Time to get away

I will be away for two weeks. Please try not to let Fannie or Freddie fail while I'm gone: I would hate to miss a big splash. And if MER, C, UBS and the rest can keep the writedowns under $10B each for a few weeks, that would be good too. But hey, I'm a realist, big things sometimes happen.

Run rat run

Labour MPs are, of course, far more concerned for themselves than either the governance of the country or their party. Here's just some of the utter nonsense, the self-serving anti democratic idiocy they and their leaders have been up to recently.

• Spending £3bn on new nuclear warheads despite not providing British troops in a war zone with the right body armour and posturing about Iran's nuclear ambitions.
  
• Umming and ahing over vehicle excise duty despite it being clearly sensible to charge more for the most polluting vehicles. And while we are on carbon issues, why doesn't aircraft fuel attact any duty at all?
  
• Utterly failing to reform the tax system to make it fairer and to prevent the rampant abuses of both corporates and wealthy individuals.
  
• Continuing to pursue the disaster that is PFI despite overwhelming evidence that there is little risk transfer to the private sector and excessive cost. Follow the New Zealand example instead and renationalise.
  
• Creating massive uncertain long dated liabilities by allowing new nuclear power stations to be built. Oh, and letting the company concerned, with a guarantee on clean up costs of course, be sold to the French.
  
• Failing to stop the free markets are the best thing ever for everything brigade from further ruining our public services. Damn it I'm a derivatives specialist and I'm far less keen on the power of the markets than Alan Milburn is. Maybe that's because I actually know something about them. And as for Hazel 'sum of all fears' Blears - heaven defend us against her kind of 'reform'.
  
• Not dealing with the utter mess that is MP's expenses. Stop spending my money on Lembit Opik. Or a ridiculously grandiose and over budget Olympics.
  
• Enacted the biggest snooping law in British history.
  

Now, I admit it, I cheered for Tony in 1997. I drank a lot of wine and ate pasta and stayed up until Portillo was gone. But now, please, can I have a Labour party back that is actually socialist, or at least has some vague aspirations other than leaving the rich alone, lining their own pockets, and trying to find some tiny chink of public life that has not yet been infected by Thatcherite free market dogma.

Salt n' pepper with that?

No, not a US rap act. But I do think that Fitch is not really pushing it in their new ratings model. According to Housing Wire:

Fitch Ratings said Thursday that it had enhanced its U.S. residential mortgage loss model, called ResiLogic, a key component of the agency’s overall approach to assessing U.S. RMBS new-issue ratings...Fitch said in its report that it is expecting home prices to decline by an average of 25 percent in real terms at the national level over the next five years, starting from the second quarter of 2008.

And that’s the base case scenario.

What is interesting about this, as Housing Wire points out, is that it will put the focus back on seasoned deals. In that kind of environment you cannot just blow out 3 month old loans into an RMBS deal - investors will want some history as well as a lot of credit enhancement. It should also be a powerful stimulus for the covered bond market - something which although strong in Europe, is still nascient in the US. (See here for the FDIC's recent press release on their policy concerning covered bonds. Or, to summarise, Shoop, Baby, Sexy.)

And now you die...

This was my favourite blog title of the day: And now young monoline... you will die. Accrued Interest makes some good points, and indeed it must be frustrating trying to run a monoline when one's de facto regulator, the ratings agencies, keep changing the capital model. However:

• It was clear that the capital models used up to mid 2008 were flawed, and so volatility in capital required for a AAA was to be expected.
  
• One of the key parts of an insurer's business model is time diversification. Business underwritten in one year diversifies that written in another, and losses in one year - subject to enough capital being available to continue - can be offset by higher premiums the next year. For the monolines though this does not work any more as there is much lower demand for muni wraps and those that are getting done are mostly being written by Berkshire. So the agencies are right to account for this change in their re-rating of the monolines.

Anyway, Bill Ackman might fancy being able to buy another small country, so it is about time for another wave of monoline downgrades.

