Taxing reputation

Readers from the investment banking industry might already have noted that my views on tax arbitrage are at the extreme end of ones commonly found within financial services. Most banks seem to take the view that helping their clients pay less tax is a good thing, especially if they can get paid to do it. I take the view that paying less tax is a crime against society, and facilitating it is one of the things that lowers the public opinion of our industry. (For more on the latter, see the coverage of UBS's US tax evasion woes here or here.)

Today, in a notable shift in the tenor of the discussion in the industry, the FT has an article on the coming crack down on tax havens (many of which, remember, are British protectorates or overseas territories). It ends:

The tiny states and protectorates that thrived in the free-wheeling second half of the 20th century are left struggling to shore up their defences against the coming storm. But as big countries try to block the leakage of much-needed tax revenues and stanch the flow of dirty money, sympathy for the tax havens is in short supply.

I really hope that this is true, and that the political will exists to stop these practices. It defies the principal of natural justice that the wealthy pay less tax than the poor. The existence of tax havens which permit individuals and corporations to evade their share of the burden of the nations which allowed them to thrive is an affront to all of us who do pay our dues.

Update. The U.S. Justice Department has expanded its probe to include Credit Suisse and HSBC according to the NYT. It seems that the reputational risk of facilitating tax evasion may be about to bite.

Civilisation Crushed - A Tale of Two Buildings

When the new Eurostar terminal at St. Pancras opened, it was to almost universal praise. See for instance here for the Guardian's take or here for the BBC. As the latter puts it:

The brick and stonework was near-perfect. The soaring roof was "detailed delicately" ... [it is a] World-beating roof

And yes, it is a lovely building, and yes, the roof is incredible, a soaring arch of glass that lifts the spirit. There's only one problem. You can't actually see it most of the time because the passenger is sunk in a tunnel of shops. Rather than let people enjoy the extraordinary Victorian space, the architect has ensured that what you actually experience is just another retail environment. It is a fantastic building ruined by an excrudescence of high street squalor.

Stansted is exactly the same. The building is one of Norman Foster's finest. It could be a nice place to use, with clear views all the way from check in to the runways, again with a high roof that lets lots of light in. Instead it is a hell of closely packed shops and restaurants, Foster's vision having been completely subordinated to the need to get as many square feet of selling in as possible. BAA are not unique in their ability to ruin the traveller's day but they are one of the leading practitioners of this all-too-common art.

The Victorians realised something that seems to be lost today: that if you make grand public spaces that are a pleasure to use, then you add joy to peoples' days. If you respect the general populace and provide a context that is fundamentally civil, then many of them, at least, will be civilised. But if you treat them as consumers whose only duty is to spend, then they will behave however they want. Is it too much to hope that one day St. Pancras or Stansted will push the shops into the background and let the building do its job?

The long tail of the monolines

Accrued Interest picked up something that I had missed, namely the continuing long slow death of the monolines. In particular Moody's downgraded the last of the AAAs, FSA and Assured Guaranty, on Friday. Read about it here. This is rather like that poignant moment when the last of bottle of 1970 Lafite is drunk - although the smiles are a little less broad.

Accounting for Warren

How should we view Warren Buffett's short put position? The FT has some comment which clarifies both Buffett's thinking and the conflict between insurance and capital markets views of risk. It is useful background to my earlier post about this position.

First the facts. Berkshire has sold long dated out of the money (forward) puts on major indices and received premium upfront. These puts are getting closer to the money as the indices concerned fall, giving rise to mark to market losses.

John Gapper's FT article points out that Buffett is usually thought of as a great investor - and he really is one - but what is less commonly discussed is where the money came from for that investment. The answer is that it is often from writing insurance. That is, Berkshire is a classic insurance company: it writes insurance, receives premiums, and invests them in the attempt to produce a bigger pot of money than is needed to meet claims. It has been highly successful at this.

