Why do we keep playing the protectorate game?

The crown dependencies are possessions of the British Crown: the Isle of Man, Jersey and Guernsey are the principal dependencies. The British Government is solely responsible for defense and international representation of the dependencies, although each island has responsibility for its own customs and immigration. All 'insular' legislation has to receive the approval of the 'Queen in Council', in effect, the Privy Council in London, with a UK minister being the Privy Councillor with responsibility for the Crown dependencies.

Acts of the British Parliament do not usually apply to the Channel Islands and the Isle of Man, unless explicitly stated, and even this is increasingly rare. When deemed advisable, Acts of Parliament may be extended to the Islands by means of an 'Order in Council', although normally the agreement of the dependency administrations would be sought first.

(This summary and the following one filleted from wikipedia [1] [2] as a prelude to the discussion that follows.)

In addition (and constitutionally distinct) there are the British Overseas Territories. These fourteen territories - including Bermuda, the British Virgin Islands and the Cayman Islands - are under UK sovereignty, but they are not part of the United Kingdom itself.

Each Overseas Territory has its own legal system independent of the United Kingdom. The legal system is generally based on English common law, with some distinctions for local circumstances. Each territory has its own Attorney General and court system. Defense of the Overseas Territories is the responsibility of the UK. Neither the overseas territories nor the crown dependencies are full members of the EU.

More or less anything to do with the constitutional affairs of these little bits of land is complicated by history, precedent, residual monarchism and colonialism, and the lack of political will for change. None of that however is reason to simply accept the status quo. Between them the dependencies and territories account for many of the world's tax havens. Their financial systems deprive the UK Exchequer of billions of tax revenue, probably hundreds of billions. They encourage tax avoidance, facilitate money laundering, and contribute little in return beyond the occasional friendly harbour for the Royal Navy. Yet we provide these islands with defense and a variety of forms of aid. That is simply illogical. It is clearly not in UK interests to support the dependencies and territories, especially given the other calls on the defense budget and the fact that this budget is smaller than it could be thanks to the tax arbitrage opportunities these very same islands provide. If they want the shield of the UK military and the UK AAA rating then they should pay UK tax. If they don't want to do that then we should cut the tax havens loose without a second thought.

Both practically and legally the UK has the apparatus to enforce a decision on the protectors and dependencies. Some will doubtless prefer to remain British - and in that case we should extend full citizenship and EU membership to them in exchange for their tax revenue: examples here might well include the islands with less developed financial systems such as the Falkland Islands, the Pitcairn Islands and South Georgia. Others such as Jersey or Bermuda may well decide to go it alone. But in that case they should be treated as any other foreign country, their populace denied UK citizenship, and UK citizens living there treated as foreign domiciled. All in all it is high time we applied some cost/benefit analysis to our constitutional arrangements.

Baltic Dry

The Baltic Dry Index is an index covering bulk shipping rates. It is calculated by the Baltic Exchange and is the most commonly quoted proxy for the price of moving dry goods by sea. What is interesting is what has been happening to the BDI over the last few years.

Take another look at that. The BDI in 2007 hit roughly six times its 2002 level. The lag in the arb between the level of the BDI and the price of ships is of course reasonably long (about two years according to Slate), but still, this is an interesting trend. There has clearly been an awfully big spike in intercontinental trade and lots of new ships are coming on line. Now consider the most recent data from investmenttools.com:

The BDI is hard to manipulate as it is based on the prices needed to hire real ships to move real cargos. As cyclical indicators go, this one appears to be screaming 'bubble breaking, get short'.

Warren's timing...

...is pretty near perfect as usual, or so it appears. The FT reports:

Shares in bond insurers MBIA and Ambac fell sharply on Friday amid concerns that a rival US bond insurer planned by billionaire Warren Buffett will eat into their ability to win new business and further damage efforts to boost their flagging capital bases.

If Berkshire Hathaway Assurance sticks to wrapping muni debt it will doubtless make a lot of money. Whether it makes a decent ROE is less clear as (one would hope anyway) the ratings agency criteria for the amount of capital needed to be a AAA bond wrapper will have changed. On the other hand if Buffett just keeps 1.1 times the amount of capital MBIA, AMBAC etc. would have for his book, he will probably do fairly well.

