-to-hold biz model. "If you have covered bonds by mortgage originators I'm not sure you need Fannie or Freddie."

Others don't see that kind of impact. "It's a tiny first step," says White. "I don't think we are going to see $5 trillion of this stuff replace the $5 trillion Fannie and Freddie either own or have securitized."

Certainly not any time soon, but the time may be right just the same.

"It's been a long haul over the past two years to keep it alive, but the market is still interested in covered bonds" says Sean Davy, a covered bonds expert and managing director at the Securities Industry and Financial Markets Association.

Inching closer to the derivatives end-game?

Posted by Richard Raeburn on his EACT Blog:

There’s an enormous amount happening on all economic and financial fronts as I write – with the equity and other markets in freefall and the USD soaring – so I am almost reluctant to blog again about OTC derivatives. In addition I am about to go to Prague for the latest (six monthly) EACT meeting. But I do think we are approaching the beginning of a very extended end-game on derivatives regulation, so here briefly are some not totally random thoughts.

We are about to be faced with a further consultation by the European Commission on its regulatory proposals (now branded as ‘EMIL’). Depending a little on whom you talk to, you may believe that the fact there is this further consultation reflects an acceptance by the Commission that the views of non-financial end users need a further airing. I suspect that the consultation is part of a long-planned process, at the end of which the Commission staff will be more than happy to hand over the topic to ESMA and other interested parties for the real implementation.

There is increasing transparency (to coin a phrase) on what will be involved going forward. The main elements that I have gathered are as follows.

The consultation is almost certain to propose that corporates are out-of-scope of the regulatory initiative – so no central clearing, cash collateral etc etc – unless a local regulator considers that hedging activities breach an investigation threshold. If that happens there will be a friendly conversation with the regulator, at which the corporate should focus on explaining the rationale for its activity; if I have been right in a lot of what I have been saying (when given the chance) the conversation will be almost entirely about risk mitigation.

If activity breaches a second and higher level then there will be a more searching – but retrospective – examination of the transactions around the legitimacy of the hedging. Systemic risk will be strongly on the minds of the regulator and I assume that if the examination fails to convince the authorities, there will be some sanction in the form of obligatory central clearing.

The devil is of course in the detail and that’s where it seems to me that ESMA and the national regulators will have a huge challenge. The particular elephant in the regulatory room is the notion of systemic risk and how that can relate to the higher of the two thresholds. The overall approach is based around the concept that that the Commission team has been talking about publicly, which is that the lower threshold is ‘qualitative’ and the higher is ‘quantitative’.

So….we need to get through what we expect to be a short consultation period with the Commission; then – whilst the rest of the Brussels governance structure turns it wheels on the Commission’s output – focus even more on what is happening on CRD IV and the BIS work to produce Basel III. The core concern here remains: what we may be in the process of winning with the OTC regulatory discussions we may promptly lose, with the application of what officials in Brussels have in the past happily described to me as ‘punitive’ capital requirements to sweep away the remaining OTC market.

In brief that is where we seem to be. The EACT meeting will be discussing the topic amongst many others over the next two days in Prague. We are also planning to mobilise additional resources, in common with some larger individual corporates, to ensure that the concerns of end users are probably articulated and communicated in Brussels and elsewhere.

Tuesday, May 25, 2010

Are We Building the Foundations for the Next Crisis Already? The case of central clearing

by Jon Gregory

Abstract: Counterparty risk has been at the heart of the recent crisis driven by the toxicity of over-the-counter (OTC) derivatives and failure of high profile financial institutions. This has led policymakers to propose laws that would require most standard OTC derivatives to be centrally cleared. Central clearing involves a central counterparty (CCP) intermediating a transaction and acting as an insurer of counterparty risk. This has advantages, potentially leading to enhanced transparency and liquidity in markets and smoothing major systemic problems. The idea is also popular since it represents a single and intuitively simple solution to the severe problem of counterparty risk. However, whilst CCPs may have a role to play in reducing counterparty risk, they can also be counterproductive to the stability of financial markets. In this paper, we argue that the introduction of CCPs should be carefully considered and that, far from reducing counterparty risk, they may actually allow it to breed and contribute to the next crisis.

Download the paper here:

Wednesday, May 19, 2010

Collateral Posting and Choice of Collateral Currency: Implications for derivative pricing and risk management

by Masaaki Fujii, Yasufumi Shimada, and Akihiko Takahashi

Abstract: In recent years, we have observed the dramatic increase of the use of collateral as an important credit risk mitigation tool. It has become even rare to make a contract without collateral agreement among the major financial institutions. In addition to the significant reduction of the counterparty exposure, collateralization has important implications for the pricing of derivatives through the change of effective funding cost. This paper has demonstrated the impact of collateralization on the derivative pricing by constructing the term structure of swap rates based on the actual market data. It has also shown the importance of the "choice" of collateral currency. Especially, when the contract allows multiple currencies as eligible collateral and free replacement among them, the paper has found that the embedded "cheapest-to-deliver" option can be quite valuable and significantly change the fair value of a trade. The implications of these findings for market risk management have been also discussed.

Download paper here:

Monday, May 17, 2010

KPMG and PwC eye rating move

From the Financial Times:

KPMG and PwC, two of the world's largest accounting firms, have considered entering the credit rating business, in a move that would pitch them against the current top three - and heavily criticised - agencies Moody's, Standard & Poor's and Fitch.

John Griffith Jones, chairman of KPMG in the UK and co-chair in Europe, told the Financial Times it had discussed the move as - being one of the four biggest accounting firms in the world - it had the skills, knowledge and people to provide credit ratings.

However, Mr Griffith Jones said KPMG was "passively considering it", not actively debating it.

"It is something that we talk about as a plausible thing to do. It is effectively something we would be proficient at doing . . . But it's not on the agenda at the moment," Mr Griffith Jones said...

Other accountancy firms said they had also seen credit ratings as a potential opportunity for auditors.

Richard Sexton, UK head of assurance at PwC, said it continually looked for areas to grow its business from its "core skills that include assurance, opinions and underpinning public trust".

Mr Griffith Jones said conflicts of interest would be a stumbling block for an auditor to offer credit ratings as they are also paid by the clients they audit.

Saturday, May 15, 2010

How to implement the Franken & LeMieux NRSRO Amendments?

Interesting post on the Baseline Scenario on how to implement the Franken and LeMieux credit rating agency-related amendments to the Senate financial sector reform bill:
The two (perhaps contradictory) amendments each try to implement a proposed solution that runs into some of the critiques. The Franken amendment has rating agencies assigned to debt issues by a neutral arbiter; critics maintain that lack of competition may reduce the quality of analysis. The LeMieux amendment removes legal mandates to obtain a NRSRO rating and the preferential treatment those issues currently receive. However, it leaves out details about whose advice agencies and public trusts should seek out instead.

This is not such a difficult problem. We already have an example of a successful private rating agency, whose imprimatur is desired or in some cases required by law, that is paid for by fees on the seller, and has been operating since 1894: Underwriters Laboratory. The UL publishes safety standards for almost 20,000 different types of products, many of which are adopted by other standard-setting organizations like ANSI (American National Standards Institute) and Canada’s IRC (Institute for Research In Construction). Although generally not actually required by federal law, the sale of many types of products in the US would be difficult without UL listing. Also, many local jurisdictions responsible for building and fire codes mandate the use of UL approved products. In all cases, the manufacturer must submit samples and pay fees to UL in order to win approval.

