UBS, the agencies, and other drama

A panoply of drama today.

First UBS. $14B. That's quite a lot. As Bloomberg reports:

The Zurich-based bank announced today a net loss of 12.5 billion Swiss francs ($11.4 billion) for the fourth quarter [...]

The bank increased markdowns directly linked to the subprime market to about $12 billion from the $10 billion it forecast in December and said an additional $2 billion of writedowns are for other U.S. residential mortgage securities.

This is in marked contrast to their prediction of a profit for Q4 made at the time of the Q3 writedown. Perhaps more significantly, as Naked Capitalism points out, this suggests more pain to come from the other players before this sorry farrago is over.

Next the bitter suspense of the bond insurers. Will they be downgraded today? Tomorrow? Sometime, never? The agencies are walking the line. If they wait for the man, Mr. Dinallo, they risk losing even more credibility. If they move too fast too soon they risk a shareholder lawsuit. (CNBC has some further insight here while the FT points out the size of the short interest in the monolines -- about 40% apparently.)

Meanwhile opinions continue to differ on how much the monolines need. Even the normally bullish WSJ says:

However, it quickly gets complicated, given that the banks themselves have differing levels of risk exposure to the bonds in question and also have differing abilities to provide cash. Calculating how much each should put up on a pro rata basis could be complicated and spark disagreement.

Moreover it is not just the banks' relative share that is in doubt, but also the size of the recapitalisation. The FT has estimates of between $10B (the monolines themselves) and $140B (Independent Strategy). You certainly don't want to low ball it and then have to go back to the market again so any plan that only puts in a couple of billion per firm has significant danger.

Update. John Thain is bullish here although he agrees that an industry wide bailout will be problematic. He said in an interview with the Financial Times on Wednesday that

He expected individual credit insurers would receive capital infusions from investors, but that it would be difficult to craft an “industry-wide” bail-out for the beleaguered guarantors.

Mr Thain said an effort by New York state regulators to help leading bond insurers maintain their credit ratings was raising interest in the sector on the part of investors including private equity groups and specialists in distressed companies.

However [...] getting banks to agree on a single approach was unlikely because they have different exposures to the credit insurers and varying opinions on what should be done.

Meanwhile Bloomberg reports:

MBIA Inc., the world's largest bond insurer, posted its biggest-ever quarterly loss and said it is considering new ways to raise capital after a slump in the value of subprime-mortgage securities the company guaranteed.

The fourth-quarter net loss was $2.3 billion, or $18.61 a share, raising concern the Armonk, New York-based company will lose its Aaa rating at Moody's Investors Service. The loss came a day after FGIC Corp.'s insurance unit became the third company to be stripped of its AAA credit rating.

Soc Gen offers 0% on balance transfers up to €50B

Some interesting things concerning the Shock Gen event:

• Margin. As Alea points out, the margin on Shock Gen's positions would have been about 4.9B euro. Didn't they notice they were funding a few billion euros more margin than they thought they were? If they thought the offsetting position was with a client, didn't they call collateral from the client? Or were they in the habit of letting clients have billions of Euros of equity exposure without margin?
  
• Unsurprisingly, shareholders are suing, claiming market manipulation.
  
• Did Shock Gen find Kerviel or did Eurex? The FT raises the issue, then suggests Eurex first raised the alarm in November.
  
• Kerviel did not lose 4.9B. He only lost 1.5B. OK, still chunky, but the other 3.4 came from management's hasty closing of the position in a falling market.
  
• Things not to say any time after Barings went bust: We all lived in fear that something within the exotic products would blow up in our face. It never came to our mind that we might have a problem with Delta One," said a top Société Générale official.
  
• Investigating judges in France have just thrown out the charge of attempted fraud against Kerviel.
  

And finally, I don't usually quote extended passages, but this from the Daily Mash (from whom I borrowed the post title) is amusing enough to be worth reproducing:

FRIENDS of rogue trader Jérôme Kerviel last night blamed his $7 billion losses on unbearable levels of stress brought on by a punishing 30 hour week.

Kerviel was known to start work as early as nine in the morning and still be at his desk at five or even five-thirty, often with just an hour and a half for lunch.

One colleague said: "He was, how you say, une workaholique. I have a family and a mistress so I would leave the office at around 2pm at the latest, if I wasn't on strike.

"But Jerome was tied to that desk. One day I came back to the office at 3pm because I had forgotten my stupid little hat, and there he was, fast asleep on the photocopier.

"At first I assumed he had been having sex with it, but then I remembered he'd been working for almost six hours."

As the losses mounted, Kerviel tried to conceal his bad trades by covering them with an intense red wine sauce, later switching to delicate pastry horns. At one point he managed to dispose of dozens of transactions by hiding them inside vol-au-vent cases and staging a fake reception...

I'll end with a few sea creatures you might find convenient if you have a few thousand equity index futures to conceal.

CPDO: Endgame

The end of some of the CPDOs nears. I did hint earlier that a yield of Libor + 200 implied that they were not AAA securities, and indeed it turns out that, once again, straightforward beta rather than alpha was the cause of the return. Anyway, Bloomberg reports:

ABN Amro Holding NV clients face 90 percent losses on two credit derivative products totaling 120 million euros ($176 million), according to Moody's Investors Service.

The so-called constant proportion debt obligations have seen their net asset value fall to 10 percent, meaning they will have to unwind, or ``cash-out,'' Moody's said in an e-mailed statement today.

Leveraging up as spreads widened didn't turn out to be such a good idea after all then. Of course, investors in the ABN product were unlucky with the size of the moves experienced:

Credit-default swaps on the Markit iTraxx Financial index of 25 European banks and insurers soared to a high of 84 basis points this week on concern credit rating downgrades at bond insurers including Ambac Financial Group Inc. and MBIA Inc. will cause bank losses to surge. The index traded as low as 20 basis points in November.

