The equity credit dislocation

I have observed before that the equity markets have not yet reacted as fully as the debt markets to the crisis - and increasingly it looks likely that they will fall further rather than that the debt markets will rise to join them. Goldman is of that mind, and has recently observed that downside vol is cheap so now is an excellent time to buy puts. Bloomberg reports that Goldman:

recommended Dow Jones Euro Stoxx 50 Index puts that expire in December and have a strike price of 3,000, or 11 percent less than the measure's closing level today.

``High inflation/low growth is an increasing downside tail risk ...If that risk crystallizes, we think it means material rather than modest downside.''

The Euro Stoxx 50 plunged 24 percent to 3,354.20 in 2008 and closed at the lowest since November 2005 last week. The December 3,000 puts on the index fell 6.7 percent to 83.50 euros today. They cost as much as 189.30 euros in March.

Hiding the pain

A couple of weeks ago I pointed out that while the US institutions have taken their write down medicine, raised new capital, and are busy getting on with trying to figure out what to do next, the Europeans have been much less assiduous in recognising their losses. Now Citigroup, via FT alphaville, comes up with a concrete example: Barclays. The corrected version of the Citi piece is said by the FT to include the following:

Barclays has reclassified some assets, most notably leveraged finance and CDOs, and accounts for them as if they were loans held to maturity. This means that these assets are not marked to market but impairment provisions are raised when the bank believes that there is a risk to the credit outlook. While this is an unusual treatment for leveraged finance, as the financing was originally intended to be sold down, the assets are at least primarily loans. The treatment is even more unusual for CDO exposures.

That four billion really does not look enough now, does it?

Update. It is not just CDOs. From the FT:

The debate has [also] focused on Barclays’ policy of accounting for leveraged loans by looking at the borrower’s financial performance rather than the price at which those loans are trading in the market.

This has puts it at odds with some US and European rivals, which value their leveraged loans on a mark-to-market basis. Most leveraged loans are trading at 80-90 per cent of their face value, with some changing hands for as little as 70 per cent.

Knowns and Unknowns through the Crunch

I have been reading Cassola et al.'s A research perspective on the propagation of the credit market turmoil from the most recent ECB research bulletin. The paper concentrates on information issues in the credit crunch. Here's how I see matters there.

Before the crunch investors had some information on asset prices as many ABS were (or seemed to be) liquid. On the other hand there were two classes of information failure relating to asset risk: ignorance (where a risk taker simply had not tried to assess risk); and model failure (where the risk taker had tried, but had got the wrong answer because their model was mis-calibrated and/or failed to include all the pertinent risk factors).

After the crunch in contrast, investors had less information on asset prices but more information on the risk of ABS. Rapid asset prices changes combined with illiquidity caused rapid selling, model recalibration, and risk takers had more information.

Then however, understanding that ABS were illiquid, that prices were both falling and uncertain, and that it was unclear who had what, investors in financial institutions became concerned about their ability to assess bank credit quality. As Cassola et al put it:

the actual extent of exposures to the problematic instruments and the health of specific financial institutions becomes only gradually more known

Hence the interbank market freeze up, amongst other things.

It seems then that a good understanding of the interplay between what's known, what's known to be unknown, what's thought to be known, and what you don't even know you need to know is important in explaining the Crunch. (Why did Rumsfeld get so much grief for this? I think it was the smartest things he has ever said.) In particular new information can suddenly throw the spotlight on something you thought you knew but in fact you didn't. Caveat emptor.

Cosmetic but effective in the short term

Just like these council workers taking down fly posters only for them to reappear in a few days, so banks are getting ABS off balance sheet by offering to finance them. The FT reports one such set of tricks here and Naked Capitalism has a discussion of Lehman's deleverage using related shenanigans here. The bottom line is obvious: if you can't sell something but you need to look as if it is gone, find somewhere to park it, pay the parking fee and transfer any risk you can get rid of, and hope that when or if the asset comes back, it is worth more.