The two different communities, insurers and derivatives folk, look at risk in entirely different ways. An actuary would ask how like a risk is to be manifest and what it will cost the insurer if it is based on history. A derivatives trader would ask what the market price of the risk is. Thus insurers and investment banks made great trading partners as the insurer will often take risk for far less than the bank thinks it is worth. This is one of the reasons AIG wrote so many default swaps: they thought that they were being well paid for them.

Another point is that for classical insurance risks like catastrophe, auto or terrorism, the accounting for the risk is on the basis of received claims. You don't take a mark to market hit on the hurricane book if the weather gets worse in the North Atlantic: you only have to provision for the loss when claims are both likely and can be estimated. This is very close to accrual accounting in banks loan books.

Derivatives, though, are different. Here Warren has to mark to market, so Berkshire suffers earnings volatility regardless of whether the puts really will pay out or not, a fact that anyway won't be known for many years. Why are investors spooked by a mark to market write-down on a derivative with eleven years left to run when they are perfectly unphased by the warming Atlantic, something that could - if it generates more hurricanes like Katrina - devastate Berkshire's cat book? Investors seem overwhelmed by the risk that they are being forced to look at, yet indifferent to the ones the accounting glosses over. Interesting, isn't it?

Baltic Dried

From Bloomberg:This is, I understand, a 22 year low. Global trade has fallen off a cliff.

Warren's puts

There is a very nice post on Financial Crookery about Warren Buffett's written puts.

Let us assume that BRK sold $40bn notional 20 year puts (over 4 indices) in 2006-2007 at an average equivalent S&P 500 level of 1400. At the prevailing swap rate and dividend yields, and implied volatility of around 24%, this would have realised premia of approximately $4.5bn, close enough to the premia actually received not to worry too much about the exact details of the transactions.

The undiscounted future value of this liability, ie the fair value expectation of payment in 2027, is presently around $19bn. (At the money long dated volatility has expanded to 38%; this option now is well in the money and the skewed volatility for 1400 strike is more like 33%). The present value of this liability, before the impact of credit spreads, is around $10bn using the current swap curve.

So far, so simple. But this valuation does not take account of the credit spread of the writer of the put...

[The writer then goes on to estimate the credit effect and to speculate on whether BRK uses such credit-effected prices for its own mark to market. My reading of FAS 157/159 is not only that it can but that it must.]

The only issue I might take issue with it is that the article uses Black Scholes with vols that seem rather low (33%) to value Warren's 18 year puts. These are far out of the money forward, and I am always a bit nervous about using Black Scholes for long-dated OTM puts - my guess would be that different process-theoretic assumptions would increase the value of the position (i.e. increase Warren's loss). Kudos to Goldman though for buying these options: all that downside vol in size must make hedging their index books fun at the moment.

That embarrassing conversation

Mark Gilbert nails it:

It’s the conversation every parent dreads. “Mom, dad, you know how I’ve always been a little different from the other kids? Well, I think it’s time you knew the truth. I think I’m, um, an investment banker!”

Quote of the day

From Willem Buiter's blog on FT.com, the cry of the small enterprise reverberates:

The very fact that we are not systemically important makes us systemically important.

The whole post is most amusing.

A tale of four champions

In a moment of whimsy, I decided to use Bloomberg's good offices to look at the performance of four national champion banks - or at least large banks - over the last little while. I picked Citi, Deutsche, Paribas and Santander. Of course you can argue that these are not real champions, and I might well agree, but let's follow the data for a moment. The first thing that leaps out is the outperformance of Paribas. Given they are a rather similar bank to Deutsche, that was a surprise. Citi's malaise has got a lot of press, Deutsche's less so. And Santander still looks over-valued in this company: concerned though I am about Citi's proposed slimming plan, at least they have a plan and shareholders who can hold management to account, whereas I am not a buyer of the Botín myth. If you fancied a punt and could figure out a way to do it cheaply*, you might consider selling CDS on DBK (sub?) debt and shorting SAN's equity. C is down so far that you might summon a lot of courage and consider buying the equity. Yes, I know, that is a big step and you might get conviscated, but if C survives, it is likely worth more than last night's close of $4.71 a share.

