Friday, January 30, 2009

Upfront CDS: Live in March

"Overhaul" of the CDS market, including upfront CDS (which I discussed at length the other day) and a formal Determinations Committee, to come in March. From Bloomberg:

Dealers plan to overhaul credit- default swaps in March to curb risks in the $28 trillion market, making the derivatives more like bonds and creating a committee that will arbitrate disputes. For the first time, the market will have a committee of dealers and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, requiring upfront payments to make them more like the actual bonds they’re linked to.
It looks like I was right about the size of the fixed coupons as well:
In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.
The Bloomberg story also has this to say about the Determinations Committee:
Few details were discussed on how members of the committee will be selected, though it will be balanced between dealers and investors, with members publicly disclosed.
I'll believe it when I see it. From what I understand, the Determinations Committee will be established via a supplement to the 2003 ISDA Credit Derivatives Definitions. As I've noted before, the ISDA is dominated by the major dealers. Having been involved in the ISDA's drafting process before, I can attest to the high quality of the process. But there's no denying that the interests of the dealers predominate. And I'm skeptical that they'll be willing to give up too much of their influence in the CDS market.

Unless I'm misreading him, George Soros is just plain wrong about this:

Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.
Umm, no. Protection buyers' profit is limited to the notional amount insured. Similarly, protection sellers' risk is also limited to the notional amount insured.

It's very difficult to get truly objective, nonpartisan analysis of stimulus issues. Most people look to the CBO for authoritative, unbiased analysis. While I respect the CBO and think it's reputation or honesty is well deserved, I also know that bills are often drafted with the CBO's scoring methodology specifically in mind. The majority party also gets to pick the head of the CBO, and there's no denying that it selects someone with similar ideological sympathies. In truth, the best place to look for nonpartisan expert analysis is the Congressional Research Service. The CRS is Congress' private think tank; it's staffed with experts on every conceivable area of policy, both substantive and procedural. CRS analysts are true experts in their field, and they do a great job sifting through the academic research and highlighting the most reliable results. Congress is fiercely protective of the CRS—the CRS's memoranda to Congressmen and Senators are confidential, and, amazingly, CRS reports aren't free to the public. (OpenCRS.com usually has slightly older versions of CRS reports, which are updated frequently.) So to cut through all the partisanship surrounding the stimulus debate, I went to the CRS reports (which my firm bizzarely pays for). The one thing that surprised me in reading over all the relevant CRS reports is that the recent evidence on tax rebates shows that they're actually quite effective as stimulus. For example, this is what the CRS report titled, Tax Cuts for Short-Run Economic Stimulus: Recent Experiences, says about the 2001 rebate:

The rebate met some important standards for an effective tax cut stimulus. Unlike many stimulus proposals in the past, particularly in the 1960s and 1970s, where the stimulus occurred during the recovery rather than the recession phase (potentially adding to inflationary pressures), its impact occurred during the recession. In addition, tax cuts are most effective as a stimulus if they are spent, and the tax reductions affected lower and moderate income taxpayers who have a high propensity to spend. At the same time, there was some concern that lump sum payments might be spent in the same fashions as a continued increase in income through tax reductions. There was some evidence that temporary rebates in the past were not spent. It appears, however, that most of the rebate was spent fairly quickly: at least 20% to 40% in the quarter received and two-thirds by the end of the second quarter after receipt.
Two-thirds of the rebate was spent within 6 months? This surprised me, since, according to Conventional Wisdom, the 2001 rebates failed as stimulus because most of it was saved rather than spent. Indeed, the most common criticism of last year's stimulus bill was "we tried tax rebates in 2001 and it didn't work." The report cites a 2006 study in the American Economic Review by David Johnson, Jonathan Parker, and Nicholas Souleles, titled Household Expenditure and the Income Tax Rebates of 2001 (ungated draft here). The paper is quite compelling. It relies on a tremendous natural experiment, nicely summarized in the abstract:
Under the Economic Growth and Tax Relief Reconciliation Act of 2001, most U.S. taxpayers received a tax rebate between July and September, 2001. The week in which the rebate was mailed was based on the second-to-last digit of the taxpayer's Social Security number, a digit that is effectively randomly assigned. Using special questions about the rebates added to the Consumer Expenditure Survey, we exploit this historically unique experiment to measure the change in consumption expenditures caused by receipt of the rebate and to test the Permanent Income Hypothesis and related models. We find that households spent about 20-40 percent of their rebates on non-durable goods during the three-month period in which their rebates were received, and roughly another third of their rebates during the subsequent three-month period. The implied effects on aggregate consumption demand are significant. The estimated responses are largest for households with relatively low liquid wealth and low income, consistent with liquidity constraints.
The authors estimate that the rebate directly increased nondurable consumption expenditures by 2.9% in the third quarter of 2001 (the quarter in which the rebates were received), and by 2.1% in the fourth quarter. And that's without including multiplier effects. The CRS report also says that the preliminary evidence on the 2008 rebate suggests that it worked surprisingly well:
Some preliminary evidence has been reported on the 2008 rebate. Although aggregate data do not show a rise in consumption to correspond with the rise in disposable income, these simple aggregate observations may not be very informative. In a preliminary study of households, Broda and Parker found that 20% of the rebate was spent in the first month. They predict that the 2008 rebate will have a significant effect on spending in subsequent months. Their study also found higher levels of spending for lower income households and those with fewer liquid assets.
The study by Broda and Parker, titled The Impact of the 2008 Tax Rebates on Consumer Spending: Preliminary Evidence, was published at the end of July. It relies on the same natural experiment as the Parker, Johnson, and Souleles study, making it extremely difficult to quibble with the methodology. Significantly, Broda and Parker found that the 2008 rebate was even more effective than the 2001 rebate (again, this is before including any multiplier effects):
Despite much recent concern that households would save the money, we find that households are doing a significant amount of extra spending because of the stimulus payments. The typical family increased their spending on food, mass-merchandise and drug products by 3.5 percent when their rebate arrived, relative to a family yet to receive its rebate. Based on these estimates and on results from previous analysis, we estimate that demand for overall nondurable consumption in the second quarter of 2008 has been boosted by 2.4 percent as a direct result of the stimulus payments, and will be held up by around 4.1 percent in the third quarter of 2008.
Unfortunately, the vast majority of commentators continue to ignore the evidence when discussing the stimulus bill, relying instead on Conventional Wisdom. James Surowiecki channeled this conventional wisdom in his New Yorker column last week:
Past tax rebates, as many economists have argued in recent weeks, haven’t seemed to boost consumption as much as was hoped. Some estimates suggest that when a rebate was handed out in 2001 less than half of it was spent. And while the results of last year’s rebate seem to have been somewhat more encouraging, much of it still went unspent.
This is, as we've just seen, demonstrably false. The evidence shows that people spent most of their rebates in the first 6 months (which, when we're talking about multi-year infrastructure projects, is quite fast). Maybe this, rather than a misguided hope for bipartisan support, is why the Obama administration included a $145 billion individual tax credit in the stimulus bill. The business tax cuts were clearly included to woo Republicans, as all the evidence shows that business tax cuts are completely ineffective as stimulus. Since the stimulus bill passed the House with exactly zero Republican votes, maybe the Obama administration should give up on bipartisanship and strip the business tax cuts out of the bill. After looking at the available evidence, however, I'm forced to support an increase in the individual tax credit. If the tax credit was increased to $200 billion, for example, the evidence suggests that roughly $133 billion of that would be spent within the first 6 months. That would tide us over nicely as we wait for the slower infrastructure projects to come online.

No, according to this article in the most recent Journal of Fixed Income:

This article investigates volatility transmission among the credit default swap (CDS), equity, and bond markets, using a multivariate GARCH model. The authors hypothesise that volatility in the bond and equity markets can originate from the CDS market where there is potential insider trading and increased trading activity due to private credit information. However, the authors find little evidence to support this. There is evidence for an alternative view that as investors search for yield across different asset classes the links among the CDS, bond, and equity markets strengthen. Volatility in any of the three markets is commonly transmitted to the other two markets.
I can't find an ungated version of the paper. (If you have a copy of the paper, feel free to email it to me; I would be much obliged.) Not good news for Chris Whalen and the other crazy conspiracy theorists.

