Paulson puts scissors in drawer, ignores loaded Uzis

The NY Times has a useful summary of the Treasury proposals for regulatory reform. Consider this:

The optimal structure should establish a new prudential financial regulator, PFRA. PFRA should focus on financial institutions with some type of explicit government guarantees associated with their business operations. Most prominent examples of this type of government guarantee in the United States would include federal deposit insurance and state-established insurance guarantee funds.

In other words, the PFRA will not include the broker/dealers as they do not have guarantees (except for the relatively small bank subs of some broker/dealers). I was wrong, then, when I said these proposals were positive: they really suck. So, in honour of this totally failing to see the big picture moment, I offer you the first annual DeM lookalike competition. One plays a government official who uses unethical but often ineffective methods to try to enforce his will. The other's a bit better at protecting the interests of his buddies. Which is Vic, which is Hank?

The procyclicality of fair value

Broadly I am a supporter of the use of carefully estimated fair values for financial instruments: I think that accrual accounting hides a lot of information that the users of financial statements deserve to know. However, there is one aspect of fair value that is troubling: how it combines with leverage to provide another incentive to procyclicality. To see this, suppose we start with a bank that is Basel 1 adequate, i.e. its leverage is less than 12.5:1 (remember 1/8% = 12.5).

	Start Year 1
Capital	100
Assets	1100
P/L	-
Leverage	11:1

This bank uses fair value for all of its assets, and the markets rise, so we find

	Start Year 1	End Year 1
Capital	100	100
Assets	1100	1200
P/L	-	100
Leverage	11:1	12:1

Of the 100 of P/L 50 is dividended to shareholders and 50 is kept as retained earnings. Retained earnings are a component of capital so we have:

	Start Year 1	End Year 1
Capital	100	150
Assets	1100	1200
P/L	-	100
Leverage	11:1	8:1

At this point management will be concerned that the ROE of the bank will suffer due to the falling leverage, so they acquire more assets to get the leverage back to 11:1, originating 450 of new assets.

	Start Year 1	End Year 1	Start Year 2
Capital	100	150	150
Assets	1100	1200	1650
P/L	-	100	-
Leverage	11:1	8:1	11:1

Unfortunately now the market falls back and the 1650 of assets are now worth only 1600. This causes a loss of 50. Losses are a deduction from capital, so now we find

	Start Year 1	End Year 1	Start Year 2	End Year 2
Capital	100	150	150	100
Assets	1100	1200	1650	1600
P/L	-	100	-	-50
Leverage	11:1	8:1	11:1	16:1

At this point the bank is capitally inadequate and either has to sell 350 of assets or raise 28 of new capital to get its leverage back under the regulatory maximum of 12.5:1. In other words, when times are good, the bank extends more credit, and when they are bad, it either has to raise new capital (and until it has recapitalised it cannot lend further) - or perhaps even worse, it may well sell assets into a falling market, exacerbating the decline.

One could argue this is not the fault of fair value, but rather of the leveraging up that took place during the rising market. However in order not to encourage this, shareholders need to understand that, unlike an accrual accounted bank, a fair value bank will have low leverage in a rising asset price environment and higher leverage in a falling one. I am not convinced that is well understood at the moment so the temptation to overleverage may well be there.

The SEC loses touch with reality

Naked Capitalism points out a scary new letter from the SEC to CEOs regarding valuations under FAS 157. The NY Times has a good summary: If Market Prices Are Too Low, Ignore Them. The offending part of the guidance is:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale.

My contempt for this is boundless. The point about mark to market is that you estimate the price of a current transaction. If there are more buyers than sellers, then prices will be falling. Whether some of those sellers are forced is irrelevant. If you had to sell today, you would be joining them, so the price they are getting is the best pricing source for a current transaction. End of.

Hank Paulson and modalistic monarchianism

Hank has decided that regulation should come in three different modes: a `Prudential Financial Regulator' to oversee financial institutions that have an explicit government guarantee such as deposit insurance, a `Business Conduct Regulator' to monitor disclosures, business practices, chartering and licensing and a `Corporate Finance Regulator' with `responsibilities for general issues related to corporate oversight in public securities markets.' See here for Bloomberg's story, and here and here for the NYT.

There would be a single banking supervisor,- presumably a merged OCC/OTS,- and a single public markets supervisor, a merged SEC/CFTC. Presumably the SEC would lose its regulatory oversight of the broker/dealers to the Prudential Financial Regulator. In a potentially rather important move, a single national insurance regulator is also suggested.

Broadly this seems like a positive step. It would at least reduce the proliferation of agencies, boards and supervisors. Rolling the supervision of the FHLBs and the GSEs into the financial regulator would be a good idea, but given that the US system is a relic of the 30s, dragging it kicking and screaming into the 1980s is a good start. I still think the political battles will be prolonged, that they are likely to result in watering down of even these fairly modest proposals, and that this is not nearly enough. But this is definitely positive.

Update. The comment on these proposals has mostly been negative. See for instance here for Paul Krugman, here for Naked Capitalism or here for the NYT. Talk of light handed, Wall Street friendly regulation misses the point. Yes, the proposal is inadequately tough, but it does break the log jam of regulatory reform. If something is done it shows that doing something is possible. In particular the proposal may address the most glaring issue in the US regulatory system: the regulatory advantage of the SEC-regulated broker/dealers vs. global banks under Basel 2. Baby steps, dear reader, baby steps.

Bad idea of the year award

An easy winner, this. From the FT:

The Federal Home Loan Banking system, a government-sponsored network of US banks, is seeking to enter the so-called “monoline” insurance market to help local governments that have been hurt by the credit market storm.

In particular, some banks in the network want to offer their top-notch credit ratings to municipal infrastructure projects – and thus fulfil the role traditionally taken by monoline insurance groups such as MBIA.

Why not have them wrap structured finance too? I mean, what could possibly go wrong with pseudo public sector entities backed by taxpayers getting into an area of finance they have never been involved with before?

FED vs. SEC, round 2

It seems as if the appetite to regulate the broker/dealers is not strong at the FED. Today Hank Paulson stepped back from the brink while he said that the Federal Reserve should ­bolster its supervision of investment banks while they access its emergency cash, he stopped short of calling for permanent regulation of the broker/dealers by the Fed. The FT reports:

Permanent regulation would be studied by the President’s Working Group on Financial Markets, including senior members of the SEC, the Fed, the Treasury and the CFTC.

Barney Frank, the Democrat who chairs the House Financial Services Committee, last week called for Congress to consider authorising the Fed to broaden its powers and act as a “financial services risk regulator”.

“To the extent that anybody is creating credit they ought to be subject to the same type of prudential supervision that now applies only to banks,” he said.

Congressional pressure on the administration and the Fed increased further when Max Baucus and Chuck Grassley, the senior lawmakers on the Senate finance committee, asked Mr Paulson as well as Ben Bernanke, Fed chairman, and Tim Geithner, president of the New York Fed, for more information on the sale of Bear Stearns to JPMorgan.

This reads to me as if the Senate sees the logic of giving the broker/dealers to the FED but the Treasury, and possibly the FED itself, is less keen to have a fight with the SEC.

