Wednesday 31 March 2010

The Tortoise and the Hare

I recently read an article by Mr Roubini (whose name always carries the editorial comment "who predicted the financial crisis) comparing India with China and what the Indian will have to do to catch up with China.

In the article Mr Roubini compares China to the hare, and India to the tortoise. Funny, we all know who won that race so why is he advocating a massive need for financial and human capital for India to run faster.

The Achilles Heel in both countries, if not all countries, is the spectre of social instability. In China the government has effected an almost total capture of household and business savings. Essentially all deposits go to state-run banks which then lend to state-linked firms at below-market rates. It's not really surprising that China has achieved an amazing growth rate:it has an almost unlimited supply of 0 percent loans, which it lends relatively consequence-free to companies that employ the very people from whom the loans come.

Sounds good, like a perpetual motion machine. Well if that's the case, then someone should explain to me why, according to China's own official statistics, that more than 600 million urban citizens live on an average of around $7 a day, and another 700 million rural peasants live on an average of $2 a day, and yet China has one of the highest number of millionaires, not to mention billionaires in the world.

Oh, and as an aside, the same statistics source cites a total population of 1.3 billion, so I guess the wealthy aren't included in the numbers?

Now, back to social instability. China is an export nation, and in the fashion of Japan and the nations of Southeast Asia they have built their exports predicated on restricted capital markets which means that China is managing capital to keep costs artificially low. This creates a system of bulk, maximum employment and a focus on market share as opposed to focusing on a rational return on investment.

It works, but only so far. If you are going to focus on exports-China's consumer sector is about the same size as France's 60 odd million consumers-then you need buyers. The US was the buyer of choice. Since the financial crisis the US's imports from China are down about a fifth.

The Chinese haven't stopped producing, yet. To do so would create massive unrest. But if you produce goods that no one buys, you end up with waste. This also means that a lot of loans made to state-linked enterprises are probably not good loans. And last year China made loans equal to about one third of their GDP. Waste and bad loans? Sounds dicey.

Now remember one last bit of the puzzle. One of the reasons the Chinese could export so much to the US is that since 2000 they have Most Favored Nation status. Right now the fact that China is one of the largest buyers of US Treasuries-and the US has a lot to sell-makes it unlikely that this would be revoked. Indeed, last week the Deputy Secretary of State James Steinberg told reporters in Washington that the US reaffirmed it does not support independence for Taiwan and restated its policy that Tibet is part of China. All this after a series of dismal treasury auctions. Next week is another auction. If that goes poorly...

Now back to India. Why is it that Mr Roubini is advocating that India emulate China?

I have no idea.

Tuesday 30 March 2010

Sarah Palin and US Treasuries trading Swaps PLUS?

The other day I was confronted with two disturbing situations. I don't necessarily believe they are related, but I did observe them on the same day which may or may not be a coincidence.

First of all, there was John McCain on the stump for his Senate seat welcoming the Sarah Palin in support of his campaign. Now this is the same Sarah Palin who singlehandly lost him the presidential election and from whom he distanced himself during and after the campaign. Now he is praising her as a great American who(m) he was proud to have bolstering his campaign? I mean damn, what on earth was he thinking? He is adding gravitas to a hockey mom who has her sights on the presidency! Does he really want Sarah "I can see Russia from my house" Palin to be one of the most powerful people in the world?!

The second observation was less eye-catching and certainly less likely to stir as much emotion as Ms Palin, but it is equally disturbing. For the first time in over 30years US Treasuries are trading cheap to swaps.

OK, generally speaking swap spreads represent the relative credit of a group of banks that pool together and every day at 11:00 GMT post LIBOR. Again, under normal conditions banks are viewed as a higher credit risk than the "risk free" rate represented by the government. So government debt under normal circumstances as a function of their yield and swap spreads trade at Swaps minus a spread. Last Friday they traded at Swaps PLUS a spread. This is perverse.

The US (and UK)Government have underwritten the banks and transferred large chunks of toxic assets to the tax payers. The result of this is that ASW spreads have imploded. By socialising the losses of banks by insuring them the stress has been transferred to the governments who are forced to issue unprecedented quantities of bonds to finance the underwriting of banks. So now the government as insurer of the banks thereby "saving" the financial system has become a credit risk itself!

Now, as I mentioned these two situations were first observed (by me) on the same day. My question is are Treasuries trading Swaps plus because of concerns about issuance, or are they trading Swaps plus reflecting the fear that any nation that could seriously consider Sarah Palin as presidential quality is doomed to failure?

Sunday 28 March 2010

The Dismal Science

There are any number of discussions currently analysing economics or "the dismal science" as it is commonly referred to all in an attempt to try and explain why all the economists in the world got it wrong and missed the great crisis of '08-'09.

Now two things jump out at me on this account. The first is that not every economist missed it. Some like Dr Doom had been calling for catastrophe for the last decade. (Brings to mind the joke that economists got five out of the last two recessions right.) The second is that the crisis began in 2007, and the houses that made the most money up to 2008 were fully aware what was going on-it just never occurred to them that the fire they were playing with could get out of hand.

Take the "seminar" held in April '07 by a major international bank for its' hedge fund and proprietary trading clients. They spoke openly of their concerns surrounding the sub prime mortgage market and that they were actively building up a portfolio hedging their exposure to the mortgage market.

