Burying Basel

It is far too early to pronounce the bloated body of Basel 2 dead, but at least the patient is ailing. In the FT Harald Benink and George Kaufman have some suggestions:

First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.

That's a good idea, but remember that Basel 2 is not based on bank's internal models. It is based on bank's ratings, which then go into the supervisor's formula. It is the supervisors who are at fault for any capital underestimate, not the banks.

Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements.

There is a (tiny) constraint already in Basel 2, in that PDs have a 0.03% floor. But the suggestion is a good one - a crude leverage ceiling would act as an additional control.

Third, we recommend that the Basel II approach using banks' own risk models should be complemented by a credible and effective form of market discipline.

I remain unconvinced that this will help much. It can't hurt, but I'm afraid that greed will outweigh fear most of the time despite the reasons to be scared that might be known.

Let me add in a few more ideas.

Fix the procyclicality of Basel 2. A risk sensitive Accord is necessarily procyclical. There is no way around this. And procyclicality is likely to intensify the depth and intensity of asset price bubbles and recessions. Basel 2 is based on one year PDs. Instead it should be based on across the cycle PDs.

Fix the incentive for less advanced banks to take the worst risks. The menu of approaches in Basel 2 makes it more expensive for advanced banks to take high PD exposures vs. standardised approach banks. Unlike VAR, which gives a reduction in capital for pretty much any market risk portfolio, the IRB is only cheaper than the standardised approach for better quality assets. This creates a perverse incentive which should be addressed.

Fix the IRB formulae. The correlation assumptions are just wrong, as is the assumption of constant default correlation. Based on the suggested QIS, they should be rewritten with much more conservative default correlation assumptions.

Cap the benefit for getting assets off balance sheet either via securitisation or into a conduit. This preserves alignment of interest and again acts as a cap on leverage.

Fannie, Freddie and other friends

Goodness, let's take one entity which has just recorded a whole year loss of $2.1B, add in another to get to a total of $11.3B of accounting errors, and then let them take more risk in a rapidly falling market backstopped by the tax payer. Winning idea. What could possibly go wrong?

Idea of the day: consider a short in Gold

I'd like to see this in Euros, but at least in terms of the depreciating dollar, gold seems strikingly overbought. Any recovery, even a dead cat bounce, is likely to be negative for gold.

Corporate bonds are good value...

...according to Deutsche Bank:

Euro investment-grade company bonds are pricing in defaults 15 to 20 times worse than the average since 1970, and six times the worst on record in that period, Deutsche Bank said, due to the turmoil in the structured credit market.

The sharp widening in spreads has come even though actual defaults on investment-grade bonds are extremely rare events, and even the global high-yield default rate remains close to historic lows.

The average five-year default rate for euro investment-grade bonds is just 0.8 percent, with the worst on record 2.4 percent, while current spreads are pricing in a rate of 15 percent, Deutsche Bank said in a note.

Buy bonds then. If you can fund them.

S&P confirms FANT.W at AAA

Yes, S&P's fantasy world where the bond insurers are AAA is developing nicely. Bloomberg reports:

MBIA Inc., battling to stave off the crippling loss of its AAA credit rating, soared in New York Stock Exchange trading after Standard & Poor's said no downgrade of the bond insurer is imminent.

The insurer remains on negative outlook, meaning that any ratings move may be lower, though not any time soon, New York- based S&P said today in a statement. Ambac Financial Group Inc., which ranks second to MBIA among bond insurers, is still being reviewed for a possible downgrade pending the company's ability to raise new capital, S&P said.

This must be so frustrating for Bill Ackman. He's basically right, but the world keeps on being irrational. And this, of course, takes the pressure off Moody's to do anything about MBIA either.

Is Fair Value Fair?

John Dizard continues the battering of mark to market in the FT:

Many now believe that like the fictional nuclear Doomsday machine, the unbending application of mark to market rules is not, in the end, a sane way to manage the world.

Here’s the problem: the mark-to-market rules assumed there would always be someone willing to buy or sell an asset at a price that bore some relation to the economic value it represented.

Well, no. Or at least, not really. The accounting principal after all is only known colloquially as 'mark to market'. The formal name is 'fair value', and fair value can be applied to assets with no market, as in FAS 157's level 3. Marking to a proxy has a long and honourable history which goes back much further than the current crisis. Anyone who has ever had a very large position or a highly structured position has probably marked to a proxy somehow or other (remember normal market size trades are a proxy for larger positions, and not necessarily a good one at that).

What would happen if we did not do that, that is if we went back to accrual? Then investors in banks would have no clue about the value of the assets on bank's balance sheets, and they would instead have to trust to something even more subjective - loan loss provisions.

Now of course fair values can change without there being a material change in the likelihood of an asset failing to pay: changes in liquidity premiums, in the cost of financing the position, and in the volatility of the position can all do that. But those changes are important information for the users of financial statements.

Dizard continues:

Right now, though, the problem is that the capital bases of the major banks and dealers are being reduced by losses on the mark-to-market value of securities faster than they can raise new money. That means that because nobody wants to buy a lot of the structured credit products, credit made available by the entire system could contract. That would lead to more losses, and a further contraction of credit.

We call that a depression. Yes, eventually you get to a level of prices where transactions will “clear”, because some people will have enough gold or soyabeans or yuan to buy the distressed assets.

And we need to know where that level is. If we intervene before it is reached, there will be an enormous loss of confidence. Rather than being in the situation of knowing the worst is over, we will instead wonder whether it is, leading to, yes, further falls in asset prices.

A rather odd bit comes later:

Furthermore, as one board member of a very large dealer told me: “Aside from the shrinking capital (from mark to market losses), you are getting more and more assets being put in the illiquid “bucket” [by the accountants]. Those illiquid assets require a bigger capital charge, so you are getting a double whammy.”

What? What capital requirement, exactly, causes this double whammy? I'd love to know. It's nothing in Basel 2, that is for sure, but the SEC website isn't that easy to search. The closest I can find is:

The requirements of paragraph (a)(7), as revised, are intended to help ensure that a broker-dealer maintains prudent amounts of liquid assets against various risks that it assumes and that it maintain a robust internal risk management system.

But I can't track down the full text of the illusive 15c3(1)(a)(7) or any of its relatives.

Dizard gets very interesting next:

Also, it has been suggested by some dealers, whose capital bases are getting too stretched to adequately maintain market liquidity, that they be given access to the Federal Reserve’s discount window and the generous Term Auction Facility. That would provide enough extra liquidity to keep more securities from being dumped into the capital-eating illiquid valuation “buckets”. This idea is likely to be taken seriously by the authorities.

Yep. The banks have become addicted pretty quickly to the crack cocaine of the TAF, aka 'post what you like and we will give you money'. The broker/dealers want some of that happy powder. Ignoring for a second the question of why being able to repo something with the FED makes it liquid, this might even be the right short term policy response. Keep fair values for the assets, but provide funding for them. The difficulty will be weaning the banks and the dealers off this cheap liquidity.

What's Broken?

