PrefBlog

Accrued Interest has come out in favour of Exchange Traded Credit Default Swaps in a new post:Bailouts, Wall Street, and the Bad Motivator, although he does not go so far as some in claiming that over-the-counter trading should be (effectively) banned.

I addressed a similar exhortation in my post Leverage, Bear Stearns & Econbrowser.

I’m not a proponent of Exchange Trading for CDSs – I can see a useful purpose being served by a clearinghouse, but exchanges are set up so that non-institutional players get to play. I will defer to any those with better information, but I don’t sense any clamour from retail to trade in Credit Swaps … several attempts to set up an exchange have died on the vine (see Update #4 to the ‘Econbrowser’ post) although I don’t know to what extent retail was invited to the party. By me, exchange trading will involve enormous listing fees and a huge bureaucracy to list a plethora of CDSs that will trade by appointment only at 100bp spreads. What’s the point?

While I have great respect for Accrued Interest, I think there are a number of misconceptions embedded in his post:

Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions.

Well, no. As I pointed out on the ‘Econbrowser’ post:

as far as the counterparties were concerned, their counterparty was not BSC per se, but wholly-owned, independently capitalized, highly rated subsidiaries of BSC. Just how adequate the capital, accurate the ratings, and ring-fenced the assets actually were is something I am not qualified to judge – seeing as how I haven’t even seen any of the guarantees and financial statements in question. But neither, it would appear, has Prof. Hamilton.

I should note that I brought this up in the comments to the Accrued Interest post:

JH: I don’t believe that this is correct. See my post Leverage, Bear Stearns & Econbrowser
…
James: I read your piece at the time. My reaction is that we don’t really know what would have happened if BSC actually declared bankruptcy.

Accrued Interest goes on to postulate:

Let’s say you allow Bear Stearns to fail and that caused XYZ bank to fail. Is that capitalism? Forcing XYZ to suffer for the sins of Bear Stearns?

I say … yes, that is capitalism, but no, it’s not forcing XYZ to suffer for the sins of BSC. It is forcing XYZ to suffer for their own sins in not demanding adequate collateralization from BSC when their position started winning (if XYZ’s trade was losing, BSC’s bankruptcy would not affect them). If XYZ failed, it would be due not only to insufficient collateralization, not only due to their extending far too great a credit line to BSC, but also a failure of regulation in not having previously assigned a capital charge to XYZ that reflected their risk.

When a position – of any kind – gets marked-to-market, P&L changes. If the position is winning and profit increases, then shareholders’ equity increases. So far, so good. But the credit exposure to the counterparty has also increased … it’s a loan to the counterparty and gets charged as such. In any reasonable regime, collateralization will reduce the risk measured from the gross exposure. It may, upon sober review of the evidence, be deemed necessary to fiddle with these various calculations of Risk Weighted Assets, but I fail to see a need for anything more.

Next! Accrued Interest then claims:

The first step is obvious. Credit-default swaps need to be exchanged-traded.

I don’t see that at all. If we accept for a moment that counter-party risk is out of hand (I don’t accept it, but let’s continue the discussion) then exchange trading is only one option. The option that minimizes change would be a clearing-house, whereby the clearing house acts as the counterparty for all trades and the clearing-house itself is guaranteed by each of its members. An exchange would incorporate this function, but the functionality does not require an exchange.

Accrued Interest continues:

There would be some relatively simple ways to bring such a thing about. What if banks were required to recognize the credit risk of their counter-parties directly?

They are. Assiduous Readers will remember that I looked at Scotiabank’s capitalization today. According to page 23 of their supplementary information, their Basel-I Risk-Weighted-Assets of 252.8-billion includes 240.5-billion of credit risk, which includes 34.0-billion of “Off-Balance Sheet Assets – Indirect Credit Instruments”. If we go to the OSFI website and look at Scotia’s 1Q08 “BCAR Derivative Components”, we find that they have Credit Derivative Contracts [OTC] of $108.9-billion outstanding (and those are REAL dollars, none of that sub-par American muck) giving rise to a replacement cost of $3.1-billion and a credit equivalent amount of $8.1-billion which (when combined with other derivatives) gives rise to a Risk-Weight-Equivalent of $10.7-billion … just over 4.2% of their total risk-weighted assets.

