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“The messenger wore a skirt,” says Marna Tucker, “Could Alan Greenspan take that?”*

by run75411

Re-posted from New Agenda April 2009, Bill reminds us of some of the history leading up to today:

Editor’s note: We are pleased to present this guest post by Bill H, who’s known around the internet as run75441, and who can usually be found writing in his area of expertise: finance.

Recently, Stanford Magazine did a nice article on one of the University’s former law review presidents who graduated at the top of the 1964 class. The first female to hold either distinction of graduating first in her class and also as president of the school’s Law Review. “Prophet and Loss.” April 2009.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” Alan Greenspan

“I thought it was counterproductive. If you want to move forward . . . you engage with parties in a constructive way,” Rubin told the Washington Post.

“My recollection was . . . this was done in a more strident way” … “characterized as being abrasive.” Arthur Levitt

It would seem these three, coupled with Larry Summers’s push back in Congress on the regulation of derivatives, had the problem and not Brooksley Born. Since then, all three men have suggested there should have been more regulation of the derivatives market that Greenspan has called its recent collapse a “once in-a-century credit tsunami.” Called a modern day Cassandra by Stanford Magazine, one could only wonder where we would be today if the economic and financial wizards had heeded her words.

Short histories on CDO/CDS . . . Collateral Debt Obligations (CDO) were invented by Drexel Burnham Lambert (Milken) as a way to package asset based securities. The CDO was tranched into similar asset backed securities of the same rating allowing investors to concentrate on the rating rather than the issuer of the bond. Ten years later, JP Morgan invented Credit Default Swaps (CDS) was used as a mechanism to bet on a 3rd party default. In 2000, CDS were made legal with the passage of the Commodity Futures Modernization Act and any regulation of them was stymied with this bills passage. Later on, an investment firm decided to team CDS and CDO together, transferring the risk from the CDO to the issuer of the CDS, and creating a synthetic CDO.

It was 1994, that Bankers Trust lost ~$800 million from various derivative investments. The chief losers were P&G and Gibson Greetings. Bankers Trust was formed by a consortium of banks, shedding the loan image for conducting trades. Bankers Trust was successfully sued by P&G for its losses by claiming racketeering and fraud. Bankers Trust also became known for its remarks about Gibson Greetings not knowing what Bankers Trust was doing. In 1998, Bankers Trust pled guilty to institutional fraud due to the failure of certain members of senior management to escheat abandoned property to the State of New York and other states. Again in 1998, LCTM was struck by a downturn in the market when Russia defaulted on government bonds, a security LCTM was holding. To make a significant profit on small differences in value, the hedge fund took high-leveraged positions. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion. When investors panicked and sold Japanese and European bonds and bought US treasuries, the spreads between LCTM holdings increased, resulting in a loss of ~$1.8 billion by August 1998. LCTM was saved by an orchestrated Fed bailout utilizing private investors.

It was in 1998 and Brooksley Born testified to Congress about the dangers of the unregulated derivatives market referencing the LCTM losses as a recent example. It was also then that deputy Treasurer Larry Summers testified to Congress that Born’s desire to regulate is “casting a shadow of regulatory uncertainty over an otherwise thriving market.” Larry’s testimony set the stage for Congress to rein in the power of the Brooksley Born’s CFTC and the passage of Phil Gramm’s Financial Service Modernization Act of 1999 prohibiting the regulation of the derivatives market (In 2005, the revised bankruptcy laws would place derivatives outside of the laws also making it the first to receive compensation). W$ and banks had clear unregulated sailing in the sea of laissez faire in 2000 with a closing of the door for debtors in 2005. It was little better than a roach motel, you could check in but you can not check out.

Again in 1999 and in the Senate that opposition arose to the passage of the Financial Services in the form of Senator Dorgan of North Dakota. An excerpt from the Senator’s speech that day before the bill was passed:

“I, obviously, am in a minority here. We have people who dressed in their best suits and they just think this is the greatest piece of legislation that has ever been given to Congress. We have choruses of folks standing outside this Chamber who spent their lifetimes working to get this done, to say: Would you just forget all that nonsense back in the 1930s about bank failures and Glass-Steagall and the requirement to separate risk from banking enterprises; just forget all that. Time has moved on. Let’s understand that. Change with the time. 