Wednesday, January 28, 2009

Upfront CDS with Fixed Coupons

I must admit, I never thought it would actually happen. But the most liquid single-name CDS are now expected to move to fixed coupons with upfront payments in the not-too-distant future. The fixed coupons will supposedly be set at 100bps and 500bps (depending on credit quality). Currently single-name CDS trade on a "running spread" or "par spread" basis—the protection buyer pays for protection by making regular spread payments (premiums) to the protection seller until the contract matures or there is a credit event. So for example, if a 5-year CDS on $10 million notional is quoted at 100bps, the protection buyer will pay $100,000 a year (usually broken into quarterly payments). Crucially, no money is exchanged upfront—this is why CDS are leveraged bets. Now the market is moving to trading on a "points upfront" basis. Contracts will have fixed coupons of either 100bps or 500bps, and upfront payments will be made at initiation to reflect the change in price. The amount paid upfront will equal the present value of the difference between the current market spread and the fixed coupon. So if a contract with a fixed coupon of 100bps is trading at 150bps, the protection buyer would make an upfront payment equal to the present value of the difference between 150bps and 100bps. If the market spread is lower than the fixed coupon, then the protection seller would have to pay the difference between the two spreads upfront. The most popular index contracts (CDX and iTraxx) trade on a similar points upfront basis. Each index series has a fixed coupon (expressed as a spread) that's set when the series is launched, and when the market spread trades away from the fixed spread (known as the "deal spread"), the parties make an upfront payment equal to the present value of the difference between the two spreads. The deal spread on the CDX IG11 is 150bps, so when the IG11 is trading around 190bps, like it is now, the protection buyer has to pay the difference between the spreads upfront. Okay, so why the move to upfront plus fixed coupons? For one thing, it will allow more effective netting between index and single-name contracts by making the cash flows more similar. This is especially important as index and single-name CDS move onto central clearinghouses—the ability to net down outstanding CDS exposures is one of the main benefits of a clearinghouse. Second, upfront plus fixed coupons also makes CDS cash flows more like bonds. Third, and most importantly, the move will help the dealers reduce their exposure to large spread movements ("jump risk"). The unholy spread widening in the aftermath of Lehman's collapse savaged some dealers as they tried to keep a net flat position. (Yes, I know, a change in the CDS market that benefits the dealers—what were the odds?) To illustrate jump risk, imagine that a hedge fund—let's call it Max Power Capital (MPC)—purchased 5-year CDS protection on GE at 100bps back in October, and that the same contract is trading at 400bps today. The trade is now "in-the-money," and MPC wants to take its profit and go home. The most common way to do this is for MPC to sell offsetting CDS protection on GE that matures on the same date as the original contract (December 20, 2013, since it was purchased in October 2008). That way, MPC would collect a profit of 300bps a year, since it would be paying annual premiums of 100bps but collecting annual premiums of 400bps. The problem with this approach is that MPC is still exposed to some default risk—the premium cash flows will stop if GE defaults before the contracts mature. To account for this leftover default risk, MPC will enter into an offsetting CDS contract with a dealer in which the dealer pays MPC the difference between the spreads (i.e., MPC's profit) upfront. Since dealers generally try to run matched books, the dealer now has another position it needs to hedge, so it has to sell an offsetting CDS with another counterparty. The problem is that the CDS on GE that mature on December 20, 2013 are now "off-the-run" — the current 5-year contract referencing GE, which is "on-the-run" because 5-year contracts are the most liquid, matures on March 20, 2013. Moreover, to match the cash flows of the two contracts, the dealer has to find a counterparty willing to make a sizable upfront payment to offset the upfront payment the dealer made to MPC. Needless to say, it's difficult and often expensive to find a counterparty willing to buy an off-the-run contract at an off-market price. When spreads suddenly gap out significantly, dealers end up making substantial upfront payments to protection buyers looking to close out their trades and take their profits. Moving to upfront CDS with fixed coupons will help the dealers in this situation because upfront payments make the contracts less sensitive to mark-to-market spread movements. It will also make it much easier for dealers to find offsetting contracts with similar upfront payments. It remains to be seen how much upfront payments reduce the liquidity of single-name CDS. Opinion in the CDS market on this issue seems to be roughly split. I suspect upfront payments won't significantly reduce liquidity for the 100 or so most heavily traded references, since the most liquid CDS contracts are the index contracts that already trade with points upfront. We shall see though.

I must admit, I never thought it would actually happen. But the most liquid single-name CDS are now expected to move to fixed coupons with upfront payments in the not-too-distant future. The fixed coupons will supposedly be set at 100bps and 500bps (depending on credit quality). Currently single-name CDS trade on a "running spread" or "par spread" basis—the protection buyer pays for protection by making regular spread payments (premiums) to the protection seller until the contract matures or there is a credit event. So for example, if a 5-year CDS on $10 million notional is quoted at 100bps, the protection buyer will pay $100,000 a year (usually broken into quarterly payments). Crucially, no money is exchanged upfront—this is why CDS are leveraged bets. Now the market is moving to trading on a "points upfront" basis. Contracts will have fixed coupons of either 100bps or 500bps, and upfront payments will be made at initiation to reflect the change in price. The amount paid upfront will equal the present value of the difference between the current market spread and the fixed coupon. So if a contract with a fixed coupon of 100bps is trading at 150bps, the protection buyer would make an upfront payment equal to the present value of the difference between 150bps and 100bps. If the market spread is lower than the fixed coupon, then the protection seller would have to pay the difference between the two spreads upfront. The most popular index contracts (CDX and iTraxx) trade on a similar points upfront basis. Each index series has a fixed coupon (expressed as a spread) that's set when the series is launched, and when the market spread trades away from the fixed spread (known as the "deal spread"), the parties make an upfront payment equal to the present value of the difference between the two spreads. The deal spread on the CDX IG11 is 150bps, so when the IG11 is trading around 190bps, like it is now, the protection buyer has to pay the difference between the spreads upfront. Okay, so why the move to upfront plus fixed coupons? For one thing, it will allow more effective netting between index and single-name contracts by making the cash flows more similar. This is especially important as index and single-name CDS move onto central clearinghouses—the ability to net down outstanding CDS exposures is one of the main benefits of a clearinghouse. Second, upfront plus fixed coupons also makes CDS cash flows more like bonds. Third, and most importantly, the move will help the dealers reduce their exposure to large spread movements ("jump risk"). The unholy spread widening in the aftermath of Lehman's collapse savaged some dealers as they tried to keep a net flat position. (Yes, I know, a change in the CDS market that benefits the dealers—what were the odds?) To illustrate jump risk, imagine that a hedge fund—let's call it Max Power Capital (MPC)—purchased 5-year CDS protection on GE at 100bps back in October, and that the same contract is trading at 400bps today. The trade is now "in-the-money," and MPC wants to take its profit and go home. The most common way to do this is for MPC to sell offsetting CDS protection on GE that matures on the same date as the original contract (December 20, 2013, since it was purchased in October 2008). That way, MPC would collect a profit of 300bps a year, since it would be paying annual premiums of 100bps but collecting annual premiums of 400bps. The problem with this approach is that MPC is still exposed to some default risk—the premium cash flows will stop if GE defaults before the contracts mature. To account for this leftover default risk, MPC will enter into an offsetting CDS contract with a dealer in which the dealer pays MPC the difference between the spreads (i.e., MPC's profit) upfront. Since dealers generally try to run matched books, the dealer now has another position it needs to hedge, so it has to sell an offsetting CDS with another counterparty. The problem is that the CDS on GE that mature on December 20, 2013 are now "off-the-run" — the current 5-year contract referencing GE, which is "on-the-run" because 5-year contracts are the most liquid, matures on March 20, 2013. Moreover, to match the cash flows of the two contracts, the dealer has to find a counterparty willing to make a sizable upfront payment to offset the upfront payment the dealer made to MPC. Needless to say, it's difficult and often expensive to find a counterparty willing to buy an off-the-run contract at an off-market price. When spreads suddenly gap out significantly, dealers end up making substantial upfront payments to protection buyers looking to close out their trades and take their profits. Moving to upfront CDS with fixed coupons will help the dealers in this situation because upfront payments make the contracts less sensitive to mark-to-market spread movements. It will also make it much easier for dealers to find offsetting contracts with similar upfront payments. It remains to be seen how much upfront payments reduce the liquidity of single-name CDS. Opinion in the CDS market on this issue seems to be roughly split. I suspect upfront payments won't significantly reduce liquidity for the 100 or so most heavily traded references, since the most liquid CDS contracts are the index contracts that already trade with points upfront. We shall see though.

