Unintended Consequences of New Reporting on Credit Default Swaps?

Gretchen Morgenson of the New York Times has a story on proposed new reporting rules for credit default swaps that in passing raises the question that if implemented on the envisioned schedule (becomes effective in fiscal year financial statements after November 15, 2008, so the impact could be soon in coming), it may lead banks to try to pretty up their balance sheets.

Now I will concede that a lot of the byplay in the article is annoying, starting with the breathless first sentence:

Everybody knows that the market for credit default swaps is one of the hottest investment arenas around. At the end of last year, according to the Bank for International Settlements, the fair value of credit default swaps outstanding totaled $2 trillion, up from “just” $133 billion three years earlier.

Funny, the article is all about how opaque the CDS market is, yet she fails to connect the dots that the BIS "fair value" figure is therefore a guesstimate. More on that:

The entire amount of insurance that has been written, also called the notional amount, is $62 trillion. The fair value of C.D.S.’s is a more meaningful figure, though, as it represents a more precise assessment of potential losses and gains. The fair value of these derivatives has had a growth rate far steeper than that of the notional amount in recent years.

Ahem. The $62 trillion number (as of its reporting date; no doubt the total now is higher) is more accurate; the fair value figure is more significant but less accurate. "Precise" and OTC markets do not go together. And calling the change in economic exposure a "growth rate" is a tad misleading. It indicates that the riskiness of the CDs has increased (as in higher risk credits have higher spreads). Is this because more CDS are being written proportionately on riskier companies, or because CDS spreads are widening on many existing credits due to the weakening of the economic environment? While what Morgenson has written is technically accurate, it should either be explained or the observation omitted (it isn't germane to the thrust of the piece).

While this isn't the only lapse, the article is nevertheless useful. From what I can tell (Google News search and blog search), this story hasn't gotten much (any?) coverage, so Morgenson is seemingly out early with it. Here's the guts of the piece:

To help investors get a grip on the financial implications for companies that have sold credit default swaps, the F.A.S.B. has suggested a list of new disclosures to be effective in financial statements for fiscal years that end after Nov. 15, 2008. That very specific deadline may ensnare some of the nation’s biggest brokerage firms with fiscal years ending in November — Lehman Brothers, Morgan Stanley and Goldman Sachs....

The F.A.S.B. proposal would cover sellers of C.D.S.’s, the entities that act as insurers. They would have to disclose such details as the nature and term of the credit derivative, the reason it was entered into and the current status of its payment and performance risk.

In addition, the seller would provide the amount of future payments it might be required to make, the fair value of the derivative and whether there are provisions that would allow the seller to recover money or assets from third parties to pay for the insurance coverage it has written.

However, if you go to the FASB website, things get curiouser. The proposal was issued at the end of May; the comment period closed on June 30. Morgenson only quotes one expert ("Jack Ciesielski, an accounting guru and the publisher of The Analyst’s Accounting Observer, an accounting advisory service for investment professionals") which unwittingly creates the impression that he pitched the story to her and she relied on him overmuch.

And there is more sloppy drafting. The use of the term "credit derivative" above tracks the language in the proposal, but the proposal provides a definition:

...the term credit derivative includes groups of similar credit derivatives

In fact, the use of "credit derivative" sent me running to the FASB site, because without the definition, it reads as if financial firms are required to make instrument-by-instrument disclosure, which is clearly not happening. Again, oddly, that section largely tracks the FASB language but omits the fact that CDS writers would also disclose the amount of collateral held.

Now the "accounting guru" does make an important observation:

As the requirements of the new disclosure sink in among companies in the next few months, Mr. Ciesielski said he expects increased volatility to emerge in the C.D.S. market. Fearful of how investors will react to the extent of their swap holdings, companies may move to unwind them or offset them when they can.

“This is something that will change behavior,” Mr. Ciesielski said. “If you don’t want to look so bad, you’re going to have to be busy in the next few months to work these down, wriggle out of them or offset them.”

The lack of apparent interest in this rule change is surprising, particularly if firms wind up shuffling exposures before the first time they become subject to the disclosures. Normally, interbank liquidity starts drying up in December; last year, it started early, in November. Let's hope this otherwise useful proposal doesn't increase year-end stresses.

KPMG Survey: Investors Leery of Derivatives, Yet Fund Managers Increasing Commitment to Them

Um, hasn't anyone heard of the saying, "The customer is always right"? Apparently not, at least if you are a fund manager.

The Wall Street Journal in "Credit Woes Lead Investors to Simplicity," reports on a KPMG/Economist Intelligence Unit survey of investors carried out in March and April. Having gone to read the report itself, I'm not happy with the Journal's characterization of it.

The Journal spun the findings as if investors such as pension funds and insurance companies were Luddites and would simply have to adapt to the Brave New World of finance:

It's easy to see the frayed nerves of credit-crunched investors reflected in the markets. But what changes, if any, will be in store based on the recent pain?

A hefty 70% of institutional investors, such as pension funds, want less to do with derivatives and other complex financial products as a result of the past year's credit-market turmoil, according to a KPMG survey to be released Tuesday.

Yet, money managers indicate these complex financial products -- described in the study as illiquid and hard-to-value instruments -- are here to stay.

Derivatives investing is increasing, with some 60% of retail and other mainstream fund managers using them -- a number that nears 75% among managers overseeing $10 billion or more, KPMG says. Derivatives are also popular among hedge funds and private-equity firms. Used appropriately, managers note, they can offset volatility in stocks and other securities and boost returns.

So what is the remedy to customer resistance? Hire talent from investment banks:

So what can investment managers do to shore up their reputations and rebuild the trust of clients who've pulled money? "Fund managers have huge opportunities to hire world-class people from investment banks" that are shedding talent, says James Suglia, chairman of KPMG's global alternatives advisory committee. Managers also have to improve the ways in which they value derivatives and take responsibility for describing the instruments and their risks in ways investors can understand. "This is less about transparency and more about simplicity and standardization," says Suglia, who helped plan and analyze the survey.

If I were an investor, I would not take great comfort from the fact that product designers who had helped cripple the global financial system and in many cases damage their own firms were now involved in managing my money.