Ship, meet iceberg

Loath though I am to quote from a Murdoch publication - just look at the sad decline of the WSJ to see what being owned by him does to a paper - I do want to comment on something by Anatole Kaletsky yesterday. Fortunately it is an utterly wrong-headed piece which misunderstands fair value accounting. First the good bit:

the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to gauge - this liquidity and maturity transformation is, in fact, the main social function that a banking system provides.

Agreed. But here's the thing. Banks can only do that if people have the confidence to give them their money to lend to someone else. That depends, for the retail investor, on deposit insurance; and for the wholesale depositor, on credit quality. Both of those in turn rely on the bank being well capitalised: regulators demand it to reduce moral hazard, and market counterparties need it as part of their risk assessment.

Now how can we tell if a bank is well capitalised if it is allowed to pretend nothing is wrong until it actually suffers losses? That is what accrual is all about - the fiction that all is well while the ship steers at full speed towards the iceberg. At least fair value shows you what is ahead.

Should the government take mortgage price risk?

Felix Rohatyn and Everett Ehrlich had some suggestions in the FT yesterday for how the bailout of the agencies (and the rest) might proceed.

One option would be to design terms on which the Treasury would create “certificates” that would be swapped for conforming mortgage assets up to a predetermined percentage of banks’ capitalisation, together with a schedule for swapping these certificates back to the Treasury over the next three to five years. This would give banks breathing space to meet capital standards while the housing market stabilised. The prospect for government participation in any upside could parallel the Chrysler bailout that worked quite successfully almost 30 years ago.

Presumably these certificates would carry the faith and credit of the U.S. government and hence would trade like T bonds. But how would the upside participation work? If the government sells the mortgages back at their then current market price - however that is determined - it is taking mortgage price risk. Possibly hundred of billions of dollars of it. For the authorities to fund illiquid assets for three to five year is reasonable: for them to take market risk over that period surely introduces massive moral hazard. Central banks are de facto funders of first resort: asking even more of them is probably a mistake.

Jamie's right

The WSJ reports that JP Morgan's CEO is skeptical of the broker/dealer's newly published capital ratios:

"I challenge those numbers," Mr. Dimon said, throwing a verbal roundhouse at rivals Goldman Sachs Group, Morgan Stanley, Merrill Lynch and Lehman Brothers.

He went on to question whether the methods the investment banks used to calculate a measure of financial strength known as the Tier 1 ratio were the same as those used by commercial banks.

In fact Dimon wasn't tough enough. He went on to say: "I'm not sure that those investment banks are using true Basel II type numbers, but we don't know the detail." In fact we do know that the SEC capital requirements are definitely not true Basel II type numbers. So Lehman's "Tier 1 ratio", say, at 13%, doesn't mean what you might think it does. Caveat lector.

Keeping the party orderly

A post on VoxEU discusses the debate between Larry Summers style 'the FED must drop money on Wall Street until the problems end' interventionists and the moral (and I believe broadly correct) position that banks ought to be left hanging to pay for their sins. Governments ought to be worried about their taxpayers, not bank shareholders. VoxEU calls this the Willem Buiter position, which is not entirely accurate (Buiter's position is more nuanced) -- but let's run with it.

The argument is that the moral hazard in permitting a Summers style bail-out is too great to permitted:

once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

...Bank of England Governor Mervyn King nicely sums up the situation: “'If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder."

This would be true without regulatory capital. But if it works as intended regulatory capital should stop the party from getting too rowdy. The current crisis came about because capital requirements were not effective in constraining banks' risk. The solution for now is a rescue with shareholder expropriation where necessary for the protection of depositors and the financial system. The solution for the future is getting regulatory capital requirements right. And minor changes to Basel 2 won't do that.

Eat (a little of) what you kill

FT alphaville is I fear too tough on some of the European Commission's proposals to alter the Capital Requirements Directive. There is in fact much to like about the Commission's original approach (if not its subsequent pirouettes). The key section of the original is:

the originator credit institution shall calculate the risk-weighted exposure amounts ... for the positions that it may hold in the securitisation. The risk-weighted exposure amounts for the originator credit institution shall not be less than [15%] of the risk-weighted exposure amounts of the securitised exposures had they not been securitised.

