Simon Johnson reaches new levels of cluelessness, criticizing "Treasury's scheme" for pricing TARP warrants, which he claims was "[b]uried in the late wire news on Friday":

This is a mistake. The only sensible way to dispose of these options is for Treasury to set a floor price, and then hold an auction that permits anyone to buy any part – e.g., people could submit sealed bids and the highest price wins. In Treasury’s scheme, there is significant risk of implicit gift exchange with banks - good jobs/political support/other favors down the road – or even explicit corruption. For sure, there will be accusations that someone at Treasury was too close to this or that bidder. Why would Treasury’s leadership want to be involved in price setting in this fashion? ... In any crisis, technical mistakes are made due to high pressure, lack of information, and political considerations; this is unavoidable. But this proposed pricing for TARP warrants looks like a pure unforced error, and should be quietly overriden by the White House – hopefully, senior congressional leaders will quickly make this point behind the scenes.

Treasury didn't "announce the rules for pricing" TARP warrants on Friday. The rules for pricing were established in the original Securities Purchase Agreements last October. Section 4.9(a) provides that after a bank has paid back its TARP money, it has the right to repurchase the warrants from Treasury at the "fair market value." The procedures for determining the fair market value—the "scheme" Johnson thinks Treasury just announced on Friday—were established in Sections 4.9(c)(i)–(ii). Essentially, the bank first submits its estimate of fair market value to Treasury. Treasury then evaluates the bank's estimate to determine if it's too low (it will be), and has 10 days to formally object (it will). After objecting, a Treasury representative will meet with the bank's CEO to try to agree on a fair market value. If they can't agree, then an appraisal procedure that uses independent appraisers will be used to determine fair market value. (The appraisal procedure is described in Section 4.9(c)(i).) Johnson criticizes Treasury's pricing procedures for "nontransparent decision making," which is ironic because what Treasury was actually announcing on Friday was the method it plans to use to estimate the fair market value of the warrants, including specific inputs and assumptions. It also announced:
Treasury will begin publishing additional information on each warrant that is repurchased, including a bank’s initial and subsequent determinations of fair market value, if applicable. Following the completion of each repurchase, Treasury will also publish the independent valuation inputs used to assess the bank’s determination of fair market value.
In other words, Treasury is making the decision making process as transparent as possible. Johnson wants Treasury to set a floor price and hold an auction for the warrants. Again, to the Treasury announcement:
If an issuer chooses not to repurchase the warrants according to its existing contractual rights, Treasury has the discretion to dispose of the warrants as it sees fit over time. In these instances, Treasury will sell the warrants through an auction process over the next few months.
This guy testifies in front of Congress as an "expert" on the financial crisis. Amazing.

The BIS has released its always-excellent Annual Report, and it doesn't disappoint. I highly recommend the Report's account of the financial panic last September and October (pp. 23-31). It's easy to forget how truly terrifying it was, and the unimaginable pressure that policymakers—especially the Federal Reserve—were under to solve new systemic threats pretty much every day. In particular, I recommend the box describing the crucial role of the money market funds in the financial contagion, and their role in spreading the funding crisis to the European banks (pp. 25-26). BIS publications always have great charts, and I've extracted some of my favorite charts from this year's Report below. One interesting thing the Report does is it provides charts of all the important market indicators with a verticle line marking the date of the Lehman bankruptcy (Sept. 15). That way, you can really appreciate how important that day was. To say that it marked the beginning of a new stage in the financial crisis is a gross understatement. Other interesting charts in the Report: Great stuff, as always.

