Wednesday, July 29, 2009

'Ratings Arbitrage' Led to Lower Credit Subprime

The deal dynamics in the 'securitization process' expanded the overall level of subprime lending and boosted the degree of risk in subprime residential mortgage-backed securities (RMBS) deals, according to a Fed working paper analysis of 1,267 securitization deals between 1997 to 2007.

A new SEC rule in 2004 that, on paper, increased capital in five large broker-dealer banks -- Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley -- led to greater demand for lower credit quality subprime mortgage purchases. The evidence in deals from these investment banks in 2005 suggest they engaged in ‘ratings arbitrage’ to bring to the secondary market the lowest cost subprime loans that could earn an AAA investment rating, according to the Fed authors.

By Robert Stowe England

July 30, 2009

The securitization process – how loans are put together and assigned credit ratings – drove up the flow of credit in subprime residential mortgage-backed securities deals in harmful ways that increased the amount of funding for lower credit quality subprime mortgages while raising the risk in these deals.

That is the one of the key conclusions of a Federal Reserve Bank working paper authored by Taylor D. Nadauld, a doctoral candidate in the Department of Finance at The Ohio State University, and Shane M. Sherlund, senior economist in household and real estate finance for the Board of Governors of the Federal Reserve System.

Securitization is the process whereby mortgages are sold into the secondary market. Whole mortgages are sold to a deal maker who places them in a pool.

The dealer then issues mortgage-backed securities "backed" by the pool of mortgages and sells the mortgage bonds to investors. The mortgage-backed securities are divided into tranches based on different segments of the loan portfolio, usually with different credit quality characteristics and which pay differing rates of return for investors.

For more information on the process of securitization, go to this link:

The authors’ analysis of 1,267 subprime residential mortgage-backed securities (RMBS) deals originated between 1997 and 2007 was first drafted in May 2008 and was updated in April 2009.

Titled “The Role of the Securitization Process in the Expansion of Subprime Credit,” the 53-page working paper was posted for public discussion earlier this month (July) on the Fed’s Web site at

The authors studied how the structure and ratings of subprime RMBS deals affected the incentives that drove the loan purchase decisions of investment banks that underwrite the deals. They also examined how the process of securitizing mortgages impacts the extension of credit by mortgage lenders.

In addition to the 1,267 deals, the authors also had data on 6.7 million loans that served as collateral for the deals. These data identified the underwriting characteristics of the loans, as well as the subsequent performance of these loans.

Key Findings

The analysis concluded with three key results.

First, mortgage pools concentrated in geographical areas with higher rates of home price appreciation were given AAA ratings on a larger share of the deal’s principal. Indeed, the authors found that a 5 percent increase in the average one-year rate of house price appreciation in a given deal correlated with a 1 percent to 3.5 percent increase in the share of a principal that received a AAA rating.

“This is an economically meaningful result because deals with a larger portion of the deal principal rated AAA can fund the purchase of the underlying loan collateral at a lower cost,” Nadauld and Sherlund wrote.

The second key result is that deal makers would seek to purchase the cheapest portfolio of loans – meaning loan pools with lower quality subprime mortgages – in the areas with the highest home price appreciation in order to provide a higher return.

For example, investment banks sought to buy higher loan-to-value mortgage pools from zip codes with the highest home price appreciation. Specifically, the authors found that the investment banks in the analysis purchased 5 percent more of the riskier loans than their competitors. Those loans had 5 percent higher loan-to-value ratios.

“We believe our evidence on the purchasing activity of the investment banks provides some evidence consistent with a theory of ‘ratings arbitrage,’” the authors write. “The loans purchased by investment banks which increase their relative demand for subprime loans defaulted at marginally higher rates.”

The authors argue that the empirical evidence that the secondary market activity can impact the availability of credit in the primary market can be found in the impact of a regulatory event in 2004, which led to a relative shift in the demand for subprime loans.

The third key result is that a 10 percent increase in the share of originated loans in 2005 being sold to the secondary market led to the origination of an additional 4 subprime loans per 100 units.

Five CSE Investment Banks

The “event” that the authors use to demonstrate a relative shift in the demand for subprime loans was a capital requirements rule change by the Securities and Exchange Commission in 2002 that went into effect in 2004 and which affected five large RMBS broker dealers.

The SEC rule change was the U.S. response to a Conglomerates Directive from the European Union that required that the affiliates of U.S. broker-dealers be subject to consolidated supervision by a U.S. regulatory authority. However, instead of increasing the capital requirements and safety and soundness of large U.S. broker dealers (each dubbed a Consolidated Supervised Entity or CSE), the rule change,relaxed capital requirements dramatically.

“In short, we argue that in 2004 the event endowed five of the five largest broker-dealers with additional capital which could be used to increase production of securitization deals,” Nadauld and Sherlund write.

The SEC rule affected Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley – the five CSEs that are a key focus of the Fed working paper. The rule change did not affect two other investment banks, Citigroup and JP Morgan Chase, because each was already under consolidated supervision by federal banking regulators.

The authors examined whether or not the increase in capital led the broker-dealers covered by the new rule to increase their demand for subprime loans. They found that the five CSE banks “did indeed increase their demand for subprime mortgages relative to competitor banks that did not experience a change in capital requirements.”

Looking at a basket of 2005 data from a number of sources, the authors found that 5.8 percent of all housing units were financed with higher priced loans (with at least 3 percentage points higher than standard rates), which the authors used as a proxy for subprime loans.

These subprime loans were sold 68.5 percent of the time into the secondary market. The five CSE banks increased their market-share in each ZIP code by an average of 61 percent from 2003 to 2005 – a dramatic indication of the impact of the additional capital on the availability of credit in the primary market, the authors contend.
Copyright 2009© by Robert Stowe England

Friday, July 24, 2009

Shanghai Embraces Two-Child Policy

Shanghai officials June 23 announced they were mounting a campaign to encourage couples to have two children instead of one. The policy applies to couples where each party is a single child. Since the fertility rate in Shanghai is 0.8 percent and has been very low for many years, most new marriages are between men and women who have no siblings and, thus, are eligible for the new two-child policy.

The allowance for couples to have two children if each had been an only child was actually adopted in 2004. It generated a modest boost in the low birth rate but not enough to reach goals for overall births set by officials. By embracing and encouraging couples to have two-children, Shanghai has officially moved beyond the one-child policy to a two-child policy. The idea of having more children is a policy aimed at addressing the problems posed by an aging population in Shanghai, which now has nearly 22 percent of its population 60 and over.

See story from China Daily in Beijing at this link:

See story from the London Telegraph at this link:

Listen to Internet audio segment from BBC on "Shanghai two child policy" at this link:

Robert Stowe England's book Aging China: The Demographic Challenge to China's Economic Prospects can be ordered at this link:

See recent report from the Center for Strategic and International Studies, titled China's Long March to Retirement Reform: The Graying of the Middle Kingdom Revisited by Keisuke Nakashima, Neil Howe, Richard Jackson, published April 22, 2009, and available at this link:

Shanghai previously made some steps to loosen its one-child policy in 2004. See story at this link:

Copyright © 2009 by Robert Stowe England

Wednesday, July 22, 2009

Pace of Non-conforming Mortgage Defaults Slows

After spiking dramatically higher in April and May, the pace of defaults for the most troubled area of the mortgage market -- non-conforming mortgages -- slowed significantly in June, according an analysis of performance data on jumbo prime, Alternative-A, and subprime loans by Five Bridges Advisors. Default rates should steadily rise until they peak in the first quarter of 2010.

By Robert Stowe England

July 22, 2009

The pace of credit deterioration for securitized prime, Alternative A (Alt-A or low documentation), and subprime mortgages – which had accelerated in April and May – slowed “significantly” in June, according to an analysis of home loan performance data from Black Box Logic, LLC by Five Bridges Advisors, LLC. Both firms are based in Bethesda, Maryland.

“The irregular and extreme spikes of recent months were conspicuously absent in June,” reports Mortgage Flash, which is published monthly by Five Bridges.

Nevertheless, during June default rates for prime, Alt-A and subprime mortgages rose to new highs. Given the rising levels of unemployment and the expectation of even higher unemployment rates, Five Bridges expects “steady further erosion of mortgage credit.”

Five Bridges reiterated its outlook that the default rates will peak in the first quarter of 2010.