This was a meeting by traders for traders. The "real money" investor accounts of the bank were not invited. The host bank was however marketing mortgage CDO's to those "real money" investors-in fact one could go so far as to say that the investors were actually supplying the hedge for which the CDO traders were seeking.

In the summer of '07, a French firm packed with French mathematicians-its' Fixed Income Department had over 100 quants cranking out models for everything-suddenly announced that it could not value three of its' funds properly and so froze them.

I was always amused by this proclamation. It was almost as funny as the claim by another major French bank that the mass of models and risk management systems built by their French mathematicians-and theirs were the best- Polytechnique but of course-couldn't catch a rogue trader.

But I digress. I would suggest that it wasn't that they couldn't value the funds, but rather that they wouldn't. There was always an argument in the Street between the mark-to-market, and the mark-to-model. The difference often representing P&L. In this case the model and the market were both clearly suggesting that the value was ugly. To admit that would open up a can of worms. Their solution was to freeze the funds because they couldn't value them.

I believe this was the trigger which set the whole crisis in motion. I also believe that there were many-and I mean many bankers who were intelligent enough to understand what was happening. These were people involved in Derivative Sales, Trading and Structuring/Origination.

They had been playing with fire for over a decade and every time it got a little too hot at one house another one would jump into the fray and so the blow-ups were relatively small and self-contained. Ironically, many of those banks that would not get involved on the origination and distribution of these products were historically not comfortable with the concept of risk in their Sales and Trading Operations, but their Bank Treasuries came to be some of the largest buyers of these constructions.

No one seriously enters into banking without the hope/intent to make a lot of money. Financial Firms provide the opportunity to get rich-they are not charity organisations,are not for the faint hearted and the moral compass seldom points to money.

Firms were supposed to be structured such that Risk Management, Trading Management, Sales Management and Senior Management knew the risks they were running, and the profits they were generating. They were all expected to manage and understand this balance. Part of the problem however was that except for Risk they all had budgets, and even Risk was dependent upon those budgets to get paid. It was really in no one's interest to speak up and block what looked to be an extremely profitable proposition.

But back to the dismal science. Economists have always tried to get their subject into the hard sciences. They created first an extremely rational human nature that presumed the existence of a utility maximising automaton. This created one set of maxims generally under the rubric "rational and efficient" markets.

Then they got caught up in the fact that humans might not be totally rational. This created a new set of maxims such as "Random Walk" and "Chaos Theory".

They continued to develop and with the onslaught of math and physics brought the power of super-computers to crunch out statistics which would somehow divine the future path of economics/markets.

Now I understand that there is a movement to take some of the "hard" science out of economics and put it more into the realm of humanism.

This might be a good start- but I am concerned they will always want to start with the premise that there is an "ideal" circumstance. There is, but it is not the one they are imagining.

What they need to recognise is that the financial markets are actually run by a relatively small oligopoly. They are in a unique position to extract huge value from an activity that is intentionally opaque. Everyone clamors for transparency, but the combination of power and money makes it very difficult to effectively enforce.

The way to break it is to go after the money. That means regulation. I wouldn't bet on it.

Friday 26 March 2010

Mutti Merkel

After having bashed Frau Merkel for jumping on the anti-CDS Bandwagon I have to tip my hat to her for having crafted an extremely clever response to the Greece problem.

In one fell swoop she has given notice to Greece and any other "Euro" nation which is in financial difficulty: If you are in trouble you must first trudge on with painful austerity measures and only if you are unable to finance yourself in the international market will any support be forthcoming. Germans will no longer "pay" unconditionally and the IMF's role is kept to a minimum, but is still held in abeyance....

Perhaps another step to a federal Europe.

Wednesday 24 March 2010

A Poor Workman blames his Tools

In following the debate around financial regulation it appears to me that there are two main hurdles to overcome which will occupy center stage without really dealing with the root of the problem.

The first obstacle is the Free-Marketeers. They profess an adherence to an Adam Smith that most of them have never read compounded by their allegiance to Milton Friedman which is used to support an agenda of greed bridled only by the occasional bout of fear that is forever lurking in the marketplace. For these people there is no debate about regulation-they would remove all regulation, everywhere, if given the chance.

They realise that the world of no regulation only exists in an extreme state when political, social and economic upheaval occurs such as in Chile after Allende, Russia after Glasnost, and perhaps Iraq after the Second Iraq War, so in all other instances their response is to clamor for self-regulation.

I am somewhat dumbfounded at this blatant ploy of self-serving self-righteousness. Watch any sport and imagine there were no referees or umpires. Every player knows the rules, and yet even in the presence of officials they continually break the rules-aka fouling-and yet I have yet to hear of anyone suggesting that a game of football should be played without a referee.

Why should we expect the players in the world of finance to act differently?

The second obstacle is the pursuit of the perfect system of regulation- as if there were one. Searching for a Fail-Safe System implies absolutes. I would maintain that outside of death and taxes there are no absolutes-and I am sure there are any number of arguments that would debate even this.