Cluedo for financial markets commentators

There is an amusing little game from Forbes here. Here is a summary of the results so far:

Default and CDS written by or referencing monolines

Recent articles (see for instance here, here, here, and here) have spurred a concern that I confess should have occurred to me earlier. What can cause an event of default by a monoline, and what happens next.

The first issue concerns the effective recovery for ISDA claims against a monoline. Here the crux is the relationship between the holding company and the insurer. As I understand it, most monolines are structured with a listed holding company and a regulated insurance sub. Obviously insurance contracts, including financial guarantee policies (whether transformed into CDS or not), are written by the insurance company, and so the insurance company has most (but not all) of the group's capital to support this risk.

Which group company writes CDS? My suspicion is that it has often been the holding company. If the regulator seizes the insurer, it is almost certainly (but check your docs) an event of default on the CDS. But in that case the regulator will almost certainly not permit CDS counterparties to be paid at the expense of claims paying ability for the insurance business - they won't let the money out of the insurer. The holding company will be left with a whole lot of liabilities and essentially no assets beyond a worthless stake in an insurer the regulator has taken over.

This is of course also an issue if you have debt issued by the holding company, or if you have transacted CDS referencing that debt. As Linklaters pointed out a few months ago, credit events can include quite minor regulatory intervention. I suspect that after such an event recoveries might be very low even if the operating sub is still perfectly capable of paying insurance claims.

Update. FT alphaville has additional reporting on FSA, CIFG and FGIC here, following their earlier story on MBIA. What I can't see in the material I have read so far is whether a breach of regulatory capital requirement of the insurance sub is likely to be credit event on (a) CDS written by the parent and/or (b) CDS referencing the parent.

Fed, SEC Near Accord To Redraw Wall Street Regulation

Am I the only one to think that a more comprehensive solution to the fractured US regulatory landscape is needed than just to increase cooperation and information-sharing between the central bank and [the] SEC as the WSJ reports is in the offing? What about alignment of capital requirements? You need to rebuild the whole building, guys, not throw a tarp over it and call it fixed.

New version of my credit crunch article

A revised version of A Preliminary Enquiry into The Causes of the Credit Crunch is available here.

TGIF...

... or perhaps not if you are a monoline. Especially a press officer at a monoline. There's lot's of steam to generate as this list of current press releases from Bloomberg admirably demonstrates. Oh yes. Long coal, short insurers.

Management acts while pools go fetid: ratings and dynamics of loss distributions

I have been reading a fascinating (if long) article Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Joseph Mason and Joshua Rosner. There is an awful lot in the document, but here I want to concentrate on one issue they raise which I had not thought about before, namely the shape and trajectory of the loss distribution through time.

Consider a corporate bond. For a holder of the bond, the (hold to maturity) loss distribution has a big lump of probability in the 95%-100% return bucket corresponding to the likelihood that they will get their money back. Then there is a gentle bell curve lower down corresponding to the distribution of recovery values. Two observations:

• As the credit quality of the corporate declines, this shape moves but typically those moves are slow. The big lump gets a little smaller and default gets a bit more likely, fattening out the curve around the expected average recovery.
  
• One of the reasons that moves are slow is that the company has management. Default is bad for these folks so they try to avoid it by altering their strategy or the capital structure and/or by asset sales. They have strategic options which they exploit, often saving the company.

Now consider a typical tranched ABS backed by a pool of collateral. Here tranching and other credit enhancement means that default is unlikely for the rated tranches. However:

• The shape of the distribution is different. In particular, the average loss given default can be much higher.
• The time evolution of the distribution is different: most static ABS pools evolve so that for a given tranche, default becomes either certain or vastly improbably.
• Thus if the pool behaves a bit better than expected, most or all of the rated tranches will be money good. Mason and Rosner say this `wastes' credit enhancement, which I don't really see, but certainly even lower tranches can become risk free in some deals fairly fast.
• On the other hand, if the pool behaves even a little worse than expected, the impact on the lower tranches can be severe. Therefore ABS downgrades, when they come, are often multiple notch downgrades.
• Note that this is partly because most ABS has no asset diversification and no time diversification: unlike a corporate, there are no strategic options for the issuer to do something that doesn't lose as much money as their current approach.