Still, given that a number of commentators thought the CPDO was a really bad idea when it launched (see for instance here or here), you can't say no one said I told you so.

Finally, perhaps in the bolting the door after the horse has run away category, I leave you with a link to a paper on Rating Criteria for CPDO Structures. It may be that this is of purely historical interest.

False positives and false negatives

The Treasury select committee report on Northern rock has some criticism for a range of targets from Alistair Darling, through the board of the bank itself, to FSA. While none of it boils down to 'hang them from the nearest telegraph pole', FSA in particular comes in for considerable censure.

According to the FT:

Sweeping new powers to oversee financial stability and prevent a repetition of the Northern Rock crisis should be handed to the Bank of England, a parliamentary committee proposes on Saturday in a report that lambasts the Financial Services Authority for systemic failure in its duty as a regulator.

I don't know the details of what FSA did or didn't do, so I won't comment on the specifics. But a few general remarks about financial supervision might be appropriate.

• Firstly it is utterly inappropriate for a regulator to comment on bank strategy. Yes the Rock had a strategy that turned out to be flawed, but provided the necessary statutory disclosures were made and the bank was capitally adequate, what could FSA do about it even if they understood the issue? Having regulators comment on strategy is tantamount to them writing a put to shareholders.
  
• Regulators have to be careful about calling wolf, especially given the impact any public intervention would have on the market. The balance between intervening too early and too late is a very difficult one, especially for a public body that is necessarily bureaucratic (not least because its actions are susceptible to judicial review). Again I'm not suggesting that FSA didn't get it wrong in this case, just that to make an informed judgment we also need information from the thousands of cases where banks did not fail. The skeptic might suggest that thousands of banks a year don't get into trouble so doing nothing is usually safe, and I'd agree, but that just emphasises the difficulty of finding a true positive in a sea of negatives.
  
• What on earth makes the Treasury select committee believe that the Bank of England would be any better at bank rescues than FSA? Surely one lesson from this debacle is that the tripartite system has one (or perhaps two) legs too many. Having a part of the Bank for FSA to hand over problem cases to will just exacerbate the communications overheads and inter-institutional conflict in the system.
  

Few would suggest FSA is the perfect regulator. But having a single body responsible for banks, investment firms, insurance companies, and financial intermediaries is a good start. Fewer regulators not more would make a good motto, as the BIS recently pointed out. Why not make a merged Bank of England/FSA truly responsible for the whole thing from soup to nuts, including authorisation, regulation, deposit protection, rescues, rate setting and the operation of the discount window? Then nothing can fall between the cracks between institutions and if something goes wrong we will really know who to blame. That might be too controversial a suggestion for the Treasury select committee, but it would be better than yet another regulatory kludge.

Update. It seems Alistair Darling agrees. He rejected the committee's advice, saying that plans put forward by a committee of MPs were flawed and would not deflect him from his own reforms of Britain's system of financial regulation.

'Sucks' is an invariant

If a model sucks today, the strong likelihood is that it will suck tomorrow. VAR sucks. Let's reprise the case.

VAR is procyclical. As markets rise, volatilities and correlations tend to fall so the VAR for a position goes down, encouraging over-leverage. When they crash, VAR goes up, encouraging firms to cut at the worst moment and exacerbating illiquidity.

VAR models are based on history. The better we calibrate to the recent past, the less accurate VAR is likely to be: this is true for both simple variance/covariance VAR models and for more sophisticated historical simulation ones.

(To see this, consider a delightful note to UBS's 2004 account.

Over the past two years, growth in asset-backed securities has outpaced other sectors in the fixed income markets. At the same time, our Investment Bank’s market share in this sector has grown, leading to an increase in exposure. To date these exposures have been represented as corporate AAA securities in VAR, leading to a conservative representation of credit spread risk.

To better reflect the risk in Var, we have increased the granularity of our risk representation of such securitized products. In July 2004, the Swiss Federal Banking Commission (SFBC) gave their approval for this change and we have implemented the revised model during third quarter.

The enhanced model added a number of historical data series, which more closely reflect the individual behavior of products such as US Agency debentures, RMBS & CMBS, and other asset backed securities such as credit card & automobile loan receivables.

Then look what happened:

In other words UBS rightly improved their model. But because the improved model was better calibrated to recent conditions, it reduced the risk shown on ABS. ABS ended up costing UBS billions.)

VAR gives no insight into the tails. Morgan Stanley's $480M loss on a (at most) $110M VAR is evidence enough of that.

Many firms have highly non-linear P/L distributions. This means they respond in a highly non-linear fashion to extreme returns, making VAR at a reasonable (i.e. statistically significant) confidence interval even less useful. The evidence for this is discussed here.

We got very lucky with the timing. VAR for reporting regulatory capital was approved in the 1996 Market Risk Amendment to Basel 1. 1996 came at the end of a relatively quiet period in most markets, with no major equity market or emerging market crashes since the 80s. If the matter had come up for consideration in 1997 (South East Asian Crisis), 1998 (Russia, LTCM), 2000 (high tech crash) or 2001 (Argentina, 9/11), the data supporting the veracity of VAR as a risk measure would have looked a lot less good.

See here for a further discussion on Bloomberg, or here for a longer one from Naked Capitalism.

VAR is a reasonable ordinary conditions risk measure. But it gives somewhere between very little and no insight into stress losses. Yet stress losses occur several times a decade. Perhaps we should move towards a simpler capital regime based on large moves and no benefit for diversification. Like, err, the one we had before 1996.