Meanwhile Fitch has given MBIA and Ambac four weeks to raise the billion or so of extra capital they need to retain their AAAs. It will be an interesting month for the monolines.

Update.A nice post from Accrued Interest points out that BHAC is basically a punt on muni investors not waking from their lethargy and actually doing some credit research.

The only risk AGO [but more broadly monolines without structured finance exposure] stock holders face is the possibility that municipal bond insurance declines as a concept. That bond buyers are no longer willing to pay for extra protection on AA-rated school districts and A-rated sewer systems. The fact is that the history of defaults on these types of credits is slim indeed, which is exactly why the municipal insurance business is so profitable. Classically, muni buyers liked insurance because it prevented them from having to do any credit research. So the question is, will investor laziness trump the fear created by current insurer troubles?

Put in those terms, I'm a buyer of OTM calls on laziness...

What works replaced by what we believe

The following quote comes from a post on the Guardian website:

What I find most striking about this, as about other items in this government's moralistic agenda, is how opposing arguments simply are not heard. It isn't just closed mindedness, the government and its supporters are in the grip of a kind of exclusivist belief system akin to a fundamentalist religion. Arguments based on individual choice, or the notion of adults making rational decisions, simply "do not compute"; they are here to protect us, like spoilt children, from the bad world out there, and they have our interests at heart, and if you don't agree then clearly you favour exploitation and slavery and oppression.

The two things that strike me about this quote are firstly how accurate it is, and secondly how many things it might be referring to: Europe; Iraq; PFI; Pensions; Trident; Nuclear Power; 42 day detention; the DNA database; ID cards. Pretty much any part of politics that is in any way controversial in fact. Even if you agree with a particular policy, the monological belief system which nourished it is deeply troubling. No government which scorns alternative views and abuses legislative privilege with deeply partisan, ill-thought out and costly nonsense as Brown's does deserves to survive, let alone win re-election.

Hard looks in Zurich

Sneaked out in the scrag end of the year, we find in the FT:

UBS, one of the biggest casualties of the subprime crisis, faces the additional prospect of scrutiny by Switzerland’s bank regulator.

The Federal Banking Commission (EBK) said on Sunday it would look into how the world’s largest wealth manager was forced to write off about $14bn on its portfolio of securities linked to US residential mortgages.

There are no surprises here of course, and one imagines that similar steps are underway at the SEC, the FED, FSA and so on for the firms they supervise. Happy New Year.

Happy Christmas

I hope yours wasn't quite as tacky as these deliciously awful figures.

Implicit liquidity support in the US

The FT in the dog end of the year has an insightful article on the Federal Home Loan system. Continuing one of this year's themes - that the hardest core free marketeers are among the most interventionist when it comes to their own business - it points out how the FHLBs are providing state aid to the mortgage banks.

What the FHLB essentially does is raise money cheaply, by virtue of having an implicit state guarantee. It then uses this to provide loans to other financial institutions, against their mortgage collateral.

The important point to grasp is that these loans have quietly ballooned in recent months: as my colleague Krishna Guha recently noted, the Fed’s Flow of Fund data shows that the FHLB system issued new loans to mortgage lenders at an unprecedented annualised rate of $746bn in the third quarter of this year. That was up from practically nothing in the second quarter. And while the FHLB does not name the lucky recipients of this largesse, the cash almost certainly went to institutions no longer able to fund themselves in the normal way – ie through the capital markets.

[...]

The real moral is that investors in Europe’s securitisation market have, in a sense, been sold a pup. In the past decade, the US has often been hailed as the cradle of modern financial capitalism, partly because it has been so wildly innovative in areas such as mortgage securitisation.

But now it is clear that this market innovation was partly built on the presence of an obscure state safety net. Europe’s problem is that in the past decade it has copied US financial innovation – such as mortgage securitisation – without adopting the other safety valves that the US had too.

I'm not sure the US market innovation was 'built' on the existence of the FHLB system: without it, the same securities might well have been issued. But it certainly is proving useful at the moment, just as the (perhaps accidentally) superior design of the FDIC insurance system in the US has thus far prevented a Northern Rock type event.