Prime, Alt-A, and subprime loans are generally described as being non-conforming loans because they vary in one way or another from the so-called agency mortgage loans backed by Fannie Mae and Freddie Mac, which are described as conforming loans.

The data analyzed by Five Bridges is also for securitized mortgages; that is; they are loans sold by the originator into the secondary market to be pooled and divided into tranches of mortgage-backed securities, which are then sold to investors.

The securities issued on pools of these non-conforming mortgages are described as private label or non-agency securities.

Securitized loans are designated as such to distinguish them from portfolio loans, which are held by the originator, who retains the credit risks associated with the loans.

Prime mortgages, also known as jumbo primes, are loans with balances above the current conforming loan limit at the time they were originated or refinanced. Currently, the conforming loan limit is the mortgage limit of $417,000 for most markets and $625,500 in high cost areas as determined by the Federal Housing Finance Agency.

Alt-A mortgages are more risky than prime loans, often because they have less documentation but are less risky than subprime loans. Both types of loans are considered to have lower credit quality than those backed by Fannie Mae and Freddie Mac.


The default rate on prime jumbo loans in June rose 56 basis points (56/100th of a percentage point) from the May level to 9.37 percent. The default rate had soared 214 basis points in May and 225 basis points in April.

Historically, prime loans have had default rate of close to 1 percent or less.


The default rate on Alt-A loans rose by 76 basis points from May to 25.4 percent in June. Again, this is significantly less than the monthly increase for May and April.

However, this default rate represents a 10-fold increase over the peak defaults in previous cycles, according to Five Bridges. From 2000 to 2007, default rates of Alt-A loans were 3 percent or less, sometimes falling below 1 percent.


The default rate on subprime loans rose by 48 basis points from May to 36.1 percent in June. This again was much less than the sharp increases in May and June.

Subprime defaults peaked at 10.05 percent in the last recession of 2001-2002.

Five Bridges’ newsletter Mortgage Flash is not available publicly. The email address for the newsletter is .

The Web site for Five Bridges Advisors is

Copyright © 2009 by Robert Stowe England

Friday, July 17, 2009

Employers Still Committed to Defined Benefit Plans

Despite recent financial turmoil, 71 percent of employers say they will focus on ensuring the long term viability of their defined benefit plans, according to a survey by CFO Research Services and Towers Perrin. The remaining 29 percent are focused on finding an alternative to their defined benefit plan. The steep downturn, however, has "qualified" employer commitment, as 51 percent also say they are more likely to seek an exit strategy from their defined benefit plan.

By Robert Stowe England

July 17, 2009

The faith of 71 percent of private sector employers in the company’s traditional defined benefit plan may have been severely shaken, but it has not been broken, according to the results of a new survey.

For 29 percent of employers, however, the financial turmoil and recession have left them focused on finding an alternative retirement benefit for their employees in the coming years.

These findings are from a survey of 439 employers in the United States, Canada and the United Kingdom by CFO Research Services and Towers Perrin, who jointly released a report on their survey last week.

Their report on the study, titled "A Qualified Commitment to DB Plans," can be found at this link:

CFO is the sponsored research arm of CFO magazine, a publication for chief financial officers. Towers Perrin is an employee benefits consulting firm. For more information on CFO Research Services, visit this link:

The Web site for Towers Perrin can be found at this link:

While these findings appear to be broadly encouraging for the future of defined benefit plans in the private sector, the confidence of employers has clearly taken a hit.

For example, 43 percent of the long-termers said that recent financial market turmoil made them more likely or much more likely to seek a defined benefit plan exit strategy.

These compares with 72 percent of the respondents focused on finding alternatives to the defined benefit plan reporting that they were more likely or much more likely to seek an exit strategy from their defined benefit plan.

Employers in the United States (61 percent) and the United Kingdom (54 percent) are more likely to seek an exit from their defined benefit plan, while a majority of Canadians (54 percent) say there is no change in their exit strategy

In the United States, only 21 percent private sector employees have access to a defined benefit plan, while 20 percent participate in the plan. See Bureau of Labor Statistics detailed data on employee benefits at this link:

American employers in the survey had a median loss of 25 percent of the value of the assets in their pension plans in 2008. By contrast, the Canadian employers had only an 11 percent loss, while the United Kingdom employers had 7 percent loss.

Given declines in corporate profits (and, in many cases losses) in the current recession, employers face greater constraints in making contributions to their defined benefit plans. Even so, 82 percent of U.S. employers in the survey do not expect to have any problems funding their plans. In Canada, 86 percent said no problem, while 62 percent in the U.K. said the same.

Support for spending on pension plan contributions among the employers who have long-term commitments was based on the ability of the defined benefit plan to give employees a secure retirement.

While the commitment shows up in the data, a clearer picture of employer views was found in comments made in follow-up interviews with several employers in the survey.

“A pension scheme is still the best,” said Graham Browne, pension manager at Barnardo’s, a U.K. children’s charity. “You’re still getting your tax relief, you’ve got the potential for a pension based on your earnings at or near retirement, and people forget that, all because of scare stories,” he added.

Funding Levels

The survey found that 34 percent of those committed to the long-term viability of their defined benefit plan would contribute enough to ensure full funding.

Another 22 percent of the long-termers were committed to achieving explicit funding goals, while 11 percent planned to make the maximum tax-deductible contribution.

Among employers seeking an alternative to their current plan, the commitment to funding the current plan was surprisingly strong. In this segment, 27 percent planned to contribute enough to ensure full funding, and 23 percent would contribute enough to achieve explicit targets, with 9 percent planned to contribute the maximum tax-deductible amount.

Plan Design

The survey also found that employers have made and are planning to make changes in the design of their defined benefit plans. For example, 29 percent reported having completed a substantial revisions in pension plan design, and another 16 percent have made design changes and anticipate further adjustments in the future.

An additional 27 percent reported that plan design modifications are underway and 19 percent said they intend to modify their plan.

Those committed to the long-term viability of their plan made fewer overall changes and expect to make fewer changes than those who are seeking an alternative.

Financial Instruments

The survey asked employers about their use of financial instruments, such as swaps, forwards, futures, options and derivatives. In all these categories, employers who have a long-term commitment to their plans were more likely to use financial instruments.

For example, 44 percent of those with a long-term focus used interest rate swaps, while 27 percent of those seeking an alternative used them.

Employers who used financial instruments found the instruments had a neutral or positive impact on the defined benefit plan during the financial crisis, according to the survey.

For example, 67 percent who used interest rate futures found no effect or a positive effect, while 22 percent reported that the use of these instruments had a negative effect.

Risk Management

The survey found that 75 percent of respondents are more likely to focus on risk management than focus on seeking additional returns.

Surprisingly, however, the use of financial instruments was more often associated with on increasing returns rather than reducing risk in the portfolio.

Among companies focused on increasing returns, for example, 53 percent were likely to use currency forwards to increase returns, while 35 percent say they use this instrument to manage risk.

Copyright © 2009 by Robert Stowe England

Wednesday, July 15, 2009

Treasury Sees Systemic Risk in Large Hedge Funds

Treasury today added a new wrinkle to the Obama Administration's proposed financial regulatory overhaul: All hedge funds and investment advisors with more than $30 million under management will have to register with the SEC. Despite the fact that no hedge funds had to be bailed out in the financial meltdown, Assistant Treasury Secretary Michael Barr said in an address that hedge funds need to be regulated because their deleveraging contributed to the financial crisis and regulators need to be able to identify potential systemic risk from the world of hedge funds.

By Robert Stowe England

July 15, 2009

Michael Barr, assistant secretary for financial institutions, today revealed a new item on the Administration's refinancial regulatory reform agenda: the regulation of hedge funds.

Hedge funds and investment advisors above the $30 million threshold will have to register with the Securities and Exchange Commission and be required to disclose to regulators and investors "more information about the characteristics of their advised hedge funds -- including asset size, borrowings, [and] off-balance sheet exposure," among other things, Barr said in a speech at the Exchequer Club of Washington, D.C.

The full text of Barr's speech, which was dedicated to explaining the rationale behind Treasury proposed regulatory overhaul, is at this link:

"Registration and disclosure will help to protect investors from fraud or abuse, and [also help] to protect the financial system from unacceptable systemic risks building up outside prudentially supervised institutions," the treasury said.