The conventional explanation for the decline in the ABCP market is that structured finance is on the slide, perhaps for good. There is another reading, though. It could be that the structured finance isn't dead - after all Morgan Stanley got a CMBS deal done recently - it could be that maturity transformation is dead. Northern Crock didn't fail because of structured finance, it failed because of funding. Of course the reality is not so clear-cut, but if there is even a grain of truth in this musing, securitisations with little or no liquidity risk and well understood collateral will continue to be executed even as other parts of the structured finance market fail.

Mitigating Moral Hazard

Willem Buiter has a typically intelligent post on Northern Rock. He ends, as one might expect, with a discussion of moral hazard:

Future Northern Rocks will be encouraged to fund themselves recklessly and to lend and invest recklessly. Their creditors are after all the beneficiaries of a free government guarantee. If their bets come off, management, super-employees shareholders and creditors benefit. If they fail, the shareholders may still lose (I hope), but taxpayer picks up the tab for the rest.

At first sight, this seems reasonable. But there are things that can be done to mitigate this moral hazard.

• We need a new insolvency regime for banks, which allows regulators to intervene at an early stage [and obviously includes intervention due to liquidity as well as solvency]. It should ensure that equity holders only get something once everyone else, including the lender of last resort, has been paid back at market rates. This mitigates moral hazard for equity holders as they do not benefit from the rescue. In order to get this right we may need to reduce some of the statutory rights of equity holders, so perhaps we will end up with a new instrument, bank stock, which grants the holder less control than ordinary equity.
  
• Revisions to compensation practices should ensure that employees, particularly senior employees, are paid in shares that lock up for an extended period. This combined with the above encourages employees to avoid the need for a rescue.
  
• Enforced liquidity ratios are needed to limit the amount of debt the bank has compared with deposit funding. That means that although debt holders benefit from government intervention, there at least aren't too many of them. Obviously this regime should apply to off balance sheet liabilities too, including derivatives contracts in the trading book.
  
• There is little moral hazard with retail depos as most of them are government guaranteed anyway. We could force banks to buy insurance against interbank and commercial deposits too if need be.

I am not necessarily suggesting all of the above is a good idea. But it does make it clear that moral hazard can be mitigated if you are willing to make enough changes.

Equity/Credit: Who's Right?

Naked Capitalism has a thought provoking article on the current disconnection between the equity markets and the credit markets, which in turn refers to FT articles by John Authers and John Dizard. Authers describes the issue:

If you believe the credit market, things have worsened sharply in the past few weeks. With spreads widening significantly, recession is a certainty in the US and Europe.

If you believe the equity market, there are grounds for optimism. Stocks are still above the low they hit in January, before the Federal Reserve made its emergency rate cut – betting that this huge monetary stimulus would ensure that any recession is shallow.

[...]

But in the past few weeks, as credit spreads have widened, the shares of those companies the credit market sees as most risky have rallied, and outperformed the rest of the market. Equity investors are making a bet that the credit market has got it wrong.

The credit market may be at levels that cannot be justified by the fundamental outlook for defaults: its investors have difficulty raising liquidity; many need to clean their balance sheets; there are unprecedented worries over various structured credit products, many of which did not exist during the last downturn in the credit cycle; and the problems of the monoline bond insurers create further uncertainty.

One has to sympathise with this last: we are in a situation at the moment where most of many instruments credit spread is compensation for factors other than default, prominent amongst them the cost of financing the position, the possible future volatility of the position, and the liquidity risk of the position.

This leaves some serious issues with equity/credit (aka capital structure arbitrage) models though. The vast majority of these models are based on the assumption that the credit spread is (risk neutral) compensation for the probability of default, and that equity is (some kind of) option on the value of a company struck at the face value of the liabilities. Given these assumptions and a few more besides, a connection between equity prices and credit spreads is established. But if there is a systematic component to credit spreads which varies strongly with time then most of these models are some trouble. And certainly their predictions earlier in the year wouldn't have ensured career success. As Dizard puts it:

Let's say you decided at the beginning of the year, with what was left of your limited partners' capital, to bet that the price of risk in both markets will converge. So, you go short a basket of stocks of investment grade companies, and simultaneously buy the CDX.IG, the index of investment grade credits. However, since, historically, stocks in the form of the S&P 500 are seven times as volatile as the CDX.IG, you levered up the CDX at the multiple required to have a hedged position. Unfortunately for you, in the first week of February, the CDX moved (down) one fourth, not one seventh, as much as equity, as dealers stopped providing liquidity. So your position just died and went to money heaven.

Leaving aside Dizard's hedge ratio calculation - which is far too naive - he is basically right. And remember you need models like these for a range of wacky convertibles, too, so this is not just a matter of interest to the CSA funds. If nothing else this little market episode will result in some improvements to equity/credit models.

Update. There is further comment from the FT, based on a report by Goldman, here. Some of the examples given here are fascinating:

In the first three weeks of February, the shares of Swedish truckmaker Scania rose 11 per cent. But the spread on its credit default swaps (CDSs) rose 60 per cent... Over the period, spreads on the 155 names in the iTraxx main index of European investment-grade companies widened 55 per cent on average. The figure for 103 names not on the index – including, for instance, Scania – was 41 per cent.

I am not brave enough to opine for certain which market is right. But it is clear that one of them is wrong. And if it is the equity market, there is a lot more pain to come.

Behind the pack

One of the major motivations for this blog was to understand how the rules of a given game determine the results, and how participants can better prepare themselves for adverse outcomes by understanding the class of behaviours the rules encourage. Subprime for instance was fundamentally caused by mis-aligned incentive structures.

A good example of a total failure to understand the rules comes from Porsche. They are threatening a legal challenge to London mayor Ken Livingstone's plans to demand a £25 congestion charge from drivers of high powered sports cars and 4x4s entering the capital. The congestion charge has been a huge success. Global warming is a major political issue which is not going away. If there is one thing Porsche could do to appear regressive and the choice of the selfish bore, suing Ken could well top the list. It looks to me like a PR gaffe equivalent to Ratner's 'total crap'.

If you want a fast car which won't make you appear egotistical, self-serving and totally without regard for others, perhaps you could try a Ferrari.

Or a Jag, as in this gorgeous, pre-Ford period XJ220:

Or even (if you must, given how terrible the suspension is as well as how polluting they are) a vintage Corvette:

Just don't buy a Porsche.

Update. Strangely enough, Matthew Lynn who I always thought of as a triffle reactionary, agrees with me.

Three balls in Frankfurt and New York: a Decade of Deflation?

The FT has a story reminding us that the FED is currently playing a game of 'go on, I'll trust you, how much do you want for that?' that would shame a small town pawn shop.

The use of the Fed’s Term Auction Facility, which allows banks to borrow at relatively attractive rates against a wider range of their assets than previously permitted, saw borrowing of nearly $50bn of one-month funds from the Fed by mid-February.

The ECB has similar tactics:

Eurozone banks increased sharply their use of mortgage-backed debt and similar structured bonds last year in order to raise money from the European Central Bank, helping to avoid liquidity problems in financial markets.

The volume of asset-backed securities pledged as collateral in ECB market operations to provide funding to banks reached €215bn ($315bn) by the end of last September, the bank said in data released on Thursday.

