Robert Johnson, director of the Economic Policy Initiative of the Roosevelt Institute, has been extremely critical of the US Government’s handling of matters related to financial services.

This past October 7, he gave testimony at the House of Representatives financial Services Committee expressing some of his concerns.  Not only was his testimony cut short, but his prepared remarks failed to be entered into record (hat tip reader Tom). This is outrageous and a deliberate attempt to expunged his testimony from record. Read the excerpt from Harper’s below (emphasis added):

Predictably, witnesses at the hearing trotted out positions urging caution in regard to the matter of reform…

[Robert] Johnson, who came last, offered the only serious critical viewpoint, saying that the American public had been “quite demoralized by…the bailouts that we experienced last fall.” After about five minutes of his testimony, Congresswoman Melissa Bean—another industry-funded committee member who chaired the hearing because [Barney] Frank was absent—had heard enough. “I’m just going to ask you to wrap up because we’re running out of time,” she told Johnson.

Johnson gamely continued. “When I hear the testimony today that are largely financial institutions and end users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States,” he said.

“I do need a final comment,” Bean interjected seconds later.

That put an end to Johnson’s testimony. “I was just called to this hearing last night, so I will provide detailed comments on your bill and a statement for the record that will finish my comments,” he concluded.

About five days later Johnson submitted his full testimony to the committee, to be included on its website along with the statements of the other eight panelists. When it wasn’t posted, Johnson asked Lynn Parramore, editor of the Roosevelt Institute’s blog, to see what was up…

Finally, she was informed that the committee’s general counsel would not allow posting of the testimony because Johnson had not submitted it during the hearing. (Of course, since Johnson had been invited at the last minute it was impossible for him to fulfill this pointless requirement.) So you still can’t read Johnson’s prepared testimony at the committee website, but you can check it out on the Roosevelt Institute’s blog.

Meanwhile, Frank’s committee has put forth its “reform” bill. “Too tepid, too weak, too late,” Johnson says of the legislation. “Very industry influenced. We had a crisis and they are pandering to the perpetrators.”

Read the full gory details below.

Source

An Object Lesson in Governmental Failure: Derivatives reform – Harper’s

Note: this post originally erroneously stated it was Simon Johnson and not Robert Johnson whose testimony was at issue.

Update: the testimony is now also embedded below for you to read.

Robert Johnson Financial Services testimony: 2009-10-07

Related posts:

• Obama caves to pressure on consumer financial protection
• A conversation with Robert Caro on Charlie Rose
• S.E.C. complicit in Madoff fraud, whistleblower says
• Geithner testifies before Congress on financial reform
• Simon Johnson: Too big to fail is “too big to exist”

This comes via the FT:

Saudi Arabia on Wednesday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.

The decision by the world’s biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world’s most heavily traded oil futures contract. It is the main contract traded on Nymex.

Before anyone tries to spin this as an anti-dollar move, you should read what else the FT article says:

In January, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, fell sharply, leaving it at a discount of almost $12 – a record gap. This dislocation in the market continued well into the summer. 

From January, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company.

The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.

The point of this move is not to undermine the dollar but to get away from the WTI contract where prices have been artificially inflated due to storage shortages at Cushing.

A friend familiar with this market also indicated that big bank punters active in this market will like this move as well as it helps them evade the position limits and regulation of the CFTC. He says, “In fact, the lack of transparency and regulation on the Dubai Merc was one of the reasons why you had such successful speculation in the oil market during the spring of 2008.”

I see a spike in oil prices as a risk to any sustained recovery. Anyone with more insight into why the Saudis made this move, do comment.

Related posts:

• Peak oil: it’s all about the Saudis
• Blame Bernanke, the dollar and oil
• Evidence that governments are underplaying peak oil
• Abu Dhabi sovereign wealth fund loses $125 billion
• Oil price rise is accelerating

I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the argument rather conspiratorial. And despite claims of an alleged smoking gun, there is no evidence in the post that that Federal Reserve is manipulating anything except interest rates. And the Fed made clear that that was what it intended to do.

Let me break down the argument made by Zero Hedge’s Tyler Durden and give a few remarks of my own on how I read the situation.

The junking of the Fed’s balance sheet

In March 2008, the Federal Reserve established the Primary Dealer Credit Facility (PDCF) to provide liquidity to the financial sector after Bear Stearns collapsed. Overnight funding had become a key source of liquidity for banks looking for cheap money (short-term rates are lower than long-term rates).

But when crisis hit, the liquidity in overnight interbank markets dried up leading to collapse at Northern Rock in October 2007 and then Bear Stearns in March 2008, institutions which were recklessly overexposed to overnight funding. This was a market failure. The Federal Reserve, therefore, stepped forward, effectively taking the entire wholesale banking market onto its balance sheet. That is what all of the Fed’s liquidity provisions are about.

The problem most of us have with this and similar facilities is the PDCF’s collateral terms. In the past the Fed accepted treasuries. Now it was accepting a lot more (including some so-called toxic assets):

The PDCF will provide overnight funding to primary dealers in exchange for a specified range of collateral, including all collateral eligible for tri-party repurchase agreements arranged by the Federal Reserve Bank of New York, as well as all investment-grade corporate securities, municipal securities, mortgage-backed securities and asset-backed securities for which a price is available.

By April 2008, when David Einhorn questioned Lehman’s earnings report, people were asking if they were going the way of Bear Stearns (see my June 2008 post “Is Lehman the next Bear Stearns?”). When Lehman did collapse, acceptable collateral expanded. In some instances it included equities as well. The Fed’s press release expanding collateral said:

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to investment-grade debt securities. The collateral for the Term Securities Lending Facility (TSLF) also has been expanded; eligible collateral for Schedule 2 auctions will now include all investment-grade debt securities. Previously, only Treasury securities, agency securities, and AAA-rated mortgage-backed and asset-backed securities could be pledged.

You’ll notice nowhere in the press release does one see the term equities. This is obviously by design because the Fed was under fire for bloating its balance sheet with junk. This process – what I call qualitative easing – was meant to be opaque.

With the panic now over, things have settled down and these facilities are likely to end. The Fed is issuing its own research to give intellectual cover to these activities. But, outrage remains nonetheless. The Fed’s own Charles Plosser, the President of the Philadelphia Fed, has said he wants to see qualitative easing end sooner rather than later. And Bloomberg News is suing the Federal Reserve under the Freedom of Information Act to reveal who it is lending money to against this dubious collateral.

That sums things up in a nutshell.  The key to note here is that the PDCF is an overnight lending facility, the TSLF is a 28-day lending facility and another program, the TALF, is a third longer-term lending facility I haven’t discussed. (See more on the TALF here and why it is a bailout).

Tyler Durden’s beef: the Plunge Protection Team

Tyler’s history of events in his post is largely consistent with what I just presented. Where his history diverges from mine is when he goes into the section headed “Implications,” saying “the Federal Reserve has now managed to singlehandedly take over the entire capital market.” At some point, he goes as far as to say:

The bolded text is all you need to know to find the smoking gun for any and all allegations of "plunge protection" or however one wishes to frame the invisible market bid.

Those are pretty strong words and I believe these claims are unsubstantiated in the post.  Why not leave it at the lesser claim that the Federal Reserve is running a loose monetary policy that encourages excessive risk – something that, while subject to interpretation, is a valid criticism?

Posts like this are exactly why I expressed concern when Bloomberg fecklessly expunged a Tyler Durden interview in August amid media hoopla over his identity:

Zero Hedge is a site replete with copious information on finance and the economy and is often a necessary voice of scepticism in the blogosphere that keeps the mainstream media honest.  We need outlets like that.  And Tyler was on Bloomberg Radio in the first place because he has something to say that is different, interesting and adds value. However, the hyperbole, tone, anonymity and confusion as to which writer is using which pseudonym at Zero Hedge has long become a liability which reduces the credibility of the site.

The claim of equity market manipulation strikes me as hyperbole.  There is no smoking gun whatsoever. It is a theory that I don’t buy into and that is not substantiated by the evidence in the post. Otherwise, Tyler and I are on exactly the same page.

I do have a few other points of disagreement.

• Why talk about the Primary Dealer Credit Facility when it is an overnight facility? The haircut is usually reset daily. How much manipulating can the Federal Reserve really do with an overnight facility? As I see it, the real problem with the Fed’s balance sheet is the loans under longer-term facilities like the TALF.
• What about the haircut on other asset classes, namely investment-grade and non-investment grade asset-backed securities and collateralized debt obligations. Forget about the plunge protection team conspiracy. To my mind, this is the real story here. The Fed says it accepts only securities “for which a price is available” as collateral. Is that really true? I am sceptical, one reason I would like to see who is getting these loans and what kind of collateral they are using.

Somehow you get the feeling there is a reason these facilities are still around, namely that some institutions need them because their capital base is so impaired right now that they would fail without the Fed taking those toxic assets off their hands.

In the end, Charles Plosser, Tyler Durden and I all agree: the Fed needs to end these programs as soon as possible.

Expect more on this issue soon via Marshall Auerback.

Update: This phrase, "PDCF usage declined, reaching zero in mid-May 2009," suggests the PDCF is not being used to goose equities. The quote comes from page seven of the following PDF document at the New York Fed from August: "The Federal Reserve’s Primary Dealer Credit Facility."