One may wish to twiddle with the numbers – converting the notional amounts and unrealized P&L in different ways to get different Risk-Weighted-Assets. But it is not correct to imply that the credit risk is not currently recognized.

Accrued Interest continues:

I think back to banks needing to reserve for losses dealt to them by XLCA/FGIC/Ambac/MBIA’s potential failure to perform on CDS contracts.

Now, this is a legitimate concern. According to OSFI Guidelines (Section 3.1.5, page 31) claims on Deposit Taking Banks of an AAA to AA- sovereign carry a risk-weight of 20%, which is the same as similarly graded corporates (section 3.1.7). Single A comes at 50%, BBB+ to BB- is 100% and let’s not go further.

If we look at the quarterly report for CM, we find:

During the quarter, we recorded a charge of US$2.30 billion ($2.28 billion) on the hedging contracts provided by ACA (including US$30 million ($30 million) against contracts unrelated to USRMM unwound during the quarter) as a result of its downgrade to non-investment grade. As at January 31, 2008, the fair value of derivative contracts with ACA net of the valuation adjustment amounted to US$70 million ($70 million). Further charges could result depending on the performance of both the underlying assets and ACA.

The problem here is: they (effectively) made a loan of USD 2.37-billion to ACA and have now written down 2.30-billion of it. Why were they making (effective) loans of this size to a single (effective) borrower?

It is my understanding that many of the monolines were refusing to write protection unless they were exempted from collaterallization, on the grounds that they were AAA rated. It is my further understanding that this was just fine by some of the banks and brokerages. Well, it’s a business decision. As long as it’s adequately charged, it can remain a business decision.

I will certainly agree that loans of this size to a single party (equivalent to about one-sixth of their October 2007 capital) should have attracted a concentration charge, on top of the regular charge for corporate debt. But this – the existence or lack thereof of concentration charges in capital requirements – is what we need to talk about, without jumping into mandatory exchange trading of CDSs!

Accrued Interest concludes:

Why not just make them reserve a larger amount for this possibility up front? Efforts to start an exchange would begin the next day.

Well … maybe. To the extent that the exchange’s clearing-house’s credit would be better than the sum of its sponsoring parts, it is entirely reasonable to suppose that $1-billion exposure to a clearing-house would be charged at less than 10x$100-million to its individual members. It may also be assumed that netting and novation will be facilitated with a clearing house, which will further reduce exposure.

Whether or not the improvement in credit quality and consequent (we hope) reduction in capital requirements balances the guaranteed extra costs and reduced flexibility implied by a clearing-house is something that can be discussed … and the decision regarding institutional participation in such a scheme becomes just another business decision. But let’s see some numbers first.

Update, 2008-5-28: Naked Capitalism reprints a Financial Times rumour of an announcement tomorrow. This will, as far as I can tell, make formal a proposal aired in April that has been well reported:

“There is not one element that is going to solve all the problems, but it is one piece of the puzzle that will help us create a more robust framework. The timing is right – whether it will be successful or not, only time will show,” says Athanassios Diplas, chief risk officer and deputy chief operating officer, global credit trading, at Deutsche Bank, speaking at Isda’s twenty-third annual general meeting in Vienna on April 17.

The initial focus of those involved in the discussions has been on index products. Over time, efforts will extend to single-name CDSs. According to Diplas, this will remove risk from the system and the worry that the failure of one dealer could cause a hazardous shock in the market.

No details were given on a time frame for when a central clearing house would be established, but Diplas says the admission criteria for participants would be strict. “The criteria will take into account how well capitalised the firm is, how the risk is dealt with, how the variation margins are going to be posted and what the expected gap risk is going to be. All these issues have to be dealt with carefully – we are not going to jump into something unless we are very confident it will work.”

