MOAB Revisited

A good friend pointed out that the real problem is the mortgages. Those are the things behind the dodgy assets, or most of them anyway. (The reasoning being that if you sort out the RMBS problem the CMBS will come mostly good.) So, if you are the US government and you want to spend a trillion dollars, give or take, here's what you do.

• You own a lot of the problem anyway via Freddie and Fannie. Immediately refi all current or less than 90 day delinquent ARM, hybrid ARM, and option ARM loans on the F&F books into 30 year fixed. That ensures a lot of them stay current.
  
• Modify the non-current ones into 30 year fixed on a reduced notional, and take equity in the homes as compensation for the writedown. Yes, you'll lose money on this, but not as much as you will lose if you don't do it.
  
• Offer Federal subsidies to any banks that will participate in doing the same in exchange for capital. You take the hit now, they give you ideally warrants but I can live with preference shares. Change the law so any problems which stop securitised loans being mod'ed in this way go away.
  

Libor At Five Year High

It's probably more than five years... From Bloomberg:More at the Big Picture.

EU to US: You broke it, you own it

The European Commission adopts the pottery barn principle according to Reuters.

The Loss Count

$591B so far according to Bloomberg. I honestly remember the time when a $10M loss in investment banking was shocking.

Now? Now there is more uncertainty than I have ever known. In '33 the banking crisis came just before FDR was inaugerated - 08's is a bit early, and that is of course making things a lot worse. A new administration could at least act decisively. Paulson tried, but a combination of a discredited president, an upcoming election, and over-reaching first draft were all obstacles. The FED will throw money at the markets, but it seems unlikely that will unjam the credit markets. It may even make things worse as banks know they don't have to deal with each other. What the financial system needs is more capital, hundreds of billions of it. Hey buddy, spare a billion? I wouldn't ask, normally, but I was expecting a handout from Congress, and the '37 Bentley costs a fortune to run.

BANG!

The noise you just heard was the FED's balance sheet exploding. S&P down 4%, FTSE down 5, TED spread at 3.5% and the FED is injecting $630B of extra liquidity. 630. Not 25 or 75 or even 200. If the combination of this and the bailout does not work, where is there to go from here?

Update. What bailout? The House just said no. Could this lead to a better structured recap, a la Krugman, or will that have to wait for the Dow to get below 10,000?

Goodbye to Consolidated Supervised Entities

With Bloomberg reporting that the bailout has been agreed after days of intense debate, the last few days have been a great time to sneak out financial news that you do not want too well read. One would never suspect the SEC of acting that way, of course, but it is interesting that the audit of the SEC's oversight of Bear Stearns came out on the 25th. The two parts are here and here, and they do not reflect very well on the SEC's Trading and Markets Division (TM). For instance:

TM became aware of numerous potential red flags prior to Bear Stearns' collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors

The broker/dealer capital regime (CSE, introduced in 2004 by the SEC as an attempt to fend off EU regulation of the broker/dealer's European subsidiaries) does not fare well either:

Bear Stearns was compliant with the CSE program's capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements

The SEC was in such a hurry to offer their 5 big clients a friendly capital regime that it approved their applications before it had even completed the inspection:

The Commission issued four of the five Orders approving firms to use the alternative capital method, and thus become CSEs (including Bear Stearns) before the inspection process was completed;

Go and read both the documents: they are peaches.

To be fair, the SEC admits there are problems. Chairman Cox released a statement saying `the CSE program was fundamentally flawed from the beginning' and ending the program forthwith.

Oh tis bliss to be a bondholder tonight

Or perhaps not. One phenomenon we have seen in the recent failures - Lehman in particular but also WaMu - is that the senior bondholders have been really screwed. Suddenly the difference between bank and bank holding company really matters. You want to be where the cash is, as Bloomberg illustrates.

Call for Jesse Jones

I have a question. Why not just spend the $700B on buying bank capital instruments, ideally equity? Of course the price of that equity will be an issue, but if the need for capital is the real issue, why not just supply capital? After all, that way the good guys (who bought reasonable assets and are just suffering confidence problems) will live to see the their assets perform, while the foolish guys (who bought rubbish) will lose out. Yes, the government will lose too in that case, but at least investing in everything rather than just bad assets gives it some upside. And like any owner, it has a vote, so if a bank needs so much capital that the government ends up as a controlling shareholder, then they will have to behave (and pay people) as their owners instruct.