The proposed regulation of hedge funds is part of a broader overhaul aimed at filling the regulatory holes that federal regulators contend contributed to the financial meltdown last year.

"This crisis . . . clearly demonstrated that risks to the system can emerge from all corners of the financial markets and from any of our financial institutions," Barr said.

"Our approach is to bring these institutions and markets into a comprehensive system, where risks are disclosed and can be monitored by regulators as necessary," he added.

The very largest hedge funds will face even more regulation, according to Barr, who did not reveal what level of assets would place a hedge fund in this category.

"Hedge funds that are found to be so large, leveraged, or interconnected that they pose a threat to financial stability will be regulated as Tier 1 [Financial Holding Companies], with the regulator having the authority and responsibility to regulate these firms not just to protect their individual safety and soundness but to protect the entire financial system," Barr explained.

These very large hedge funds would be under the regulatory oversight of both the Federal Reserve and the proposed Financial Services Oversight Council contained in the broader overhaul measure.

Barr identified three segments of the financial markets that have been targeted for new regulation: over-the-counter derivatives markets, the securitization markets, and hedge funds.

Barr briefly explained why hedge funds need to be regulated.

"Hedge funds do not appear to have been at the center of the current crisis," he acknowledged, "but deleveraging by hedge funds contributed to the strain on financial markets."

The lack of transparency in hedge funds "contributed to market uncertainity and instability," the assistant secretary said.

"These firms continue to present unknown risks, and that lack of transparency is no longer tenable," Barr explained.

"We need a system that lets regulators see risks as they emerge across the financial system," Barr said.

In summing up the Administration's reform proposal, Barr observed, "Markets require clear rules of the road, consumers rely on the truth and fair dealing of financial institutions, and regulation must be consistent, comprehensive and accountable."

"The President's plan lays a new foundation for financial regulation that will once again help to make our markets vital and strong."

Copyright © 2009 by Robert Stowe England

Monday, July 13, 2009

Whalen: Make Derivative Pricing Models Public

Congress should compel over-the-counter (OTC) derivatives dealers to publish monthly the pricing models they use or register the models with the Securities and Exchange Commission, says risk analyst Christopher Whalen. Such disclosure will, he contends, reduce the complexity of derivatives. Even so, an outright ban would work better to eliminate the "horrible damage" they have inflicted on the global financial system, he argues in responses to 33 questions submitted by the chairman and ranking member of a Senate panel following his testimony last month.

In his answers to Senators' questions, Whalen also opposes the agreement between the New York Fed and the derivatives dealers to clear trades through the Intercontinental Exchange (ICE), a start-up he says is controlled by the banks and which shares half its profits with the banks. This agreement, while ostensibly putting in place a necessary clearinghouse mechanism, fails to run trades through an independent exchange, such as the Chicago Mercantile Exchange or the New York Stock Exchange. Thus, it fails to achieve the important goal of reducing systemic risk and illustrates how the regulator has been captured by the regulated, Whalen argues.

By Robert Stowe England

July 13, 2009

If Congress is unwilling to bite the bullet and ban over-the-counter credit derivatives like credit default swaps (CDS), then it should compel dealers who offer them to publish their models or register them with the Securities and Exchange Commission.

That’s the suggestion made by Christopher Whalen, managing director, Institutional Risk Analytics, Inc., of Los Angeles, in a written reply to a question submitted to him by Senator Jim Bunning (R-Ky.), ranking member of the Senate Subcommittee on Securities, Insurance and Investment.

"To the extent that the Congress is willing to continue to tolerate speculation in derivatives for which no cash market basis exists and [that] are instead based upon models," Whalen wrote, "then the dealers should be compelled to publish these models on a monthly basis for the entire market to see and assess."

Whalen's comment appears in a July 13 letter to Senator Chris Dodd, Chairman of the Senate Committee on Banking, Housing and Urban Affairs in which he answers 25 questions submitted by Bunning, as well as 8 questions submitted by Subcommittee Chair Senator Jack Reed, Rhode Island Democrat.

Mind Over Market has obtained a copy of Whalen's letter and published it at this link:

Public disclosure of pricing models would set off a series of events that would ultimately be beneficial, Whalen wrote.

First, “it would likely lead to a multiplicity of new lawsuits by investors against the OTC derivative dealers.” This, in turn would “greatly lessen the complexity of these instruments,” Whalen wrote.

“Think of this as a 'market based' solution driven by the trial lawyers,” wrote Whalen, who urged Congress to ban OTC credit derivatives in his testimony June 22.

In his response, Whalen also reiterated his denunciation of complex credit derivatives as a fraud on investors.

“A derivative that is created without the benefit of an actively traded cash market is essentially a deception,” he wrote.

“In the case of credit default swaps and other 'derivatives' where no actively traded cash market exists, the dealer pretends that a model can serve as a substitute for a true cash market basis,” he continued.

“But such a pretense on the part of the dealer is patently unfair and, in my view, is really an act of securities fraud that should be prohibited as a matter of law and regulation.”

"No amount of disclosure can address that basic flaw in the CDS and other markets which lack a cash basis," Whalen warned.

Role for a Clearinghouse?

Whalen also challenged the value of a clearinghouse run by the Intercontinental Exchange and supported by the New York Fed and the major OTC derivatives dealers. Here is a link to ICE's Web site:

There was no need to set up a new dealer-owned clearinghouse in the first place, he says, because "such mechanism already existed in the regulated, public markets and exchanges," Whalen wrote in his response to Senator Bunning.

"For example, in the futures markets, a buyer and seller agreeing to a transaction will submit it to a clearing member, which forwards it to the clearinghouse," he wrote.

"As the sell-side counterparty to the buyer and the buy-side counterparty to the seller, the clearinghouse assumes the risk that a party to the transaction might fail to pay on its obligations," Whalen wrote.

"It can do this because it is fully regulated and . . . well capitalized," Whalen explained. "As the Chicago Mercantile Exchange is fond of saying, in 110 years no futures clearinghouse has ever defaulted."

The New York Fed originally argued that "a central counterparty was necessary to reduce risks that a major OTC dealer firm might default," Whalen explained.

However, this idea was "firmly resisted" by the banks because it would lead to billions of foregone profits dealer banks earn each year "on the cash and securities which they required their hedge fund, pension fund and other swap counterparties to put up as collateral."

The collateral was too valuable to give up. As Whalen explained, "Re-pledging or loaning these customer securities to other clients is very lucrative for the dealers and losing control over the clients collateral would dramatically impact large bank profits."

Moving to cut-off an "inevitable" regulatory clampdown, dealers bought the Clearing Corporation, "an inactive company that had been the clearinghouse for the Chicago Board of Trade," Whalen wrote.

"If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the logic of the [government-sponsored enterprise] mindset," Whalen explained in written response.

Meanwhile, the Chicago Mercantile Exchange and the New York Stock Exchange were "eager to get into the business," Whalen explained.

"If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing."

So, the banks cut a deal. They sold The Clearing Corporation to the Intercontinental Exchange (ICE), a recent start-up "funded with money originally provided by, you guessed it, the banks," Whalen wrote.

Under the deal set up by the banks with ICE, the banks receive half the profit of all trades.

"And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings." Whalen wrote.

"That's right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units." (See Footnote 1)

Whalen received 25 questions from Senator Bunning, along with another 8 questions from Senator Jack Reed (D-R.I.), chairman of the Subcommittee. The questions were forwarded to Whalen by Senator Christopher Dodd (D-Conn) .

For more information on Whalen’s June 22 testimony, see Mind Over Market's story at this link:

Questions from Senator Jim Bunning (Kentucky Republican)
Ranking Member, Senate Subcommittee on Securities, Insurance and Investment

1a. Do you believe the existence of an actively traded cash market is or should be a necessary condition for the creation of a derivative under law and regulation?

Yes. As I stated in my prepared remarks, where there is no underlying cash market that both parties to a derivatives transaction may observe, then the derivative has no true economic “basis” in the markets, and is entirely speculative. Where there is no cash market, there is, by definition, no price discovery. A derivative that is created without the benefit of an actively traded cash market is essentially a deception. In the case of credit default swaps and other “derivatives” where no actively traded cash market exists, the dealer pretends that a model can serve as a substitute for a true cash market basis. But such a pretense on the part of the dealer is patently unfair and, in my view, is really an act of securities fraud that should be prohibited as a matter of law and regulation.