Tanking PFI

I have blogged before on the idiocies of PFI - how Gordon Brown has a reputation for economic prudence given he facilitated this is beyond my ken - but the latest news is even more extraordinary. Not only are we paying more for our infrastructure than we should, but now the very future of an important project, the Airbus tanker project, is under threat. According to the FT:

The turmoil in credit markets has dealt a big blow to the UK government’s defence procurement programme, putting in jeopardy plans to help fund a new fleet of Airbus tankers for the Royal Air Force with a bond issue.

The issue is that the bonds financing this project were expected to be wrapped by Ambac. This is beyond crazy: in many instances either explicitly or implicitly (because the project cannot be allowed to fail) the government backstops PFI, so there is no need for a wrap. It is only the bizarre fiction of PFI that pretends that there is any risk transfer, and hence any need for an insurer to be involved. PFI is a waste of public funds on an extraordinary scale: it is time we held Gordon accountable for it.

One more thought on pay...

The columns of the FT have been reverberating with comments on banker's pay recently (see here, here, here and here) with a predictably strident reaction from the blogosphere (see, if you must, here, here and here). One issue here that hasn't received attention, though, is the wonderful effect of diversification for managers.

Suppose you are a junior trader with a budget of $5M and you get paid 10% of your excess P/L over $3M. Your bonus is therefore 10% x max(0, P/L - $3M). Suppose the average trader makes budget, just, and the SD of returns is $2M. Then while the average trader makes $200K, a bad or unlucky guy 2 SD from the mean makes 10% x max(0, 5M - 2 x 2M - 3M) = 0. Fair enough.

Note though that the trader owns a call, and you maximise the value of the call by increasing volatility. So the trader is incentivised to make their P/L volatility as large as possible.

Now consider the desk heads. Suppose each employs ten traders, so their budget is $50M. They too get paid on the same basis, so their bonus is 10% x max(0, P/L - $30M). The mean is $50M but the SD goes as the square root of the number of traders employed, so it is root ten times $2M or about $6M assuming zero correlation. Therefore while the average desk head takes home $2M every Christmas, a bad one 2 SD from the mean has a bonus of 10% x max(0, 50M - 2 x 6M - 30M) = $800K. So even a pretty bad (or unlucky) desk head makes money. Of course the zero correlation assumption is a stretch but note that the desk head owns a call on a basket, so they should maximise both volatility of the basket components and their correlation.

Finally consider the head of the business employing a thousand traders. By the same logic, their budget is $500M, and they get paid 10% x max(0, P/L - $300M). Their volatility though is only root thousand times $2M or $20M. So a really terrible manager four SDs from the mean still earns 10% x max(0, 500 - 4 x 20 - 300) = $12M. Very nice. Diversification works beautifully in executive pay, at least if you are one of the executives. Shareholders may have a different perspective.

How big might the hole be?

Following on from my musings earlier in the week that it was the (perhaps false) hope of a monoline bailout that caused the market recovery, possibly together with a bounce back after the negative price impact of Soc Gen's liquidation of its rogue trader position, let us turn to the result of a downgrade of Ambac and MBIA. Bloomberg has an item about a recent research piece:

Banks may need to raise as much as $143 billion to meet regulators' requirements should rating firms downgrade bond insurers, Barclays Capital analysts said.

Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Financial Group Inc. are cut one level from AAA, and six times more for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today.

If that is even within spitting distance of the truth, it explains why the markets reacted so positively to the news of a possible bail-out, and why if permabears like Pershing Square's Bill Ackman are correct the bounce in MBIA and Ambac is both purely temporary and very troubling for the banks.

The problem with the proposed rescue is knowing how big it might need to be - Dinallo thinks $20B, but Egan Jones' estimates are an order of magnitude higher - and who stands most to gain and hence who should put the most in. Without reliable mark to markets on the wraps the monolines have written (which remember are mostly insurance and hence not MTM), how can Dinallo determine who contributes what? Without FED involvement it is hard to see how this can work, and even if they do 'persuade' banks to contribute - as they were signally unable to do with the MLEC - figuring out the flows will be a difficult business.

Soc Gen Shock

Soc Gen has discovered there is less behind those nice sturdy vault doors than they thought. 4.9B Euros less, approximately, according to Bloomberg, thanks to the activities of a rogue trader, Jérôme Kerviel. They are raising 5.5B Euros of fresh capital.

The similarities with Barings border on the eerie. The trades were in equity index futures. They weren't complex, nor did they involve options. Although the trader did not control the middle office, as Leeson did, he did have extensive knowledge of it from prior employment there, and hence managed to evade the firm's controls. See here for the full statement.

Finally in a delicious irony, as FT alphaville points out, Soc Gen is Risk Magazine's equity derivatives house of the year. (Recall that NatWest was high in Risk Magazine's GBP and DEM interest rate derivatives league tables in 1994-996 just before they revealed their interest rate derivatives loss in, err, GBP and DEM.)

It is absolutely extraordinary that this can happen in 2008. To generate a five billion loss on asset backed securities is unfortunate. To do it on equity index futures is incredible. If the fictitious positions were exchange traded futures did they not do basic position reconciliation from the exchange to their systems? What about margin? If they were OTC forwards did they allow the trader to control confirmations from counterparties? What about collateral? The autopsy on this one will be interesting.

Meanwhile on Radio 4 this evening there has just been speculation that the dramatic falls in markets around the world earlier in the week were caused in part by Soc Gen liquidating its positions. If this is true and we got the 75 bps FED rate cut as a result, there is going to be some serious trouble. Surely Soc Gen couldn't have dumped ten of billions of index futures without telling the regulators could they?