What would make derivatives more user friendly is getting them traded on exchanges, which would increase transparency and standardize terms. But that isn't considered seriously in the KPMG report.

The idea that you can "describe instruments in terms investors can understand" is fraught with peril. To have a real understanding of many of types of derivatives requires not merely a solid grounding in calculus, but enough continued use of it that you have an intuitive feel for how at least the more common variants of certain types of derivatives behave. Having the fund manager describe instruments whose behavior is non-linear and complex to clients that don't have the math skills puts the fund manager in the INEVITABLE position of making simplifications which are bound at some point to prove inaccurate. That means the fund manager is running a real risk of misrepresentation of risk in trying to communicate the behavior of these products to less sophisticated clients. Has anyone thought through the liability issue here? Isn't it easier to sell the customer what he wants and understands rather than what you think he ought to want?

The report is more nuanced, but the details give one even less confidence in the recommendation to put the objectives of the vendor over the preferences of the customer. To wit:

There is evidence, in the light of the credit crisis, that some aspects of fund management require urgent attention. The skillsets of staff, for instance, have to some degree failed to keep up with growing sophistication. One in five fund managers that have invested in complex financial instruments, such as derivatives, CDOs or structured products, admit to having no in house specialists with relevant experience.

It's a safe bet this level is underreported. Back to the survey findings:

There is a widespread feeling that fund management firms need to re-evaluate what kind of business they are conducting and the risks they are running. Four out of ten firms surveyed for this report say they have already formalized risk frameworks in the past two years as a result of managing more complex strategies, with a similar number planning to do so over the coming two years. Valuation methods have come under intense scrutiny during the credit crisis and a third of firms have reviewed this activity, while a further third will do so in the next two years.

I may be reading too much into this bland statement, but these kind of reviews and changes generally occur as the result of major screw-ups. Again, not encouraging in terms of the ability of fund managers to handle these products safely. And get this:

An even higher proportion, 38 percent of respondents, have reviewed governance arrangements – particularly relevant in the cases of funds that used risky instruments to enhance returns on supposedly low volatility funds – and a further quarter will do so in the next two years.

So the firms had sufficiently lax controls and/or lacked the understanding of the instruments that a significant minority had funds using derivatives to incur higher risks (of course in search of higher returns) in excess of the risk parameters for the funds. Charming.

So the report clearly indicates that investors are right to be wary: the fund managers in many cases didn't have enough expertise to handle high-octane strategies, and worse, allowed supposedly low risk funds to use derivatives in an apparent attempt to circumvent their risk constraints.

If that didn't sap your confidence, these two charts might (click to enlarge):




But KPMG still delivers a "Dare to be Great" speech:

The credit crisis will sharpen the minds of fund managers: in a time of increasing uncertainty and investor conservatism, they need to demonstrate their added-value proposition. The concern is that investors will reject further innovation, particularly if it involves complex strategies and instruments. As mentioned previously, 70 percent of investors say the credit crisis has reduced their appetite for complex products. The fund management industry will need to prove the doubters wrong by developing products and services that perform well over the cycle and in changing economic environments.

Maybe instead it's time for investors to recognize that there is no such thing as a free lunch. If a product beats an index, it's a given that you are assuming more risk than simple market exposure. And you are probably paying extra fees for this privilege too. Investors, in their new-found desire for simplicity, may also start to set more modest and realistic objectives in light of their true tolerance for losses. And fund managers may also have to adapt to an era of less complex products and lower fees.

How Dangerous Are OTC Markets?

This week's Institutional Risk Analytics has an alarming title: "Is Risk Management Even Possible in an OTC Marketplace?" By all indications, the article points to a strong "no".

As much as I am a harsh critic of so-called financial innovation, the headline goes further than the case the article makes. OTC markets covers a large territory. The Treasury, corporate, and agency bond markets are OTC. Because those instruments are offered publicly (ie, the size and terms of each issue are known) and the valuation process for these securities is pretty straightforward, the potential for trading in them to cause a large scale problem is no greater than in other simple products (remember, it's possible to create disasters via simple operator error, such as believing as Walter Wriston did, that countries don't go bankrupt).

Even in derivatives-land, some products are sufficiently straightforward, such as simple ("plain vanilla") interest rate and currency swaps, as to not pose undue risks if properly managed. But the problem is that financial firms have come to have high return requirements, and these simple products aren't very lucrative (indeed, some are marginally profitable but the dealers stay in the market because most large players prefer institutions that make markets in the full range of financial products).

A general pattern in the last 15+ years is that large financial firms have take on more and more risk in order to keep their returns high and their profits growing. Some of that is via leverage, some of that is via launching or expanding the market for new products (think CDS and CDOs), some of it is by taking risks they shunned before (think of leveraged loans).

I've only excerpted some bits of this article, but in case you decide to read it in its entirety (which I do recommend), I wanted to address some quotes that give a misleading impression. One is at the start of the article:

OTC derivatives had been legally permitted for the first time in 1993 by a regulatory exemption that Wendy Gramm had adopted as virtually her last act as CFTC chair.

That's not correct. OTC equity options and FX options had been around well before 1990. Swiss Bank formed a joint venture, which was a precursor to a full buyout, of O'Connor & Associates, a Chicago-based derivatives trading firm. The reason for the deal was O'Connor's leadership in OTC equity and FX options. Um, those are derivatives, and regulated by the CBOE, which is a self-regulatory organization under the supervision of the SEC. Bankers Trust was another big player in those markets back then. I hate to sound pedantic, but it makes me crazy when people make definitive statements that are just plain wrong.

Putting this quibble aside, the article has a very good section on how the FDIC is gearing up for a big increase in bank failures. The rest of the article focuses on the problems posed by OTC markets. Some excerpts:

One veteran federal regulator, who provided comments on our upcoming article for the Journal of Structured Finance, put to rest some of our fears that Washington is clueless about the nature of the OTC problem....:

Regulator: You suggest in your article that the issues raised by OTC markets have not been discussed within the regulatory community, but in fact it has and is being discussed intensively. Whether or not the OTC market needs to be officially "regulated" seems debatable, especially since regulators do not have the legal authority to enforce such a change.