1b. If not, what specific, objective means besides a cash basis market could or should be used as the underlying relationship for a derivative?

See above. To the extent that the Congress is willing to continue to tolerate speculation in derivatives for which no cash market basis exists and are instead based upon models, then the dealers should be compelled to publish these models on a monthly basis for the entire market to see and assess. Requiring SEC registration might be another effective solution. Enhanced disclosure of models for OTC derivatives would likely lead to a multiplicity of new lawsuits by investors against the OTC derivatives dealers, thus the effect of compelling the disclosure of models used to price OTC derivatives would be to greatly lessen the complexity of these instruments. Think of this as a “market based” solution driven by the trial lawyers.

2. Why should the models to price OTC derivatives not be published? If there is no visible cash basis for a derivative, and the model is effectively the basis, why should the models not be public?

See response to 1b.

3. What is the best way to draw the line between legitimate hedges and purely speculative bets? For example, should we require an insurable interest for purchasers of credit protection, require delivery of the reference asset, or something else?

Allowing speculators using OTC derivatives to effectively take positions against securities and companies in which they have no economic interest is a form of gaming that the Congress and federal regulators should reject. The term “hedge” implies that the user has an economic position or exposure to a form of risk. The use of cash settlement OTC contracts by parties who have no interest in the underlying assets or company creates perverse incentives that essentially equate an owner of an asset with the speculator with no economic interest. The AIG episode illustrates an extreme example of this problem where AIG was actively using derivatives to engage in securities fraud, both for itself and others, and apparently with the full support and knowledge of the OTC dealers. Allowing speculators to use cash settlement OTC derivatives to game against real companies and real assets to which they have no connection creates systemic risk in our financial system and should be prohibited by law and regulation.

4. Is the concern that increased regulation of derivatives contracts in the United States will just move the business overseas a real issue? It seems to me that regulating the contracts written in the U.S. and allowing American firms to only buy or sell such regulated contracts would solve the problem. What else would need to be done?

No. Those critics who proclaim that regulation of OTC derivatives such as CDS will force the activity offshore are mistaken. Where will they take this vile business? London? No. The EU? No. China? No. Russia? No. Let the proponents of this market go where they will. The government of the US should not allow itself to be held hostage by speculators.

The fact is, the US and EU are the only political jurisdictions in the world that are sufficiently confused as the true, speculative nature of CDS to allow their financial institutions to serve as a host for this reckless activity. Regulating the speculative activities of US banks in the OTC derivatives markets and banning all OTC derivatives for which there is no actively traded bash basis market will effectively solve the problem of systemic risk.

5. In addition to the administration’s proposed changes to gain on sale accounting for derivatives, what other changes need to be made to accounting and tax rules to reflect the actual risks and benefits of derivatives?

The key change that must be made is to distinguish between true derivatives, where there is an observable cash market basis, and pseudo derivatives based upon models such as CDS and collateralized debt obligations (“CDOs”) which have no observable basis and which have caused such horrible damage to the global financial system. Where there is no active market price for the underlying relationship upon which the derivative is “derived,” then the bank or other counterparty should be required to reserve 100% of the gross exposure of the position to cover the market, liquidity and counterparty risks created by these illiquid, difficult to value gaming instruments. Congress should explicitly forbid “netting” of OTC contracts such as CDS and any other derivative structure for which there is no cash basis market since there is no objective, independent way to value these instruments. How can any financial institution pretend to “manage” the risk of a CDS instrument or CDO when the only objective means of valuation is a private model maintained by a dealer?

6. Is there any reason standardized derivatives should not be traded on an exchange?

No. All derivatives for which there is an active cash market basis may easily be traded on exchanges. Only those OTC derivatives for which there is no cash market and thus no price discovery will not be practical for exchange trading. The problem here is a basic one since the clearing members of an exchange are not likely to be willing to interpose their capital to jointly and severally guarantee a market based on a CDS model. Unless the clearing members and the customers of a partnership exchange possess the discipline of a cash market basis to support and validate valuations, then it is unlikely that an exchange-based approach will be practical.

7. How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than re-negotiate the debt?

The simple answer is to require that CDS only be held by those with an economic interest in the debtor that is the underlying “basis” for the derivative. If, as under current law and regulation, you allow speculators with no economic interest in a debtor to employ CDS, then all weak banks and companies may be pushed into insolvency by parties whose sole interest is their failure. Allowing speculators to use CDS against debtors in which they have no economic interest essentially voids the traditional social purpose of the US bankruptcy laws, namely a) to recover the maximum value for creditors of the bankruptcy estate in an equal and fair way and b) to provide a fresh start for the company, which has historically been seen as a benefit in social terms. The Congress needs to recall that the requirement imposed in the 18th Century by our nation’s founders to establish federal bankruptcy courts had both a practical and a social good component.

8. How do we reduce the disincentive for creditors to perform strong credit research when they can just buy credit protection instead?

You cannot. CDS is essentially a low-cost substitute for performing actual credit research. As with credit ratings, investors use CDS to create or adjust exposures based upon market perception rather than a true analysis of the underlying value. And best of all, the spreads that are usually reflected in CDS pricing often are wrong and do not accurately reflect the true economic cost of default. Thus when speculators employ CDS to purchase protection against a default, the pricing is usually well-below the true economic value of the default. Or to put it another way, AIG was not nearly compensated for the risks that it took in the CDS markets – even though AIG was an insurer and arguably should have understood the difference between short-term “price” of an illiquid bond or loan vs. long-term “value” of a default event.

9. Do net sellers of credit protection carry that exposure on their balance sheet as an asset? If not, why shouldn’t they?

The treatment of CDS varies by country. All CDS positions, long or short, should be reflected as a contingent liability or asset, and carried on balance sheet in the appropriate way. The treatment used in the insurance industry for such obligations may be the best model for the Congress to consider as a point of departure for any legislation.

10. In her testimony Chairman Schapiro mentioned synthetic exposure. Why is synthetic exposure through derivatives a good idea? Isn’t that just another form of leverage?

Yes, it is another form of leverage and Chairman Shapiro addressed this issue directly. When a user of CDS creates the equivalent of a cash market position in a listed security, then that position should be reported to the SEC and disclosed to the marketplace. Allowing speculators to synthetically create the functional equivalent of a cash market position using CDS arguably is a violation of existing law and regulation. Why should an investor be required, for example, to disclose a conventional option to purchase listed shares but not the economic equivalent in CDS? This dichotomy only illustrates the true purpose of CDS, namely to evade established prudential norms and regulation.

11. Regarding synthetic exposure, if there is greater demand for an asset than there are available assets, why shouldn’t the economic benefit of that demand – higher value – flow to the creators or owners of that asset instead of allowing a dealer to create and profit from a synthetic version of that asset?

Agreed. One of the pernicious and truly hideous effects of OTC instruments such as CDS is that they equate true “owners” of assets with speculators who create ersatz positions in these assets via derivatives; that is, they “rent” the asset with no accountability to the owner. It could be argued that such activity amounts to an act of thievery and one that is encouraged by federal bank regulators, particularly the academic economists who dominate the Fed’s Board of Governors! Since the users of cash-settlement OTC contracts never have to deliver the underlying reference assets to the buyer, there is no economic connection between the real asset and the OTC derivative. Again, to repeat, this activity is best described as gaming, not risk management.

12. One of the arguments for credit default swaps is that they are more liquid than the reference asset. That may well be true, but if there is greater demand for exposure to the asset than there is supply, and synthetic exposure was not allowed, why wouldn’t that demand lead to a greater supply and thus more liquidity?

Arguments that CDS are more liquid that the reference assets are disingenuous and stand the world on its head. As above, why allow a derivative at all when there is no cash reference market? Allowing speculators to create a short market in an illiquid corporate bond, for example, via single-name CDS does not improve price discovery in the underlying asset since there is no market in the first place. And since the “players” in this ersatz market are required to neither borrow nor deliver the underlying reference asset, the entire exercise is pointless in terms of price discovery. The only purpose is to allow the large dealer banks to extract supra-normal returns and increase systemic risk. Again, it is just as easy to speculate on the outcome of a horse race as on the price of a CDS since there is no mechanistic connection between the wager and the actual reference “asset” or event.

13. Is there any justification for allowing more credit protection to be sold on a reference asset than the value of the asset?