Felix on Finance

I am currently reading The Last Tycoons, an excellent book about the rise of Lazard Frères. Felix Rohatyn is a prominent character in the book: he was one of Lazard's best known bankers in the 70s and 80s, perhaps one of the best known investment bankers in the world. One quote from Felix particularly struck me:

I believe in the free market, but I do not believe in laissez-faire. I do not believe that, at the end of the 20th century, in complicated advanced industrial societies, an absolute free market system exists or is desirable. If it does not exist, I do not think we should pretend we can cure the problems we have with simply free-market solutions.

Isn't that an interesting thing for one of the most talented M&A bankers of all time to say?

Update. Naked Capitalism refers back to an earlier post re-examining the benefits of free trade from a developmental perspective, which in turn reminded me of my own riff on the topic. It would be nice after the crisis is over to look at some of these free market failures in detail. My suspicion is still that the lack of alignment of interests between mortgagees, mortgage originators, and securitisation buyers was one of the major, perhaps the major cause.

Death to the MLEC and a delay to the ABX 08-01s

An update on two deaths foretold (neither of which you need an instrument as sophisticated as the Lowell refractor here to see):

• As suggested earlier, the MLEC is dead.
  

Confirmation from the WSJ is, here.

• And also as predicted, the ABX 08-01s aren't coming any time soon.
  

Finally, in the bleedingly obvious category, Bloomberg tells us that monoline wraps are less valued than they used to be.

On the management of liquidity risk

Some highlights from FSA's discussion paper 07/07, Review of the liquidity requirements for banks and building societies follow.

On the nature of liquidity risk:

Liquidity stresses are low-frequency, but extreme severity, events that are not well-understood ... liquidity risks can grow in severity very rapidly... liquidity risk appears to be that it is hard to predict.

On incentive structures:

Even if some banks mitigate their liquidity risk they face a competitive disadvantage if other banks do not and therefore have lower costs. As liquidity stresses are low-frequency, but extreme severity events, this disadvantage may endure for long periods of time. In a perfect market, these other banks would not be able to exploit this cost advantage, as depositors and other counterparties would be reluctant to do business with them because of their failure to mitigate liquidity risk. In practice, it is often difficult even for wholesale depositors or counterparties to assess from the outside the liquidity position of a bank, and almost impossible for a retail depositor or investor to do this...

On stress tests:

Stress tests should consider both ‘chronic’ and ‘shock’ plausible liquidity stresses.

• A ‘shock’ stress is an extreme, but short duration (e.g. a few days or weeks) stress.
  
• A ‘chronic’ stress is less severe but may continue for several months.
  

Recent events have been a ‘chronic’ stress – the wholesale deposits, corporate paper and certificates of deposits have not closed completely for a short period of time, rather they have remained open but for the last several months we have seen decreased volumes and significant maturity shortening.

The market-wide stress tests need to take account of plausible disruptions and closures of not only the unsecured funding markets, but also of the secured funding markets, and also of both at the same time.

On funding sources:

Recent events have stressed the importance of diversification of funding sources – by counterparty, by market and by product - as a liquidity risk management tool. However, assumptions as to how effective diversification across sources of funding will be during a liquidity stress should be cautious. In recent months, diversification across funding product types, e.g. wholesale deposits, corporate paper, certificates of deposit, secured finance such as repo, covered bond, securitisation etc, has only proved to be of limited use. Simultaneously, there has been a complete closure of the securitisation market, a near-complete closure of the covered bond market and decreased volumes and significant shortening of duration in available wholesale deposits, corporate paper or certificates of deposit funding. And this has all occurred simultaneously in the major currency zones – Euro, US$ and sterling.

On liquidity lines:

During the recent market-wide liquidity stress, banks that held liquidity lines proved extremely reluctant to call upon them. There appear to be two main reasons for this.

• First, there was a perception that if a bank was seen drawing down on a liquidity promise this might be seen as sign of weakness. The fear was that this would damage the bank’s reputation and so make it more difficult to raise liquidity from other sources, possibly more than negating the help to liquidity gained by the draw down.
  
• Second, at least for some liquidity promises, there appeared to be a strong commercial expectation between the bank and the counterparty that the promise would not be called. And this is perhaps linked to the first bullet point, as drawing down against such an expectation would heighten the risk of damage to a bank’s reputation.