*Selling short-dated out of the money calls is another choice if the borrow is expensive or impossible.

If you go down to the woods today...

...beware the four big bears. From dshort.com:How low can it go? Quite a bit lower, of course. But I do sense real value in the market. For the first time in two years, I'm thinking about a cautious long of UK industrials with solid earnings. Not US, because of the currency risk. Not banks, because one big problem - like Citi needing a further bailout - could further bomb the sector. Not insurers because I distrust their accounting. And certainly not retail.

No arbitrage requires arbitrageurs

No arbitrage conditions are not natural laws. You can only rely on them if there are enough arbitrageurs around to keep the markets in line. At the moment, that isn't true in many settings. John Dizard points out an example from the Tips market:

seven-year Tips bonds are asset swapping at 130 basis points over Libor

As Dizard says, this is partly because the Tips are illiquid and hard to finance (and thus to leverage), and partly because there is not enough risk capital around:

The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds. The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry, and then were sold off by merciless prime brokers.

More awful journalism on credit derivatives

The ignorant journalist's favourite whipping boy, the CDS market, gets another undeserved beating today, this time from Alan Kohler in the Business Spectator. Managing a considerable density of mis-information, Mr. Kohler is rather histrionic:

As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm

Would that be a cataclysm like the Lehman CDS one, or like the Fannie and Freddie one? How would sir like his non-event today?

The triggering of default on the trillions of dollars worth of synthetic CDOs that were sold before 2007 could be a disaster that tips the world from recession into depression. Nobody knows, but it won’t be a small event.

Or just perhaps it will be totally orderly just like all the other CDS settlements so far.

CDOs were invented by Michael Milken’s Drexel Burnham Lambert in the late 1980s

No, CMOs were invented by the Freddie Mac in 1983. The first CBOs were based on that structure.

About a decade later, a team working within JP Morgan Chase invented credit default swaps, which are contractual bets between two parties about whether a third party will default on its debt. In 2000 these were made legal

Again no. They were legal when they were first traded, in the early 1990s. (U.S. law, it may surprise Mr. Kohler to learn, is not the only relevant one.) At this point I have to confess I gave up. Anyone who makes that many basic errors in the first few paragraphs while using over-blown and emotive language does not deserve to be read.

There is an upside

From the BBC:

Prices of some of the world's most revered wines are falling sharply...he price of the 2005 vintage of Bordeaux's famous Chateau Lafite Rothschild has dropped 25% since the summer.

Remember, folks, only buy the best vintages. '82 and '85 are great claret years. My view is that '86 has been consistently over-valued so I tend to ignore it, leaving just those two for current drinking. The '89 and '90s will be ready soon. The best '95s and '96s will probably need ten years. Goodness only knows when the 2000s will be ready.

Fannie and Freddie get real

The highlights of the current new realism:

• Freddie Mac has asked the US government for $13.8B;
  
• It suffered a record $25.3B quarterly loss and said that shareholders’ equity was a negative $13.7B. So after being bailed out, it will be worth $100M, presumably.
  
• A significant part of Freddie's writedowns was $14.3B of deferred tax assets.
  
• Fannie reported a $29B quarterly loss last week of which $21.4B were deferred tax assets.
  
• Fannie said it might need more than the $100bn earmarked for each of the two companies in order to stay in business.
  
• But it does at least claim to have a positive net worth.

Can I say neue sachlichkeit now?

And the winner is...

...Wachovia by a country mile.

Local players for local teams

Recently Sepp Blatter told MEPs he wants to limit the number of foreign players on the pitch to 5. He believes this will encourage clubs to develop home grown talent and to protect the local identity of teams.