The good thing about this plan, then, is that it does not try to identify bad banks or bad assets - it scatters cash willy nilly over everyone, and expects that it will make money out of the ones who don't need (and some of those who do). Moreover knowing that the government is a firm buyer acts as a contingent capital instrument: the market won't mess with you because the worst that can happen is the equity holders are diluted. The CDS spread of the US goes to hell in this version, of course, but that has happened already so it isn't worth worrying about.

More comment (from the Post) can be found here.

Mark to Paulson

Everyone is worried about the prices that Hank will pay with the taxpayer's money in his bailout plan. That is understandable, and I would be worried too if it was my money.

However there is some possibility that it won't be a disaster every time the MOAB buys an asset. Here's why.

On average, across the cycle, you are paid more to take credit risk than it costs you in defaults. So if you were arbitrarily well capitalised and could wait forever, simply buying a diversified pool of credit risky assets will make money. (Whether it has a decent ROE is another question.)

The reasons for this gap between fundamental long term buy and hold value and market value are numerous: cost of funds (not everyone funds at Libor flat), liquidity premiums, volatility of the spread (which requires capital to support it, at least for mark to market holders) and so on.

Now of course Hank isn't buying a diversified pool, and he is not buying across the cycle. He's buying what the banks want to sell, and he's buying in the next year or two.

Still, it is at least good to know that if you buy for more than the market price, and hold to maturity (or at least until the liquidity and funding premiums have fallen substantially), you _could_ (not will, but could) make money. (Bloomberg has more on the MOAB as a carry trade.)

On 'Fundamental Value'

There is a lot of talk at the moment about fundamental value. This mostly focusses on how good it would be if the market prices of assets rose back towards 'fundamental value', and what the government could do to assist that process.

There's only one problem. You can never know what the number is.

Consider a loan. Either it defaults, in which case you get some interest followed by recovery; or it doesn't, in which case you get scheduled P&I. In both cases the fundamental value is the PV of the cashflows. But you don't know whether it will default or not, so you can't combine the fundamental value on default with that for no default to get a single number.

In credit risk modelling we solve this problem by positing a probability of default, and then deriving that PD from spreads. But that's an argument that depends on the credit spread being fair compensation for default risk.

And of course ontologically it makes no sense to talk about a 'probability' of default. Either default happens or it doesn't and we only get one chance at finding out. Given that we can't take the same obligator, duplicate them a hundred times, and look at their performance on each occasion, we can never know that our 'probability' is correct. Thus there is literally no such thing as a 'fundamental value' in any scientific sense because we could never know whether we had such a thing.

An Important Intervention

The markets can breathe easy. A deal has been done. Read about it here. Or if you must, here. But the first one is better, I promise.

Update. Turning from the flippant story to the serious one, it seems that in the cold hard light of morning, nothing has been agreed. As Bloomberg reports:

Negotiations for a $700 billion rescue of the U.S. financial system stalled as House Republicans undercut the Bush administration

We are going to have an interesting OIS spread today, doubtless. These are the most incredible times I have known in the markets, and I think that vatic prediction would simply be a matter of luck. Take care out there: here be dragons.

Further update. Brad Setser gives the following extraordinary account of some of the fire breathing:

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);

Increased its “other assets” by about $80b (from $98.67b to $183.89b);

Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period.

Holding The Wrong-doers to Account

On a day when piffle seems to be widespread, Bloomberg reminds us that there may well be a case to answer in some quarters:

Frank Raiter says his former employer, Standard & Poor's, placed a ``For Sale'' sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company's top mortgage official, to grade a real estate investment he'd never reviewed.

Understandably, reform of the ratings agencies has taken a back seat to the Paulson bailout. But it does need to be done. Furthermore we do need to look back in anger at the doings of the Greenspan boom and, where there is good evidence of malfeasance, hold the perpetrators accountable. If Raiter is correct in his account, the case against S&P appears to be strong.

Update. The second part of the Bloomberg series is also interesting (if marred by the most annoying pop-up I have come across in a while). A highlight:

An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the ``threat of losing deals.''

A modern day version of the Pecora Commission is clearly required.

Is $700B enough?

Just one data point. The RFC, the New Deal era `save the banks (and everyone else)' vehicle, ended up spending fifty billion dollars. From 1933 to 1938, they spent roughly ten billion on bank capital alone. In 2008 dollars fifty billion is roughly (using the Oregon State adjustments to 1935) $780B. So the sizing of the Paulson plan is, on that basis at least, plausible.

The Site That Supports our Shorts

I am joining FT alphaville's campaign in support of shorts. Hot pants are obviously a big winner. Board shorts need your help. I will even go as far as culottes. But leiderhosen are obviously completely beyond the pale.