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• TALF: A bailout if one reads the fine print
• A few words from a reader on TALF mechanics
• Understand the Fed’s balance sheet
• Bloomberg News sues the Fed under Freedom of Information Act

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

In case it’s not obvious:

• Charlie is a too big to fail bank.
• The matches are debt, the firecrackers are derivatives, the M-80s are asset-backed securities and the dynamite is OTC derivatives.
• You (Ms. Watkins) are Brooksley Born
• The headmaster is Alan Greenspan
• Little John is another smaller community bank
• The other children are banks and citizens of the broader economy
• The frog-glass incident was LTCM’s collapse
• The lit dynamite incident was Lehman Brothers

In the past, I have likened regulators to referees or playground monitors to illustrate why the concept that markets are self-regulating is absurd. In the last post, “Frontline – The Warning: Who Knew About the Looming Financial Crisis?” Alan Greenspan was at war with regulator Brooksley Born over this concept of self-regulation. Born believed that regulation was a necessity in any financial market. Greenspan believed that markets are inherently self-regulating. Even fraud was self-regulating through market discipline in his view. I believe he has now repudiated this. However, Born lost that battle with ugly consequences when the market she wanted regulated, OTC derivatives, blew up via AIG.

Self-regulation is to regulation as self-importance is to importance.

Note: Even though, I am pointing to Buiter’s piece here, I am not a believer in regulation-heavy in the least. Nevertheless, his ideas do merit consideration.

Related posts:

• Deregulation efforts from the late 1990s were blocked
• A conversation with Richard Posner on Charlie Rose
• Greenspan: financial crisis ‘will happen again’
• A conversation about AIG on Charlie Rose
• Forstmann on Charlie Rose: easy money caused crisis

Janet Tavakoli was a recent guest on “On the Edge with Max Keiser” and had some troubling things to say about the state of the present U.S. financial system. 

She believes the liquidity pumped into the system will not be sufficient to reflate the economy because of over-leveraged U.S. households. The real burden of debt is already increasing as nominal GDP contracts.  This means the system is now more fragile than ever.

Meanwhile, banks have been recapitalized in an effort to save the system when mechanisms to organize a bankruptcy resolution process for too big to fail institutions would be much less costly for the economy. This is a topic I covered in a recent post.

Steve Keen told Max that the only way out of this is a debt jubilee – a notion I believe is a political non-starter. So expect this end in a debt deflationary scenario as the Fed and other central banks are not yet getting any traction except in asset prices.

Below is the video of Max Keiser talking to Tavakoli by phone.  Tavakoli provides some enlightening words about fraud, derivatives, and broker-dealer bankruptcy. The video runs about 10 minutes.

Related posts:

• Janet Tavakoli: C-Span Q&A
• Steve Keen: On the Edge with Max Keiser
• Citi agrees to do cramdowns
• Forstmann on Charlie Rose: easy money caused crisis
• Chicago Tribune near bankruptcy

I am astounded at how quickly we have returned to the pre-crisis days of yore. Credit spreads are down, the stock market is up, volatility is down, earnings are up and bonuses are up.  It looks like happy days are here again.

But, I can’t help thinking this is all too much and too soon.  It’s as if we have learnt absolutely zero from the financial crisis.  Witness the recent goings on at Barclays.  The deal they have done with a newly-formed hedge fund called Protium is all over the news these days. 

The story goes like this: Barclays has a bunch of so-called toxic assets on its books that are marked way down from face value – over $12 billion worth. They are selling these assets to a supposedly arms-length hedge fund and loaning that fund the money to buy the assets.  In a weird vendor-financing way, Barclays has now removed the risk of the assets from its balance sheet, but has also capped their upside because any gain or loss now accrues to the hedge fund.

This fund, Protium Finance is based in the Cayman Islands. No one knows who is financing it. But, there is a Barclays connection in that 45 former Barclays employees are the actual asset managers via a fund called C12 Capital Management which manages the assets on Protium’s behalf.

Now, if all of this seems odd and mysterious, it should.  The structure of these arrangements is so opaque I am still not sure if I have the outline correct in my head.  Here’s how Reuters describes it:

Consider the terms of the deal that Barclays has disclosed.

The bank will sell $12.3 billion of assets to Protium, a fund whose backers are not identified. To fund the purchase, Barclays is lending the entity $12.6 billion for 10 years and Protium’s backers are contributing a further $450 million. The loan and the external capital injection exceed the amount that Protium is actually paying Barclays. This excess capital will be used by Protium to buy other distressed assets.

Protium intends to repay the loan out of the cashflows generated by the assets.
So far so clear. But here there’s a bit of a twist. The Barclays loan ranks junior to the $450 million of external capital Protium is raising. This means that almost all of the risk seems to remain with the Barclays shareholders. Yet all of the upside after the loan is repaid goes to Protium.

So if the assets, which have already been heavily written down, ultimately turn out to be worth $14 billion, say, rather than $12.3 billion, Protium would take home $1.4 billion. Not a bad return on its $450 million. But if the assets were to fall in value by a similar amount, to $10.6 billion, Protium would still get its $450 million back.

What’s more, Protium gets a fixed 7 percent return on its senior capital contribution, while the Barclays subordinated loan is struggling on at 2.75 percent over Libor — which would at present imply an interest rate of about 4 percent.

Got that?  Barclays claims this deal gives shareholders “more stable risk-adjusted returns for our shareholders over time.” So, my interpretation of Barclay’s animus behind is to reduce the number of volatile assets on its balance sheet in order to avoid having to mark-to-market.  While Barclays says this is not regulatory arbitrage because the loan behind the exchange with Protium is still on Barclays books, we all know that loans are viewed as less risky than some dodgy and marked down toxic assets.  And the bank is still on the hook for the assets via the 10-year loan it has given Protium.

Gillian Tett gives voice to the concerns that this is just another version of those ill-fated SIVs which we were causing problems in late 2007.

…entities such as SIVs and conduits have traditionally had a semi-detached status with banks. That served the banks dangerously well in the years of the credit boom, since they used SIVs as a place to store irritating stuff which they did not want cluttering up their balance sheet – such as a household stuffing rubbish into a cellar, so that it does not mess up the smart front room.

These days, of course, the word “SIV” has become almost as taboo as the phrase “subprime securitisation”. Yet, as I perused this week’s announcement that Barclays plans to sell $12.3bn of credit assets to a “newly established fund” called Protium Finance – which will be independent but mostly financed by a loan from Barclays – it was hard to escape a twinge of déjà vu.

To be sure, the details of the Barclays plan differ in some crucial ways from the old SIVs-cum-cellars. One central sin that bedevilled the SIVs was that banks often used them for regulatory arbitrage. Another was a reliance on cheap, short-term financing – which disappeared, with disastrous consequences, when the crisis started in 2007.

However, as Barclays repeatedly stressed this week, Protium is not focused on regulatory arbitrage: those $12.3bn assets will stay on Barclays’ balance sheet for regulatory purposes, in the sense that the bank will be forced to make big capital provisions against a $12.6bn loan it is extending to Protium. Moreover, Protium is not exposed to the funding risk that blew up the SIVs, thanks to that monster loan.

But in another sense, there is an uneasy echo of the past. Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).

Whether you think this sort of think is wise or not, what the Barclays-Protium transaction makes abundantly clear is that risk is back. Global institutions are back to their old ways and there is nothing anyone is willing to do about it. When we face another crisis, you will know why.

Do read the Tett piece because she makes important conclusions regarding the lack of a coordinated regulatory response and the desire of banks to move to unregulated vehicles when the regulators do come a-calling.

Related posts:

• Are European banks sitting on 16.3 trillion in toxic assets?
• Bear Stearns: Last 72 hours chronicled in new book
• Doubling down at AIG
• B&B gets its money, HBOS and Barclays don’t
• Barclays gets “core Lehman” assets

The bloggers at bloggers at UMKC’s economics blog have been making the case that California’s IOUs are a currency.  Randy Wray’s entry last Monday was particularly provocative because he suggests a movement to loosen national government power is supporting similar moves in other jurisdictions. Wray writes:

Some commentators have argued that the proposed California "warrants" are similar to local currencies (see, e.g., Mark Thoma). In this piece I discuss experiments with local currencies and continue my argument that if California were to accept its own "warrants" in payment to itself, it could turn these into a functioning currency free of the defects of local currencies.

Interest in local currencies has soared in recent years, with nearly 100 U.S. communities experimenting with them. While proponents offer a variety of arguments in favor of local currencies, they share three common themes. First, there is concern that the use of a national, monopoly, currency creates a variety of economic, social, and environmental problems. Second, local currencies are said to improve regional communities, again across several dimensions including economic, social, political and environmental spheres. Third, many proponents want to reduce the power of national government, recognizing a relation between the monopoly of currency issue and centralization. They believe that decentralized money would shift power back to the communities.