Update, 2008-6-19: See the market update of June 9 for news of how the proposal is moving along. Accrued Interest has posted another good piece about CDS clearing and exposures.

The usually reliable Prof. James Hamilton of Econbrowser disappointed me today with a rather alarmist post on leverage and Bear Stearns:

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion.
…
But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren’t traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.

And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I’m afraid the answer is, they figured Bear was too big for the Fed to allow it to fail.

There are a number of problems with these statements; first let’s take the question of the counterparties’ willingness to deal with Bear Stearns (BSC). According to their 10-K:

In connection with the Company’s dealer activities, the Company formed BSFP and its wholly owned subsidiary, Bear Stearns Trading Risk Management Inc. (“BSTRM”). BSFP is a wholly owned subsidiary of the Company. BSFP and BSTRM were established to provide clients with a AAA-rated counterparty that offers a wide range of global derivative products. BSFP is structured so that if a specified trigger event (including certain credit rating downgrades of the Company, the failure of BSFP to maintain its credit rating and the occurrence of a bankruptcy event with respect to the Company) occurs, BSFP will perform on all of its contracts to their original maturities with the assistance of an independent derivatives portfolio manager who would assume the active management of BSFP’s portfolio. BSTRM is structured so that, on the occurrence of a specified trigger event, it will cash-settle all outstanding derivative contracts in a predetermined manner. Clients can use either structure. The AAA/Aaa ratings that BSFP and BSTRM have received are based on their ability to meet their respective obligations without any additional capital from the Company. In the unlikely occurrence of a trigger event, the Company does not expect any significant incremental impact on the liquidity or financial condition of the Company. At November 30, 2007, there was a potential cash settlement payable by BSTRM of $210 million on the occurrence of a trigger event.

So, as far as the counterparties were concerned, their counterparty was not BSC per se, but wholly-owned, independently capitalized, highly rated subsidiaries of BSC. Just how adequate the capital, accurate the ratings, and ring-fenced the assets actually were is something I am not qualified to judge – seeing as how I haven’t even seen any of the guarantees and financial statements in question. But neither, it would appear, has Prof. Hamilton.

Now let’s take another aspect of the charges: But these weren’t traded on a regular exchange, so there was no margin requirement. Any private agreement can have any collateral requirement agreed upon. There is no need to seek the imprimatur of an Exchange prior to demanding collateral as part of a private transaction. Page 93 of the PDF with BSC’s 10-K shows a table of their winning positions at year end and a comparison with the collateral received, broken down by credit rating of the counterparty:

The Company measures its actual credit exposure (the replacement cost of counterparty contracts) on a daily basis. Master netting agreements, collateral and credit insurance are used to mitigate counterparty credit risk. The credit exposures reflect these risk-reducing features to the extent they are legally enforceable. The Company’s net replacement cost of derivatives contracts in a gain position at November 30, 2007 and November 30, 2006 approximated $12.54 billion and $4.99 billion, respectively. Exchange-traded financial instruments, which typically are guaranteed by a highly rated clearing organization, have margin requirements that substantially mitigate risk of credit loss.

Their financial statements for 2007 show $15.6-billion “Securities Received as Collateral” and $15.7-billion “Securities Owned and Pledged as Collateral”.

Of particular note is the discussion on page 19 of the PDF:

A reduction in our credit ratings could adversely affect our liquidity and competitive position and increase our borrowing costs. Our access to external sources of financing, as well as the cost of that financing, is dependent on various factors and could be adversely affected by a deterioration of our long-and short-term debt ratings, which are influenced by a number of factors. These include, but are not limited to: material changes in operating margins; earnings trends and volatility; the prudence of funding and liquidity management practices; financial leverage on an absolute basis or relative to peers; the composition of the balance sheet and/or capital structure; geographic and business diversification; and our market share and competitive position in the business segments in which we operate. Material deterioration in any one or a combination of these factors could result in a downgrade of our credit ratings, thus increasing the cost of and/or limiting the availability of unsecured financing. Additionally, a reduction in our credit ratings could also trigger incremental collateral requirements, predominantly in the OTC derivatives market.