(OK, OK, here is an earlier post on Naked Shorts.)

New York really wants London to succeed

According to Bloomberg:

New York State will begin to regulate part of the $62 trillion market for credit-default swaps, Governor David Paterson said.

The state will treat contracts in which the buyer also owns the underlying security as insurance, Paterson said today in a news release.

That's it then. London always was ahead of New York in structured credit: now, provided we do not do something similarly stupid, we can own this market.

It is worth pointing out, en passant, how successful treating credit derivatives as just another insurance contract has been so far. The largest two firms to adopt that paradigm were MBIA and Ambac. Unless you count AIG of course. Still, New York will still have better looking trucks. That's something.

Update. The Economist has a nice article, Guilt by suspicion, about the benefits of derivatives and the mud slung at them. I do think it is worth remembering that the cause of all of this mess was not derivatives, it was mortgages.

And then there were none

The US now has zero broker/dealer. Bloomberg reports:

Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve's approval of their bid to become banks ends the ascendancy of the securities firms,

Now it gets interesting. I assume they will have to do bank capital adequacy calculations. And when they do, we will finally have a direct comparison of how inadequate the SEC's regime was...

I bought a bank - and I liked it. With apologies to Katy Perry

This was never the way I planned
Not my intention
I got so brave, pen in hand
Lost my discretion
It's not what, I'm used to
Just wanna try you on
I'm curious for you
Caught my attention

I bought a bank and I liked it
The size of her assets, her leverage
I bought a bank just to try it
I hope my regulator don't mind it
It felt so wrong
It felt so right
Don't mean I'm solvent tonight
I bought a bank and I liked it
I liked it

No, I don't even know your NAV
It doesn't matter,
You're my experimental game
Just human nature,
It's not what,
Good banks do
Not how they should behave
My board gets so confused
Hard to obey

I bought a bank and I liked it
The size of her assets, her leverage
I bought a bank just to try it
I hope my regulator don't mind it
It felt so wrong
It felt so right
Don't mean I'm solvent tonight
I bought a bank and I liked it
I liked it

Us banks we are so magical
Big desks, red ink, so cheap
Hard to resist seems so valuable
Too good to deny it
Ain't no big deal, it's innocent


I bought a bank and I liked it
The size of her assets, her leverage
I bought a bank just to try it
I hope my regulator don't mind it
It felt so wrong
It felt so right
Don't mean I'm solvent tonight
I bought a bank and I liked it
I liked it

Linky goodness

Some morning reading:

On the duty of auditors. A taxing matter addresses the inherent conflict of interest and suggests that it might be a good idea for auditors to be hired by the SEC rather than the company.

Ultimate loss projections are increased by Moody's. MBIA and Ambac have not been in a train wreck for weeks and they are getting jealous of all the attention Fannie, Freddie, AIG, Lehman, Merrill and so on are getting. The FT has the details.

One aspect of a run on a broker/dealer. Dealbreaker points out how a B/D share price fall can push clients into moving money from non-seg'd to seg'd accounts. The result is akin to a run on a bank.

And finally, given that Cristiano Ronaldo is on a lot of people's lists as `worst role model in sport', please will the Treasury drop AIG's sponsorship of Man U as a matter of urgency, or at very least demand that Ronaldo's legs are pledged as long term collateral and lodged permanently in a vault at the New York FED?

How SEC Regulatory Exemptions were too little, too late

The Big Picture (which I usually love) has picked up a story from the American Banker (which I cannot link to as it is behind a firewall). It seems:

"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.

The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.

Up to a point, your honour. The way it really worked was this.

The SEC had a deeply antiquated set of capital rules which in particular provided no capital requirement AT ALL for OTC derivatives. Under pressure from the EU they reluctantly conceded that consolidated supervisiion for capital might be a good idea. They took the market risk rules from Basel - basically VAR - and put their own spin on them. (That's diplomatic. Some would say `bastardised them'.) They ignored some parts of the Basel project, like operational risk.

The big 5 B/Ds were permitted to apply for permission to be supervised as investment bank holding companies (IBHC)s. The rules for them are here.

Whether the IBHC regime increased leverage isn't clear to me simply because the net capital requirements before it did not include all the entities - you literally could not tell how much risk the firms were running from their capital requirements. The new rules certainly permitted asset growth and on balance sheet leverage did increase. Criticising the SEC for bringing broker/dealer capital requirements kicking and screaming into the 1990s is however unfair, even if they did it in 2004. The new regime clearly wasn't good enough, but it was better than the thing it replaced, if only in that it actually required capital for all the market risks the B/Ds were taking.