On regulatory tolerance for liquidity risk:

We are also clear that we do not seek to operate a zero-failure regime.

Brace yourselves. New rules coming.

Renaissance man

Alea reports a talk that James Simons, founder of Renaissance Technologies, gave at NYU recently. Simons is a highly successful quant investor so his remarks are interesting. The part of the Alea article that really piqued my interest was:

[...] perhaps the most interesting observation came in response to a question posed by the moderator, Nobel Prize-winner Robert Engle: “Why don’t you publish your research, the theory behind your trading methods? If not while you are active in the markets, perhaps later on.”

Simons’ reply – there is nothing to publish. Quantitative investment is not physics. The markets have no fundamental, set-in-stone truths, no immutable laws. Financial “truth” changes constantly, so that a new paper would be needed almost every week.

The implication is that there is no eternal theorem of finance that could serve as an infallible guide through all the ages. Indeed, there can be no Einstein or Newton of finance. Even the math genius raking in $1 billion and consistently generating 30%-plus annual returns wouldn’t qualify. The terrain is just too lawless.

Simon's view seems to me to be obviously true, although I don't quite agree with the Alea spin. It isn't that there is no law, it is that the law changes as the behaviour of market participants change. Yesterday's arb is today's theorem is tomorrow's unrealistic simplification. As I said over a year ago, mostly the market trades based on the current orthodoxy. But big news changes that orthodoxy - as is happening at the moment in the liquidity markets, and so to make a lot of money you need to be willing to keep changing your theory of asset prices.

This neatly brings me to a related topic, the non-equilibrium nature of financial markets. In retrospect, Walras' idea of an auctioneer groping towards equilibrium (word of the week - tâtonnement) is really unhelpful because it suggests that there is enough time for this process to be completed and equilibrium reached before the next piece of news hits the market. I don't think this is true. Rather I conjecture that the process is much more like a game of tetherball, with each new news item changing people's opinions and hence moving the market long before equilibrium is reached from the previous piece. The ball almost never hangs by the pole, so any theory which analyses where it will come to rest isn't much use in determining who is going to win the game.

The last piece of the puzzle is the primary role of transactions. There are no prices without transactions to establish them - lots of transactions. So it is only opinions about asset prices which lead to trading that matter. You can be right for a long period about the fundamentals, but if your assumption about how fundamentals lead to trading is wrong then you will lose money. For example I called the weakness of Japan completely correctly through the 2nd half of the 1990s and first half of 2000s, but I was wrong for extended periods on dollar/yen because I hadn't accounted for the actions of the BoJ and other market participants beliefs about the BoJ. To make a lot of money you need to predict what most other market participants trading-related beliefs will be and get your position on before they do. Predicting fundamentals is only useful if they will influence future trading: on the flip side, predicting wrong beliefs is just as good as predicting right ones if they pertain for long enough for you to make money.

Making an impact

I said a little while ago:

To make a real difference, the central banks need to parachute in hundreds, not tens of billions.

And now (from Bloomberg):

The European Central Bank loaned 348.6 billion euros ($501.5 billion) for two weeks to banks to bring down the cost of money at year-end.

The FT comments further:

Emergency help for financial markets entered new territory on Monday as the European Central Bank announced it would on Tuesday offer unlimited funds at below market interest rates in a special operation to head off a year-end liquidity crisis.

The surprise move, which follows last week’s co-ordinated barrage of measures by the world’s central banks to increase market liquidity, suggests the ECB is still frustrated at the failure to ease financial market tensions.

[...]

“This is basically Father Christmas to those who have access,” said Erik Nielsen, economist at Goldman Sachs. “They are bailing out people who have not really adjusted their balance sheets to the new reality.” But Julian Callow, economist at Barclays Capital in London, said the ECB was “simply doing their job at being lender of last resort”.

The ECB had announced that Tuesday’s weekly money market operation would mature on January 4 – covering the year-end. But on Monday night it said it would satisfy all bids offering 4.21 per cent or more. Prior to the announcement, the cost of borrowing two-week money hit 4.9 per cent but it fell sharply afterwards as the ECB move in effect put a cap on market interest rate.