The comparison to NRSROs is apt. In both cases, a third party sets standards based on theory, models, and best practices. In both cases, the issue is the assessment of risk by experts in that type of risk. In both cases, approval is desired by the market or required by local ordinance or rules. And in both cases, the seller pays the fees; so the third party might be led to relax their standards in order to capture some extra fee income. Yet in the case of fire safety the model has been functioning well for over 100 years, but in financial safety there has been a rash of fires as one rated product after another has blown up. Why?

There are a few key differences. Until 2007, UL was completely non-profit, so as long as user fees covered their costs there was little incentive to chase extra revenue by relaxing standards. There is no real competition in the US market for UL (although Europe has its own standard-setting body that manages the ), so manufacturers have little leverage to push for easier standards. The LeMieux amendment could allow for the creation of a not-for-profit entity to take the place of NRSROs, while the Franken amendment would reduce competition, limiting it to delivering a better, more reliable rating rather than adjusting standards to capture fees.

Critics of the amendments, including those who support a buyer-pays model, need to address the question of why the UL model for risk assessment has worked well, and why it can’t be applied to debt rating. Is the model broken? If so, I expect a rash of building fires any day. Is rating of financial safety fundamentally different than, say, electrical safety?
Some of the comments are kind of interesting too:
The analogy between UL and the NRSROs doesn’t take one very far. The products that the organizations rate are just too different, and the chief difference is simply that UL-rated products are tangible. As a result, it doesn’t generally pay for manufacturers to game the approval process by adding complexity that hides fundamental safety deficiencies. In the world of tangible products, increased complexity almost always equals increased manufacturing costs and lower expected profit. By contrast, in the securities world, increased complexity has a negligible impact on the cost of “manufacturing” the security and can result in a higher expected profit to the issuer and underwriter by hiding features that accrue to their benefit....

When a fire happens, it can generally be traced to a single root cause, or maybe two (e.g., somebody was smoking in bed + the sprinkler system failed).

Put another way, the conditions that cause physical failures do not change from year to year, because the laws of physics do not change.

As a result, if UL failed to do their job properly, it would be pretty easy to tell. It would not even take an expert.

In the financial sector, the top experts always disagree about what is safe and what is dangerous. That is the nature of the sector.

The financial sector is different because its “laws” change daily. The cause of the crisis was not ratings agency failure. The cause was a universal desire to get something for nothing combined with low interest rates. Had the ratings agencies tried to be careful, they would simply have been ignored, because nobody wants to hear about risks when they see their neighbors are getting rich doing nothing year after year after year.

What drives bank securitisation? The Spanish experience

Published in the Journal of Banking & Finance (Clara Cardone-Riportellaa, Reyes Samaniego-Medinab and Antonio Trujillo-Ponce):

Abstract: This paper analyses the reasons why Spanish banks securitised in the period 2000-2007 on such a large scale that Spain has become the European country with the second-largest issuance volume after the U.K. The results obtained by applying a logistic regression model to a sample of 408 observations indicate that liquidity and the search for improved performance are the decisive factors in securitisation. We find no evidence to support hypotheses regarding credit risk transfer and regulatory capital arbitrage. Our study also presents a more detailed analysis that differentiates between asset and liability securitisation programmes.

Download the paper here ($$).

Friday, May 14, 2010

Ooops Again! S&P Cuts to Junk Re-Remics It Rated AAA in 2009

From the Bloomberg story:

Standard & Poor’s cut to junk the ratings on certain securities, backed by U.S. mortgage bonds, that it granted AAA grades when they were created last year by Credit Suisse Group, Jefferies Group Inc. and Royal Bank of Scotland Group Plc.

The reductions were among downgrades to 308 classes of so- called re-remics, or re-securitizations, created from 2005 through 2009, the New York-based ratings company said today in a statement. About $150 million of the debt issued last year, as recently as July, with top rankings were lowered below investment grades, according to data compiled by Bloomberg.

Such re-securitizations, used by Wall Street after the credit crisis began to help create more valuable debt to sell or to restructure investors’ holdings, last year expanded from home-loan bonds to commercial-mortgage securities and collateralized loan obligations backed by company loans.

Residential re-remics exceeded $40 billion last year, according to newsletter Asset-Backed Alert. The notes differ in several ways, such as by including fewer underlying bonds, from the so-called collateralized debt obligations created during the credit boom that in some cases had AAA rated classes that defaulted and returned nothing to investors in less than a year.

Remics, or real estate mortgage investment conduits, are the formal name of certain mortgage bonds. Some of the new securities created in re-remic deals offer investors an additional layer of protection from losses and downgrades, which boost the capital needs of banks and insurers and can force some investors to sell debt.

For more on Re-Remics see Box 2.3 in the October 2009 IMF Global Financial Stability Report here.

One Provision Overlooked in Senate version of reform leglislation

Shahien Nasiripour in the Financial Fix:

In passing a measure that attempts to end their oligopoly, the Senate purposely did not include a provision in the House bill that forces major credit rating agencies to be accountable to investors by scrapping a Securities and Exchange Commission rule that has shielded them from civil lawsuits for nearly 30 years.

The provision, known as Rule 436(g), insulates the 10 credit rating agencies recognized by the government as "Nationally Recognized Statistical Rating Organizations" from liability if they knowingly make false or misleading statements in connection with securities registration statements to dupe investors. Other experts -- like the rating agencies not part of the group of 10 -- are legally liable for their statements "to assure that disclosure regarding securities is accurate," according to a 2009 SEC document supporting the removal of the exemption.

In short, if a Standard & Poor's or Moody's Investors Service knowingly tries to deceive an investor, under current law that investor can't sue.

Here's what was in the House version:

Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.
Shahien Nasiripour continues:

But the Senate bill, like the House bill, does provide investors with an improved ability to sue credit raters for faulty ratings. A spokesman for LeMieux pointed to these provisions when asked why his amendment did not include the House language on the 436(g) rule.

The agencies have enjoyed a near-perfect legal record by claiming that their ratings fall under the protection of the First Amendment -- free speech, they've successfully argued. The House and Senate bills attempt to address this by strengthening investors' hand when it comes to suing the rating agencies, but the First Amendment defense may be hard to overcome, as ultimately the courts decide -- not Congress.

Still, according to experts like Barbara Roper, director of investor protection at the Consumer Federation of America, the bills are a big improvement over the status quo. Many consumer groups say the provisions approved Thursday strengthened the Senate bill.

Elsewhere in those amendments were measures that remove various references in federal law to credit ratings, which had compelled their use and guaranteed the majors' oligopoly, and a government mechanism that would inject government officials into deciding which agency rates which securities.

Regarding the removal of the references, federal regulators will largely be forced to define creditworthiness, rather than regulations that currently rely on the credit rating agencies for that.

