CDS Death Spiral in full swing again

http://ftalphaville.ft.com/blog/2011/09/30/689791/le-spleen-de-morgan-stanley/

If you learn nothing from history, you are bound to repeat the mistakes of the past - the horror story of uncontrolled short selling via an easily manipulated CDS market is creating havoc again. Basically the rising spreads are nothing else but a concerted effort to create a run on banks and countries. We warned about this repeatedly during the 2008-09 crash but regulators and politicians have not heeded the warnings, now they reap the whirlwind.

CDS trading still poses danger to financial stability

During the height of the Credit Crunch we have repeatedly warned about the dangers of a self-feeding spiral that could destabilise companies and banks in particular. Nothing has been learned and the market's attack on Bankamerica seems to become a repeat performance of the chaos that was allowed to dominate the markets back then.

Mitsubishi/Morgan Stanley JV loses big on Derivative Bet

One should have thought that the turmoil of the past few years has led managements in all securities units to batten down the hatches and keep to a strict regime of risk management in all trading activities. That two major participants in the global investment banking business have to book a loss of nearly 1 billion dollars on a trading strategy that went wrong beggars belief. The more things change, the more they seem to stay the same....

Who is Steven Maijoor?

The regulatory vampire squid that is being created by an EU officialdom that is several stages removed from any democratic control is likely to nominate a professor with only the scantiest first-hand experience in the financial markets to be the head of the European Securities and Markets Authority. Bureaucracies such as the one created to 'regulate' the financial system in the EU have as their primary aim the expansion of their own powers and the creation of jobs for those working for them. If the EU and its member governments would really have wanted to improve the functioning of the financial system they would have had ample time to design a better legal framework during the past two years. Are we on an inevitable path towards a situation where there will be more regulators and compliance officers working in finance than wealth-producing professionals? In that case, we should have a good look at the banking and insurance system as it was during the good old days of the Soviet Union in order to prepare ourselves.

Goldman Sachs in controversy about CDS trade

We have for a long time called for more effective regulation of the market in credit derivatives. Therefore we are not surprised when details about Goldman's involvement in some controversial trades were disclosed by Carl Levin, chairman of the Senate permanent sub-committee on investigations.

More pessimism about outlook for investment banking

Andy Kessler is always interesting to read. In his latest piece in the Wall Street Journal he makes a pessimistic prognosis for the investment banking industry. He thinks that current - and prospective - levels of business activity cannot support the present number of traders, salespeople and deal makers. While we think there is a chance that emerging markets and markets in Eastern Europe and Asia will to a certain extent help to reduce this pressure on the industry it will at best help to keep levels of employment and activity at similar levels to what they are now.

SEC: non-report on 1000 point drop in Dow Jones

After a weekend of heavy-duty gardening your correspondent is back to the real world. This comment on the SEC's effort to bring light into the precipitous 1000 Dow point decline on May 6 caught our eye: "If the SEC were charged with writing a report on the causes of the New Orleans flood, it would provide a hundred pages telling us how many cubic meters of water there were, how many molecules of oxygen and hydrogen the water contained, and plenty of assurances that water is usually good for the health, but it would forget to mention hurricane Katrina and the broken levy." (Mark Mitchell on www.deepcapture.com). We could not have described the lame response of the 'regulators' much more accurately. Thank God the 'accident' happened in the USA as a similar incident in London would have led to the creation of a 'Royal Commission of Inquiry' at the cost of millions of pounds in lawyer's fees.

Client or Counterparty?

The controversy about Goldman Sachs' sale of the Abacus CDO raises an interesting question: are counterparties of securities firms entitled to be protected beyond the requirements of the securities laws? In our opinion, the relationship between a trader (or any business) and a customer is by nature antagonistic: one wants the highest possible price while the other wants the lowest possible one. As noted by Adam Smith, the best safeguard is an open and competitive market. This allows the 'invisible hand' to produce an outcome where both parties to the contract pursue their own (egoistic) interests and the best outcome for both of them (and society) is produced at the same time.Unfortunately, too many customers of securities firms are lulled into complacency by PR, fancy 'research', 'seminars' and other freebies and forget to do their own homework. This applies not only to retail investors but paradoxically also to 'sophisticated' investors. Already the term 'client' is designed to make the customer's eyes glaze over and induce them to think that a friendly uncle is going to sell them the latest inventions of the quant wizards on the derivative desk. But the dictionary tells us that a client is 'One that depends on the protection of another'. In reality the term should really only be applied to clients of doctors or lawyers. Fee-based financial advisors in private banks and traditional money management firms can also claim to be on the investor's side.
To ask for full disclosure from a securities dealer would be like asking a Bond Street jeweler to disclose the production cost of the latest Rolex watch and 'advise' the customer on the merits of the purchase.