Market update

Some amazing numbers: 3m TED spread 275bps, 1 month OIS/Libor over 100. AIG CDS at 1500 over, down from 3500 over earlier. Goldie down 20%, Morgan Stanley 30% odd. WaMu not bust yet, but give it a few days. Russian market shut after the index fell 17% yesterday. And the FED has run out of money. Welcome to 1929 Part II. Like all sequels it isn't as good as the original, but it has a few moments of interest.

Short: docklands CMBS, any bank rated less than AA+, dollars, TIPs, AIG senior CDS
Long: equity in too big to fail banks, on the run 2-3y Bunds, corporates with no gearing and solid recession proof earnings.

Fundamentals and long term credit worthiness is irrelevant. This is a strenuous flight to quality. Anything that isn't a government bond is suspect and only worth buying if the potential upside is huge. It might not be quite the end of the world as we know it, but I do feel fine, and it is an interesting time.

The Regulatory Big Picture

Amid extraordinary scenes - the failure of Lehman, the purchase of Merrill, a $85B FED line to AIG (albeit it at L + 850) - it is appropriate to consider the big questions that face the Americans.

Firstly, note that the FED has acted, but that what it has done is very much policy making on the fly. Suspension of Section 23a of the Federal Reserve Act, for instance, may well be illegal. And in the AIG support, the FED is off the edge of the US regulatory map. The politicians want to get involved, and in due course they will.

So what are the questions?

Firstly, is there any role left for separately regulated broker/dealers? My sense chimes with the majority opinion that the answer to that is no. With 2 big clients left out of 5 at the start of the year, the SEC (and specifically its capital regime) does not emerge covered in glory. How should the broker/dealers be supervised going forward?

Secondly the insolvency regime for financials needs to be addressed urgently, in the UK just as much as the US. In particular exactly when can the regulator seize the vehicle, what happens to the holders of subordinated claims at that point, how derivatives claims (with their effectively supersenior definitions of termination events) interact with that, and the issues involved in making cross border insolvency fair need to be thought about hard.

Thirdly and perhaps even more controversially, what about insurers? US state insurance regulation is complex, capital requirements for financial risk are simplistic, and the US regime has not come out of the Crunch looking good. Think of the monolines as well as AIG. I am not sure the European answer is much better, but at least Solvency 2 is an attempt to address the issues.

Finally, a lot boils down to leverage. Capital rules were supposed to constrain leverage. They didn't, thanks to numerous failings. Free passes to SIVs and conduits, the lack of capital for liquidity risk, VAR based market risk capital which ignored fat tails, capital based on rating, the Basel 2 treatment of residential property: all of these were gross failures of regulatory prudence. It is, I fear - and I know how many careers this would threaten and how unlikely as a result it is to happen - time to throw away Basel 2 and start again. We need a set of capital rules which are appropriate for a wide diversity of risk taking, from AIG FP through Cheyne Finance and MBIA to Lehman Brothers (R.I.P.) and on to traditional banks like Santander. They need to be anti-cyclical, and they need to be fair. That means no grossly preferred asset classes, accounting methods, nor ways of taking risk. It is a big job, but it desperately needs doing. Whither Basel 3?

Capital? Moroni

Warning. You are now entering 'Capital is anything you want it to be' land, which is quite close to Moroni. Well, that may be a bit unfair. In the slightly less sensational prose of Reuters, US regulators propose cutting bank goodwill deductions. More background on this and other regulatory changes is in the New York Times here.

I'm all in favour of flexbility in times of crisis, so I support (even as I question the legality of) the FED's suspension of section 23a. I think anticyclical capital requirements are a good idea. But the deduction of goodwill is vital to stop acquisitive banks growing too fast. Ah but wait, someone has to buy WaMu. Then there's Morgan Stanley. And Goldman. And... The goodwill change will make all of these deals a lot easier.

AIG and Credit Support Default

It is reasonably well known in the derivatives markets that a lot of AIG FP's CSAs have collateral on downgrade clauses. Specifically AIG FP has to post more if the AIG parent company is downgraded. The parent is on downgrade watch. Market gossip has it that the amount of collateral required is substantial, probably (irresponsible rumour has it) more than $10B. So AIG will borrow from the FED (or as FT alphaville has it, give a bridge loan to itself) and pledge it straight back to, err, the FED's clients and their peers. Seen that way it makes complete sense for the FED to lend...