However, there are open questions about the LeMieux-Cantwell provision. The House bill, largely authored by Rep. Paul Kanjorski (D-Pa.), directs the various federal agencies that would need to modify their rules, like the Office of the Comptroller of the Currency, the SEC and the Federal Deposit Insurance Corporation, to harmonize their standards of creditworthiness "to the extent feasible." The Senate provision includes no such language.

Also, the House bill compels federal agencies to look for other such references to credit ratings in their rules and regulations, and modify them so they instead refer to government-defined standards. The Senate amendment doesn't include this, either.

The measures in the LeMieux-Cantwell amendment won't take effect until two years after the bill is enacted into law; the House provisions take effect within six months.

Thursday, May 13, 2010

Corporate CDS: A Market That's Not a Market?

Donald van Deventer reports that, based on recent DTCC data, only 2 corporate reference names have daily average non-dealer CDS volume over 40 trades, only 72 have more than 5 trades (see For more go to:

Senate Votes to Exempt Qualified Mortgages from Risk Retention

Original posted on the Housing Wire by Diana Golobay:

The US Senate consented unanimously to the Sen. Mary Landrieu (D-LA) amendment on S 3217, the Restoring American Financial Stability Act sponsored by Sen. Chris Dodd (D-CT), that will exempt certain qualifying mortgages from credit risk retention requirements.

The provision is already being praised by industry professionals who say that ensuring the underlying quality of mortgages eliminates the need for risk retention by lenders and securitizers. Risk retention requirements, also called ’skin in the game,’ required financial institutions to hold a reserve fund worth 5% of arranged deals, set aside to compensate for any poor performance.

“This amendment will prevent reckless competition based on loose underwriting standards by focusing risk retention on the truly risky loan products and underwriting practices that created the mortgage market turmoil in the first place,” said Glen Corso, managing director of the Community Mortgage Banking Project (CMBP), in a statement.

Corso added: “Creating a ‘qualified mortgage’ exemption ensures that responsible borrowers using traditionally underwritten mortgages will not be forced to pay higher interest rates in order to discourage the risky behavior of others.”

Edward Yingling, CEO of the American Bankers Association said passing such a provision would have been at the fiscal expense of the nation. “An across-the-board five percent risk retention requirement would have reduced credit availability by an estimated $125bn per year, hampering economic recovery and job growth.”

Senators also approved an amendment by Sen. Mike Crapo (R-ID) that modifies the Landrieu amendment on credit risk requirements, to consider commercial real estate and other asset classes.

“What the amendment does is take the exclusive focus off of just one form of risk retention and allows the regulator to evaluate the best approach to address risk retention by asset class,” Crapo said from the Senate floor yesterday. “This still includes a percent retention, if necessary, as well as underwriting standards that actually get at the heart of loans and even strong and uniform representations and warranties which are important to the investors, such as pension funds, mutual funds and endowments who fuel the lending and securitized credit markets.”

He added: “The amendment simply gives important direction to the regulators on structuring reforms by asset class.”

Senators shot down an amendment on derivatives sponsored by Sen. Saxby Chambliss (R-GA). It would have implemented regulatory oversight of the swap markets and improved regulator’s access to information about all swaps, according to a statement. The amendment also aimed to encourage clearing while preventing concentration of inadequately hedged risks in central clearinghouses and ensuring that corporate end users can continue to hedge their unique business risks.

“This amendment would remove the underlying bill’s mandatory exchange trading requirement and removes the mandatory clearing provisions. This is just not acceptable,” said Sen. Blanche Lincoln (D-AR) from the Senate floor. “We understand and know from our experience with the futures market what the clearing does and the stability that it brings to the marketplace.”

Lincoln added: “It is absolutely essential. This amendment removes real price transparency to the public”

She noted the Dodd-Lincoln amendment — which still awaits a Senate vote — provides realtime price transparency to the public and to the regulators while reforming the over-the-counter derivatives market.

S&P on Proposed U.S. Covered Bond Legislation

NEW YORK (Standard & Poor's) May 7, 2010--If the United States Covered Bond
Act of 2010 (H.R. 4884) is enacted in its current form, it would create a
legal framework for the issuance of covered bonds in the U.S. The bill,
introduced in the House of Representatives by Representative Scott Garrett
(R-N.J.) on March 18, seeks to develop a covered bond market in the U.S. and
create specific provisions aimed at protecting covered bondholders from the
effects of an issuer's bankruptcy.

Covered bonds are essentially bank-issued securities that are typically
collateralized by mortgage loans or public sector assets. Unlike traditional
securitizations, investors have dual recourse to both the issuing bank and to
the assets backing the covered bonds. Because of this dual recourse, covered
bonds offer investors exposure to the mortgage market, yet are seen to have a
stronger credit profile than traditional residential-mortgage backed
securities (RMBS). At year-end 2009, 24 European countries had enacted
legislation governing the issuance of covered bonds.

Based on observations in other jurisdictions, Standard & Poor's believes the
proposed legislation might aid the further development of the covered bond
market in the U.S. However, additional clarification and analysis is required
for us to determine any potential impact that the legislation could have on
our ratings on covered bonds issued by financial institutions domiciled in the

Covered bonds have been a long-standing part of the European capital markets.
They provide investors with access to a greater variety of mortgage-backed and
public sector-backed securities, and they provide issuers with access to
liquid pools of capital that have financed various types of real estate and
public sector lending in many European countries. Outstanding European covered
bond totaled approximately €2.5 trillion (approximately USD3.4 trillion) at
year-end 2009, and very strong issuance continued through the first quarter of

Rep. Garrett's bill addresses, among other matters, covered bondholder rights
and protections in the event of a default of the covered bond or the
insolvency of the issuer or sponsor of the covered bond program, which is an
important aspect of Standard & Poor's analysis of covered bond legislation
(see "Expanding European Covered Bond Universe Puts Spotlight on Key Analytics,
" published July 16, 2004). We believe that greater certainty over the process
and timing to gain access to the covered asset pool would be beneficial for
investors. And, in our opinion, the proposed legislation could mitigate the
effect of collateral liquidation in a very short period, which could otherwise
adversely affect market values of the collateral.

On Dec. 16, 2009, we published our updated methodology and assumptions for
assessing asset-liability mismatch risk in covered bonds (see "Revised
Methodology And Assumptions For Assessing Asset-Liability Mismatch Risk In
Covered Bonds"). In the criteria we introduced a link between the rating on
the covered bond and the rating on the issuing bank. The linkage, which
provides a maximum uplift of seven notches on covered bond ratings, is
intended to communicate the potential risks to assets and cash flows when, in
our view, the program is exposed to asset-liability mismatches. If the
asset-liability mismatch risk is not structurally addressed, based on our
criteria, the amount of the potential rating uplift will be limited based on
our assessment of two factors: 1) the degree of the asset-liability mismatch
that a covered bond program is exposed to, and 2) the program categorization
that encompasses our view of the ability to obtain third-party liquidity or
sell assets to fund any mismatch. The program categorization is dependent on
our assessment of the range of funding options available to the program and
the likelihood of the program sponsor's ability to access these options, which
is largely based on our view of the systemic importance of covered bonds to a
particular jurisdiction's financial system.