Last week, after the major CDS dealers refused to commit to a firm mid-year deadline for the introduction of a European clearinghouse, the EU threatened to introduce legislation mandating central clearing for CDS:

Barring a last minute change of heart by dealers, EU Internal Market Commissioner Charlie McCreevy will propose that a provision for mandatory clearing be inserted into the reform of EU bank capital rules the European Parliament and EU states are now adopting
The dealers, however, were not impressed:
"It's a certainty the market will move without a mandate but the dealers will do it on their own terms and their own timetable," one dealing company said.
A ballsy quote given the current political environment, if you ask me. But it looks like the EU has blinked:
Brussels on Tuesday opened the door to renewed negotiations over establishing a European clearing system for the huge credit default swap market. “There is still time to have further talks,” said Charlie McCreevy, EU internal market commissioner, as he attended a financial services conference in Brussels. The commissioner’s softer approach contrasts with threats by Brussels to bring in legislation that would force the creation of a so-called European solution for the clearing of over-the-counter products. Talks with industry players, including exchanges, clearers and dealers in such OTC markets broke down after the dealer community failed to commit to a timetable for establishing a clearing solution by the middle of the year.
Bringing the all-time score to: ISDA (et al.): 4,793 Regulators: 0

The FDIC wants to run the "bad bank" the government might set up:

The Federal Deposit Insurance Corp. may manage the so-called bad bank that the Obama administration is likely to set up as it tries to break the back of the credit crisis, two people familiar with the matter said. FDIC Chairman Sheila Bair is pushing to run the operation, which would buy the toxic assets clogging banks’ balance sheets, one of the people said. Bair is arguing that her agency has expertise and could help finance the effort by issuing bonds guaranteed by the FDIC, a second person said. President Barack Obama’s team may announce the outlines of its financial-rescue plan as early as next week, an administration official said. “It doesn’t make sense to give the authority to anybody else but the FDIC,” said John Douglas, a former general counsel at the agency who now is a partner at Paul, Hastings, Janofsky & Walker, a law firm in Atlanta. “That’s what the FDIC does, it takes bad assets out of banks and manages and sells them.”
The FDIC doesn't strike me as the right agency to run the bad bank. The FDIC has experience selling the assets of failed banks, but it doesn't have a lot of experience with the kinds of assets that are likely to go into the bad bank. As the Bloomberg article notes, the bad bank "would buy the toxic assets clogging banks’ balance sheets." The toxic assets are mostly structured credit products—CDOs (super-senior and mezzanine), MBS CDOs, ABS, CMBS, synthetic CDOs, etc. To my knowledge, the FDIC doesn't have much experience with structured credit products. And believe you me, these aren't products you can learn about on the fly. This looks to me like more Sheila Bair looking out for Sheila Bair. Maybe she should spend less time on the phone with journalists.

Tuesday, January 27, 2009

Real Estate Derivatives

Nice piece by Zachary Karabell in Newsweek about Robert Shiller's push to establish a liquid market in real estate derivatives. Shiller has long been a leading proponent of real estate derivatives. I've plugged real estate derivatives before, and I still think it's important that homeowners have a way to reduce their exposure to fluctuations in the local housing market. Other interesting proposals along these same lines can be found here and here. I still don't think real estate derivatives will ever gain a sufficient level of liquidity to really get going, but I hope I'm wrong.

Now that the Senate has confirmed Geithner, we'll find out who the new President of the New York Fed will be (an extremely powerful position). The WSJ says it's likely to be William Dudley, who currently runs the NY Fed's markets desk:

Mr. Geithner's confirmation will free the Federal Reserve Bank of New York to announce his successor as president of the regional Fed bank. William Dudley, a former Goldman Sachs economist who runs the New York Fed's influential markets desk, is likely to get the job. An announcement could come as early as Tuesday. The New York Fed is the Federal Reserve's eyes and ears to Wall Street, and the markets' desk has been in charge of implementing many of the Fed's new lending and investment programs, making the job one of the most important in central banking. The choice of Mr. Dudley gives the New York Fed an assurance of continuity at a tumultuous time at the bank. Several of the Fed's biggest programs -- including one aimed at boosting the consumer loan market and another supporting mortgages -- are still in the process of being ramped up. Mr. Dudley is known inside the Fed and at Goldman as a tenacious pragmatist who has logged long hours during the financial crisis and developed a strong relationship with Mr. Geithner. His elevation to the top job at the New York Fed also gives him a bigger voice in monetary policy, since he will be a regular voting member on interest-rate decisions.
I don't know anything about Dudley, but I trust Geithner's judgment. Dudley's bio is here. Unfortunately, the selection of Dudley will undoubtedly bring the Goldman conspirasists out of the woodwork yet again.

A surprisingly common criticism of the TARP is that it didn't require banks receiving bailout money to lend to small businesses and consumers. Joe Nocera of the NYT penned a whole column about "the dirty little secret of the banking industry," which was that "it has no intention of using the money to make new loans."

Elizabeth Warren's TARP Oversight Panel has also criticized the Treasury for not requiring banks to lend money. For example, the Panel's second report stated:

If, as Treasury has stated, the goal of capital infusions was to increase consumer and small businesslending, why were funds not concentrated among businesses with substantial small business and consumer lending or authorized only when a financial institution presented a business plan to use the funds for small business or consumer lending?
The purpose of the equity injections was to recapitalize the banks, which were (and still are) woefully undercapitalized. Forcing them to immediately turn around and make more risky loans — and small business and consumer loans are historically risky loans — is a really stupid idea.

But don't take it from me. Take it from Richard Caballero of MIT, Anil Kashyap of Chicago, and Takeo Hoshi of UC San Diego. Their paper in the December 2008 issue of the American Economic Review, "Zombie Lending and Depressed Restructuring in Japan," examines "the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s." The paper is behind a firewall, but there's a draft version (which might differ slightly from the final version) available here. Since it's hard to understate the paper's relevance to the current criticisms of TARP, I quote at length:
This paper explores the role that misdirected bank lending played in prolonging the Japanese macroeconomic stagnation that began in the early 1990s. The investigation focuses on the widespread practice of Japanese banks of continuing to lend to otherwise insolvent firms. We document the prevalence of this forbearance lending and show its distorting effects on healthy firms that were competing with the impaired firms.
...
Aside from a couple of crisis periods when regulators were forced to recognize a few insolvencies and temporarily nationalize the offending banks, the banks were surprisingly unconstrained by the regulators.

The one exception is that banks had to comply (or appear to comply) with the international standards governing their minimum level of capital (the so-called Basle capital standards). This meant that when banks wanted to call in a nonperforming loan, they were likely to have to write off existing capital, which in turn pushed them up against the minimum capital levels. The fear of falling below the capital standards led many banks to continue to extend credit to insolvent borrowers, gambling that somehow these firms would recover or that the government would bail them out. Failing to roll over the loans also would have sparked public criticism that banks were worsening the recession by denying credit to needy corporations. Indeed, the government also encouraged the banks to increase their lending to small and medium-sized firms to ease the apparent “credit crunch,” especially after 1998. The continued financing, or “evergreening,” can therefore be seen as a rational response by the banks to these various pressures.
...
By keeping these unprofitable borrowers (which we call “zombies”) alive, the banks allowed them to distort competition throughout the rest of the economy. The zombies’ distortions came in many ways, including depressing market prices for their products, raising market wages by hanging on to the workers whose productivity at the current firms declined, and, more generally, congesting the markets where they participated. Effectively, the growing government liability that came from guaranteeing the deposits of banks that supported the zombies served as a very inefficient program to sustain employment. Thus, the normal competitive outcome whereby the zombies would shed workers and lose market share was thwarted. More importantly, the low prices and high wages reduce the profits and collateral that new and more productive firms could generate, thereby discouraging their entry and investment. Therefore, even solvent banks saw no particularly good lending opportunities in Japan.
...
We find that investment and employment growth for healthy firms falls as the percentage of zombies in their industry rises. Moreover, the gap in productivity between zombie and non-zombie firms rises as the percentage of zombies rises. These findings are consistent with the predictions that zombies crowd the market and that the congestion has real effects on the healthy firms in the economy. Simple extrapolations using our regression coefficients suggest that cumulative size of the distortions (in terms of investment, or employment) is substantial. For instance, compared with the hypothetical case where the prevalence of zombies in the 1990s remained at the historical average instead of rising, we find the investment was depressed between 4 and 36 percent per year (depending on the industry considered).

This is the best sentence on the New York Times op-ed page today:

This is William Kristol’s last column
Don't let the door hit you on the way out.