It is worth remembering that this massive liquifaction of the banking system was one of the key features of Japanese economic policy during the decade of deflation. The central banks are playing a very dangerous game here and it cannot last for many more months without addicting the banks to cheap funds and very low liquidity premiums - an addiction the Japanese example shows is very difficult to recover from.

Update.Credit slips has an interesting if perhaps overly bearish macroeconomic perspective on the potential for an extended period of deflation.

Credit Suisse: "Repricing of certain asset-backed positions"

With the markets in structured finance plummeting, there is clearly an incentive to polish up valuations for inventory positions. It appears as if some traders have given in to temptation at Credit Suisse. A press release today reveals an overestimate of inventory value amounting to $2.85B and the BBC reports that structured credit traders in London have been suspended.

What is interesting about this is how completely predictable it is. With the current market illiquidity, it is very difficult to price some structured credit products. At best you are marking many of them as a spread to some proxy such as the ABX or TABX. Clearly for CS to be confident that the positions are mismarked, they can't be just in the margin of error: they must be well outside it. Which given the size of the margin at the moment, means that it might well have been fairly egregious...

Update. The WSJ's take on the difficulty of marking to market in the current conditions is here.

Alignment of interests

I am probably boring about alignment of interests - because I think it is so important. Without it, trading requires a lot of due diligence and you are always unsure if you have missed something. With it, you can have more confidence that your counterparty is not intentionally trying to screw you - the possibility that they are unintentionally screwing you of course remains.

Today the FT points out securitised loans are more likely to default than ones the banks underwrote for their own books:

Defaults on US subprime loans that have been repackaged and sold to non-bank investors have been 20 per cent higher than those kept on the books of lenders in the traditional manner, the study found.

This is completely unsurprising. Psychologically it is very hard to take the same care with something that you know is ending up on someone else's balance sheet as with something that will be yours. Especially if your non-interest income relies on servicing fees. Fixing this isn't hard - simply limit the benefit available from securitisation, requiring banks to keep some of the risk - but it is necessary.

Never mind the quality, feel the fees

Oh to be a litigator today. There are so many delicious cases to sate yourself on. Should you take on one of the 'significant legal challenges which will hold up the resolution of the monoline issues for years'? Sue the State of New York perhaps, or something in Wisconsin? Or maybe you want to represent CPDO investors in a suit against the banks who ran them, the ratings agencies who rated them, or both? With the current deleveraging, these cases may well be filed soon. Or perhaps you fancy having a go at Citigroup over their suspension of hedge fund redemptions? Then of course there are the hedge funds who own significant positions in Northern Rock. And that's just one day's news.

Update. A nice take on subprime-related litigation is here.

Not too hard, Darling

Good grief, Alistair, there was no need to react that way. One minute I'm calling him a wimp and the next he's nationalised a bank. That, to be fair, does show backbone, and is probably the best thing for the public purse. Certainly if the Virgin and management bids did not offer value to the senior creditors, notably the Bank of England, Darling was right to nationalise the bank. Undoubtedly there will be lawsuits from shareholders who are still under the (mistaken) impression that the stock has any value, and there may well be a judicial review of the tripartite authorities' actions, which could provide further embarrassment to FSA. But for the moment Darling has done the best thing he could to stem the flow of public funds into the rock. Further coverage from the FT is here and Darling's statement is here. The crock is dead: long live the crock.

Update. It appears that the government is going to let an independent assessor decide what shareholders in the Crock are going to get. How about this for a way of making the assessment: shareholders can either take max(0,PV(current assets) - PV(current liabilities)) [which is probably zero], or they can hang on to their shares until the son of the Crock is floated in two, three, four or whatever years time. Anything more than that is simply a taxpayer subsidy to the hedge funds. As Martin Wolf says

Shareholders live and die by the judgment of the market. In this case, they have died. That is what “risk capital” means.

Certainly fair vs. possibly damaged

Alistair Darling almost did a sensible thing, then he lost his nerve. The UK's current treatment of non-dom taxation is embarrassingly regressive and can hardly assist the fight against money laundering. More than that, though, it is simply unjust. People living and working in England should pay for the facilities and services they enjoy. For them to be essentially exempt from tax is certainly unfair. The other side of the argument is that if they were taxed, some of them might leave. But so far all we have is threats and the usual partisan lobbying from the likes of the CBI. Neither Alistair Darling no anyone else knows who would leave or what the impact of their departure would be (although Willem Buiter has a guess). Yet in the face of nothing more than some predictable finger wagging, Darling has given in. Where can I vote for a politician with some guts please? Or at least one who gets some stronger evidence than hearsay before making a decision.

Monoline pot pourri

It's a make your own posting for the weekend: just a few random facts which you can cook up, or not, as you see fit.

• FGIC wants to be split into two, leaving a muni insurer and the rest, primarily structured finance (of which much is U.S. RMBS, prime and subprime).
  
• There is no word as yet as to how they will work out how much capital goes to each piece, nor how the evident contractual law implications of this will be worked out.
  
• Ambac is domiciled in the state of Wisconsin. Insurance regulation is a state by state matter and so Dinallo has no authority there. The man who does, Sean Dilweg, is keeping quiet.
  
• Moody's downgrade of FGIC was Moody's from Aaa to A3, six notches. That's quite a big fall.
  
• The text of MBIA's response to Ackman's 'Dear Regulator' letter is here. Note in particular pace my earlier post about the structure of the contracts written, our reserves are based on reasonable estimates of probable losses, in accordance with the guidance [in FAS 5], i.e. insurance accounting.
  
• The text of Dinallo's testimony is here. Am I alone is detecting a note of self criticism in:

  “The primary goal of insurance regulation with respect to financial oversight is to ensure that the insurer maintains an adequate level of solvency and is able to honour policyholders’ claims. The business model for the financial guaranty insurance companies, however, requires that they hold levels of capital that will allow them to maintain the AAA rating necessary to write new business.
  
  “It has become clear that the loss of the AAA rating essentially cripples the company’s ability to do business as a going concern and puts the insurer in a “run-off’ mode. We now are considering whether the sustainability of the business model should be the regulatory standard going forward. While we of course consider claims paying ability as the benchmark, our goal for the future, for all insurers, is to do higher level risk-based examinations.

• Eliot Spitzer's position -- that reverberations from the crisis facing the bond insurers could cause "substantial damage" to the US economy -- certainly seems reasonable considering the write offs at UBS. And on Friday Citi estimated that there are another $18B to come. More generally bank default swap spreads have gone out in response to the monoline break up plan.
  
• On the bright side, though, there is at least a credible new ratings system proposal here.
  

What form of structured finance protection have the monolines written?

This is a valid question as we go into any restructuring of the bond insurers, and the answer is more complicated than it appears at first sight. Here are some of the issues.

Many corporate bonds pay interest and final principal - you get coupons for some period, then a return of principal.