Given the relative infancy of the covered bond market in the U.S., it's
difficult to assess how, if at all, the proposed bill would alter the systemic
importance of the U.S. covered bond market in the short term. However,
notwithstanding the exact impact, if any, on our criteria for rating U.S.
covered bonds, we believe that through the introduction of specific investor
protection provisions and clarity on their timing, the proposed United States
Covered Bond Act of 2010 could be a catalyst for the further development of
the U.S. covered bond market as an additional source of private capital to
finance U.S. homeowners.

S&P FAQ On The Implementation Of SEC Rule 17g-5

NEW YORK (Standard & Poor's) May 7, 2010--The compliance date for the
Securities and Exchange Commission's (SEC's) amended Rule 17g-5 for structured
finance transactions (the Rule) is June 2, 2010. Standard & Poor's Ratings
Services supports the goal of the Rule to provide market participants,
particularly investors, with as many credit rating opinions as possible. In
addition to providing greater transparency, the Rule can help mitigate
"ratings shopping" by encouraging nationally recognized statistical rating
organizations (NRSROs) to compete on the quality of their ratings.

Standard & Poor's has been working to create a password-protected Web site
(the Web site) to identify structured finance transactions covered by the
Rule. In the meantime, we continue to work with market participants to assist
in the effective implementation of the Rule. To further clarify important
implementation issues, we provide our current understanding of the Rule in the
following frequently asked questions (FAQs).

Please note that these FAQs address complicated interpretive issues that are
not free from doubt, and these FAQs are therefore based on our current good
faith understanding of the Rule. These FAQs are not intended to be, and may
not be relied upon as, legal advice. We may revise these FAQs in light of any
formal or informal guidance provided by the SEC or its staff after the date of
this publication.


Q: What is Standard & Poor's standard for posting information on the Web site
for complying with the Rule?

A: For securities under review by Standard & Poor's before June 2:


Standard & Poor's will not post any information on the Web site about
securities for which we have sufficient information to begin the ratings


If Standard & Poor's currently has insufficient information to begin the
rating process, but receives sufficient information prior to June 2, we
will inform the appropriate participants if a transaction will be posted.

When Standard & Poor's starts the process of determining an initial credit
rating on or after June 2, we will post information about securities on the
Web site when:


Standard & Poor's has received a signed engagement letter, and


Standard & Poor's has received sufficient information.

Q: Does the Rule apply globally, including securitizations backed by non-U.S.
originated assets or sold in local currency to local investors?

A: For transactions rated based on our global ratings scale, we will treat the
Rule as one that applies globally. However, absent further SEC guidance, we
will treat transactions rated solely on a national scale and relating to
securities issued outside the U.S. (e.g., brAAA in Brazil) as not covered by
the Rule.

For additional information concerning market participant's disclosure
requirements, please refer to the SEC's adopting release, which is available

Q: Does the Rule apply to ratings that are not available to the public?

A: Standard & Poor's will treat published ratings issued on or after June 2 on
publicly offered or privately-placed transactions (e.g., 144A offerings) as
covered by the Rule. We will treat ratings that are kept strictly confidential
by the issuer and sponsor as not covered by the Rule.

Q: What asset classes are covered by the Rule?

A: Standard & Poor's will apply the Rule to traditional structured finance
products, such as residential mortgage-backed securities (RMBS), commercial
mortgage-backed securities (CMBS), collateralized loan obligations (CLOs),
collateralized debt obligations (CDOs), and asset-backed securities (ABS)
(including in each case synthetic, hybrid, consumer, and commercial
transactions, as applicable). Given the uncertainty surrounding parts of the
Rule, we expect that we will make coverage determinations on a case-by-case
basis. We are reviewing the treatment under the Rule of existing ratings and
surveillance on ratings assigned before June 2, such as asset-backed
commercial paper (ABCP) programs. We will update the market as soon as we have
more information on this issue.

Standard & Poor's will continue to update the market with developments on
implementation and interpretation of the Rule as information becomes
available. Market participants should feel free to contact us with comments or

Wednesday, May 12, 2010

Odd trends in CDS liquidity

Original posted on FT Alphaville by Joseph Cotterill:

CDS liquidity is suddenly on the rise somewhere in developed markets, Fitch said on Wednesday, using its, er, unique liquidity scoring.

(The lower Fitch’s score, the more liquid contracts on a given reference entity are, which, according to Fitch, indicates greater uncertainty over credit risk.)

However, Fitch’s findings are perhaps not what you think, if you’ve been following Europe’s sovereign debt crisis.

Sovereign CDS remains significantly liquid in developed markets, as you can see from the red line hugging the bottom of Fitch’s chart below — but it has recently become rather less runny (click to enlarge):

Uncertainty in the run up to the weekend’s European rescue package is still to be factored in, no doubt, but it’s still a bit odd. A whiff of regulatory risk is closing positions, perhaps? We can’t be sure.

Even so, take a look at this sector-level CDS liquidity chart (click to enlarge):

Financials pop out of the picture. As for explanation, here’s Fitch, emphasis FT Alphaville’s:

The Sector Liquidity chart shows the average CDS liquidity for the 25 most‐liquid reference entities within each sector. Remembering that the lower the liquidity score, the more liquid the contract, CDS on financial institutions and sovereigns appear to be trading with the most liquidity. Digging deeper, it is apparent that of the 25 most liquid financials, 23 are domiciled in North America with the remaining two in Europe. The Security and Exchange Commission’s lawsuit against Goldman Sachs & Co. in addition to ongoing debates in the Senate over the proposed financial regulations bill, have contributed to renewed uncertainty…

Well, there are a fair few complicated legal risks facing Goldman. Banks have had a rally in CDS tightening over the past few days, on the other hand. For example, Markit’s Senior Financials Index dropped -15bps, to 123bps, on Wednesday. (Goldman is still elevated at 184bps).

Still, who are Fitch’s most CDS-liquid European banks? As the agency says:

CDS written on Banco Santander continue to trade with more liquidity than any other bank in the region, followed by Lloyds TSB Bank plc of the UK and Bank VTB (JSC) of Russia.

Santander CDS has also tightened like lightning since the weekend’s eurozone bailout, reaching 127 bps on Wednesday from 157bps the day before, Markit said.

Very odd bedfellows, though.

Electronic Swaps Trading Surges as Pressure for Increased Oversight of OTC Derivatives Trading Grows

May 12, 2010 (Jersey City, NJ); Tradeweb, a leading global provider of regulated electronic markets, today announced that institutional trading of interest rate swaps on its multi-dealer-to-client marketplace increased by more than 71% in the first four months of the year, compared to the same period in 2009. Average daily trading volume for interest rate swaps now exceeds $4 billion. The continued surge in electronic trading on Tradeweb coincides with ongoing demands from global legislators for trading of OTC derivatives on regulated execution venues and/or Swap Execution Facilities (SEFs), as noted in the proposed U.S. legislation.

"The industry has crossed the threshold and there is now a clear and unambiguous shift towards the electronic trading of OTC derivatives. Electronic trading is here today and is providing the benefits and safeguards that are being sought by global regulators," said Lee Olesky, CEO of Tradeweb. "Legislative reform will undoubtedly accelerate this trend towards greater efficiency and transparency, but the initial vote for change is coming from the market."