The IRA: So the US and other nations must simply accept the fact that OTC markets are here to stay and that these inefficient markets will periodically destroy a large financial institution? That seems like a recipe for disaster, financially and politically.

Regulator: Part of the problem is cultural. Today we think that all markets are at a minimum weak form efficient. The Efficient Market Hypothesis is taught as gospel. The underlying assumptions of modern economic thought -- ready prices, informational symmetry, and rational expectations -- are all suspect and have been for a long time. We tend to view economics and modeling as a science governed by laws similar to the laws of nature. We believe that markets can be confined to probability spaces we understand and can reasonably estimate. This is not true.

The IRA: So you agree with our view that risk management of OTC markets is essentially impossible? Or does your statement apply to all financial markets?

Regulator: The reality is that economics is a social science and the attempts to make it "hard" are always going to run aground on the reality that human actions don't follow the "simple" laws of nature; they learn, adapt, herd, swarm, fall prey to trends, forget, remember, forget again - and in a semi-rational and sometimes irrational manner. The probability spaces are impacted by things traditional theory freely jettisons in order to make the model tractable. Therefore, risk models, upon which so much of the OTC market rests, are simply a way to communicate and express views of value -- usually rather naive and simplistic views -- and miss huge chunks of the real underlying "human action" risks.

The IRA: Ludwig von Mises, the author of Human Action, would be pleased to hear your comments. So, again, you agree with our view that most alleged "risk management" systems deployed on Wall Street are really just tools used to do deals and have no real capacity to measure let alone limit risk?

Regulator: The risk and pricing models are often created in order to convince traders and end-user investors that all these financial transactions -- behind which are human behaviors and cash flows -- are "manageable" and can be properly understood with the right analytics, data and "secret sauce." This witchcraft and sorcery can turn a toad into a prince, a rotten apple into a juicy melon. But it's all spurious precision. It's all vaporware. The models are used to create liquidity, which spurs volume, which garners big commissions and large EPS for dealers. The senior managers know that the models and assumptions upon which the higher spread product is based for things like OTC complex instruments are garbage, but you need a "basis" upon which to talk and compare so you can drive business. This charade works 90% of the time when things are calm, but as Hynman Minsky wrote in 1980 "stability is ultimately destabilizing." When risk regimes change, those who don't "know" these truisms find themselves naked.

We then spoke to Bob Feinberg, our favorite observer of financial services policy on Capitol Hill, about the state of the banking industry and congressional efforts to address the subprime financial meltdown....

Feinberg: At the last CMRE event that Elizabeth Currier allowed you and I to attend, which was in 2004, Larry Kudlow called for monetary reflation in order to make the economy look healthy so George W. Bush could be re-elected. It's happening again this year on behalf of all incumbents. The late Bob Weintraub called this the presidential cycle. It doesn't always work. In 1992, Greenspan didn't accommodate "41" (aka George H.W. Bush), and for a time there was doubt as to Greenspan's reappointment because 41 blamed Greenspan for his defeat. Fighting deflation becomes the Fed's excuse for pre-election monetary expansion, even if there is no deflation in sight. The way Greenspan put it in 2004 was that deflation was a low-probability, high-value event that must be staved off, just to be safe.

The IRA: But is it even possible to reflate the US economy when the financial industry is in such a terrible state?

Feinberg: I stand by my previous view about the model being broken, but I don't think people realize that this can't be fixed, that industries have life cycles, and the banking industry is about a half century past its best-if-used-by date. Greenspan once said to the Senate Banking Committee that some people would say that the only thing banks do is live off the yield curve. Whenever that model isn't available, they have to resort to extremely risky gambits to try to earn the returns Wall Street demands. It's a 19th century business model that got an extension thanks to the ability to arbitrage securities, but once they actually try to create new products, these instruments must be risky and opaque. So they've ended up as GSEs, CDOs and CDEs (Capital-Destroying Entities). Another acronym is the Disaster-Prone Organization (DPO), an expression coined by Prof. Anthony F.C. Sutton in his book, St. Clair, in which he laid out the reasons for the failure of the coal industry, which was just as powerful in its day as the banks are now.

The IRA: So you see the US banking industry going the way of king coal? Obviously the neither the Fed nor the Congress is willing to admit that a big constituency like the banking industry is moribund.

Feinberg: The bottom line is that the system is broken and can't be fixed. The reason the banks keep coming up with opaque products is that they're trying to de-commoditize a business that is mature and adds little or no value to the economy. In fact, over time and on net, the banking system destroys value. I wonder what song and dance the geniuses at Treasury are going to come up with next to justify buying worthless CDOs in the name of "reliquefying the market." I'm fascinated by the application of Gresham's Law to this situation; that bad collateral is manifestly driving out the good. I even read that banks are making bad loans in order to create some bad collateral, because the Fed will buy it.

The IRA: I take it that you do not expect the Congress to propose significant reforms of market structure?

Feinberg: After LTCM, the President's Working Group did a report and found that the financial system was just fine. After Amaranth, I think, some congressional committee(s), certainly Senate Banking, asked the PWG to go back and take a look at what they said in 1998, and PWG came back and said it had nothing to add. They asserted that the opaque market for derivatives could best be monitored by the banking regulators. I think this assertion needs to be rethought given what's happened with Bear and LEH..

AIG's CEO Sullivan Resigns; Willmustad Named CEO

In a board meeting where it was believed that Martin Sullivan, AIG CEO, would resign, the expected took place. Robert Willmustad has been designated CEO of the insurer. From the Wall Street Journal:

Robert Willumstad, a former Citigroup Inc. executive and chairman of the board of American International Group Inc., has been appointed chief executive of AIG, effective immediately....

Stephen Bollenbach, a director of AIG who is well-liked by some dissident AIG shareholders, including billionaire Eli Broad, will be named lead director....

The decision to put Mr. Willumstad in charge and make Mr. Bollenbach lead director appeared to be designed to placate big shareholders who were frustrated with the board's performance and had wanted fresh blood to lead the company. Some had wanted the board to conduct a search for an outside successor to Mr. Sullivan.....