Sadly, Tanta is no longer around to shred the idiocy that Gretchen Morgenson produces. That's too bad, because Morgenson's column on credit default swaps yesterday was a doozy. It's hard to know what to say about a column that's so detached from reality. It's sad that people will read this column and believe that it's true. Felix Salmon covered most of Morgenson's nonsense pretty well, so I'll only add a couple things. Morgenson starts with this:

Any honest assessment [of the financial crisis] must include the role that credit-default swaps have played in this mess: it’s the elephant in the room, the $30 trillion market that people do not want to talk about.
The CDS market is "the elephant in the room"? Clearly Morgenson is impressed by big numbers, so here's one for her: the market for interest rate swaps is a $356 trillion market! Just look at the relative size of the OTC derivative markets:
Of course, interest rate swaps aren't going to bring down the financial system, and the $356 trillion number doesn't reflect the true risk of interest rate swaps. But credit default swaps also won't bring down the financial system, and the $30 trillion number also doesn't reflect the true risk in the CDS market. And since claiming the $30 trillion number represents the risk in the CDS market would be tantamount to lying to her readers, Morgenson included this:
While the amount of credit insurance outstanding is around $30 trillion, Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., says he believes fully half that amount isn’t problematic because it consists of winning and losing stakes that offset each other.
That's an extremely conservative estimate, to say the least. Most people in the CDS market estimate that the true risk in the CDS market is about 1/10th of gross notional outstanding. Consider that roughly 90% of CDS trades in the DTCC warehouse are dealer-to-dealer, and that the dealer banks generally run matched books:
Netting out all the outstanding CDS trades would probably reduce the notional outstanding to about $5-$7 trillion (the 10-to-1 ratio is probably accurate, but I'm accounting for the contracts that aren't in the DTCC warehouse). Morgenson also pushes two proposals for how to "fix" the CDS market, both of which are too stupid to even merit discussion. Suffice to say that one of the proposals is from Chris Whalen, who, as I noted the other day, appears to be totally bat-shit crazy.

Sunday, January 25, 2009

Merrill and the Basis Trade

Felix Salmon is wondering, after reading this WSJ article, if the main source of Merrill Lynch's staggering $15bn loss in Q4 was the infamous "basis trade." In a basis trade, an investor buys a corporate bond and simultaneously buys CDS protection on the bond. There's a "negative basis" when the price of the CDS is lower than the price of the bond (usually defined by the bond's asset-swap spread or Z-spread). In other words, the basis is negative when the coupon payments the investor receives on the bond are higher than the premiums the investor pays out on the CDS. Conversely, there's a positive basis when the price of the CDS is lower than the price of the bond. The basis trade, and trades like it, have been extremely popular on Wall Street in the past few years. Deutsche Bank's "star trader" Boaz Weinstein supposedly lost over $1bn on basis trades when the corporate bond market froze in September. From what I hear, Merrill's biggest losses didn't come from basis trades per se, but came more generally from its massive exposure to Lehman as a counterparty on CDS trades. Now, some of Merrill's exposure to Lehman as a counterparty definitely came from CDS trades that were part of a larger basis trade. Remember, Merrill surprised the Street in October by reporting a $2bn pre-tax trading loss in Q3 that was, according to Merrill:

Primarily related to the default and spread movements of certain government sponsored entities and major U.S. broker-dealers.
Any CDS contract with Lehman as counterparty needed to be replaced when Lehman collapsed. Remember the emergency "Risk Reduction Trading Session" the ISDA opened on the Sunday that Lehman was preparing to file for bankruptcy? That was so that the major dealers could start replacing their derivative contracts where Lehman was the counterparty with contracts with other counterparties. The emergency trading session was a disaster (about which more later), but it was especially disastrous for Merrill. Remember the timing. The emergency trading session ran from 2 pm to 6 pm on the Sunday that Lehman was preparing to file for bankruptcy. The news that BofA was in advanced talks to buy Merrill didn't break until around 5 pm. Before that announcement, everyone was looking for who would be the next to fall, and the consensus was that Merrill was next in line. So traders turned their guns on Merrill. In a standard CDS, no money is exchanged upfront. But when a firm looking to enter into a CDS contract might default before the contract matures, counterparties start to demand money upfront—known as "points upfront" or "initial margin." Since Merrill was expected to collapse if it couldn't find a buyer, and news of the BofA deal had not yet leaked, counterparties were demanding that Merrill make huge upfront payments in order to enter into a CDS contract. And because Merrill had huge exposure to Lehman as a counterparty, it had a lot of contracts it needed to replace. I'm not saying that all of Merrill's losses, or even most of its losses, came in the emergency trading session—it took banks weeks, if not months, to replace all their trades with Lehman. The emergency trading session was just a microcosm of the next few weeks/months. Upfront payments have become relatively common in CDS trades since Lehman's collapse. Even after the BofA deal was announced, counterparties were still demanding points upfront from Merrill (though not as much as in those dark hours before the BofA deal was announced). My feeling is that a good chunk of Merrill's losses came from the sheer number of CDS contracts it had to replace when Lehman collapsed. Merrill had a lot more CDS contracts with Lehman than anyone thought—Moody's said the number was "outside of our expectations." Merrill has taken a loss on virtually every one of those contracts, as it had to replace them with pricey off-market CDS, some of which required sizable upfront payments. And since Merrill's $2bn Q3 trading loss only reflects the CDS contracts it replaced before Sept. 30, it's a good bet that these losses extended into Q4. While CDS that were part of basis trades no doubt account for some of the contracts Merrill had with Lehman, I don't think the basis trade is really the culprit here. The culprit is Merrill's outsized exposure to Lehman as a counterparty. Addendum: When the ISDA announced the emergency trading session on the Sunday that Lehman collapsed, I had a good laugh, and took great pleasure in explaining to my wife all the reasons why the trading session, as well as the following few weeks in the CDS market, would be a clusterfuck of the highest order. At that point I was still a "former structured finance lawyer," so the situation was amusing to me. Of course, a few hours later my old boss called and said: "I need you to come back. This is gonna be Armaggedon." Since he's one of the nicest men on the face of the earth, I couldn't refuse. Karma is a bitch.

At least the Obama administration (Tim Geithner really) recognizes that a CDS clearinghouse won't magically heal the financial markets, and won't even touch a huge segment of the CDS market. Contemporary politics being the three-ring circus that it is, I suppose that's all you can really hope for. Stephen Labaton writes in the NYT:

The administration is also preparing to require that derivatives like credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use. ... Officials said some credit default swaps with unique characteristics negotiated between companies might not be able to trade on exchanges or through clearinghouses. But standardized or uniform ones could. “We want to make sure that the standardized part of those markets move into a central clearinghouse and onto exchanges as quickly as possible,” Mr. Geithner testified. “I think that’s really important for the system. It will help reduce risk and the system as a whole.”
But then Labaton starts to have problems with, ummm, logic:
The new trading procedures for derivatives could also enable regulators to impose capital and collateral requirements on companies that issue credit default swaps that would make them safer investments. American International Group, one of the largest issuer of such swaps, never had to post collateral and nearly collapsed as a result of issuing a huge volume of such instruments that it was unable to support.
Wait, AIG "never had to post collateral" on its credit default swaps? Then why did the government give them all that money? No, AIG nearly collapsed because of collateral calls on its CDS positions. You can't have it both ways.

In addition to this morning's revelations in the FT regarding Merrill's bonus payments stunt, CNBC is now reporting that John Thain spent $1.2m to redecorate his office. Apparently Ken Lewis has had enough. I don't blame him. From Bloomberg:

Bank of America Corp. Chief Executive Officer Kenneth Lewis will hold an emergency meeting today with John Thain to discuss Thain’s future with the firm, a person familiar with the matter said. Thain, 53, the former CEO of Merrill Lynch & Co., is under pressure after Merrill reported a $15.4 billion fourth-quarter loss and Bank of America was forced to return to the government for a new funding package. Thain spent $1.2 million to redecorate his office at New York-based Merrill, CNBC reported today.
Good riddance.