Tradeweb provides a competitive multi-dealer-to-client electronic swaps marketplace, which enables institutional investors to receive simultaneous quotes from multiple dealers. The benefits that this "request-for-quote" model provides are aligned with the core principles of a SEF. These benefits include pre- and post-trade price transparency; efficient trade execution and processing; digital records of all trades and trade inquiries; and a permanent audit trail. The core principles for becoming a regulated SEF are set out in pending U.S. legislation. If passed, Tradeweb‘s U.S. swaps marketplace plans to register as a SEF.

More than 55,000 interest rate swap trades, with an aggregate notional in excess of $5 trillion, have now been executed on Tradeweb's platform since the original launch. Over 1,600 trades took place in April 2010 alone, an increase of 189% over April 2009, and 38% up on March 2010. In total, more than 280 swap dealers and major swap participants have executed interest rate swap trades electronically on Tradeweb since launch.

Total global interest rate swaps volume on Tradeweb since the introduction of the platform in 2005 has grown at a compound annual growth rate of 55%.

In addition to leading the move towards electronic trading of OTC derivatives, Tradeweb recently announced the first electronic interest rate swap trade on a multi-dealer platform to be centrally cleared by an institutional client. This follows the completion of electronic links from Tradeweb to the major derivatives clearing houses. Institutional clients are now able to fully automate their workflow on Tradeweb - from trade execution through clearing, enabling institutions to better manage operational, systemic and market risk.

These links support the legislative focus on central clearing for all standardized swap contracts, and the push for the trading of all cleared swap transactions on regulated execution venues.

Tuesday, May 11, 2010

FDIC Board Approves NPR Regarding Safe Harbor Protection for Securitizations

The Board of Directors of the Federal Deposit Insurance Corporation (FDIC) today approved a Notice of Proposed Rulemaking (NPR) to clarify the safe harbor protection in a conservatorship or receivership for financial assets transferred by an insured depository institution (IDI) in connection with a securitization or participation. This action was necessitated by the changes adopted by the Financial Accounting Standards Board in June 2009 to the accounting standards on which the FDIC's prior rule, 12 C.F.R. Part 360.6, was based.

In March, the FDIC Board extended a transitional safe harbor that permanently grandfathered securitization or participations in process through September 30, 2010. Earlier this year, the FDIC Board approved for public comment an ANPR regarding what standards should be applied to securitizations seeking safe harbor treatment for transactions created after September 30th. Conditions for safe harbor treatment focused on greater clarity in the securitization capital structure, enhanced disclosure requirements, and risk retention and origination requirements.

The FDIC received comments on the ANPR from a wide variety of interested parties. In response, the FDIC has proposed some changes to the standards in the NPR, but has retained a clear focus on improved transparency and a better alignment of incentives for strong underwriting in the securitization process. Among the key proposed changes from the sample regulatory text included with the ANPR, the FDIC is proposing 1) a 5% reserve fund for RMBS in order to cover potential put backs during the first year of the securitization, rather than the prior 12 month seasoning requirement; 2) required disclosure of any competing ownership interests held by the servicer, or its affiliates, in other loans secured by the same property; and 3) requiring deferred compensation only for rating agencies, rather than all service providers. The NPR also includes clarifications of the prior text to simplify compliance. Significantly, the FDIC's proposed disclosure and risk retention requirements are aligned with those proposed in April by the Securities and Exchange Commission. Upon final adoption by the SEC of the disclosure requirements in the new Regulation AB, the FDIC anticipates that compliance with those requirements will satisfy the disclosure requirements in the FDIC's proposed rule. The FDIC will continue to work closely with the SEC on these issues.

FDIC Chairman Bair said, "The market is clearly trying to find a new securitization model, with investors placing a premium on transparency throughout the process. With the system awash in cash, investor appetite is coming back. Now is the time to act to put prudent controls in place before the significant issues we saw during the crisis return."

"We must acknowledge the role that the "originate to distribute" model played during the crisis. Insured institutions and our economy have lost many billions because our mortgage finance system broke down."

"The proposed rule compliments other regulatory and legislative efforts to correct the weaknesses in securitization that contributed to the crisis. The proposed NPR will help support stronger, sustainable securitizations – that are consistent with securitization's role as a source of funding and risk management tool for insured banks."

The NPR will be open to public comment for 45 days following publication in the Federal Register.

Download the complete document here:

Darrell Duffie on Banning Naked CDS Transactions

Posted on Grasping Reality With Both Hands:

Among other things, [the amendment to the Senate financial reform bill that would ban naked CDS transactions] means a big limitation on the entire securitization market, since in many cases the loan default risk is transferred into the structured credit product through a CDS. (This is not to be confused with a synthetic CDO, which is much different, and not such a big loss in my view.) So, lots of loans to ordinary individual Americans (their credit card loans, home equity loans, mortgages, and so on) and American operating companies will get somewhat more expensive. (This effect is not huge. Credit card or home equity interest rates will not go up 4%, say, but they would be higher because of this, other things equal.) [Disclosure: I am a director of Moody's Corporation since late 2008. Moody's makes money rating these products. There would be fewer of them to rate if this passes.]

There seems to be a presumption that buying CDS protection is fine as long as you have lent money to the borrower. That's a bad presumption. Example: I lend you money. There are covenants on the loan that protect me by requiring you to run your business prudently, and to not borrow too much. Then I ask a CDS protection seller, X, to sell me protection on you. Now I don't care if you default or not, so I won't worry about monitoring or enforcing those covenants, because X will pay me if you go under. Bad news. Even worse, where it might be efficient to help you avoid default, so that I can eventually get my money back, I will pull the rug from under you by calling in the loan. You won't be able to pay me back, but I am covered by X. Bad news. CDS can be misused more easily by those buying protection when having lent to the borrower ("legitimate CDS" in this amendment), than by those who have not lent, and have no ability to affect the borrower.

Lost ability of Americans to reduce their risk. Another Example: This one was part of testimony to the House Financial Services last week, on the panel on which I sat. A congressman (Rep. Manzullo, I think) asked how John Deere, a tractor manufacturer in his district, could use derivatives in its business. I gave an example in which John Deere sells 1000 tractors to a Greek company. Another panelist, Bob Pickel, explained that the Greek buyer of tractors would probably not be available as a referenced name in the CDS market, but that John Deere could get a reasonable hedge against the default risk of Greek firms by buying CDS protection referencing Greek sovereign bonds. That is true. But, this amendment would rule that out. John Deere would be unable to hedge the default risk on the receivables of its tractor sales. This is just one of many examples in which CDS protection buyers who reference a proxy name to get a hedge would no longer be able to hedge. Also, the definition of a "valid credit instrument" will probably be too narrow to allow people to hedge against losses when a borrower defaults that are not losses on a valid credit instrument. For example, if Company X defaults, I will lose the opportunity to collect money owed to me on the foreign exchange derivatives I have with X. If Country Y defaults, the market value of my factories in Country Y would decline precipitously. I could no longer hedge that. Why would anyone want to prevent an American company from protecting itself from losses this way?

The reporting requirement is redundant. All CDS and all other OTC derivatives in the SEC's regulatory domain will be required to be reported to the SEC already under the "data repositories" provision of the bill.