This is really good. It means that institutions cannot get rid of more than 85% of the capital, whatever they do, and so they are encouraged to keep at least 15% of the risk. I would feel happier with 25%, but 15% is a good start at ensuring alignment of interests.

Of course the objection to this is that - since this is an EU rather than a Basel proposal - it leads to a competitive disadvantage to EU banks. For here we get the Commission's suggestion of a requirement that any originator keeps 10% of any risk if they want to sell to an EU bank. That, admittedly, isn't a very sensible suggestion. The original proposal was just about portfolio credit risk transfer, not syndicated loans, not single name CDS. Rather than frantically making alternative proposals the Commission should stick to the original idea, and ideally try to persuade the Basel Committee to agree to it too. Capping regulatory relief on securitised exposure at 85% is sensible. Bravo Brussels. Now don't stuff it up by panicing when the Banks say they don't like it. They don't have to like it. It just has to be the right thing to do.

Five into ten does not go

Bloomberg points out:

The [U.S.] debt limit is $9.815 trillion and the current outstanding public debt subject to that limit is about $9.4 trillion, according to the Treasury.

In other words, actual US borrowing is within $415B of the maximum permitted by Congress. Now while more or less everything I know about the US budget process comes from an episode of the West Wing, it does seem clear that this $400B ceiling limits Hank's ability to do much meaningful for Freddie and Fannie. And comparing $9.4T with $5T makes the impact of bringing the agencies' $5T of mortgages onto the government balance sheet clear. Hank must be hoping the markets bought his `we'll fix it' speech because if he actually has to do something, is room for manoeuvre is limited.

Papering over the window

The Economist points out something really cute about the GSE's having access to the FED window:

The Fed does not just accept any old assets as collateral; it wants assets that are “safe”. As well as Treasury bonds, it is willing to accept paper issued by “government-sponsored enterprises” (GSEs). But the two most prominent GSEs are Fannie Mae and Freddie Mac. In theory, therefore, the two companies could issue their own debt and exchange it for loans from the government—the equivalent of having access to the printing press.

I just love the way unintended consequences sometimes result from attempts to make things better, don't you? But fortunately no one could think that Fannie or Freddie would abuse their access to the window, so the Economist is just engaging in idle speculation, isn't it?

(Eat my) Naked Shorts

Naked shorting is wrong. To see why, consider a company with 1,000,000 shares, trading at $10: it has a market cap of $10M. If a hedge fund sells shares it does not own and does not borrow - a naked short - it creates new shares. Suppose it shorts 250K shares. Then there are 1.25M shares out there - 1M real ones, and 250K created by the short - and so the stock price should fall to $8 to keep the market cap at $10M. Naked shorting destroys share prices without any real fundamentals, and so is illegal in many markets.

Note that how easy it is to put the short on depends partly on dividends. I'll let Dealbreaker.com take over on that one:

To understand how a dividend cut can make short-selling easier, it's important to understand the mechanics of short-selling. Many stocks that short-sellers borrow are held by brokerage customers in margin accounts. When companies don't pay dividends, brokerage customers are encouraged to hold shares in those margin accounts.

The tax code creates this incentive system by treating dividend payments differently from substitute payments investors receive when their shares are lent to short sellers. When a customer's shares are lent out, the customer doesn't receive dividends. Instead, the customers receives a payment in-lieu of dividend, which lacks the tax advantages of actual dividends. Brokerage customers respond to this by holding high dividend paying stocks outside of margin accounts, making it more difficult for short-sellers to locate shares to borrow. The other side of the coin is that they move non-dividend paying stocks to margin accounts.

One might en passant suggest that people not sign up to margin accounts that allow their brokers to lend the stock, but that is another matter.

Now for what the SEC has done. It has not removed the problem of naked shorting in the US. Rather it has fixed it for 19 (and only 19) stocks. Dealbreaker again:

[The plan for these 19 financial stocks] requires short sellers to have not just located the stocks they want to borrow in order to short, but to actually borrow. From our read, 100% delivery of the stocks at settlement is required.