The procyclical nature of increased collateral requirements upon a reduction in credit rating could well have been a major factor in the debacle.

However, the sheer fact of the existence of collateral in the derivatives agreements is not the end of the story. There’s also the SEC’s role as supervisor of broker-dealer capital:

Broker-dealers must meet certain financial responsibility requirements, including:

• maintaining minimum amounts of liquid assets, or net capital;
• taking certain steps to safeguard the customer funds and securities; and
• making and preserving accurate books and records.

Getting the details on these calculations is a little hellish, but I did find a statement of the rule – under “Ratio Requirements” is:

[(a)(1)(ii)] No broker or dealer, other than one that elects the provisions of paragraph (a)(1)(ii) of this section, shall permit its aggregate indebtedness to all other persons to exceed 1500 percent of its net capital (or 800 percent of its net capital for 12 months after commencing business as a broker or dealer).

[(a)(1)(ii)] A broker or dealer may elect not to be subject to the Aggregate Indebtedness Standard of paragraph (a)(1)(i) of this section. That broker or dealer shall not permit its net capital to be less than the greater of $250,000 or 2 percent of aggregate debit items computed in accordance with the Formula for Determination of Reserve Requirements for Brokers and Dealers (Exhibit A to Rule 15c3-3).

I will note at this point that I do not purport to be an expert on US Broker/Dealer Regulation!

It seems to me, however, (based on a very quick glance through some areas of interest in the quoted document) that most of the credit calculations are very similar to – if not identical to – the Basel rules for banks. I will also note that:

Off-balance sheet items are multiplied by the appropriate credit conversion factor (CCF) outlined in Table 39, to give a balance sheet equivalent value. The credit equivalent is similarly multiplied by the relevant CRW to calculate a RWA.
…
When banks sell protection, these long credit exposures are treated the same as a written guarantee on the underlying credit. Thus, if the Reference Entity is a corporate, then this will attract 100% CCF and 100% CRW.

When banks buy protection, regulators will typically be willing to allow a degree of capital relief if the default swap is directly offsetting an underlying long credit position. In the UK, for example, the treatment is similar to that of a guarantee. Banks can choose whether to replace the underlying corporate exposure (100% risk weighted) with that of the protection seller (20% if it is an OECD bank).

The exposure on an interest rate swap is equal to its profit-and-loss (there should, however, be some additional capital requirement resulting from “gap risk”, to the extent that there is a mismatched book); writing a naked CDS is equivalent, for risk management purposes, to buying a bond.

What’s the problem with that?

To get back to Prof. Hamilton’s post, I consider his proposal for compulsory exchange trading to be disappointing because it does not, in and of itself, do anything to address the problem that he is attempting to resolve.

The scare number is $13.4-trillion, and Prof. Hamilton alleges: If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional.

There is no indication in the post that the actual effects on capital of this $13.4-trillion capital exposure have been examined, let alone an argument made that the current reserves against this exposure are inadequate – or even the easiest representation made, that the “2 percent of aggregate debit items” is too low and should be increased.

It should be clear that we do not want a financial system in which nothing ever fails and nobody ever loses money. As I have argued in the past, we should be aiming for a financial system with a good solid banking core surrounded by a riskier layer of brokerages (or “Large Complex Financial Institutions”, as the BoE calls them) surrounded in turn by a wild-and-wooly shadow-banking system comprised of hedge funds, SIVs and anything else that gets dreamed up so the dreamer can make a buck.

As I indicated yesterday, I don’t like arguments along the lines of “Bear Stearns blew up, so we need to do this”. It’s a non-sequiter, and Bear Stearns is not the greatest example in the world anyway, in that (as far as I have been able to tell) it didn’t blow up for any particular fundamental reason, but simply succumbed to a run-on-the-bank panic. The hysteria of mid-March – very ably chopped off by Bernanke’s action in both ensuring continuity of business with drastic punishment of the owners – is something that cannot be legislated against.