In this context it is worth studying the SEC's letter to the Basel committee concerning the Bear. This is mostly concerned with liquidity risk, but it does include the following data on two Bear, Stearns companies capital requirements:

	BSSC Net Capital ($ billion)
	Required	Excess
31-Dec	1.26	3.38
31-Jan	1.30	2.92
14-Mar	1.27	>2.00 (estimated)

	BS&Co. Net Capital ($ billion)
	Required	Excess
31-Jan	0.56	2.71
14-Mar	0.58	>2.00 (estimated)

Am I the only one to be shocked by the absolute size of those numbers? Only a couple of billion required capital for a major broker/dealer? Surely it should be at least ten. I really wonder what BSC's capital requirement would be if it were regulated as a bank. Perhaps we will be able to see from the rise in JP's capital requirement. And I bet it will be a lot more than a couple of bucks.


Update. Just to contextualise the Bear's capital numbers above, I looked up the Tier 1 for a range of players. WaMu, for instance, has Tier 1 as of Y/E 07 of $22.4B. Credit Suisse is about $35B, Deutsche about $45B. Even recently maligned HBOS has about $48B. The Bear's 2006 Annual Report records it had net capital of $4.03B, or rather less than Deutsche's capital for operational risk alone. With capital that small, why on earth was the Bear rated single A?

My King for a repo

Should the Bank reduce its collateral quality requirements and/or buy ABS outright? It is certainly thinking about it. The FT reports:

Mervyn King indicated on Wednesday that the Bank of England was poised to take a revolutionary step and buy or swap illiquid assets on banks’ books for cash or liquid assets as way to find a “longer-term resolution” to the problems faced by British banks.

One of Mervyn's motivations is to try to reopen the market for these assets, or at least allow them to be financed until such a time as the market reopens.

Commenting on the “fragility” that exists in the financial system, Mr King said there was an “overhang on banks’ balance sheets of assets in which markets have closed”

“These assets cannot now be sold or used to secure funding in the market – they are difficult to finance. That has created uncertainty about the strength of banks’ financial positions”.

This is, if late, at least right. Many ABS assets have no market at the moment. Hence they cannot be marked to market. That in turn means that they are not good collateral and hence they cannot be used in secured funding. Having to use unsecured funds to finance these assets is gumming up banks' balance sheets and making them reluctant to lend. A short term answer to this problem is a key step in regularising the markets. However, this intervention needs to be strictly limited. The FT reports:

In the short-term, [King] said the Bank would continue to lend against mortgage-backed securities and other asset-backed securities where markets are closed, but he added that such lending, while “a useful bridge to a longer-term solution” can “be only a temporary measure”.

Weaning the banks off cheap financing of illiquid assets will be difficult and there is very little experience to draw on. But still King's proposed action is the right one, even if he does not know how the story ends.

He was not specific about the longer-term resolution, since he said “it is too soon to say where these discussions will lead”, but he indicated more radical moves were necessary because “it is unrealistic to assume that markets for many asset-backed securities are likely to re-open speedily or, when they do, to their previous levels of activity”.

It is important to ensure that this does not introduce too much moral hazard, nor does it act as a guarantor for new issues.

“First,” [King] said, “the risk of losses on their lending should remain with banks’ shareholders”. This implies the Bank would only accept assets at well below face value, or would insist on banks’ indemnifying taxpayers for the credit risk they would adopt if they took hold of the assets.

“Second,” he added, “a longer-term solution must focus on the overhang of assets and not subsidise issues of new assets”. Mr King is keen not to allow another frenzy of lending and it implies the Bank would not be willing to take any new mortgage-backed securities on its books.

The devil is in the details, of course, but all-in-all the Bank's strategy is encouraging.

Privatised Infrastructure and the sad case of Heathrow

Heathrow, like Gatwick and Stanstead, is operated by BAA. Despite the positive impression created by the new Terminal 5, most of Heathrow is in a terrible state. It's old. It has little or no natural light. It's cramped. And it is stuffed full of shops and nasty food outlets to keep the waiting masses spending. Compared with many large airports - Hong Kong springs immediately to mind - it's embarrassing. Worse, the squalor and massive misery generation of Heathrow was entirely avoidable.

Stock companies have one aim: generating shareholder value. They have a legal obligation to work to that one end. They explicitly shouldn't care about national pride, client unhappiness, or holding back the broader economy if it gets in the way of making more money for shareholders. Hence not only can you not blame BAA for Heathrow, you should expect Heathrow to be as it is given it is privately owned and lightly regulated. BAA are doing what they are supposed to do: making money for their owners, Ferrovial. (Or in BAA's case, losing rather less money than they otherwise would.) The fact that this does not serve the countries' best interests, nor passengers, nor airlines, is irrelevant.

This is why private ownership of public infrastructure is inherently problematic. And why we won't be getting an airport anywhere near as good as Hong Kong's any time soon. Now wish me well - I have to use Heathrow again on Friday.

Update. It seems BAA can't even manage to run a brand new terminal properly. The BBC reports:

Cancelled flights and baggage delays have blighted the opening day of Heathrow's new £4.3bn Terminal 5.

British Airways, which has sole use of the terminal, was forced to cancel 34 flights by 1400 GMT due to "teething problems" encountered in the morning.

And it carried on. On Sunday we heard from the Guardian:

British Airways warned last night that the disruption that has plagued Heathrow's Terminal Five could run through this week as it emerged that 15,000 bags have yet to be returned to their owners. This figure is three times higher than BA had originally admitted to. Following three days of cancellations which saw more than 150 flights grounded and thousands of passengers disrupted, the airline, which has exclusive use of T5, said that a further 37 flights would not take off today.

Burying bad valuations

Even though this article appeared on the Sunday before a Bank Holiday Monday, I don't really think it was deliberately buried. It is just that it might be troubling to some. From the FT:

The first public price estimates for specific structured credit securities to have emerged since the start of the credit crisis show that values have fallen sharply.

Some securities have lost almost a third of their value – even though many were considered to be so safe that they carried top-notch ratings from the credit ratings agencies.

Meanwhile, some subprime mortgage-linked securities issued by groups such as UBS have lost almost 95 per cent of their value.

The price estimates were made in a legal filing following a decision by JPMorgan Chase to ­publish detailed securities valuations in a Canadian court. The securities are linked to commercial loans and medium-grade mortgages.

The estimates are likely to be scrutinised by auditors and regulators since they come at a time when the issue of security pricing has become controversial.

Banks are under pressure from regulators to book losses they have incurred on such instruments. However, trading has virtually dried up in many corners of the credit markets, and it is hard to compare prices for these instruments between banks.

Many regulators and investors fear that banks are still varying in the degree to which they have booked losses on their credit instruments in recent months – not least because it is hard for auditors to compare internal estimates with external benchmarks.

The figures have emerged because the US bank is leading an effort to restructure a group of 20 Canadian structured investment vehicles that issued $32bn of asset-backed commercial paper.

JPMorgan and Ernst & Young lodged a report with an Ontario court gives estimates for the securities held by the Canadian SIVs based on implied values.