A standard CDS on a corporate bond uses a notion of credit event which typically includes default, failure to pay and bankruptcy. If the bond displays a credit event, then the CDS protection buyer stops paying the premium on the CDS and has the right to receive recompense in a short period, perhaps 3 or 5 days. This recompense is either through the right to deliver a bond and receive par (physical settlement) or through the right to receive an estimate of par minus recovery as a cash payment (cash settlement). Some key features include rapid payment, the ability to go short - by purchasing cash settled CDS without owning the bond - and the derivatives (i.e. mark to market) nature of the instrument. Note too that the premium is risky in a standard CDS: if default happens, you stop paying it.

There are insurance policies which behave much like CDS. These are part of a wider class of insurance known as financial guarantee policies. The difference here is that they are legally insurance (and hence have a different legal, accounting, regulatory and tax framework). In particular this is not a mark to market instrument, and in most jurisdictions you have to be an insurance company to write insurance. Note also that insurance typically requires an insurable interest - I cannot profit from buying fire insurance on your house even if it burns down - so if you purchase a financial guarantee policy directly it might not allow you to go short.

The fact that there are two instruments, CDS and financial guarantee policies, which can act much the same way yet have very different accounting should be a matter of shame to the FASB and the IASC.

Another possibility for obtaining protection is a bond wrap. Bond wraps are part of a wider class of insurance policies known as financial guarantee policies. In a bond wrap the policy runs to maturity of the bond, you have to keep paying premium until that date (so the premium is not risky), and the policy writer agrees to make good the scheduled cashflows of the bond should the original bond issuer suffer a credit event. Thus here you get paid on the original schedule, and if there is a credit event you substitute the risk of the issuer for that of the policy writer. Most of the muni policies the monolines have written are in this form. The advantage from their perspective are not only insurance accounting, but also lack of cashflow stress: unlike a CDS you typically have plenty of time to find the cash to make the principal repayment.

With amortising securities the issues become more complex since there is the possibility of a principal and interest payment at each coupon date. You can write standard CDS on amortising securities, but it is also possible to write a pay as you go CDS. This imports bond wrap technology into derivatives, and gives the protection holder the right to demand payments on the original schedule from the CDS writer.

For corporate bonds, amortising or not, matters are fairly straightforward since the failure to receive any cashflow (or at least a material one) is an event of default. For ABS you might not want that feature though: in a typical credit card deal, for instance, there will be a certain level of delinquencies which all parties expect, and if you have a credit event which triggers cash settlement based on default, then many junior ABS would suffer that event in the first month. Moreover in many ABS the collateral prepays, so you do not know when you will get your principal back. This means that to define a CDS or financial guarantee you need to tease out the cashflows each security should get in a given month given the level of prepayments, see what cashflow it actually gets, and define protection based on the difference.

Matters get even more difficult when you have amortising collateral in a CDO but some of the tranches have bullet maturities. Remember too that in some cases the CDO issuance SPV can be technically unable to pay without the CDO collateral having lost value: this can happen in particular due to liquidity risk. Figuring out exactly who pays whom what when something bad happens in a CDO of ABS is sufficiently complex that standard documentation has not been available until recently. Most transactions historically used bespoke documentation, and figuring out exactly which risks were transferred was not a trivial business.

Finally, note that the legal final maturity of ABS is often well beyond the last cashflow date. For a mortgage deal, for instance, it might be 35 years. So a contract which only gives you the right to claim ultimate principal at legal final maturity is like buying protection on a long dated zero coupon bond.

My guess is that most but not all of the monoline's structured finance business involved taking middle or upper tranche ABS and writing pay as you go style protection on it in the form of a financial guarantee. This has considerable accounting advantages over writing standard bullet CDS, as well as the advantages the monolines enjoy as a result of insurance rather than banking capital. Finally it means that the monolines have relatively little immediate cashflow stress even though their structured finance portfolio would be, on a mark to market basis, highly underwater. None of that means that there is no problem with their business -- just that if this is going to be a train wreck, it will be a slow motion one.

In any event we do need to know the answer to this question as it determines the capital needs. If they have written CDS with collateral agreements then the monolines need enough capital to support the mark to market volatility of the trades. If they have just written insurance then they only need enough to support the ultimate realised losses on the portfolio. Those numbers are very different (and it impacts how right Bill Ackman is).

Some people have suggested that one of the villains of the current crisis is mark to market. I don't agree: mark to market gives one view of the value of a portfolio; insurance accounting another. But certainly having a portfolio of similar risks subject to wildly differing accounting principles in the same legal entity is unhelpful.

Your crunch update

Courtesy of Markit.

The ABX AAAs (scale in cents on the dollar so falling is bad).

The CMBX AAAs (scale in bps spread so rising is bad).

And the CDX North America Investment grade corporate credit index (both):

In the words of the Klaxons, It's Not Over Yet. In fact, it looks as if it is only just getting going.

Let No Man Rent Asunder

Eric Dinallo, New York’s insurance superintendent, testified today at a hearing of the House Financial Services subcommittee. Both the FT and Bloomberg report various parts of his evidence. The FT first:

[Dinallo] said on Thursday that a government bail-out of troubled bond insurers ”is not planned”. [...]

Mr Dinallo, told lawmakers that finding a solution to allow Ambac, MBIA and others to maintain triple-A credit ratings on which their guarantee business depends was an ”extraordinarily difficult problem”.

Certainly he wins marks for honesty on the latter point. But according to Bloomberg matters got more interesting:

New York regulators may consider splitting bond insurance companies into two businesses to protect municipal debt from losses on subprime mortgage securities.

How could this possibly work? It does not suffice simply to split the liabilities: you have to split the assets too. Presumably any split would have to be equitable to equity holders (and to senior debt holders), so equity would have to be split pari passu with risk. But estimating the economic capital required for a large monoline is about as difficult a problem as we have in financial modeling at the moment, especially given that the muni business diversifies the structured finance business so the standalone capital requirements of the two pieces are more than those of the original whole. Moreover does Dinallo really have the power to do this if shareholders are hostile?

Update. Eliot Spitzer has upped the anti. According to the FT, he has given the bond insurers three to five business days to find fresh capital, or face a potential break-up by state regulators who want to safeguard the municipal bond markets. Oh, and Moody's has downgraded FGIC. So no pressure then. At least we can watch the auction market fall apart while we wait. And join Paul Krugman in speculating on what's next.

Warren has form...

The offer from Berkshire Hathaway to take the monolines' stable profitable business - muni wraps - and leave the unstable loss-making part - structured finance - reminds me of LTCM. It is a little discussed part of the LTCM saga that Buffett made an offer to acquire the assets (but not of course the liabilities) of LTCM just before the 11 bank FED-sponsored bail out that eventually rescued the fund. (More details of the LTCM farrago are here and here while Naked Capitalism has more on Warren's offer to the monolines here.) Then as now the question is why on earth anyone would accept the Buffett proposal.

For the monolines it does not seem as if Dinallo can force them to, and provided they can carry on paying claims, they can operate at least in semi run off for some years. Who knows, the CDO market might even have recovered by then. Even after a downgrade I do not see what would persuade the monolines to do a cash negative deal such as Buffett is offering: they would just bleed to death faster. Which does rather beg the question as to why he proposed something that they are palpably so far from being able to accept.

Central bank policy: who wins?