None of this means that ABS ratings are wrong, necessarily, but it does mean that the users of ratings need to understand the key differences in the time evolution of credit risk between corporates and ABS.

Liquifying the ECB balance sheet

The Economist points out an issue:

The European Central Bank (ECB), widely praised for providing banks with ample liquidity during the credit crunch, now has a problem: how to encourage banks to place freshly created asset-backed securities (ABS) with investors, rather than dumping them, like so much radioactive waste, in its vaults...

On the face of it there is no immediate problem. Only around 16% of the ECB's collateral so far is ABS. Banks are drinking from the liquidity fountain and keeping the cost of high-street mortgages contained at the same time, which they might not be able to do otherwise.

But it is not helping the revival of a publicly traded ABS market, and may be fostering the creation of even murkier securities. Many of today's ABS are even less transparent than those sold before the crisis—the ECB requires a rating by only one agency, not the usual two, and pre-sale reports are often sloppily prepared.

What's the answer? Well one obvious one is slowly, and with considerable vigilance over the market impact, to raise the haircuts. Countercyclical central bank window haircuts make sense. As matters improve, the ECB can tone down its roll as financer of first (and only) choice.

Another is to permit the assignment of the financing as I mentioned earlier. The ECB could allow banks to sell the securities and transfer the obligation to repay to a third party. Obviously that means the ECB would have to be willing to offer liquidity for a short period to firms who were not necessarily member banks. But if that helps restart the ABS market, it might be a small price to pay.

Liability Fair Value

Tom Selling from The Accounting Onion was kind enough to point out his blog to me. Reading a post on FAS 157, it suddenly occurred to me that the implementation the audit firms have permitted of 157 on liabilities, based on the FASB staff position, isn't consistent with the conceptual framework of 157.

The standard says:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Suppose I run David's Broker/dealer, DBD. DBD bonds are liquid and so have an observable credit spread. If DBD credit spreads go out, DBD bond holders using fair value suffer losses which are reported in their P&L. But if DBD wants to buy back those bonds in an orderly transaction between market participants, DBD bond holders are very likely to force it to pay par plus accrued (at least if DBD is a going concern). Moreover it's illegal for DBD to buy its own bonds back in the secondary market in most jurisdictions so the value of the liabilities for DBD is not symmetrical with the value to the holders: it cannot take advantage of its elevated credit spread even if it has the money to buy back the bonds. Hence the staff position doesn't reflect economic reality, and what most people feel in their gut - that 157 gains on liabilities due to credit spread widening are bunk - really is true.

I'll end with a quote from the amusingly petulant comment the Basel Committee issued on IAS 39:

it would be wholly unsatisfactory if an entity which was insolvent in the sense of its assets being worth less than the par value of its liabilities nonetheless appeared to be solvent because the fair value of its liabilities was recognised on its balance sheet, with the fair value below nominal value...we recommend that the exposure draft’s guidance on the fair value option be revised ...[to] exclude the mark to market of own credit risk from the fair value option by limiting the mark solely to valuation changes due to general market movements

The ECB on Eurozone Bank Loss Recognition

More from the ECB financial stability review. We take up the story with a discussion of the losses in large complex financial institutions:

The impact of the sub-prime crisis can be seen in the figures disclosed by banks in their financial statements in two main ways: valuation changes on various assets and increases in credit impairments. Most of the figures recorded in banks’ accounts are valuation changes and relate to securities whose value has been adversely affected by the sub-prime turbulence. Under International Financial Reporting Standards, euro area banks value these securities depending on the accounting category in which they were included at the time of recognition [principally] fair-value [and] available for sale.