The restriction of a maximum of 60 days for a dealer to be "short" without owning a credit instrument is not very elegant, to say the least.

If it passes, it will not be the end of the world, but it is a step backward. The cost-benefit analysis: Cost: moderate. Benefit: none that I can see...

Bank Regulations Miss the Point on Skin in the Game

Posted on the Mortgage Bankers Association website by Rob Story Jr.:

Modernizing the regulation of our financial institutions will play a critical role in restoring confidence in our financial system and facilitating the recovery of our national economy. For almost two years, the financial services industry has been working with legislators and regulators to improve oversight and protect consumers without restricting consumers' access to affordable financial products.

An often overlooked concept found in both House and Senate reform bills seeks to ensure that loan originators have an additional financial interest in the long-term success of the loan by requiring lenders to retain a portion of a loan's risk on their books if they sell the loan to the secondary market. Though well-intentioned, this approach to risk retention has the potential to have unintended consequences stifling the recovery of both the residential and commercial real estate markets. More important, it would be duplicative of the current risk-retention requirements and require lenders to put aside large amounts of capital, limiting the credit available to consumers.

As it pertains to real estate financing, the principle, known as "skin in the game" or "risk retention," is built on the fallacious notion that residential and commercial mortgage lenders can make reckless loans with no regard for the long-term performance of those loans because once a loan is sold to the secondary market, the lender is free of any responsibility for how the loan was underwritten.

This couldn't be further from the truth. When I sell a loan, whether it is secured by a residential or commercial property, to a secondary market investor, I make representations and warranties to the buyer with respect to the borrower, the underwriting of the loan, the documentation and the property securing the loan.If the loan fails - that is, if it goes into foreclosure - because of an error or oversight on my part, I am required to buy back the loan or reimburse the buyer. Investors, now more than ever, enforce those warranties to hold me accountable for the loans I have made.

Enacting broad risk retention, requiring lenders to keep a portion of the original loan on their books, has the potential to eliminate a sizable percentage of the mortgage-lending capacity in this country. There is an entire segment of the residential mortgage-lending industry that only does mortgages and does not take deposits from customers. Those lenders make loans to borrowers, sell the loans into the secondary market (with representations and warranties) and then use the money they receive from the sales of the loans to make the next mortgage to another borrower.

Requiring these independent mortgage lenders--many of which are small businesses--to retain a portion of every mortgage they sell would render their business model unsustainable. Elimination of this critical segment of the market - often smaller lenders that serve underrepresented areas and borrowers -would limit capacity and choice for consumers, driving up borrowing costs or limiting access to mortgages altogether, which is the last thing we need in a real estate market that is just beginning to see signs of recovery.

Additionally, elimination of these businesses ultimately would mean job losses, which, again, would not be helpful in the current economic environment. Mortgage banking companies that would be forced out of business by this provision employ between 45,000 and 55,000 people.

In order to avoid this, legislators should provide explicit exemptions from additional risk-retention requirements for qualified residential loans that have particular features and meet certain underwriting guidelines. For example, a fully documented, fully amortized mortgage with a 30-year fixed rate has well-understood risk characteristics.

The market for residential real estate already contains mechanisms that serve to ensure that risk is appropriately accounted for.Consumers are best served by a marketplace that gives them choices and competition. Driving competition and liquidity from the residential mortgage market with broad, one-size-fits-all risk-retention requirements is not the means to bringing back confidence and stability to our markets.

CPSS and IOSCO consult on policy guidance for central counterparties and trade repositories in the OTC derivatives market

The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have today issued two consultative reports containing proposals aimed at strengthening the OTC derivatives market.

The first report, Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties (RCCP) to OTC derivatives CCPs, presents guidance for central counterparties (CCPs) that clear over-the-counter (OTC) derivatives products.

The second report, Considerations for trade repositories in OTC derivatives markets, presents a set of considerations for trade repositories (TRs) in OTC derivatives markets and for relevant authorities over TRs.

"These two complementary sets of high-level guidance constitute an important response of the CPSS and IOSCO to the recent financial crisis. They also reflect the G20's recommendations for the strengthening of the OTC derivatives market," said William C Dudley, CPSS Chairman, and Kathleen Casey, Chairman of the Technical Committee of IOSCO.

Guidance on the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs

In response to the recent financial crisis, authorities in many jurisdictions have set out important policy initiatives encouraging greater use of CCPs for OTC derivatives markets. Recently, several CCPs have begun to provide clearing and settlement services for OTC credit default swaps. A CCP interposes itself between counterparties to financial transactions, acting as the buyer to every seller and the seller to every buyer.

Mr Dudley and Ms Casey said: "This is a positive development because a well designed CCP can reduce the risks and uncertainties faced by market participants and contribute to financial stability. As the greater use of CCPs for OTC derivatives will increase their systemic importance, it is critical that their risk management should be robust and comprehensive. Moreover, because of the complex risk characteristics and market design of OTC derivatives products, clearing them safely and efficiently through a CCP raises more complex issues than the clearing of exchange-traded or cash products does."

These issues were not fully discussed in the 2004 report of the existing RCCP. Consequently, the CPSS and the Technical Committee of IOSCO have identified such issues and developed international guidance tailored to the unique characteristics of OTC derivatives products and markets. The aim is to promote consistent interpretation, understanding and implementation of the RCCP across CCPs that handle OTC derivatives.

Considerations for trade repositories in OTC derivatives markets

The financial crisis highlighted a severe lack of market transparency in OTC derivatives markets. As an important step in addressing this issue, OTC derivatives market participants, with the support of the regulatory community, are committed to establishing and making use of trade repositories. A TR in OTC derivatives markets is a centralised registry that maintains an electronic database of open OTC derivative transaction records.

Mr Dudley and Ms Casey said: "The CPSS and the Technical Committee of IOSCO welcome various ongoing industry initiatives and associated close regulatory cooperation in this relatively new area of the financial market infrastructure, which will play a key role in identifying signs of systemic risk and threats to market integrity in the future financial system".

Recognising the growing importance of TRs in enhancing market transparency and supporting clearing and settlement arrangements for OTC derivatives transactions, the CPSS and the Technical Committee of IOSCO have developed a set of factors that should be considered by TRs in designing and operating their services and by relevant authorities in regulating and overseeing TRs.

Consultation process

The two reports are being issued as consultation documents. Comments are invited from any interested parties by 25 June 2010 (for contact details, see Note 1). There will be an outreach event with the industry as part of the consultation process.

The CPSS and the Technical Committee of IOSCO do not plan to issue finalised reports after the consultation period. Instead, the guidance presented in the reports, as well as the feedback received in the consultation process, will be incorporated in the general review of the international standards for financial market infrastructures that was launched by the CPSS and the Technical Committee of IOSCO in February this year.