This is undoubtedly a data point but it is not definitive. Remember these are estimates, and liquidity has largely or completely disappeared in these instruments. It may be that the idea that the value of these instruments is impossible to determine precisely in the current market is lost on the court, but that particular fallacy should not trouble market participants.

JP loves the Bear

Perhaps it will not be entirely unrequited at $10 a share. The NYT has the scoop, the FT has additional details, and some amusing speculation can be found on Naked Capitalism.

Update. It's official (or at least on Bloomberg). JP ups the offer to roughly $10/share, and buys 39.5% of the firm in newly-issued stock (40% or more requires a shareholder vote). That's done then. Who caught the bride's bouquet?

Interest rate markets turbulence

One of the features of an illiquid, crisis-hit market is that arbitrage relationships break down. Another is a dramatic rise in settlement risk as bonds, even the best bonds, become illiquid. We are seeing both at the moment:

• The usual relationship between forward Libors and spot is breaking down by as much as ten basis points. In Euros for instance the 3m Libor 3m forward given by the futures is significantly different from that given by the spot Libors. (Sorry, I can't find a link to this.)
  
• Alea reports on a massive increase in repo market fails. The raw data is here.

The FT reports that a fund has been caught in another IRD storm:

A $3bn London hedge fund lost more than a quarter of its value on Monday as it became the biggest victim of the unwinding of a popular Japanese government bond trade that hit many rivals this week.

Endeavour Capital, run by former Salomon Smith Barney fixed-income traders, told investors it fell 27 per cent as a highly leveraged bet on the spread between short- and long-dated JGBs was hit by contagion from the US financial crisis and domestic worries. [...]

Hedge funds scrambled to unwind the so-called “box trade” – betting that 20-year bond and swap spreads would widen as seven-year spreads narrowed – early on Monday when the market moved sharply against them.

Presumably then they were long 20 year swap spread and short seven year, under the assumption that sevens were wide compared with twenties. Reuters gives more detail:

On Tuesday the 20-year swap rate was quoted at 2.050 percent compared with a 20-year bond yield of 2.150 percent, meaning the swap rate is 10 basis points below the bond yield.

The spread had reached to near -20 basis points on Monday when hedge funds and players were scrambling to unwind positions in a market where it is increasingly difficult to get trades done due to the worsening credit crisis, especially in the United States.

By contrast, the five-year yen swap spread soared to a record peak near 40 basis points last week. That move has stemmed partly from the jump in yen LIBOR rates due to the money market squeeze in the United States and Europe.

(The emphasis is mine and I have removed the Reuters tickers.)

In thin markets with forced sellers it is worth bearing in mind the simple fact that if there are more sellers than buyers, prices go down. Usually moves follow arbitrage channels as there are enough prop players willing and able to exploit opportunities. But at the moment there is not enough risk capital to bring these arbs in. Until there is, the markets will remain disconnected.

Update. Paul Krugman sets out another aspect of this dislocation here, noting that plummeting 1m T bill rates have not resulted in a matching fall in FED funds. They have fallen, but bank's reluctance to lend to each other even via the FED has kept FED funds at a relatively high spread over 1m CMT.

Small chance of a big change

In a potentially highly significant news item, the FT reports that

Congress is set to scrutinise the regulatory framework for investment banks following the Federal Reserve's decision to offer emergency finance - a move that could lead to tighter regulation of these financial groups.

Why is this such a big deal? Well, I suspect that not many Europeans realise the extent of the division between banks and broker/dealers in the US. Large banks are lead regulated by the FED (or the OCC - it's complicated). Broker/dealers are lead regulated by the SEC. The two regulatory frameworks are vastly different. Thus Citigroup is not regulated by the same people or to the same standards as Goldman Sachs. In some areas - notably market manipulation - the SEC is very tough. But some observers doubt that it has either the skills or the desire to regulate the wholesale market activities of the broker/dealers as strictly as the FED does, and its capital requirements are certainly not the same. The failure of the Bear and the subsequent opening of the FED window to the broker/dealers, something that was previously a privilege reserved for banks, seems to have woken people up. Turning back to the FT we find:

"It's clear that there needs to be regulation of the investment banks. Regulation does prevent some of the worst abuses. You can't have certain institutions playing by a different set of rules than others," Barney Frank, chairman of the House financial services committee, told the Financial Times.

Mr Frank said the fact that investment banks were reaping the same benefits as commercial banks but with lighter regulation had "made it easier for us to make the case" for regulatory change. He said the issue would be a "major subject" for the House financial services committee, which he chairs, in the spring.

There will be enormous push back on any move to have the FED take over regulation of the broker/dealers, some from the SEC, some from the firms themselves. Getting something done here will be require political will and astute handling of a diverse community of vested interests, so the assumption must be that nothing much will come of it. But if there is change, it will have a profound impact on US financial services.

Update. There is a reasonable discussion of the historical background (from Glass Steagall to Gramm Leach Bliley) in the CityEconomist blog here.

Dark clouds lifting?

The FT reports:

The dark cloud of uncertainty over the credit ratings of bond insurers Ambac and MBIA is slowly lifting, and sentiment in the credit markets and stock markets is improving as a result.

Moody’s Investors Service and Standard and Poor’s this week reconfirmed the triple-A ratings for MBIA. Standard and Poor’s had also confirmed its top rating for Ambac, where discussions continue about a deal with banks to inject fresh funds and restructure its business.

That may well be true, but the share prices don't reflect it. Courtesy of Bloomberg:
This is turning into a complicated and difficult to navigate mixture of politics and economics. On a mark-to-market basis the largest monolines are almost certainly not AAA -- but they are not mark-to-market players. Their leverage is terrifying. But they have powerful friends, and it is increasingly being seen to be in the industry's interests that they survive at least in run-off if not as fully fledged players. Muni insurance is getting tougher with some states opting out entirely and Buffett soaking up much of the other business.

Bridging the solvency/liquidity split

I have long argued that the split between solvency and liquidity is a false dichotomy in the current market. Decreasing liquidity can of itself and without changes in expectations of default depress the price of an asset and hence create a solvency problem. Similarly institutions that whose insolvency is rumoured find their liabilities illiquid. The FED's actions recently would, I suggest, support this view. They have been creating liquidity - as Alea notes by selling treasuries and repoing in illiquid assets, primarily ABS - in order to support asset prices. This explicit management of liquidity premiums is as important a factor as interest rate cuts. The early signs are that the two effects are working, especially now the primary dealers can assess the FED too. We'll see.

Update. The argument above broadly motivates my concerns with the positions of those, like Willem Buiter, argue that central banks should repo in ABS collateral, but should do so at aggressive haircuts. (See here for Buiter on Radio 4's today programme - be warned that that link might not persist for long however.) In purely financial terms Buiter is correct: this is the prudent approach. However it is seriously unhelpful in meeting the broader policy objective of reducing soaring liquidity premiums. If the Bank takes risk on the collateral it is much more likely to be effective in ensuring that it does not take as much risk on its counterparties.

What a bargain?

If the JP deal to buy the Bear holds at $2 a share, they have got themselves a rather attractive looking deal. It must have taken courage to get to this point, and I'm sure they will find some nasties once all the stones are lifted, but the overall impression from the call is of a transaction that works well for JP, if not for Bear shareholders, especially given their option on the Bear's HQ. If the Bear can go for $2, though, it makes one wonder what Lehman is worth.