Mr. Willumstad's background makes him uniquely qualified for that role. As the former president of Citigroup and a longtime lieutenant to its onetime chief executive, Sanford I. Weill, Mr. Willumstad brought to AIG extensive experience with sprawling financial empires built by strong-willed leaders...

Investors in the other companies have called for breakups, but it's not clear how AIG could be easily broken up. Another issue facing a new leader would be dealing with AIG's entrenched culture, where many employees have been for their entire careers.

Since when is Citi under Sandy Weill a model of good management? Weill was very good at doing deals and integrating them successfully, but that it is a different skill set than running an operation on an ongoing basis.

What the Journal's report fails to stress is that the multi-billion losses posted the last two quarters, which undid Sullivan's credibility, were the the result of writedowns on credit default swaps on subprime deals. AIG has taken issue with the mark-to-market treatment, saying, for instance, in the case of the insurer's 4Q writedown, that the economic losses were only $900 million, less than 10% of the $11.1 billion writedown. However, auditors also cited faulty accounting.

A friend who had the misfortune to join AIG in a senior role right before Maurice Greenberg's departure said his exit made insurer like a car where the axles had been removed: it was still rolling on but the wheels were about to come off. All decisions, even trivial ones, had to be approved by Greenberg, and the lack of normal decision making processes was paralyzing the company. I do not know how far Sullivan got in delegating authority, but it would be very difficult for someone who did not know AIG from the inside to step into the CEO slot if Sullivan has not made much progress on that issue.

From an earlier report in the Wall Street Journal:

It's not clear what a new chief executive, interim or permanent, can do to solve those problems [writedowns and depressed stock price] amid ongoing upheaval in the mortgage and credit markets. No new CEO can cure what ails American real estate...

And a new leader who isn't closely tied to the Greenberg era could also have room to maneuver. Even as Mr. Sullivan tried to steer AIG past the accounting scandal, he had to contend with the fact that Mr. Greenberg – his onetime mentor – leads another firm, Starr International Co., that is AIG's largest shareholder.

AIG and Mr. Greenberg are also engaged in a number of ongoing and contentious legal battles. Someone without that shared history and who hasn't been fighting those battles for the past three years might have an easier time negotiating an end to the tensions...

Mr. Sullivan spent his first year or so on the job merely trying to steady the ship. That's a monumental undertaking, given that AIG has operations in over 100 countries and a diverse range of businesses that runs from car insurance to consumer loans to aircraft leasing.

A successor who came from outside the company would have to tackle that stabilizing job again, most likely without Mr. Sullivan's long-standing relationships with the leaders of many of those varied businesses, or detailed knowledge of their operations.

Like It or Not, the Credit Default Swaps Market is Too Big to Fail

A piece by John Dizard in the Financial Times, "Get used to underwriting big lenders," made me realize a bit of cognitive blindness. Central banks are committed to backstopping the credit default swaps market.

Of course, that should be obvious. The Bank of England, ECB, Fed, and other central banks have intervened in various ways to shore up the financial system. The CDS market is a subset of that, ergo it is included. And the most compelling reason for the Bear Stearns salvage operation was to prevent the nightmare scenario of cascading counterparty failures from becoming a reality.

Somehow, the idea that major monetary authorities are now underwriting the opaque, ill-understood, never-been-through-a-real-downturn CDS market seemed ludicrous. But as another FT writer, Lucy Kellaway noted apropos management fads, "No idea is too ridiculous to be put into practice."

Recently, plans to have a central clearinghouse and even put CDS on exchanges have been moving forward, and that's progress of a sort. The ideas of getting these contracts cleared centrally, and better yet, traded on exchanges, is one of the best and conceptually most straightforward reform ideas around (yes, clearinghouses can fail too, but historically they have done so far less frequently than individual institutions). But don't kid yourself that that will have much impact on the outstanding contracts. New ones can be done under the new regime; current ones are just about certain to stay where they are.

For instance, this Bloomberg story makes it sound as if changes can be implemented quickly:

Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms. A guarantee may encourage more trading of default swaps, said NanaOtsuki of UBS AG, one of the banks involved in the agreement....

The group will reduce the volume of outstanding contracts through multilateral trade terminations. They also agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.

Clearing and settlement is a detail-oriented process, yet at the same time, procedures need to be standardized to allow for efficient processing of large volumes of transactions. Agreeing on documentation and procedures will take time, implementing it will take additional time. The article cited New York Fed president Timothy Geithner saying he planned to make "meaningful progress" in the next six months. That's about as ambiguous a commitment that one can make.

I have a good deal of trouble understanding the notion that existing bi-lateral contracts can be replaced with ones with a clearinghouse, If you are the CDS protection writer, you'll want to move it over, and arguably the protection buyer wouldn't mind, since the clearinghouse's credit would be presumably be better than that of the protection writer. But these contracts are customized, so the new ones would have to corresponding terms (otherwise, you have to renegotiate, which is time consuming and costly). Similarly, it would be difficult to design a computer system and back office procedures to handle heterogeneous instruments. Finally, there is great variation in how much margin has to be posted on current contracts; those with favorable arrangements will refuse to transfer to the clearinghouse.

Despite the central banks' belief that they can contain and contend with the risk of CDS counterparty failures, I keep thinking of a story I heard in business school. One of the professors, who came from a family active in government service and had had some posts himself, said he could distinctly remember the day in 1968 when he first realized that there were limits to what America could do, that it could not simultaneously combat poverty, fight a ground war in Asia, and send a man to the moon. Central banks would benefit from thinking through what their version of triage would be if their powers were tested.

From the Financial Times:

For at least another couple of years, if not considerably longer, counterparty risk in the credit derivatives market, and its associated trades, will be effectively underwritten by the central banks of the US, Europe, the UK, Japan, and, towed like a dinghy, Switzerland. Never mind the legislative or regulatory rule writing; the logistics and technology are not here yet for credit derivatives to substantially shift over to a clearing house-cleared, efficiently margined, mode. Yes, before the PR people send me the e-mails, I know the exchanges have put some software and facilities in place, but what is available does not have the scale or articulation necessary to replace the bilateral bank-and-dealer system.