But look at the debate on financial regulation. At its' most basic level and yet apparently of the gravest importance is the question as to what structure should the regulator have. Should there be separate regulators that specialise in various sectors? Should there be a single agency which integrates all of the sectors? Should there be one agency for safety and soundness and another for business conduct and consumer protection? Should there be an institutional approach which separates banks, broker-dealers, insurance companies etc. and places them under their own regulator? How do we manage states versus federal jurisdictions, or national versus international or even multinational?
And of course, should there be a hybrid system which takes the best from all?

I don't know that there is any one right structure. I do know that the current system allows institutions to shop around to find the regulator that best suits their needs. This might be deemed to be clever by the perpetrators. I also know that the institution and the individuals responsible at such institutions should indeed be viewed as perpetrators and be held to account and that does not mean merely a slap on the wrist.

I believe the single biggest failure of the current regulatory system is that it is very difficult to separate the gamekeepers from the poachers. Everybody has an angle, and their motto seems to be: "Separate the Fools from their Money".

Tuesday 23 March 2010

Simple Right and Wrong

Last night while watching the news my medical student daughter turned to me and said that her biggest disappointment has been to realise that her image of adults as mature, intelligent beings is shattered almost daily. She had thought that adulthood would free her from the schoolyard shenanigans of her youth.

This outburst was triggered by a report on how some former ministers who are still currently MP's in the UK Parliament are either actively engaged in lobbying for business or are trying to position themselves to do so for when they leave Parliament.

The rules clearly say that ex-Ministers must wait 12 months before they engage in lobbying. The accused all deny wrongdoing.

I spent years discussing with my children good and bad; right and wrong. The goal was to instill a moral compass. I wasn't trying to create good Samaritans, but rather to provide a framework, which I am sure somehow morphed into a belief that the adult world was a righteous one.

Watching ex-Ministers decry their innocence while caught with their hands in the till reveals a different reality.

Scroll forward to the passage of the Health Care Bill in the US and listen to Newt Gingrich describe this bill as political suicide-and then compare it to the passage of Civil Rights Legislation under LBJ which he also described as political suicide.

What planet is Mr Gingrich on? Is he seriously suggesting that LBJ was wrong to enact Civil Rights legislation which essentially granted all Americans the rights theoretically safeguarded in the Constitution?

Contrast this sentiment with President Obama's invocation to vote for Health Care: "Every once in a while a moment comes where you have a chance to vindicate all those best hopes that you had about yourself, about this country,” he said. “This is one of those moments.”

Regardless of your views on the Health Care Bill, here is an adult beseeching politicians to essentially do what they think is right. Not what will get them elected; not what will further their careers; but to actually do what we all do when we enter the polling booth-vote our conscience.

Monday 22 March 2010

CDO/CDS Part VI

Now today we should be discussing the passage of the Health Care Bill in Congress but I will leave that to tomorrow as at the same time I would like to discuss Senator Dodd's regulatory reform bill.

But first I will finish with the CDO/CDS discussion.

In the Cash as well as the Synthetic CDO there were on average 4 names which were very cheap (i.e. yielded much more than their rating would have suggested) which, because of their rating still fit the requirements to achieve the sought after AAA rating. Every financial engineer knew that; any good salesman knew that; and any investor who understood that would fall out of basket of potential clients because they would want to remove those names which would give a stronger investment, at a significantly lower yield.

The investor of choice could be convinced of the validity of the rating agencies; could be made to pay up for a AAA piece of paper; and would crash and burn with their CDO portfolios when the market turned and one or more of the "cheap names" defaulted.

It is an old adage that if something looks too good to be true it probably isn't. If a traditional AAA security like IBM yielded .15% more than the risk-free rate what did the investor buying a AAA CDO yielding .30% think they were buying? Actually the real question should have been what additional risk were they taking on to earn .15% more, and was it worth it?

Lastly, almost as an aside let's talk about AIG and their role in the Synthetic CDO debacle.

The financial engineers were so sure of their statistical analysis that they came to the conclusion that the AAA securities they were creating were so secure that they could actually slice off the top of the structure and create a part of the security called the "super-senior or super AAA". That's how they described it.

The truth was that they were carrying more risk than they wanted to and so they went around and found investors who were interested in taking on that part of the default risk that should never default. The bankers found people like AIG Financial Products and bought insurance for the top of the structure.

Think of it like this. At the bottom of the Capital Structure is the First Loss Piece. Any losses in the portfolio are first attributed to this portion. It usually makes up the first 3%. On top of this is the mezzanine slice, another ~15% and would be rated BBB normally and would take the next losses above the original 3%. On top of this is the AAA piece which would be the next ~67% and would take the next set of loss, and on top of this was the super-AAA, the top ~15% which would take the remaining losses. Strangely the bankers chose to go to people like AIG and pay them .15% to assume the risk of the super-AAA. AIG FP convinced their parent AIG that they were just providing financial insurance. They would get paid .15% on billions of dollars of financial risk which should never be realised. Sound like "something for nothing". AIG FP thought it was as if they were getting paid to insure for flood risk in the desert. Obviously the geniuses at AIG FP had never been to the desert and didn't know that what looks like a dry gully or wadi quickly becomes a death trap when there is a flash flood and that rain occurs more often than they thought and when it does, it's a real problem.