Christopher Whalen, the managing director of a firm called Institutional Risk Analytics, is a ubiquitous commentator on financial markets. This is despite the fact that, from everything I've seen, he's totally crazy. Par for the course when it comes to financial market bobbleheads, I suppose. I expect financial market bobbleheads to exhibit a certain amount of craziness—after all, the shows they appear on are aimed at retail investors, and they're just trying to make headlines. But Whalen's claim that Tim Geithner is "too close to Goldman Sachs" is Ben Stein-level crazy. From an interview with Yahoo Finance:

"I believe Tim Geithner only represents part of Wall Street - Goldman Sachs," [Whalen] says, suggesting Goldman was the "primary beneficiary of the AIG bailout" and notes Goldman alum Stephen Friedman serves on the board of the NY Fed.
When the interviewer stated, "effectively, your argument is that Tim Geithner is in bed with Goldman Sachs," Whalen responded, "I believe so." Nevermind that Geithner has never worked for Goldman, or any Wall Street institution for that matter. No evidence required. This is Yahoo Finance. The only thing resembling evidence Whalen cites (other than a rumor about Geithner spending time on the phone with Robert Rubin that Whalen actually started himself) is "the reporting in the New York Times about the AIG bailout," by which he means the preposterous—and thoroughly discreditedarticle by Gretchen Morgenson. Morgenson effectively asserted that the Fed's decision to bail out AIG was improperly influenced by Goldman, which is idiotic for a number of reasons, but especially because the Fed hired Morgan Stanley to advise them on the AIG bailout. No mention of this in the Times article, of course, because we can't let pesky facts get in the way of a good Goldman conspiracy theory. What is it about Goldman Sachs that drives the Ben Steins and Chris Whalens of the world so crazy? Honestly, I've never understood it.

I suspect there's more to the story, but suffice it to say that if true, then this is an outrageous stunt:

Merrill Lynch took the unusual step of accelerating bonus payments by a month last year, doling out billions of dollars to employees just three days before the closing of its sale to Bank of America. The timing is notable because the money was paid as Merrill’s losses were mounting and Ken Lewis, BofA’s chief executive, was seeking additional funds from the government’s troubled asset recovery programme to help close the deal. Merrill and BofA shareholders voted to approve the takeover on December 5. Three days later, Merrill’s compensation committee approved the bonuses, which were paid on December 29. In past years, Merrill had paid bonuses later – usually late January or early February, according to company officials. ... Despite the magnitude of the losses, Merrill had set aside $15bn for 2008 compensation, a sum that was only 6 per cent lower than the total in 2007, when the investment bank’s losses were smaller. ... BofA said: “Merrill Lynch was an independent company until January 1 2009. John Thain (Merrill’s chief executive) decided to pay year-end incentives in December as opposed to their normal date in January. BofA was informed of his decision.” BofA declined to specify when Mr Thain informed the bank of his decision.
It's clear now that Ken Lewis bought a lemon. And by Ken Lewis, I mean U.S. taxpayers.

Wednesday, January 21, 2009

Suspend State Sales Taxes!

The main point of a fiscal stimulus package is to offset the decline in consumer spending, which accounts for over 70% of GDP. We need to avoid the Paradox of Thrift, and all that. As Paul Krugman put it:

[W]hat the economy needs now is something to take the place of retrenching consumers. That means a major fiscal stimulus.
The argument against tax cuts as fiscal stimulus is that consumers won't spend the extra money, but rather will increase savings or pay down debt. We want people to spend, and spend now. So why oh why aren't people talking about temporarily suspending state sales taxes as a way to quickly increase consumer spending? Suspending state sales taxes would encourage consumers to spend more by lowering the price of spending, and making the suspension of sales taxes temporary would encourage consumers to spend before the sales tax holiday is over—that is, to spend right now. Laurence Kotlikoff and Ed Leamer have offered a very nice sketch of how such a policy would work. The proposal has been endorsed by Stanford's Robert Hall and Susan Woodward, and was evidently quite a hit at the annual American Economics Association meetings, winning converts like Alan Blinder of Princeton. Here's Kotlikoff and Leamer's overview of their proposal:
A better way to spur consumer spending is for Uncle Sam to run a six-month national sale by having a) state governments suspend their sales taxes and b) the federal government make up the lost state sales revenues. The national sale could be implemented immediately. Here’s how it would work. Uncle Sam would pay each state a fixed percentage — say 5 per cent — of the 2007 consumption of its residents. States would be required to reduce their retail sales tax rates by enough to generate a six-month revenue loss (calculated using 2007 data) equal to the amount they’ll receive from Uncle Sam. For states with low or zero sales tax rates, implementing this policy requires making their sales tax rates negative, ie subsidising purchases. Shoppers would see a negative tax on their sales receipts, lowering their outlays. State governments would reimburse businesses for paying the subsidy and, in turn, be reimbursed by the Feds. States would be free to broaden their sales tax bases to apply the National Sale to all retail sales, not just the sales currently covered in their sales tax systems. To make the policy progressive, states could also reduce sales tax rates by more for goods and services that are disproportionately consumed by the poor. ... [This plan] will apply economic medicine where it’s most needed – on consumer spending, giving everyone an incentive to spend now and begin again to trust our economy and its institutions.
So why has this proposal been largely absent from the public debate? I have no clue.

From Frank Partnoy, writing in the FT:

When a company pays out more in compensation than its market capitalisation, as Citigroup did, the end is near.
Hard to argue with that.

Now you can compare (most of) the S&P 100 equity index with a corresponding index based on CDS market prices. From the WSJ:

Ratings agency Standard & Poor's Wednesday launched a new index to help investors compare the performance of the US equity- and credit derivatives markets. In fact, the agency has created three new indexes that will add to the benchmark CDX indexes already widely used in this $29 trillion market for insurance against default. The S&P US Investment Grade Index lists the 100 most liquid names in the CDS markets with top-shelf credit ratings. And the S&P CDS US High Yield Index references 80 companies with lower ratings. Each of these names will have equal weighting. But in a first for the credit default swaps market, S&P will also publish an index tracking credit risk premiums for companies listed on an equity index benchmark. The S&P 100 CDS Index tracks 80-90 of the most liquid names in the corresponding equity index, with matching weighting. They comprise the names with the most heavily traded credit default swaps. ... The S&P 100 CDS Index is the first tool that allows investors to directly compare risk premiums in the credit markets with stocks. That means investors now have a standard for comparing two markets that have attracted much controversy during this financial crisis, since they're heavily used to express negative views on companies. ... The indexes will be calculated at the end of each day, using CMA datavision as primary source of pricing.
I'm not sure how the S&P US Investment Grade and High Yield indexes will distinguish themselves from the CDX Investment Grade and High Yield indexes (CDX.NA.IG and CDX.NA.HY). I'll have to look into that more.

Saturday, January 17, 2009

Keeping a CDS clearinghouse in perspective

A central clearinghouse for credit default swaps (CDS) will undoubtedly provide benefits to the CDS market: increased transparency, a reduction in counterparty risk, efficient multilateral netting, a uniform valuation method, etc. But commentators seem to believe that a CDS clearinghouse is a "solution" to the problems in the CDS market. It is not. Steven Pearlstein, who virtually embodies Washington Establishment thinking on financial matters (and that's not a compliment), provides a perfect example of this sentiment:

The top priority ought to be on setting up a new clearinghouse for those credit-default swaps that everyone's heard about but few understand. ... It would offer the advantage of finally bringing credit-default swaps out from the shadows and into a regulated marketplace where they can be standardized, traded and priced in a way that everyone can see. The logic is simple: better to have the government bail out the CDS market, and finally bring it under government regulation, than be put in the position of having to bail out a dozen more AIGs out of a fear that their failure would also take down the CDS market.
Let's be clear: AIG would have failed even with a CDS clearinghouse in place. If you think that AIG's failure proves that the CDS market needs to be regulated, and that a well-regulated clearinghouse is the solution, then you're sadly mistaken. A central clearinghouse will only clear standardized single-name and index CDS. No clearinghouse will clear CDS on structured products like mortgage-backed securities (MBS) or collateralized debt obligations (CDOs). AIG's failure had nothing to do with the single-name and index CDS that a clearinghouse will handle, and everything to do with the CDS it had written on structured products, particularly MBS and CDOs. This Wall Street Journal piece illustrates the crucial difference:
As of Nov. 5, AIG had posted $37.3 billion of collateral to its trading partners on the CDO swaps, but just $2.6 billion on the other two types [single-name CDS on corporate bonds and European banks].
Setting up a central clearinghouse won't have any effect on CDS on MBS or CDOs, which are what brought AIG down. AIG would have been subject to the same crippling collateral calls even if a CDS clearinghouse had been in place in September, because no clearinghouse would have cleared the CDS contracts that were the source of the collateral calls. I'm all in favor of a CDS clearinghouse, but it's important to remember exactly what kinds of benefits a clearinghouse would provide. And of course, this assumes that we'll ever actually get a meaningful clearinghouse, which, as I've said, I'm not convinced we will.