Update. BSC closed on Wednesday at $5.33, well over JP's offer. Will Joseph Lewis, one of the largest shareholders, be able to arrange a better deal? The cultural fit with JP can't be good, but at $2 they probably are not too concerned about that. Barclays might be a better fit, but are they in a position to find the cash, especially without FED support? One rumour doing the rounds is that Deutsche were interested. In any event, the consensus seems to be that JP has got it more or less sown up: see here for a discussion from Dealbreaker.

Meanwhile, Felix Salmon has a nice discussion on why the Bear share price is so far above JP's offer. The argument is that the bond holders have a lot to lose if the purchase does not go through and much to gain if it does. So they are buying the stock in order to vote for the merger.

No safe harbour for tax cheats

From last Wednesday's Guardian:

Millionaires claiming residency in Monaco have told the Guardian they plan to circumvent the new rules by abandoning their weekly commute or transferring board meetings to offshore locations.

[...] Keith Luxon, a banker and seven-year Monaco resident, said the change was "completely unjust. It will have a big impact.

"Whether it's here, Jersey, Guernsey or the Isle of Man, the guys will have to change the way they work. The classic example is someone who flies in and out of London 90 days a year for work. Under the new rules he is suddenly a UK resident for tax purposes. Some people are talking about taking this to the European court of human rights."

To defend the fundamental human right to not pay tax, I suppose? While there is probably an element of sensationalism in journalism like this, the fundamental point is clear: there are a small number of people who have both the means and the desire to avoid UK tax despite gaining their income primarily in the UK. The whole tax system loses legitimacy if we cannot share the burden of providing societies' infrastructure equally among those who use it. Bankers could not bank without a system of law and the police to enforce it, without employees educated in schools and universities, or without a transport system to facilitate their movements. I'm probably becoming boring on this topic but it really affronts me that the Monagasque expats and their ilk are allowed to shirk their responsibilities. 90 days is far too long permit people to work in the UK without paying tax: let's call it 30 shall we?

The FED and unintended consequences

Robert Peston (via FT alpahville) has a suspicion:

Well, the point of Tuesday’s dramatic $200bn intervention by the Federal Reserve in mortgage-backed markets was to stabilise the price of US government agency AAA-rated residential mortgage-backed securities and – by implication – to encourage the big banks NOT to seize assets in the way they’ve been doing at Carlyle.

Right now, it’s not clear that the Fed’s medicine has worked.

In fact, it’s arguable that the banks’ seizure of Carlyle’s $20bn-odd in assets has actually been encouraged by the Fed's mortgages-for-Treasuries offer. Because the Fed’s new lending emergency lending facility allows the banks to swap mortgage-backed debt for Treasury Bills in a way that Carlyle could not do.

So it would be rational for the banks to take Carlyle’s assets and exchange them for top-quality, liquid US government bonds, rather than leave loans in place to a business, Carlyle, whose assets remained highly illiquid.

I think if this were true, we could safely call it an unintended consequence of a safety mechanism. It is worth pointing out, though, that Carlyle was not that highly leveraged given its assets. 32:1 (or 28:1, accounts differ) on Agency pass throughs is not a huge gearing. The Banks do have an incentive to liquidate at the moment -- CCC is basically a one way bet on the Treasury/Agency spread so CCC's default is strongly correlated with the value of its collateral. However, is it legal not to sell the collateral after a credit support default? I rather thought that any excess of the sale price over the amount owing on the repo belonged to Carlyle (remember there is a repo haircut so the banks have not lent the full face value of the bonds), so don't they have to sell the bonds rather than put them into the TSLF?

No more BS?

Liquidity depends on confidence, and the Bear lost it. Rumours have been circulating all week - see here for a summary from Naked Capitalism - and finally the Bear had to be bailed out on Friday. The SEC comments:

The decision by the Federal Reserve Bank of New York to provide The Bear Stearns Companies temporary funding through J.P. Morgan Chase & Co. today followed a significant deterioration in Bear Stearns' liquidity on Thursday. The Division of Trading and Markets has monitored both the capital and the liquidity of the firm on a daily basis in recent weeks. [...]

"As of its most recent capital calculation as of the end of February 2008, Bear Stearns' holding company capital exceeded relevant regulatory standards. According to the information supplied to the SEC by Bear Stearns as of Tuesday, March 11, the holding company had a substantial capital cushion. In addition, as of March 11, the firm had over $17 billion in cash and unencumbered liquid assets.

"Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns' excess liquidity rapidly eroded.

As so the FED stepped in and we have the current back-to-back rescue via JPM.

There are several interesting questions about this. One is why the FED acted at all. Bear Stearns is not one of the largest firms - it does not feature on the Bank of England list of systemically important institutions for instance - but it is a key player in three areas of stress at the moment, prime brokerage, muni bonds and MBS trading. Certainly the failure of the Bear would have had an impact on confidence, and it might well have caused some knock on hedge fund failures. But if BSC is too big to fail then the CEOs of a range of institutions across the US must be sleeping easier at the moment.

The second is how the FED acted. Apparently it could have lent to BSC directly (at least after a board vote in favour) but instead it chose to lend to JPM with JPM on-lending to BSC. JPM has no risk here so one obvious reason for their involvement is that they want to buy some or all of the Bear. Certainly the Bear's HQ, the prime brokerage operation, perhaps parts of the mortgage business, and apparently asset management are interesting potential suitors. (Why anyone would want an asset management operation involved in a recent hedge fund collapse is another question.) Anyway, perhaps 'suitor' is the wrong word. Do we have a term in English for the man you are about to be forced into an arranged marriage with?

Now if I were you, I'd move straight on and check the successor language in your ISDA docs and/or prime brokerage agreement. Figuring out who your new counterparty is might take a little work as this story plays out.

Quote of the day

From Paul Krugman:

You see, $400 billion sounds like a lot, but it’s still small compared with the problem.

It would be funny if it wasn't true. Just to put it into context, Buiter thinks it will take two trillion to solve the problem.

How am I doing?

It is always good to take a look at the positions you were thinking about after the fact and see how they did. Let's see:

• A short in gold. Definitely not a good start, although I am sanguine about this one in the longer term. Gold at over $1000 does not make sense.
  
• Long the iTraxx and short the components stock. Too early to tell.
  
• Long yen, short dollar. With the dollar at a hundred yen, that is doing very nicely. I'd probably take it off here.
  
• A modest long MBIA and Ambac stock. This is basically a long irrationality position. It is underwater so far and needs a tight stop/loss: one issue will be whether the recently announced ratings reforms break their business model even further.
  
• Short Baltic Dry. That worked, and would have been taken off by now.
  
• Long a FTD basket on the subordinated prefs of national champion banks. Positive carry but looking sickly on a mark to market basis. Still a trade I believe in though.
  

Maybe I do have a future in global macro... from these shoots and so on.Incidentally, the FTD position is interesting given AIG's comments on fair value. According to the FT:

American International Group is urging regulators to change controversial accounting rules on asset valuations to stem the tide of writedowns that have wreaked havoc on Wall Street. [...]