Update. The Bank of France knew but neither they nor Soc Gen told the FED according to Bloomberg. That's shocking.

The Guardian is uneqivocal here: 'SocGen's desperate race to clear up the damage and unravel Kerviel's trading positions were at the heart of the stockmarket turmoil on Monday when share prices across Europe crumbled by 7%.' We won't know if that is really true for a while, but for now I'll leave you with a link to a summary of the Market Abuse Directive. Note in particular

Market manipulation comprises three parts. These are: transactions and orders to trade that give false or misleading signals or secure the price of a financial instrument at an artificial level. [...]

Update. There is a nice New York Times article on Soc Gen's unwind, Société Générale’s Sales May Have Incited Market Plunge, with details of the notionals transacted on Monday and Tuesday here. They going to be in serious trouble with the FED if these suspicions turn out to be true.

The cost of capital, America edition

Bank of America that is.

BofA is marketing $13B of securities according to Bloomberg:

The sale will be split between $5 billion to $6 billion of perpetual securities that may yield 8 percent, and $6 billion to $7 billion of convertibles that may yield 7.25 percent to 7.75 percent, said the person [familiar with the offering]

Why so much? Their writedown was only $5B. What do they need the other 7 for?

Just in the nick of time

Did the rate cut work? No.

Did the bailout of the monolines work? Yes.

The week so far in pictures (respectively the Dow, Dax and FTSE).



It seems that worries about losses to banks on wrapped bonds, the closure of the muni market, and yet more structured finance write downs were more pressing than rates.

Update. Fixing the monolines will take time, according to the New York State Insurance Department. I wonder how the markets will react if this bailout goes the way of the MLEC. Naked Capitalism certainly thinks the signs are not encouraging and Gillian Tett has some further comment on the balance between moral hazard and systemic risk.

Need a job in structured finance?

Lots of CDO sales people and traders do... Here is the latest CDO issuance data.

Source SIFMA via Alea.

Social Mores and Default Frequency

Before 1990 defaults on Hong Kong credit cards were very rare. It seems that then the holders viewed paying back their debt as a matter of face, and they would borrow from family or friends rather than default on an obligation to a bank. Between 1990 and 2000 the default frequency slowly rose, and now there is very little difference between U.S. and HK cards. It appears as if a more western attitude now prevails, with consequences for the holders of card deals.

A similar cultural change seems to be taking place in the U.S. Let's pick up the story with Bank of America CEO Ken Lewis:

There's been a change in social attitudes toward default [...] We're seeing people who are current on their credit cards but are defaulting on their mortgages, [...] I'm astonished that people would walk away from their homes.

Tanta takes up the story, quoting the recent Wachovia earnings call:

Part of one of the challenges is, and we've mentioned this before, a lot of this current losses have been coming out of California and it's -- they've been from people that have otherwise had the capacity to pay, but have basically just decided not to.

This could be huge for the CDRs on RMBS. And no one is coming to the rescue.

Monday a bad choice of day to be away from the market

Times to treasure.

Fitch downgraded Ambac on Friday and the firm subsequently posted a $3.2B loss. This is the beginning of the end for the monolines, and the roughly $2T of bonds they have wrapped. The knock on effects in the muni market will be huge.

Then we had some equity market action: the DAX plummeted 7.2% and the CAC 40 fell 6.7%. The Hang Seng was down 5.5% and the FTSE was off 5.5% too with banks around the world particularly hard hit. The equity/credit realignment is starting to occur.

Finally BofA surprised with a $5.28B writedown, leaving net income down 95%. Still, it was at least positive.

Next, the FED goes cut crazy.

Baltic Dried

It seems my earlier skepticism about the level of the Baltic Dry Index was justified:

Volatility smolatility

The FT points out what is perhaps obvious, that volatility of equity indices is rising. I hadn't appreciated the size of the issue, though, until I saw this:

Wednesday’s intra-day whipsaw of 632 points on the Dow Jones Industrial Average is the fifth largest on record (the top four all occurred during the tech bubble collapse).
[...]
The Vix is rising off a long period of relative calm – it averaged 13 in the three years ending July 2007.

13? 13 is far, far too low. I remember FTSE five year ATM vols going to 40 at the peak of the LTCM debacle. Even in the glory days before that 13 was a low number for short dated vol (the VIX is ATM one month S&P vol). Still, that little episode must be causing some amusing calibration issues for mean reverting stochastic vol models...

Prising apart the Merrill writedown

The headline is Merrill Posts Record Loss on $16.7 Billion Writedown. Let's take the Merrill earnings release and pull it apart a bit. Specifically, consider the CDO positions.

A first glance, the position seems fairly benign.

But now consider the footnotes:

(2) Primarily consists of principal amortization for U.S. super senior ABS CDO net exposures, as well as changes in hedges and increases due to ineffective hedges.

Now, amortisation reduces exposure. But the high grade number is up. So the increase must be due to ineffective hedges. This emphasises that these are net numbers.

(3) For total U.S. super senior ABS CDOs, long exposures (including associated gains and losses reported in income and other net changes in net exposures) were $46.1 billion and $30.4 billion at September 28, 2007 and December 28, 2007, respectively. Short exposures (including associated gains and losses reported in income and other net changes in net exposures) were $31.3 billion and $23.6 billion at September 28, 2007 and December 28, 2007. Short exposures primarily consist of purchases of credit default swap protection from various third parties, including monoline financial guarantors, insurers and other market participants.

Ah. Those would be the monolines that are doing so well at the moment. I don't want to rain on Merrill's parade, but if I were an investor, I might want to know a bit more about those hedge counterparties other than their ratings. The weighted average spread they trade at in the CDS market perhaps. That would give some idea of where between a net $4.8B and a gross $30.4B the exposure really lies.