Friday, January 16, 2009

Sheila Bair Hearts Derivatives

Sheila Bair has become something of a hero to some progressives, supposedly because she's "a principled regulator who stood up against the good ole boys club." Apparently all you have to do to become a "principled regulator" is spit out a bunch of vague platitudes to naïve journalists about how we should help "ordinary Americans" instead of Evil Wall Street Banks. Must be nice. But back when Bair was the head of the CFTC, and there was an intense debate over whether more regulation of derivatives was needed, here's what Bair had to say (from an October 1993 Bloomberg article):

THE Commodity Futures Trading Commission (CFTC) has given the US$ 4.8 trillion derivatives market a clean bill of health, saying that fundamental changes in the way the market is regulated are not needed. ... "We have a strong affinity for derivatives at this agency," said acting CFTC chairman Sheila Bair. "We like them."
The article doesn't appear to be available online (I'll excerpt more below), but if you have a Bloomberg, the article is from October 26, 1993, and the headline is "CFTC Study Finds Little Risk from Derivatives." Here's some more from the Bloomberg article, which shows that Bair is almost the opposite of a "principled regulator who stood up against the good ole boys club":
In January this year, the CFTC largely exempted certain swap agreements from most commission regulations. In addition, members of House and Senate committees are likely to be sceptical of any report that finds few immediate risks posed by derivatives markets. Consider the comment from a recent speech by Jeffrey Duncan, senior finance policy analyst with the House sub-committee on telecommunications and finance: "In almost every instance, before the catastrophe hit, we were told not to worry - Wall Street's financial wizards had everything under control." "While the chief financial officers of Fortune 500 companies can probably be expected to understand and manage the risks associated with derivatives, what about the municipal governments that are getting into this market?" Mr Duncan said. [ed: Sure enough, in 1994 Orange County lost over $2 billion through derivatives bets, and was forced to file for bankruptcy.] A case in point is Van Wert County, Ohio, which lost about $ 100,000 on its holdings of interest-only mortgage securities. The loss was equivalent to the county's entire payroll for almost two weeks. ... Some regulators have expressed concern that a failure by one bank or corporation to meet its derivatives payments could trigger a banking crisis. Felix Rohatyn of investment banking firm Lazard Freres has warned of "26 year olds with computers creating financial hydrogen bombs". That prompted some members of Congress to question whether more rules were needed for the largely unregulated market. House Banking Committee chairman Henry Gonzalez, for example, has scheduled hearings on derivatives trading, and has expressed concern about the involvement of banks in derivatives markets. For her part, Ms Bair said there was "no cause for concern at this time" because most derivatives market participants "are adhering to sound risk management practices". ... Derivatives trading had exploded over the past decade, the CFTC said. The commission said the total notional principal amount in the interest rate and currency swap markets alone came to about $ 4.8 trillion at the end of last year, up from about $ 870 billion just five years earlier. The number of new interest rate and currency swap contracts rose to 104,000 last year from 63,000 in 1990, an annualised growth rate of 28.5 per cent.
Sheila Bair, principled regulator? Please.

Thursday, January 15, 2009

Bloomberg on CDS clearinghouses

Bloomberg has a story headlined, "ICE Emerges as Credit-Default Swap Clearinghouse Frontrunner":

Intercontinental Exchange Inc., the second-largest U.S. futures market, is emerging as the leading candidate to run a clearinghouse for the $29 trillion market for credit-default swaps. Analysts at Morgan Stanley and CreditSights Inc. said this week that Atlanta-based Intercontinental, also known as ICE, will likely be the industry choice to back the contracts because of its partnership with Goldman Sachs Group Inc., JPMorgan Chase & Co. and seven other banks that account for over 80 percent of the trading. ... An ICE victory would mean the securities firms that control a market responsible for billions of dollars of losses will continue to shape the way the contracts are traded.
This should surprise no one, as I've noted before. The major CDS dealers, who have absolutely dominated the market since its inception, are going to continue to dominate the CDS market. Shocking. (Note that one of Bloomberg's sources for the claim that ICE is the frontrunner is Morgan Stanley, which is one of the major dealers backing the ICE clearinghouse. The headline could have been: "Major CDS Dealer Says that CDS Dealers Totally Rock.") Back to Bloomberg:
“People have some concerns over the banks’ influence, but no matter what entity this goes to, you’re going to have a lot of dealer influence,” said Brian Yelvington, a New York-based strategist at fixed-income research firm CreditSights. “I don’t see how you get away from that.”
Neither do I. Like I said before, no dealers, no meaningful clearinghouse. But CME, bless its little heart, just refuses to give up:
CME Group, which traces its roots to 1848, says it’s premature to declare a winner in credit-default swaps clearing. “This is way too soon to make any pronouncements about what will happen competitively in the market,” CEO Craig Donohue, 47, said last month in an interview. “You have two very different proposals out there. Many of the dealers we’re talking to very much want to keep their options open to participate on more than one platform.”
The Bloomberg article doesn't offer any new information on the status of ICE's application with the New York Fed (which the Fed effectively rejected once already). I don't think there's any way the ICE clearinghouse gets up and running before the end of March. A clearinghouse needs all the contracts it clears to include a CDS settlement auction provision, and the ISDA says that settlement auctions won't be hardwired into the 2003 Credit Derivatives Definitions until mid-March. Remember when the dealers were assuring regulators everywhere that they'd be clearing trades by the end of 2008 at the latest?

Wednesday, January 14, 2009

Getting the Signals Crossed

Now we know why the Obama administration asked President Bush to go ahead and request the remaining $350 billion of TARP funds: Bank of America needs another bailout. No details are available yet, but everyone's assuming that the BofA deal will be roughly similar to the deal Treasury struck with Citi in November. The Treasury has already committed the first $350 billion of TARP funds, so it's essentially committing money that it doesn't have yet. They'll get the money eventually, of course, though with tighter restrictions on its use. This episode just goes to show that Treasury and Fed officials have to be really careful about what they say and do in public. Ever since the Lehman/AIG failures, there have been Treasury and Fed officials at every major bank, constantly monitoring their books. Everyone in the market knows this. So when the Obama administration asked President Bush to go ahead and request the second half of the TARP funds, rather than waiting until Obama is sworn in on Jan. 20, the market was seriously spooked. Everyone interpreted the move to mean that one of the major banks was in trouble again, and will need another bailout to survive. Since everyone knows that Treasury and Fed officials are constantly monitoring the major banks' books, the move to request the second half of the TARP funds sent a signal to the market that something is wrong at one of the major banks, and the problem is urgent (otherwise why not wait until after the inauguration to request the funds?). As soon as Obama had Bush request the funds, the race was on to figure out which bank was in trouble. At first everyone thought it was Citi, since it had just announced plans to raise capital by breaking itself up, including spinning off Smith Barney in exchange for $3bn from Morgan Stanley. To give you a sense of the fear that gripped the market after the Obama administration's ominous move, CDS spreads on Citi jumped an unheard of 100bps today (spreads don't usually move more than 5-10bps in a single day). Deutsche Bank's announcement this morning that it had lost $6.3 billion in Q4 just added fuel to the fire. Now we know that the bank that's in trouble is BofA, not Citi. It's now clear that the BofA Bailout 2.0 is the reason Obama had Bush request the rest of the TARP funds, but that just confirms that the market was right to interpret Obama's move as a signal that one of the major banks was in trouble. The moral of the story is that Obama, Geithner, Bernanke, Summers et al. need to realize that since Treasury and Fed officials are constantly monitoring the major banks' books, their statements and actions could, if they're not careful, send the wrong signal about the health of U.S. banks.

Relating to my discussion yesterday of whether the BIS should reduce the penalty for excluding the "modified restructuring" (Mod-R) credit event from CDS contracts, which is currently a 40% reduction in capital relief, a friend at a dealer bank has informed me that the spread between contracts with Mod-R and contracts with no restructuring credit event (known as "No-R") is roughly 9 basis points. In other words, the market value of CDS contracts with restructuring is only slightly higher than the market value of CDS contracts without restructuring as a credit event. The BIS, however, contends that contracts with restructuring are worth 40% more than contracts without restructuring. While CDS market pricing isn't perfect by any means, it still suggests that the penalty for excluding Mod-R should be significantly less than a 40% reduction in capital relief. The BIS was receptive to this argument after the Conseco/Argentina fiascos spawned Mod-R and Mod-Mod-R (the European version), even though it didn't ever actually reduce the capital charge for excluding restructuring, so it'll be interesting to see what the BIS ends up doing. [Edited to fix a minor math error, which had no effect on the overall argument. Note to self: don't do math while wasting time in an airport lounge area.]