A few days ago, I mentioned in passing the idea that there is an experiment going on at the moment with central banks policy: it seems unlikely that the FED, the ECB and the Bank of England are all right in their reactions to the crunch. Larry Elliott focussed on the rates part of the puzzle, weighing up the pros and cons of the different levels of rates in USD, EUR and GBP versus the inflationary environment.

The other part of this puzzle is collateral, or more precisely what collateral is eligible at the window. Here too policy differs: the ECB for instance is remarkably generous in the range of collateral it permits banks to post at the window. Indeed posting RMBS as collateral with the ECB is basically keeping the Spanish banking system afloat (i.e. liquid) at the moment. Similarly the collateral eligible at the FED's new TAF is rather widely defined, and the Bank of England perhaps belatedly has extended the range of admissible collateral recently.

As Willem Buiter points out, central banks have a duty to provide liquidity to the market in times of stress. He says furthermore (although the emphasis is mine):

There is no moral hazards as long as central banks provide the liquidity against properly priced collateral, which is in addition subject to the usual 'liquidity haircuts' on this fair valuation.

Right now I think it is reasonable to doubt if this collateral is properly priced. Certainly the idea that a bank can take a bunch of mortgages, package it up as RMBS, and repo it with the central bank without market scrutiny of any kind is bizarre. If this paper has never traded, why does the bank feel comfortable that it is worth par?

The wide range of eligible collateral and lack of scrutiny in valuation of that collateral has succeeded in liquifying the banking system. It was probably the right short term policy reaction. But as the situation improves central banks will need to wean the market off the crack cocaine of cheap liquidity with no questions asked about collateral value. How (if?) they do this may prove as significant as the path of rates for the final outcome.

Monetising default correlation

Reuters reports that default correlation on the investment-grade Markit iTraxx Europe index reached new highs of 45 percent on Tuesday. Suppose you believe that this was too high: what could you do?

The effect of increasing default correlation is to move value up in a CDO. So if you believe the market spreads of the assets are right - or if you have no view on them - you can still take a view on default correlation by trading different parts of a CDO. For instance in the iTraxx if you believe that the implied default correlation is too high, then that implies that the CDS spread available for writing protection on the supersenior is too high and the CDS spread on the junior is too low. So you buy protection on the junior, sell protection on the supersenior, and make money if the market comes to believe you are right. Alternatively you could buy protection on junior and hedge by selling protection on the individual names (although that is quite a lot of trading for the iTraxx).

With that preliminary you can see why implied default correlation - the level the market demands for trading the index - is so high. Market participants are long risk on the supersenior and are trying to get out. Hence the cost of protection on the supersenior has ballooned out and thus implied default correlation is high. This does not mean that the market necessarily believes that companies are more correlated (or riskier): it just means that there are more buyers than sellers of protection on the senior tranches right now.

Update. FT alphaville has more background and a pretty graph of fair value CDS spread by tranche as a function of correlation here.

When is an SPV yours?

Standard Chartered has withdrawn support from its SIV, Whistlejacket. It appears that like many SIVs, the value of Whistlejacket's assets has been falling fast. The contraction of the ABCP market meant that Whistlejacket had been unable to roll its short term funding. Standard had previously pledged to support Whistlejacket by writing it short term liquidity, effectively stepping in the place of the ABCP buyers. However it appears as if that liquidity line was contingent on the net asset value of the SIV being sufficiently big and, with falling markets, that test was no longer met. Hence any liquidity provided by Standard would not be contractually required - in Basel II terminology it would be implicit support. The consequences of taking Whistlejacket's assets on balance sheet by providing implicit support were presumably too much for Standard Chartered.

This brings us to a difficult question that both regulators and accountants need to answer. When is an SIV yours, i.e. when should it consolidate for regulatory and/or accounting purposes?

A few thoughts.

• Accounting consolidation should follow regulatory consolidation and vice versa. Whatever they do, the regulators and accounting standards folks should agree about when a securitisation is ineffective. If a SPV consolidates, there should be full regulatory capital on it. If it doesn't then some measure of regulatory capital relief should be available.
  
• The IAS (if not the FASB) consolidation rules are based on the ideas of control and benefit. Broadly the test for whether you consolidate a SPV require a test of who benefits from its activities and who controls it. The principles here are not bad, but I would suggest that they don't allow for the idea of contingent control - mostly I do not control the SPV, but if something bad happens (like the closure of the ABCP market) then I get it back. Perhaps in order to clarify the situation consolidation should be automatic if an issuer has a position in multiple positions in the capital structure (such as equity and a supersenior liquidity line). That would at least make the assessment of benefit and control easier.
  
• Regulators must accept that there are legitimate reasons for securitising assets and must provide a safe harbour for good structures. Failure to do this will not just damage the banks - it will damage the financial system.
  
• Regulatory capital relief should be contingent on alignment of interests. Whenever the seller of an asset has an incentive to conceal information from the buyer, and especially if the seller is also the servicer, then clearly trouble is possible.
  
• Regulatory capital relief should be based on the extent of the risk transferred. Overly penal rules which do not have this effect - such as Basel II - simply encourage regulatory arb transactions rather than genuine risk transfer. Despite a number of attempts the supervisors have not yet managed to write rules that do not permit capital arbitrage so there is no reason to believe they can get it right on the next attempt.
  
• If issuers are found to have provided implicit support they should be required to restate their regulatory capital, earnings and balance sheets for all periods when they took advantage of the sham securitisation, and to make public disclosure of this restatement.
  

I do believe that securitisation is a useful tool for the financial system. We are still learning how to use it appropriately. Now a concerted effort is needed to rewrite both regulatory and accounting rules to incentivise effective structures. Making consolidation harder to avoid or capital higher won't do that. It will just encourage another round of game playing which, when the next bubble bursts, will have even worse consequences.

Pap(er) from the Financial Stability Forum

The financial stability forum working group on the crash has produced an interim report. It is an insightful document as it gives some clues about the regulator's thinking (and lack thereof). I will focus on the suggested areas of action at the back of the document: the first part discusses the causes of the crash, and that is rather old ground.

1. Supervisory framework and oversight
Capital arrangements: A resilient framework for capital requirements is central to creating appropriate capital buffers in the system and the right incentives for risk management. The implementation of Basel II, and the use of its three reinforcing pillars, is an important step to achieve this.

I read that with a heavy heart. Basel II is fatally flawed, as a number of authors have demonstrated, and just pressing on with it is tantamount to fiddling with Rome burns.

The Basel Committee will take account of the lessons from recent events and assess whether refinements to the Basel II framework are needed, including with respect to the calibration of certain aspects of the securitisation framework.

It is not just the securitisation framework. It is the entire philosophy behind and calibration of the accord. Remember that residential mortgages were one of the bigger winners in Basel II. Remember that ratings are central. Remember the bizarre behaviour of the IRB formula. The supervisors need to start again.

The turmoil has demonstrated the need for larger and more robust liquidity buffers and an internationally shared view among supervisors on sound liquidity risk management guidelines.

How about capital for liquidity risk? Or if the regulators are not willing to go that far, they will at least have to say what they mean by an adequate liquidity buffer. How would you work out how much is enough?

Firms’ managements need to act proactively in response to stress test results.