Look how mild this is so far

Honestly, this really is not (so far, and I know it is early US time) a big problem. Yet. Yes the FTSE is off nearly 5%, and the S&P is down 2.3%. But that's all. I had expected the equity markets to take this much harder.

Update. It is now close to the close, and the US is still only down 4%. Even 6% on the DJIA would not get into the top twenty all time biggest percentage declines. Today is not a rout.

The 5 Step Plan

We may be turning Japanese I really think so.FT alphaville has a salutory post on Japanification. The post suggest five steps in crisis management:

1. In order to head off the debt/deflation vicious spiral, monetary policy needs to be extraordinarily stimulative. The risk of runaway inflation is minimal.

Agreed, but even more important is that liquidity policy needs to be very loose. I should be able to repo my dry cleaning receipts at the central bank, at least for a while. The FED's steps to not so much open the window as knock out the whole back wall out with a JCB are absolutely right here.

2. Fiscal policy has a job to do when the money multiplier collapses. Forget about crowding out - bullish bond markets will absorb all the supply they can get.

Agreed again. It is time for some good old fashioned Keynesian stimulus. Could we please fix the railways as part of that? And how about some other green measures too? Spend on infrastructure for the future.

3.”Strong hands” ( investors with risk-taking capacity) are like gold-dust. The sovereign wealth funds of emerging economies are now in the position to play the role that hedge funds and vulture funds did in Japan and Asia in the 1990s. They should be welcomed, not shafted, criticised, or over-regulated.

Ummm, to some extent. Politically it may be better to pass on more costs to future generations than to pass ownership of the financial system East. Just as energy security is a concern, so should the ownership of the financial system. So yes, welcome capital, but not without some care.

4. Forget about moral hazard. Somebody has to take the credit risk. Future generations are the best candidate because they’re going to have a better life than us, with all kinds of cool gizmos and hobbies. They won’t notice, really.

With the proviso that the equity holders of failed or failing institutions need to be thoroughly caned, yes. The state can and should take a boat load of asset price risk in order to bail out the financial system. The price will be future regulation.

5. No schadenfreude. Never ask for whom the bell tolls. It tolls for thy portfolio.

Awww, c'mon. Merrill was (mostly) a great firm. To see it as part of BofA is a great shame and I certainly have no wish to chortle about that. But no little laughs about Jimmy Cayne? Now you really are asking too much.

Citi and BofA: Will History Repeat Itself?

Citibank was a large commercial bank which started to develop its own investment banking capability. Then a large capital markets broker/dealer, Salomon Brothers, got into trouble, so Citi bought them. And it snapped up Smith Barney too, so it had retail brokerage. The resulting behemoth tried to do too much and got into big trouble in the credit crunch with one of the largest write-offs of any bank. Using cheap funding from the commercial bank to fund credit assets in the broker/dealer was not a good idea.

Bank of America was a large commercial bank which started to develop its own investment banking capability but then more or less gave up. Merrill Lynch, a large capital markets and retail broker/dealer got into trouble and BofA have just bought them. Can we guess what might happen next readers? Are Universal Banks really the answer to every problem in the financial system?

I have had just about as much fun as I can take...

...in investment banking. That, if you remember, was what Kenneth Lewis, Bank of America’s chief executive, said a year ago. Now it appears BofA is looking at Lehman. Fun, fun, fun. Still, broker/dealers almost never end up being sold to the people who would get the most from them -- remember DLJ and Credit Suisse -- but rather to those whose greed exceeds their fear by the largest amount. HSBC appears to be driven be fear: if BoA isn't, it may end up with a rather better deal in its second crunch acquisition than it did in its first.

Update. Michael Lewis is most amusing on Bloomberg's site:

KDB proved it may have finally grasped what should be for Asians a cardinal investment principle: Never buy anything an American investment banker is selling.

A New Approach To Bank Supervision

The Onion has the answer:It's worth a try don't you think?

Cheyne Pain

Ah, the lawyers may be slow, but they are remorseless. Like the slugs in my friend's garden, there is little you can do to stop them. From the FT:

Abu Dhabi Commercial Bank’s class action lawsuit for fraud, negligent misrepresentation and unjust enrichment over its investment in a complex fund is a fascinating collection of details and allegations that cut to the heart of the credit boom and messy aftermath...

ADCB bought mezz notes paying Libor plus 150 and rated single A: these are now worth squat. Back to the FT:

ADCB’s suit accuses Morgan Stanley, Bank of New York Mellon, Moody’s Investors Service and Standard & Poor’s of misleading investors about the quality of assets the Cheyne vehicle bought and held from its inception in 2005 to its collapse just two years later.