We have folks outside who have worked on this very hard and who very much want this to happen. We have a lot of folks in here who are very compliant to say: Absolutely, let me be the lead singer. And here we are. We have this bill, which I will bet, in 5, 10, 15 years from now, we will be back thinking of this bill like we thought of the bill passed in the late 1970s and early 1980s, in which this Congress unhitched the savings and loans so some sleepy little Texas institution could gather brokered deposits from all around America and, like a giant rocket, become a huge enterprise. And guess what. With all the speculation in the S&Ls and brokered deposits and all the things that went with it that this Congress allowed, what did it cost the American taxpayer to bail out that bunch of failures? What did it cost? Hundreds of billions of dollars. I will bet one day somebody is going to look back at this and they are going to say: How on Earth could we have thought it made sense to allow the banking industry to concentrate, through merger and acquisition, to become bigger and bigger and bigger; far more firms in the category of too big to fail?

Senator Dorgan’s Speech, November 4, 1999 on “Gramm-Leach-Bliley Act” also known as the Financial Services Modernization Act

Larry Summers has been present throughout much of this change, supporting it, denigrating the opposition, and now claiming his experience at D. E Shaw gives him an insider’ knowledge as to how the derivatives market works. While President of Harvard University; Larry received a letter (May 12, 2002) from Iris Mack, a new employee of the Harvard Management Company managing Harvard’s endowment funds. A Doctorate in Mathematics from Harvard and a former employee of Enron who dealt in derivative trades, she expressed concerns about the trades (swaps and other complex financial instruments) being made by the funds and the lack of understanding of the trades by the traders. On July 1, Iris was called into the office of Jack Meyer, the chief manager of Harvard Management. On July 2, Iris was fired for making what Harvard Management termed as: “baseless allegations against HMC to individuals outside of HMC.” “Ex-Employee Says She Warned Harvard of Risky Moves” Boston Globe, April 3, 2009. While Harvard Management Company claims above normal returns on its endowment funds, it has spent much of last year selling off private equity and investments to raise cash.

The attitude expressed by our head of the Economic Council is one of “trust me now” as I have all of the experience necessary to fix the current economic and financial problems even though he has helped to initiate today’s issues by denigrating Brooksley Born’s request for regulatory power to Congress, even though he ignored the advice of Iris Mack at Harvard University, even though he consulted to D.E. Shaw, a hedge fund, and making ~$5.2 million while being the financial engineer’s engineer, and even though he has been repeatedly wrong in his direction and advice to Congress and Industry. In the name of deregulation and global efficiency, Larry was its cheer leader while signing off on a letter encouraging the dumping of toxic wastes in Asia at the World Bank. He helped to shepherd China into the WTO claiming:

“’The agreement with China is a one-way street,’ Summers said. ‘China opens its markets to an unprecedented degree, while in return the United States simply maintains its current market access policies,’ he said. ‘It is difficult’, Summers added, ‘to discern any disadvantage to the United States in passing this legislation.’”

— Robert Waldman, Economist, Angry Bear blog.

Personality, ego, and a blind belief in the ability of the market place to dictate the proper path and the correction has gotten in front of common sense. Maybe it is time to sideline Summers and his protégé Geithner in favor of Born, Mack, and Dorgan. Each has shown more foresight into how today’s problems and issues were created and how to resolve them.

“I certainly am not pleased with the results,” she adds. “I think the market grew so enormously, with so little oversight and regulation, that it made the financial crisis much deeper and more pervasive than it otherwise would have been.”   

Brooksley Born, Stanford Magazine, April 2009

*“The messenger wore a skirt,” says Marna Tucker, a Washington lawyer and a longtime friend of Born. “Could Alan Greenspan take that?”

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Default Events, Legal Contracts, Derivatives, and Greece

Barry Ritholtz, who generally knows better, blew a gasket at ISDA for yesterday’s ruling that Greek bonds are not yet in default. Specifically,

“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”

>

Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

Let’s sidebar the reality—that there is no true “market” for CDS in general, let alone Sovereign Debt CDS; Donald R. van Deventer of Kamakura Corporation has been all over this, both on his blog and especially on Twitter—and just note that ISDA made the correct decision.

Greece has not, to borrow Barry’s phrase, “refus[ed] to make good on their obligations in full or on time.” ISDA did not declare a Default Event yesterday because there has not yet been a Default Event.

Default Event is a very specific term. The sample in Janet Tavakoli‘s Credit Derivatives and Synthetic Structures (a book to which I have referred before and undoubtedly will again) runs pretty much three full pages (pp. 88-91). But the general concept is straightforward: there is a minimum threshold (say, 10% of an issue), the principal or interest due of which the entity explicitly refuses to pay or fails to pay that then materially impacts the buyer of Credit Protection (CDS).