This is of course in conflict with European employment law, which is why we have to endure one of the worst role models in European football - Ronaldo - playing for an English team*. So I would go further. Not only would I limit the number of foreign players in every football team to 5, but I would limit the number of non-local players to 5. At least 6 members of the team should be born within, what, ten miles of the ground? Or, because that advantages teams with high local population densities, let's just draw a circle that takes in five million people centred on the ground, and if you are in that, you are officially local. If you're not, you count as one of the five non-locals.

This would restore the original purpose of football teams: to represent the area they are in. Liverpool would do well - a lot of them are scousers anyway, thanks to an enlightened youth development programme. But some of the Spanish would have to go, as would some of the French national side in London (Arsenal). Manchester United might be encouraged to give a damn about the North West again. In general the megaclubs would reconnect with their areas and the playing field (to use a cliche) would be more level.

* Look how many hits you get on a google search for Ronaldo and petulant...

Update. Here are the birthplaces of a few of the current England squad: Gabriel Agbonlahor, Birmingham; Peter Crouch, Macclesfield; Frank Lampard, Romford; Steven Gerrard, Whiston (Merseyside); John Terry, Barking (London, although not too far off his playing style too); Micah Richards, Birmingham. The London clubs would actually do reasonably under the arrangement, the Brummy ones would be gainers, and the North East would struggle. Although not as much as Michael Owen (birthplace Chester) struggles to stay fit.

AIG and default correlation mis-estimation

Felix Salmon has a nice piece on AIG FP's strategy and why it went so badly wrong.

When AIG wrote protection on CDOs and the like, it got insurance premiums in return, and considered those premiums to essentially be free money, since (according to AIG's own models, and those of the ratings agencies) the chances of those CDOs defaulting were essentially zero.

...AIG's biggest mistake was in failing to realize that this business couldn't scale in the way that most insurance does scale. Most insurance does scale: if you insure a house against fire, for instance, it's easy to lose much more money than was paid in insurance premiums. But if you insure houses across the country against fire, you'd need a nationwide conflagration in order to lose lots of money.

... The reason AIG's models said the CDOs couldn't suffer any losses was that house prices don't fall in all areas of the country simultaneously. Since AIG was only insuring the last-loss CDO tranches, investors with lower-rated tranches took the risk that prices in Florida, or Arizona, or California might fall. AIG would only lose money if prices fell in all those states at once -- which is, of course, exactly what happened.

In other words, AIG's models assumed default correlation would be low, and that there was a good measure of diversification benefit between the different CDOs it had written protection on. In reality once house prices turned down there was very little diversification, default correlations leaped up, and the mark to market on many of AIG's contracts turned against them, necessitating the collateral postings that brought the insurer into the welcoming arms of the FED.

The regulation of insurance in the U.S.

The Aleph Blog has a remarkably wrong-headed piece on insurance regulation here, suggesting that federal insurance regulation is a bad thing and that the FED should have let the AIG parent fail.

Some comments. First, the US is the only major economy that does not have a national regulatory framework for insurance. Instead it is regulated at the state level. Some of the states do it well, some less well. Many of them are different. How can it possibly make sense to have over 30 regulatory frameworks for the same product in one country?

Secondly US insurance regulation is a long way behind the curve even in the best states. While the EU is on solvency two, with fairly sophisticated capital modelling, the US framework does not require enough capital for credit risk, which is why the monolines and AIG got into so much trouble in the first place. Their leverage was not effectively constrained by their capital requirements (and in some cases their accounting framework encouraged them to take risks more cheaply than banks would). The U.S. needs to address the arbitrage whereby it is significantly cheaper for some insurance companies to take credit risk than for banks.

Thirdly, letting AIG fail was not a realistic option however much moral hazard its bailout presented. I continue to dislike the bailout. However depriving the banks of hundreds of billions of dollars of protection is simply not sensible at the moment: you would only have to spend the money recapitalising them.

Debt deflation

Gavin Davies has a nice summary in the Guardian of Irving Fisher's debt deflation theory. I'll edit slightly:

Deflation is defined as a pervasive decline in the general price level... When such a decline starts, three very dangerous things can happen.