This will be dramatic, even if it is the slow moving drama of a test match. I look forward to the show.

More Lehman Musing

I'm glad I took profits on LEH and got out: it's down 30% today. Dow Jones say that KDB are no longer interested, and the BBC thinks they have funding stress. Which they might well do. The WSJ reports heavy activity in the out of the money puts, while Reuters discusses the on again off again sale of Neuberger.

Surely this is a great time for a bid. Buying Lehman would finally catapult HSBC into the premier league of investment banking. BNP Paribas could use the US coverage, but they may be busy contemplating Fortis. It would be a fantastic trade for Unicredito too, and I wouldn't put it past Ermotti -- do they have the capital to spare though? And could they afford Lehman, even at current prices? RBS is sadly digesting ABN (what a silly purchase that was) and so probably isn't interested. CIBC presumably had a look, as we know did RBC. I still like HSBC here...

Graph of the day year?

From the Short View on the FT, US bank borrowings from the FED over time:That really speaks for itself, doesn't it?

A quick hat tip to the importance of debt deflation

Sadly I don't have time to address this properly, but I do want to make a quick connection between Ben Bernanke's favourite theory of the Great Depression - Irving Fisher's idea of debt deflation - and the current situation. Krugman is insightful here:

when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that such selloffs are self-defeating when everyone does it: if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence of what he called a “stampede to liquidate” is a severe economic slump.

That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money.

For more historical context and comment, see The London Banker.

The easiest job in Britian.

The FT is wrong. Valuing shares in the Crock is not hard. Say zero. Keep saying zero, whatever happens. Nothing comes of nothing, say again.

F&F: It is a Credit Event

From Bloomberg:

Thirteen ``major'' dealers of credit-default swaps agreed ``unanimously'' that the rescue constitutes a credit event triggering payment or delivery of the companies' bonds, the International Swaps and Derivatives Association said in a memo obtained by Bloomberg News today.

So the CDS are triggered. What I urgently want to know is is this a termination event on the enormous portfolio of IRD that Fannie and Freddie have as hedges against prepayment risk. Remember these two are amongst the largest players in the interest rate derivatives market, mostly as buyers of convexity. I can't believe many people want an unwind so the situation should be manageable.

Update. Just in case you are not a regular reader of the components of the major credit indices, it is worth point out that Fannie and Freddie are both in the CDX.

The Holders of F&F Prefs

The part of the Fannie and Freddie bailout that worries me is the prefs. From the FDIC:

The federal banking agencies have been assessing the exposures of banks and thrifts to Fannie Mae and Freddie Mac. The agencies believe that, while many institutions hold common or preferred shares of these two government-sponsored enterprises, a limited number of smaller institutions have holdings that are significant compared to their capital.

The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are prepared to work with these institutions to develop capital-restoration plans pursuant to the capital regulations and the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act.

All institutions are reminded that investments in preferred stock and common stock with readily determinable fair value should be reported as available-for-sale equity security holdings, and that any net unrealized losses on these securities are deducted from regulatory capital.

You've got a few hours before the US market opens. Can you figure out who has those holdings that are `significant compared to their capital' in time for the open?

Update The WSJ says F&F have $36B of prefs outstanding. That's a chunky loss for the financial system if they really do turn out to be worth basically nothing.

What works

Sometimes, just sometimes, you read something so good that it makes every other piece of journalism you've read recently seem thin, dull, and without insight. Ross McKibbin's article in the current LRB is that good.

McKibbin cut through the rhetoric admirably. He points out the hollowness of Blair's promise to go with 'what works', indeed to the very antithesis of it:

The culture of the focus group does not, however, lead to an apolitical politics. On the contrary, it reinforces the political status quo and encourages a hard-nosed, ‘realistic’ view of the electorate that denies the voter any political loyalty, except to ‘what works’. ‘What works’, though, is anything but an objective criterion: these days it is what the right-wing press says ‘works’. The war on drugs doesn’t work; nor does building more prisons; nor, one suspects, will many of the anti-terror laws. But that doesn’t stop ministers from pursuing all of them vigorously. New Labour in practice is much more wedded to what-works politics than the Conservatives were under Thatcher, who was openly and self-consciously ideological.

Much of the present malaise in British politics flows from this. Among other things, what-works gives the wrong answers.