  1. Comments on Guidance on the application of 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC derivatives CCPs should be sent to both the CPSS Secretariat ( and the IOSCO secretariat (
    Comments on Considerations for trade repositories in OTC derivatives markets should be sent to both the CPSS Secretariat ( and the IOSCO secretariat (
    The comments will be published on the websites of the Bank for International Settlements and IOSCO unless commentators have requested otherwise.
  2. The start of the general review of the international standards for financial market infrastructures was announced by the CPSS and the Technical Committee of IOSCO in their press release of 2 February 2010 (available on the websites of the BIS and IOSCO).
  3. The reports have been prepared for the CPSS and the Technical Committee of IOSCO by a joint CPSS-IOSCO working group co-chaired by Daniela Russo at the European Central Bank and Jeffrey Mooney at the US Securities and Exchange Commission.
  4. The Committee on Payment and Settlement Systems (CPSS) serves as a forum for central banks to monitor and analyse developments in payment and settlement arrangements as well as in cross-border and multicurrency settlement schemes. The chairman of the CPSS is William C Dudley, President of the Federal Reserve Bank of New York. The CPSS secretariat is hosted by the BIS. More information about the CPSS and all its publications can be found on the BIS website at
  5. IOSCO is recognised as the leading international policy forum for securities regulators. The organisation's membership regulates more than 95% of the world's securities markets in over 100 jurisdictions, and its membership is steadily growing.
  6. The Technical Committee, a specialised working group established by IOSCO's Executive Committee, is made up of 18 agencies that regulate some of the world's larger, more developed and internationalised markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms Kathleen Casey, a Commissioner of the US Securities and Exchange Commission, is the Chairman of the Technical Committee. The members of the Technical Committee are Australia, Brazil, China, France, Germany, Hong Kong SAR, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, the United Kingdom and the United States.

Al Franken's plan to end the credit rating conflicts

Posted in the Washington Post by Senator Al Franken:

I was heartened to read the May 5 editorial "A standard and poor remedy," highlighting the disturbing conflicts of interest in Wall Street's credit rating system. For the past two weeks, I've been working with Professor Matthew Richardson of New York University's Stern School of Business, mentioned in the editorial, to craft an amendment that would fundamentally change the incentives driving the rating industry.

As the editorial pointed out, the market is plagued by conflicts of interest and doesn't reward ratings for their accuracy: The current system allows investment banks to shop around to get the most favorable bond rating.

My amendment would create an independent board to assign a rating agency to each newly issued bond, taking into consideration the capacity and expertise of each agency. It would monitor their performance over time and reward the best actors with more assignments. This would eliminate conflicts of interest and make the system more accurate, fair and transparent. It would increase competition by giving smaller rating agencies an opportunity to compete against the largest three agencies, which have abused the current model.

We must take action that would change the way the system works by putting accuracy ahead of profits.

And here's a Q&A from Ezra Klein's blog on the Washington Post:

Why did you decide to focus on the rating agencies?

The agencies were an enormous part of the problem. They were giving AAA ratings to products that didn't deserve them. There's this inherent conflict of interest where the issuers of these financial products were shopping for raters. It's become very clear that what's going on was they had an incentive to inflate the ratings to get more business. In some cases the agencies were just stupid, but there was also a reason to be stupid. They had motive.

How does your amendment fix the problem?

Instead of the issuer shopping for ratings, we'd form a board under the SEC that would decide which rating agency rates each instrument. I don't mandate how they do it. But it wouldn't have to be totally random. The board would be comprised mainly of investors and people who manage pensions and university endowments. One of the advantages of this is that it'd inject more competitions into the business. Right now, we have Moody's and Standard & Poor's and Fitch doing 94 percent of the ratings. This board could give business to smaller agencies. You'd be rewarded on accuracy and so the incentive would be to be more accurate.

And that, you hope, takes care of the problem wherein the rating agencies actually do a worse job because they're now guaranteed to get business?

Right. Depending on the nature of the product, you'd be able to judge the accuracy over some period of time. Developing a track record of accuracy would be in your interest as opposed to rewarding the exact thing we don't want, which is inflating ratings on behalf of the banks.

Another criticism people have raised about this approach is that giving the government more power over the agencies will leave them more beholden to the government. Right now, the agencies have been criticized for downgrading Greece, and in the future, with our deficit, you could imagine them downgrading America. But not if they rely on the federal government for work.

Well, maybe there'd be part of this where they're not rating government securities. I'm not sure how that would work. But this is about the securities that got us into trouble. So it might not be how we'd do a Treasury bond.

Rather than bringing them further into the government's embrace, why not just kick the rating agencies out altogether? Right now, the government credentials them, uses their "AAA" rating in certain laws and generally makes sure they're central to the system. Why not let them rise or fall on their own?

I think that would be a problem. You could say let's just not have any rating agencies. But we'd have a problem if we didn't have rating agencies at all. I think what you want are rating agencies that do a good job.

To press you on that, though, you'd still have rating agencies. It just wouldn't be the government saying you have to listen to them. And that seems like a good thing to me. Even if you get rid of the conflict-of-interest problem, it still seems to me that these players exist to tell Wall Street that it doesn't really need to know what it's doing. You can be an English literature major who's only been on Wall Street for five months and as long as you know it's "AAA" or "BBB," you're good to go.

I think the government sanction in this amendment would incentivize accuracy and mean that these agencies would do their due diligence and compete and be a bit smarter than the ones in Michael Lewis's book, who seemed particularly easy to fool.

It has occasionally seemed to me that the best reform would be to tax the banks and use the money to make the people at the rating agencies the highest-paid folks on Wall Street.

Well, there might be something to that. I don't prescribe how much they'll get paid but if you are rewarded by your track record, people who do a better job will be paid more.

Do you know if your amendment will get a vote?

I'm not certain. But probably next week sometime. We've been talking to the banking committee staff and I hope that it does come up next week, either as is or in some form. We're very prescriptive in this for how the board will look and there are other ways to skin this cat.

OTC Derivatives Market in India

By Dayanand Arora and Francis Xavier Rathinam:

Abstract: The OTC derivative market in India, though in its infancy, is an interesting case, because it came out unscathed in the present global crisis. The paper seeks to prove the point that this is because of India’s cautious regulatory framework and support institutions such as a centralised counter party (CCP). This case study about the Indian OTC derivativesmarkets can serve as a model for other developing countries.

The paper analyses the regulatory structure of the Indian OTC derivatives market, particularly the role of OTC-traded versus exchange-traded derivatives, the role of reporting platforms and the role of a centralized counterparty (CCP) for the transparent functioning of the market. It further explores some of the open issues, such as competition in reporting platforms and counterparty services and supervision of the off-balance sheet business of financial institutions, to ensure stable growth of OTC derivatives markets.

Read the Vox column here, and download the whole paper here:

Monday, May 10, 2010

BIS announces modest increase in OTC derivatives

From the BIS website... Key developments in the second half of 2009:

  • Notional amounts of all types of OTC derivatives contracts outstanding increased by 2% during the second half of 2009, rising to $615 trillion at the year-end. Interest rate and foreign exchange derivatives accounted for most of this increase. By contrast, overall gross market values decreased by 15%, following a contraction of 22% in the previous six-month period. Gross credit exposures fell by 6%, following an 18% decline in the previous period.
  • Notional amounts outstanding of CDS contracts continued to decline (-9%), albeit at a slower pace than in the first half of 2009 (-14%), while positions on commodities also receded, by 21%. CDS gross market values shrank by 40%, a similar rate of decline to that seen in the first half of the year (-42%). This brought the market value of the CDS contracts down to 35% of its end-2008 peak.