Caught in the net

From Naked Capitalism:

Annual Premium as a Percent of Exposure:

MBIA 18 basis points
Ambac 21 basis points

Leverage (Net Debt Service Outstanding/Statutory Capital)

MBIA 147X
Ambac 143X

That speaks for itself I think.

Update. The testing times continue for the monolines. From Bloomberg:

New York-based Ambac dropped as much as 65 percent and Armonk, New York-based MBIA fell 38 percent after Moody's and S&P said late yesterday they are reviewing the rankings the companies depend on to sell bond insurance. Credit-default swaps on both guarantors rose to records, signifying investors see a growing chance that the companies won't be able to pay their debt.

Ambac, which yesterday cut its dividend and ousted its chief executive officer after reporting greater-than-expected write downs on the bonds it insures, said Moody's decision was ``surprising.''

Surprising as in we are surprised you finally worked out that we are leveraged up the kazoo? MBIA's surplus notes, despite their 14% coupon, are now trading at 84 cents on the dollar. And Bill Ackman thinks they will never pay a penny.

Gold cards glisten no more

Do you remember when prime card backed ABS was the best kind of ABS money could buy? I do... but it isn't any longer.

The ABCs of counterparty credit

The FT has an article on the failure of SCC, a Dublin-based credit derivatives product company or CDPC. SCC was only twenty five times leveraged, a relatively low level compared with some of the other CDPCs. But it did have a small absolute level of capital, $200M, and no rating.

What is interesting is why SCC collapsed. It wasn't that it had written CDS on underlyings that defaults. No, as with ACA, it defaulted because it could not post sufficient collateral. Let's pick up the story with the FT:

Court documents from Nomura’s attempts to liquidate the company and SCC’s successful response to secure a Chapter 11-style restructuring show that between the end of June and August 16 last year, collateral demands rose from $55m to $438m. SCC managed to put up $175m worth before running out of funds and sparking Nomura’s High Court petition to have the firm liquidated.

The ravages wrought by mark-to-market accounting are visible in the tens of billions of losses among investment banks, the collapse of the structured investment vehicle industry and in the ever-more precarious position of the bond insurers.

And yet, credit losses from actual defaults outside of the US subprime mortgage market remain minimal. SCC told the High Court that expected losses over the life of its contracts would be a fraction of the collateral it had to post.

Now of course we have no idea whether SCC is right about that claim or not, but the key point is that credit support default is a real honest to goodness game over default. The relevant question for a CDS counterparty is therefore not only whether they are sufficiently well capitalised to remain solvent under a claim: it is also whether they are sufficiently liquid to be able to adhere to the terms of their CSA. It's the volatility of the mark to market of their portfolio that matters, not only the ultimate loss. Did the prime brokers think about when they were buying protection I wonder?

The cost of capital, monoline edition

14%, according to Reuters.

Private Wisdom, General Ignorance

Equity Private is posting again. That is the cause for some celebration. Her creativity have obviously been refreshed by an absence from the blogosphere (what an ugly word) and she has some acerbic gems at the moment. My favourites:

My own disposition is towards limited market efficiency--prices reflect all sufficiently scrutinized information, subject to sufficiently saturating capital. This implies two major sources of pricing error:

1. Insufficient distribution of material information.
2. Insufficient capital applied by those in possession of material information.

This seems so obviously true that I wouldn't remark on it but for the sheer prevalence of the opposing view - unlimited market efficiency, aka not long enough out of business school disease. As we move further into the crunch, 2. is becoming an important driver of investment opportunities, so one might hope that the wisdom of the doctrine of limited efficiency will become more readily apparent.


Ms. Private then goes on to discuss those strategies (such as buying AAA yielding Libor + 40) that appear to generate alpha, i.e. return without risk.

The correct response to investment strategies that appear to generate abnormal returns but are of such complexity to defy understand is not to invest. Or, to emphasize the commenter of earlier fame [Alea]:

If you couldn’t determine the conditions under which the transaction would lose money, you didn’t execute.

Follow that? If you don't understand what you are buying, don't buy. Quite simple. Or so you would think.

Cheap debt does not cause losses. Being on the wrong side of information asymmetry does. When structures are complex, falling back to a careful look at incentives often is the best (and only) behavioral prediction mechanism.

So true. But, just as with '86 Lafite vs. the '85, just because something is obviously worse doesn't mean that some people won't buy it.

The Dangers of Wanting It All (Wanting It Now)

There has been a lot written recently on the Japanese scenario - of the U.S. falling into a deflationary spiral with a banking system that can't function due to the weight of non-performing assets. This ranges from rumour (step forward Naked Capitalism) through calls to action (a nice Bloomberg article by William Pesek) to doom mongering (Robert Schiller in the Times). There's probably some denial out there too.

Here's my tuppence. The real problem with Japan wasn't low rates - although they did not help. It was low liquidity premiums. In the 90s you could pretty much repo a dry cleaning receipt for the purchase price of the clothes. With no liquidity premium, there was no incentive to take liquidity risk, and hence no incentive for the banks to lend their way back into solvency. Of course the accounting didn't help, as it allowed banks to keep non performing assets on their balance sheets at par. But it was their ability to finance their assets that allowed the deflationary cycle to continue for a decade in Japan. Right now we need a wave of liquidity to keep the banking system functioning. But equally, soon, the central bank spigot must be slowly closed.