(The emphasis is mine.)

In other words the impact so far on Eurozone banks has mostly been confined to fair value instruments. For accrual accounted loans we have not yet seen massive increases in loan loss provisions. Clearly there are some European countries with their own property market issues - the UK, Spain, Ireland, the Baltics, perhaps Poland - so we definitely have not seen the end of this story yet.

The ECB then points out the inherent superiority of FAS 157 vs. IAS 39:

the way in which banks calculate mark-to-market valuation changes and whether these valuation changes are comparable across banks have attracted increased attention in the current period. Before the turmoil, under IFRS, banks disclosed limited information concerning the amount and type of assets that were marked to model. This situation in the euro area is in contrast to the United States where new Generally Accepted Accounting Principles (GAAP) require certain disclosures concerning the portion of assets in a portfolio that are purely marked to model.

In other words the Europeans can hide both their methodology and the split between mark to market and mark to model whereas the Americans can't.

Mortgage eye candy data from the NYT

Florida and Nevada I can understand but that Michigan/Ohio/Indiana cluster is interesting. My shorthand - if it's a CSI location it has a mortgage problem - clearly needs to be revised unless CSI New York is renamed to CSI Lansing.

Conditions update from the ECB Part II

A few more items that interested me from the ECB document discussed earlier.

The Turn. The spike in rates over year end is known to interest rate traders as the turn. Look at how it intensified in 2007 vs. earlier years:

Country Linkages. A fascinating graphic of the interbank linkages between countries:

Delevergage. The change in typical repo/securities lending haircuts from March 2007 to a year later:

The procylicality of securitisation. The ECB finds that securitisation assisted the supply of credit in the good times:

the spectacular increase in securitisation activity in the euro area, coupled with the low level of bank risk and favourable financial conditions of banks, seem to have had a positive effect on the supply of credit

But crucially there is a negative effect on credit supply when the securitisation market becomes more difficult:

the importance of the bank lending channel changes over time and deterioration in the business cycle or the financial condition of banks could have an adverse affect on bank loan supply.

Conditions update from the ECB

The most recent ECB financial stability review is a mine of useful information. Here are a few nuggets from the first chapter: more to follow.

U.S. Cash out refi. As many people don't have much equity left in their homes and remortgage conditions are very difficult, cash out refi and 2nd lien financing has fallen off a cliff. This source of spending money is bound to have an effect even if other things were equal.

ARM resets. The current low U.S. rate environment should at least cushion the wave of upcoming ARM resets. Here are the three most important ARM rates:

ABCP. This has not completely disappeared, but at $750B volumes are running at around 60% of the pre-Crunch levels. Non asset backed CP has not been significantly affected.

ABS spreads. These remain elevated in all areas, not just RMBS:

Procylicality of the capital rules. Increased volatility, higher credit spreads and decreased diversification benefits means capital requirements are higher even though institutions have been deleveraging. Here for instance is the distribution of changes in VAR for large complex financial institutions:


The role of the structured finance in the Crunch. This is a reasonably even-handed account so the salient points are worth quoting:

Notwithstanding the positive contribution they can make in facilitating portfolio diversification and the distribution of risk across a wide range of investors ... structured finance markets played a central role in propagating the initial sub-prime mortgage market shock across broader credit markets...

Factors that played a central role in the recent market turmoil included a loss of confidence in the valuation of complex structured products and an increase in uncertainty among investors about the adequacy of their ratings in a context of scant information for risk assessment. This highlighted an already well-known weakness of the originate-and-distribute business model of banks. In particular, it showed that the ability to transfer credit risks may detract from adequate assessment and pricing of credit risk by loan originators and that it can dilute incentives for gathering and passing on accurate information.

Furthermore, some instruments that were intended to facilitate a transfer of risk away from the banking sector fell short of their objective, as the triggering of contractual liquidity clauses brought initially transferred risk back onto the sponsoring banks’ balance sheets.