So now the credit crisis starts to bite. the "cheap" names in the portfolio start to deteriorate and so no longer fit the requirements for the AAA rating. When the bottom 3% collapses, then the bottom of the next 15% becomes the bottom of the structure, weakening the mezzanine which means that the top 15% of the super-AAA is no longer super-AAA, but rather just AAA. The flash flood has started. Suddenly names like Ford and GMAC which were part of the "good" names in the pool of 100 are no longer good and they fall outside of the guidelines etc.

Now forget the corporate names, and remember the Sub-prime structures. Same story, except that not only does the bottom 3% disappear, but the next 15% as well, and if the real estate market plunges 50%, so does the CDO. Before an investor can blink their AAA security is A, or worse. A security that was valued at 100 is now trading at 20-if you can find a buyer.

Those mortgages held by the GSE's are crushed. The first-loss pieces held by the investment banks are crushed. The providers of super-AAA insurance are crushed.

Welcome to the Credit Crisis.

Friday 19 March 2010

Gung-ho Leadership Style?

Taking a brief respite from the world of CDS/CDO's I want to reflect on what is really meant when someone is described as having a "Gung-ho" leadership style.

Apparently this unofficial motto of the US Marine Corps stems from a bastardisation of the Chinese "Gongye Hezhoushe" which initially was Gong He and became Gung Ho meaning "work together" and morphed into "Can Do".

Now in my 30 years involvement with Wall Street my experience tells me that anyone who is either described or describes themselves as "Gung Ho" has generally been an accident waiting to happen. Dick Fuld is my best example, and not surprisingly he, like Jasjit Bhattal, are both of Lehman Brothers.

So when I hear that Nomura has promoted Mr. Bhattal to the Board and given him responsibility for a new wholesale banking unit that includes investment banking, equities trading and other non-retail activities my first thought is to buy the stock-he will walk over corpses to achieve success-and be ready to dump the stock when his time runs out and we find that the there are so many corpses that that the closet is no longer big enough to hide them all.

Gung Ho works in the Marines, and perhaps in contact sports, but the "win at any cost" mentality will eventually get tripped up in the world of international finance, as assuredly as night follows day.

Thursday 18 March 2010

CDS/CDO's Part V- The Rise of the G(r)eeks

In Part I we discussed how purchasers of corporate bonds were actually impliciltly involved in the credit options market. We went on to discuss how this was explained to the Italian banks and this was the beginnings of the cash CDO market. As time went by, and as the available assets became more expensive, some financial engineers suggested that instead of just talking about the embedded options, they should actually extract the options from the structure and start to trade just the option and forget about the "risk-free" component of a bond.

If an investor were being "paid" in the form of a yield premium to "sell" a put on a specific credit, it would be simple to insert an alternative buyer i.e. not the issuer, but rather a trader who had a view of the value of a specific credit. This idea was than expanded to allow traders to "sell" the option, as well as buy it.

A new terminology evolved so instead of buying or selling puts the credit default market spoke of buying and selling protection. If you "liked" a credit, you bought protection; if you didn't like it you sold protection. "Liking" a credit could be a relative value- the real driver was whether it was viewed as being rich or cheap.

This became the CDS market. The Geeks extrapolated the idea and created a structure which would allow them to "synthetically" create a CDO. They could get investors to buy protection on a group of corporate credits or "names" which created the same position for the investor as if they had sold puts, but in this case they actually purchased the protection, and of course paid a good price to do so.

The financial engineers were very good at statistics and they had created a correlation model which allowed them to present a list of 100 names to the investors, which in aggregate would be rated AAA, but in reality the trading desk would find a smaller pool of names which statistically replicated the 100 names, the aggregate cost of which was much lower than the price paid by the investor.

The rating agencies were statistically focused as well and their guidelines meant that there were on average 4 or 5 questionable names-i.e. poor credit risks given their ratings- which could be put into the pool of 100 names in order to get the yield on the pool higher, but were almost preprogrammed to create problems in the pool sooner or later due to the pyramid structure of the synthetic CDO cash flow.

This will be discussed tomorrow.

Wednesday 17 March 2010

CDO Part IV or A Sow's Ear is, er, a Sow's Ear

So now we have a product which piles assets together and then slices the whole into different pieces which when stacked on top of one another are the total capital structure.

As mentioned, the bottom of the pile, the equity or first-loss piece is understood to be the riskiest, and the top of the pile, the AAA rated piece, is the most secure. Well two things happened at this point.

The original "cash" CDO's, were made up of pools of actual assets such as bonds or loans or other such assets. That was fine as long as there was an adequate pool of assets to draw from. As it turns out, some asset classes such as corporate bonds became somewhat scarce, or too expensive. The rating agencies which granted the AAA ratings used historical default rates of the ratings they themselves had given and created guidelines as to what mix of bonds were required in order to create AAA tranches.

All the investment banks had similar models to find the right mix of bonds to meet these requirements which created excess demand for said bonds which made them more expensive thus lowering the yields which had made the CDO attractive in the first place. One solution was to find different assets-enter Sub-prime mortgages. Another was to create synthetic structures-enter the rise of CDS.

First let's deal with the Cash CDO's and thus to Sub-prime.

Part of the pursuit of happiness in the USA is to own a house, two cars, two kids etc. Credit was freely available, and there was a strong desire by many members of Congress, among them Barney Frank, Chairman of the House Financial Services Committee, to support home ownership for all. The way this was engineered was essentially to set up guidelines which if adhered to by the mortgage originators would make the mortgages they were granting eligible to be guaranteed under either FNMA or FHLC. "If they were adhered to" is the operable phrase here.