Derivative Clearinghouse no magic Bullet?

Harvard's Mark Roe makes a valid point when he doubts the benefits of relying on central clearing as a tool for the reduction in counter party and systemic risk in the financial markets. We argue that stress tests have to be designed so that even dramatic price changes like those experienced in the 1987 stock market crash of in the recent credit crunch pose no risk to the system. This may well mean that paltry levels of margin are on the way out. 20 percent and more may become the 'new normal'

Credit Derivatives: Ban speculative Buyers of 'Protection'

News that speculators are betting that municipalities and federal states in the USA may default highlights the urgent need for reform of the credit derivatives market. Not only does the ballooning of outstanding trades create a substantial risk of default by one of the participants in the market it also creates problems in the wider economy by accelerating and exaggerating real or perceived weakness in the credit ratings of various issuers. There is no reason why those without an insurable asset should be allowed to buy 'credit protection' - nothing is 'protected' and it is but a speculation on default. The argument that you need speculators to facilitate a liquid market so that  investors (banks, bond investors) with genuine reasons can protect themselves,  does not hold as you really need only SELLERS of credit protection to satisfy this requirement. So speculators are more than welcome to provide liquidity as sellers of credit protection. Adjusting legislation would mean that derivatives traded outside recognised exchanges would again be unenforceable if they are not hedging against a pre-existing risk.

Lacking CDO Disclosure: Who is to blame?

It takes two to tango. The present discussion about the alleged lack of disclosure in CDO transactions directs most of the criticism towards the structuring and originating parties in the large investment banks (and their cooperators in hedge funds). While this criticism may well be valid in some - or the majority of the cases - one should not forget that no-one was forced to buy these structured products. Any attempt at regulatory reform would be simplified if the effort would primarily be directed at the buy-side. If the list of permitted transactions would be updated so that structured products are strictly controlled the supply would quickly adjust itself - both in terms of quantity and - even more importantly - in terms of quality of disclosure.

Glass Steagall is good for you!

We continue to be amazed by the hysteric reaction of bankers to the possible introduction of a separation of business lines along the regulations imposed by the defunct Glass-Steagall Act of 1932 that separated commercial and investment banking for more than sixty years in the USA. Looking at it from another perspective - and not just short term/short sighted business perspectives - was the global success and dominance of the US investment banks not partially due to this enforced separation? Would the enterprise spirit not have been severely dented by keeping the entrepreneurial spirit constrained by the bureaucratic management structures of the commercial banks? A similar argument could be made in case of the City of London where the free-wheeling spirit of the financial community goes back over centuries and is in stark contrast to the top-down models of the continental European banking industry.

Goldman's CDO Investors - were they stupid?

The CDO product at the center of the SEC's case against Goldman Sachs raises the question: were the 'sophisticated' investors (including ironically the middleman Goldman Sachs) that bought into this transaction stupid or victims (or both)? Leaving the legal and factual arguments for the moment out of the discussion - what was the motivation that caused the fund managers at IKB and ABN Amro to buy securities that were one or two steps removed from any real underlying economic transaction? Speaking from experience I can see them as busy, maybe even diligent people who were working in a set of parameters that prevented them from questioning certain assumptions at the heart of the structured product business: that securitised products contain what the label promises, that companies with a certain public image behave in a way that confirms this image, that all players on the field can be trusted to pursue goals that do not harm the other participants.
Securitisation in particular is critically dependent on trust as the buyers in effect must give a certain amount of leeway to the creator of the product they are purchasing. The whole business idea underlying securitisation is the fact that the buyer does not want to - or is not able to - to buy the underlying assets himself. In effect, he buys a packaged product and can never expect to fully analyse all the assets - would he do so he could as well purchase these assets directly thus disposing of the need for securitisation.

Betting on my neighbours house?

Lynn Stout's point about Goldman Sachs' Abacus Mortgage Derivatives Deal (New York Times) illustrates the need for stricter derivatives regulation:

"...much of the blame for investors’ losses in the Abacus deal can be laid at the feet of an obscure statute passed by Congress in 2000, the “Commodities Futures Modernization Act.”
If we allow the unscrupulous to buy fire insurance on other people’s houses, the incidence of arson would rise sharply. In one dramatic move, that act eliminated a longstanding legal rule that deemed derivatives bets made outside regulated exchanges to be legally enforceable only if one of the parties to the bet was hedging against a pre-existing risk."