First, real (inflation-adjusted) interest rates rise, and the central bank becomes powerless to prevent this, because it cannot reduce the level of nominal interest rates below zero. As the rate of deflation gets larger, the real rate of interest actually increases, and this perversely tightens the stance of monetary policy.

Second, the real level of debt in the economy also rises. Most debt is denominated in fixed nominal quantities (£100 for instance), so when the price of goods declines, more goods are needed to pay down the same quantity of debt.

Third, consumers - expecting price declines to continue - delay purchases because the real value of cash is likely to be higher in the future. This reduces demand, pushing the economy further into depression.

Monetary policy does not work in this regime: a fiscal stimulus is needed. Thus the central bank prints money (inflation not being a concern) and the government spends it on something, ideally something useful. Green Keynes anyone?

Update. Krugman has more on the same topic in the NYT here. As he says, to pull us out of this downward spiral, the federal government will have to provide economic stimulus in the form of higher spending and greater aid to those in distress.

That AIG bailout again

AIG wrote CDS protection to a bunch of banks. Spreads have blown out and AIG is not AAA, so they have to post collateral. They couldn't, so the FED lent it to them at Libor + 850. That was last month's story.

This month's story is a new bailout. Let's see if we can follow the story in the WSJ:

Many banks that previously bought protection from the insurer on securities backed by now-troubled mortgage assets stand to recoup the bulk of their investments under a plan by AIG and the Federal Reserve Bank of New York to buy around $70 billion of those securities via a new company. These securities are collateralized debt obligations backed by subprime-mortgage bonds, commercial-mortgage loans and other assets.

...

The banks also will sell the CDOs to the new facility at market prices averaging 50 cents on the dollar. The banks that participate will be compensated for the securities' par value in exchange for allowing AIG to unwind the credit-default swaps it wrote.

So the Journal is suggesting that the new facility will buy the securities and cancel the CDS AIG has written. Note that that does not just get the banks off AIG counterparty risk: it also frees up funding for the underlying assets. If eventual recoveries are greater than market prices predict, then the new entity at least gets to keep the difference. Still, it does seem a strange way to proceed. Even if you thought that it was important to ensure that the protection buyers did not lose - clearly a key feature of the bailout - why would you buy the underlyings rather than simply loan AIG money to meet collateral calls and recapitalise them if necessary?

11/11

Walking through Green and St. James' Parks on Sunday, and listening to silence on the radio at 11 o'clock, I am struck for the first time in some years by the dignity of Armistice day. Given Iraq and Afghanistan I suppose we are more ready to remember war, and more aware of its consequences. The New Zealand War Memorial - introduced I think in 2006 - is particularly simple and moving: we shall remember them.

The pain in Spain stays mainly on the plain

Or perhaps post-industrial wasteland is more apposite, for those of you who have been to Santander's headquarters in Boadilla. Anyway. The self-proclaimed over-capitalised and conservative bank isn't. Well-capitalised that is. There is a 7.2B EUR rights issue, according to the FT.

There are two readings of this. One is that if even a bank as old fashioned as SAN needs new money, the financial system is going to hell in a handcart and practically everyone needs new capital.

The other (not necessarily exclusive) interpretation is that SAN has some accrual accounted nasties on its balance sheet which, if they were fair value accounted, would already have produced substantial write-downs. SAN can only go to the fountain once because the admission that it needs new capital is tantamount to the one that its loan loss provisions are not sufficiently prudent. And once you say that, investors might never trust you again.

Personally, I am in favour of transparency. If I were CFO of a bank with a substantial banking book under accrual, I would disclose my estimate of fair value for the book just to keep the analysts quiet. Like JPMorgan seems to (the details are not clear), I would also use that estimate as the basis for my loan loss provision. But then I (thank the Gods) don't work in Boadilla.