The mortgage originators came up with self-qualifying mortgages which were presented in a fashion that made them eligible for guarantees by the federal agencies. Originally these were NINA loans reserved for the most credit-worthy borrowers who could demonstrate good credit histories regarding past mortgages and could demonstrate access to income. Somehow this got twisted into NINJA loans, No Income No Job (or) Assets which were used for the least credit-worthy home buyers, the Sub-Prime market.

Now a mortgage originator is not required to keep the mortgages granted on their books. In fact, what they like to do is grant the loans under documentation which they could present as adhering to the federal guidelines, and on that basis sell the loans on to an investment bank, after taking their 1% or higher fee.

The investment bank is happy to buy these loans as the federal guaranty makes them eligible to meet the rating agency guidelines necessary to get a AAA rating. The final investor WAS happy, because they get a AAA asset significantly cheaper than other similarly rated assets.

But wait a minute. We start out with loans with documentation granting loans to people who have no income, no jobs, no assets, and because they are self-qualifying, don't have to provide any paperwork to suggest they can actually afford the mortgage they are receiving. Forget about the initial Adjustable Rate Periods, the Balloon Payments and any other offers intended to entice people to take out mortgages- they knew they could not maintain the payment UNLESS the real estate market only rose- or if pigs flew.

This is called a pyramid scheme, and this kind of activity has been going on since the creation of the United States (see "The Exchange Artist" by Jane Kamenesky). The fact that the original customers fell for the "free lunch" is nothing new. The fact that the mortgage originators were willing to grant loans and get them qualified for federal guarantees allowing them to pocket their 1% fees and sell them on to investment banks, is disgraceful at best, and actually probably closer to criminal. The investment banks, accepting the guarantees at face value were happy to buy them, pool them, and sell them to investors who were also happy to take the ratings at face value and buy AAA assets cheaply.

The trouble is these AAA securities were being sold as Silk Purses-but they were made out of Sow's Ears, and sooner or later the "silk" will wear off, and all you are left with is a pig.

Tomorrow, Synthetic CDO's.

Tuesday 16 March 2010

CDO Part III- The Ghosts of Basle I and II

From Part II we left off with the Italian bankers being very happy because they were able to both monetise some of their balance sheet and maintain the same risk position and get paid a higher rate of return for holding the equity piece.

Of course, most transactions are a zero-sum game so someone else would have to get paid less as the total return available had not been changed.

To help facilitate these transactions there were important changes in the rules concerning Risk-weightings as the market moved from Basle I to Basle II.

The Basle Rulings emanate from the Bank for International Settlements in Basle and is an institution which acts as Banker to the world's Central Banks and issues guidelines to banks in general.

The relevant rules from Basle I were focused on Capital Adequacy Ratios and specifically were designed to determine the correct amount of capital that banks reserved relevant to their credit risks.

Banks are required to hold 8% capital reserves against their holdings which is viewed as being sufficient to cover declines in said holdings. The trouble with this approach, from a bank's point of view was that they had to hold 8% regardless of the credit risk of the holding. In other words if a bank held a position in a US Treasury or in a small BBB rated company, they still had to reserve the same amount of capital. This could have led to banks only holding low rated corporates which would increase their credit risk position. The Regulators wanted to avoid this and so came up with a methodology to differentiate between credits known as Risk-weighting.

Basically starting at the bottom all corporate bonds with a minimum rating of investment grade were given a Risk-weighting of 100% of the 8%. Mortgages were given a weighting of 50% i.e.50% of 8% or 4%; Banks were given a 20% weighting i.e. 1.6%; Government Sponsored Enterprises (like FNMA or EADS as example) were weighted 10% requiring .8% capital reserve, and OECD Sovereign Risk was given a 0% risk-weighting meaning no capital reserve was required. All of these Risk-Weightings were then applied to the assets held by the bank to determine the banks Capital Adequacy Ratio.

This was obviously not perfect but it allowed for a better understanding of a bank's risks and by default pushed banks towards lower risk weighted assets which were of a higher credit quality. Basle I didn't however differentiate between BBB and AAA corporate assets and so banks tended to gravitate to the lower end of the range in order to maximise their return.

Basle II was intended to remedy this and so it introduced, amongst a number of changes designed to minimise credit arbitrage opportunities, new calculations to determine Risk-weightings. What was important in this was the introduction of a differentiation of risk weightings for corporates. AAA to AA- corporates were no longer 100% but were reduced to 20%;A+ to A- were reduced to 50%; BBB+ to BBB- stayed at 100%; below B-went up to 150%; and unrated were weighted 100%.

Now we go back to the "risk-free portion of a corporate bond that the banks split off from the credit "put". Yes, the corporate credits on the books of the Italian banks were BBB+ at best, or often unrated. The AAA piece that was created however, was weighted 20%. Of course it had to be sold cheaper than a "real" AAA piece, but it wouldn't be as cheap as it should given that regardless of how you slice it, the credit was still backed by the original issuer-but the buyers didn't look at that. They looked at the AAA rating; at a 20% weighting; and piled in.