However, previous adventures in local currencies have failed miserably as Wray later attests:

As discussed, most local currencies have failed (of the 82 created between 1991 and 2004, only 17 remained by 2004). Those that succeeded shared some combination of the following characteristics: an exchange rate pegged to a strong national currency by a trusted institution; substantial supplies of unemployed or underemployed workers; businesses operating below capacity; and a strong community spirit, led by liberal, middle class residents. These characteristics are not always easy to replicate nor are they necessarily desirable. If the goal is to displace the national monopoly currency, linking the local currency to it appears inconsistent—especially if one fears national government policy is inflating away the value of the nation’s currency.

So I have another idea, which I got from a knowledgeable reader nicknamed aitrader.  How about a Gold-backed IOU system.  In response to a recent post I wrote on the similarities in the troubles in California and Ireland, he wrote:

Now here’s a curve ball for ya: what would happen if a state or even a private bank were to issue currency redeemable in gold or silver? What would the implications be for the US Federal Reserve? This was the situation for many years in the US. Private banks often issued their own paper currency redeemable in gold and silver. There is nothing illegal about this, though one would assume a new law would be crafted and passed to prevent this from occurring. On that note here is what happened recently to a private currency issuer, http://en.wikipedia.org/wiki/Liberty_Dollar#Fed….
Interesting times…

So, let me explore his idea using Ireland instead of California.  I want to use Ireland as the example here because, in discussing my California-Ireland post, the Economist pointed out that Ireland is the place where true problems lie. The Economist says:

There is a problem with Mr Harrison’s thesis in the fiscal policy department, however. California has faced credit downgrades, but only because it is legally prevented from running deficits—it must default if it cannot make all its payments out of pocket. But California has a relatively small debt load, so far as nations go. If the state were allowed to run annual deficits, it seems highly unlikely that it would face pressure to balance its budget amid recession.

Ireland, on the other hand, is confronted by actual market pressures to prove that it can meet its obligations; it’s in trouble in an absolute sense. Ironically, both have fiscal difficulties that are not rooted in their federal status; Irish borrowing is limited by markets while California’s borrowing is constrained by the state constitution.

Point taken. So Let’s solve this problem.

Say Brian Lenihan is dispatched to consider how to prevent the government from sacking tens of thousands of workers in order to prevent the Irish from defaulting on its debt. 

He suggests that California’s IOUs are a model for Ireland, but he goes one step further adding a redemption in 5 years at a 40% premium to the present spot price for gold, which represents a 7% annual return.  Today, spot gold is trading at $950 an ounce. So, a 40% premium is about $1330 an ounce for gold.  Lenihan would offer this deal to any and all creditors of the State in lieu of cash.  The IOUs would be tradable in standardized amounts of 20, 50, 100, 1000, 10,000 and 1000,000 euros in order to facilitate a secondary market.

I got this idea from the high yield market where often bonds are issued with an embedded option to convert to equity at a premium or with PIK preferred shares thrown in as a kicker.  The point of these options is to provide a sweetener to investors in order to get the deal done.  These are the same kinds of deals that Warren Buffett did with General Electric and Goldman Sachs in 2008, and that he has previously done with USAir (now US Airways) and Salomon Brothers (now a part of Citigroup). If the embedded option increases in value significantly, the debtholder can make a lot of extra money.  For Buffett’s options in Goldman, this has already occurred.

Here’s what the ‘investor’ gets in the case of the Irish IOUs:

1. Bonds backed by the full faith and credit of the State paying a rate of interest that I suggest be a slight premium to the official 5-year bond.
2. A 5-year out of the money European option to buy gold for the full face value of the bond at today’s price.  Obviously,if you think gold is going up you would be willing to pay a lot for this option.
3. An IOU that is not just backed by the full faith and credit of the sovereign like most currencies, but that has a tangible link to a real asset, gold.

What does the sovereign get?

1. Ireland conserves cash without having to issue bonds.  Ostensibly this would mean interest rates on Irish bonds could remain lower. That’s a huge deal, especially since these IOUs would not be considered legal tender.
2. Ireland removes the restriction imposed by the Maastricht treaty as the IOUs are not cash and reduce the budget deficit.  In effect, the government is free to add fiscal stimulus without those restrictions.

Obviously, the Irish government would have to hedge their gold commitment by buying Gold futures. But, the Irish could then legitimately claim that its IOUs were more than just a piece of paper.  And, they would remove some of the constraints now impose upon it by foregoing their own currency.

Related posts:

• Pre-payments are reducing value of mortgage-backed securities
• Ireland: government blew the boom
• Gold hits all-time record high
• Spain and Ireland ‘thrown to the wolves’ after ECB move
• Ireland gets deflation

Back in April, I mentioned a story about BTA, a bank in Kazakhstan that had been nationalized by the state in February.  The interesting bit about the story was that interested parties from abroad (including Morgan Stanley) had significant Credit Default Swap contracts (CDS) written against losses in the banks bonds.  In essence, foreign investors would be better off if BTA failed than if it had not been seized by the State.  And this interest in the bank’s failure created a self-fulfilling prophecy. See my post “CDS contracts and the implosion of several Eastern European economies” for more details.

Fast forward to today and now we learn of a gargantuan $7.9 billion loss at BTA.  DealBook reports:

BTA, the largest Kazakhstani bank, confirmed losses and write-downs for 2008 of $7.9 billion in a financial statement issued Monday, even as it pursues the restructuring of its debt.

According to the bank’s financial statement, actions by previous management led its portfolio to deteriorate for the year, resulting in the loss of 1.188 trillion tenge, the Kazakh currency.

Explaining the causes of the loss, the bank said:

Certain loan documentation, including collateral and associated additional agreements, primarily relating to financing of projects outside Kazakhstan, is no longer available. In addition, many loans were transferred to new borrowers that do not have adequate sources of repayment. Moreover, no collateral was provided by these new borrowers. Consequently all transferred loans are unsecured. A number of significant borrowers, primarily registered outside Kazakhstan, have ceased servicing their loans, have not allowed the Bank to monitor collateral or failed to provide information about their financial performance.

BTA spokespersons were not immediately available for comment.

Fraud is an issue and the bank is now being sued by shareholders.  But, I do want to concentrate on the CDS issue and its role in forcing the bank’s hand. In my view, CDS contracts should be seen as a major change in how parties to a bankruptcies react. They distort incentives for interested parties, and create a whole new group of ‘stakeholders’ through naked CDS (i.e. where the holders of the CDS have no underlying interest in the bonds).

In situations of systemic stress as we have just witnessed, CDS have the potential of increasing the number of bankruptcies and volatility in the financial system.  In my view, that is why they must be regulated – and not just in the United States, but globally, as this case in Kazakhstan attests. If CDS contracts could help drive a major foreign company into bankruptcy and an American finance firm could suffer massive losses as a result (not the case for Morgan Stanley here), I imagine this is something that U.S. regulators would want to know and prepare for.

Source

Kazakh Bank Confirms $7.9 Billion in Losses – DealBook

Related posts:

• Georgia bank fails with $1.1 billion in assets
• JPMorgan Chase: Large exposure to real economy downturn
• Seven more bank failures brings total to 64
• Goldman loses $2.1 in the third quarter
• $467 billion in writedowns and counting

Reuters is reporting that the ratings agencies are about to get into some serious legal problems.  You see,during the bubble years, the ratings agencies gave a gold-standard AAA rating to what now seems to be dubious investment vehicles.  Now, investors are angry and they are starting to sue.

Calpers, the biggest U.S. public pension fund, has sued the three largest credit rating agencies for giving perfect grades to securities that later suffered huge subprime mortgage losses.

The California Public Employees’ Retirement System said in a lawsuit filed last week in California Superior Court in San Francisco that it might lose more than $1 billion from structured investment vehicles, or SIVs, that received top grades from Moody’s Investors Service Inc, Standard & Poor’s and Fitch Inc.

SIVs are complex packages of loans and debt, including subprime mortgages and collateralized debt obligations, pooled by investment banks and which then issue debt to investors.

By giving these securities their highest ratings, the agencies "made negligent misrepresentations" to the pension fund, Calpers said. Such ratings, which typically accompany investments with almost no risk of loss, "proved to be wildly inaccurate and unreasonably high."

Calpers seeks unspecified damages.

The ratings agencies deny these claims. ""The claim is without legal or factual merit, and we will take action to have it dismissed," a McGraw-Hill spokesman said.  McGraw-Hill, you will recall, is the same company that created a bit of a stir when it refused to release a book critical of the ratings agencies written by blogger Barry Ritholtz (see my February article “McGraw Hill drops book critical of its own subsidiary”).  The book was picked up by another publisher and has gone on to become widely read and critically acclaimed.

It does make you wonder about the ratings agencies.  Just last week I mentioned that they were up to their old ways again, rating assets from tarnished investment pools Aaa.  While some find their ratings defensible, the conflicts of interest inherent in the ratings agencies’ business models has led others to call for an investigation of ratings practices.  Apparently, these calls have borne fruit. The Financial Time reports:

The Securities and Exchange Commission has created a new group of examiners to oversee credit rating agencies, which came under sharp criticism for their role during the financial crisis.

The SEC has already adopted a number of measures to increase transparency at credit rating agencies, which are paid by the issuers they rate. But greater oversight is needed with officials expected to conduct both routine and special examinations of their activities, Ms Schapiro is set to tell a Congressional oversight hearing on Tuesday.