So the central bankers, and, by extension, taxpayers, will be underwriting the present system for some time.

Not that they are happy about it, and their unhappiness will be expressed through harsher capital ratios and the forcing of common equity issuance on ever-worse terms. You can expect more contradictory public policies, such as calls for re-stimulation of the economy accompanied by regulatory insistence on putting more securitisations on the balance sheet, reducing lending capacity.

The process will be harder on the banks and dealers, and therefore on those who depend on them, thanks to the central banks' hesitancy in forcing recapitalisations last year and earlier this year. Back then, I thought it would make sense for central banks such as the Fed or the European Central Bank to push for big, co-sponsored roadshows to raise capital for the institutions under their umbrellas. The capital raises should have been larger, less piecemeal, and been done quickly.

Instead, the central banks were, it seems, hoping that the relief rally in financial stocks that followed the Bear Stearns takeover would go on long enough, and be strong enough, for sufficient capital to be raised on favourable terms. We are now seeing that relief rally peter out.

There was also a fantasy on the part of some regulators that it was possible to return in short order to a world where credit was priced and extended by committees within banks. This on-balance-sheet world, though, presupposed that the people, or, as they call them now, "skill sets" existed within banks. I remember the floors of company credit analysts at Chase and Citi in the 1970s and early 1980s. They aren't there now.

So until the misfiring, jerry-built structure of securitised, market-priced, semi-automated credit is repaired in a systematic way by people who know what they are doing, there really is no choice but to effectively guarantee the big institutions' debt.

When markets such as those for credit default swaps are transparent, one-price- for-one-credit systems, with reliable information from trusted sources (ie, not legacy rating agencies), then we can allow individual institutions to fail. Not now.

But regulators, taxpayers, and speculators can take out their frustrations with the lack of competence at the top of governments and financial institutions by relentlessly pounding down the institutions' stock prices, and voting the governments out of office.

That process will take a while. So the short-bank-and-dealer-equity-long-their-debt trade won't get "arbed away" any time soon.

Is Securitization Coming Back?

In a nutshell, yes, but not in the way the industry hopes.

In a Financial Times article. Gillian Tett files a somewhat dumbfounded report from the European Securitization Forum in Cannes. While the event has gone wildly downscale from last year's bash, the participants were hopeful that the return of good times was just around the corner. As we'll see posthaste, Tett doesn't buy it. She sees regulators primed to attack the loopholes and oversights that allowed the high profit products, particularly CDOs, to flourish. Yes, securitization will come back, but it seems certain to be only the plain vanilla, low margin sort.

There's another constraint that Tett omits, Securitization depends on credit enhancement. That can be accomplished three ways: overcollateralization, credit default swaps, and insurance. The latter two were the most common methods for more complicated deals. Yet as the credit crisis has progressed, CDS protection writing capacity is scarce and costly, and measures to move CDS to exchanges and force standardization of terms would make them less suitable for new issues. Paul Jackson wrote about the problem shortly after the annual meeting of the American securitization industry's big confab:

While the monoline business may or may not be less important in the municipal bond markets due to the unbelievably low incidence of defaults, the guaranty business is actually far more important to the MBS business than most have given attention to thus far — precisely because defaults can and do happen.

For secondary mortgage market participants, resolving this crisis isn’t just a piece of the puzzle; it might be the puzzle. At the American Securitization Conference in Las Vegas last week, many investment bankers suggested on panels and in hallways that the bond insurer mess is the single largest issue keeping the private-party market from having a chance at establishing any modicum of recovery going forward.

As we know, the monolines have gone down for the count.

From the Financial Times:

[W]hat was more noteworthy about this week’s {European Securitisation Forum] gathering in Cannes was just how many bankers still seem to think – or hope – that this champagne drought will prove short-lived.

For while nobody is brave enough right now to predict that subprime mortgages are about to return, there was plenty of excitement in Cannes about opportunities in other asset classes. Auto loans, for example, are currently considered hot; so is Islamic finance. Meanwhile, one banker chirpily predicted that we will soon see the launch of some CDOs based on Russian consumer debt. “This stuff always comes back. Just give it a few months,” he said.

Well, perhaps. But I suspect that some of this optimism is pretty delusional. For the events of the last year have not just hurt investor confidence in the securitisation process, they have also left regulators horrified by the degree to which bankers have abused banking loopholes in recent years.

In normal times, bankers tend to be pretty cynical – even scathing – about what these regulators might think. (Indeed, one top representative from PWC had the temerity to declare in Cannes this week that the industry already had the regulators “under control”, although he noted the European parliament was less malleable.)

I suspect, however, that bankers would be foolish to discount the regulators this time. For some of the ideas currently floating around the supervisory community could potentially have a big impact on the securitisation world for years to come.

Take the matter of the capital treatment of trading books. In recent weeks, some Western supervisors have conducted intensive analysis on banks’ trading books and discovered, to their horror, that some banks have been exploiting so many regulatory loopholes in recent years that they have got away with posting virtually no capital reserves against assets, such as the senior tranches of CDOs.

This situation reflects badly on the regulators who devised these rules – and even worse on supervisors who were supposed to police them. However, now they have woken up to the problem, many regulators want to act, probably by imposing much higher capital charges for assets in the trading book.

This has big implications for parts of the CDO world. Most notably, the banks will have far less economic incentive to create instruments such as mortgage-bond CDOs, or so-called single-tranche CDOs, if they can no longer park the senior CDO debt on their trading books for free.

In other words, one upshot of the regulatory rules is that when securitisation does return, it is likely to be in a dramatically simpler form, centred around more traditional lines of business, such as creating mortgage-backed bonds. And the key point about this is that these “simple” business lines tend to be far less profitable than the complex stuff or, more accurately, wacky stuff that uses free money in spades.

So the upshot is this: securitisation is certainly not dead; but it is unlikely to produce endless champagne again anytime soon. And anybody setting out for the ESF events in the coming years had better develop a taste for cheap beer.

UBS CDS Lawsuit: Harbinger of Things to Come?