Under AIG’s proposal, which has been presented to regulators and policymakers, companies and their auditors would estimate the maximum losses they were likely to incur over time and only recognise these in their profits.

All other unrealised losses would be recorded on the balance sheet but would not affect profits. In AIG’s case, this method would have reduced the impact of the $11bn writedown on fourth-quarter results to $900m.

Given AIG's losses, this is not just nonsense, it is self-serving nonsense. 'Let me make up the earnings I would like to have had' is not an accounting principle, it is a CFO's fevered fantasy.

The FT reports a more measured version of that sentiment:

“It might be hurting but fudging the accounting is not the answer,” said one Big Four partner. “Investors can make their own mind up as to whether the outlook will get better, but they can’t do that for a company without a clear, fairly valued starting point.”

“If management are going to use more of their own judgments in valuations, I’d think markets would be looking to build rather more risk premium into these companies,” said Ken Wild, global leader for international accounting standards at Deloitte.

And that is exactly the point. Investors, like Buffett, are mature enough to understand volatility in earnings if a good enough case is made for the position that is generating that volatility. But that case has to be made. It is not good enough for corporates to say 'trust me' and neglect to provide the users of financial statements with information on what the real earnings are. For the FTD basket the case is basically 'too big to fail'. I think that's a reasonable investment: you might well think it is nonsense. But the point is that if I was investing your money, then you would need to know what the market thinks of the position I put on, not just what I think of it.

Monoline CDS settlement

FT alphaville has a post pointing out the results of an ISDA exercise on CDS written on the monolines. ISDA has investigated both CDS written on the monolines themselves, and on bonds wrapped by them, and come up with what is presumably close to a comprehensive list. At first sight the notionals are a little scary: $134B relating to MBIA for instance. But note that first many of these contracts will net, and secondly many are pay as you go CDS on the underlying ABS, and hence may not be triggered by the default of the insurer. I'm therefore not sure we can necessarily conclude as alphaville does that if there were a credit event (which may be something other than default, remember)

there’s no way they’d all get paid in the timely, efficient and full manner implied on the ISDA CDS tin

Rather I think the right reading is that ISDA is pointing out that if there is a credit event, there will be a lot of work to do for dealers in agreeing settlement prices not just of the monoline's senior debt, but for the wrapped bonds. It is those bonds where there will be a wide range of prices (not least because many of them are illiquid) but at least if the dealers know what is out there, they will be prepared.

Top rated fiction

What does AAA mean? Almost nothing it seems. Hot on the heals of the agencies' failure to downgrade MBIA and Ambac there is a lovely interactive graph from Bloomberg showing the collateral support for the AAA bonds in the ABX: Bloomberg concludes only 6 of the 80 deserve the rating.

Barney Frank has noticed that the disconnection of ratings from default probability is an issue for municipalities, who have been given a rating far below their PD, then charged for insuring their debt on that basis. And he wants to see some changes. According to Bloomberg:

Barney Frank gave ratings companies a month to fix ``ridiculous'' standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

``I am going to say to the rating agencies and to the insurers: they have about a month to fix this,'' Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. ``We're going to tell them they have to straighten it out.''

I think I like this guy...

Let's look at the prospects for the monolines then. Barney is going to ensure the good quality states and other munis are rated AAA. A lot of muni insurance business goes away because of that. Buffett will eat much of the rest. And the structured finance market has disappeared too. Hmmm, business model, what business model?

Structured finance documentation issues

Take an OTC market that has grown really, really quickly. It's a safe bet that there will be documentation difficulties. After all, documenting all of those trades is a lot of work. For credit derivatives it is a particular problem in that there have been several sets of ISDA definitions (including the 1999 definitions, the 2003 definitions and the 2005 supplement - and that's without worrying about pay as you go credit derivatives). Regulators have been worried about credit derivatives documentation for a while: see here for an FSA 'Dear CEO' letter about getting your docs signed and here for an earlier news story.

Now it seems that legal risk is starting to really bite. The FT reports that

[...] more than 100 collateralised debt obligations (CDOs) and structured investment vehicles (SIVs) have already entered the murky post-event of default (EOD) state. This number will grow in the coming weeks.

Unfortunately, the legal documents that govern these transactions are so poorly written – full of ambiguities, inconsistencies, “circular references” and worse, contradictions – that many investors, trustees and respective legal advisors do not know how to interpret them.

For instance, in a number of cases it is not clear whether the assets should be sold (liquidation) or let to run off (acceleration). Moreover, even the rules to distribute the money post-EOD (who gets what) are unclear.

This is completely unsurprising. Desperate lawyers struggling to document the last trade before the next one closes make mistakes - anyone does if they are under enough time pressure. No one hired enough lawyers in the good times because there weren't enough lawyers: the market had grown faster than the skill base supporting it. What happens next will be insightful.

Buy bonds now, Tonto

I am reminded of the terrible joke about the Lone Ranger and Tonto. They are surrounded by hostile Indians, their horses are dying, they have no cover, and their enemies have arrows pointed at them. The Lone Ranger turns to Tonto and says "What shall we do?" Tonto replies: "Who's this 'we' white boy?"The bond market is similarly one way at the moment. The FT comments on the spread widening in high grade debt here, while FT alphaville discusses the related turmoil in the CDS market here, the latter partly related to concerns over the stability of Bear, Stearns. Yet actual experienced defaults are low and even taking into account a severe recession, many high grade bonds represent excellent compensation for default risk. The problem is that they may be even better value tomorrow, given that some of that compensation is also for liquidity risk, and liquidity is terrible in many parts of the market right now. Until we can kick the 'they will be even cheaper tomorrow' mindset, spreads will remain wide.

Introducing your new bad boy, the $200B TSLF

The wave of cash keeps on coming. This is a new level of seriousness about liquidity risk management in the latest annoucement from the FED. From Bloomberg:

The Federal Reserve, struggling to contain a crisis of confidence in credit markets, plans to lend up to $200 billion in exchange for mortgage-backed securities.

The FED statement itself makes the mechanism clear:

The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.

This action is also coordinated with other central banks, and simultaneously the FED is increasing the size of its swap lines with, amongst others, the ECB. See FT alphaville for more comment and links to the other central bank announcements.

If this does not bring Agency spreads in under 200bps, we are in such trouble... As Krugman puts it, this is a big slap in the face for the market. Or if you insist on doing without hyperbole, an extensive exercise in sterlised monetary intervention on the asset side of the balance sheet. I prefer 'slap in the face' myself.

Update. The FT in an editorial is not sanguine that the TSLF will have much effect:

Whether it has any effect depends, as it has with every central bank intervention since last July, on whether this is a crisis of liquidity or solvency. If it is simply the case that banks do not have the cash to lend against mortgage bonds then this will have an effect. If, on the other hand, banks are worried that the mortgage bonds or their owners will default, then they will be unlikely to lend even if they can refinance at the Fed.