We may agree that a positive social purpose may be served by, say, increasing the capital requirement to 3% of debits from the current 2%. Or we may wish to say that corporate bonds should attract a capital charge of 15% rather than their current 10%. Or we may wish to say that interest-rate swaps are charged at rate of not just their P&L, but their P&L + 1% of notional, to account for gap risk.

But to insist that derivative trading be moved to an exchange simply moves the problem and does nothing either to demonstrate that there is, in fact, a problem or to solve it once it’s defined.

Update: In related news (hat tip: Naked Capitalism), former Fed Governor Volker has called for (as far as I can see) transfer of brokerage supervision to the Fed from the SEC:

Volcker hinted at the Fed’s recent role facilitating the rescue and proposed takeover of Bear Stearns by J.P. Morgan Chase. The Fed, he said, “felt it necessary to extend that safety net” to systemically important institutions by “providing direct support for one important investment bank experiencing a devastating run, and then potentially extending such support to other investment banks that appeared vulnerable [to] speculative attack,” Volcker said.

“Hence, the natural corollary is that systemically important investment banks should be regulated and supervised along at least the basic lines appropriate for commercial banks that they closely resemble in key respects,” he said.

Update #2 : Naked Capitalism also commented on the Econbrowser post and commented (with very little evidence, I must say) that most of the $13.4-trillion was interest rate swaps, not CDS. He’s probably right, mind you, but there’s not much to go on.

Update #3: As reported on PrefBlog on May 7:

And it looks like the big Wall Street dealers are going to have to lift their skirts a bit:

The U.S. Securities and Exchange Commission will require Wall Street investment banks to disclose their capital and liquidity levels, after speculation about a cash shortage at Bear Stearns Cos. triggered a run on the firm.

“One of the lessons learned from the Bear Stearns experience is that in a crisis of confidence, there is great need for reliable, current information about capital and liquidity,” SEC Chairman Christopher Cox told reporters in Washington today. “Making that information public can certainly help.”

We’ll see what the details are, but this is a good development for investors.

Update #4: eFinancial News reported on April 7:

The race to introduce listed credit derivatives products was won last year when four exchanges launched their first contracts. However, thanks to fears over liquidity, the winners gained little more than frustration and embarrassment.

Eurex, the Chicago Mercantile Exchange, the then independent Chicago Board of Trade (now part of CME Group) and the Chicago Board Options Exchange all launched credit derivatives contracts &em; but not one is traded today.

The exchanges and clearing houses have not, however, given up their credit ambitions. At last month’s Futures Industry Association conference in Florida, the chief executives of the four main derivatives exchanges – the CME, Eurex, NYSE Euronext’s Liffe and the Intercontinental Exchange – unanimously agreed credit derivatives were the single biggest growth area for their businesses.

In their “Global Structured Credit Strategy” publication of May 13, 2008, Citi’s Structured Products Group opined that regulators would force either an exchange or a clearing house down the street’s throat, willy nilly (hat tip: An Assiduous Reader).

Update, 2008-6-3: More Bear Stearns discussion from the June 3 Market Action Review:

Accrued Interest has written some more about the Bear Stearns affair with an emphasis on the idea that Lehman now finds itself in much the same position. He also links to a three-part review by the WSJ which, as he says, is excellent.

Derek DeCloet (last mentioned on PrefBlog regarding a column about regulatory pay scales) has written a column in the Globe titled Pull the Plug on Raters’ Special Status in which he discusses the repeal of the exemption given to credit rating agencies under National Policy 51-201 (to be horrifyingly precise, he discusses Regulation FD, which is the regulatory policy of some foreign country. But in Canada, it’s NP 51-201).