Saturday, June 27, 2009

Bespoke Derivatives

Apparently commentators are upset because the administration's financial reform proposal only requires "standardized" derivatives to be cleared through central counterparties (CCPs), and not bespoke derivatives. James Kwak even questions "why we need customized derivatives in the first place." He claims he can't even think of an example of when a firm would legitimately need to use a bespoke derivative. Umm, how about something like portfolio default swaps? A portfolio default swap is a credit derivative that transfers a predetermined amount of credit risk on a reference portfolio. For example, a pension fund with a large corporate bond portfolio might decide that it needs to reduce its exposure to 40 specific bonds that have a total notional amount of $100bn. The pension fund could enter into a portfolio default swap with a dealer in which the dealer agrees to protect the pension fund against the first $20bn of default-related losses on the reference portfolio (the 40 identified bonds) over the next 5 years, in exchange for quarterly premiums from the pension fund. This kind of situation happens all the time, and it's perfectly legitimate for the pension fund to enter into the swap with the dealer. But portfolio default swaps can't be "standardized," because the reference portfolio in every swap is specific to the protection buyer. They're classic bespoke derivatives. Along the same lines, basket default swaps are also derivatives that can't be standardized. The most common basket default swap is a "first-to-default basket," in which payment is triggered by the first default—and only the first default—in a basket of identified bonds. Again, basket default swaps can't be standardized because the reference basket is specific to the protection buyer. Also, CDS on structured products (e.g., ABS) are, by definition, bespoke derivatives because the reference ABS are all different. Yes, I know, CDS on CDOs are what brought down AIG, so some people think CDS on structured products are inherently evil. But that's not really a serious argument. The internet bubble brought down plenty of funds, but that doesn't mean stocks are inherently evil instruments. And anyway, the administration's proposal would impose conservative initial margin requirements on bespoke derivatives like CDS on structured products, which would prevent another institution from making a $400bn levered bet through OTC derivatives the way AIG did. I'm not even getting into classically bespoke derivatives like barriers (knock-in/knock-out options) or forward rate swaps, but suffice to say there are legitimate uses for all of these instruments. I should also note that what Kwak claims is a "terrible example" of when a firm would need to use a bespoke derivative is, in reality, a very good example. The example was a firm that needs to hedge a credit exposure in an odd amount of money, and Kwak says that's a terrible example because the firm would be "perfectly fine" with only being able to buy CDS in multiples of $10,000. Spoken like someone who hasn't managed money a day in his life. (I actually laughed out lout when I read that part.) I don't know a single corporate treasurer or portfolio manager who would be "perfectly fine" with that. Hedging in odd amounts of money is a very common—and perfectly legitimate—use of bespoke derivatives.

Amherst Holdings, if you'll remember, is the Texas brokerage that duped the big Wall Street banks by (somehow) arranging for the servicer on several subprime MBS to exercise its "cleanup call" provisions, much to the banks' surprise. Exercising the cleanup calls essentially made the CDS contracts on the subprime MBS that the banks had bought from Amherst worthless. Amherst has been poaching talent from Wall Street recently, and its most prominent hire was probably Laurie Goodman, the former UBS fixed income analyst and well-known mortgage securitization expert. As it happens, Goodman is also the co-author of Subprime Mortgage Credit Derivatives, one of the ubiquitous Wiley Finance reference books. Ironically, a footnote on page 222 says:

Modeling the call is an interesting topic, as [cleanup] calls have historically not been exercised in an economically “ruthless” manner.
Until now. Maybe Goodman just wanted a data point for her model. In fact, until proven otherwise, I'm going to assume that was the real reason Amherst put on the trades. Goodman wanted a slightly more robust model. Models strike again!

Wednesday, June 24, 2009

AIG Internal Memo on Collateral Calls

CBS News somehow obtained a fascinating AIG internal memo from November 2007 detailing the status of the collateral calls on AIG's CDS portfolio. The memo was evidently written by AIG Financial Products VP Andrew Forster, and it provides tremendous data on AIG's CDS portfolio—it's easily the most and best data in the public domain. CBS also obtained an email from then-AIGFP chief Joseph Cassano to another AIG exec describing Forster's memo, but the only new piece of information in the email is that Cassano struggles with punctuation. The memo breaks down AIG's entire CDO CDS portfolio by counterparty, includes all the deal names, and most interestingly, shows how each dealer was pricing each deal. As the protection seller, AIG generally had to post collateral based on the value of the reference CDO bonds. As the price of the reference CDOs fell, AIG generally had to post additional collateral to compensate for the price decline. That's all well and good if you can accurately price the CDOs, but the CDO market was more or less completely illiquid by November 2007, so there were no reliable market prices available. Pricing methods were therefore highly subjective (and unreliable), and dealer quotes were all over the map. The memo stresses this point:

The market is so illiquid that there are no willing takers of risk currently so valuations are simply best guesses and there is no two way market in any sense of the term. ... There is no one dealer with more knowledge than the others or with a better deal flow of trades and all admit to "guesstimating" prices.
To simplify greatly, the lower a dealer was pricing the reference CDOs, the more collateral it could demand from AIG. (And just in case you're confused by the terminology in the memo, a "CSA" is a Credit Support Annex, which is an annex to the ISDA Master Agreement, and governs collateral calls in CDS transactions.) So how were the various dealers pricing the reference CDO bonds in November 2007? Not surprisingly, Goldman seems to have been pricing the reference CDOs in its trades more aggressively than the other dealers. [Add: I should also note that another way to put it is that Goldman was pricing the reference CDOs more "realistically" than the other dealers.] For example, the memo notes on page 7 that Goldman was pricing a deal called Independence V at 67.5 for purposes of collateral calls, whereas Merrill was pricing Independence V at 90. More broadly, Goldman's average price for its reference CDOs was 74; Merrill's average price was 83. The memo also notes that SocGen and Calyon both relied heavily on Goldman for pricing, which would explain why this Bloomberg article from Monday essentially accused Goldman and SocGen of killing AIG. What's also interesting (though not at all surprising I suppose) is how willing AIG was to play fast and loose with collateral thresholds. Thresholds are the amount by which the reference CDO has to decline in value before the protection seller is required to start posting collateral to compensate for price declines. A 10% threshold to the CSA means that the protection seller wouldn't be required to start posting collateral until the value of the reference CDO fell below 90%. Given that AIG sold around $400bn of CDS protection (on net), you'd think that AIG would have insisted on high thresholds so that it wouldn't be exposed to mark-to-market risk on hundreds of billions worth of structured products at once. But no. According to the internal memo, several of AIG's CDS contracts (with multiple dealers) included no threshold to the CSA at all. The majority of its CDS contracts with Goldman, which was its biggest counterparty, had thresholds of only 4%. I guess I shouldn't be surprised anymore when I learn that AIGFP did something that stupid/reckless. But I still am.

Floyd Norris praises the SEC for hiring University of Texas law professor Henry Hu. Norris likes this hire because Hu "was the first one [he] saw to point out that credit [default] swaps could be used to leave a creditor hoping that a company would go into bankruptcy." I sincerely hope that's not true (seeing as Norris is the NYT's chief financial correspondent), but I'm afraid it probably is. Apparently this is Hu's reputation—Felix Salmon calls him "the intellectual father of the CDS-help-cause-bankruptcies meme." Another academic who's evidently viewed as being prescient on the issue of CDS and restructurings is Stephen Lubben, who blogs at Credit Slips. Lubben has even referred to himself as "the professor that cried CDS."

This is highly amusing because Professors Hu and Lubben each observed for the first time that CDS could make creditors less willing to agree to out-of-court restructurings in the summer of 2007, which was at least 5 years after the first time CDS actually did have this effect on a major restructuring. How either one of these professors can be considered "prescient" on this issue is beyond me. Academia truly is its own little world.

People (and professors, apparently) seem to forget that CDS were around in the 2001 recession too. Clearly the blogosphere—as well as the NYT's chief financial correspondent—could benefit from a quick history lesson, so here goes.

Off the top of my head, the first major restructuring that I can remember being significantly hindered by CDS was Marconi, and that was back in 2001-2002. Marconi was negotiating a restructuring with a bank syndicate, but for a long time certain syndicate participants (cough, UBS, cough cough) refused to agree to any restructuring that didn't constitute a "credit event" under the 1999 ISDA Credit Derivatives Definitions. The holdout banks had purchased CDS on Marconi to hedge their exposure, and if they were going to agree to a pretty drastic restructuring, they wanted to make sure they got the benefit of their hedges. After more than a year of restructuring negotiations, the banks agreed to a debt-for-equity swap that qualified as a credit event under most of the CDS contracts, but also pretty much wiped out shareholders.

Mirant Corp.'s 2003 bankruptcy was also largely a result of CDS. Several creditors had purchased CDS protection on Mirant, and one major creditor in particular, which rhymes with Pitigroup, was relatively open about the fact that it didn't agree to a restructuring because it needed a bankruptcy filing to trigger its CDS contracts referencing Mirant. The bank that rhymes with Pitigroup's refusal to agree to a restructuring (which came at the last minute and was a big surprise, if I remember correctly) effectively torpedoed any chance Mirant had of avoiding bankruptcy.

The Marconi and Mirant restructurings weren't minor events by any means, and they also weren't the only restructurings hindered by CDS (just the first two that popped into my head). The trade press was littered with articles in 2003-2004 about how CDS were hindering restructurings.

The FT ran an article in 2004—almost 3 years before Professors Hu and Lubben began theorizing about CDS and restructurings—under the headline, Restructuring at risk from CDSs. The article read:

The rapidly expanding market for credit derivatives threatens to make it more difficult and more costly to rescue companies that get into trouble, restructuring specialists have warned.