Gretchen Morgenson of the New York Times in "First Comes the Swap. Then It’s the Knives." delves into a dispute between UBS an Paramax, a Connecticut-based hedge fund group over a credit default swap written by Paramax in 2007 on a subprime CDO (you can already guess how this movie ends).

Morgenson-bashing is a popular sport, so I must note that this article is written almost entirely based on court filings, and Morgenson generally does a decent job with them.

The short form of this sorry tale is that as losses mounted on this dodgy CDO, Paramax stopped putting up collateral as required in the contract and UBS sued. Where this gets interesting is that Paramax countersued, arguing that they had been reluctant to go into the deal and UBS had given them assurances that they would be lenient in marking losses to market.

What surprises me is that Morgenson doesn't make more hay about what seem to be an obvious fraud perpetrated upon the investors. UBS used a hedge fund group with only $200 million in equity to insure a $1.3 billion deal, and the hedge fund did do via a special purpose entity with only $4.6 million in equity.

Note further that most hedge funds have formal or informal limits as to how much of the fund's total assets they can put at risk in any one position; for most, it's 5% or less; 10% would be a very high number. Yes, you can argue that the risk insured was the super-senior tranche, and therefore very low risk. But the maximum amount you can assume that Paramax would be willing to part with would be $20 million (maybe $40 million if you assumed some gearing, but as the case proves, Paramax was good for only a bit over $20 million). That's only 1.5% of the value of the instrument. Thus, it was clear from the outset that the insurance was fraudulent. But UBS was clearly well aware of Paramax's limits, so the next question is: was UBS solely responsible for pulling a fast one on the CDO buyers, or is Paramax a co-conspirator?

Experts expect increasing credit problems leading to disputes over the enforceability of credit default swaps contracts. Many are likely to hinge on ambiguities in contract language rather than side assurances, as the UBS/Paramax case does.

But since over 30% of the credit default swaps were written by hedge funds, many of whom were probably as incapable as Paramax of performing in the event of a default, it's not unreasonable to assume that some of these CDS lawsuits will lay the foundation for investor litigation.

From the New York Times:

Investors don’t often get a peek inside the vast, opaque and unregulated world of credit default swap...But the legal battle between UBS, the Swiss investment bank, and Paramax Capital, a group of hedge funds in Stamford, Conn., is giving investors a gander at how this freewheeling market works...

There is no central market where investors can watch credit default swaps trade and see their prices. Each transaction is conducted away from regulators’ prying eyes. While there are common aspects to many of these contracts, so-called bespoke deals also exist, hand-tailored to the requirements of the parties involved in the transaction.

The swap that is central to the UBS-Paramax dispute is one of these customized deals, dating from May 2007, well into the mortgage crisis. The swap was created to insure $1.31 billion in highly rated notes that reflected performance of subprime mortgages in a collateralized debt obligation underwritten by UBS.

The swap insured these notes, known as the “super senior tranche” of the debt obligation, because they were rated triple-A by both Standard & Poor’s and Moody’s Investors Service.

Officials at Paramax declined to comment on the litigation and the swap that led to it. A UBS spokesman said the company “is confident in the merits of our case.”

According to the story that unfolds in the court documents, in early 2007, UBS approached Paramax, a small hedge fund with just $200 million in capital, to insure the notes. After months of discussion, Paramax established a special-purpose entity to conduct the swap and capitalized it with $4.6 million.

Under the terms of the deal, UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined.

That they did. Almost immediately.

By early November, UBS had asked Paramax for $33 million in additional collateral. Paramax refused, and UBS sued the fund, contending breach of contract, in mid-December 2007 in New York State Supreme Court. Paramax filed a counterclaim in January.

In court filings answering the complaint, Paramax tells its side of this story — and intriguing it is. The fund said it knew when it entered into the swap with UBS that the swap was risky and could require a good deal more capital than it had to deploy if the underlying securities fell in value. Paramax was concerned, the court filing said, that UBS could mark to market downward the value of the notes, causing a call for more collateral beyond the initial $4.6 million.

To allay the fund’s concerns, the documents say, Eric S. Rothman, the UBS managing director who arranged the deal, assured Paramax that mark-to-market risk was low. During a Feb. 22, 2007, phone call, Paramax contends in the filing, it was informed by Mr. Rothman that “UBS set its marks on the basis of ‘subjective’ evaluations that permitted it to keep market fluctuations from impacting its marks.” The filing also says: “Rothman explained that he was responsible for all marks on UBS’s super senior positions and that he could justify ‘subjective’ marks on the Paramax swap because of the unique and bespoke nature of the deal.”

Mr. Rothman is no longer employed at UBS. He could not be reached for comment.

In later discussions, according to court documents, Mr. Rothman contended that even if significant defaults arose in the underlying mortgages, UBS’s marking of the position “might not be as bad as you’d first think.”

On April 10, the hedge fund’s filing said, Mr. Rothman pressed Paramax to “please close this trade already”; in mid-May, the hedge fund pulled the trigger on the deal.

Six weeks later, in early July, Paramax said, it received its first margin call from UBS, for $2.36 million. On Aug. 10, UBS asked for an additional $12.7 million in collateral from Paramax and, on Aug. 22, called for almost $14 million more. The margin calls added up to almost $30 million, more than six times what Paramax had posted in initial collateral.

Paramax subsequently arranged with UBS to substitute the credit default swap with a restructured note that would not generate further margin calls. Based on those discussions, over the summer Paramax supplied UBS with $29.3 million to cover the margin calls.

But UBS submitted another margin call to Paramax in November, which the hedge fund declined to cover. Paramax contends in its filing that UBS’s margin calls exaggerated changes in the market.

On Dec. 10, UBS announced that it would take a $10 billion write-down in the fourth quarter of 2007, much of it related to “super senior” holdings like those it had insured with Paramax. Three days later, UBS advised Paramax that a default had occurred in the notes Paramax had insured. In December, after failing to reach a settlement with Paramax, UBS sued the hedge fund. Paramax responded by filing a counterclaim, asking that UBS return the $33.9 million that it lost in the swap.