Download full report here:

Experian Provides New Level of Transparency for Non-Agency MBSs

NEW YORK, May 10 /PRNewswire/ -- Experian®, the global information services company, today announced the launch of CreditHorizons(SM) for Securities, a data-feed product that provides the missing link to understanding the true creditworthiness of the underlying borrowers in each mortgage deal. CreditHorizons for Securities consists of anonymized U.S. consumer credit profiles that have been matched to the private-label securitized mortgage deals in the industry-leading loan-level database from First American CoreLogic/Loan Performance.

Investors who currently utilize only traditional loan-level data will find that CreditHorizons for Securities affords them a new set of influencers in delinquency and loss forecasting, helping to optimize pricing strategies, improve risk management and hedging strategies and increase confidence in residential mortgage–backed securities buy and sell decisions.

"Monthly trustee and servicer data sets provide a limited foundation for predicting payment patterns," said Ethan Klemperer, general manager of Experian Capital Markets. "To compete profitably in today's market, investors need upgraded valuation methods with increased transparency and predictive power. We're delighted to work with First American CoreLogic to launch CreditHorizons for Securities, providing the critical behavioral data needed to determine the true value and future payment trend of clients' securities."

"We're pleased to join Experian in bringing CreditHorizons for Securities to the marketplace," said George Livermore, president, data and analytics segment for The First American Corporation. "By augmenting existing modeling with consumer credit information, investors obtain a holistic view of the underlying collateral and can better predict delinquency and default probabilities for their residential mortgage–backed securities portfolios."

Experian's CreditHorizons for Securities offers a predefined set of more than 50 anonymized consumer credit data variables that have been carefully evaluated and selected for their predictive ability by Experian's team of credit experts. Maintaining a relatively small number of variables ensures that the product is user-friendly and easy to implement.

Can a Clearinghouse Really Stop the Next Financial Crisis?

Posted on the Harvard Law School Forum by Mark Roe:

As the Senate finalizes its financial reform legislation, a consensus is developing that if we could just get derivatives traded through a centralized clearinghouse we could avoid a financial crisis like the one we just went through.

This is false. Clearinghouses provide efficiencies in transparency and trading, but they are no cure-all. They can even exacerbate problems in a financial crisis.

If I agree to sell you a product next month through a clearinghouse, I’ll deliver the product to the clearinghouse and you’ll deliver the cash to the clearinghouse on the due date. Let’s say we both have many trades going through the clearinghouse and we’ve posted collateral to cover any single trade that fails. This is more efficient than each of us posting collateral privately for each trade. Moreover, we’re not worried that I won’t deliver or you won’t pay because we both count on the clearinghouse to deliver and pay up if one of us doesn’t.

This clearing system makes trading more efficient. If you default, the cost is spread through the clearinghouse so I don’t get hurt severely. And if the clearinghouse has enough collateral from you, there’s no loss to spread. But there’s also a potential downside: The clearinghouse reduces our incentives to worry about counterparty risk. Your business might collapse before you need to pay up, but that’s not my problem because the clearinghouse pays me anyway. The clearinghouse weakens private market discipline.

Still, if the clearinghouse is as good or better at checking up on your creditworthiness as I am, all will be well. But one has to wonder how good a clearinghouse will be, or can be.

Consider two of our biggest derivatives-related failures-Long-Term Capital Management in 1998 and the subprime market in 2008. When Russia’s ruble dropped unexpectedly, LTCM was exposed on its more than $1 trillion in interest-rate and foreign-exchange derivatives. It could not pay up and collapsed. Ten years later the market rapidly revalued subprime mortgage securities, rendering several institutions insolvent. AIG, for example, was over-exposed in credit default swaps tied to the value of subprime mortgages.

Could a clearinghouse really have been ahead of the curve in getting sufficient capital posted before these problems became serious and well-known? I’m not so sure. Worse yet, major types of derivatives have built-in discontinuities-”jump-to-default” in derivatives-speak.

For a credit default swap, one counterparty guarantees the debt of another company to you, in return for you paying a fee for that guarantee. If no one goes bankrupt, the counterparty just collects the fees from you. But if the guarantee is called because the company you were worried about goes bankrupt, the counterparty must all of a sudden pay out a huge amount immediately. Yet the guarantor is often called upon to pay in a weak economy, just when it can itself be too weak to pay. You get credit default protection on your real-estate investments from me, just in case the economy turns sour. But just when you need me the most, in a sour economy, I turn out to be so over-extended I can’t pay up. Collateralizing and monitoring such discontinuous obligations will not be so easy for the clearinghouse.

Moreover, if trillions of dollars of derivatives trading goes through a clearinghouse, we will have created another institution that’s too big to fail. Regulators worried that an interconnected Bear or AIG could drag down the economy. Imagine what an interconnected clearinghouse’s failure could do.

AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail-but then maybe each would be too small to do enough good.

The Senate bill would allow a clearinghouse to grab new collateral out from failing derivatives-trading banks to cover old, but suddenly toxic, debts the banks owe to the clearinghouse. This could harm other creditors and cause the firm to suffer a run. Nevertheless, to protect itself in a declining market, a clearinghouse would have to make those big collateral calls. That’s good if it protects the clearinghouse. But it’s bad if it starts a run on a weakened but important bank.

One key but missing element in the search for reform hasn’t yet obtained traction in Washington. Derivatives players obtained exceptions from typical bankruptcy and bank resolution rules in the past few decades for their contracts with a bankrupt counterparty. This allowed them to grab and keep collateral other creditors cannot. That gives derivatives traders reason to pay less attention to their counterparties’ riskiness and weakens market discipline. These rules should be changed before the Senate is done.

To say that a clearinghouse solution is very incomplete is not to say there is an easy solution out there. We may be unable to do more than to make incomplete improvements and muddle through.

Derivatives trades first of all should not just be centrally cleared, but should also be taken out from the government-guaranteed entities, such as commercial banks (or at least we need to impose tight capital requirements on those banks that deal in derivatives). Derivatives traders like doing business with Citibank, because they know the government won’t let Citibank go down. But this puts taxpayers at risk. It would be better to run those trades through an affiliate, not through the bank, so counterparties realize they might not be bailed out if the affiliate failed.

If a banking affiliate’s counterparty is the clearinghouse, then the clearinghouse will have incentives to make sure that the affiliate is well-capitalized. This is particularly so if the clearinghouse won’t get any special priority treatment in a bankruptcy.

Critics of proposals to establish separate bank affiliates for derivatives trading complain about the large amount of capital that would be needed for such affiliates. But the capital that might be needed to buttress a bank affiliate indicates some level of the value (i.e., the taxpayer subsidy) to derivatives players of trading with a too-big-to-fail entity that they know the government will step in to save. They are implicitly getting insurance and should pay for it.

And, since a clearinghouse is itself at risk of being too big to fail, regulators need to police its capital and collateral requirements. If the derivatives market sees the clearinghouse as too big to fail, the potential for derivatives players making overly risky derivatives trades becomes real. Clearinghouses can help manage some systemic risk if they’re run right. If not, they can become the Fannie and Freddies of the next financial meltdown.