No. See reply to Question 12.

14. Besides the level of regulation and trading on an exchange, there seems to be little difference in swaps and futures. What is the need for both? In other words, what can swaps do that forward contracts cannot?

A swap and futures/options are functionally equivalent. The OTC swaps for oil or interest rates can be and are actively traded against the corresponding exchange traded products because they share a common cash market basis. The advantage of OTC contracts is that they allow for customization regarding size and time periods for the counterparties. There is nothing inherently wrong with maintaining these two markets, exchange traded and OTC, side by side, so long as a cash market basis for both exists and is equally visible to the buyer and the seller. Only when the cash market basis is obscured or nonexistent does systemic risk increase because a) the pricing is entirely speculative and thus subject to sudden changes in liquidity and b) cash settlement of OTC contracts such as CDS allows the risk inherent due to the lack of true price discovery to expand infinitely.

15. One of the arguments for keeping over the counter derivatives is the need for customization. What are specific examples of terms that need to be customized because there are no adequate substitutes in the standardized market? Also, what are the actual increased costs of buying those standard contracts?

The spreads on OTC contracts generally are wider than exchange traded instruments, a difference that illustrates the inefficiency of OTC markets vs. exchange traded markets. That said, the ability to specify size and duration of these instruments is valuable to end users and the Congress should allow the more sophisticated private participants in the markets to make that choice. For example, if a large energy company or airline wants to enter into a swap to hedge fuel sales or costs, respectively, in a way the exchange traded contracts will not, then the user of derivatives ought to have that choice to employ the OTC instruments. Again, OTC markets in and of themselves are not problematic and do not create systemic risk.

16. There seems to be agreement that all derivatives trades need to be reported to someone. Who should the trades be reported to, and what information should be reported? And is there any information that should not be made available to the public?

All open positions in OTC derivatives above a certain percentage of the outstanding contracts in any market should be a) reported to the CFTC and b) publicly disclosed in aggregate form. Such disclosure would greatly enhance market efficiency, but it does not mitigate the concerns regarding CDS and other contracts for which there is no liquid, actively traded cash basis market. No amount of disclosure can address that basic flaw in the CDS and other markets which lack a cash basis.

17. What is insufficient about the clearing house proposed by the dealers and New York Fed?

The proposed clearing house is entirely controlled by the dealer banks. As we wrote in The Institutional Risk Analyst in May of this year:

In 2005, the New York Fed began to fear that the OTC derivatives market, at that time with a notional value of over $400 trillion dollars, was a sloppy mess - and it was. Encouraged by the Congress and regulators in Washington, the OTC market was a threat to the solvency of the entire global financial system - and supervisory personnel in the field and the Fed and other agencies had been raising the issue for years - all to no effect. This is part of the reason why we recommended to the Senate Banking Committee earlier this year that the Fed be completely relieved of responsibility for supervising banks and other financial institutions.

Parties were not properly documenting trades and collateral practices were ad hoc, for example. To address these problems, the Fed of New York began working with 11 of the largest dealer firms, including Bear Stearns, Merrill Lynch, Lehman, C, JPM,
Credit Suisse and [Goldman Sachs]. Among the "solutions" arrived at by these talks was the creation of a clearinghouse to reduce counterparty credit risk and serve as the intermediary to every trade. The fact that such mechanism already existed in the regulated, public markets and exchanges did not prevent the Fed and OTC dealers from leading a multi-year effort to study the problem further - again, dragging their collective feet to maximize the earnings made from the existing OTC market before the inevitable regulatory clampdown.

For example, in the futures markets, a buyer and seller agreeing to a transaction will submit it to a clearing member, which forwards it to the clearinghouse. As the sell-side counterparty to the buyer and the buy-side counterparty to the seller, the clearinghouse assumes the risk that a party to the transaction might fail to pay on its obligations. It can do this because it is fully regulated and by well capitalized[entities]. As the Chicago Mercantile Exchange is fond of saying, in 110 years no futures clearinghouse has ever defaulted.

While the NY Fed believed that a central counterparty was necessary to reduce risks that a major OTC dealer firm might default, the banks firmly esisted the notion. After all, they make billions of dollars each year on the cash and securities which they required their hedge fund, pension fund and other swap counterparties to put up as collateral. Re-pledging or loaning these customer securities to other clients is very lucrative for the dealers and losing control over the clients collateral would dramatically impact large bank profits.

A clearinghouse would eliminate the need for counterparties to post collateral and a lucrative source of revenue for the dealer firms. So they bought the Clearing Corporation, an inactive company that had been the clearinghouse for the Chicago Board of Trade. If they had to clear their trades, the dealer firms reasoned, at least they would find a way to profit by controlling the new clearing firm. Such is the
logic of the GSE mindset.

Meanwhile, other viable candidates for OTC derivatives clearing were eager to get into the business, such as the Chicago Mercantile Exchange and the New York Stock Exchange. Both had over 200 years experience in clearing trades and were well suited to serve as the impartial central counterparty to the banks and their customers.

If the NYSE and CME were to trade derivatives, the big banks knew they would not be able to control their fees or capture the profits from clearing. Therefore, they sold The Clearing Corp. to the Intercontinental Exchange, or ICE, a recent start-up in the OTC derivatives business which had been funded with money originally provided by, you guessed it, the banks. In the deal with ICE, the banks receive half the profit of all trades cleared through the company. And the large OTC dealer banks made sure, through their connections with officials at the Fed and Treasury, that ICE was the winner chosen over the NYSE and CME offerings. That's right, we hear that Tim Geithner personally intervened to make sure that ICE won over the NYSE and CME clearing units. (See Footnote 1)
18. How do we prevent a clearing house or exchange from being too big to fail? And should they have access to Fed borrowing?

Limit trading in OTC derivatives by a) requiring sellers to deliver the basis of the derivative upon expiration of the contract and b) ban those derivatives for which there is no actively traded cash basis market. If such reforms are enacted, there should be no need for the Fed to ever support a multilateral exchange or clearing house.

19. What price discovery information do credit default swaps provide, when the market is functioning properly, that cannot be found somewhere else?

None. The argument that a derivative can aid in price discovery for an illiquid cash basis is circular and ridiculous. Trading in CDS is merely gaming between the parties vs. current market prices. As mentioned above, most single name CDS trade against the short-term yields/prices of the supposed basis, thus these contracts arguably do not provide any price discovery vs. the true cost of insuring against default. For example, the day before Lehman Brothers filed bankruptcy, the CDS was trading at roughly 700bp over the Treasury yield curve or roughly 7% per year (plus upfront fees totaling another couple of percentage points) to insure against default. Yet when Lehman filed for bankruptcy, the resulting default required the payment of 9,700bp to the buyers of protection or par less the 3% recovery rate determined by the ISDA auction process. Clearly, receiving 7% and having to pay 97% is not an indication of effective price discovery! The sad fact is that many (but by no means all) users of CDS employ these instruments to trade or hedge current market exposures, not to correctly price the cost of default insurance.

20. Selling credit default swaps is often said to be the same as being long in bonds. However, when buying bonds, you have to provide real capital up front and there is a limit to the lending. So it sounds like selling swaps may be a bet in the same direction as buying bonds, but is essentially a highly leveraged bet. Is that the case, and if so, should it be treated that way for accounting purposes?

That is correct. In order to sell a bond short, the seller must be able to borrow the collateral and deliver same. In CDS, since there is no obligation to deliver the underlying basis for the contract, the leverage is far higher and, more important, there is no real connection between the price discovery in the cash market and the CDS. While services such as Bloomberg and others use cash market yields to estimate what they believe the valuation of CDS should be, there is no objective confirmation of this in the marketplace. The buyers of CDS protection should be required to deliver the underlying instrument in order to collect on the insurance. Indeed, this was the rule in the OTC market until the after the bankruptcy of Delphi Corporation. (See Footnote 2) At a minimum, the Congress should compel ISDA to roll-back the template for CDS contracts to the pre-Delphi configuration and require that buyers of protection deliver the underlying basis.

21. Why should we have two regulators of derivatives, with two interpretations of the laws and regulations? Doesn’t that just lead to regulation shopping and avoidance?