Banks’ need for liquidity is hard to observe directly, but the evidence implies that the greater problem is solvency, and that the latest intervention will therefore have little effect. First, the price of insuring the credit risk of banks’ own debt has soared, suggesting worries about their solvency. Second, even triple-A mortgage bonds have fallen in price, and a number of leveraged investors, such as Peloton Capital, have failed. That suggests ample reason to worry about repayment. Third, Wall Street banks insist that they have plenty of cash.

I don't entirely buy this line of argument: you cannot split liquidity completely from solvency, in that if an asset turns illiquid, its price falls reflecting that extra risk. Yes, banks might have enough cash short term to meet their obligations. But if the FED can liquify these newly illiquid assets - MBS - then it can address one of the major causes of solvency concerns. Liquidity support is price support in this sense.

Note also that the FT is buying the conventional line that the cost of insuring a bond reflects the market's perception of default risk. That just isn't so at the moment in the main. It reflects the fact that there are more buyers of protection than sellers, mostly due to deleverage. The 'arbitrage' relationship between probability of default and CDS spread only holds if there is enough risk capital around to pull the spread in if it goes wide by selling protection. That is not the case today.

When is safety a good idea?

Faced with that title, the experienced reader will immediately say 'it depends what you mean by safety'. Let's start with a seemingly innocuous proposition: 'if you can make something safer at no or little cost, you should'. One potential counterexample here is bicycle helmets. While the evidence is by no means definitive, it does suggest that making people wear helmets makes cycling less safe. What seems to happen is that people feel safer when wearing a helmet and hence take more risks. They are not that much safer, so the extra risks they take introduce more risk than the helmets remove. It may well be the case that helmets make bike accidents involving banging the head safer, but they make accidents in general more likely, it seems. In short requiring their use involves risk transformation rather than risk reduction.

Another good example is safety glass. Some forms of safety glass (as I have recently found out) don't shatter: a sheet is in fact composed of two pieces of glass bonded either side of a transparent but tough plastic film, so even if the individual glass sheets break, they remain bonded to the plastic. That's all very well if you want to avoid glass shards flying all over the place in the event of a breakage. But it does mean when you want to remove the glass you can't just cover the area with some material to pick up the shards then smash it: you actually have to cut the sheet out of the frame. This is a much more dangerous job than removing ordinary glass as a number of small cuts on my fingers testify. Very minor injuries aside, though, what is interesting is that something that was created as a safety feature actually turns out to increase risk in certain situations. A good question therefore in designing any kind of safety mechanism - in mechanisms, electronics, software, finance or regulation - is:

When might the behaviour we think is unsafe actually be useful? And what will happen then if the safety mechanism prevents it?

One might even argue that collateral is functioning that way at the moment. Clearly in ordinary conditions, calling collateral reduces risk. But if the failure to post collateral actually pushes your counterparty into default, as happened to Carlyle Capital Corp, it might not be such a good idea after all. And, as JPMorganChase recently pointed out, the banking system is currently facing a systemic margin call. Hmmm....

Quote of the Day

I don't usually do this, but this one is too good not to pass on.

Getting the FBI to do your due diligence doesn't seem like a particularly great business strategy.

From Marketwatch via Calculated Risk a propos Countrywide.

Decision making and compensation

Alea references a fascinating paper by Richard Herring and Susan Wachter, Bubbles in Real Estate Markets. This makes an important point about the stability of financial return distributions:

The ability to estimate the probability of a shock – like a collapse in real estate prices – depends on two key factors. First is the frequency with which the shock occurs relative to the frequency of changes in the underlying causal structure. If the structure changes every time a shock occurs, then events do not generate useful evidence regarding probabilities.

And of course this is the case in most (all?) financial situations. The next crisis is never like the last one, in part because trading behaviour is changed by memories of the last one, in part because of product innovation and the changing structure of financial intermediation.

The important question then is

How do banks make decisions with regard to low-frequency shocks with uncertain probabilities? Specialists in cognitive psychology have found that decision-makers, even trained statisticians, tend to formulate subjective probabilities on the basis of the “availability heuristic,” the ease with which the decision-maker can imagine that the event will occur. [...]

This tendency to underestimate shock probabilities is exacerbated by the threshold heuristic (Simon(1978)). This is the rule of thumb by which busy decision-makers allocate their scarcest resource, managerial attention. When the subjective probability falls below some threshold amount, it is disregarded and treated as if it were zero.

Compensation policies make this worse. Suppose you buy insurance against a rare event that everyone else ignores. Your return suffers relative to them, and hence in most years (when the rare event does not happen), you are paid less. On the other hand, if the event does happen, the bank's total income will almost certainly fall anyway, compensation will be tight, and you will likely not be rewarded properly for being the far-sighted manager you are. On the other hand, in the bad year those who did not buy the insurance acted like nearly all their peers, and hence will probably not be punished too badly.

The TAF, liquidity, and partial nationalisation

Interfluidity (IF) points out some suggestive detail in the FED's recent announcement about the TAF. In particular, IF brings up the collapse of distinctions in collateral types in the New York FED statement:

When the Desk arranges its conventional RPs, it accepts propositions from dealers in three collateral “tranches.” In the first tranche, dealers may pledge only Treasury securities. In the second tranche, dealers have the option to pledge federal agency debt in addition to Treasury securities. In the third tranche, dealers have the option to pledge mortgage-backed securities issued or fully guaranteed by federal agencies in addition to federal agency debt or Treasury securities. With the special “single-tranche” RPs announced today, dealers have the option to pledge either mortgage-backed securities issued or fully guaranteed by federal agencies, federal agency debt, or Treasury securities.

This lack of distinction between Treasury securities (known value, known liquidity, pretty much) and MBS (unknown value, problematic liquidity) is very troubling. It is, in James Hamilton's wonderful phrase (via IF) monetary policy using the asset side of the balance sheet.

IF then goes to compare the size of the FED's liquidity injection ($200B) with an estimate of U.S. bank equity ($2T). That is a reasonable comparison. What is less reasonable is the assertion that these positions are equity like, and so represent a 'partial nationalisation' of the U.S. banking system. With equity comes two things: an ownership stake (and hence participation in profits once debt has been paid); and control. Repo, even repo of assets of uncertain value, is neither. In fact the FED has the worst of both worlds right now, at least in terms of these positions. Like an equity holder it is providing funding for an uncertain period - since if it withdraws these auctions some banks will fail - and like the equity holder it has the downside of bank assets proving problematic. But it does not have control, nor does it have equity-like upside. In particular it cannot force the banks to lend. And that is probably what the economy needs most at the moment.

What worked, what didn't

The Senior Supervisors Group recent document, Observations on Risk Management Practices during the Recent Market Turbulence is a more interesting read than the Financial Stability Forum interim report not least because it compares leading firms who have come through recent events relatively unscathed with those that suffered some of the largest impacts.

Some of the highlight follow, with my emphasis. First the SSG identifies four firm-wide risk management practices that differentiated performance:

Through robust dialogue among members of the senior management team (including the chief executive officer, the chief risk officer, and others at that level), business line risk owners, and control functions, firms that performed well through year-end 2007 generally shared quantitative and qualitative [risk] information more effectively across the organization.

This is pure risk culture. Firms which keep risk data to the high priesthood of risk management and a few senior business leaders are not using as much of the brainpower of their organisation as they could. Further, this kind of culture tends to go with authoritarian, vertical management styles which makes it much harder to discuss issues openly and honestly.