Investor uncertainty about both the value of structured credit products and the extent to which risk had been redistributed within the financial system by them drove an initial asset sell-off. This triggered a further drop in prices and financial institutions which held such securities were obliged to mark them to market, which led to them having to bear sizeable write-downs. In addition ... important links to third parties in the valuation of the structures came to the fore, such as the role of financial guarantee insurers.

The GSEs ate my mortgage

If you are a U.S. residential mortgage consumer and you don't want a jumbo (and I don't mean these wonderfully horrible elephants) then the overwhelming likelihood at the moment is that your loan will be funded by a government agency. Freddie and Fannie currently have more than 80% of the mortgage funding market according to AP (link via MSN here). That is double what it was a year ago. And for debt consolidation and refi, amongst other things, there is the FHA. Add in their contribution, which amounts to providing insurance on roughly 10% of new loans, and the GSEs one way or another are supporting over 90% of the market. And that is without counting the FHLBs. We have a problem Houston.

Rated Wrong

It was obvious in 1999 when the first consultative paper on Basel 2 came out that using ratings as the basic risk assessment tool for regulatory purposes was a mistake. Belatedly it seems that the supervisors have realised their error. From the FT:

US regulators on Wednesday raised concerns about their own reliance on the credit ratings that are hardwired into the global financial system as they revealed new proposals aimed at addressing conflicts of interest in the industry.

Christopher Cox, chairman of the Securities and Exchange Commission, said the agency would soon consider whether to reform many of its rules “that make explicit reference to credit ratings”.

The problem is if they don't trust firms own internal assessments what will they use instead? Credit spreads? That would be even more procyclical. I wonder if it is time for a bring back 8% of notional campaign.

What is not expected

There has been some talk recently (perhaps inevitably) about the next crisis to hit. Suggestions include:

• A wave of U.S. Bank failures. According to Reuters: Future U.S. bank failures linked to the downturn in the real estate market may include "institutions of greater size" than in the recent past, Federal Deposit Insurance Corp Chairman Sheila Bair said on Thursday.
  
• Monoline downgrade related issues. Well regarded doomster Meredith Whitney says that Citi, Merrill, UBS Face Monoline Losses.
  
• The forthcoming option ARM crisis. Hundreds of thousands of option ARMs will reset in the next year. The new rates will be unaffordable, leading to a wave of foreclosures. As Business Week reports:

According to Credit Suisse (CS), monthly option recasts are expected to accelerate starting in April, 2009, from $5 billion to a peak of about $10 billion in January, 2010. Today, outstanding option ARM loans in the U.S. total about $500 billion, about 60% of which were sold to California homeowners, according to Credit Suisse. Option ARMs were especially popular in the state, where they were heavily marketed during the boom by such companies as Countrywide Financial, Washington Mutual, and Wachovia.

But will these issues really cause further problems? After all, they are well-known. The FDIC has been talking about bank failures since the winter. Few people other than MBIA and Ambac have believed that MBIA and Ambac are AAA for years. And the Credit Suisse chart on volumes of ARM resets is in general circulation. Isn't it surprising bad news that spooks the market rather than merely expected bad news?

Rather little CMBS

Whither the CMBX? Specifically, where are the 08-01s going to come from, given that CMBS issuance has plunged along with prices. According to the FT:

The amount [of CMBS] issued in the first five months of this year fell 89 per cent to $10.8bn, the lowest level since the late 1990s, according to Commercial Mortgage Alert. Overall issuance last year was $253bn.

That does not just mean hard times for securitisation desks and commercial property investors looking for leverage. It means that it is hard to build a representative index of recent deals. Spreads have come in a little from the wide levels earlier in the year, but it will take months for the market to recover. Could it be a good time to buy what little there is out there?

Merrill vs. XLCA

In an important case for the structured finance market, Merrill has won a court ruling in its favour in a case against XL. Reuters reports:

Security Capital Assurance had said it severed seven credit guarantee contracts with a Merrill unit because the investment bank had given key rights promised to SCA under the contracts to at least one other party.