A river runs through it

A river of money that is. Writing in the FT, Raghuram Rajan comments on recent bonus decisions:

Banks have recently been acknowledging enormous losses, yet those losses are barely reflected in employee compensation. For example, Morgan Stanley announced a $9.4bn charge-off in the fourth quarter and at the same time increased its bonus pool by 18 per cent. The justification was that many employees had a banner year and their compensation should not be held hostage to mistakes that were made in the subprime market.

[...]

Even so, most readers would suspect something is not right here.

FT alphaville provides further background:

Banks structured bonuses to include a greater proportion of restricted stock, which is released over several years. And they set explicit targets for compensation costs as a proportion of revenues, typically around 50 per cent.

The pitch to investors was simple: we may give our staff half of everything they bring in, but this will rise and fall in line with the state of the business.

This formula worked well in boom years, but is beginning to creak. Of the Wall Street banks that have released fourth-quarter earnings so far, the two most affected by the subprime meltdown reported sharp increases in their compensation ratios. In 2007, Morgan Stanley’s wage and bonuses bill rose 18 per cent, to $16.6bn.

This in a year when the bank’s revenues fell 6 per cent, it wrote off $9.4bn in subprime losses, and was forced to raise $5bn from China Investment Corporation. At Bear Stearns, the bonus pot shrank by a fifth, but revenues fell more than a third.

[...]

There is a certain logic to this largesse. The subprime losses are generally the work of a small number of people working in the fixed income division. Meanwhile, other parts of the business have enjoyed record years. It may be in the bank’s interests to pay to keep its best people, even if there’s not much left for shareholders.

This argument fails to acknowledge the fact that all employees benefited when the fixed income operations were raking in the profits during the credit boom, and should probably share in the losses. It also highlights a fundamental flaw in the bonus culture: that costs and benefits associated with risk-taking are not equally shared.

Here's the problem. Suppose after costs you split the pile 50/50 between shareholders and staff. Staff expect 50% of what they make. But there is no such thing as a negative bonus, and all attempts at delaying compensation or holding money back for later have proved profoundly demotivating and ineffective. So while most people are making money, paying 50% of the upside to staff is fine. But if one group loses, oh say $10B and everyone else makes money, you have a real problem, and one that slashing bonuses for the head of the business does not solve. In reality there is no collective responsibility in most investment banks and little sense of working for shareholders. Bankers are more like piece workers than traditional employees - but your average piece worker can't endanger his employer's capital base. The only solution to this issue will be if shareholders demand it and if the industry collectively changes: if anyone breaks ranks to gain competitive advantage, reform will fail. And we know how good investment banks are at cooperation...

Why isn't Warren stomping on the monolines?

Bloomberg reports that MBIA is falling again:

MBIA Inc., the giant bond insurer hobbled by the collapse of the subprime market, will cut its dividend 62 percent and raise $1 billion in a sale of notes to boost capital and preserve its AAA credit rating.

The Armonk, New York-based company has declined 81 percent on the New York Stock Exchange in the past 12 months and fell 4.2 percent today after it reported fourth-quarter writedowns and expenses of about $4 billion related to mortgage securities.

Bizarrely Buffett may be willing to help, despite his interest in setting up a competitor:

``We're looking at multiple ways to participate in the industry,'' Ajit Jain, head of Berkshire's new bond insurer, said today in an interview. Berkshire, based in Omaha, Nebraska, is ``looking at ways to support the existing insurers in terms of reinsurance and capital,'' he said.

Part of the reason the monolines are in focus is, as Naked Capitalism reports, that Countrywide is rumoured to be close to bankruptcy. If it were to go down, it would trigger a wave of claims on the wraps the monolines have written that they likely could not pay. In this context, why doesn't Buffett just let his competitors go down? Or has it been gently suggested to him that it would be in the U.S. national interest if he used that spare cash to support the industry? Certainly the NYT's account of the support Buffett got for setting up his new monoline is bizarre. To pick some of the juicier bits:

Shortly before Thanksgiving, Eric R. Dinallo, the insurance regulator for New York State, did something unusual. He called Warren E. Buffett’s right-hand man on insurance, Ajit Jain, and suggested that he start a new company to insure municipal bonds in New York....

To be a New York company, Berkshire, with its main insurance offices in Stamford, Conn., would technically need to run its new business from offices in New York. But Mr. Dinallo agreed that Berkshire could set up a token office in New York and do most of its work in Connecticut...

For its part, Berkshire agreed to put up $105 million in capital to start, $30 million more than the minimum required by New York. But “to minimize the amount of capital trapped in the entity,” Mr. Jain said, Mr. Dinallo worked out a way for Berkshire to increase its leverage by permitting it to exceed the usual limits on reinsurance, or insurance on the risk the new company acquired.

Offices Up, Rents Down

One of the few resonant sentences in the new Basel Accord - a document which mostly reads as if it were written by a committee (as it was) - concerns commercial real estate:

In view of the experience in numerous countries that commercial property lending has been a recurring cause of troubled assets in the banking industry over the past few decades, the Committee holds to the view that mortgages on commercial real estate do not, in principle, justify other than a 100% weighting of the loans secured.

Right on cue, CRE is again springing into the prescribed line as a cause of troubled assets. The Economist points out:

From up high, London is a picture of vigorous renewal. In just about every direction, construction cranes point contemplatively to the skies. They also point to the great boom that has taken place in commercial property in recent years. The collapse of that boom, which now threatens to slash the values of these gleaming office towers and destroy the savings of millions, may pose almost as great a threat to Britain's banking system as the subprime crisis that has been roiling financial markets since late in 2007.

What is interesting is the extent of the downturn indicated by the IPD forwards. These provide an indication of where commercial real estate derivatives market participants are willing to trade on a forward basis - and they forecast a 30% fall over the next three years. Thirty, not three. That's one thing Basel got right then...