The ECB said the move was “fully consistent” with its aim of keeping interest rates close to its main policy rate of 4 per cent.

The latest move underlines the limited impact of last week’s co-ordinated central bank intervention and highlights continued operational differences between the ECB and the more incremental Fed and Bank of England.

This is starting to make sense. Some people think that banks are hoarding funds because they fear further big credit losses next year and they don't trust their counterparties. While that might explain a small part of the drying up of liquidity, I don't buy it as the explanation for most of it. I think most people are only just waking up to the magnitude of the demand for liquidity in the current environment. To illustrate this further, consider CDO issuance. In the first two quarters of 2007 this was around $175B (per quarter). In the third, it was $63B. The difference has to come from somewhere: those assets need to be funded. So that alone creates a $110B need. Add in ABCP (from $1.2T to $800B) and you get another $400B. That's half a trillion dollars of extra liquidity just from those two sources. Keep those helicopters in the air, Ben, we need the money.

A grand to come in

From the Guardian:

Families who sponsor visits by overseas relatives to Britain will first have to pay a bond, expected to be £1,000, under new immigration proposals out this week.

This is a bad idea in so many ways. Firstly I bet the cost of deporting an illegal immigrant is a lot more than £1K: the Guardian says it is £11K. So the scheme won't pay for the downside. It will however cost a fortune to administer. And it will leave the impression that the cost of breaking your visa terms is £1,000, so people will be encouraged to do that if it is worth a grand to them to stay. My guess is that it will increase rather than decrease the number of overstays.

A Christmas present from the ABX

It's not much, but the ABX BBB- has bounced since the lows of late November:

As you would expect, the effect is more noticeable on the AAAs:

Now of course things can go down again from here, but this is at least that rare commodity, positive news on the ABX.

Jump to the courts

The WSJ reports an amusing scrap over Sagittarius, a $985M CDO sold to investors in March by Wachovia and structured, it appears, by Deutsche (who is the trustee). Several UBS funds are investors, and an MBIA affiliate, LaCrosse, is a swap counterparty to Sagittarius. Sagittarius has MBS assets so apparently there was a default event. What happened next is the interesting part:

The day after the event of default, LaCrosse sent Deutsche Bank a letter saying that no interest or principal should be paid to other junior noteholders.

Other investors, unnamed in the legal filing, disagreed, telling Deutsche that MBIA's position "is neither reasonable nor correct," according to court papers filed by Deutsche Dec. 3. These other bondholders also might disagree about how they would share continuing payments, assuming they got any money. The disputed payments total several million dollars and will pile up until the dispute is settled, according to a person familiar with the matter.

With its legal filing, Deutsche is essentially asking the court to guide it on whom exactly should be paid.

It appears MBIA's view is that it is supersenior via the swap, and hence no one should get any cash until they are whole. The others, unsurprisingly, disagree. In any event this highlights the importance of understanding where any derivatives sit in seniority vis a vis the note investors. Default contingent market risk can be ugly, and it's quite hard to hedge.

JP has the right take here I think. Analyst Chris Flanagan wrote in a report recently:

"If there's one safe prediction for 2008, it is that legal teams will be busy".

May all your reindeer in 2008 be made of pecans, or not, as you desire. Unless you are a lawyer, of course. They can find their own nuts.

The MLEC finally falls

Vikram has bowed to the more or less inevitable and consolidated his SIVs. The MLEC is dead. Long live the MLEC. But not the capital noteholders, obviously. Now let's see how long the dividend lasts. Anybody want to buy Smith Barney?

Dying for Goldman

Goldman has announced that it will publish a mortality index, presumably to stimulate growth in the mortality swap business. Insurance-linked capital markets products have been around the market for a while without really catching on - I remember being told that mortality swaps were the new credit derivatives - but this might stimulate the market a little. All the same, I'd want to be sure I wasn't one of the 46,000 odd individuals in the index just in case. Getting between Goldie and an index fixing might just be bad for your health...

Capital substitutes

Bloomberg reports that Ambac is doing something to try to stave off the loss of its AAA:

Ambac Financial Group Inc., struggling to avoid the crippling loss of its AAA credit rating, took out insurance on $29 billion in securities it guarantees.