Warning: Credit Default Swaps May Not Work As Advertised (And That's Even When They Do Work)

Satyajit Das has a very useful post, "The Credit Default Swap (“CDS”) Market – Will It Unravel?," in which he describes some of the ways that CDS may fail to perform as expected in real world situations, ie, when companies start getting in trouble. While this work isn't quite at the Tanta Uber-Nerd level of detail, it does get more granular than most discussions, which I thought was useful.

Two aspects of Das' article merit mention. First, he goes through what most may find a surprisingly long list of various ways CDS might not fully cover the risks they are supposed to guarantee even before getting to the big bugaboo of counterparty failure. One case that Das has mentioned elsewhere is that in the one big test of the CDS market to date, Delphi. CDS protection buyers got 37 cents on the dollar when the recovery value on the senior bonds was set by Fitch at 1-10%, meaning the fall in the value of the credit was 90+ cents per dollar, yet the CDS holder got only about 40% of that. That's a considerable shortfall.

Second, he alludes to rather than spells out the coming-to-a-courtroom-near-you battles over defaulting LBO debt. In this world of covenant lite deals, creditors lack the big stick they had to force either bankruptcy or a restructuring of the debt, namely, if you breached the covenants, the lender could accelerate (demand payment of) the debt. Now if borrowers don't pay, creditors don't seem to have much (any?) leverage.

How does this affect CDS? Per Das, for many CDS, non-payment is NOT an event of default. So what good is insurance if it doesn't cover the most likely outcome for the debt in question? This will make for some interesting theater.

This post also provides some third party estimates of possible losses from CDS counterparty failures. From Das:

The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments...

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band ....

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work...

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented....

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested.

Signs of Worsening Credit Conditions

Two UK columnists looked at the credit markets, and neither liked what he saw. And they wrote it up more colorfully than most of their American counterparts would have.

The first, Nils Pratley of the Guardian, tells us that that the idea that the credit crisis is on the wane is more than a tad optimistic:

Some say the credit crisis is over. Not Tom Attwood, managing director of Intermediate Capital Group (ICG), a firm which makes few waves outside financial circles. Its business is mezzanine finance, specialist high-risk lending to private equity firms. That puts it at the frontline of the financial turmoil and Attwood's bleak assessment of conditions yesterday is worth quoting.

Sub-prime, he says, was merely a catalyst to the bursting of the credit bubble. It was going to happen anyway. "Credit disciplines across almost all markets were bypassed in favour of loan book growth at almost any cost."

So far, so uncontroversial, and Attwood has been singing a similar tune for a while. The key point is that he can't spot the break in the clouds that many bankers claim to see. "What was a liquidity crisis is likely to lead to a credit crisis," he says. "Buy-outs structured in the benign credit climate prior to August 2007 were often over-geared with no margin for safety. This is likely to lead to an increase in default rates over the next year or two."

A year or two? Well, yes. ICG assumes there will be a recession in the US, the UK, Spain - the markets most pumped up with credit - and a slowdown elsewhere.

His bottom line is: "There is no sign of a return to liquidity in debt markets as a whole. Raising new funds will become increasingly difficult across the board."...

But the implication is that an awful lot of duff loans are still to surface. Attwood's killer fact is that in 1999 ICG was one of three funds in Europe in the mezzanine and leveraged loan business; by 2007, there were 112. Some of the inexperienced losers are known already, but there's surely more pain to be revealed.

Ambrose Evans-Pritchard of the Telegraph looks at the rise of credit default swaps prices on investment banks and increasing interbank spreads, both indicators of heightened concern about counterparty and systemic risk.

No wonder Mishkin resigned. He probably doesn't want to go though another month like March. But his end-of-August departure date may not be soon enough to save him from more crisis management.

From the Telegraph:

The debt markets in the US and Europe have begun to flash warning signals yet again, raising fears that the global credit crisis could be entering another turbulent phase.

The cost of insuring against default on the bonds of Lehman Brothers, Merrill Lynch and other big banks and brokerages has surged over the last two weeks, threatening to reach the stress levels seen before the Bear Stearns debacle. Spreads on inter-bank Libor and Euribor rates in Europe are back near record levels.

Credit default swaps (CDS) on Lehman debt have risen from around 130 in late April to 247, while Merrill debt has spiked to 196. Most analysts had thought the coast was clear for such broker dealers after the US Federal Reserve invoked an emergency clause in March to let them borrow directly from its lending window.

But there are now concerns that the Fed itself may be exhausting its $800bn (£399bn) stock of assets. It has swapped almost $300bn of 10-year Treasuries for questionable mortgage debt, and provided Term Auction Credit of $130bn.

"The steep rise in swap spreads this week is ominous," said John Hussman, head of the Hussman Funds. "The deterioration is in stark contrast to what investors have come to hope since March."

Lehman Brothers took writedowns of just $200m on its $6.5bn portfolio of sub-prime debt in the first quarter even though a quarter of the securities had "junk" ratings, typically worth a fraction of face value.

Willem Sels, a credit analyst at Dresdner Kleinwort, said the banks are beginning to face waves of defaults on credit cards, car loans, and now corporate loans. "We believe we're entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come," he said.

The jump in corporate bankruptcies has not yet been picked up by the usual indicators, which tend to lag the market, lulling investors into a false sense of security. The true losses are already known to specialists in the business, said Mr Sels.

Note the Fed does have ways to surmount its balance sheet constraints other than selling liabilities (which would be inflationary), but it is possible that the markets will react badly to any such move. The pushback would probably come in the form of higher interest rates on ten year and longer maturity Treasuries. Oh, wait, we're seeing that already:

Treasurys were tripped up for a second day Wednesday, due to a poor auction and better-than-expected durable-goods data.

The selling pushed yields on the two and 10-year notes above the upper end of the trading range that has been in place since late April.

The 10-year note's yield rose above 4% for the first time since early January, while yields on the two and five-year notes hit their strongest levels in four months on an intraday basis.

The benchmark 10-year note dropped 23/32 point, or $7.1875 for every $1,000 invested, to yield 4.009%. That is up from 3.923% Tuesday as yields rise when bond prices fall. The two-year note lost 7/32 point to 2.611%.