And everybody was happy. The Italian bank raised some cash; the investor got a cheap AAA and only had to put up 1.6% instead of the standard 8%; and the investment bank made 6-8% on the face value! Selling BBB as a cheap AAA leaves a lot of spread!

Tomorrow we will move from these structured credit trades into true CDO's and introduce the sub-prime mortgage into the mix.

Monday 15 March 2010

REPO 105

I will make a brief tangent from my discussion of CDO's to comment on Anton Vukas's report on Lehman Brothers and the use of "Repo 105".

Repo or Repurchase Agreements are a means of financing positions for the owners of securities and is a way of lending on a collateralized basis for the lenders. The key is ownership of the securities during the transaction. The owners maintain ownership during the transaction-unless they are unable to repay the lender's financing in which case the securities become the possession of the lender. This is similar to a mortgage-the bank providing the financing can only have access to the house if the mortgagee doesn't make their payments. As long as the mortgagee is current the ownership of the house stays with them.

It is important to understand that this is collateralized lending- not a transfer of ownership. In fact, although the name Repo has survived, the original name reflects the fact that it consisted of selling a security and then repurchasing it on an agreed date for an agreed price. This was soon recognised as being an actual transfer of ownership (and hence risk), and was not the intent. For this reason the market evolved into the collateralized lending market as it is today. One of main drivers of the change was precisely to stop organisations from entering into so-called "window dressing" transactions designed to give the appearance of liquidity, solid core-ratios or whatever to external viewers.

Lehman Brothers was fully aware of the prohibitions to window-dressing, but rather than expose their (untenable) financial state they scoured the market for a solution to their problem. Their "salvation" was to be a legal opinion from Linklaters which allowed Lehman Brothers to "sell" their securities and then buy them back on a prearranged date for a prearranged price. If it appears surprising that Lehman would do this it is even more surprising that Linklaters would write an opinion justifying it.

Window dressing is illegal in the UK as it is in most developed markets. The purpose of balance sheets and income statements is to provide accuracy and transparency which allows third parties to evaluate a company's financial position.

I have already written earlier on my distaste for the accounting profession which created the framework for off-balance sheet accounting as if hiding contingent liabilities made them any less contingent! But for a major legal firm to write an opinion supporting balance sheet manipulation reeks of either the utmost stupidity-or the utmost arrogance-not to mention greed.

What is equally ridiculous is the attempt by Richard Fuld's lawyer Patricia Hynes to claim that "Mr Fuld did not know what those transactions were--he didn't structure or negotiate them, nor was he aware of their accounting treatment". Well Mr. Fuld, in his own words, was the one "who ultimately signs off" and that he was "comfortable with our valuations" and that "we have always had a rigorous internal process". Maybe Ms Hynes is referring to a different Mr. Fuld?

Just think. If a firm like Lehman Brothers was willing to engage in such actions to deliberately deceive it's shareholders and regulators as to it's financial health, what would they be willing to do to unsuspecting investors when structuring and marketing structured products....

Friday 12 March 2010

CDS Part II

Although the majority of corporate bondholders still have no clue as to the embedded option they have purchased the same cannot be said for the investment banks. With the introduction of Interest Rate Swaps in the early 1980's and the development of the Asset Swap the seeds for the great crisis were already being sown.

If a corporate bond could be separated into an interest rate component and a credit component, then couldn't one just focus on the credit component and forget about funded or unfunded investments?

The investment banking community certainly thought so and went out and searched for investors for whom this would be interesting and found the Italian regional banks.

They had illiquid corporate credits on their books which was tying up their liquidity. The investment bankers came up with a strategy to monetise these investments-the CDO(or it's close cousin the CLO). The Italians were told that since they were already short the put to the issuers they should keep that piece of the structure which became known as the equity or first-loss piece. The investment bank would take the rest of the capital structure and sell it to investors under the "guise" of it being the "the risk-free component"-or at least as good as because as the top of the capital structure it could be rated AAA!

And that's what led to the Credit Crisis. More tomorrow.

Thursday 11 March 2010

The Fundamentals of CDS

Adair Turner's reversal would be humorous if it were not that he is chairman of the FSA. Yesterday he was crowing with the best of them of the evils of naked CDS, and today he is quoted as having said "that these so-called naked swaps weren't the 'key driver' of the Greek debt crisis and it would be wrong to ban them".

Now either the media has to start quoting what people actually say, or have we entered the age of Newspeak where the news is always updated to suit the new requirements?

At least the reports on Merkel and Sarkozy repeat their inane comments of yesterday essentially suggesting a crackdown on derivatives trading to prevent a rerun of the Greek crisis. Wait a minute. Yesterday they were screaming about credit derivatives, and today it's just derivatives. Maybe they realised they were a bit to forward on their skis?

So, today I will start a brief course on CDS. To start at the beginning, everyone who has ever purchased a corporate bond has participated in a credit derivative. They have essentially sold a put to the issuer. (A put is an option which allows the holder to "put" the instrument to the seller.)

A corporate bond is made up of the risk free rate-a reflection of the underlying level of treasuries of the same maturity; and a yield premium to reflect the fact there exists a higher risk in the corporate credit. This yield premium is the credit spread that an investor demands/is paid to invest in a corporate bond.

So for example GMAC issued a 10 year corporate bond today. It had a coupon of 8% as compared to the equivalent UST 10 year which has a coupon of 3.625. This differential of 4.375% (or 437.5 basis points)is the credit spread. How did it come about?