The world's second-biggest bond insurer agreed to transfer the risk that the securities will default to Assured Guaranty Ltd., according to a statement today. Reinsuring the debt will free up capital backing those bonds, Ambac said. Ambac fell as much as 7.6 percent in New York Stock Exchange trading on concern the deal alone won't be enough to save its credit rating.

The market reaction is understandable: to be safe, Ambac needs $2-4B of new capital, and this deal won't free up nearly that much. To put it into context, it guarantees about $550B of securities, so this deal covers around 5% of its portfolio. With the ratings agencies on the prowl and considering downgrades, it is crunch time for the monolines.

``We're heading into maybe the most turbulent few weeks the bond insurers have ever seen,'' said Matt Fabian, a senior analyst and managing director at Municipal Market Advisors, an independent research firm in Concord, Massachusetts. ``There could be some very serious numbers floating around before Christmas.''

Ambac's agreement probably freed up $1 billion or less of capital, Fabian said. The ratings companies are likely to demand more, he said.

What is interesting, though, is the following comments from Robert Genader, Ambac CEO:

``Reinsurance is a valuable, capital-efficient and shareholder-friendly tool for managing risk and capital''.

He's right. You always have an alternative to increasing capital (as MBIA did with its share placing last week): you can decrease risk. Hedging and (re)insurance both achieve that: if you can reduce risk using either of them more cheaply than you can raise new capital, it makes sense to transform your capital requirement rather than your capital base. Anybody want another $100B of bond risk on a reinsurance basis?

A AAA monoline failure edges closer

According to Bloomberg:

Security Capital Assurance Ltd. may lose its AAA credit rating at Fitch Ratings, the first top-ranked bond insurer put on notice since the industry came under scrutiny last month because of rising defaults on subprime mortgages that back securities they guaranteed.

Short munis, long treasuries.

Update. The tail end of the field is starting to fall behind:

FGIC Corp. and XL Capital Assurance Inc., two bond insurers, may lose their Aaa credit ratings at Moody's Investors Service after a slump in the value of the debt they guarantee.

MBIA Inc., the largest bond insurer, and CIFG Guaranty had their outlooks lowered to ``negative'' by the New York-based ratings company today. The Aaa rankings of Ambac Financial Group Inc., Assured Guaranty Corp., and Financial Security Assurance Inc. were all affirmed, signaling no plans to change them, Moody's said. Radian Group Inc. was also affirmed.

Remember that the wrapped bond market is over $1T: this warning puts over 80,000 separate bond issues on negative watch according to Calculated Risk. If the ratings agencies hold their nerve and do actually downgrade a major monoline, the market impact will be enormous.

Wolfing down the crunch

There is a fascinating article by Martin Wolf in today's FT. As usual, let me quote selectively and comment.

[The credit crunch has] called into question the workability of securitised lending, at least in its current form. The argument for this change – one, I admit, I accepted – was that it would shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it. What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”, which proved to be only notionally off balance sheet.

I would distinguish between asset-backed lending and securitised lending, but Wolf is broadly right. It has turned out that the information asymmetry problems in the ABS market are too large to be easily dealt with in some case. The lack of alignment of interests has made this worse.

Banks became more leveraged through the use of SIVs, conduits and so on, but these vehicles just allowed banks to do what they always did - take liquidity, default and term structure risk - more efficiently. The real issue is why only one of these risks, default risk, has regulatory capital assigned against it. (There is no capital charge for interest rate risk in the banking book, and no capital charge for liquidity risk.)

What, more precisely, should a central bank do when liquidity dries up in important markets? Equally, the crisis suggests that liquidity has been significantly underpriced.

Cut rates and broaden the range of collateral eligible at the window, as the FED has just done.

Does this mean that the regulatory framework for banks is fundamentally flawed?

Yes. See here, here, here and here.

What is left of the idea that we can rely on financial institutions to manage risk through their own models?

A better understanding of model risk as here, here, or here.

What, moreover, can reasonably be expected of the rating agencies?

Not a lot. Why did you ever think otherwise?

A market in US mortgages is hardly terra incognita. If banks and rating agencies got this wrong, what else must be brought into question?