At firms that performed better in late 2007, management had established, before the turmoil began, rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. These firms were skeptical of rating agencies’ assessments of complex structured credit securities and consequently had developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately. Finally, when they reached decisions on values, they sought to use those values consistently across the firm, including for their own and their counterparties’ positions. Subsequent to the onset of the turmoil, these firms were also more likely to test their valuation estimates by selling a small percentage of relevant assets to observe a price or by looking for other clues, such as disputes over the value of collateral, to assess the accuracy of their valuations of the same or similar assets.

Clearly anyone trading complex securities should have independent expertise to value them. Equally clearly once they have been valued, that value should be used consistenly throughout the firm. What's shocking here is that some leading firms - this survey comprises eleven of the largest banks - did not have these basic control processes in place.

Those firms that avoided more significant problems through our year-end review period aligned treasury functions more closely with risk management processes, incorporating information from all businesses in global liquidity planning, including actual and contingent liquidity risk. These firms had created internal pricing mechanisms that provided incentives for individual business lines to control activities that might otherwise lead to significant balance sheet growth or unexpected reductions in capital. In particular, these firms had charged business lines appropriately for building contingent liquidity exposures to reflect the cost of obtaining liquidity in a more difficult market environment.

It so often comes down to incentive structures doesn't it? If you charge businesses for actual and contingent liquidity, including writing liquidity lines to conduits, then they will make sure the firm is paid enough for these structures. If you don't, they will be pretty much given away.

Firms that tended to avoid significant challenges through year-end 2007 typically had management information systems that assess risk positions using a number of tools that draw on differing underlying assumptions. Generally, management at the better performing firms had more adaptive (rather than static) risk measurement processes and systems that could rapidly alter underlying assumptions in risk measures to reflect current circumstances. They could quickly vary assumptions regarding characteristics such as asset correlations in risk measures and could customize forward-looking scenario analyses to incorporate management’s best sense of changing market conditions. Most importantly, managers at better performing firms relied on a wide range of measures of risk, sometimes including notional amounts of gross and net positions as well as profit and loss reporting, to gather more information and different perspectives on the same exposures. Moreover, they effectively balanced the use of quantitative rigor with qualitative assessments.

This is very interesting. If you have different tools with different assumptions, you have a reasonable handle on model risk. If you have one system, or multiple systems which all use the same assumptions, then you don't. Flexible systems are clearly important, but perhaps even more significant is the mindset of looking at risk in different ways, and being sceptical about the results of any one analysis.

The report then goes on to look at three business lines where varying practices produced different outcomes. The first, unsurprisingly, is CDO structuring, warehousing, and trading businesses. Here the key issue was whether

Internal incentives were missing or inadequately calibrated to the true risk of the exposures to the super-senior tranches of CDOs.

To be fair, I doubt anyone really got this right. What may have happened, though, is that positions that were originally acquired with the intention of selling them on became prop positions when they couldn't be sold at the mark rather than being written down until they did sell.

Next, syndication of leveraged financing loans:

Some firms worked aggressively to defend or expand market share in the syndication of leveraged financing loans, and many of those that later faced challenges in this business did not properly account for the price risk inherent in the syndicated leveraged lending pipelines.

Buying business is fine. But if you are going to pay for league table position, then at least know how much you paid for it.

Finally in conduit and SIV business we find:

Several firms did not properly recognize or control for the contingent liquidity risk in their conduit businesses or recognize the reputational risks associated with the SIV business.

For me the interesting part here is the reputational incentive. All the accounting and regulatory arguments that got these assets off balance sheet depending on the risk really passing to SIV and conduit investors. Firms that recognised that their reputational risk tolerance meant that this risk really had not been transferred clearly did better than those that pretended that the accounting and regulation followed the reality.

Cable wants to lock them in

Tax super-rich properly, Cable tells Brown:

'If we are not careful, Russian and Ukranian oligarchs living in £80m houses might go somewhere else,' Vince Cable tells Lib Dem conference. 'That's tough. Let them go'

Cable, the Liberal Democrats' Treasury spokesman, condemned what he described as "our spineless government" for allowing the rich to enjoy tax breaks not available to the poor.

"The idea that the super-rich should be elevated above taxation is immoral and deeply insulting to those on modest incomes who pay their full whack of tax," Cable said, in a speech to his party's spring conference in Liverpool.

If showing courage on the wrong issues was a hallmark of Tony's administration, craven cowardice is a hallmark of Gordon's. Vince Cable has picked a good issue here, where both the popular will and fairness are on his side. Let's hope Gordon is sufficiently embarrassed to actually do something.Tax avoidance is not a victimless crime. It is just a crime with many, many victims. Tesco's unethical if hardly unusual scam to avoid paying tax on £1B of earnings, for instance, is morally equivalent to a theft of about £10 from every British tax payer. (Roughly 30 million tax payers, roughly £300M tax saved.) Worse, it is a crime the government could prevent by a reform of the law so they are complicit to this tax avoidance. Flat rate tax systems might be regressive, but that is easily fixed, and crucially (when combined with rigorous policing of transfer pricing) they make it a lot harder for one group to avoid their responsibilities and raise a finger (corporate or individual) to society.

A 'To Do' list

There is a lot going on at the moment, and I don't have time to write the extended posts I would like to on each of these topics, so for the weekend here's some material to be fleshed out later.

• Is global regulation or accounting a good thing? A post at Information Arbitrage made me consider the issue. They are in favour, pointing out that a complicated amalgam of rules, regulations and standards [...] places enormous friction on global transactions and doesn't really protect investors any better than under a standard, global, common sense regime. Certain inhomogenous standards are costly and advantage some institutions over others. But crucially that diversity may protect the system. At least in a country-specific regime, if a rule leads to perverse behaviour, it only screws up that country. If global rules are wrong, the whole system suffers. Given that we do not know how to write completely safe regulations for financial institutions, perhaps having a choice of regimes is a good thing?
  
• Q. When is it a good idea to voluntarily modify the term of issued securities to your financial detriment? A. When it avoids having to pony up cash that otherwise it might stress you to find. Financial Crookery explains all in a post on LYONS.
  
• Spreads, including the Libor/OIS spread, the iTraxx, and the Italy/Germany spread, are going out again, and the FED is trying to bring it in by expanding the size of TAF auctions. What is interesting about this is that liquidity, rather than rates, are being used as the tool of choice. Alea notes some unfortunate timing too, here, and Interfluidity has a provocative post here.
• Corporates think CDS spreads are wrong, and are pricing new debt off secondary bond prices rather than CDS again. Given some parts of the CDS market are pretty much one way right now, that makes sense.
  
• What did banks do wrong? See here for a summary.
  
• What is a safe level of capital for liquidity risk? Carlyle's fund was apparently leveraged 28:1 and they are being carried out. That implies that for a leveraged Agency position - a position with no credit risk remember - the capital for liquidity risk is at least 4%. Scary, huh?