Greece has not yet refused to pay anything.*

There is a payment due on 20 March—19 days still in the future. The financial markets—heck, everyone who runs a diner in Queens—may well believe that no payment will be made on 20 March, but that hasn’t happened yet. And the Greek government specifically has not said it won’t make the payment; it has said, “Hey, take these bonds instead.”

It is true that, cet. par., the market value of the bonds being offered is about 25% the supposed economic value of the current ones. So anyone taking the deal would have to be assuming that the market value of the current bonds is somewhere around 25, just as the French and German banks have them marked.

The market may also agree that one of the reasons people may well accept the offer is that, otherwise, they expect that the Greeks will default on the current bonds.

But they haven’t yet, and this is not Minority Report (though we can all agree Phil Dick would recognize, if not approve of, the current financial world).

So ISDA correctly ruled—the key phrase is “based on current evidence”—that there is not yet a Default Event. If everyone says “we will tender our securities due 20 March for the exchange offered,” there will not be a default of those bonds.

You, I, and Bill Gross can all agree that the likelihood of this happening is about equal to the chance that Rick Perry will be elected U.S. President this year. But there has not been a Default Event.

Wait two or three weeks.

The thing Barry most overlooks is that yesterday’s ISDA ruling is, if anything, good for CDS buyers.

What will be the economic difference of waiting to holders of the CDSes? I don’t know for certain, but if you’re looking at the standard ISDA CDS contract, there’s a reasonable assumption that (1) the market price of the bond will not change for the better and (2) it is a certainty that the Accrued Interest on the bond will be greater when they declare a Default Event than it is now.

Keep in mind: in a standard CDS, declaration of default terminates the contract. Accruals end, market pricing is to be determined by calling a few dealers, and the only thing left is to go through the pockets and look for loose change.**

Yesterday’s ISDA ruling means the CDS buyers will be owed more Accrued Interest when (in two, or at most three, weeks) a Default Event is declared.

What about the principal repayment due? Recall again that the payment due is generally the net of the current market price subtracted from the initial principal amount (assumed to be par—100—but in any event greater than the current market value).

I’m inclined to argue there is optimism in the current market that will not be there in two weeks: it’s not that liquid a market, there is a floor on the price of the economic equivalent of the new offer, and there is time value in the option to convert.***

If ISDA had declared default yesterday—that is, assumed that Greece wasn’t just “mostly dead”****—they would have taken the current market price [P0]. Even before the delays and roundelays, that was likely to be greater than the market price of those bonds in a week or two[P1, when default is declared.

That is, P0 is greater than P1. And since the payment due is based on [100*****-Pt], the principal amount due to CDS holders when default is declared will also be greater.

ISDA followed the letter of the contract: the Greeks have not yet defaulted on an obligation, nor have they stated that they intend to do so. When they do—there are few, if any, in the market who would treat the clause as a possible “If”—a Default Event will be declared and the CDS contracts will be expected to pay as they are due. And that payment will, in all likelihood, be higher than the payment that would have been due if ISDA had ruled differently yesterday.

And if they don’t, then I’ll be agreeing with Barry that the whole thing was a scam from the start—though I would still argue that JPMorganChaseBear stealing more than $1,000,000,000 in customer funds from MF Global clients is a bigger one, which is something like saying that coprophagia is even worse in liquid form.

When the CDS contracts actually have to be paid, then the fun will begin. If potential for insolvency is your idea of fun. But that’s another story.

*They have seen S&P downgrade their credit rating, but that’s a separate issue.

**Obligatory reference. It will pay off.

***The Worst Case scenario is that you assume the new bonds are the only value in the transaction, and discount their value back over the cost of basically two-week money. The best case scenario is some combination of the price of the new bonds and expectations of either getting a better deal later and/or post-litigation gains. The lattice may be ugly, but it yields an expected value higher than the Worst Case, and therefore higher than the market price of the bonds as the time to exercise approaches.

****See ** above.

*****Or the other initial contract price; in any case, a fixed value greater than Pt.

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Is This A Bad Thing? Sane Economists would say No.

Yes, I’m working with the null set again, but Peter Bockvar, chez Ritholtz, raises the most common objection to the Greek restructuring’s likely effect on the CDS market:

[I]t will…potentially destroy [the sovereign CDS] market to the point where it will go away. The unintended consequence of what will be next will be those looking to hedge sovereign exposure, mostly banks, will then have to short sovereign debt or outright cut credit to the region. EU officials better be careful what they wish for the holders of Greek CDS.