SCA said its XL Capital Assurance unit was promised control rights on the $3.1 billion of portfolios it had guaranteed for Merrill Lynch International, but Merrill Lynch had given those same rights to one or more third parties.

By terminating the contract, SCA was hoping to get out from under an obligation that could cost it hundreds of millions of dollars.

Basically the case was about who in the tranche structure controls voting rights on the underlying collateral: it appears that SCA was insuring a mezz tranche while MBIA was above it. SCA seems to have argued that the MBIA contract had voting rights that belonged to them. According to Bloomberg:

Merrill argued that, even though Armonk, New York-based MBIA was covering CDO tiers more senior to those insured by XLCA, the bank could still vote the shares according to XLCA's directions.

The case is important because if the assignment of voting rights is unclear, or subject to later litigation despite the provisions of the documentation, any writer of protection on a tranche potentially has wiggle room to avoid payment. I just hope for the sake of the broader structured finance market that the docs here hold up to further legal scrutiny.

Mea Culpa

Goodness was I wrong about MER and LEH vs. GS and MS... Experience sometimes is not cheap at any price.

The Guts of Geithner

I suspect that some in the SEC want them for garters right now. His remarks in the FT are sensible, but there is a consolidated supervision humdinger:

The institutions that play a central role in money and funding markets – including the main globally active banks and investment banks – need to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity.

Note in fact two substantial proposals in one sentence. Supervising the investment banks and the depositary institutions in the same framework - sayonara SEC - and capital requirements for liquidity risk. Is there the political will to get this done against what will doubtless be massive push back by the investment banks and their friendly local SEC?

Credit Crunching

A preliminary version of my article on the causes of the credit crunch can be found here. Comments are most welcome.

What does a CDS spread on a monoline mean?

That is not quite such a stupid question as it first appears. Consider an industrial corporate. The CDS spread on a company like this reflects were buyers and sellers of credit protection are willing to deal. If the corporate is liquid in the CDS market - roughly 1000 are - then there is typically a two way market and the CDS spread provides valuable information on the market's perception of the company's credit worthiness. Notice that typically counterparties in the CDS market are financials, often well-rated ones - so counterparty default risk is fairly low - and that the default correlation between the typical underlying company and protection providers is also low.

But now consider the monolines. Firstly CDS on them is not a two way market at the moment. There are lots of people who want to buy protection and few new sellers. It has been that way for a while. And secondly the default correlation between the typical monoline and the typical CDS market counterparty is much higher than for most other CDS references: a world in which Ambac is in default isn't good for JPMorgan, for instance. Therefore one could expect a fairly big difference between quoted CDS market spreads on the monolines and where you could actually get a trade done with an uncorrelated high quality counterparty (the German government, say).

I am not saying that the monolines should not trade at hundreds of basis points or that Moody's implied ratings are necessarily wrong. But I do think one should be cautious about what Ambac or MBIA's CDS spread means exactly.

Bill Ackman I salute you

S&P lowered Ambac and MBIA to AA today. They are under review from Moody's. Fitch, only six months late rather than the year or so of the other two agencies, downgraded them in January. Bill Ackman made another big pot of money. And there's a nice opportunity opening in zombie monoline runoff...

Short LEH?

Clearly there is a lot of money shorting Lehman, and I won't deny it can't go down further. But honestly, do you think the Americans will let another broker/dealer fail? They had five big ones before the Bear: now it's four. Three feels like too few to me, and I suspect both the FED and the SEC agree. I think I might be a seller of the default swaps.

And by the way, in what possible world are Merill and Lehman A- but Ambac and MBIA still AAA? Admittedly there are signs that Moody's might finally (six months too late) be ready to do the right thing with the monolines, but really, these four ratings taken together make no sense.

Are central counterparties a good idea?