The government's durable-goods report in April set off the selling, as it alleviated worries of a protracted recession. That bolstered speculation in interest-rate futures markets that the Federal Reserve may start tightening monetary policy by year end amid continued inflation concerns.

Note one bit of cheery news: this Journal piece did say the TED spread, another indictor of perceptions of interbank risk, was tightening.

Credit Derivatives Clearing House Planned For September

There's an odd little story on the home page of the Financial Times website, odd in three respects.

First, it discusses a development, namely, the launch of a credit derivatives clearinghouse that is important enough that it ought to be reported more broadly, yet several searches on Google News came up empty-handed. Readers no doubt know that credit default swaps, a type of credit derivative, are believed to be the product that led the Fed to sponsor the bail-out of Bear Stearns. Its exposures were large enough to run the risk of creating a cascade of counterparty defaults. A central clearing house would have made that impossible.

Second, the story is remarkably vague as to what kind of "credit derivatives" we are talking about here. The intent of proposals like this is to get the $62 trillion credit default swaps market out of its current, opaque, bi-lateral trading configuration. Many have proposed trading CDS on an exchange (centralized clearing would be part of that structure). But it isn't clear whether all CDS will be included (many are written on "single names" meaning individual companies) or perhaps a subset, say some of the big baskets. Also noteworthy is that this proposal merely involves clearing, not making prices more transparent to customers.

Third, and the most revealing, is that the FT raises the notion that this move may be cosmetic, designed to forestall regulation.

From the Financial Times:

Efforts to tackle the risk surrounding privately negotiated credit derivatives will take a step forward on Thursday when 11 of the world’s biggest investment banks announce the creation of the first central clearer for the opaque contracts by September.

The absence of a central clearer has made such contracts risky because there is no guarantee that parties will pay out.

This systemic risk has fuelled the global credit crunch, prompting regulators to step up pressure on banks to show they are trying to make the system more dependable.

Credit derivatives allow investors to make bets on the creditworthiness of baskets of corporate debt. Global growth in the notional value of such contracts grew by 81 per cent last year to a value of $62,200bn.

Credit derivatives contracts are predominantly negotiated privately between traders who rely on their assessments of each other’s ability to pay under the terms of the contract. A clearer uses funds contributed by traders to guarantee against default.

“The credit crisis has definitely heightened interest in this kind of solution among the regulators,” said Kevin McClear, chief operating officer of The Clearing Corporation, the Chicago-based institution backed by the banks that will act as the new clearer. “We don’t think there’s a better approach to reducing systemic risk.”

The need to act fast to pre-empt stiffer regulation in the wake of the credit crisis has given impetus to a proposal that has been 18 months in the making. It has also been accelerated by attempts by other clearers, such as LCH.Clearnet, Europe’s largest independent clearer, and the CME Group, the Chicago-based derivatives exchange, to muscle in on the business potential of clearing such over-the-counter derivatives.

Thursday’s proposal is the result of an agreement between The Clearing Corporation (also known as CCorp) and the Depository Trust and Clearing Corporation (DTCC), the New York-based clearing group.

CCorp’s backers – including Goldman Sachs, Citigroup, JPMorgan, Bear Stearns and Morgan Stanley – will establish a guarantee fund to cover losses if any firm should fail.

While Thursday’s announcement is sure to be welcomed, questions remain about whether the proposal will raise industry standards or if it is largely cosmetic.

Credit Default Swaps Losses Estimated at $150 Billion

A story on Bloomberg this morning uncharacteristically lacks a news hook but gives a good deal of color on counterparty risk in the credit default swaps market.

The story argues that the other shoe may finally drop in the $62 trillion CDS market due to rising junk bond defaults. We've long seen that market as a disaster in the making. With economic exposures estimated at 2% of notional amount, $1,2 trillion is at risk, making it larger than the subprime market. Thus the $150 billion in losses estimated by BNP Paribas analyst Andera Cicione is plausible.

From Bloomberg:

Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis....

The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.

``It is a Damocles sword waiting to fall,'' says Soros,...``To allow a market of that size to develop without regulatory supervision is really unacceptable,'' Soros says.....

The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist....

``The Fed's fear was that they didn't adequately monitor counterparty risk in credit-default swaps -- so they had no idea of where to lend nor where significant lumpy exposures may lie,'' he says.

Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.

Note that Fed only has access to regulated bank CDS exposures, but not that of investment banks or hedge funds, both of which are significant protection writers. Hedge funds, for instance, are estimated to have written 31% in CDS protection. Back to Bloomberg:

The credit-default-swap market has been untested until now because there's been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody's Investors Service.

Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.

Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002....

A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader....

``This is going to complicate the financial crisis,'' Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default - - this requires proving which bond or loan holders weren't paid -- and the amount of payments due.

``It's going to become extremely messy,'' he says. ``I'm really scared this is going to freeze up the financial system.''

Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it's only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.

``That's a very conservative estimate,'' he says, adding that his study finds that losses resulting from hedge funds that can't pay their counterparties for defaults could exceed $150 billion.....

Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won't have the cash to meet the banks' requests, he says.

Sellers of protection aren't required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says.....

``I think there's a major risk of counterparty default from hedge funds,'' Cicione says. ``It's inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.''

The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.

``It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,'' the report said. ``It can be difficult even to quantify the amount of risk that has been transferred.''

Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says....

``It creates a huge concentration of risk,'' Das says. ``The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don't think the regulators have the information that they need to work that out.''

And traders, even the banks that serve as dealers, don't always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.

More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company's debt or collateralized debt obligations...

Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, [hedge fund advisor Tim] Backshall says. For many investors, this system is a headache.

To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.

``It's terribly primitive,'' Backshall says. ``The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.''

In the past three years, at least two companies have developed software programs that automatically parse an investor's incoming messages, yank out CDS prices and build them into real-time price displays.

The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software....

BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.

``Apart from JPMorgan, there aren't many other banks out there capable of doing this,'' he says. ``That's what's worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can't expect the Fed to run a broker, so someone has to take on assets and obligations.''

Banks have a vested interest in keepi