This is the hardest thing for a supervisor - forcing firms to conduct stress tests is easy. Forcing them to respond to the results of them is much harder. How exactly are they going to require firms to act without taking over management's role?

Off-balance sheet activities: Basel II strengthens incentives in the financial system to manage risks appropriately and will reduce the regulatory arbitrage that generated large off-balance-sheet risk exposures.

Basel II just creates different regulatory arbitrages, at least as currently drafted. Putting a cap on the benefit from any securitisation would be easy first step towards removing those, but the suspicion is that the supervisors are mired in attempts to revise the already complex language of Basel II without seeing the bigger picture. Off balance sheet vehicles are fine provided they are genuinely off balance sheet and there is no implicit support. The problem is that supervisors currently have a set of rules which is penal with regard to genuine risk transfer and laughably generous with regard to sham transfer. Until they can figure out which is which any attempt to revise the rules is likely to damage perfectly reasonable trades.

2. Underpinnings of the originate-to-distribute model
The underpinnings of the OTD model – including origination and underwriting standards, transparency at each stage of the securitisation process, the role and uses of credit ratings – need to be strengthened. [...]

This paragraph is motherhood-and-apple-pie. Pious hope may be necessary, but so are concrete proposals.

3. The uses and role of credit ratings
Investors, many of whom have relied inappropriately on ratings in making investment decisions, must obtain the information needed to exercise due diligence.

Investment guidelines should recognise the uncertainty around ratings an differentiate products according to their risk characteristics.

Yes, but you don't regulate many of the investors, so while this is true it does not amount to a mug of beans.

CRAs must clarify and augment the information they provide to investors on structured finance products. They should ensure that uncertainties surrounding their models and rating methodologies are made transparent. We welcome that CRAs are considering differentiating ratings of such products from corporate ratings. [...]

That is a reasonable idea but it is hard to see how to standardise model risk disclosure. The concern will be that these disclosures will turn out to be boilerplate text rather than a real attempt to analyse the sensitivity of a securities' value to the choice of model.

CRAs need to take adequate steps to address concerns about potential conflicts of interest, including concerns about their remuneration models.

Clearly. That bullet is going to be very difficult for the agencies to dodge.

4. Market transparency
Financial institutions need to improve the usability of disclosed information about risk exposures and valuations, including those related to structured products and off-balance sheet vehicles

Again, the industry has proved adept at making disclosures that meet the required standards but don't actually disclose much useful information. Just look at the memo accounts for any big investment banks. So while one can sympathise with the idea of more transparency, it will need very careful management to be effective.

Further improvements are needed in firms’ valuation methodologies and in the data that they use as inputs to their valuation processes, in particular when markets are illiquid.

You can't improve the view in a mist. Valuation in the presence of size issue, liquidity issues, or model risk is inherently uncertain. Instead the users of financial statements need to be aware of that uncertainty, and we need to develop ways of quantifying it.

5. Supervisory and regulatory responsiveness to risks
Supervisors, central banks and financial authorities - individually and collectively - need to become more effective in translating risk analysis into action.

The point above applies. It is easy to say this. What are you going to do to make sure that this action actually happens?

6. Authorities’ ability to respond to crises
Central banks’ operational frameworks must be able to supply liquidity effectively when markets and institutions are under stress. Central banks are actively investigating what lessons they can draw from recent experiences for their operational frameworks, including the capacity to provide liquidity broadly and flexibly under stressed conditions, for their communication with markets, and for the steps that might be advisable across central banks to address liquidity needs in globalised financial markets.

All of this is a little depressing. It feels as if the FSF is flailing around at roughly the level of an undergraduate seminar. We are going to need more than a bit of disclosure, a wider range of collateral at the window, and management promising on the life of their favourite pet that honestly they will take action if risk gets too big to get us out of this mess.

Update. The FT uses the FSF paper as a launchpad to discuss the broader lessons of the crunch here. Meanwhile Larry Elliott in the Guardian makes the interesting point that the FED, the ECB and the Bank cannot all be right about rates. I might get to that on Wednesday.

Profit from the Bayesians

The markets do not only trade on participants' assessment of the value of securities. They also trade on participants' assessment of the beliefs of other participants about the value of securities. If you think everyone is going to sell a stock tomorrow, you'll sell it today, regardless of your assessment of its long term value, because if need be you can buy it back more cheaply the day after tomorrow.

If you can successfully determine what market participants will do, arbitrage opportunities sometimes result. At the moment there may be one concerning the quantitative equity funds. We know roughly what these funds do - they try to exploit market dislocations. The fund has an idea of what is a dislocation because it has a model of what relationships 'should' hold. And these models are often calibrated using some form of Bayesian network.

Now here's the interesting bit. It seems many of these funds have broadly the same position, or at least the same kinds of position. We suspect this because when one quant fund liquidates it appears that some of the others take a bath. The fund being liquidated had longs and shorts based on their model and when these longs are sold, causing these stocks to fall in price, and the shorts are bought back, causing them to rise, presumably the opposite behaviour to the one predicted by the model is observed. Since funds share models or at least modeling assumptions, this hurts a number of quant funds simultaneously.

So, here's the plan. First figure out what that model portfolio looks like, roughly. It should not be too hard to make a plausible guess of the basic structure of the Bayesian model some of the funds use: just run it, and get a portfolio - we'll call this portfolio A. Then figure out a portfolio that mostly is market neutral (and in particular does not lose much money on those days that the market relationships predicted by the model do hold) but makes a lot of money if portfolio A has a really bad day. You can think of this as a far out of the money put on the model's correctness. Wait for next quant fund liquidation (which is bound to come as someone is always over-leveraged) then buy a yacht. Or some kind of boat, anyway.

Negative basis trading

The FT recently discussed negative basis trades. Here is the basic idea.

• A bank buys a bond, typically a long dated one.
  
• The bank buys a CDS or a financial guarantee policy to maturity of the bond from a counterparty, often a monoline.
  
• The bank would then hedge against the risk that the protection it had bought was ineffective often with another monoline.

This was profitable despite the multiple layers of protection since the credit spread of the bond was bigger than the cost of the first and second hedges combined. Remember a bond spread includes compensation for much more than the risk of default: it includes compensation for illiquidity, for the volatility of the value of the bond, and so on. The bank is basically monetising those premiums.

Most of these trades were done in the trading book so the banks concerned booked the PV of the difference between the credit spread of the bond and the cost of the protection up front.

With the monolines at AAA and monoline protection some tens of basis points, this approach was not a huge issue. But now monoline protection is hundreds of basis points and the AAA ratings might not be with us very long. Also, the bonds used were often either the supersenior tranches of CDOs or long dated inflation linked debt. The latter isn't a problem: the former is, since the underlying credit quality of these bonds has gone South for the winter too. And negative basis trades are out there in size. The FT says:

Bob McKee, an analyst at Independent Strategy, a London research house, believes that up to $150bn worth of CDO business done by the monolines could be negative basis trades.