A small town in Switzerland

The Basel committee is meeting soon, unusually enough actually in Basel, although I suspect in a rather nicer hotel than this.Gillian Tett discusses the gathering. The BCBS has a significant problem on their hands:

Thus the crucial question confronting the central bankers this weekend, as they fly in to snowy Switzerland is twofold: first, are we on the verge of a new downward lurch? And second, is there anything the G10 bankers can actually do to stop this?

The problem Tett identifies relates to mark to market:

But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.

That's not hard to fix. Give a temporary waiver to the bank for capital calculations relating to these assets. Allow banks to move existing ABS securities and derivatives into the banking book for a short period, and let the banks know how long they have to get back inside the park. And don't tell anyone you are doing it. That will restore confidence. Tett herself is skeptical that this is possible:

But I would be surprised if any action occurs soon.

Perhaps coordinated action is unlikely. But it would not surprise me if this was already happening.

Incidentally this brings out an interesting point. Do the regulators have the power to do this? They have complete power over regulatory capital, but not over accounting. I'm not sure if it would even, strictly speaking, be legal for a bank to move a fair value asset under IAS 39 into the banking book and not mark it. The regulators could permit the banks to ignore the deduction to Tier 1 caused by losses on these instruments, but the key difference is that these losses would still have to be published in the banks' income statements. Perhaps that is something the central bankers should discuss.

Why are Agencies so wide?

Following yesterday's announcement that a Carlyle fund is in default over its repo arrangements on Agency RMBS, Bloomberg comments on the agency/treasury spread:

Yields on agency mortgage-backed securities rose to their highest relative to U.S. Treasuries in 22 years as banks stepped up margin calls and concerns grew that the Federal Reserve may be unable to curb the credit slump.

The difference in yields, or spread, on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10-year government notes widened about 7 basis points, to 223 basis points, the highest since 1986 and 89 basis points higher than Jan. 15.

Why? There are a number of reasonable explanations. Firstly and most obviously there are more buyers than sellers of treasuries and more sellers than buyers of agency MBS. Why does no one step in to arbitrage the spread? Because there is little risk capital in this market that is not deployed, and/or anyone with money is waiting for things to get worse.

Next, even if we do accept that an arbitrage relationship holds between treasuries and agencies, (1) the liquidity premium on agencies is high; (2) the credit spread on agencies is increasing [since as the agencies lose money and become more highly leveraged, the likelihood of government support must decline somewhat]; and (3) regulatory risk in the mortgage market makes it unclear what the cashflows of the underlying assets will be anyway. (Remember even if the agency guarantee holds good, a reduction of principal on the asset pool causes prepayment, thus regulatory risk effects the optionality of the pass through.)

Three new signs of doom

Two from Bloomberg and one from the FT:

• 1. Auction-rate bond failures show no sign of abating after investors abandoned the market for variable-rate municipal securities. Almost 70% of the periodic auctions in the $330B failed this week as investment banks stopped buying the securities investors didn't want.
  
• 2. Carlyle Capital Corp., the publicly traded credit fund backed by private-equity firm Carlyle Group, said it received a notice of default after failing to meet a margin call yesterday. [...] The last few days have created a market environment where the repo counterparties’ margin prices for our AAA-rated U.S. government agency floating rate capped securities issued by Fannie Mae and Freddie Mac are not representative of the underlying recoverable value of these securities. Unfortunately, this disconnect has created instability and variability in our repo financing arrangements, Chief Executive Officer John Stomber said in the statement.
  
• 3. The recovery for Peleton's investors in its flagship fund is zero. Nada. Niente. Squat. Even LTCM's investors got 7 cents on the dollar...
  

The Monoline Game

Will one and a half be enough? Ambac tumbled yesterday on news that instead of an expected bank-based recapitalisation in excess of $2B, the monoline would instead do a $1B rights issue and sell $500M of hybrid securities. This is really calling S&P and Moody's bluff. If Ambac's judgment is that that they do not have the bottle to downgrade it, only a billion of new equity feels like a reraise on the river after flat calling the turn.

Ambac has also decided not to split. Presumably given Dinallo has no authority to force them to, and the legal risk of good insurer/bad insurer is great, this at least counts as rational.

Happy Birthday Blog

On the second birthday of this blog, it is perhaps worth spending a moment on the name. Deus ex Macchiato* is so named for two reasons: the God in the machine is one, as I'm interested in how the rules of a particular situation determine the behaviour. Sometimes simple constraints can have unexpected consequences - a great example is how the Market Abuse Directive prevented the Bank of England from intervening early in the Northern Rock crisis. The 'Macchiato' comes from a system that works really well: coffee in Italy. It's cheap, it's good, and everyone expects it to work. No Italian would expect a local bar to serve anything other than a great coffee, and few would pay more than a euro for it.As I contemplate the brownish steamed milk that the average British coffee shop provides, it interests me how a small change in the rules can provide a big difference in outcomes. Whether you are a finance professional, an engineer, an IT specialist, a regulator or a politician, you might perhaps have reason to be interested in systems engineering seen that way. Your scheduled programme from the frontier resumes shortly.

*απὸ μηχανῆς θεός is a literal translation - a calque - from the Greek. Originally it referred to the actors playing Gods being lowered by a crane onto the stage. That might have spoilt the illusion, but it was the only way to achieve what was needed.

Update. There is an article by Jenni Russell today in the Guardian which gives another good example of how badly written rules and ill-chosen performance metrics can lead to undesirable outcomes.

Just imagine you are part of the government. Among your principal concerns are how to hold society together at a time of rapid change. You worry about social and community cohesion and the practical, psychological and economic isolation of the elderly, the disabled, rural-dwellers and the poor. You set up a Department of Communities and spend billions on initiatives to create thriving, sustainable communities that will offer a sense of community, identity and belonging. Sustainability is another key concern. You care about the planet and exhort people to make fewer car journeys and walk or cycle more.

You inherit, all around the country, a network of local offices which happen to provide many of the functions you seek. They give people access to cash, benefits and government services, as well as connecting them through the post. The majority are combined with a shop, which makes them a social hub and meeting point. The postmasters who run them are an informal source of support and advice on everything from benefit claims to what to do in the event of a death. In cities almost everyone lives within half a mile's walk of one, and frequently their presence is what sustains a small shopping parade. In rural areas they allow people to lead local lives, and are often the last service left in places that have been steadily stripped of buses, shops and schools. So what do you do? In the name of economic efficiency, you take government business out of their hands, and then start closing them down, in their thousands. [...]

The Post Office is not an independent actor. Its strategy is decided by the government which, as its sole shareholder, defines its purpose and the level of financial support. Labour has already shut 4,500 offices and made many more unprofitable by moving key business, such as the payment of pensions or TV licences, to banks or the net. Now it is demanding that the network must close 2,500 of the remaining 14,000 offices because they are making "unsustainable" losses of £200m a year. The government announces that it will carry on subsidising the network, at £3m a week, but only for the next three years. I asked the Post Office press officer what the company's mission was. "To go into profit by 2011," she said. What about community needs? "You'll have to ask the government about that."

What is so outrageous about this strategy is that the government is acting within completely artificial constraints. Separating the Post Office from Royal Mail 20 years ago, removing key functions five years ago, and defining the network as a business, are all political decisions, not a matter of economic fact.