‘’I also have directed the Commission staff to explore possible new regulations in this area, including limiting the potential for rating shopping,’’ Ms Schapiro said in prepared testimony to the House Financial Services subcommittee on capital markets.

These investigations are long overdue.  The conflicts between the rating agencies consulting business and ratings business are exactly the types of conflicts we saw with audit firms during the tech and telecom bubble in the 1990s.  And this led to disaster at firms like Enron as the Enron auditor Arthur Andersen looked the other way.

Moreover, as it stands today, audited firms actually pay for their ratings, making the ratings agencies revenue stream dependent on the firms they audit. My hope is that conflicts like this can be stopped.  So, I welcome the SEC investigation and look forward to seeing substantive changes.

Meanwhile, it may take legal action like the one being initiated by Calpers to affect real change because, to date, few substantive regulatory changes have been made despite a crisis which is more than two years old.

Related posts:

• McGraw Hill drops book critical of its own subsidiary
• Lawsuits: Rating agencies are next
• S&P cuts ratings of big U.S. banks
• S&P cuts HBOS counterparty credit ratings
• Hungary cut to a notch above junk by S&P

This past weekend I saw the film Food Inc, which I recommend highly to anyone looking to see how deregulation has affected industries other than finance.  While the subject of Food Inc was how the industrialization of food policy in the U.S. has had unintended negative consequences, I couldn’t help but draw connections to the world of finance. The one area that had the most salient overtones was the part of the movie dealing with diversification.

In the food industry, economic policy has favoured large enterprises such that there is significant concentration of production and distribution.  At one point in the film, we learned that there were just a handful of slaughterhouses in the United States which account for the vast majority of the beef we eat. While this has reduced food prices for end consumers, it has also meant that those few companies controlling America’s distribution system have an enormous diversity of animals running through their slaughterhouses.  Any hamburger we consume might contain the beef of hundreds of different cows.

That can be problematic. The filmmakers brought this point home by showing a clip of a cow too weak to stand on its own legs being coerced to the slaughterhouse. Imagine that this cow is diseased. E.coli gets into the production process.  Suddenly, you have tens of thousands of tons of beef that is infected and could kill.  This is why the beef industry has seen fit to recall hundreds of thousands of tons of beef in order to protect end consumers.  These measures are draconian and costly, but necessary.

In effect we are seeing a case in which large firms bring advantages through economies of scale that lowers cost.  Nevertheless, the diversity inherent in the production at those firms carries hidden risks in that one or two bad animals can taint thousands of tons of beef.

This is also exactly what you see in financial services through the securitization process. We have Mortgage-backed securities (MBS) and Collateralized debt obligations (CDOs) and CDOs of CDOs which contain all manner of debt from credit cards to residential mortgages, commercial mortgages, auto loans, student loans, and on down the line.  The enormous companies which package up these securities take the debt obligations from thousands of people and businesses in order to create their securities. 

Think of these securitization groups as the slaughterhouses of finance. the securitization groups go on to distribute their packaged securities to investors of all ilk through their vast network of retail and institutional customers. In fact, they carve up these obligations so finely that what seemed like dodgy credits on an individual basis often got the AAA seal of approval from the credit rating agencies. Diversification seemed to make a sow’s ear into a silk purse. It’s almost like financial alchemy – turning the riskiest of risky assets into bullet-proof top-of-the-line securities that even widows and orphans could invest in.

There is one problem, though – alchemy doesn’t work. The financial slaughterhouses were destined to take on too many bad loans eventually.  All it takes is one or two extremely depressed economic area in Los Angeles or Las Vegas or Stockton to taint dozens of pools of mortgages.  Think of it this way: a fairly large area like Las Vegas gets crushed by an economic downturn and the result is people defaulting on credit card loans, student loans, auto loans and mortgages. Businesses then default and commercial property loans go sour too.  The result?  All of the AAA asset pools are now infected with sick loans. Large losses can be expected across the board.  Diversification has gone from being a boon to a nightmare.

I would argue that diversification, in spreading junk assets widely – even into the best fixed income asset classes – created a problem that was an order of magnitude larger than had these assets been held to maturity on the loan originator’s books.  Forget about the fraud or the incentives to securitize more and more for a second. Even without those problems, the fact that dodgy assets were spread far and wide guaranteed some measure of systemic risk when asset pools became infected.

In the food industry, companies recall tainted meat at huge cost to the distributors.  The analogous action in financial services would have seen the same practice, with banks buying back their dud assets as they did in the auction rate securities scandal. But, we all know why that never happened. If they had done, many a bank would be bankrupt. So, instead, the banks were bailed out. Slaughterhouses, indeed.

Related posts:

• Will banks exiting TARP take back their toxic waste now?
• A few words from a reader on TALF mechanics
• Bank bankruptcy or bailout?
• What is a credit writedown?
• What Home-Loan Banks reveal about the effects of mark-to-market

This is a very good explanatory piece from CNBC on how counterparty credit risk makes the credit default swap market a financial weapon of mass destruction.  Note they are not talking about eliminating the CDS market, but merely regulating and standardizing it to prevent a potentially catastrophic domino effect.

Related posts:

• Lehman Brothers: a primer on Credit Default Swaps
• Definition of the day: the law of unintended consequences
• Treasury credit default swaps rise dramatically
• Glencore: credit default swaps suggest something amiss
• CDS Market: Did Fannie and Freddie Default?

From the London School of Economics website:

Below is an audio recording of approximately 78 minutes where Gillian Tett takes us inside the shadowy world of complex finance and derivatives and explains how the business of slicing and dicing debt led us to the devastating global credit crunch.

Gillian Tett has worked as a journalist for the Financial Times for fifteen years. In 2008 she won the British Press Award for the Financial Journalist of the Year. This event marks the publication of her latest book Fool’s Gold :How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe.

Date: Thursday 30 April 2009
Time: 6.30-8pm
Venue: Old Theatre, Old Building
Speaker: Gillian Tett
Chair: Professor Willem Buiter

Related posts:

• Gillian Tett: Washington is talking to Swedes about banking crisis solutions
• Hugh Hendry: “China is Santa Claus”
• The Swedish roots of the UK bailout plan
• Marc Faber: I advise every American to hold his gold outside of the United States
• CDS contracts and the implosion of several Eastern European economies

As the possibility of bankruptcy draws nearer, General Motors is moving to sell non-core assets and to broker arrangements with bondholders and unions alike which will keep it out of bankruptcy. In a 9AM press conference today, new General Motors head Fritz Henderson announced a debt-for-equity swap offer for GM bondholders which would cut debt dramatically at the company. It is also looking to make some substantial cuts in workforce as well as eliminating venerated brands like Pontiac.

General Motors Corp. said Monday it will continue to reduce its work force and dealer network and eliminate its Pontiac brand by the end of next year as the auto maker works furiously to survive

GM is also starting an exchange offer for $27 billion of its unsecured public notes as part of its restructuring plan, saying a successful exchange offer would allow it to restructure out of bankruptcy court.

The company said by the end of the year, it will employ 21,000 fewer hourly workers than it does now.

The company is offering to exchange 225 common shares for each $1,000 principal amount of outstanding notes. The stock closed Friday at $1.69 a share and shares were recently up 11% at $1.87 in premarket trading.

The exchange will commence only if 90% of bondholders agree to the terms. Under the plan, if GM fails to get adequate participation, it would file for bankruptcy protection.

GM, which is surviving on federal loans, is racing to restructure by June 1 under close watch of the Obama administration.

The U.S. Treasury will extend an additional $11.6 billion to GM, in addition to $15.4 billion in existing loans. The government will forgive half the debt in exchange for equity in a restructured GM.

GM, in setting forth tough terms for a bond exchange and requiring almost compete participation, has stepped up the likelihood for a Chapter 11 filing on June 1 without further government intervention.

The company said it will focus on four core brands in the U.S. — Chevrolet, Cadillac, Buick and GMC — as it looks to make fewer different models and focus on product development programs.

It will also restructure its U.S. dealer organization, reducing its U.S. dealer count by more than 40% by the end of next year, a reduction of 500 more dealers four years sooner than its earlier viability plan.

Chief Executive Fritz Henderson said the company is taking “tough but necessary actions” that are critical to GM’s long-term viability.

The company added that negotiations regarding contract changes with the United Auto Workers union are still ongoing.

In my view, the success of GM’s plans hinges very much on its ability to cut its mammoth debt load. So, it is the debt-for-equity swap which is most important. Let’s see what reaction this announcement receives from bondholders.

I am unclear as to whether a debt-for-equity swap could count as a default event in the Credit Default Swap market.

Sources
GM Scrambles to Survive – WSJ

Related posts:

• GM headed for bankruptcy
• GM considers keeping Opel, raising capital
• GM gets the green light on its section 363 bankruptcy
• Chrysler: bulls make money, bears make money, pigs get slaughtered
• The case of the dissident Chrysler bondholders

On Friday, the German daily Süddeutsche Zeitung (SZ) leaked a bombshell – a confidential report by Bafin, the Federal Financial Supervisory Authority, found that German banks were sitting on over 800 billion euros in toxic assets. Just three months ago, the reports coming out suggested the problem was only half as large, 400 billion euros.