Tuesday, January 13, 2009

Yglegias on Affordable Housing

Matt Yglesias is on the right track regarding affordable housing, but he still makes a couple important mistakes:

At the margin, adding new market-rate housing units reduces the cost of housing, making housing more affordable. In other words, given a choice between a project with 20 affordable units and 20 market-rate ones or a project with 40 market-rate units the former is more desirable from an affordability standpoint. But the 40 market-rate units is better for affordability than is letting the site remain as a vacant lot or a very low-density use. The best kind of incentives, meanwhile, do both. For example, you let developers build a taller building than the local zoning code would normally allow, but only if some of the additional square footage is devoted to affordable housing.
First, it's not always true that 40 market-rate units is better for affordability than letting the site remain vacant/low-density. Whether 40 market-rate units is better for affordability depends on the area's "filtering" rate—that is, the rate at which housing units move through the quality hierarchy, usually through depreciation, but also through investments to upgrade the units. In a fast-growing metropolitan area where further construction of new housing can be expected to continue, urban economists (Steven Malpezzi in particular, if memory serves me right) have generally found that the supply of affordable housing is indeed very sensitive to the supply of more expensive housing. In that kind of metropolitan area, Matt is right that building 40 market-rate units is better for affordability than letting the site remain vacant. However, in metropolitan areas that are more hostile to new housing (e.g., San Francisco, LA, Boston), the filtering rate is glacially slow. In those metropolitan areas, the opportunity cost of building 40 market-rate units on scarce developable land could well outweigh the small benefit to affordability. The opportunity cost of building 40 market-rate units is much higher if the units are in or near the urban core, because it uses scarce land on which new affordable units can be built (low-income families generally need to live closer to the urban core because of transportation costs). The choice is never "40 market-rate units or nothing." Housing is a durable good, so the time horizon for alternatives needs to be much longer. It's extremely short-sighted to say "40 market-rate units is better than nothing, so build away!" Matt's second mistake is more troubling. He argues that giving developers an incentive to build both market-rate and affordable units are "the best kind of incentives," using a version of a "density bonus" as an example. Density bonuses are better than inclusionary zoning—which force developers to keep a certain percentage of the units they're building "affordable"—but both are part of the same family of policies, all of which are deeply misguided. At best, these policies are woefully inadequate; sadly, most of the time they're downright counterproductive. These policies are often touted as "market-friendly," but that's true only on an extremely superficial level. Density restrictions (commonly referred to as "large lot zoning") are a very large part of the reason it's unprofitable to build affordable housing units in the first place. The solution isn't to trade exemptions from large lot zoning regulations for a handful of affordable housing units; the solution is to change the large lot zoning regulations. Inclusionary zoning and density bonuses are an ineffective sideshow, and to the extent that these kinds of policies distract housing advocates from policies that would actually increase the supply of affordable housing, they're harmful to the cause of affordable housing.

Every time you forget how cartoonishly unserious the world of politics is, something like this comes along to remind you:

Sen. Charles E. Grassley, ranking Republican on the Senate Finance Committee, is raising questions about a housekeeper who worked briefly for Treasury Secretary-nominee Timothy Geithner without proper immigration papers, and multiple years when Mr. Geithner didn't pay Social Security and Medicare taxes for himself. ... According to people familiar with the matter, Mr. Geithner employed a housekeeper whose immigration papers expired during her tenure with Mr. Geithner, currently president of the Federal Reserve Bank of New York. The woman went on to get a green card to work legally in the country and federal immigration authorities didn't press charges against her, these people said. The second issue involved taxes due while Mr. Geithner worked for the International Monetary Fund between 2001 and 2004. As an employee, Mr. Geithner was technically considered self-employed and was required to pay Social Security and Medicare taxes for himself as both an employer and an employee. He apparently failed to do so, resulting in Internal Revenue Service audits his last two years at the IMF. As soon as the IRS brought the issue to his attention, he paid the taxes with interest, these people said.
Dear Chuck Grassley: We're in the midst of an epic financial crisis, and you want to talk about the nominee for Treasury Secretary's old housekeeper, and a couple mistakes he made—and immediately corrected—on his tax forms? You're a fucking United States Senator for god's sakes. Act like it.

Continuing my recent credit default swap theme, I'm going to discuss a couple of important changes in the CDS market that are now imminent. First, after talking about it for years, market participants in the US have agreed to drop the "restructuring" credit event — which is actually called "modified restructuring," and is commonly known as Mod-R — for standard US single name CDS. From Reuters:

A protection buyer can be paid out the insurance when a borrower files for bankruptcy, fails to make an interest or principal payment on their debt or, in some cases, when a company restructures its debt. Changes expected to roll out as early as next month, however, will remove the restructuring trigger for standard contracts in North America. Buyers of protection may still request restructuring triggers in tailored trades, although it would cost more. The changes will standardize contracts on single company debt with those on indexes, which do not include restructuring.
Removing Mod-R from standard investment grade corporate CDS is an important step on the path to a central clearinghouse, for one thing because it allows the clearinghouse to net an index CDS and its single-name components. The restructuring credit event has always been a source of problems, and Mod-R has been a fiasco. Mod-R puts different limitations on the maturity of deliverable obligations depending on whether the buyer or seller triggers the termination, which was a stupid idea to begin with. It would also make it very difficult for a clearinghouse to conduct a cash settlement, because what maturity should the bonds in the auction be? The solution to the cash settlement problem that has gained the most traction so far—bucketing maturities together and holding separate auctions for each bucket—seems unworkable to me, so I'm glad they decided to just scrap Mod-R entirely from standard CDS contracts. Neither the US high yield index (CDX.NA.HY) nor high yield single-name CDS include a restructuring credit event, so the era of Mod-R should thankfully come to an end soon. However, it looks like no such change will occur for European CDS, which will continue to use "modified modified restructuring" (known as Mod-Mod-R) in both single-name and index CDS. The maturity limitations on deliverable obligations under Mod-Mod-R aren't nearly as retarded restrictive as the limitations under Mod-R. Still, with a record number of restructurings expected this year, I have to believe the European market will end up regretting the decision to keep Mod-Mod-R. The second important change in the CDS market will be a direct result of the elimination of Mod-R. As it currently stands, eliminating Mod-R from standard US contracts will force banks to take a hefty capital charge, which would lead to another round of forced liquidations as banks raise cash to meet capital ratios. As the Reuters article notes:
For banks, however, the move may prove expensive. It will reduce by 40 percent the capital relief awarded by using use CDS to hedge bond and loan holdings, said Bank of America analyst Glen Taksler. "The downside to removing restructuring is that banks get full capital relief from buying CDS with restructuring, but only 60 percent capital relief without restructuring," Taksler said. Banks may react to the change by selling bonds and loans, which could pressure their valuations. ... Market participants are in discussions with regulators with the hope of removing or reducing the penalty for excluding restructuring as a trigger in contracts, said a person familiar with the discussions who declined to be identified.
Given current market conditions, it makes sense for the BIS to reduce the penalty for removing Mod-R as a trigger in CDS contracts, and I think that's ultimately what they'll do. Remember, only investment grade corporate CDS trade with a Mod-R provision. With all the emergency government programs supporting commercial financing, such as the Commercial Paper Funding Facility (CPFF), a restructuring of investment grade debt will likely be much less costly to bondholders than it would be in a normal market. Moreover, with DIP financing hard to come by, and a much higher chance that Chapter 11 bankruptcy will turn into Chapter 7 liquidation, banks will be able to extract much more stringent restructuring terms. If restructurings will be less costly to banks, then it makes sense to reduce the capital charge for failing to have CDS protection for restructuring.

Monday, January 12, 2009

Et tu, Smithsonian?

TPM flags a whopper in the caption beneath the Smithsonian's new portrait of George W. Bush (which is fortunately being disputed by Sen. Bernie Sanders):

The current wording of the caption states that Bush's term was marked by "the attacks on September 11, 2001, that led to wars in Afghanistan and Iraq."
The Smithsonian's historians should know better. The claim that 9/11 led to the Iraq war, in the sense that the U.S. entered into the Iraq war as retribution for 9/11, is demonstrably false, and no amount of partisan posturing should affect the Smithsonian's account of history. Yes, a few Republican egos will be bruised if the Smithsonian acknowledges that 9/11 had nothing to do with the Iraq war, but that's a small price to pay for an accurate description of something so historically significant.