I have no problem with shorting at all, and there is some evidence that it makes the market more efficient. But naked shorting should be illegal not just for 19 US stocks, but for all of them. Get the borrow on first, then you can do the short.

Heathrowics

I had to travel via Heathrow today, so I went on the airport website to check the state of the public transport links to Terminal 5. It said `Service not available.' And you can't fault a short and wholly accurate summary like that. Please, Gordo, would you nationalise BAA -- or shall I just give up on flying?

Fantasy capital

A post on Accrued Interest concerning Fannie and Freddie caught my eye. Two quotes. First:

delinquencies on their guarantee portfolio remain relatively small (0.81% for Freddie Mac and 1.22% for Fannie Mae)...

And second

Under current statues, the GSEs minimum capital required is 0.45% of of their guarantee portfolio

So their current level of losses is roughly twice the capital requirement - a level of capital which was presumably intended to cover unexpected losses at a high degree of confidence. If a more craven example of the supine nature of the US regulatory environment were needed, I don't know where to find it.

The pain in Spain stays mainly away from the plain

From Reuters via a decidedly dubious post on FT alphaville (which signally fails the ask if the large European retail banks are hiding all the pain in accrual accounted books): the largest Spanish corporate default ever happened yesterday.

Spanish property company Martinsa Fadesa said it would file for administration after it failed to raise funds and meet debt payments, marking one of the biggest corporate failures in the country's history...

The company added in a statement that it would focus on selling assets to repay creditors, which include Caja Madrid, La Caixa, Ahorro Corporacion and Morgan Stanley.

Spain is a classical bursting bubble market with a way further to fall. Speculative building has been rampant, particularly on the coasts, and development controls were lax. Now prices are falling and controls are tightening the construction companies and their financiers are feeling a lot of pain. If Caja wasn't the Spanish version of a GSE, it might well be in trouble. In fact the parallels between the Spanish Caja and Freddie & Fannie are a little too obvious for comfort...

Harbingers of Doom

You can tell you are in a bad market when all the old bull stories come out again. I remember in 2000 being told by a fervent believer in Lernout & Hauspie (RIP) how if a stock went down 2% a day and you bought every day on the way down until it had halved in price, then it turned around and went up 2% every day, you would make your money back a fortnight into the turnaround. Or something. It doesn't matter. Lernout went down and down and then defaulted.

It's the same with the Buffett quotes. From the WSJ:

If a stock [I own] goes down 50%, I'd look forward to it. In fact, I would offer you a significant sum of money if you could give me the opportunity for all of my stocks to go down 50% over the next month."

And yes, if you are as good a stock picker as Warren, that's true. But if you are not, and the chances are you are not worth tens of billions, so you really really aren't, then it is just a great way to get hosed on a bigger notional. Be careful out there people, and keep the poker face. It's not over yet.

When do Fannie and Freddie consolidate?

A question to anyone who knows _a lot_ about public sector accounting. Just how much help exactly can the U.S. provide to Fannie and Freddie before those $5T of mortgages consolidate onto the government balance sheet? And would the US still be AAA with another $5T of liabilities?

Update. Bloomberg has caught up with this one.

There's nothing sacrosanct about the U.S.'s AAA rating, no matter what dogma and orthodoxy might suggest. Many financial assets that claimed AAA status before the credit crunch turned out to be irredeemably tarnished; there's a non-negligible risk that Treasuries will prove to be similarly spoiled.

The ten year CDS spread on US treasuries settled in Euros is now more than twenty basis points.

Keep the red flag flying here

Over the White House, that is.

Willem Buiter is most entertaining on the GSE bailout:

The financial assistance offered to US homeowners through the spagetti of federal financial inducements (ranging from the tax deductability of nominal interest payments to the subsidisation of mortgage financing provided by the FHA and the GSEs) is not primarily socialism for the rich. It is socialism for the electorally sensitive, rather like the agricultural welfare state that exists in the US.