This is because credit default swaps (CDSs), the most popular credit derivative, detach risk exposure from ownership and bring new and frequently inexperienced participants to the negotiating table.

"They are raising problems because of the way they divide ownership from risk of loss," said Richard Nevins, a restructuring specialist at Jefferies, an investment bank. "They produce perverse incentives for creditors to frustrate a successful restructuring because they get more from failure."
Coming out of the 2001 recessionary cycle, an industry group made up of bankers and lawyers (INSOL) conducted a lengthy study on the impact of credit derivatives on restructuring and bankruptcy. The result was a 65-page report, published in 2006, called Credit Derivatives in Restructurings: A Guidance Booklet. The purpose of the report was described in the executive summary:
Some concerns have been expressed that the presence of credit derivatives will make restructurings more difficult, and there have been reports that problems have already arisen from time to time, but it has not been established how often they have arisen.
...
The purpose of this booklet is to raise awareness of the potential impact of credit derivatives – in particular credit default swaps – on restructurings (including possible changes in behavioural dynamics resulting from positions in credit derivatives of participants around the restructuring table) and to provide a point of reference for those involved in restructurings facing situations where participants may hold such a position.
The INSOL report, which was well over a year in the making, was still published a year before Professors Hu and Lubben first observed that CDS could possibly change the incentives of creditors in restructuring negotiations.

Given that history, it's fair to say that I'm less excited than Floyd Norris about the SEC's decision to hire Professor Hu. If the SEC wants real experts on staff, it should start trying to attract experienced market practitioners. Pure academics are much cheaper, of course, but pretty much everyone in the financial industry agrees that for the SEC to be an effective regulator, it has to start competing for talent.

UPDATE: An anonymous commenter points out that The Economist ran an article on the Marconi workout, and the broader effect that credit derivatives were having on restructuring, way back in 2003. Some highlights from the article:
Marconi's case is a good example of the growing complexity of corporate workouts. No longer is it only company executives and their bankers that sit round a table rescheduling loans. Others also have seats, including investors who bought loans and bonds at a discount, and those who have bought credit-default swaps—insurance against a company's going bust.

The old, straightforward clash between a company and its creditors has been replaced by a mish-mash of interests. ... The holder of a credit default swap might prefer the company to go into bankruptcy. More complicated still, some around the table may be trading in and out of their positions each day, with their motives changing accordingly.
...
Those leading the restructuring could only speculate about the motives of some people at the table. There was great uncertainty over whether credit-default swaps had been triggered (in fact, they never were) [ed: actually, yes, they were]. Some banks seemed keen for Marconi to die, which suggested that they had credit insurance.
The article also casually makes reference to CDS affecting another workout at the time, which just underscores how much this issue was common knowledge even back in 2003:
Meanwhile, workouts are getting no easier. Only this week a Swiss company was taken to the brink of bankruptcy by maverick bank behaviour: credit derivatives were the suspected cause.
Remember, this article was published over 4 years before Hu and Lubben first started their "pioneering" work theorizing about CDS and restructuring/bankruptcy.

Tuesday, June 23, 2009

Two-Year Auction

This morning Bloomberg was reporting that today's $40bn auction of 2YR Treasury notes was expected to go well, and they weren't lying. The auction drew a yield of 1.15 percent (5 bps lower than the consensus estimate), and 2YR yields closed at 1.10 percent. Demand was also very strong—3.19 bid-to-cover—and that's probably the most important takeaway, given the scary weak demand at recent 10YR and (especially) 30YR auctions. Foreign central banks were big buyers today. A good start to this week's record $104bn in Treasury note auctions.

Sorry for the lack of posting over the past couple of weeks. I've been insanely, mind-bogglingly busy recently. But things are starting to let up, so I plan to resume posting forthwith.