Sunday, January 11, 2009

Thoughts on regulating the CDS market

I've received a few requests for my thoughts on various forms of regulation for the CDS market. When I was working on credit default swaps in the first half of this decade, during the big push to standardize CDS contracts, I never in my wildest dreams thought that CDS would become a popular topic of discussion, or that anyone outside the world of structured finance law would ever willingly ask me to discuss CDS! First of all, I think it's very clear that the current regulatory posture—that is, an unregulated dealer-driven OTC market—is not a viable option anymore. CDS are way too important to remain unregulated. CDS can be structured to mimic so many other financial instruments that they simply cannot exist in the shadows anymore. In addition to their traditional role of hedging credit risk on corporate bonds, CDS are now used: as stand-alone synthetic trades; in synthetic CDOs; to hedge credit risk on ABS or CDOs; to take long/short positions on indexes of U.S. or European corporate bonds (CDX.NA.IG, iTraxx Crossover, etc.); to hedge region-specific macroeconomic risks (via baskets of sovereign CDS); and so on. I don't think CDS have been a major contributor to the financial meltdown, despite the media's wild accusations, which are driven largely by the combination of huge (though completely irrelevant) numbers like $62 trillion(!), and the media's sheer ignorance of CDS. Felix Salmon has been a notable exception, and has done a terrific job explaining CDS in simple terms—much better than I ever could have done, as I definitely don't have that particular gift. Alas, not everyone reads Salmon's blog, so misperceptions about CDS remain widespread in the media (memo to the New York Times: hire Salmon as a financial reporter and fire the incompetent Gretchen Morgenson—immediately). To be perfectly honest, sometimes I think Salmon has been a little too sanguine on CDS, such as when he dismissed concerns about counterparty risk, saying that it was "something the banks were pretty much on top of all along, and so far it hasn't been a big deal." In reality, counterparty risk has been a huge deal in the CDS market since Bear collapsed; for example, a Greenwich Association survey from August found that over 75% of institutions agreed that "counterparty risk in credit default swaps represents a serious threat to global financial markets." Counterparty risk in the CDS market isn't a huge deal relative to other problems in the financial sector, but it's still a very real problem that needs to be addressed. Regardless of whether CDS have actually been a source of systemic risk, there's no doubt that the CDS market is big enough to be a source of systemic risk, and that in itself justifies some level of government oversight. We can't rely on the International Swaps and Derivatives Association (ISDA) to regulate CDS, nor should we. The ISDA is dominated by the major dealers—JPMorgan, BofA, UBS, Deutsche Bank, Goldman, Morgan Stanley, Citi, and Credit Suisse. The ISDA is interested in a CDS market that's safe for the dealer banks, yet also remains a dealer-dominated market. Because the dealers usually carry matched books—that is, they hedge all the CDS positions, for example by offsetting each CDS they sell by buying the exact same CDS from another counterparty. So it's fair to say that the ISDA isn't terribly interested in where all that risk ends up, just as long as it doesn't end up with the dealer banks. As it turns out, most of the risk is concentrated in AIG and the monolines. Of course, this was widely known in the CDS market for years, but the ISDA never tried very hard to do anything about these dangerous risk concentrations because the dealers needed AIG and the monolines for liquidity—especially for CDS on ABS and CDOs, and for bespoke CDS, where the dealers' fees are substantial. Don't get me wrong, the ISDA is a fine organization, and it's done yeoman's work negotiating and implementing improved contractual terms for CDS. But the ISDA is not a substitute for a regulator. And no matter how hard it tries to keep the CDS market unregulated, the ISDA can't get the genie back in the bottle this time. One potential solution is a central clearinghouse. A clearinghouse is the counterparty to every trade, thus eliminating counterparty risk. Counterparty risk was acute in the aftermath of Lehman's bankruptcy, since it was one of the major CDS dealers. Right now, there are four companies racing to set up a clearinghouse: IntercontinentalExchange (ICE), CME Group, NYSE Euronext, and Eurex. The dealer banks are backing ICE, so it's widely expected to be the dominant clearinghouse. However, I'm not convinced that a central clearinghouse will end up working. For one thing, a clearinghouse would only clear standardized trades. That's all well and good, but a large segment of the CDS market is bespoke. This is especially true for CDS on ABS and CDOs, as the terms of these CDS are tailored to the specific form of the underlying structured security. It took a while for the market to even settle on the standard template for CDS on ABS and CDOs—the ISDA introduced the standard pay-as-you-go template in June 2005 (the template is known, inexplicably and over my strong objections, as PAUG, rather than PAYGO). But even with a standard PAUG template, the terms of these CDS aren't standardized in the sense that each CDS on ABS isn't the same. There are important toggles within the PAUG template—for instance, the treatment of an interest shortfall depends on whether the contract uses the "no cap," "variable cap," or "fixed cap" toggle. And of course, the underlying structured securities are often significantly different, with material terms such as attachment and detachment points running the gamut. There's no way a clearinghouse would clear CDS on ABS or CDOs—in fact, CME already said it won't clear CDS on MBS or sovereigns—so this entire market would be unaffected by the introduction of a central clearinghouse. Even single-name CDS are often bespoke. For example, the Threshold and Minimum Transfer Amount, which are important in terms of when collateral must be paid, can differ substantially (I can't even count all the different combinations of Thresholds and MTAs I've seen). How much of the existing bespoke single-name CDS would migrate onto a central clearinghouse? It's not entirely clear. Also, it's not clear from the ICE proposal that all parties would be able to face the clearinghouse. It's complicated, but sometimes clearinghouses are structured so that non-members can't face the clearinghouse, but instead must transact with a clearinghouse member, with the clearinghouse simply guaranteeing payment if a member defaults. I hear that this is what ICE is trying to do. Essentially, ICE is trying to keep the structure of the current OTC market, only now with a central clearinghouse to guarantee all the major counterparties. I'm not sure the New York Fed will approve that proposal. The New York Fed already rejected ICE's first proposal, which included a provision allowing the major dealers to form a committee that would have had final authority over which contracts would be cleared. If the dealers aren't willing to let everyone face the clearinghouse, or they're not willing to let the clearinghouse be governed independently, then I don't see how ICE can get approval to set up a clearinghouse. A lot depends on the initial margin that the clearinghouse requires. The dealers will likely try to undercut CME et al. on initial margin to attract more liquidity, but if ICE Trust (the name of the proposed clearinghouse) is governed independently from the dealers, then they may not be able to keep the initial margin low enough to maintain the level of liquidity that has made the CDS market so attractive. The initial margin requirements that the clearinghouses have been throwing around sound pretty onerous to me—high enough that liquidity would be seriously impaired. If that ends up being the case, will the major dealers try to keep most of the CDS market off the clearinghouses and flowing through them instead? Without the major dealers, of course, a central clearinghouse solution won't work. Best-case scenario, I can see one clearinghouse for standardized single-name corporate CDS, the CDX indexes, and the iTraxx indexes. If that clearinghouse is ICE, then those trades will continue to be highly liquid. If that clearinghouse is CME, NYSE Euronext, or Eurex, or even all three, then it's unclear how much of that market would flow through the clearinghouse and how much would remain with the dealers.

Saturday, January 10, 2009

Rodge Cohen as New York Fed President?

The WSJ reports a few more names on the list of candidates interviewing for the powerful position of New York Fed President. The most intruiging one is Rodge Cohen, the legendary Sullivan & Cromwell chairman. If they could get him, Cohen would be a fantasic choice. He's incredibly well-respected on Wall Street, and few people in the world have a better understanding of the global banking system. He's already been acting as a de facto intermediary between Wall Street and the government during the financial crisis, which is essentially what the New York Fed President does anyway. Cohen is no spring chicken though. He's thought (or, I should say, widely rumored) to be close to retirement, so I'm not sure he'd be interested in the job.

Saturday, January 3, 2009

NYT Graphics

I like to beat up on NYT reporters as much as anyone—they haven't had a good financial reporter since Peter Truell, and Gretchen Morgenson is awful. But let's not kid ourselves: the NYT can put together some amazing graphics. I wish there was a page on the NYT's website for just graphics (or as Barry Ritholtz would say, "chart porn"). I know virtually nothing about how newspapers operate, so I don't know if that's something the NYT farms out or does in-house. Whoever does it, they're top-notch.