Yes, in terms of efficiency, we should not have two regulators of derivatives, but the purpose of the involvement by the two agencies is not identical. When a derivative results in the creation of the economic equivalent of a listed security, then investors must be given notice via SEC disclosure. It should be possible for CFTC to exercise primary regulatory oversight of these markets while preserving the role of the SEC in enforcing the legal duty to disclose events that are material to investors in listed securities.

22. Why is synthetic exposure through derivatives a good idea? Isn’t that just another form of leverage?

Yes, it is another form of leverage against real assets. Like any form of leverage, it must be disclosed and subject to adequate prudential safeguards such as collateral and disclosure.

23. What is good about the Administration proposal?

At least we are now talking about some of the important issues, but the Administration proposal essentially mirrors the position of the large banks and should not be taken as objective advice by the Congress.

24. Mr. Whalen, you suggest making all derivatives subject to the Commodity Exchange Act. The S.E.C. says some derivatives should be treated like securities. Is that an acceptable option?

See response to Question 21.

25. Is there anything else you would like to say for the record?

To repeat my earlier testimony, the supra-normal returns paid to the dealers in the CDS market is a tax. Like most state lotteries, the deliberate inefficiency of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pay the CDS tax via wider spreads and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. And for every large, overt failure like AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. How does the continuance of this market serve the public interest?

Questions from Senator Francis “Jack” Reed (Rhode Island Democrat)
Chairman, Senate Subcommittee on Securities, Insurance, and Investment

1. Are there differences between the SEC and CFTC’s approaches for regulating their respective markets and institutions that we should take into consideration when thinking about the regulation of the OTC derivatives markets?

The CFTC should be tasked with the functional regulation of all derivatives markets. The SEC should cooperate with the CFTC, especially in terms of the disclosure of any derivative that creates the economic equivalent of a position in a listed security.

2. The Administration’s proposal would require, among other things, clearing of all standardized derivatives through regulated central counterparties (CCPs). What is the best process or approach for defining standardized products? How much regulatory interpretation will be necessary?

The clearing of standardized contracts is a fairly straight-forward proposition and involves risks that may be managed with existing regulation. Perhaps the biggest challenge is to require the terminology used, for example, in a CDS or CDO created from a mortgage backed security, be standardized. As my colleague Ann Rutledge stated in the interview which I included in the hearing record: “The first key issue is that we need to do to reform our markets is to have a standard vocabulary for the definition of what is a delinquency, a default, and loss.”

3. Are there key areas of disagreement between market participants about how central counterparties should operate? For example, what are the different levels of access these central counterparties grant to different market participants? What are the benefits and drawbacks of different ways of structuring these central counterparties?

In the OTC derivatives market, only the dealers have access to the clearinghouse. In an exchange based market, all of the participants face the clearinghouse and there is thus far greater equality in terms of price discovery and execution cost. From this perspective, an exchange type model is far superior, especially seen from the perspective of non-dealer participants.

4. One key topic touched on at the hearing is the extent to which standardized products should be required to be traded on exchanges. What is your understanding of any areas of disagreement about how rigorous new requirements should be in terms of mandating, versus just encouraging, exchange trading of standardized OTC derivatives?

Standardized products do not have to be traded on an exchange. The mere fact of standardization, as in the case of currency and interest rate swaps, will have the desired positive benefits. In many respects, the issue of standardization is a canard and misses the true public policy issues posed by certain OTC derivatives such as CDS in terms of a) the lack of an actively traded cash basis market and b) the creation of excessive risk in the financial system by allowing cash settlement.

5. Can you share your views on the benefits of customized OTC derivatives products? About how much of the market is truly customized products?

See answer to Question 15 above.

6. The Administration’s proposal would subject the OTC derivatives dealers and all other firms whose activities in those markets create large exposures to counterparties to a “robust and appropriate regime of prudential supervision and regulation,” including capital requirements, business conduct standards, and reporting requirements. What legislative changes would be required to create margining and capital requirements for OTC derivative market participants? Who should enforce these requirements for various market participants? What are the key factors that should be considered in setting these requirements?

Under current law, the Fed and SEC already have the ability to impose such a regime. The only lacking is the will to regulate. The Congress does not need to pass major legislation. What is required is congressional oversight of the Executive Branch and, if needed, action to compel the Fed and Treasury to serve the public interest instead of the narrow interests of the largest dealer banks. If the Fed and Treasury are unable or unwilling to take the lead on requiring “robust and appropriate regime of prudential supervision and regulation” for the large banks that control the OTC markets, then the Congress should follow my recommendation and strip the Treasury and Fed of all powers in terms of regulating and supervising banks and create a new prudential regulator that is insulated from the partisan politics of Executive Branch appointments. The biggest problem facing the US today in terms of financial regulation is the capture of regulators by the banks which they are supposed to supervise!

7. One concern that some market participants have expressed is that mandatory margining requirements will drain capital from firms at a time when capital is already highly constrained. Is there a risk that mandatory margining will result in companies choosing not to hedge as much and therefore have the unintended consequence of increasing risk? How can you craft margin requirements to avoid this?

This seems to be a false argument. Dealers lacking capital to cover their risk should reduce those risk and related leverage. Why should dealers be able to access markets via OTC markets and thereby evade the leverage, margin limits and prudential regulations that have been long-established in organized markets? The more leverage that is available to market participants via OTC derivatives, the greater the systemic risk. Thus it seems that the Congress, if it truly wishes to limit systemic risk, must conform the margin requirements in the OTC markets to those prevailing elsewhere in the US financial markets. To do otherwise is inconsistent and would seem to undermine the whole purpose of financial regulation.

8. Is there a risk that regulating the OTC derivatives markets will dramatically alter the landscape of market participants or otherwise have unintended consequences we aren’t aware of?

As I mentioned in my testimony, the chief result of regulation will be to lessen the supra-normal returns earned by the dealers in the OTC markets and thereby expose the fundamental lack of profitability in these institutions. If the Congress has the courage and sense of purpose to reject the pretense that OTC markets for instruments such as CDS actually enhance market stability or bank profits on a rick adjusted basis, then we can return banks to being what they should be – namely low-risk utilities – and end the threat of systemic risk one and for all. So long as the Congress refuses to act, then the most irresponsible and aggressive speculators will continue to use our banking system to create ever more complex and opaque securities, and systemic risk will increase and eventually destroy our economy and our nation.

Footnote 1: See “Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives,” The Institutional Risk Analyst, May 18, 2009.

Footnote 2: See Boberski, David, CDS Delivery Option: Better Pricing of Credit Default Swaps, Bloomberg Books (2009), Pages 101-104.

Copyright © 2009 by Robert Stowe England

Thursday, July 9, 2009

Credit Derivatives Remain 'Largest' Systemic Risk

The markets for over-the-counter (OTC) credit default swaps (CDS) and collateralized debt obligations (CDOs) can never overcome their opaque and complex nature; further, they were designed to hoodwink potential purchasers and to obscure their essentially fraudulent nature, according to risk analyst Christopher Whalen.

CDS and CDO's provide supersized financial returns to the Wall Street dealers who construct them while imposing a tax on the financial system, the global economy and the public, Whalen contends. Rather than spread risk, as claimed, they are the chief source of systemic risk and Congress should ban them forever, he recommends. All other OTC derivatives need to be brought under the regulation of the Commodity Futures Trading Commission, he adds.

By Robert Stowe England

July 9, 2009
(Updated July 10, 2009)

As Congress tackles the issue of regulatory reform of the financial system, the most important thing it can do is to ban over-the-counter credit derivatives because they pose “the largest source of systemic risk in the global financial markets.”

That is the message from Christopher Whalen, the co-founder and managing director of Institutional Risk Analytics, a Los Angeles publisher of risk ratings and provider of financial analysis and valuation tools.

Whalen gave his views in testimony June 22 and follow-up responses provided to questions from the Senate Committee on Banking, Housing and Urban Affairs, both of which can be found at this link:

Whalen’s testimony blasted the unregulated over-the-counter (OTC) market for credit default swaps (CDS) -- which brought down AIG last fall and cost taxpayers hundreds of billions of dollars in bailouts so far - as well as the market for Collateralized Debt Obligations (CDOs).