Why AIG must be kept afloat

It has written an awful lot of CDS protection. If it goes down, the contracts accelerate and the banks who bought protection get recovery on the current MTM. Recovery is unlikely to be more than 50 cents on the dollar, and so the protection buyers would suffer large losses. At least a hundred billion, I would estimate, probably more. So you have the choice between letting AIG fail and putting 100B or more into the protection buyers, or giving it another 50B and trying to keep it afloat. That's a no brainer.

How many ABX CDS are there?

Alea had a misleading note on the DTCC reporting of credit derivatives. I usually like Alea, but this post, suggesting there were only single digit numbers of contracts on many of the ABX subindices, gave the wrong impression. Turning to the DTCC itself, we find net notionals in most of the subindices in the single digit billions, with high hundreds or low thousands of contracts.

It's your day, Bill

'Twas the day of the election, and there was much celebration. No one stirred in the farmhouse before noon on the following day, and the word went round that from somewhere or other the agencies had acquired the money to buy themselves another case of courage. So Moody's cut Ambac to junk. They weren't too late really. If you count in geological time.

English and Welsh Universities

The Guardian has a provocative piece entitled Now is the time for a thorough review of our university system. I certainly agree with the sentiment expressed in there. The English and Welsh* University system has been sliding towards mediocrity for years. Here's my take.

• Student fees do not compensate institutions for the cost of providing world class education. Just look at the comparison between what Stanford or Harvard charge and fees in England and Wales.
  
• Fees are however high enough to put some people off going to University.
  
• Either we need to raise fees to an economic level, and allow our institutions to compete globally, or we need to remove them, and dramatically increase University funding. My preference is for the latter, but even the former would be better than letting our institutions wither and further.
  
• Thus far some of the gap has been made up via charging fees for Master's students. Non-EU students are a cash cow for nearly all institutions in England and Wales; some (like the LSE) even extend that dubious practice to EU students. Many of these Masters courses now have a lower standard than undergraduate degrees. Surely it cannot be to the credit of our University system that a UK MSc is now worth less than a BSc? And even if you ignore the reputational risk and the waste of effort on students who can't even speak English let alone reach the standard of a postgraduate degree from an institution with some self respect, this source of funding is going to be much harder to come by going forward. That, combined with business plans in some Universities which require postgraduate numbers to grow by 10% a year, is going to be a problem.

The Blair and Brown governments have done a reasonably job in dealing with school funding, the academies mess aside. But higher education has not been properly resourced since the 70s. Student fees have failed in two ways: they don't address the funding gap, and they put prospective students off. We need more money from somewhere, and it isn't going to be from yet more non-EU Masters students. If you want a Keynesian stimulus, Universities are one good place to start.

* The situation is slightly different in Scotland as there student fees have been abolished. However, funding issues remain even for the Scottish institutions. To my shame I have no idea of what the situation is in Northern Ireland.

The new treasury secretary

Bloomberg is suggesting Tim Geithner or Larry Summers. Personally I like President Servalan for the role. She has the right qualities for the role. In particular she knows how to get rough with rebel organisations, like the banks. Just ask Roj Blake...

The uses of common stock companies

I like Chardonnay: everything from the better Californians, like Paul Hobbs, to the majesty of mature Montrachet. But I wouldn't serve it with everything. Chocolate wouldn't work, for instance; neither would beef stew.

It is the same with stock-holder owned corporations. They are very good at a number of things, which is why they are such an important part of the financial system. But at the end of the day, a stock company exists for the good of the stock holders. It is dangerously naive to expect them to behave in the interests of any one. So it should be no surprise that the banks are finding ways to get around government restrictions on paying dividends. (The FT coverage is here.)

The big picture is that if you want to achieve an objective that is not obviously aligned with shareholder value, then using a stock company to do it might not be efficient. That holds just as much for lending as it does for running transport infrastructure or conserving the environment. It isn't that companies can't do these things. It is just that they might not be that good at it, particularly if they can't figure out how to make a lot of money in the process. If you use a flame thrower for trimming the lawn, don't be surprised when the grass is burnt.