The English translation of this is that Mr. Bockvar suggests—I can’t swear that he believes, though I know which way to bet—that the current prices for sovereign debt are artificially high because of the existence of the Sovereign Debt CDS market.

So, unless you are trading acvtively in both markets, as a buyer, you are being charged too much for sovereign debt.

Wouldn’t it be better to know that up front?

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Europe’s at it again…

Key European CDS are starting to turn in the more northern direction again, as the German-French ‘pact for competitiveness’ faces near-unanimous pushback across Europe.

Credit default swaps (CDS) are a market security used by investors to buy 5-yr protection (in this case) against default (or the like). As the spread rises the implied probability of default does too. Current market values imply a 39% probability of default by the Irish sovereign (listed in legend), 20% by that of Spain, and 14% by the Italian sovereign, etc. Cash bond spreads are blowing out again, too, where Spain now must pay a 216 bps premium over Germany on a 10-yr loan (the sovereign bond). I’d say that’s not totally irrational.

I completely understand why these negotiations are stalling. I’m Spain – it’s not clear that Spain commented against the pact based on this article, but I digress – why would I agree to a deal that forces more ‘competitive’ measures, which really just means quashing indexed wage growh, reducing the government deficit, adhering to a fiscal policy rule (which, by the way should be modeled after Germany’s debt brake), and adopting a standardized tax rate? Okay, I will if you (Germany) will. Meaning, I’ll increase my competitiveness by stripping away aggregate demand if you allow prices to rise. I’m Germany – no way. (Please see my previous post which argues that a successful transition to a more stable Eurozone depends on higher Germany inflation.)

Der Spiegel spells it out pretty succinctly in an article that is now two weeks old but still totally relevant:

Germany will only agree to additional guarantees for the euro rescue fund — as the Commission and other parties have called for — if its partners approve its competitiveness pact.


Simply put: we (Germany) will only agree to eventually bail you out if you agree to our harsh demands at that time, or you agree to our harsh demands now. You’re choice.

This political drama is far from over. (More exciting analysis below the jump)

(Dan here…Kantoos responds to Rebecca…http://kantoos.wordpress.com/2011/02/15/rebecca-wilder-on-eurozone-monetary-policy-and-german-inflation/ )

Here’s another little fact to think about: The price to buy protection against a default by the Japanese sovereign is just 77 bps, that’s only 23 bps above that for the German sovereign. This is ironic because Germany is the premiere demander of fiscal austerity, while Japan is not (to say the least) with gross debt equal to 221% of GDP (according to the IMF) – or is it?

The table below lists common characteristics usually associated with rising CDS spreads (CDS spreads are current as of 4pm today and may vary according to pricing source): the stock of debt held by foreigners (any currency denomination) and the stock of gross public debt. The final column illustrates the ability of a country to print fiat currency that is not backed by anything but government decree.

I think it’s pretty clear: Japan and the US have very elevated government debt, but low external holdings AND can print their own money to finance liabilities (which by the way are in most part denominated in their respective currencies). Clearly markets’ attach weight to this simple fact via low CDS spreads.


To be continued….

Rebecca Wilder

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Egyptian CDS in line with Portuguese CDS

It occurred to me that some Angry Bear readers may be interested in a short analysis of the Egyptian bond market. Professionally, I’m a macroeconomic analyst and portfolio manager on a global fixed income team. Since we do trade emerging market debt, of which Egyptian debt is categorized, I’ll be happy to comment.

The gist of the article is this: markets are pricing the probability of default in Portugal and Egypt similarly – I’d sell protection on the Egyptian debt. At this point, I should state the following disclaimer: this is not a trade recommendation, nor does this represent my firm’s views on Egypt or Portugal.

Some bond market developments of late:

  1. Egypt holds a BBB- rating on its local currency debt by Fitch and S&P (BB+ on its foreign currency debt). The local currency debt in Egypt is at the lowest of the investment-grade ratings, while on January 20, 2011, Fitch put Egypt on credit-watch negative.
  2. The Egyptian pound is heavily managed. Over the last week, the USD gained just 0.9% against the pound. Maintaining a stronger nominal currency is common in developing economies to temper the effects of import prices (in this case, food).
  3. The 5.75% 10-yr Egyptian international bond, which is denominated in USD, sold off 7% over the last week. According to JP Morgan, Egypt is well underperforming the index (Egpyt is roughly 0.5% of the index): the year to date total return on the Egyptian international bonds is -10%, while that of the JP Morgan Emerging Market Bond Index Global (EMBIG) is -0.7%.
  4. Credit default swap spreads jumped 50% over the last week to 454 basis points (bps), according to one Bloomberg source (no link, subscription required). CDS are bilateral contracts between two parties, so pricing varies somewhat – but the trend is the same among all sources: up. This means that it’s becoming increasingly expensive to buy protection against Egyptian sovereign default.