Well when one buys a corporate bond the starting point is what would the equivalent UST yield. In this case it yields 3.625%. The additional yield achieved is the result of the investor "selling a put"-in this case on GMAC back to GMAC. GMAC "pays" the investor 4.375% for this put which in the event that GMAC were to default the investor is left with (relatively) worthless GMAC credit. Unfortunately for the investor their risk is not just the additional spread they received, but also the "risk free" 3.625% they would have received if they had just bought a UST is at risk because they didn't buy a UST, they bought GMAC!

I will discuss how this imbedded option in a corporate bond became the CDS market tomorrow.

Wednesday 10 March 2010

Constitutional Conservatives

Recently I read a lot about constitutional conservatives.

Some are "loyal to our Constitution, our founding fathers and the good institutions and social contrivances brought into being by those principles" according to Tony Blankley-a far right commentator who is still mired in the the states vs federal rights debate despite the fact that the Confederates lost the Civil War.

Mr Blankley seems to forget that there exists one group of people who are constitutional "literalists", and another group who are constitutional "original intentists". After reading some of his articles I think being a constitutional conservative means "my opinion is right", especially if the opposition when to an Ivy League school and drinks Chablis and eats brie!

Others are like ex-Minnesota Governor Tim Pawlenty who thinks that being a constitutional conservative includes taking a nine-iron and smashing the window out of big government and warns liberals that he is "planting the flag on constitutional ground. And if you try to take our freedoms, we will fight back". He continues in this vein, "We're on the side of the rule of law. We're on the side of limited government. And like Grant, we fight". And lastly, he forgets the separation of Church and State, "Americans need to accept that 'God's in charge".

What these two conservatives have succeeded in doing is convincing me that demagoguery is not dead in the US even if one can only hope it is dying.

Tuesday 9 March 2010

The Evils of CDS-Not!

It was rather disappointing to see Mutti Merkel come out recently railing against the demon of credit derivatives as if they were the cause of Greece's plight. The trend seems to be to blame derivatives for all the evils of the financial and by extension fiscal world. It might make for good populist rhetoric, but it is completely beside the point in both determining the cause of the current crisis as well as being the lightning rod to avoid the next one.

As I have mentioned before, the real culprits in this charade are the Regulators and the big accounting firms that through FASB and GAAP have created byzantine accounting practices which remove clarity and often enough support the use of derivatives in a non-speculative but definitely dangerous fashion.

So Frau Merkel decides to rail against the use of Credit Derivatives and is joined by a plethora of luminaries.

Bundesbank President Axel Weber is thought-provoking claiming "Not everybody who buys protection has an underlying exposure. It's a very intransparent market". Imagine that there are people who take outright positions through CDS.

UK FSA Chairman Adair Turner chimes in that CDS, and naked CDS in particular need to be examined by policy makers. Being British I guess he might get a rise out of using the term "naked" but I doubt his understanding of CDS suffices for any serious examination.

EC President Jose Barroso also wants to "examine closely the relevance of banning purely speculative naked sales on CDS". Just how close do you want to get to the nakedness Jose? Speculative, naked, sales. Just for arguments sake every trade is speculative unless you have inside information....so banning speculation might not be such a good idea. Naked just means outright exposure.

Richard Portes, a professor of economics at London Business School said "Naked CDS serve no useful purpose and are dangerous". He goes on to say "They do not help significantly price discovery or liquidity". Well, he too likes "naked", and maybe he is confusing the use of CDS with plumbing for depths by the Royal Navy.

Every time an instrument of any sort trades, unless it is either an accident or fraud, it "discovers the price". The fact is that traders sense that Greece is in trouble and by trading "against" Greece they will either force it out of the Euro, OR force the European Union to step up and commit.

In fact that is the problem right now. There is still no clarity on a Federal Europe and it remains unclear as to how this problem in Greece, and maybe other countries will be solved and so in the meantime to divert the attention of the masses away from the real problem that Greece is a mess it is much easier to attack CDS.

So what does Papandreou do? He claims that "unprincipled speculators" threatened a new global financial crisis and that he would discuss this with Obama.

Unprincipled speculators?! What about unprincipled government officials who use Interest Rate Swaps to obfuscate the true state of Greece's finances in conjunction with the likes of Goldman Sachs and others whose only concern is profitability.

Nothing wrong with profitability, and someone like Goldman Sachs is generally more than clever enough to understand the letter of the law and use it to their advantage....

And you wonder why I think Self-Regulation is a joke.

Monday 8 March 2010

Charities and Waste

Last night I attended a fundraising event for a small charity aimed at helping destitute women and poverty stricken children in Nepal.

I will start out saying that normally I prefer to support charities focusing on problems in my own country(s) i.e. the US or the UK but my daughter asked me to attend and so I did.

As I mentioned this was a small charity and it was somewhat amateur in its' organisation, and yet therefore much more focused on those for whom the charity is intended as opposed to the image of the charity.

For, as it turned out, I was sitting next to a woman who although not directly involved with the organisation of this event is generally engaged in the "business" of charity and as such broadsided me with some rather disturbing comments on the sector.