Thursday, June 11, 2009

The Amherst Trade

The WSJ article about Texas brokerage Amherst Holdings duping the big Wall Street banks is a hot topic today. Based solely on the WSJ article, it appears that Amherst sold CDS on $335 million of subprime MBS to various Wall Street banks over the past year, including J.P. Morgan, RBS, and BofA. The mortgage-backed securities were about as toxic as they come (California, vintage 2005—so you know it's good):

Following a wave of refinancing and defaults, only $29 million of the loans were left outstanding by March 2009, half of which were delinquent or in default. ... The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months.
In April, the servicer, Aurora Loan Services, surprised the banks by exercising its "cleanup call" provisions "at the behest of Amherst." Cleanup calls give a specified party (in this case, the servicer) the right to purchase all the remaining mortgages when the remaining pool balance falls below 10% of the original balance. When Aurora exercised its cleanup calls, it apparently made the noteholders whole, which made the banks' CDS worthless. The banks are crying foul, and most people aren't inclined to feel sorry for them. However, it's possible that the banks have a valid complaint. It's impossible to say who's right without seeing any of the documents, so take this post with a grain of salt. I should note that it's possible that the banks' objections are based on the specific terms of the cleanup calls. For example, some cleanup call provisions prohibit the servicer from exercising the call unless the aggregate fair market value of the mortgage loans exceeds the stated principal balance of the mortgage loans. If that restriction were in place, then the banks would have every right to complain (more on this later). I suspect the main issue is the arrangement between Aurora and Amherst. The Journal says that Aurora exercised the cleanup calls "at the behest of Amherst," and the key is what that means. Amherst refused to comment on its arrangement with Aurora, but "it doesn't deny that it took this approach" (whatever that means). I'm guessing the banks were so shocked because it made no sense for Aurora to exercise the cleanup calls. It received a deeply discounted pool of subprime mortgages, half of which were deliquent or in default. And yet it made noteholders whole? Something doesn't add up. The banks' traders are apparently puzzled too:
Since the mortgage securities were valued at just $3 million or so in the market, well below the $27 million they were redeemed for, traders believe Amherst entered into an uneconomic transaction to profit from its swap positions.
The simplest explanation is that Amherst made up the difference, essentially paying Aurora to exercise its cleanup calls. If true, then Amherst was just artificially propping up the value of securities on which it sold CDS protection in order to prevent the protection buyers from collecting payouts. That could raise potential market manipulation issues. Moreover, if Amherst had already arranged for Aurora to exercise its cleanup calls before selling CDS on the mortgage-backed securities, then the banks might also have valid legal complaints (duty of good faith?). Of course, this is pure speculation on my part. It's very possible that the banks have no legal argument, and are just whining about getting their asses handed to them by a Texas brokerage. Amherst may not be the biggest brokerage around, but they have some serious financial talent, including former UBS managing director (and well-known securitization analyst) Laurie Goodman. All I'm saying is that based on the limited information in the WSJ article, Amherst's trade seems a little sketchy, and the banks may have a valid complaint.

It appears settled that the Obama administration's overhaul of financial regulations will not include a CFTC-SEC merger. This is disappointing, especially because the administration is apparently foregoing this no-brainer reform just to avoid the inevitable turf wars in Congress. My disappointment aside, the fact that the SEC and the CFTC will both continue to exist as independent agencies probably means that we're headed for a new Shad-Johnson Accord, this time for OTC derivatives. This requires a bit of explanation. The SEC and the CFTC share jurisdiction over the derivatives markets—or, more accurately, they split jurisdiction over the derivatives markets. The relationship between the two agencies has been awkward at best, and frequently openly hostile. Prior to 1981, it was unclear which agency had jurisdiction over which derivatives markets (less clear than usual, that is), and both agencies claimed as much authority as possible. In 1981, however, then-SEC chairman John Shad and then-CFTC chairman Phil Johnson finally sat down and hammered out an agreement clarifying each agency's jurisdiction, which became known as the Shad-Johnson Accord. Under the Shad-Johnson Accord, the CFTC was given jurisdiction over all futures (which included futures on stock indexes), options on futures and commodities, and certain futures and options on futures on stock indexes. Shad-Johnson gave the SEC jurisdiction over options on individual securities, options on certain indexes of securities, and exchange-traded options on foreign currency. (I'm ignoring some issues in Shad-Johnson, such as the Treasury Amendment and the question of OTC options on foreign currencies, the SEC's veto authority over stock index futures, and the prohibition on single-stock futures. Trust me, you don't want to go there.) You get the picture. Welcome to U.S. financial regulation. Now that the Obama administration has decided to bring OTC derivatives into the regulatory fold, they have to decide how to allocate regulatory authority over OTC derivatives. In theory, the administration could give exclusive jurisdiction over OTC derivatives to one agency or the other. That option obviously has the benefit of simplicity. However, early indications are that the administration is going to split jurisdiction over OTC derivatives, in effect creating Shad-Johnson 2. A recent article in the NYT reported that Shad-Johnson 2 is already being formulated:

[O]fficials said this week that Mr. Gensler [the CFTC chair] and Mary L. Schapiro, his counterpart at the S.E.C., had reached an informal understanding that would enable their respective agencies to share authority over the derivatives market.
However, the way Gensler worded his testimony last week suggests to me that the CFTC isn't wild about sharing jurisdiction over OTC derivatives with the SEC. Gensler stated:
The term "OTC derivative" should be defined, and the CFTC should be given clear authority over all such instruments. To the extent that specific types of OTC derivatives might best be regulated by other regulatory agencies, care must be taken to avoid unnecessary duplication and overlap.
Gensler's not-so-subtle attempt to give the CFTC default jurisdiction over all OTC derivatives suggests that Shad-Johnson 2 is far from finalized. It'll be interesting to see how this plays out. Well, interesting to me, at least.

Wednesday, June 10, 2009

On Judge Sotomayor

I don't plan to discuss Judge Sotomayor's nomination on a regular basis—debates over Supreme Court nominees are purely political, and have absolutely nothing to do with jurisprudence. I don't think it's possible to accurately predict what kind of Supreme Court justice a federal judge will be based on her record as a circuit and district judge. That said, I hope Judge Sotomayor is confirmed. She has always struck me as careful and willing to embrace complexity, which are two attributes I value very highly in judges. Plus, I'm excited about being able to say that I appeared before a Supreme Court justice twice back when she was a federal district judge.

Saturday, June 6, 2009

Memories

Remember when the stress tests had been "downgraded to irrelevance," and the PPIP was the only aspect of the Geithner plan that really mattered? Whoops. Turns out the stress tests were rather important, spurring the major banks to raise $65 billion in new capital in less than a month, with more capital raises on the way. And the PPIP? Well, the Legacy Securities Program is still on track to start purchases in July. But the PPIP's other half—the Legacy Loans Program—has already been downgraded to extinction. Ah, memories.

Sheila Bair has publicly opposed the creation of a single systemic risk regulator, and has instead been pushing for a "systemic risk council" that would include the Treasury, the Fed, the SEC, and (surprise!) the FDIC. This is a bad idea. The primary benefit of a single systemic risk regulator is its ability to see how the different areas of the financial markets interact with each other. The financial regulatory structure in the U.S. is famously balkanized, with the SEC, CFTC, OCC, OTS, FDIC, and the Fed each focusing on its own little slice of the financial markets. The regulators don't necessarily have the ability to see how developments in one area of the financial markets affect another, separately regulated, area of the financial markets. And even if they do see how developments in their sphere are affecting (or being affected by) other areas of the financial markets, the only thing regulators care about is making sure the losses fall outside their own sphere. For instance, when a thrift that's owned by a large financial holding company is holding risky assets, OTS often forces management at the holding company to shift the assets from the thrift's books to the parents'. Problem solved! A "systemic risk council" would do a poor job of monitoring risks across different areas of the financial markets. Each regulator would come to the council's meetings and, like always, report that his agency's area of the market is just fine (whether it's true or not, as no regulator will admit that his agency has been doing a poor job of supervising its area). Then they'd all congratulate each other on doing such a damn fine job. Meeting adjourned. Also, it's important to note that we've already tried Bair's approach to some extent. After Black Monday in 1987, we created the President's Working Group on Financial Markets (PWG), a committee of financial market regulators that broadly deals with systemic risks. You can see how well that's worked out. To take my favorite example, the PWG started working on a report on market instability after the two Bear Stearns hedge funds collapsed in August 2007, which was the opening salvo of the credit crisis. The PWG finally released its report on March 13, 2008, which was the day that Bear Stearns officially collapsed, and one the most frightening days of the entire financial crisis. (Incidentally, the FDIC isn't a member of the PWG. The group includes the Treasury, the Fed, the SEC, and the CFTC, and has informally included the OCC and the New York Fed during the current financial crisis. Conveniently, Bair's systemic risk council would finally place the FDIC at the adults' table, and would relegate the CFTC and the OCC to the kids' table.)