(The building, by the way, is Lehman in London.)

What are the dynamics of risky bond prices?

The Basel Committee's two papers on incremental risk in the trading book (incremental to that captured by VAR, that is) - here and here - led me to muse on what the real dynamics of risky bond prices are.

Firstly clearly there is an interest rate risk component. Let's ignore that as it is the best understood.

Second there is jump to default risk. The phrase itself is slightly misleading in that bond prices often fall a long way in the period before default, and indeed recoveries are sometimes higher than pre-default bond prices would suggest. Skip to default might a better term. Still, the idea that there is a jump process which can cause non-continuous changes in risky bond prices is reasonable.

Then there are 'everyday' movements in credit spreads. Now, here's the six hundred and forty billion dollar question (OK, OK, not the size of the corporate bond market I know) - if you take out the jumps, is what you are left with even vaguely normal? My guess is that it isn't, and that autocorrelation is significant even after jumps have been taken out. The hard part is that you need a lot of credit spread data to look at this kind of thing, and it isn't easy to come by. CDS data won't do in this instance simply because single name CDS have only been liquid for ten years or so, and you'd at least want data going back well before the '98 LTCM/Russian crisis. I'll get around to this sometime soon...

Spread dynamics are the flipside to my earlier post on what CDS spreads mean: that was about what causes the spread to move; this is about how you can model those movements.

Affronted by accounting

Bloomberg Opinion has a nice piece by Jonathan Weil. He points out that Wachovia's accounts show it having a positive net worth of about $50B but Wells Fargo is buying it for $15B. The difference, of course, is accounting. Or as Mr. Weil puts it:

The reality is that Wachovia's management, including Chief Executive Officer Robert Steel, still won't admit the company's balance sheet is a farce and has been for a long time. More worrisome, though, is that nobody with any authority is calling them on it, even today. That includes Wachovia's auditor, KPMG LLP, as well as the Securities and Exchange Commission and banking regulators such as the Federal Reserve and FDIC.

If those lapdogs won't stop Wachovia from conjuring up bogus asset values, it's only prudent to assume they're letting lots of other companies bake their books in less obvious ways.

This is a glaring example, it is true. Clearly Wachovia's loan loss provisions are not adequate, in Wells' view, to cover their likely losses. Wachovia seem to think that Wells have a point, moreover, at least to the extent that they have not sought a higher price.

Now I am the first to agree that determining the fair values for anything as complicated as a large bank's book is difficult. And forced sellers are likely to get less than willing ones. But $35B is a big gap.

Recent accounting changes are making the situation worse, as Deutsche's recent profit illustrates. This profit was entirely due to an accounting reclassification which, perfectly legally, moved the bank further from fair value. Is this state of affairs really what the users of financial statements want? Both auditors, in their often gutless appraisal of loan loss reserves and of level 3 marking methodologies, and accounting standards setters, in caving to pressure from the banks to permit more earnings manipulation, are to blame. Show some backbone boys. Make them mark it down.

What do CDS spreads mean?

Naked capitalism suggests that some observers are perplexed by widening CDS spreads on US government debt.

How, they ask, could a private sector contract against default be expected to pay out in the case of a US government default – which would be the equivalent of a nuclear explosion in the financial markets?

The ten year Euro-settled spread has gone out considerably:All that is going on, of course, is that people are buying the contract because they think the spread will go out further. That will happen if more people buy it. More buyers than sellers equals rising prices. The actual default of the US has little to do with it for the buyers: they care about spread movements, and making money from them. Sellers are presumably happy to take what they view as an immaterial risk.

Update. Bloomberg has an article which confirms the idea that a lot of CDS trading is driven by speculation on the spread rather than insurance against default. They report that the most active contracts recently include those on Italy and Spain. Dubious though both countries' finances may be, default from either is vastly unlikely - but spread widening is rather likely.