Wearing a cap

Further to the discussion on Saturday, here are some more thoughts on risks in pensions and who should bear them.

Pensions are complicated things. Consider a typical defined benefit scheme. Here the pensioner has a right to a certain level of pension - often index linked - and the employer has an obligation to provide it. The pension is simply collateral against that obligation.

The first risk, then, is that the employer cannot meet that obligation, typically because they have defaulted, and the pension fund is not adequate. It is this risk that pensions protection legislation is meant to address.

The second risk is that the fund is not judged be adequate to meet the employer's liability, causing the need to 'top up' the fund. I say 'is not judged to be' rather than 'is not' because the law requires an assessment of the future likelihood of adequacy to be made rather than a spot assessment. Ignoring for a moment the veracity of the assessment - which is questionable - let's look at how a fund might fail to be sufficient to meet an employer's liabilities.

There are two moving parts here: the fund assets, and the fund liabilities. Funds are typically invested in some or all of corporate bonds, equities, and inflation linked bonds, plus perhaps other asset classes. Therefore they are typically:

• Short credit spreads (if credit spreads increase, the fund loses money on a MTM basis);
  
• Short nominal rates (because if rates increase, fixed rate bonds are worth less);
  
• Long equities; and
  
• Long CPI inflation (to the extent that they hold inflation-linked assets).
  

On the liability side the fund is:

• Short longevity (if people live longer it has to pay a pension for longer and hence loses money);
  
• Short wage inflation (if final salaries increase, so do pensions);
  
• Short CPI inflation (if inflation increases, so do index-linked pensions);
  
• Long nominal rates (because future liabilities are discounted back to today along some interest rate curve).
  

The risk is then that the spread assets - liabilities goes negative. In a DB scheme then the employer has to top up a fund if this spread falls beneath some threshold value, and hence they are short an option on the spread. In a defined contribution ('DC') scheme the pensioner bears all the risk and hence they are short this complicated spread cap: if their funds don't meet their pension expectations, then they have to find the cash for their retirement from somewhere else.

The details of the cap in any particular situation of course depend on how funds are invested, but typically it will have some elements of equity risk, interest rate risk, corporate credit spread risk, and both wage and CPI inflation risk, together with the risk of the comovement of these factors (which you can simplistically think of as correlation risk). Given it is a very long dated instrument - perhaps as much as ninety years for someone entering the workforce now - and very complicated, it is hardly a surprise that it is difficult to know what it is worth.

Note in particular that because we have a long-dated problem, the details of the dynamics of each component of the spread are crucial. It might be reasonable to assume that some of them, such as corporate credit spreads, are mean reverting. This makes the problem easier. For others, notably inflation and equity returns, there seems no reason at all to assume long term mean reversion. This means there is an awful lot of model risk in pensions analysis.

Some dimensions of pensions risk can be minimised: for instance if the scheme holds inflation linked gilts then it can hedged inflation risk and bears no equity risk. However it still have longevity risk, and (absent a liquid longevity swap market anyway) contingent inflation risk (since if longevity increases the fund is mismatched on the duration of its assets vs. its liabilities and hence has inflation term structure risk). Moreover, of course, a low risk pension fund has to be much more comprehensively funded than one that is taking market risk in multiple dimensions (equities, corporate credit, property, alternative investments, ...) Finally note that longevity risk is remarked considerably less often than other risk components so it is less visible - but that does not mean that it is not there.

The key policy question, then, in pension is who should bear the risk of underfunding, i.e. who should write the spread cap. Recently, there has been a suggestion that rather than one party bearing all of the risk as in current DB and DC schemes, perhaps it should be shared between employers, employees, perhaps with a far out of the money state backstop*. (See here for a further discussion.)

This is certainly a policy option that could be considered. Pensions policy is bedeviled by a failure to address risk issues openly, not least because most pensioners do not want to face the harsh reality that either a pension has significant risk or it is extremely costly to fund. Education is needed to address this point. Once we are ready for the debate, though, I would suggest there is room for a creative sharing of risk. There are no easy options here, not least because of the considerable uncertainty in estimating the size of the risk. But the problem is hard enough without artificially restricting the domain of possible solutions.

*One issue not addressed here is the use of DC schemes to reduce employer contributions. DC does not imply lesser employer contributions and legislation could (and probably should) stop employers using DC as a way of reducing their funding obligations.

Mr. Bean as the Fat Controller

The key question with any private sector involvement in public projects is whether the extra return shareholders rightly demand is compensated by increases in efficiency. Often the answer to that is no, which is why PFI makes so little sense - especially when you remember that there is rather little risk transfer to the private sector in many PFI projects. The latest rail debacle over the west coast main line is certainly evidence that the current mess of operating companies, National Rail, and private infrastructure contractors makes no sense -- our rail policy is fatally flawed. Let's renationalise the lot before our railway turns into a historical relic.

Actuaries confirm inductive hypothesis shock

Here's what an actuary used to do.

Look at the markets. Assume the future will continue to be like the average of the past. Take massive amounts of hugely long dated risk on that basis.

Unsurprisingly that strategy didn't work that well which is why we have a pensions crisis (as I discussed earlier: see here or here). The latest in this slow motion train wreck is that UK life insurers have finally woken up to the continuing improvements in longevity and are now shoring up their reserves, again, to account for this.

Over the past hundred years, life expectancy in the UK has increased by four months every 10 years. Now all we need is for insurers to start to appreciate that they are not just short longevity but they are also short longevity vol...