So let’s call a spade a bloody shovel: nationalise Freddie Mac and Fannie Mae. They should never have been privatised in the first place. Cost the exercise. Increase taxes or cut other public spending to finance the exercise. But stop pretending. Stop lying about the financial viability of institutions designed to hand out subsidies to favoured constituencies. These GSEs were designed to make losses. They are expected to make losses. If they don’t make losses they are not serving their political purpose.

So I call on Secretary Paulson, Chairman Bernanke and Director Lockhart to drop the market-friendly fig-leaf. Be a socialist and proud of it. Come out of the red closet. The Soviet Union may have collapsed, but the cause of socialism is alive and well in the USA. Granted, the US version of socialism is imperfect thus far. The federal authorities have mainly intervened to socialise the losses in the financial sector while allowing the profits to continue to be drained off into selected private pockets. But that is bound to be an oversight. It surely cannot be the intention of such committed Marxists to target taxpayer-funded largesse solely at the very rich and at a few favoured, electorally sensitive constituencies. Fannie and Freddie are, or will be, safe in the hands of comrades Paulson, Bernanke and Lockhart.

The real estate bust in pictures

Some Friday illustrations. First the Markit ABX AAA 0702s, down again this week.And a heat map of foreclosures. Note the California and Nevada clusters are joining up, and Arizona is also a problem area - get not so much your kicks, but certainly your bargain properties on Route 66. Michigan isn't going down as fast as it was, but Florida continues to be problematic, and Northern Colorado is a new hot spot.

Calculated Bunk

Calculated Risk has a post on Fannie and Freddie that defies belief. Commenting on the suggestion that the US government should bail out the agencies without screwing the stock holders - for instance by buying new sub debt to provide liquidity - they say:

If this blog's comment threads are any kind of representation of a slice of reality--I am often agnostic on that question, but still--there are more than a few people who are more interested in getting a front-row ticket to a morality play than working through a financial crisis with the least (further) damage to the banking system. Lord knows that a lot of bad policy can be floated along under the guise of "pragmatism," but I for one would rather try debating with a pragmatist than a purist or a moralist.

Two words Tanta - moral hazard. It is vital that any government support of the agencies is at the cost of the equity owners. To do anything else isn't pragmatism, it is the grossest and least defensible public subsidy of the providers of risk capital. By all means let the US government support the Agencies if it judges that to be in the national interest. But do it in such a way that those who were perfectly happy with the rewards of Fannie and Freddie's absurdly high leverage also bear the consequences of it. Capitalism is a broad church but it does not include privatised gain and socialised loss.

Fannie and Freddie's Bad Week

Taken from CNN and Bloomberg, some tidbits on the GSEs:

• At the end of last year, Fannie alone had packaged and guaranteed about $2.8 trillion worth of mortgages, approximately 23% of all outstanding US mortgage debt.
  
• Egan Jones estimates that Freddie alone will need to raise $7 billion over the next two quarters due to writedowns and losses. The company's market capitalization is $8.7 billion.
  
• In an April report, Standard & Poor's said an Armageddon scenario whereby Fannie and Freddie are insolvent is unlikely, but that if it happened, the cost to U.S. taxpayers would be more than $1 trillion.
  
• Former St. Louis Federal Reserve President William Poole said recently: ``Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer''
  
• ``I worry about those institutions,'' retired Richmond Fed President Alfred Broaddus said. ``They are huge. They dwarf the Bear Stearns issue. In the very worst case scenario, I don't know how you do it other than extend money and the public takes the loss.''
  
• CDS on Fannie and Freddie senior debt now trade at more than 80bps.
  
• The one year return on both of the stocks is approximately -80%.
  

Update. The FT fills in some more background.

Investors were unnerved by a warning from Bill Poole, former president of the Federal Reserve Bank of St Louis, that the chances that a bail-out of Fannie and Freddie might be needed were increasing.

Mr Poole said Freddie Mac owed $5.2bn (£2.6bn) more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules.