He also points out, amusingly, that we do in fact have three parties in parliament. They are just not the three parties whose names appear on the ballot paper. A more accurate arrangement based on ideology rather history would have:

A party of the moderate left, undoubtedly led by Vince Cable, which would include some Labour backbenchers (but no member of the present government), some Lib Dems (but probably not their leader), and perhaps Tories like Kenneth Clarke and Ed Vaizey. There would be a centreish party which would include Brown, some members of the cabinet, most Lib Dems, a large part of the Parliamentary Labour Party, probably William Hague, Theresa May, Alan Duncan and a few other Tories; Cameron and Osborne might be honorary or temporary members. The party of the right would include everyone else (including many members of the government).

There is much else of value in the full article and I would encourage you to read it. But even if you don't, at least rejoice that there is still journalism of this quality going on in this country.

The Q is dead

Long live son of the Q. If there is one. The FASB explains that:

it expects to issue three separate but related Exposure Drafts on or around September 15, 2008, for public comment...

The proposed Statement to amend Statement 140, would, among other things, remove the concept of a qualifying special-purpose entity (SPE) and would remove the exception from applying Interpretation 46(R) to qualifying special-purpose entities (SPEs).

Now Qs are not the only way to do a securitisation under US accounting, but there are a common way. The standard won't come into effect until 2010 according to Housing Wire, and we are still a long way from the cliff edge given the comment period. Still this proposed change is something the structured finance community needs to take very very seriously.

The strange and the completely predictable

Two facts. It is with no shock whatsoever that I report that Moody's has made yet another stuff up in CPDO modelling.

What is bizarre, though, is that someone at the FT seems to know what a copula is. See here for both.

Drug policy

The ECB is taking steps to withdraw the crack cocaine of the Eurozone financial system, cheap liquidity. From the FT:

the cost of raising funds from the ECB against any kind of asset-backed bond or unsecured bank debt will rise, once the rules are implemented in February...

The most straightforward changes were an increase in the haircuts, or discount, applied to the worth of collateral. For asset-backed securities, such as mortgage-backed bonds, this was increased to a flat rate of 12 per cent from a base of 2 per cent. If a bank has created such a bond and kept it on balance sheet for repo purposes, a further 5 per cent haircut is added.

For normal unsecured bank debt, the haircut is also increased by 5 percentage points from a 1.5 per cent base.

As Willem Buiter points out, this is going to be interesting for those Eurozone banking systems that are suffering from a housing crash and a concomitant liquidity drought:

Between August 2007 and July 2008, the share of Spanish banks in the Eurosystem’s allocation of main refinancing operations and longer-term refinancing operations went up from about 4 percent to over 10.5 percent. The share of Irish banks went up from around 4.5 percent to 9.5 percent.

I still think Buiter is wrong on the central policy issue: the ECB should take (some limited) risk if by so doing it helps reliquify the financial system as a whole. But like him I applaud these steps towards stopping the gaming of the ECB's collateral facility. And I think this is a big signal to short Spanish and Irish banks with lots of 2005-2007 vintage mortgage exposure.

What is a derivatives pricing model anyway?

I had a conversation about this last night and thought it was worth writing some of it down and extending it a little. So...

Let's begin with the market. For our purposes there are some known current market variables which we assume are correct. This could be a stock price, interest rates, a dividend yield -- and perhaps one or more implied volatilities.

Secondly we have a model. The model is often, but not always, standard, i.e. shared between most market participants. Let's start with standard models. Here the model is first calibrated to the known market variables.

At this point we are ready to use the model. There is a safe form of use and a less safe one. In the safe one we use the model as an interpolator. For instance we know the coupons of the current 2, 3, 5, 7 and 10 year par swaps (plus the interest rate futures prices and deposits) and we want to find the fair value coupon for a 4.3 year swap. Or we know the prices of 1000, 1050 and 1100 strike index options and we want to price a 1040 strike OTC of the same maturity.

The less safe use is when we use the model as an extrapolator. We want a 12 year swap rate, for instance, or the price of a 1200 strike option. That's not too bad provided we don't go too far beyond the available market data, but it is definitely a leap.

(Both of these, by the way, count as FAS 157 level 2.)

Note that there are two ways that we realise P/L in derivatives. Either we trade them or we hedge them. If we are in the flow business then trading is important. We need to use the same model as everyone else simply because we are in the oranges business and we need to kInow what everyone else thinks an orange is worth. We take a spread just like traders of other assets, buying for a dollar and selling for a dollar ten, or whatever. The book might well be hedged while we are waiting to trade, but basically we are in the moving business. Swaps books, index options, short term single stock, FX, interest rate and commodity options, and much plain vanilla options trading falls into this camp.