This new account has been all over the news in Germany because Germans are becoming quite frightened about the health of their banking system and are angry because the German economy was largely absent from the bubbles of the past decade. Germans are beginning to ask quite openly why banks like Commerzbank and the state-owned land banks as well as institutions like Hypo Real Estate are being rescued with taxpayer money. This is a debate now ongoing in a number of countries, the U.S., the U.K. and Ireland most prominent among them. In an election year in Germany, this issue is sure to have an impact.

The account in SZ reads as follows (my translation):

Giant Billion euro risk: The financial crisis has hit German banks far harder than was previously known. Loans and securities in problem areas add up to 816 billion euros, according to a Bafin paper made available to the Süddeutsche Zeitung.

The financial crisis has hit German banks significantly harder than was previously known. This news comes from an internal study from the Financial Supervisor Bafin. The paper first gives an overview of which loans and securities institutions own in the problem lines of business. Their risk adds up to 816 billion euros. Particularly affected are HRE, several Landesbanken Bank and Commerzbank.

At Commerzbank alone, according to the Bafin study available to the Süddeutsche Zeitung, there are securities and loans worth 101 billion euros affected by the financial crisis. This includes 49 billion euros from the balance sheet of the acquired Dresdner Bank. Commerzbank is, thus, similarly affected by the financial crisis as the Land Bank of Hamburg and Schleswig-Holstein, HSH Nordbank, for which Bafin tallies 105 billion euros.

In Westdeutsche Landesbank with 84 billion euros and the Landesbank Baden-Württemberg with 92 billion euros, the supervisors see risks of a similar magnitude. Much better are Deutsche Bank with 21 billion euros, as well as Postbank and Hypovereinsbank with five billion euros each. The worst according to the Bafin paper, prior to nationalization, is Hypo Real Estate (HRE), which holds 268 billion euros in problem assets.

Banks back out bill

Most of the 17 listed banks reject the figures as misleading. “We do not know who put the figures together and they cannot be verified,” said a spokesman for Commerzbank. HSH Nordbank said the bank auditors and Rescue Fund Soffin of HSH had sufficiently and adequately accounted for losses. Other institutions have referred to figures in their annual reports or that they had secured the facilities.

Commerzbank has received state aid of 18.2 billion euros to date. In its annual report the Bank itself had broken down risks and pointed to other “significant liabilities” that threatened different areas of the securities and credit business. However, among banks, investors and supervisors it is still controversial as to which paper can be understood as junk.

A Bafin spokeswoman said to SZ, that the figures do not deal with actual or potential losses. The data also could not be used “to draw conclusions about the creditworthiness of banks.”

Study of great significance

The internal study is of great importance for the government. The calculations by Bafin flow into the plans for the establishment of so-called Bad Banks — repository institutions for problem assets. According to the plans of the Ministry of Finance, only about one third of the assets listed in the document will come into question for removal into a bad bank. The government wants, with the help the Bad Banks, to restore the function of financial markets and lay the foundation for a rebound.

The figures from Bafin, are, therefore, no surprise for the government. Even in the documents that Finance Minister Peer Steinbrück had sent Chancellor Angela Merkel weeks before for the preparation of the banking summit on Tuesday, there was talk of 853 billion euros of potentially vulnerable assets. These figures from the beginning of the year, are no longer deemed up-to-date. The paper cites a new measurement date, the 26th of February.

This account should make clear how shaky many of Germany’s financial institutions are. Moreover, it is not altogether obvious which markets are deemed ‘toxic.’ German banks have a lot of residential real estate-related paper. But they also have assets related to the imploding European commercial property market and the Eastern European property markets. I suspect that the problem is even larger than is mentioned here.

If you recall, there was a big dust-up in February over a leaked EU document which suggested there were 16.3 trillion in toxic assets amongst European banks. In my view, the Europeans have their heads in the sand regarding the magnitude of the problem. The banking situation is much worse on the continent than its citizens are led by government to believe.

In any event, Bafin is now seeking to obtain prosecutions for the damaging leak. Forget about the toxic asset problem, go after those who have brought it into the full light of day.

Source
Bilanz des Schreckens – Süddeutsche Zeitung
Bafin erstattet Anzeige – Süddeutsche Zeitung

Related posts:

• The German $400 billion toxic asset time bomb
• Germany partially nationalizes second-largest bank
• The Germans get tough with the state banks
• Are European banks sitting on 16.3 trillion in toxic assets?
• Germans must get their head out of sand on banks

If you read my recent post on How big banks earned so much money this quarter you would see that much of the income at Wells, JPMorgan, US Bank and others came from refinancing old mortgages. While this may be a boon to present income, it is very much a problem for the legacy mortgage-backed securities which contain the old mortgages. Let me explain.

When I was in business school, I took a course on debt markets with Professor Suresh Sundaresan, which was very helpful for me when I later joined a large bank in London. Professor Sundaresan worked at Lehman Brothers in their fixed income and derivatives area in the mid-1980s and was very familiar with all of the debt products we discussed in class.

One thing I found quite useful about the course was its explanation of the mortgage markets and mortgage-backed securities (MBS).  The mortgage market is a lot more complicated than other bond markets because MBS are not like other bonds. There is an embedded option contained in all mortgages, the pre-payment option, which makes valuation extremely tricky. In Chapter 9 of his book on “Securitization and Mortgage-Backed Securities,” which I have just consulted, Sundaresan talks about prepayment risk and what it means to the lower value of MBS.  He says the following in his book:

Mortgages permit the homeowners to prepay their loans. This prepayment provision introduces timing uncertainty into the originating bank’s cash flows from its loan portfolio. For example, if the bank originates a pool of mortgages with a weighted-average rate of 8% and six months later the mortgage rate drop significantly below 8%, say to 7%, then the loan portfolio is certain to experience significant prepayments as borrowers rush to refinance their mortgages with less-costly loans. The lender has a long position in the mortgage loan that entitles him to monthly scheduled payments, but also has sold an option to the homeowners that gives them the right [but not the obligation] to prepay the loan when the circumstances demand it. This means that the bank cannot predict the future cash flows from its loan portfolio with certainty. Clearly, the option to repay will be priced into the loan by the bank and the borrower will pay a higher interest rate on the loan as a consequence.

Here’s the deal. The bank does not want its customers to pre-pay because that means less income from interest payments for the bank. Less income lowers the value of the mortgage. So, pre-payments are bad for anyone holding debt or derivative instruments related to the expected cash flow of those mortgage loans.

As Sundaresan indicates, the originators and MBS packagers understand this and have tacked on a ‘fee’ in the form of a higher loan interest rate to cover their expected pre-payment risk.

Enter the Federal Reserve. To stave off a deflationary spiral, the Federal Reserve has lowered the effective short-term interest rate to zero and it is in the process of buying up shed loads of MBS paper and long-term bonds in order to artificially reduce long-term rates as well. The problem here lies in the term ‘expected’ from the previous paragraph, because the so-called toxic MBS paper now clogging balance sheets are now unexpectedly pre-paying at a record rate. This lowers the expected cash flow from those assets significantly, making the underlying assets worth even less.

Moreover, there is a certain perverse adverse selection at work here because not everyone can get a loan these days. That means that the individuals pre-paying are likely to be the most qualified borrowers. This leaves existing MBS borrower pools significantly worse off.

For example, say you have a mortgage-backed security collateralized by mortgage assets from prime borrowers. We enter a recession and a number of loans in that pool become distressed and a number of the borrowers in that pool default. This means that your MBS asset is worth less.

Simultaneously, interest rates drop unexpectedly and a number of the borrowers re-finance their mortgage meaning they pre-pay the mortgage in your pool. You are not going to get the interest payments that you had expected to receive. Again, this means that your MBS asset is worth less.

What’s more is that because of the recession, credit conditions are unusually tight and only the best qualified borrowers are refinancing. So the borrowers left in your asset pool are net lower-quality borrowers. Translation: you should now expect a higher default rate of those left in the pool. Again, this means that your MBS asset is worth less.

To sum up:

1. You just got the shaft because a recession has meant higher default rates generally.
2. You just got the shaft because of unexpected pre-payment and lower cash flows that result from this.
3. You just got the shaft because your pool of borrowers has been adversely impacted by the Fed’s interference in the MBS market

All of this is very bad for existing or so-called legacy assets.  Moreover, these assets must be marked-to-market to reflect asset value impairment.  So, this will mean massive writedowns going forward.

But, wait a minute, didn’t we just change the accounting rules? Enter new mark-to-market accounting a.k.a. mark-to-make-believe.  Because of the guidance on marked-to-market accounting in FAS 157-e, you can deem these changes to be temporary impairments.  There is no need to mark to market.  Problem solved.

Here’s what Wells Fargo had to say about its marking-to-market last quarter in their earnings release (PDF):

The net unrealized loss on securities available for sale declined to $4.7 billion at March 31, 2009, from $9.9 billion at December 31, 2008. Approximately $850 million of the improvement was due to declining interest rates and narrower credit spreads. The remainder was due to the early adoption of FAS FSP 157-4, which clarified the use of trading prices in determining fair value for distressed securities in illiquid markets, thus moderating the need to use excessively distressed prices in valuing these securities in illiquid markets as we had done in prior periods.