And needless to say, investors have taken note despite attempts by Bernanke and Paulson to reassure the markets. Fannie was down 13% yesterday; Freddie, 22%. It seems that my earlier sarcasm really was justified. Oh and the NYT says that a regulatory takeover is being considered. It's probably too late to short the stock, but is selling default swaps on the senior debt a good trade at the moment?

Update. John Dizard thinks so. From the FT:

I have what Wall Street calls a "strong buy" recommendation: buy the senior debt of Fannie Mae and Freddie Mac. You can get a risk-free spread over US Treasuries. If you want more leverage, and you have a line with a credit default swap dealer, then sell five-year protection on the names.

What wimps: the EU waters down capital proposals for securitisations

The commission has bottled the capital treatment of securitisations. According to Bloomberg:

European Union officials scaled back a plan to stiffen capital requirements for asset-backed bonds, responding to banking industry objections the measure would have hurt European lenders without reducing risk.

The revised proposal, posted online last week, would let banks freely invest in securitizations -- such as the mortgage bonds that sparked the credit crisis of the past year -- as long as the issuer owns 10 percent of the assets. Banks wouldn't have to set aside any capital for those holdings. An earlier version would have forced issuers to retain 15 percent.

15 was already too low. 25 or 30 is more like it. 10 does little to align interests between securitisation buyers and sellers, which is the key issue.

Ben goes for the broker/dealers

News flash: Bernanke has been speaking on consolidated supervision of US institutions. According to Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks.

(The emphasis is mine.)

Fair Value and Insurers

CFO.com has an excellent post on Fair Value accounting. One quote in particular amused me:

James Tisch, who was effectively the sole voice of dissent on the first panel, complained bitterly that fair value accounting required reams of nearly incomprehensible disclosure information and often forced his company to make poor economic choices.

Tisch ... said that if insurance companies had to run mark-to-market accounting through their income statements, "[they] would essentially be out of business"

And that, as we have seen with the financial guarantee insurers, is clearly right. But perhaps if the insurers were forced to use fair value, they might deploy less leverage and pay a little more attention to what the market is telling them.

Why I like $140 oil

A surprisingly not ill-informed and annoying article by George Monbiot (isn't it nice when someone who is usually foolish says something sensible?) considers the good things about $140 oil. One of them is that it is stopping a lot of unsustainable fishing:

No east Asian government was prepared to conserve the stocks of tuna; now one-third of the tuna boats in Japan, China, Taiwan and South Korea will stay in dock for the next few months because they can't afford to sail. The unsustainable quotas set on the US Pacific seaboard won't be met this year, because the price of oil is rising faster than the price of fish. The indefinite strike called by Spanish fishermen is the best news European fisheries have had for years. Beam trawlermen - who trash the seafloor and scoop up a massive bycatch of unwanted species - warn that their industry could collapse within a year. Hurray to that too.

Let me add to that. Hurray if the oil price ruins the road transport industry. We should be sending much more cargo by rail and river anyway. Hurray if it causes people to drive less and to buy smaller and less polluting cars. Not only should Gordon go ahead with higher vehicle duty on the most polluting cars, he should extend that idea to lorries, planes, and indeed every other source of pollution. The only way to realign the economy to the post carbon age is to get the incentives right. $140 oil helps, but $200 or $250 oil would be even better.

Update. The high oil price appears to be working in Washington. According to a Washington Metro press release:

Twenty of Metrorail’s top 25 highest weekday ridership days have occurred since April of this year.

Fannie and Freddie take a bath

Specifically they are down about 20% so far today, with Bloomberg reporting that they may need tens of billions more capital. The agency/treasury spread is over 200bps, and CDS on these (supposedly US government credit risk) firm's sub debt are at around 180 over. The predicted chickens are coming home to roost. And we all know that chickens in the bath are not a lot of fun.

The value of the flip flop

What do you call a Frenchman in sandals? Phillipe Phillop.

With that out of the way, we can get to the point. Long or Short Capital, a good financial satire site, has an occasional series of Quotes Entirely Relevant to Investing. Well here's one, an entirely serious one, from an excellent article by Julian Baggini:

The trouble with most people is not that they lack the courage to stick to their guns, but they don't have the greater bravery to change course. Consistency is a good thing, but not when it is understood as simply refusing to change your mind...To worry more about whether you've stuck with your views than about how they stack up now is to value loyalty to ideas more than fidelity to the truth.