Derivative Trading can be moved to Exchanges

While it has to be accepted that not all derivatives can be traded as standardised products the overwhelming majority could be accommodated on exchanges if a few simple modifications were made: in particular, the available expiration dates have to be frequent enough (monthly series) so that most requirements can be handled. Does a corporation really need to hedge interest rate risk to a date outside the available expiration cycles? We do not think that is necessary in the majority of cases. With sufficient incentive (different capital and accounting treatment in favor of listed derivatives) most companies would choose standard contracts. Concentration of activity in listed exchanges would create a tremendous increase in liquidity and this - in addition to much higher transparency in pricing - would lead to a snowball effect in favor of listed products. Would clearing houses be able to accommodate the rise in volume and consequent rise in risk in case one party should fail? This certainly could be a problem but at least the problem would be out in the open and not hidden in the (off)balance sheets of banks (usually in the footnotes). There they are posing the same level of risk but it is clear that the only guarantee in case of a failure of a counter party is the (implicit) guarantee by the taxpayer. A clearing system has to be designed to be robust enough to withstand any conceivable failure. This means sufficient margin collateral. Stress tests have to be designed so that even dramatic price changes like those experienced in the 1987 stock market crash of in the recent credit crunch pose no risk to the system.

P.S.: Today's article in The Times about disputed valuations concerning the sale of Lehman-related derivatives during a margin call illustrates that trading of derivatives on exchanges would create a more transparent pricing system.

Can trust in Securitizations be revived?

The discussion about the feasibility of reviving the securitization business revolves to a large extent about how to ensure that investors can trust the integrity of the packaging process that is behind the creation of the securities backed by the underlying loans and mortgages. The concept of securitization from the buyer's perspective means that as an investor he gets access to a multitude of loans that are individually too small to be of interest (in the case of the institutional buyer) or too large (for a small retail investor). Both are unwilling or unable to conduct individual due diligence on every single underlying loan and in effect have contracted out the credit research to the institution that creates the loan bundle they are acquiring. 
While in an ideal world the 'free market' would take care of the problem of moral hazard and ensure that no loans of questionable value are sold or purchased we do agree that the requirement for packagers to retain a substantial stake in the securitized product is a sensible suggestion. While this may well raise to cost of the securitized package we think this is a price worth paying given the abuses that helped create the credit crunch of 2007-09.

Lehman: Masters of the Universe R.I.P.

The sense of hubris that was prevalent at Lehman Brothers before the fall is well documented in a new book The Devil’s Casino: Friendship, Betrayal and the High Stakes Games Played Inside Lehman Brothers, by Vicky Ward. It mentions that one of the top honchos in the firm, Chris Pettit, got by with a personal spending budget of $ 15 million (!!) a year. With leadership of that kind it is no surprise that the company had to hit the rocks sooner or later. The question one has to ask is what lessons - if any - has the securities industry from the credit crunch?

How to regulate Derivatives

Warren Buffett famously described Derivatives as Weapons of 'Financial mass destruction' (2002 Letter to Shareholders of Berkshire Hathaway). While we think that this catchy phrase exaggerates the dangers of derivatives it has to be accepted that these contracts are essentially bets similar to futures contracts. As they are highly leveraged - in contrast to futures contracts there often is no margin at all - and no money may change hands when the initial contract is signed they are susceptible to outright fraud or abuse by overambitious traders and financiers. We would like to add to the debate by suggesting that all forms of derivatives are subject to meaningful margin requirements (including capital requirements in balance sheets of banks, insurance companies, corporations and public entities).

Blueprint for Global Derivatives Market

Derivatives are in essence a bet on the price of the underlying asset. Economically they are a zero-sum game where the losing side funds the gains of the successful side. Like all bets the derivative markets serve to redistribute wealth minus the costs of running the market. As a consequence of the credit crisis reform of the derivative markets has moved to the top of the political agenda. This is not the place to discuss the role that derivatives have played in the financial crisis. But if more players are active in a market it can only be expected that moves above (and below) underlying value are exacerbated - despite the fact that derivative instruments are often claimed to help move prices back to their underlying trend. I do not agree that moving all derivative trading to exchanges is necessary to avoid bubbles and excessive risks associated with derivative positions as advocated by many commentators. For an new example see the paper just published by Deutsche Boerse. Instead, I think that higher capital requirements to support open positions will be sufficient to reduce the danger (real or imagined) attributed to derivative markets.

Dangers of Derivatives

Martin Mayer wrote this article in 1999 and it shows that the risks associates with derivatives was not only foreseen by Warren Buffet. Now it is up to the regulators to make sure that this cannot happen again.