Nice.

And if you think people aren’t fooled by all of this, think again. Bank stocks are way, way up.

Related posts:

• What is a credit writedown?
• The fixed rate mortgage is king again
• Lawsuit: steering mortgage applicants could mean more writedowns
• TALF: A bailout if one reads the fine print
• Alt-A: defaults lie ahead of us, not behind us

I am still away on Holiday in Mexico but have been checking the news and was not surprised to learn about the recent Wells Fargo announcement. I am coming off the fence here and looking for a bullish outcome on financial services.

The bank said profit will be $3bn in the first quarter, thanks to better-than-expected results at newly-acquired lender Wachovia.

Wells Fargo bought Wachovia, which was the fourth-largest US bank, after it almost collapsed last year.

“Wachovia’s outstanding franchise has proven to be everything we thought it would,” the bank said.

Despite obvious problems with the bailout packages provided by the U.S. government and a huge amount of writedowns still coming due, I now fully anticipate that 2009 will surprise to the upside in financial services. As I am still away I cannot post in detail.

However, I see financial services companies shedding troubled assets, not marking other assets to market and having an enormous margin spread due to ridiculously low interest rates. To me, this is a huge buy signal. Last week, I thought a small position in out-of-the-money calls on BofA or Wells was a good idea before Wells gapped up this morning (I still think Citi is dead money). This is now less of a good risk-reward opportunity. But, don’t think Wells is alone in expecting a monster quarter here. Could we see the same at JPM or BAC? BAC has a huge tax dodge from its Countrywide acquisition so unless they haven’t finished with monster surprise writedowns, I expect a good number there as well and that looks like the best play in the space right now (despite a 20% rally today).

Remember Warren Buffet’s call about Wells back in March?

Warren Buffett answers questions from viewers on CNBC. He talks about his investment philosophy and recent stock picking performance. He bought ConocoPhillips at the top. And he made poor investments in Irish banks. About Wells Fargo, he says “the spreads are enormous.” And he still likes US Bancorp and defends his S&P 500 derivatives bet.

Ultimately, the Wells profit announcement should make one believe that this rally is for real and, despite a potential decline due to an overbought position, can continue through to the Fall after a pullback.

To be clear, I think this is a cyclical rebound a.k.a fake recovery and it is also a massive transfer of wealth from U.S. taxpayers to banks.  But it is a rebound nonetheless and financials will benefit.

Source
Wells Fargo expects record profit- BBC News

Related posts:

• Wells sells $600 million in distressed assets at 35 cents on dollar
• Dividends are under pressure
• Whitney Tilson of T2 Partners, a new media darling, strikes a bullish tone
• How refinancing helps the likes of Bank of America and Wells Fargo
• How much money is Wells Fargo really making?

Because I received a message via e-mail that my previous post on mark-to-market was misleading, I thought I would clarify what is happening with FAS 157 and provide some good links.

The long and short of the rule is it gives more specific guidance as to when a market is distressed and an asset must not be marked-to-market as a result.  Moreover, it allows assets which are not permanently impaired to be excluded from mark-to-market and defines the reporting requirement of how to do so.

You should note that only a small percentage of assets on financial companies’ balance sheets are actually marked-to-market, even for money center banks that have written down the greatest amount of assets.  Nevertheless, I do project this rule will reduce the number of writedowns, particularly from residential real estate where bankruptcy and default is not a factor (i.e. temporary impairment).

One other point, I have mentioned before that banks are hiding impaired and distressed assets in Level 3 assets.  This change gives them the ability to do so legally under the current accounting rules (see Buiter’s piece).  You can bet the IASB will soon follow.

The rule change passed by one vote.

Here is what the new rule states (I have highlighted some of the important parts in the beginning):

April 2, 2009 Board Meeting

Determining whether a market is not active and a transaction is not distressed. The Board discussed comment letters received on proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. In response to comment letters and additional feedback received, the Board decided to make significant revisions to the proposed FSP. The Board decided that the final FSP would

1. Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).
2. Clarify and include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
3. Eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP will instead require an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
4. Include an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
5. Require an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
6. Apply to all fair value measurements when appropriate.

The Board also affirmed its previous decision that the FSP would be applied prospectively and that retrospective application would not be permitted. The Board decided that the FSP would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity early adopting this FSP must also early adopt FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, Recognition and Presentation of Other-Than-Temporary Impairments. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, it must also elect to early adopt this FSP and FSP FAS 115-2, FAS 124-2, and EITF 99-20-2.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Recognition and presentation of other-than-temporary impairments. The Board discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments. The Board made the following decisions in response to comment letters and additional feedback received:

1. 1. The Board decided that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities.
   1. The Board decided to replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert
      1. It does not have the intent to sell the security; and
      2. It is more likely than not it will not have to sell the security before recovery of its costs basis.
   2. The guidance will incorporate examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired and how those factors interact with the requirement to assert that the entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis.
   3. When an entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
   4. An entity will be required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses.
   5. The FSP will include guidance stipulating that credit losses should be measured on the basis of an entity’s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments.
   6. The guidance will clarify that existing premiums or discounts and subsequent changes in estimated cash flows or fair value should continue to be accounted for in accordance with existing guidance (for example, EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets”).
   1. An entity will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.
   2. An entity will be required to present separately in the financial statement where the components of other comprehensive income are reported, amounts recognized in accumulated other comprehensive income related to the noncredit portion of other-than-temporary impairments recognized for available-for-sale and held-to-maturity debt securities.
   1. The disclosure requirements of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, will be modified to require an entity to provide the following:
      1. The cost basis of available-for-sale and held-to maturity debt securities by major security type
      2. The methodology and key inputs, such as performance indicators of the underlying assets in the security, loan to collateral value ratios, third-party guarantees, levels of subordination, and vintage, used to measure the portion of an other-than-temporary impairment related to credit losses by major security type
      3. A rollforward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income.
   2. Statement 115 and FSP FAS 115-1 and FAS 124-1 will also be modified to require that major security classes be based on the nature and risks of the security and additional types of securities will be included in the list of major security types listed in Statement 115.
   3. The above additional disclosures, as well as all existing Statement 115 and FSP FAS 115-1 and FAS 124-1 disclosures, will be required for interim periods

Scope

Recognition

Presentation

Disclosures

When adopting the new guidance, an entity will be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery. The cost basis used to calculate accretable yield will also be adjusted to reflect this adjustment (that is, the entity will no longer accrete the noncredit component of a previously recognized other-than-temporary impairment through earnings).

The Board decided that the FSP will be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, or FSP FAS 157-4, it must also elect to early adopt this FSP.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Related articles
More Mark-to-Market Myths – Paul Kedrosky
How the FASB aids and abets obfuscation by wonky zombie banks – Willem Buiter

Related posts:

• What Home-Loan Banks reveal about the effects of mark-to-market
• A reader’s excellent comments on mark-to-market accounting
• FASB: Mark all financial assets at fair value
• FAS 157 and the significance of distress versus bankruptcy
• Pre-payments are reducing value of mortgage-backed securities

This comes via Marc Chandler of Brown Brothers Harriman and is an even-handed review of what just happened:

As widely expected FASB modified fair value accounting rules. The key seems to be for assets for which there is not a market. The last traded price does not have to be used. Rather other methods, like discounted cash flows can be used. In essence, previously there was a presumption that if there was not market for an instrument, it is distressed. Within a few hours FASB is expected to make another announcement about the treatment of permanently distressed assets. Financial stocks appear to have led the equity rally in recent days, ostensibly partly on the anticipation of today’s FASB announcement. Although it seems clear that the political pressure was brought to bear on FASB helped expedite the decision, this seemed to be the direction that they were moving. Cynics will claim this is a thinly veiled attempt to disguise the seriousness of the financial crisis and losses being faced. On the other hand, there are many who see the mark-to-market as an unreasonable demand for financial instruments with no markets. Regardless though of the merits or de-merits, the net impact could help boost bank earnings, reduce the need for capital injections and may help encourage participation in P-PIP and TALF programs.

Tyler Durden also has some things to say about the changes in mark-to-market rules:

Well, now that banks are all good in perpetuity, there goes the need for the PPIP. Hopefully this at least means that Bill Gross and Larry Fink won’t make billions compliments of U.S. taxpayers. But don’t take my word for it: the head of the world’s largest hedge fund voices these very concerns. In fact, Dalio is so disgusted by the insanity in equity markets, rumor is he has moved out of trading equities entirely.

It all sounds very much like the S&L rule changes, doesn’t it? Oh, and a reminder of what happened then: S&L’s went on to invest and lend recklessly, making the eventual bailout much, much bigger. Everyone in finance could see this coming from a mile away.

See what I had to say about this in October in my post, “S&L crisis chronology and accounting rules.”

Addendum: I have posted an update called “A few comments about mark-to-market” as the Mark-to-market is dead title was rather misleading.