Yes, and here's why. (This example is taken from a paper by Markus Brunnermeier.) Suppose we have a circle of identical interest rate swaps: A <-> B <-> C <-> D and back to A. All parties are fully market risk hedged. B wants to reduce its counterparty risk so it offers to assign A its swap with C. A refuses because it is troubled by C's credit quality. Therefore B has to continue to put up capital to support its exposure to both A and C.

With a central counterparty P however, everyone would face P and these issues would not arise.

Can a derivatives business survive a single A rating?

Merrill and Lehman were downgraded to single A yesterday: Morgan Stanley is at A+ according to Bloomberg. If only one of them was being downgraded, the news would be catastrophic. As it is, is the new standard for a derivatives counterparty becoming single A? And if not, how will the broker/dealers derivatives business survive?

Consider prime jumbos

Yields are attractive. From the FT:

US mortgage rates soared last week amid a sharp rise in Treasury market yields, as investors started to bet that inflation pressures could prompt the Federal Reserve to raise interest rates later this year.

The sell-off pushed rates on 30-year fixed-rate mortgages to an 11-week high of 6.02 per cent, up from 5.81 per cent a week earlier, according to Bankrate.com. Meanwhile, the so-called “jumbo” mortgages – or those for loans above $417,000 – rose to 7.21 per cent from 7.05 per cent.

A rough duration hedge is 7 year swaps at 4.4%. I'll take more than two and half percent running for prime jumbos vs. swaps.

Right target, wrong ammo

The FT reports:

International regulators and supervisors have started drawing up plans to make it far more expensive for investment banks to hold large volumes of complex financial instruments, such as mortgage-linked securities, in their trading books... though the Basel rules require banks to hold large capital reserves against the risk of credit default in their loan book, regulators only require small buffers for assets held in the trading book if these are labelled as low-risk, according to so-called Value at Risk models.

Up to a point your honour. Certainly there is a well-documented problem with the imprudence of VAR models, especially (but not only) ones which do not capture all the relevant risk factors. But the credit risk rules are not a shining example of prudence either, especially for low PD portfolios.
One need only compare JPMorgan's capital allocation for market risk -- $9.5B at Y/E 2007 -- with its VAR -- $107M -- to see the problem with trading book capital based on VAR alone. But the solution is not to dump on structured products alone: it is to revamp the entire market risk regime.

First Comes the Swap. Then It’s the Bad Journalism

Continuing a long tradition of dissing something you don't understand, Gretchen Morgenson has an ill-informed article in the NYT on a dispute between UBS and a hedge fund over a CDS. Let's start with the errors:

INVESTORS don’t often get a peek inside the vast, opaque and unregulated world of credit default swaps, those privately traded insurance contracts that essentially allow participants to bet on or against a debt issuer’s financial condition. (Remember, these are the same instruments that played such a pivotal role in the collapse of Bear Stearns.)

Plain wrong. Lack of liquidity played a pivotal role in the collapse of the Bear. CDS had little to do with it.

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes.

Again wrong. Regulators have the right to look at all transactions, OTC or otherwise. FSA for instance has a legal right to demand any document at any time: the FED is similarly engaged with its firms' OTC deals. If UBS's regulators can't see its CDS exposure that has much more to do with Swiss Banking law than with CDS. As I pointed out earlier, just because something is on exchange does not mean that price discovery are reliable: in many ways CDS levels are more readily available and liquid than most exchange traded single stock options.

The article does then make a not-entirely-terrible job of explaining the dispute between UBS and the fund. It appears an MD at UBS (who I am assuming is a sales person) assured the fund, Paramax, that UBS's collateral calls would not be based on aggressive marks. The court papers apparently claim he:

assured Paramax that mark-to-market risk was low... Paramax contends in the filing, it was informed ... that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” ... [the salesperson] was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Again, _if_ this is true, it has nothing to do with CDS. It could happen in any market. If it happened, it would be a dramatic failure of segregation of duties, but nothing about CDS makes this more or less likely.