If you want to know more about CDS, please see a helpful 2009 publication by Deutsche Bank.

And this is where it gets interesting: it currently costs the same to buy 5-yr protection on Egyptian bonds (454 bps) as on Portuguese bonds (456 bps). And Portugal is rated A- (negative outlook).

(more after the jump)
The chart above illustrates a panel of CDS data for countries with similar market risk, where S&P’s local currency rating is listed in the legend. The CDS quoted above are priced in USD, rather than the local currency; but the spreads do quantify the market’s assigned probability of default : 29.3% for Egypt vs. 29% for Portugal (with a 30% recovery rate on both).

Generally the decision to default comes in two flavors: the ‘willingness’ and ‘ability’ to pay. Also, default can take many forms, like missed coupon payments, terming out debt liabilities, or bankruptcy (corporate).

Willingess. A quick analysis of ‘governance’ indicators at the World Bank says that on the face of it, Portugal is probably more willing to pay its debts. The governance measures are corruption, government effectiveness, political stability, regulatory quality, rule of law, and voice and accountability. Read about the methodology of the governance indicators here and get the data here.

In sum, Portugal ranks much higher on the total of the World Bank governance indicators, 6.4, compared to -2.6 for Egypt (I use a strict sum of the 6 components).

Ability. According to the IMF’s most recent World Economic Outlook (October 2010 database), Egypt is expected to grow an average 13.9% per year in nominal terms over the next three years (2010-2013). In contrast, Portugal is expected to grow just 1.7% on average for the next three years.

According to Bloomberg, on January 27, 2011, the yield on a Portuguese 1-year local bond is 3.42%, while that for a local Egyptian bond is 10.99%. I’ll take odds of payment on the one with nominal growth that exceeds the payment – Egypt.

A quick look at the WEI shows the following statistics for 2011:

Country Subject Descriptor 2011
Egypt General government net lending/borrowing -7.622
Portugal General government net lending/borrowing -5.232
Egypt General government net debt 60.993
Portugal General government net debt 82.864
Egypt General government gross debt 71.725
Portugal General government gross debt 87.086
Egypt Current account balance -1.605
Portugal Current account balance -9.171
International Monetary Fund, World Economic Outlook Database, October 2010

The 2011 outlook demonstrates the following: government deficits are similar in Portugal and Egypt; government debt is higher in Portugal, a country that has no monetary sovereignty; Portugal has relatively fewer reserves (comparing gross debt to net debt); and the current account deficit in Portugal dwarfs that of Egypt.

If I was an investment bank, I’d rather sell protection on Egypt than Portugal at these prices.

Rebecca Wilder

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Congress thinks by analogy….and so we are stuck

by cactus

Congress thinks by analogy

I don’t remember what link I followed to get to this, but never in my life did I expect to agree 100% on any issue with David Stockman. Yes, that David Stockman. Holy wow:

DAVID STOCKMAN: Credit default swaps, OK? And we weren’t bailing out AIG. We were bailing out the banks, because the banks had bought a lot of low-caliber or subprime loans, wrapped some insurance around it from AIG, and said, presto, we have a AAA, a security on our balance sheet.
They didn’t. They had garbage on their balance sheet. And the bailout was to make sure that they didn’t suffer multi $10 billion write-downs on that AIG-supported loan.

PAUL SOLMAN: So, if you had been in the administration after Lehman Brothers, you wouldn’t have supported bailing out AIG?

DAVID STOCKMAN: No, absolutely not. It was the single most, you know, drastic error in policy in modern history, going back to the 1930s. This was exactly the wrong thing to do.

It’s destroyed any basis for fiscal discipline in the United States. I was a member of Congress, and I know how they think. And they think by analogy. If you did it for John, you have got to do it for Bob. There is no way that any congressman is ever going to vote against farm subsidies or ethanol subsidies or housing subsidies or anything else, refrigerator subsidies, once we have made this tremendous bailout for Wall Street, and we stepped into AIG.

________________________________
by cactus

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