A credit default swap is a counterparty agreement in which the seller promises the purchaser to pay the remaining interest and principal on the debt if there is a default. In return, the purchaser makes regular payments to the seller to provide the insurance against default. See a definition at this link:

A collateralized debt obligation is a derivative security backed by a pool of other bonds and loans. It pays a stream of income to the purchaser and is divided into tranches with differing levels of risk. See definition at this link:

Whalen argued that unregulated credit derivatives, which represent a big slice of the world’s huge OTC derivatives markets, are based on deceptive contracts sold to credulous buyers who are participating in a gaming activity and not investing.

“A situation where one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans as a fraud,” Whalen told the Senate Banking Committee.

Whalen laid out a roster of indictments against big Wall Street derivatives dealers.

“It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system,” the analyst told the Senate panel.

“Simply stated, CDS and CDO markets currently are parasitic,” Whalen said. “These markets subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.”

“Seen in this context, AIG was the most visible ‘sucker’ identified by Wall Street, an easy mark that was systematically targeted and drained of capital by [JP Morgan Chase, Goldman Sachs] and other CDS dealers, in a striking example of predatory behavior,” Whalen said.

AIG is not alone. CDS contracts and CDOs constitute a large share of the toxic waste assets on the books of financial institutions in the United States and around the globe. Write-offs and mark-downs of these assets have weakened the financial system and contributed to a global recession.

Risk analysts have argued that the pricing of CDS contracts is not sufficient to cover any claims and indeed that in the case of AIG, they never intended to pay them. See article at this link cited by Whalen in his testimony:

Geithner's Testimony

On July 10 Secretary of the Treasury Timothy Geithner was the sole witness at a joint hearing of the House Committee on Financial Services and the House Committee on Agriculture. The hearing focused on a potential legislative and regulatory proposal on coordinating regulation of OTC derviatives that is set to emerge from the Securities and Exchange Commission and the Commodity Futures Trade Commission (CFTC).

See this link for Geithnner's prepared testimony:

The industry favors a clearinghouse approach for credit derivatives, which Treasury is also backing. See story at this link:

Here is a press release from this past spring describing recent research by the TABB Group of Westborough, Massachusetts, on trends in the credit default swaps market around the globe:

A Behemoth Market

The systemic risk from the OTC credit derivatives is partly due to its sheer size.

According to the Bank for International Settlements, the notional value of OTC derivatives in December 2008 stood at $592 trillion, with a gross market value outstanding of $34 trillion. Credit and equity derivatives represented $48.4 trillion and had a gross market value outstanding of $6.8 trillion.

If one just looks at CDS only, their notional value is greater than all the money invested in the U.S. stock market, American mortgages and U.S. Treasuries combined. Indeed, they are almost as large as the output of the entire world. See information at this link:

While notional values certainly overstate the exposure, it is hard to get a handle on the real exposure that the financial system has to credit derivatives. A June 26 estimate from the U.S. Office of the Comptroller of the Currency (OCC) sets the net credit exposure of U.S. commercial banks only (many contracts are held by hedge funds and other non-bank firms) at $695 billion for the first quarter of 2009, a 50 percent increase over the exposure level in the fourth quarter of 2008.

U.S. banks also face a potential future exposure at $723 billion for a total credit exposure of $1.418 trillion, according to the OCC.

Deceptive and Unfair

In his criticism of the OTC derivatives market, Whalen was careful to distinguish between two very different types of derivatives markets, only one of which he sees as legitimate.

On the legit side, there are derivatives contacts that are based on a clear, visible cash market, Whalen explains. This includes, for example, currency swaps, interest rate swaps, and natural gas swaps. “Both buyers and sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection,” Whalen stated.

However, on the other hand, in the case of another type of contract – those for CDS and “more obscure” CDOs – “the basis for the derivative is non-existent or difficult/expensive to calculate,” he stated.

Part of the pricing difficulty arises from that fact they are based on models developed by their creators. “The buyer of CDS or CDOs has no access to such models and, thus, really has no idea whatsoever how the dealer values the OTC derivative,” Whalen testified.

More importantly, Whalen explained, the dealer models “are almost always and uniformly wrong and are, thus, completely useless to value the CDS or CDO.”

Whalen argued that most CDS contracts and structured financial instruments are “deceptive by design” and “deliberately fraudulent instruments for which no cash basis exists” and for this reason should be banned.

“If we as a nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives,” he said, “then how can we expect our financial institutions and markets to be safe and sound?”

Whalen contends that the fundamental understanding that makes financial markets work, and which has been built into financial law and regulation, rests on the principle that “equal representation under the law [goes] hand-in-hand with proportional requital.” By that, he meant “that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain.”

What Needs to Be Done

In response to a question about how to modernize oversight of the OTC derivatives market,
Whalen laid out in his written resonse what he thought Congress should do to address the problems in the derivatives market.

First, he said, Congress should require that OTC contracts be subject to The Commodity Exchange Act (CEA) of 1936, a step that would bring them under the oversight of the Commodity Futures Trading Commission (CFTC).

Congress should also instruct the CFTC to begin a systematic review and rule-making process. The purpose would be to either conform OTC markets to minimum standards of disclosure, collateral and transparency. Or, require that the OTC contracts be migrated onto organized, bilateral exchanges.

“It is time for Congress to right the wrong done over a decade ago to [former] Commissioner Brooksley Born and her colleagues at the CFTC,” Whalen wrote.

“This wrong was committed in part by the Congress and part by then-Treasury Secretary Larry Summers, and then-Fed Chairman Alan Greenspan, and former Treasury Secretary Robert Rubin, among others, who all worked together to effectively block action that would have subjected OTC contracts to the full supervision of the CFTC.”

Whalen also faulted Summers, Greenspan and Rubin for vilifying Born and others at the CFTC.

Second, Congress should admit it erred in 2000 by blocking CFTC regulation of OTC derivatives. That decision set the stage for an explosion in the derivatives market, according to the risk analyst.

Third, Whalen urged that Congress, after bringing OTC markets under the oversight of the CFTC, should “take further time for hearings and fact finding to consider what other changes should occur in terms of the law and the operational structure of the SEC and the CFTC.”

Finally, Whalen explained why the above prescription does not work for credit derivates and why they should be banned: “It is probably not possible to move” the market for CDS and complex structure assets to an exchange.

“Because CDS contracts generally do not have a cash market or basis upon which to draw for the purpose of valuation, as a matter of law regulation, these investments are entirely speculative, unsuitable for most banks and investors, and thus should be banned entirely.”

Whalen’s proposal to bring the OTC derivatives market under the wing of the CFTC is also a slap at the potential ability of the Federal Reserve Board and the Treasury to oversee systemic risk.

Indeed, the risk analyst warned Congress that as it set about to reform financial regulation, members should ignore “the views of existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury,” since their views are “large duplicative” of JP Morgan Chase, Goldman Sachs and the other larger OTC derivatives dealers who have essentially “captured” their regulators.

Whalen argued against the need for a systemic risk regulator.

Systemic risk “is a function of inefficient markets and opaque, illiquid financial instruments such CDS and complex structured assets.” If Congress imposes regulation on the OTC derivatives market, the “perceived need for a systemic regulator will disappear,” Whalen wrote.

“All that will be left to do then is to “celebrate the end of one of the darkest, most alarming periods of speculative mania seen in many generations,” Whalen wrote.

Whalen also attacked the idea that the unregulated derivatives market is “innovative,” a view former Fed Chairman Alan Greenspan once advocated.

Imposing appropriate prudential and legal limitations on OTC derivatives would have enormous benefits for investors in terms of better pricing, increase transparency regarding market and liquidity risk and improved surveillance and oversight by regulators,” Whalen wrote in response to a question from Senate panel about how his proposals would affect different market participants.

The regulation of OTC derivatives will “limit predatory behavior by lenders and major Wall Street dealer firms,” Whalen argued. “If you do not allow overly-complex financial instruments to exist in the first place, then the Congress will effectively limit systemic risk in financial markets.”

Doom for Derivatives Dealers?

Ultimately, the regulation of OTC derivatives will take away from JP Morgan Chase and Goldman Sachs the ability to make outsized profits on credit derivatives, Whalen explained in his written responses.

“Why then are the large banks, led by [JP Morgan Chase], engaged in such a desperate battle over the reform of the OTC derivatives market?” he asked. “For the world’s largest banks, the OTC derivatives market is the last remaining source of supra-normal profits,” Whalen told Congress.

“Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by [JP Morgan Chase, Goldman Sachs] and the remaining legacy OTC dealers, the largest banks cannot survive and must shrink dramatically,” Whalen wrote.