SNAFU

In the financial markets there is nothing really new. Some vaguely good news:

• The ABCP market has expanded a little, for the first time since August 2007;
  
• The 3m swap spread has come in a little; and
  
• Despite all the talk, a major monoline has not yet defaulted or even lost its AAA.
  

Meanwhile the realignment is continuing:

• The VIX is up;
  
• Shares are broadly down although they are still bizarrely high compared with bond spreads;
  
• Corporate defaults are expected to rise according to Citi and JPM and the iTraxx is a little wider;
  
• The rerating and downgrading of CDO tranches continues; and
  
• The tightening of the ABX over Christmas was temporary.
  

How muni insurance works

There is a very nice article on Accrued Interest summarising the muni market. It helpfully discusses who the muni issuers are, the difference between general obligations and revenue bonds, muni default rates, and the role of the monolines in wrapping muni bonds. What we need next would be a summary of the tax games in muni land...

Procyclical leverage

In an important and useful paper, Liquidity, Monetary Policy and Financial Cycles, Tobias Adrian and Hyun Song Shin discuss the phenomenon of procyclical leverage. The argument goes roughly like this:

Consider an increase in the price of financial assets. That strengthens the balance sheets of banks and hedge funds holding those assets, i.e. the total net worth of hedge funds and banks increases as a proportion of their total assets. When balance sheets become stronger, leverage falls. Therefore to maintain or increase leverage they must respond to rising asset prices by borrowing more.

(I've summarised but the broad thrust of the author's argument is there.) Note too that rising asset prices tend to occur with low or falling volatility so VAR-based capital models will show low risk and hence encourage further leveraging up.

The next bit is obvious:

If we further hypothesize that greater demand for the asset tends to put upward pressure on its price, then there is the potential for a feedback effect in which stronger balance sheets feed greater demand for the asset, which in turn raises the asset's price and lead to stronger balance sheets, causing further buying, leverage, and price rises.

Of course

The mechanism works exactly in reverse in downturns.

The possibility of this phenomenon has been noted before in theory (see for instance my discussion here or here), but Adrian and Shin present compelling evidence that procyclical (balance sheet) leverage is a historical reality. This is shown for instance in the chart above which illustrates the close relationship between asset growth and liability growth for U.S. broker/dealers.

2008 will be a year of deleverage, balance sheet repair, capital raising, and price rediscovery. That's if things go well and institutions can find enough liquidity to finance themselves during this process. Meanwhile the quick, bold and cash rich will find good opportunities among oversold assets. Just don't go in the water too early: it will be cold out there for a while.

You have jingle mail

Anyone who is even thinking about owning U.S. RMBS, or ABS backed in part by RMBS, needs to understand in detail how the underlying mortgages can not pay. In particular, in some U.S. states, mortgagees can simply mail the keys back to the mortgage lender - a practice sometimes known as jingle mail - and walk away without personal bankruptcy. In times of failing house prices, like, err, now, that gives rise to perverse incentives. Consider the following post on brokeroutpost (a site for american mortgage brokers) picked up by Calculated Risk (with the punctuation and spelling mildly edited):

I got an agreement of sale today from a realtor looking for a prequal on a shortsale, the buyer lives next door, he has a current mortgage for $800,000 on a home he purchased in 2005 with no money down, the home he has under contact is right across the street from his present home, the offer is for $500,000 and it looks like the bank will accept it.

The borrower plans to buy it as a primary, once he moves in, they will stop making payments on the $800,000 loan that they have with CW. He qualifies full doc and has a 770 FICO, he figures letting his credit tank is not a big deal when he is lowering his mortgage debt by $300,000 .

I told him the new bank may deny the deal based on occupancy, tried to convince him to go NOO but he does not want the higher rate.

Let's pick this apart. Someone has a house with a 100% mortgage of $800K. The house is worth less. He can move over the road into a $500K (current price) house, and he has a good credit score so he will get a mortgage for the new house. Then he will agree a sale of his current property to the mortgage lender for much less than the loan amount and accept the impact it has on his credit rating.

(A short sale is an arrangement between the current owner of a home and the bank that lent them the money to buy their home to accept an offer for less than the total amount owed to pay off the home. Presumably here the bank would rather get a certain recovery than have the keys in the post and have the uncertainty of what they might be able to realise for the property in due course.)

The comments on this post are fascinating. Firstly it seems that no one, yet, has managed to show that this is actually illegal.

As far as breaking a law, I wish someone would say how, because everyone I have quizzed, replies with a blank stare.

Some people even think it is part of the game:

In my opinion, a mortgage is a contract which allows both parties to walk away from their deal if they don't like what is going on. If the borrower doesn't like the agreement they are in, it is their right walk away. When they do however, the bank has the right to get their collateral. It's just how it is.

It gets better: even knowing the story, some people like the risk.

I will do this loan for .25% less than his best quote.

[...]

I see no reason to walk away from the deal, his present mortgage is not my concern.

And it appears that you can even minimise the impact on your credit rating:

He would not damage his credit if he does it right. He could move into the house across the street and then short sale the house that he owes the larger amount.

Now I don't know how much of this to believe, and I should point out these people are if not estate agents, then pretty close, so I would take a couple of kilos of salt along for the meeting. But still. From the perspective of a security holder supported by the original loan, we appear to see:

• The collateral value is less than the amount we have lent;
  
• There may well be people willing to finance an alternative loan to someone they know is about to default on their previous obligation;
  
• Worst of all, the original lender is going to agree to a loss of principal, perhaps because a bird in the hand is worth two in the bush, but more likely because their foreclosure group is so busy any recovery is worth something given the number of houses they are trying to sell. Which is all very well if it is their loss - but it might well be the ABS holders.
  

Did ABS holders really understand this kind of thing could happen when they bought the securities?