It's not the market, it is the structure. Dollar yen spot is probably the most liquid asset in the world, and certainly one that is very well commented upon. Yet I can structure a dollar yen exotic option whose price is genuinely uncertain (because it is radically different depending on your modeling assumptions). There is a measure of caveat emptor here, though: why did people buy structures they did not understand?

Do you remember the lecturing by US officials, not least to the Japanese, about the importance of letting asset prices reach equilibrium and transparency enter markets as soon as possible? That, however, was in a far-off country. Now we see Hank Paulson, US Treasury secretary, trying to organise a cartel of holders of toxic securitised assets in the “superSIV”. More importantly, we see the US Treasury intervene directly in the rate-setting process on mortgages, in an attempt to shore up the housing market.

As George Monbiot pointed out in a nice article about Matt Ridley (ex chairman of Northern Rock), it is often the most vocal proponents of the open market for other people who are the most dirigist when it comes to their own business. Yes, there is a massive measure of hypocrisy here, and moreover the intervention is not well-designed: the MLEC is looking more and more dodgy, and the Bush proposal for mortgage modifications will either cover very few borrowers or make lawyers rich.

A US recession is possible.

Yep. Likely even.

A leading regulator gets it. Finally. Maybe.

Sheila Bair, chairman of the Federal Deposit Insurance Corporation, is trying to wake her fellow supervisors up to the issues in the internal models approaches to capital in Basel 2. She is reported to have said:

Current financial market turmoil has shown up the weaknesses of the models used in the advanced approaches to assessing credit risk under the international Basel II bank safety rules...

The first lesson of the crisis in terms of the Basel II capital adequacy rules is “beware models!”

Bair is right of course. The models are necessarily inaccurate, since calibration is problematic, procyclical, and tend to support asset price bubbles.

The weaknesses “startlingly revealed” in the Basel II models by the turmoil “are a very bright, flashing yellow light warning us to drive very carefully,” ...

The FDIC chairman has previously expressed doubts about what she has described as the “untried” risk models underlying the advanced Basel II approaches that banks can use to assess their credit and operational risks and determine the minimum capital they need absorb shock losses.

Remember just because it backtests for some period doesn't mean it is right. A stopped clock backtests well in the few seconds around the time it is stopped at.

Update. The Telegraph (yes, I know, but I couldn't find a reference from a reputable paper in a hurry) carries a report on a slightly alarmist but interesting speech from Peter Spencer of the Ernst and Young Item Club. Spencer says that the Basel 2 rules

..are the root cause of the crunch and were serving to worsen the City's plight.

Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.

Presumably the idea is that now lines of credit below 364 days are not free in capital terms, banks are rationing capital and hence not lending. This seems unlikely, especially as the capital usage of short term interbank lending is low. I wonder what evidence Spencer has.

The FED and liquidity

It has become too much of a cliche to post a picture of the deep blue sea before talking about liquidity risk, so here's a muddy river instead...

With that out of the way, the news is that the FED is modifying its liquidity arrangements, allowing it to provide repo facilities to banks without using the window. Details are scant so far, but clearly the FED is worried about the size of the three month swap spread, and it is using both of the tools available to it -- rates and the management of liquidity premiums -- to calm the markets.

Update. Ah. This is all part of coordinated central bank action. Interestingly:

The Bank of England will increase the amount offered in its next auction on 18 December from £2.85bn to £11.35bn, of which £10bn will be offered for three months.

Crucially, it will accept a slightly wider range of assets as collateral for the loans.

The FED press release describing its new term auction facility is here and the WSJ comment is here. From the latter:

At the discount window, the Fed can accept numerous types of collateral, including riskier subprime mortgage-backed securities, as long as the value of the collateral exceeds the loan by enough to protect the Fed from loss. But though the Fed eased the terms and cost of such loans in August, banks continue to shun them for fear of appearing desperate.

Under the new method, the Fed will hold four auctions of discount-window credit. The first two, for $20 billion each, will be held next Monday and Thursday for four- and five-week terms, respectively; two more, for undetermined amounts, will be on Jan. 14 and 28. The auctions are structured so that the rate on the loans will be no lower than the market's expectations for the fed-funds rate, and probably no higher than the discount rate.