Great traders have great ideas. But more than that, when they have an idea that does not work out, they take the trade off. They don't invest too much in any particular idea -- because they know that if it doesn't work out, they need to be able to recognise that, learn the lesson and move on.

Picture of the day: migration of AAA ABS CDO ratings

From FT alphaville:

The FED proposes the standardised approaches in Basel 2

Having said that Basel 2 was only for the 20 largest banks, and that those firms had to use the most advanced methods in Basel 2, the FED has backtracked. It is suggesting that the standardized framework would be available for banks, bank holding companies, and savings associations not subject to the advanced approaches. This is very interesting. Why the U turn I wonder? There is a story here, but I don't know what it is yet

Update. Apparently WaMu and Wells Fargo, of the big banks, want to use the standardised approach. And the FDIC has swallowed its concerns and is supporting the roll out of Basel 2 to the smaller banks. This is really as shame. The FDIC was one of the few voices of sanity in the international regulatory `we haven't got it wrong really oh no despite the biggest banking crisis in a generation' hullabaloo. But as to why the FED won, I am still in the dark.

How important is securitisation for funding mortgages?

Very. The FT quotes research by Meredith Whitney at Oppenheimer which suggests that since 2000, the volume of US mortgage lending financed by securitisations was seven times higher than the level funded on balance sheet. In 2005-07 alone, securitisations accounted for $2,500B of American mortgages, compared with $431B for on-balance-sheet loans. (I'm paraphrasing rather than quoting as the FT article is so badly written.) And that is one reason why you'd better hope the plain vanilla RMBS market comes back to full health fairly soon.
Update. Deutsche has a nice graphic on the rollercoaster of securitised mortgage lending:

Blame the actuaries

Yet another story about the travails of the monolines - this time on guaranteed investment contracts - made me think about who is really to blame for the mess these companies are in. It's the people who made their underwriting decisions: their actuaries. They decided that there was little risk in guaranteeing investment returns for extended periods. They decided writing hundreds of billions of dollars of financial guarantees on ABS was a good risk return tradeoff. For that matter their colleagues in the life companies decided that variable annuity life policies were a good idea. (These policies, like a GIC, guarantee a return on a risky investments so they act a lot like long dated written puts: needless to say, the actuaries did not price them that way. Now that the equity markets are tumbling you can expect to see some life companies getting into distress...)

So perhaps one lesson that shines out of this mess is do not let an actuary price or risk manage a financial contract without help from a professional. They are not certain to screw it up. But the evidence of the last few years suggests that there is a real risk that they might get it very wrong indeed.

What does delta hedging a tranche mean?

Some old research from, of all people, Bear Stearns, makes fascinating reading. It is about delta hedging CDX and iTraxx tranches, just about the simplest possible hedging problem in structured credit (in that index itself is the hedge, and both that and the tranches are liquid).

Suppose we have sold a tranche of the CDX. What it the delta with respect to the index? The standard definition would say something like

delta = (price of tranche at index spread plus 1bp - price of tranche at index spread) / 1bp

But there is a hidden correlation assumption: we calculate this delta at constant base correlation. Thus delta hedging will only be P/L minimising if

• spread movements are small;
• rehedging is possible after a small spread movement; and
• base correlation remains constant.

The first two assumptions have not held recently with even the hitherto liquid CDX and iTraxx displaying jumps and illiquidity. But interestingly even back in 2004 the last one was known not to hold either. Here is the tracking error of delta hedging each of the CDX tranches from the Bear's research:
And here are the realised deltas (i.e. I think the best deltas ex post) vs. the calculated ones (ex ante from the model):
And remember, that is the easiest hedge in structured credit. If the simplest position to hedge when the market was not particularly troubled gives you 3% tracking errors, what is it like trying to delta hedge a bespoke hybrid CDO at the moment?