by www.highyieldblog.com
The banking committee discussion on derivatives included a comprehensive
list of (well known) issues of the field of financial weapons of mass destruction.
Derivatives, securitizations and off-balance sheet exposure all were
contributing factors to the current crisis (as they have been in 1987
and 1998). Credit Default Swaps seem to have been the hot topic.
CDS are often falsely compared with insurance but actually I think
they should just be seen to mimic a long- or short credit position rather
than representing an insurance contract. The only difference is that
financial institutions do have to properly account for credit positions
which they obviously don't have to for CDS.
I have made a small list of the topics covered (they were discussed mostly
on a very general level if not to say that only phrases have been exchanged).
I don't think that it makes any sense to discuss any of them in great length,
because they are all knowns and most of what has to be done seems to be
quite obvious. However, at the end of this post you will find a list of the topics
discussed (in no particular order and of course incomplete):
But had I fallen asleep during the hearing or was there a ban of a few topics?
I have in no word heard anyone talking about accounting or mark-to-market.
Also structured finance (ABS's, CDO's, etc.), which in my view is a huge deal,
has rarely been touched even when unrealized/unrecognized losses are huge
(and continue to be under development). This factor may even a (bad) reason
for regulatory bodies to slow down the needed changes because institutions/
government have a hard time to stomach (and finance) such further losses.
So I maybe have a slight idea why they did not want to touch this too much
but accounting definitely is another major topic which has been addressed at all.
Treasury secretary to the President: "Hey Mister President, our
WS friends just wiped out the whole banking system, largely with
instruments they did (partly not understand) and did not have to
account for properly, should we fix it right away or should we first
dry to bring in some more equity from dumb SWF funds and
some greenshoot dummies?"
There also was, long overdue, discussion of the "empty creditor" problem. I
missed clear language on a solution on this. In my view every debtholder
(or debtholders acting as a group) which hold(s) a "blocking position" in
one class of debt instruments should be subject to disclosure similar as
equity holders. They should fully disclose their holdings (insiders should
do so in the same way) and they should have to disclose all their
derivatives dealings in this company (same thing with insiders).
Junior Credit Hedgie to his boss: "Hey master of the universe,
our huge basis trades which we so easily were able to put on
our credit arb book during the crisis when everyone had to de-lever
- you remember those with the wide and (almost) riskless spreads
may not be available to us in the next credit cycle because even
the banking committee has recognized what is going on with this so called
"extra return" basis trades". Master of the universe: "Oh my god!
Do you mean those where we can put the companies into bankruptcy
by not answering the phone when they need us for any kind of out of
court restructuring?" "Yes master, but don't worry, the companies
will all hit the wall before the new rules are in place."
One final topic I wanted to mention is the enormous difficulty everyone seems
to have to evaluate and trade these extraordinarily complex structured securities
(CDO's & ABS's). This is especially the case since the market has turned.
The talent to master such challenges was flowing freely until prices turned south
but since then no one seems to have the slightest clue if they should trade at
10 or 80 cents on the dollar. I tell you something: There is no problem at all,
other than that the prices moves and risen liquidity discounts have wiped out
large portions of equity. There is no lack of willing buyers.
The extend to which the models have been false is not the problem, it is rather
that the input variables have to be changed. And come one, we are talking
about pools of assets withing asset classes which are not completely exotics.
Most of them are well understood and hundreds of billions and more than a
trillion in size. But certainly everyone thinks we are talking about and dealing
in rare stamps.
Here is my suggestion: Let every CDO and ABS transaction done by a
broker/dealer to be print on TRACE (the reporting system for USD corporate
bond trading) in the same way ad B/D's have to report all USD denominated
corporate bonds trades. Within a few days everyone who has a basic
understanding of securitizations will be able to price each of those tens of
thousands of "exotic" instruments on each layer of the capital structure
within a range of at least 5 points.
Bank CFO to Bank CEO: "Vikram, call the government".
It is true that only a few trades take place each day but it is just not true that
one could not price them based on some market price points. At least it will
be clear than someone could not mark a junior tranche above the level of
where senior tranches are trading. There are other relatively simple ways
to improve transparency in those structures as well but I think no one is
interested in them. To mention two: require all dealers transacting in such
securities to post the full set of documents (indentures, trustee reports,
payment reports, marketing books, rating reports, prospectuses, term
sheets and a summary of the capital structure/waterfall features) into
a central and freely available website.
Require or incentives to simplify capital structures, structural
features and prospectuses.
Obviously the market prices of structured instruments are lower than
most would like them to be but I think recognizing will work, remove
the zombie factor from the system and re-mobilize private capital.
The later one most probably only over a longer period of time I guess.
List of issues discussed in the banking committee hearing:
- counterparty risk, systemic risk (too interconnected and/or too
big to fail), centralized clearing and notional risk reduction,
exchange trading, netting, margins/collateral, capital requirements
- customized versus standardized contracts, derivatives written on
illiquid cash instruments, future innovation, link of derivatives markets
to securities markets, replication of economics without purchasing
instruments, shorting without securities lending in cash market,
legitimacy of exotic and non standard products (more than half is
standardized)
- transparency, efficiency, disclosure rules, reporting, price discovery,
electronic transmission of price data, trade information warehouse,
detailed reporting to regulators and dissemination of aggregates to
public, disclosure of material contracts by companies, hidden ownership
issues (f.i. equity total return swaps to avoid disclosure)
- insurable interest/credit protection as source of incentive for lenders
to put "empty creditors" into bankruptcy
- regulation of participants and marketplaces, enforcement against
fraud, shutdown of problematic practices, regulatory bodies (SEC,
CFTC, FED, Systemic Risk Regulator), capturing of all regulatory gaps,
risk of creation of perverse incentives. regulating dealers, settlement
process, encouragement for exchange trading and standardization
(higher capital requirements for non-standardized products), need for
international cooperation, standardization challenges, circumvention
of dealers to hide transactions
- benefits of OTC derivatives to society (f.i. important to manage risk,
influence on capital formation), private and social costs and benefits,
risk of regulation for smaller players, retail investor protection
- problems of OTC- and dealer centric markets, bilateral transactions,
customer margin segregation, exotic transactions, systemic risk,
integrity, business conduct
- dealers profits and incentives (information advantage/anonymity), risk
management processes (operational risk, model risk, financial risk) and
challenges (complex, opaque, illiquid, difficult to value), risk controls,
trading limits, stress testing, types of market participants, real economic
hedges versus investment/speculation & trading, credit procedures for
counterparties
- buy side investor concerns, need for transparency and third party as
holders of collateral, backlog of unconfirmed and unprocessed trades