She was adamant that the big UK Charities that line the High Street are very well if not over funded in terms of cash as well as in terms of physical donations. Nothing wrong with that, except that over funded "name" charities create a "crowding out" effect for the lesser known names who have much less headline recognition and limited marketing expertise and/or exposure despite the fact that many of the smaller organisations are much more "direct" in their undertakings.

My Tischdame went on to explain that the big names actually empty their stores weekly into the rubbish bin so as to maintain the image that they have a massive turnover which in turn encourages donations which will then have be thrown away and so the circle turns.

This was so disturbing to her that she chased up the management ladder to get an explanation. First and foremost everyone she spoke to first hauled out the old chestnut of "Health and Safety". When pressured, as she was certainly not to be fobbed off by so churlish an excuse, it came out that "in order to keep up their image they were forced to keep product moving in their shop windows, and yes it was distressing but what should they do?".

Now I was always concerned that the wastage in charities was in the costs associated with the bureaucracies they had developed which consumed sizable chunks out of the "charity dollars/pounds/euros donations they received. I had always donated clothes, toys and bric-a-brac in general with the thought that this way the physical objects were actually being of some use to persons in need.

If the description of what is going on is indeed true-and I have no reason to doubt it isn't-perhaps my cynicism is more a reflection of reality than I had previously thought.

Friday 5 March 2010

The Strange Case Of Senator Jim Bunning

The other day the hononorable gentleman from Kentucky chose to get religion and decided to block a one month extension of unemployment benefits and funded road projects because he didn't know where the US$10 billion was going to come from. Now there is newly passed legislation in the US known as PAYGO which was intended to stop Congress from passing legislation for which they couldn't pay.

Now I am all for controlling spending and I don't like running up large deficits any more than the next person. Still it was interesting (if not perverted) that Senator Bunning chose to draw a line in the sand to prevent the payment of unemployment benefits when we have 10% unemployment-a lot of whom are lower skilled workers-and block road projects-the type of employment many of the unemployed could do.

It is true that Senator Bunning did complain that the vote was making him late for a basketball game, and it is also true that Senator Bunnings response to questions on his motives was to salute the reporters with his middle finger.

But my real concern is why would Senator Bunning choose this bit of legislation to get tough on? Maybe he thinks with 10% unemployment unemployment payments only encourage shiftless Americans to remain unemployed. Or perhaps there are no roads that require repair in that paragon of virtue and extravagance the sovereign state of Kentucky.

Thursday 4 March 2010

Building Homes for the Army

Recently I was travelling in the United States which is always a sobering experience. I was in California which might explain some of the weirdness but I think it had more to do with trying to watch television in a world where the minimum advertising time in a 60 minute frame is 16 minutes. That's over 25% of every hour! It certainly made for some disjointed viewing of just about everything which might explain the rise in ADD in the USA.

Despite this assault on my senses I managed to sit through a news broadcast on MNBC which I believe is the All-News channel for NBC. It was therefore somewhat reassuring if not outright surprising that although there were still incessant interruptions that the programme gave a reasonably open presentation of the news even if to do so required it to be presented more like a talk show.

The "article" which caught my attention was on the imminent demise of a number of developers in Hinesville,Georgia who understood that the nearby Army Base was going to be receiving 1000's of new troops with their families and so they went out and invested millions of dollars into building the infrastructure and housing they understood the Army would need.

It is unclear what was actually promised-or not- by the Army. What is clear is that the developers saw an opportunity and piled in to the tune of at least $25million. Now they were all crying because the Army isn't going to bring the troops required. I was unable to find much empathy for these guys. They say they invested their money because they knew the Army was coming. What they actually did was speculate that the Army was coming, and are now crying that they were misled. If the Army presented them with contracts then the Army would be compelled to respect those contracts. This clearly did not happen. They got some news they believed to be(and may have been) in good faith and on the basis of that they went ahead and invested.

I think the fact that they speculated and lost is unfortunate, but no more so than for any other entrepreneur who analyses the market and decides to invest only to have it blow up in their face.

There are some more serious concerns this whole drama unearths. Firstly, were they operating on insider information. If the Army wants Housing built it is normally the case that it is put out to bid? That clearly didn't happen here. Secondly, what ROI were these developers hoping to make on building for the Army without a contract and yet still willing to invest millions of dollars? Lastly, and this is the most disturbing aspect to me. What has happened to our Armed Forces that their housing has become part of Real Estate Developers "get rich" schemes? This is a case unfortunately of the "chickens coming home to roost".

Go to a US Armed Forces Base anywhere in the world and you will see that it is built by Bechtel, Haliburtion or someone similar. That it is fed by Sysco or some other industrialised food processor at the mess, and by BurgerKing and PizzaHut in "town". There is talk of privatising the Medical Corp-they already tried with the VA Hospitals. None of this seems that strange when one considers the number of Private Security Firms such as Blackwater which operate as mercenaries for the US Army-but it should!

The government of the United States is for the people, of the people, by the people. Nowhere did our Founding Fathers mean that "for the people" meant for the people to free ride on the government and yet that is what has been happening. The very same people who protest against big government and high taxes are happily living high off the government whose only income is taxes. Except that the result would be catastrophic for every layer of society it would be interesting to see what would happen if there were no taxes. No taxes; no services; no national debt; no America.

I guess the Tea-Partyers can't think that far ahead.