Doubtless there are some who will use these trades as another stick to beat the already bloodied body of structured finance. I would suggest the reality is somewhat different. The problem isn't the trades themselves: it is the selective use of mark to market. Marking the trades up front is fine providing you do it properly. That means:

• Credit adjusting the pricing of all derivatives. The details are complex here but basically you PV the value of net cashflows from a counterparty back along their risky credit curve rather than along the Libor curve. This has the effect as a counterparties' credit quality decreases of automatically marking down your trades.
  
• In particular valuing trades with realistic default correlation assumptions. In particular the only time that you need written protection on supersenior ABS is when the ABS market is in trouble - and that is just when the monolines are in trouble. Therefore the probability of joint default of the bond and the protection seller is not
  
  PD(bond defaults) x PD(monoline defaults)
  
  As it would be if they were independent. Instead it is something a lot closer to
  
  min(PD(bond defaults), PD(monoline defaults))
  
  Since the default correlation is so high. For the full negative basis trade it is reasonably close to
  
  min(PD(bond defaults), PD(monoline1 defaults), PD(monoline2 defaults))
  
  The real problem, then, is that some banks may have used naive default correlation assumptions in marking these trades and hence they are carrying them at an inflated value.
  
• Using realistic funding assumptions in valuing the position. I shudder to think about this, but it would not be massively surprising to discover that some of these trades were also valued under the assumption that the bank could fund the bond at Libor flat forever. That means in effect that the position has again be overvalued up front and will show a net carry loss over time.

Of course none of these issues would have seen the light of day without the declining credit quality of the monolines. But it does highlight the fact that those banks which have prudent P/L recognition and state of the art valuation policies are much better placed to withstand market turmoil than those who don't.

Downgrades rising

The ratings agencies are starting to notice how high the water has risen around the monolines. Today XL Capital reported a billion dollar loss for the 4th quarter and Moody's cut them from AAA to A-. In one step.

Can MBIA and Ambac be far off? Given mounting regulatory pressure the agencies surely cannot delay long. Admittedly the monolines are scrambling to raise new capital but the WSJ thinks that the rescue plans won't prevent downgrades. One hopes for the sake of the credibility of the whole system, that they are right.

CMBS blows out

The recent spread widening on Markit's CMBX indices indicates that contagion from RMBS is no longer a concern: the infection has happened. Here are the AAAs

170 over (Update: 200 over) is quite a chunky spread for paper with this degree of subordination. Note that in CMBS there are many fewer pieces of collateral - since each deal is individually so much bigger - so it really is possible to understand each asset backing the deal. I suspect that those people willing to go and measure the footfall in Alabama shopping centres and talk to office realtors in downtown Seattle will find that some of the underlying AAA bonds still look pretty good.

Meanwhile in the UK not only is the IPD showing sharp falls - 8.7% in Q4 2007 - but also investors are withdrawing money fast from commercial property funds. Or at least as fast as the funds will let them.

Dramatic news: CDS still not 100% evil

There is a somewhat alarmist article by Satayjit Das in the FT currently concerning CDS. Das apparently used to be a practitioner so he does not have the excuse of being a journalist. Let's see what he has to say:

May 2006, Alan Greenspan, the former Federal Reserve chairman, noted: “The credit default swap is probably the most important instrument in finance. … What CDS did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.”

The reality may prove different.

Fair enough so far: 'all of the risk' was bound to be an incendiary phrase.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses. Current debate has focused on the size of the market. But the key problem is that a combination of documentation and counterparty risks means that the market may not function as participants and regulators hope if actual defaults occur.

Hoping is not a robust way of managing risk. Documenting the trade that you intended (rather than an entirely different one) is usually a better defence. Just as you should always read the prospectus before buying a security, so you should also understand the documentation of a derivative in detail before assessing the extent to which it hedges your risk. This is hardly new, or difficult.

CDS documentation, which is highly standardised, generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are also technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, for example, the volume of CDS outstanding was $28bn against $5.2bn of bonds and loans. On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

A CDS is a derivative. Its price is derived from the underlying. The clue is in the name. And yes, like many derivatives, there can be a squeeze on the underlying. This happens in commodity derivatives in particular, yet Das does not suggest that these are imperfect hedges as a result (remember the Hunt Brothers and silver). Why pick on CDS?

Shortage of deliverable items and practical restrictions on settling CDS contracts have forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement (based on the market price of defaulted bonds) for physical delivery. In Delphi, the protocol resulted in a settlement price of 63.38 per cent (the market estimate of recovery by the lender). The protection buyer received 36.62 per cent (100 per cent - 63.38 per cent) or $3.662m per $10m CDS contract. Fitch Ratings assigned a recovery rating to Delphi’s senior unsecured obligation equating to a 0-10 per cent recovery band - far below the price established through the protocol. The buyer of protection may have potentially received a payment on its hedge below its actual losses – effectively it would not have been fully hedged.

Yes, that is recovery rate risk. You get exactly the same phenomenon if you sell a bond post default before the actual workout is known. But presumably if you had a bond and a CDS, the CDS cash settlement would match where dealers were trading the bond, so the fact that the subsequent recovery was different would not matter as you would have settled the CDS and sold the bond, leaving you with no exposure. Of course if you were using the CDS to protect a non tradeable loan, then you could get caught out, but that is basis risk not recovery risk.

Is it just me, or is there a massive dose of caveat emptor missing from all this? The buyers of CDS are not retail investors: they are banks and hedge funds, and it is their job to understand the details of the trades they undertake. Just because something doesn't do what you think it ought to doesn't make it bad -- it just means you have not done your homework.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. Some 60-70 per cent of ultimate CDS protection sellers are financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, Merrill Lynch took a charge of $3.1bn against counterparty risk on hedges with financial guarantors.

The term 'substitute' may be a little misleading here. There is only a direct credit risk if there is a credit event. Therefore the CDS buyer is exposed only to both a credit event then a default of the CDS counterparty. If the counterparty defaults first, they have a claim to the value of the current mark to market of the CDS against the counterparty.

In the case of hedge funds, the CDS is marked to market daily. Any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. As the case of ACA highlighted, banks may not be willing or able to close out positions where collateral isn’t posted. Collateral models also use historical volatility and correlation that may underestimate the risk.

Ice cream makers which use vanilla when you wanted chocolate may produce the wrong flavour too. Most banks - and most cooks - are aware of the need to use the right tool for the job. Moreover (as Das does not make clear) VAR based collateral models which cross margin a whole portfolio of exposures may underestimate risk due to giving too much benefit for diversification within any derivatives portfolio. (I have discussed credit support default earlier so I won't go into more details here, suffice to say that the issues are not unique to CDS.)

Clearly a number of people have it in for credit derivatives right now. I'm reminded of the ill conceived (and subsequently abandoned) rules on credit risk mitigation proposed in the first consultative papers on Basel 2. It is sad, though, to see the FT jumping on the bandwagon. Like any tool CDS can be used well or poorly. If you want a complete hedge to a credit exposure, sell it. If you don't want to do that then you have to understand how the derivative behaves as the underlying exposure moves, just as in any other risk mitigation situation. CDS are neither uniquely dangerous nor a miraculous answer to any credit risk problem. Demonising a structure helps no one, however easy a target it offers. Or as my old boss used to say: if you want a complete hedge, buy a garden.