New CFTC chair Gary Gensler provided a much more detailed description of the administration's OTC derivatives reform proposal on Thursday. While we still don't have nearly enough information to render judgment on the proposal, let me just say that I'm extremely impressed so far. The administration—by which I primarily mean Tim Geithner and Gensler—seems to be striking exactly the right balance. While they could still go off the rails on any number of unresolved issues, you get the sense that they understand the derivatives markets too well to make any calamitous mistakes. Obviously, a description of a new regulatory regime for OTC derivatives that's only 9 pages long is going to generate a lot of questions from the law firms. (I have a treatise on derivatives law and regulation that's over 2,000 pages long, so it's fair to say that Gensler's description leaves some things out.) On a first read, the one question that jumps out at me as the most important is how the CFTC plans to use the authority to impose initial margin requirements on off-exchange customized derivatives. Are they planning on reviewing every customized derivative prior to settlement to determine whether initial margin requirements are needed? In other words, will dealers be required to get a green light from the CFTC on initial margins before they can settle a customized trade? I highly doubt this is what the CFTC has in mind at this point, but when you consider the scheme the proposal sets up to make sure that derivatives that aren't cleared by a clearinghouse are truly "customized," things get a bit murkier. Presumably, off-clearinghouse derivatives can only be duplicated so many times before the CFTC deems them to be "standardized" and requires them to be traded through a clearinghouse. But if that's the case, then there would only be very limited circumstances in which the CFTC would ever impose initial margin requirements on a customized derivative—that is, unless they're planning on reviewing every customized derivative prior to settlement. Of course, that would likely be incredibly cumbersome, and could easily kill the bespoke market. Anyway, that's the question that really jumped off the page at me. Aren't you glad you don't do this for a living?

Thursday, June 4, 2009

Yes, the SEC Regulates Derivatives

Felix Salmon apparently thinks the SEC is "charged with regulating securities but not derivatives." Ezra Klein is quick to offer a me-too post, mocking the SEC for saying "derivatives" when it should have said "securities." Klein says that "[i]t's all the worse because the SEC doesn't have the authority to regulate derivatives, even though that appears to be what some of its employees think the agency is doing." Oy. The SEC does, in fact, have the authority to regulate derivatives. It regulates options (e.g., calls, puts, straddles) on individual securities, options on certain indexes of securities, such as the S&P 100, and exchange-traded options on foreign currency. Options are unquestionably derivatives. What Salmon and Klein probably meant was that the SEC doesn't have the authority to regulate swaps. But swaps aren't the only kinds of derivatives by any means. Confusing swaps and derivatives is what leads idiot journalists* to constantly mislabel derivatives as "unregulated financial instruments." (If journalists think derivatives are all unregulated, then I'm curious what they think the Commodity Futures Trading Commission does?) * UPDATE: Felix Salmon has the grace to issue a mea culpa. Also, the last paragraph of my post is very poorly worded, so just to clarify, I didn't mean that Salmon and Ezra Klein are "idiot journalists." I've praised Salmon before, even suggesting that the New York Times immediately hire him as their financial reporter (after firing Gretchen Morgenson, of course, if only to post-humously vindicate Tanta). I'm sure he understands that not all derivatives are swaps, and that the entire purpose of the CFTC is to regulate certain types of derivatives. The "idiot journalists" I was referring to are the ones who wouldn't know a derivative from a dermatologist, but nevertheless describe derivatives as "unregulated financial instruments" in article after article. As you can probably imagine, that's frustrating for someone like me.

Wednesday, June 3, 2009

Elizabeth Warren and Securitization

Speaking of takedowns, don't miss ABS and MBS veteran Linda Lowell's long takedown of COP chair Elizabeth Warren over at HousingWire. Short version: Warren doesn't know the first thing about securitization markets, and it shows.

I started writing a post the other day about how Niall Ferguson was just embarrassing himself by claiming victory in his dispute with Paul Krugman, but I never got around to finishing it. Luckily, Martin Wolf was not so easily distracted, and has delivered an epic takedown of Ferguson. In short, Ferguson claimed that monetary and fiscal expansion were "contradictory," because "if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up." Krugman correctly pointed out that this was a ridiculous claim. Ferguson, being perhaps the most egotistical commentator in the world, subsequently declared that the recent rise in 10YR Treasury yields had "settled" the dispute in his favor, and wrote an entire op-ed in the FT congratulating himself. As Wolf notes, while 10YR Treasury yields have risen recently, they're still well below their long-run average:

Over to Wolf:

So what is the disagreement? Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance; second, huge fiscal deficits are both unnecessary and counterproductive; and, finally, there is reason to fear an inflationary outcome. These are widely held views. Are they right? The first point is, on the evidence, wrong. The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets. At the end of December 2008, US 10-year Treasury yields fell to the frighteningly low level of 2.1 per cent from close to 4 per cent in October (see chart). Partly as a result of this fall and partly because of a surprising rise in the yield on inflation-protected bonds (Tips), implied expected inflation reached a low of close to zero. The deflation scare had become all too real. What has happened is a sudden return to normality: after some turmoil, the yield on conventional US government bonds closed at 3.5 per cent last week, while the yield on Tips fell to 1.9 per cent. So expected inflation went to a level in keeping with Federal Reserve objectives, at close to 1.6 per cent. Much the same has happened in the UK, with a rise in expected inflation from a low of 1.3 per cent in March to 2.3 per cent. Fear of deflationary meltdown has gone. Hurrah! ... If inflation expectations are not worth worrying about, so far, what about the other concern caused by huge bond issuance: crowding out of private borrowers? This would show itself in rising real interest rates. Again, the evidence is overwhelmingly to the contrary.

The most recent yield on Tips is below 2 per cent, while that on UK index-linked securities is close to 1 per cent. Meanwhile, as confidence has grown, spreads between corporate bonds and Treasuries have fallen (see chart). One can also use estimates of expected inflation derived from government bonds to estimate real rates of interest on corporate bonds. These have also fallen sharply (see chart). While riskier bonds are yielding more than they were two years ago, they are yielding far less than in late 2008. This, too, is very good news indeed.

Back in September 2005, Tim Geithner summoned the so-called Fourteen Families (i.e., the fourteen major dealer banks) to the New York Fed to discuss the horrendous state of the infrastructure in the credit derivatives market. In particular, Geithner was concerned about the enormous backlog of unexecuted confirmations—essentially, backlogs of CDS trades that banks hadn't gotten around to formally completing yet. In a crisis, the legal risks posed by huge backlogs of unexecuted confirmations would create a considerable amount of uncertainty, which could potentially cause the CDS market to freeze up, further exacerbating the crisis. Geithner worked tirelessly to improve the infrastructure in the CDS market, and to bring down the backlogs of unexecuted confirmations. How successful was he? Very:

Unexecuted confirmations in dealer portfolios aged more than 30 days have dropped from 97,650 outstanding in September, 2005, to 2,479 in March, 2009. Over the same time period, total monthly trade volume has increased from 130,004 to 408,472.
And did the CDS market freeze up in the aftermath of Lehman's failure? No. In fact, according to Fitch's CDS Market Liquidity Index, September 19th—the Friday of Lehman Week—was the most liquid day in the CDS market since the index started in March 2006.

I read an inhuman number of books (partly due to the amount of time I spend on planes and in airports), and one of the things I like to do is to informally keep track of the most (and least) timely and/or prescient books I come across. For the dot-com bubble, for example, one of the most timely/prescient books was Bob Shiller's Irrational Exuberance (published in March 2000), and the least timely/prescient book was, obviously, Kevin Hassett and James Glassman's Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market (published in October 1999). For the current financial crisis, here are the most timely and/or prescient books I've come across so far:

Too Big to Fail: The Hazards of Bank Bailouts, by Gary Stern and Ron Feldman (March 2004)
House Prices and the Macroeconomy: Implications for Banking and Price Stability, by Charles Goodhart and Boris Hofmann (March 2007)
Systemic Financial Crises: Resolving Large Bank Insolvencies, edited by Douglas Evanoff & George Kaufman (June 2005)
Fragile Finance: Debt, Speculation and Crisis in the Age of Global Credit, by Anastasia Nesvetailova (December 2007)
And here are the least timely and/or prescient books I've come across:
Why the Real Estate Boom Will Not Bust—And How You Can Profit from It, by David Lereah (February 2006)
The Complete Guide to Flipping Properties, 2nd Edition, by Steve Berges (January 2008)
This one is a little too early, but the title is just too good to leave off the list: Real Estate Riches: How to Become Rich Using Your Banker's Money, by Dolf de Roos (October 2001)
The David Lereah book in particular is pure comedic gold. I'm sure there are lots more books in the "least timely and/or prescient" category, but I generally don't browse the Personal Finance/Self-Help books (which is where the really crazy books are usually located), so I haven't come across them. I'm more interested in books that are incredibly timely and/or prescient anyway, because there will always be yahoos writing ridiculous get-rich-quick books, but it's much harder to accurately anticipate events.