Clearly this is a helpful step from the FED and the comment has mostly been positive. Ken Thompson, chief executive of Wachovia said:

More than lowering rates in the economy, just having this banking system liquefied will make a huge difference...

[The reason rates for loans among banks are so high, he said, is that banks and investors] are still fearful of each other and everybody is worried about counterparty risk and so people are hoarding their balance sheets, and this will help that.

Watch the 3m swap spread and see what happens. Ooops.

One final update. Dealbreaker.com points out that the FED is using very old repo haircuts. 85% for a AAA CDO with no mark is indeed generous. Surely they will notice this and fix it. Unless they intended to blow the current liquidity premiums out of the water.

Meanwhile interfluidity takes a dim view of the TAF. One of the points they make is that the TAF is large compared with FED borrowing for much of the year. That's true, but it is still small compared with the problem: a single big conduit is tens of billions of dollars, roughly the size of the entire TAF. To make a real difference, the central banks need to parachute in hundreds, not tens of billions.

The cost of capital

There will be a fair amount written about the UBS writedown, so I'll stick with the other part of the story, the mandatory CB it is issuing. This will pay a 9% coupon. Citi on the other hand, is paying 11% on the mandatory issued to plugs its capital hole. Assuming (which is a big leap) that both of them went for par, how do we explain this difference?

Update.To plug its capital hole, WaMu is issueing a perpetual pref convertible into common stock. This is still being priced, but the word is that it will pay a coupon of between 7.5 and 8%. It would be really interesting to get the details of all 3 of these instruments, their levels of subordination, conversion features and so on and put them in a capital structure model. WaMu's is optional conversion rather than mandatory so it is not immediately obvious how it compares with the Citi and UBS offerings.

Meanwhile Morgan Stanley is paying 9% on its mandatory CB, issued to plug a $5B capital hole after taking a further $5.7B writedown.

Vertical slices

From FT alphaville and worth quoting in full:

Citi’s SIVs have reduced their assets by $15bn in the past couple of months.

But it’s not the figure, or the reduction, that’s news. Speculation that the Citi seven currently have around $66bn under management was actually first mooted a little while back.

Here’s the interesting bit, about how the assets have been offloaded,

…through quiet side deals with some junior investors, according to people familiar with the business.

A bit more detail:

…people familiar with the vehicles say their size has been cut from $83bn at the end of September to about $66bn largely by selling pro-rata portions of a SIV’s portfolio of assets to investors in the most junior notes at market values. Citi is also talking to some investors about directly swapping their holdings for underlying assets.

In other words, Citi are basically saying to junior noteholders, that they’re unlikely to get anything back for their notes, but as consolation, they can buy assets from the SIV at market value - probably slightly below what they’re really worth. Quite an audacious palm-off. On the other end, we assume the money from these sales is being used to refund MTN investors (given that Citi are themselves assuming CP liabilities).

And as the FT report says, Citi is also looking at organising direct asset for note swaps.

Both of these have got to be negotiation intense options, surely with sky-high lawyers’ bills to boot. So the fact that they’re being pushed doesn’t sound like it bodes well for M-LEC.

Update. Some further background from S&P is here.

What does a CRO do all day?

I'm late on the news that JP has hired a chief risk officer. (On the other hand it took JP a year to get around to it, so arguably I'm not the only one who is late.) Anyway, this brought to mind an old article of Rick Bookstaber's about what a CRO does. Bookstaber says in part:

What about the job of the risk taker? Well, a risk taker does, after all, take risk. He tries to do so intelligently, that is, he tries to put on positions that he hopes have a high return per unit of risk. But how much risk he takes and where he takes it has to be dictated by someone. You can’t just say “take risk, and good luck”.

The job of the risk manager at these firms is to convey the risk parameters to the risk takers, to define the boundaries.

I'm not sure that I buy that as the complete job description. To me it smells too much of risk measurement plus limits. Where is the risk management? Surely a CRO should be involved in advising the board on the firm's overall risk appetite, its macroscopic risk position, and capital allocation. He or she isn't just a goto person for yes/no decisions on positions the traders like: they should be proactively working with the Board to tailor the firm's risk position to optimise ROE and protect shareholders.