A conflict addressed?

Bloomberg reports that IOSCO is starting to address one of the most severe conflicts of interest in structured finance: the payment of the ratings agencies for rating structured notes by the issueing bank.

Regulators may restrict Moody's Investors Service and Standard & Poor's from advising banks on structured debt securities after criticism the firms failed to downgrade subprime-related notes as investor losses mounted.

Ratings firms may face a code of conduct prohibiting ``advice on the design of structured products which an agency also rates,'' the International Organization of Securities Commissions in Madrid said today. IOSCO, the forum of securities regulators, also called on financial institutions to disclose their risk of losses from structured finance.

Regulators including Michel Prada, France's chief securities official and chairman of IOSCO's Technical Committee, have rebuked ratings companies for being involved in creating the securities responsible for at least $146 billion of losses in the wake of the subprime slump.

``This doesn't address the core issue, which is ratings being paid for by issuers,'' said Christian Stracke, a strategist at CreditSights Inc. in London. ``It's a good first step but it leaves a lot of wiggle room.''

Borrowers pay for credit ratings rather than investors. Potential conflicts of interest between rating companies and the banks that pay their fees were flagged last year by European Central Bank President Jean-Claude Trichet and U.S. Senate Banking Committee Chairman Christopher Dodd. The Securities and Exchange Commission said in August it was examining the way the companies assign ratings.

[...]

Moody's earned $884 million in 2006, or 43 percent of total revenue, from rating so-called structured notes, securities that package asset- and mortgage-backed debt, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That's more than triple the $274 million generated in 2001.

Clearly there is more to do before this issue is fully resolved.

Awake the CDO

Some parts of the CDO market are closed. According to Bloomberg:

Buying and selling of collateralized debt obligations based on mortgage bonds, high-yield loans or preferred shares has ground to a near-halt, traders said at the securitization industry's largest conference.

``We're definitely in a period of very low liquidity at the moment, which has actually been dropping precipitously in the last few weeks,'' Ross Heller, an executive director at JPMorgan Securities Inc., said yesterday [...]

The slowdown of the more than $2 trillion CDO market follows record downgrades in mortgage-linked securities last year. Some AAA rated debt lost all its value. [...]

Demand for new CDOs has stalled, with just one created in the U.S. so far this year, according to JPMorgan. [...]

Fitch Ratings today said it may downgrade the $220 billion of CDOs it assesses that are based on corporate securities. The New York-based company said it may lower the notes by as much as five levels after failing to accurately assess the risk of debt that packages other assets.

I bet the bar at the ASF resembles a wake at the moment. The closure of the markets for CDOs based on MBS, high yield and bank preference shares is predictable: that high yield CDOs are also effected is less so. I can't believe there are many ratings driven investors left so the Fitch downgrade should not change too many people's view of the tranches. It might change capital requirements, but that is not a constraint for most investors.

A different explanation for the CDO liquidity squeeze comes to mind: a rather more ordinary one. Investors are simply nervous about corporate credit risk. They expect default frequencies to rise in a recession, but they do not know how much. As FT alphaville points out:

The iTraxx Crossover index of mostly junk-rated corporate debt closed above the 500 basis point level on Tuesday for the first time, and on Wednesday morning pushed higher still to 515bp. The index hit its highest intra-day level, 530bp, during the global equity sell-off in January.

The iTraxx Europe index of investment-grade credits also hovered around a record, at 90bp in morning trade.

Investors will not be buying high grade CDOs until they have a goodidea how far this is going to go. That should mean that there are serious bargains (if not stately dress) in the secondary market for anyone willing to take a view on default correlation.

There should be similar opportunities in preference share CDOs. Certainly a first to default note on a basket of the prefs of too big to fail banks (Citi, BNP Paribas, Deutsche, RBS) could have a very attractive yield at this point.

The Triumph of the Past?

John Dizard wrote a provocative article for the FT recently. He discussed what amount to little more than a rumour, albeit possibly a well informed one, about the views of leading regulators and central bankers concerning the future of securitisation.

The official [central banking] world, and those close to it, are anticipating that we're going back to an on-balance-sheet financial industry. That is, the extension of credit will be done, to a much greater degree, through direct lending by depository institutions rather than through the securitisation of structured products. The frenetic expansion of securitised and, it was supposed wisely distributed, risk turned out to be not quite so wise after all.

The problem with putting credit on bank balance sheets is that those balance sheets aren't big enough to cover the losses from past practices and to continue to expand credit at an adequate pace. Shareholders' equity and reserves aren't there, at least in the necessary size.

Very true, the central bankers will say. So we'll just have to get some new shareholders. The "real money investors" are there, and not just the sovereign wealth funds. What about the present shareholders, I ask, my face turning white? As Colbert memorably said: "A banker is a soldier in the service of the state." So perhaps the rally in bank shares might be a little premature. The central banking world is expecting a serious shake-out of individual and perhaps institutional participants.

This is worth examining in some detail. First, how could central bankers compel or at least strongly suggest to banks that they desist from securitisation? Presumably without any changes at some point the securitisation market will come back - indeed some MBS deals have been done already this year. So to rein in what they evidently see as the Gorgon, the central bankers will have to do something. The only available policy lever is regulation: capital charges will have to go up markedly to throttle off demand.

Note too that there are different reasons for banks to use the securitisation market, some of them less toxic than others. At the benign end of the spectrum selling the AAA to get sub-Libor funding on an opportunistic basis (and obviously not assuming that this can be done as part of your funding strategy) is natural for smaller banks. Without it, the barriers to entry get even higher and the benefits of consolidation more significant: do we really want more banks which are too big to fail?

On the other hand, clearly supervisors have a vested interest in preventing regulatory capital arbitrage via securitisation. Basel 2 does not do this: it simply introduces new arbitrages from the ones available under Basel 1. There are fewer of them perhaps but they are still there.

The final motivation for securitisation is pure arbitrage. Sometimes the assets really are worth more in securitised form. This may be because they are illiquid, hard to originate, or hard to assess. Institutions with an edge, be it origination or market knowledge/credibility, can legitimately exploit that. Remember too that securitisations are like blenders: they can liquidify previously illiquid assets. That in itself can make them more valuable.

Could one hope that the supervisors will continue to permit the good securitisation yet design rules which make the bad more difficult if not impossible? It seems unlikely. If there is any wiggle room at all in the rules the industry will find it. So to be sure of banning the bad kind of securitisation it is likely that the rules will end up disincentivising the good kind too. If Dizard is right, then, Basel 3 will tend to favour large banks with a low cost of funds and plenty of capital.

The next part of the problem is that there are not too many of those left. So most banks will be forced to scale back on risk taking while they rebuild capital and delever. The consequences of that for the G10 economies will be profoundly negative: credit in all forms will become much harder to obtain, market making will be less practiced and hence liquidity will decrease, and growth will slow. Banks are too addicted to securitisation to go cold turkey without the detox effecting the broader economy. Instead I suggest central bankers should be looking at something more like nicotine patches: get rid of the most harmful form and manage dependence without generating too much discomfort. An over-reaction, however, seems most likely.