In the hedging business in contrast we trade things that we do not expect to have flow in. Most exotic option businesses are an example here, as are many long dated OTC options. There is no active market here so instead we have to hedge the product to maturity. Thus here the model hedge ratios are just as important as the model prices. Valuation should reflect the P/L we can capture by hedging using the model greeks over the life of the trade. Thus standard models are more questionable in the hedging business than in the moving business since it is not just their prices -- which are correct by construction -- but also their greeks that matter.

Things start to get really hairy when we move away from standard models. Now we are almost certainly dealing with products where there is no active market (some kinds of FX exotics are a counterexample) and we do not even know that the model prices are correct. There is genuine disagreement across the market as to what some of these things are worth. Different models also produce radically different hedge ratios. How can we judge the correctness of such a model? The answer is evident from the previous paragraph: it is correct if the valuation predicted can genuinely be captured by hedging using the model hedge ratios. [Note that this does not necessarily give a unique 'correct' model.]

In summary then: for flow businesses we need interpolators between known prices and, to a lesser extent, extrapolators. For storage businesses we need models which produce good hedge ratios.

Short contemporary art

Except Chinese contemporary art, obvious. From the FT:

modern art has mainly been bought by the nouveaux riches who made their money in the bull market: the hedge fund managers, the investment bankers, the media moguls. Most of these would-be collectors are running for cover, having been battered by the credit crunch, with bonuses and bumper payouts now just a memory. The few rich left – the Russians, oil sheikhs and the like – don’t buy much contemporary art. The years of easy money, which have driven so much asset price inflation, are surely over and now is the reckoning, when the froth evaporates.

I agree with Luke Johnson. This year's Frieze is going to be interesting.

Good insurer bad insurer

Lawyers to your keyboards. Ambac is pushing ahead with the good insurer/bad insurer model. From Bloomberg:

Ambac rose as much as 15 percent in late trading as Wisconsin regulators, which have jurisdiction over the New York-based company, approved a plan to move $850M out of Ambac Assurance Corp. into the new business, according to a statement today. Ambac is seeking to obtain an AAA credit rating ... for Connie Lee.

Apart from the obvious questions -- who gets the capital, who gets the muni derivatives, and why anyone thinks structured finance counterparties might be remotely comfortable with all this -- don't we have a bad enough history with two syllable first name one syllable second name companies? I mean, Indy Mac, Fannie Mae, Freddie Mac, ... Connie Lee -- it is not encouraging, is it?

The Functions of Capital

It occurred to me as I was sweeping up the fallen leaves from my Hebe this afternoon that the marxist critique of capitalism would be stronger if it included the destructive effects of leverage. After all capitalism implies a duty to maximise ROE, and doing that requires leverage. But too much leverage gives you a banking crisis.

Partly these observations were motivated by a very fine article on Naked Capitalism. It points out that regulators still seem to be struggling with three evident truths:

• The need to address information asymmetries in securitisation while preserving the risk distributions benefits it offers;
• The importance of anti- rather than pro-cyclical capital requirements in promoting financial stability; and
• Banks will always play capital games to maximise their ROE while appearing to be well capitalised and it is regulators duty to stop them.

If these three are not obvious to the supervisory community then there will be another crisis.

Positions

OK, Lehman has done well, so time to take that off. 30% in ten days is good enough for me.

Long USD vs. GBP has done well too, and USD/EUR is flat. Both of them can come off too.

Do I sense a degree of herding in the market at the moment?

Fallacies of Planning

I read a post on Overcoming Bias that referenced the planning fallacy. I thought this was going to turn out to be more interesting that it did, so instead of the original content, let me propose a different planning fallacy.

The fallacy is simply that people tend to believe that executing the plan will achieve the desired objective and only that. We are used to plans working in simple cases: I'm hungry, so I make a plan to go to the fridge. I execute the plan and lo, food is mine.

We are even used to plans not working: I might slip on the way to the fridge and end up on the floor swearing rather than happily nibbling some dairy delicacy. But typically if a simple plan works, then the consequences are simple and easy to guess. The amount of cheese in the fridge decreases. Big deal.

Plans for complex objectives, however, usually involve unexpected (and therefore by definition unintended) consequences. Lowering rates doesn't lower Libor because banks hoard cash. Saying you will protect the Agencies does not reassure the markets because they don't believe you or they don't know what 'protect' means, exactly -- or for some other reason entirely. And so on. I suggest that the study of planning failures (and successes) should be compulsory for politicians and economists.