“No matter how good an operator of commercial banks [JP Morgan Chase chief executive officer] Jamie Dimon may be, his bank is doomed without its near monopoly in OTC derivatives,” Whalen stated.

“Seen from that perspective, the rescues of Bear Stearns and AIG were meant to protect not investors nor the global markets, but rather to protect [JP Morgan Chase, Goldman Sachs] and the small group of dealers who benefit from the continuance of their monopoly over the OTC derivatives market,” Whalen wrote.

Administration Proposal a ‘Canard’

Whalen also spoke against the Obama Administration’s proposal for financial market regulatory reform.

“Americans have historically stood against efforts to reduce transparency and make markets less efficient – but that is exactly how this Committee should view proposals from the Obama Administration and Treasury to ‘reform’ the OTC derivatives markets,” Whalen testified.

The risk analyst called the Administration’s proposal “a canard” because it does not reform the market but instead preserves it essentially as it is.

The Administration’s OTC derivatives market proposal is “an attempt by the White House and the Treasury Department to leave in place the de facto monopoly over the OTC markets by the largest dealer banks, led by [JP Morgan Chase, Goldman Sachs] and other institutions,” Whalen wrote.

“For example,” he continued, “the centralized clearing model proposed by the Treasury has some notable attributes, but still leaves the OTC markets under the complete control of the dealer banks, with little public disclosure of prices, no transparency, and no accountability to other dealers and market participants.”

“The proposal,” he added, “to require centralized clearing does not address the issues of pricing, basis risk and transparency.”

Copyright © 2009 by Robert Stowe England

Copyright 2009© by Robert Stowe England

Wednesday, July 1, 2009

Will a Jobless Recovery Boost Unemployment?

According to an analysis by the San Francisco Fed, the American economy may be facing a jobless recovery similar to the one after the 1991 recession. Two current trends suggest such an outcome: an increase in the rate at which workers settle for involuntary part-time employment and a decline in the rate of temporary layoffs.

The San Francisco Fed’s earlier expectation in May was that unemployment could peak at 11 percent in mid-2010 -- significantly higher than the consensus forecast of 10 percent by early 2010. Given the accelerating pace of joblessness, an updated analysis based on the factors cited by the San Francisco Fed would suggest that the peak might be even higher at 11.5 percent or 12 percent.

By Robert Stowe England

July 1, 2009

(Updated July 2 with new unemployment data)

An analysis of labor market data suggests that this recession may be followed by a jobless recovery like the one following 1991 rather than a sharp rebound in hiring that occurred after the recession in the early 1980s, according to an Economic Letter from the Federal Reserve Bank of San Francisco.

A jobless recovery is a term used by economists to describe a weak economic recovery that does not produce sufficient jobs quickly enough to prevent continuing increases in unemployment well into the economic growth cycle.

The FRBSF Economic Letter, authored by Mary Daly, Bart Hobijn, and Joyce Kwok, can be found at this link:

In its analysis, the San Francisco Fed examined the evidence from historic and current flow patterns of workers moving into unemployment (firings) and workers moving out of unemployment (hirings) in the current recession. They also examined trends in temporary layoffs and involuntary part-time employment.

Current trends were then compared to historic trends to look for guidance on how the recovery from the current recession is likely to unfold.

The authors identify two distinct flow patterns in hirings and firings that have shaped past recessions and recoveries since World War II.

One pattern is from the recessions in the 1970s and 1980s, which were marked by “nearly equivalent relative increases” in both the rate at which workers were fired and the decrease in the rate at which people were hired. In the recovery that followed these recessions, hiring and firing levels returned quickly to normal, and unemployment fell.

By contrast, there was a different pattern in the 1991 and 2001 recessions, when unemployment rates rose more as a result of the rate of decrease in hirings than by the rate of increase in firings.

In the recovery after the 1991 and 2001 recessions, the pace at which hiring and firing returned to normal levels was slower. There was not a quick rebound in hirings or a quick decline in the rate of firings as occurred in the 1970s and 1980s. This, in turn, led to a jobless recovery where unemployment remained high.

Recovery Scenarios

During the current recession, which began in December 2007, the pattern of inflows and outflows has been more like those of the 1970s and 1980s. That is, the pace at which firings have risen has been matched by a similar pace at which hirings have declined.

The authors lay out three scenarios for the recovery.

In one scenario, if the rate of hirings and firings were to remain the same as they have been through April 2009, then unemployment would be expected to rise to a peak around 10 percent in early 2010, roughly in line with the current Blue Chip consensus forecast, whose publisher can be found at this link:

The authors then considered two additional alternative scenarios. One is a rapid rebound, as occurred in the 1982-1983 recovery. The other is a jobless recovery like the one in the 1991-1992 recovery, where the unemployment rate peaked much later in the cycle than it did in the 1982-1983 recovery.

The authors then examine two other labor market trends to further their analysis: the rate of temporary layoffs and the rate of involuntary part-time employment. Information on these trends is reported by households in the Current Population Survey. Data from the CPS can be found at this link:

In the current recession, the share of workers laid off is very low compared to the past. This means that there are fewer workers waiting to be called back to their jobs than in prior recessions.

Indeed, the share of workers temporarily laid off in this recession has fallen from 12.8 percent in December 2007 to 11.9 percent in April. (For May 2009 data see this link:

By contrast, the share of workers temporarily laid off rose from 16.1 percent in July 1981 to 20.7 percent in November 1982.

A similar contrast exists with data on involuntary part-time workers. In the current recession, the share of workers employed part-time against their wishes rose from 3.0 percent in December 2007 to 5.8 percent in April 2009, an all-time high.

“This increase has been broad-based, occurring in a wide range of occupations,” the Economic Letter states. (For May 2009 data see this link: and look for data under part-time employment for economic purposes.)

The authors combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization, which can be seen in the figure accompanying this article.

For the month of April, the combined total of the unemployment rate and the rate of involuntary part-time employment was 14.7 percent. This measurement “shows that the labor market has considerably more slack than the official unemployment rate indicates.” In other words, the labor situation is worse than indicated by the unemployment rate alone.

On June 5 the Department of Labor announced that the unemployment rate rose from 8.9 percent in April to 9.4 percent in May. (See the press release at this link: .)

Since the San Francisco Fed’s analysis was completed ahead of this jump in joblessness, it was not reflected in its review and projected scenarios. Indeed, the jump in the May unemployment rate added fuel to the argument for a higher peak in unemployment for this recession and recovery.

Update July 2: The unemployment rate rose from 9.4 percent in May to 9.5 percent in June, the highest level since August 1983, almost 26 years ago. See press release at this link: Since the recession began, the unemployment rate has almost doubled, rising 4.6 percentage points from its 4.9 percent level in December 2007.

Importantly, job losses rose to 467,000 from the prior month's 345,000 loss (revised downward to 322,000), dashing expectations job losses were decelerating. The increase in payroll job losses was the first in four months. The higher loss number spooked the market and increased speculation the onset of a recovery could be further delayed.

The July 2 report also showed anemic wage growth. Average hourly earnings of production and nonsupervisory workers on private nonfarm payrolls were unchanged at $18.53. The report further showed a decline in the average workweek for production and nonsupervisory workers on private nonfarm payrolls, which fell by 0.1 hour to 33.0 hours--the lowest level on record for the series, which began in 1964.

Given the uptick in the pace of rising unemployment, the question now is this: If the jobless recovery scenario unfolds, as expected by the San Francisco Fed, will unemployment still peak at 11 percent or will it rise closer to 11.5 percent or 12 percent before it peaks? And if rises higher, will the peak come later than mid-2010?


Note: The San Francisco Fed authors cite the following labor market studies that guided their analysis:

Robert E. Hall, “Job Loss, Job-Finding, and Unemployment in the U.S. Economy over the Past Fifty Years,” National Bureau of Economic Research, Macroeconomics Annual, 2005. pp. 101-137.

Robert J. Shimer, “The Cyclical Behavior of Equilibrium Unemployment and Vacancies,” American Economic Review 95(1) (2005): pp. 25-49.

Robert J. Shimer, “Reassessing the Ins and Outs of Unemployment,” National Bureau of Economic Research Working Paper 13421 (2007).

Copyright 2009© by Robert Stowe England