Related posts:

• A reminder about new mark-to-market rules in Europe
• Paulson’s Economic Patriot Act is about marking to market
• What Home-Loan Banks reveal about the effects of mark-to-market
• S&L crisis chronology and accounting rules
• A few comments about mark-to-market

I am sure you realize by now that I believe Larry Summers is soft on derivatives, soft on regulation and soft on banking executives.  He exemplifies the self-regulatory zeal of the previous boom.  Given his indifference to responsible regulatory oversight of derivatives and other markets, the following account, now public does seem to fit a pattern.

A former quantitative analyst at Harvard Management Company, the university’s once-vaunted endowment manager, tells the Harvard Crimson she was fired for voicing concern to then-university president Larry Summers’ chief of staff about the money manager’s risky use of derivatives the traders didn’t understand.

The episode dates back to 2002, when analyst Iris Mack, whose website identifies her as the second African American woman to earn a Harvard PhD. in applied math (and someone who likes primary colors) joined the much-venerated Harvard Management Company, which invests the university’s then $18 billion endowment, to find what she termed a “frightening” state of affairs.

“The group I was working for had no background whatsoever to be working on [derivatives],” Mack says, adding that, to her knowledge, several of her colleagues were not licensed securities traders. “Sometimes the ways they handled even basic Black-Scholes models [widely used to price stock options] were puzzling.”So Mack took inventory of the abuses — high employee turnover, lax risk management practices and a “low level of productivity in the workplace” were among others, and detailed them in an email to Marne Levine, Summers’ chief of staff and a Treasury staffer on the Obama Transition Team. (Summers was the only person to whom Meyers reported, and according to a recent Forbes story he personally ordered the university’s biggest derivatives trade, a purchase of interest rate swaps that cost the university billions this year.)

A month after sending her email, Mack was fired after a meeting in which the endowment fund’s then-chief furnished her the emails and castigated her for making “baseless accusations.” She later sued for wrongful termination and settled out-of-court with the university. But she claims the practices “shocked” her, and — the punchline is — she had joined the company from Enron.

Which is also to say, lest you dismiss Mack as an opportunistic snitch capitalizing on Summers fateful opposition to regulating the derivatives that wreaked havoc on the financial system, she had a pretty valid reason to believe in the importance of whistleblowing.

“I’m not trying to pretend I’m omniscient or anything, but a lot of people who were quantitative traders, in the back of our minds, we knew a lot of these models were just that: guestimates,” Mack says. “I have mixed feelings, on the one hand, I wasn’t crazy, I knew what I was talking about. But maybe if more and more people had spoken up, the economy wouldn’t be the way it is now.”Mack is doing her part to affect change: she’s a vociferous advocate of better math education for minorities and like FDIC chairman Sheila Bair, the writer of a children’s book. It’s called Mama Says Money Don’t Grow On Trees (sequel idea: *…Unless You Are A Monstrously Overleveraged Bank With Access To The Federal Reserve Discount Window!).

If Mack’s allegations are true Harvard certainly paid the price for its recklessness: Summers’ swaps sowed the seeds for a financial disaster at HMC:

It doesn’t feel good to be borrowing at 6% while holding assets with negative returns. Harvard has oversize positions in emerging market stocks and private equity partnerships, both disaster areas in the past eight months. The one category that has done well since last June is conventional Treasury bonds, and Harvard appears to have owned little of these. As of its last public disclosure on this score, it had a modest 16% allocation to fixed income, consisting of 7% in inflation-indexed bonds, 4% in corporates and the rest in high-yield and foreign debt.For a long while Harvard’s daring investment style was the envy of the endowment world. It made light bets in plain old stocks and bonds and went hell-for-leather into exotic and illiquid holdings: commodities, timberland, hedge funds, emerging market equities and private equity partnerships. The risky strategy paid off with market-beating results as long as the market was going up. But risk brings pain in a market crash. Although the full extent of the damage won’t be known until Harvard releases the endowment numbers for June 30, 2009, the university is already working on the assumption that the portfolio will be down 30%, or $11 billion.

Mack’s boss at HMC, Jack Meyer, parted ways with the university in 2005. His bets were still paying off but his relationship with Summers had reportedly cooled — among other things, over alumni outcry led by the university’s Class of 1969 over the hedge fund-sized bonuses being awarded to employees of a supposed nonprofit. But if there’s anything we’ve learned from the past year, gratuitous compensation and gratuitous risk go hand-in-hand.

“The events of the last year show that the whole procedure of rewarding people so handsomely based on increases on paper value of the endowment was deeply flawed,” says a spokesman for the [Class of 1969], which recently sent a letter to the Harvard president suggesting HMC staffers return $21 million of their latest bonuses. “Even now we don’t really know how well it has done in the last ten years.”

Tim Geithner has taken a lot of heat for the Obama Administration because the new Administration seems to be just as fawning over the financial services industry as the old Bush administration. But, Larry Summers, as the White House’s Chief economic counsel, has a lot to say about the direction of economic policy.

If the allegations here are true, clearly Summers violated the law. More to the point for today, one should have little doubt that Obama and his team have a much cozier relationship with Wall Street than Main Street as reflected in the kid’s glove approach to banks and the hardball approach with the automakers.

It seems that some in the White House want to party like it’s 1999 and not in a good way.

Source
Harvard Derivatives Whiz Fired For Emailing Larry Summers About “Frightening” Trades? – TPM

Related posts:

• Channeling my inner Larry Summers
• Warren: The middle class “became the turkey at the thanksgiving dinner"
• Is Bernanke Toast? If he is, Summers is a shoo-in
• Deregulation efforts from the late 1990s were blocked
• The real story behind those greedy AIG bankers

The OCC’s Quarterly Report on Bank Trading and Derivatives Activities
for the Fourth Quarter 2008 is out. And derivatives exposure is way up. U.S. commercial banks now have a massive $200 trillion with a T in derivatives exposure, which is 14x U.S. GDP.

And here’s the interesting bit, 5 banks have 96% of the exposure. Wanna guess who? Hint, it’s the same big banks getting massive bailouts right now. And one of them has three times the exposure as the next closest company.

2009-34a

Source
OCC’s Quarterly Report on Bank Trading and Derivatives Activities
Fourth Quarter 2008 (PDF) – OCC website

Related posts:

• Are European banks sitting on 16.3 trillion in toxic assets?
• Regional banks: Zions falls
• Santander: US, Spanish and UK mortgage exposure
• Earnings results at Swedish banks show large writedowns in Baltics
• Some banks not paying TARP dividends

This comes via Angus Robertson of Research Recap:

The performance of auto loan securities has been mixed, but Standard & Poor’s Credit Research points out that overall ratings on the ABS have been remarkably stable in spite of the recession.

In a new report on the sector, S & P says that delinquencies and write-downs among certain auto loan ABS, vintage 2007-08, have outstripped the peak losses of 2000-01. Even so, S & P has downgraded only one transaction this year due to collateral performance.

In our view, the weak economy, combined with reduced investor appetite for ABS, has caused many securitizers to curtail loan volume and underwrite loans for borrowers with better credit and at lower advance rates.

Similarly, Fitch Ratings says the robust structures of many auto ABS are allowing them to build “credit enhancement” despite higher losses. In fact, Fitch announced nine upgrades of auto ABS in February.

As for credit card ABS, as many consumers know, issuers are cutting underlying credit lines and increasing rates on existing balances – moves that are preserving credit quality on those securities.

On the other hand, student loan ABS were under considerable rating pressure in February, with Fitch downgrading 56 rated securities.

Overall, downgrades on the long-term ratings reflect the effect of increased funding costs on the transaction due to failed auctions [and]..follow a review of all auction-rate transactions to determine the ability of each to withstand increased funding costs going forward.

If you recall, I recently posted some updates via Angus on the Prime RMBS market and on Leveraged Loans. Both of these forecasts were very downbeat in contrast to this update on auto loans. Credit card charge-offs are at multi-decade highs and commercial real estate is getting hammered (see my posts here and here).

All of which is to say that auto loans look the best of the asset-backed security lot. There are many more ABS writedowns coming due in 2009, which will impair bank balance sheets even more. At a minimum, however, the auto loan update is the first bit of positive news on the ABS market that we have heard in a while.

Related posts:

• Moody’s anticipates huge increase in leveraged loan defaults
• What Home-Loan Banks reveal about the effects of mark-to-market
• New Writedown Risk: Alt-A
• The U.S. banking crisis: where are we?
• What’s in your wallet? Probably higher interest rates.

This video from the Charlie Rose show should give one a fairly complete view of most of the relevant finance and political issues surrounding the AIG situation. (hat tip Calculated Risk)

Participants include bank analyst Meredith Whitney and Gretchen Morgenson of the NY Times, and Carol Loomis of Fortune. Why is Hank Greenberg in this panel? It seems incongruous since most of these problems happened while he was the head of AIG. Very strange.

Related posts:

• A conversation about the growing fiscal deficit on Charlie Rose
• Jeremy Grantham: “Pull the trigger”
• A conversation with Robert Caro on Charlie Rose
• A conversation with Pete Peterson on Charlie Rose
• A conversation with Peter Orszag on Charlie Rose

As I mentioned in my post, “TALF: A bailout if one reads the fine print” the TALF is not a program ONLY for U.S. institutions. It is a vehicle for re-starting the U.S. asset-backed securities credit markets. In fact, the first recipient of TALF money may be Nissan Motors, a Japanese company (Hat tip Marc):

via email:

After focusing on the big banks and AIG, official attention has broadened in recent weeks to include help for home owners, consumers and small businesses. The Fed’s Term Asset-Backed Securities Loan Facility (TALF) is aimed re-opening access to credit by consumers and small businesses by re-opening the market for the securization of such credit. The Federal Reserve is committed to buying up to $1 trillion worth of such ABS.

After much tweaking of the rules to ensure a successful launch, the program is ready. Ironically, Nissan, the Japanese auto maker, may be the first participant. It security will likely be priced tomorrow, the deadline for investors to apply to the Fed for loans to buy the debt. Reports indicate Nissan is preparing a package of $1.3 bln in auto loans that may the first to qualify under the TALF program. The largest AAA portion of Nissan’s securities matures in a little less than 2 years and indicative prices suggest 185-200 bp premium to the benchmark.

Here in Q1 09, about $2.3 bln of auto-backed debt has been issued. This is less than a third of the amount issued in Q1 08 and illustrates the drying up of the market. It also highlights the significance of the Nissan deal–increasing the auto ABS brought to market by 50%.

The Fed had initially hoped to start TALF in Feb. Procedural and legal issues have been behind the delay. However, the size of the program has been lifted from $200 bln initially proposed.

Bloomberg says substantially the same thing.

The Obama administration is counting on the TALF plan to help end the credit crunch and recession, thawing the market for asset-backed securities so lenders can make new loans to consumers. The program, first announced in November, was hampered by delays as investors, dealers and issuers worked on details.

“A number of people were concerned that some glitches might not have been ironed out this week” in time to meet the first deadline for investors to apply for the Fed loans, said Malcolm Dorris, a senior partner in the securitization group at law firm Dechert LLP in New York. “Getting a deal done in March is good for the program. We are still in the wait-and-see stage.”

Investors have shunned debt backed by consumer loans as unemployment has climbed in the worst financial crisis since the Great Depression. Sales of the bonds plunged 40 percent last year to $106 billion, according to data compiled by Bloomberg, choking off funding to lenders. About $2.3 billion of debt backed by auto loans has been sold this year, compared with more than $9.6 billion in the same period of 2008, according to data from JPMorgan Chase & Co…

The first phase of the TALF will finance the purchase of as much as $200 billion of AAA rated securities containing loans for autos, education, credit cards and small businesses. Officials eventually plan to include other assets, including commercial mortgage-backed securities.

The Fed originally planned to start the TALF in February, then delayed the debut to ensure “all our legal and procedural steps had been taken,” Bernanke said in congressional testimony Feb. 25. On March 3, the Fed and Treasury said applications for the first deals would be due in two weeks, with loans disbursed on March 25.

The largest AAA portion of the Nissan sale maturing in 1.98 years may price to yield between about 185 basis points and 200 basis points more than benchmark interest rates, the person said. JPMorgan and Bank of America Corp. are underwriting the bonds.

This is the big test. If credit markets are not freed up by these moves, we must hope there is a Plan B.

Sources
Fed’s TALF Consumer Lending Program Starts With Nissan Debt – Bloomberg.com
Nissan to Sell $1.3 Billion of Auto Debt Through TALF – Bloomberg.com

Related posts:

• Kasriel says that Fed could get stuffed under TALF
• A few words from a reader on TALF mechanics
• TALF: A bailout if one reads the fine print
• TALF: ‘the great liquidation’ begins for hedge funds and shadow banks
• TALF details suggest Obama doesn’t get it

This comes via the website The Agonist (Hat tip Scott).  I have bolded the important bits:

So what are AIG’s arguments for making these bonus payments?

1. All 450 employees of AIG in London, where the derivatives contracts were booked and managed, signed retention contracts at the request of management in early 2008. This was at a time when AIG was falling apart but not yet taken over by the U.S. government. The retention contracts called for certain amounts to be paid out of profitability, which now is no longer available, and fixed amounts to be paid regardless. These fixed amounts are the bonuses now under question, and there is more due in 2009.
2. Once AIG was taken over by the U.S. Treasury, the mission changed to winding down the portfolio. There was no real reason why employees would want to stay under such circumstances, so the retention contracts took on added importance. Most of the payments are in the $1,000 to $50,000 range, but seven executives are to receive in excess of $3 million.
3. New AIG management sought advice from outside counsel on whether it could renege on these retention bonuses. Getting outside lawyers to give advice on these matters is standard procedure in banking because it gives cover to the management for difficult decisions. Banking lawyers are peculiar resources, because they are not frequently consulted, but when they are their opinions carry irrefutable weight in decision making
4. The lawyers said breaching the contracts would expose AIG to serious consequences. First, under Connecticut law the parent company could be sued by the employees for willful abrogation of a legal contract. The suits would be easy to win and the penalty is double the amount under dispute. Second, all of AIG’s derivatives contracts around the world have standard cross-default clauses, which say that if AIG fails to make a payment in excess of $25 million, all swaps, options and similar derivatives contracts could be placed in default. Failing to make this bonus payment of $165 million could lead to massive claims of default against AIG on all of its derivatives contracts.
5. AIG management made a third argument. The portfolio has been reduced by 25%, which is probably where all the billions of dollars of Treasury money went when Goldman Sachs, Deutsche Bank and other big players agreed to an early termination and close out of their contracts with AIG. Every closed contract distorts the hedged position of the AIG portfolio, and expert traders are needed therefore to adjust the hedges appropriately. If these traders weren’t kept on staff by AIG, billions of dollars could be lost through inaccurate hedging. Moreover, some of the contracts are “bespoke” – Londonese for complex and one-of-a-kind – and only existing AIG traders and support staff understand them enough to be able to close them out.
6. AIG management is working to reduce the contractual retention bonuses due the rest of this year, and they expect to get agreement from the staff on a 30% minimum reduction. Staffing has been reduced from 450 people to 370. All employees have seen their retirement fund wiped out since it was held in AIG stock. Management have agreed to salaries of $1.00. The effect of all these adverse changes is that the current employees are working for far less than they were in 2007 and 2008, and possibly for less than they could achieve in the market.

The post also says:

There is a sub-plot here as well – a second story arc as the TV people would say – involving the U.S. government. Treasury Secretary Geithner didn’t know about these payments until last week, when the Federal Reserve notified him that round two of retention payments was due on the 15th of the month (apparently round one worth $55 million was paid out last December 15th). It appears that the Federal Reserve seems to be heavily involved in the details of what goes on at AIG now that it is effectively owned and managed by the government, even though it is the Treasury that is the actual owner.

Read the full post over at the Agonist. It is very informative.

UPDATE: 1000 ET. Angela Somers, Special Counsel at Allen & Overy (formerly at Cadwalader), gives a good view on the legal issues involved here via CNBC. The long and short for me is that bankruptcy could have prevented this as I have noted in a previous post. However, Somers does say that, even in bankruptcy these employees would have been needed.

Source
The Real Story Behind Those Greedy AIG Bankers – The Agonist

Related posts:

• Has anyone figured out the AIG employees are in London?
• Did Larry Summers fire derivatives whistleblower at Harvard
• AIG: Bankruptcy would have avoided the bonus debacle
• SEC charges BofA of lying to investors over Merrill but settles
• Deregulation efforts from the late 1990s were blocked

UPDATE 26 Mar 2009: Paul Kedrosky has a good post up on how collateral in CDS contracts work.  See Collateral 101: How It Works at AIG and Elsewhere

Back on March 6th, I noted that the nationalized insurance company AIG had settled Credit Default Swaps contracts with a number of counterparties at the top of the market. In effect, AIG was offering a hidden subsidy to its counterparties by settling the contracts and exchanging collateral for money at inflated prices.

As an example, imagine AIG made a deal with Goldman Sachs to make Goldman whole if Company X defaulted on its bond payments. In this arrangement, Goldman might hold bonds of Company X (and then again, it might not) against which it wanted downside protection via this contract with AIG. Now, after Lehman Brothers defaulted, in all likelihood the price of downside protection for Company X skyrocketed along with the Credit Default Swaps of all other companies. That means any contractual settlement during the time frame of market dislocation was made at unrealistically high levels which no insurer would reasonably accept… that is, except AIG. Goldman would be receiving money that it would not normally receive were it not for the fact that AIG was controlled by the Federal Reserve.

This is the crux of the issue. AIG was effectively nationalized. Thereafter it settled contractual arrangements which it was under no obligation to settle at prices which reflected an enormous premium due to dislocated markets. Therefore, the company gave free money to its counterparties — all large international financial institutions. By the way, many of these institutions are not even American companies.

Who ended up footing the bill? American taxpayers.

On the back of recent outsized bonus revelations at AIG, those in the know about this are indignant. As a result, AIG has released a list of counterparties which Federal Reserve Vice Chairman Donald Kohn had originally refused to give. Below is the document detailing these activities.

Counterparties_tcm385-153017

Related posts:

• The Fed offers banks an outrageous subsidy via AIG
• Lehman Brothers: a primer on Credit Default Swaps
• CDS Market: Did Fannie and Freddie Default?
• JPMorgan Chase: Large exposure to real economy downturn
• Large bank loses $7.9 billion: CDS involved