His source material for the column was a speech by David Einhorn, which was reported briefly by PrefBlog on April 18:

From the oh-hell-I’ve-run-out-of-time-here’s-some-links Department comes a speech by David Einhorn of GreenLight Capital, referenced by another blog. Einhorn is always thoughtful and entertaining, although it must be remembered that at all times he is talking his book. The problem with the current speech is that there is not enough detail – for instance, he equates Carlyle’s leverage of 30:1 which was based on GSE paper held naked with brokerages leverage, which is (er, I meant to say “should be”, of course!) hedged – to a greater or lesser degree, depending upon the institution’s committment to moderately sane risk management. But there are some interesting nuggets in the speech that offer food for thought.

Mr. DeCloet first takes care to establish his credentials as a hard nosed analyst, getting straight to the facts of any matter placed before him:

The markets’ most powerful brand is a letter (well, three letters): “AAA.” Or at least it was, until the rating agencies – Standard & Poor’s, Moody’s and others – debased it by handing it out the way parade clowns throw bonbons at little children.

Denigrating the ratings agencies is very fashionable!

Mr. DeCloet does not specify the nature of the debasement, nor does he show how he, or anybody else, did better without the benefit of hindsight. Track records are considered somewhat old-fashioned, these days, and three-hundred pound slobs at baseball parks denigrating the athletes between hot dog bites are considered the epitome of judicious analysts.

For those who are interested, I will reprint some material from the BoE Financial Stability Report, showing expected losses by sub-prime tranche:

Chart A also shows how the projected losses affect securities of different seniority. The more junior securities, with lower credit ratings, bear the first losses. But losses are projected to rise to levels that would eventually affect AA-rated securities. AAA-rated securities do not incur losses in this projection. But there is sufficient uncertainty that even these top-rated securities could conceivably bear some losses. For example, if all seriously delinquent mortgages defaulted after a year and the LGD rate was 55%, projected credit losses would reach US$193 billion, or 23% of outstanding principal. This loss rate would be high enough to affect some AAA-rated sub-prime mortgage-backed securities.

Good heavens, here we are in the middle of a financial cataclysm, and the BoE says “some AAA-rated sub-prime mortgage-backed securities” at the center of it could conceivably be affected.

Gee, Mr. DeCloet, can you get me some of those bonbons? They look pretty good to me!

He then arrives at his main point:

So the rating agencies’ role is a serious one, far more important than that of, say, equity analysts. If Citigroup’s crack research department says Royal Bank is about to be hit with $5-billion in losses, investors can choose to sell, ignore it or just laugh. But beyond that, it doesn’t really affect real-life business decisions. But if S&P were to say the same thing – watch out. The difference is the insider status.

I take issue with that last statement. I assert that there are two differences with an impact that exceeds insider status: reputation and regulation.

Reputation comes from the lengthy track record of the major agencies. They make available their transition analyses which show that – for all their errors and occasional spectacular folly – their advice is pretty good. Much better than most of their detractors, at any rate! Problems occur when investors place blind confidence in the ratings (everything should be checked), misuse the ratings (they are advice on credit. They are not advice on market prices or liquidity or tomorrow’s headline. What’s more, they are credit opinions, not credit facts) or, simply, do not diversify enough (if taking a small position in something is good, taking a large position is not necessarily better).

The problems with regulation is due to the extraordinary confidence placed in the credit ratings agencies – and in the ability of the marketplace to value credit in a sober and analytical manner – by the regulators. Basel I placed far too high confidence in the credit ratings of a bank’s holdings as a measure of its risk, and some regulators did not impose an assets to capital multiple cap on the banks under their supervision as a safety check. Among other things, this meant that there was an entire marketplace for AAA tranches with all the buyers buying the same thing for the same reasons … and that engendered a huge amount of “cliff risk”, sometimes referred to as “crowded trades” (as indicated by BoC Governor Carney in March).

The agencies, on the other hand, have just been trucking along, making their quota of mistakes and dispensing their advice, as they have done for the past 100-odd years.

For all that I disagree with his arguments, I agree with Mr. DeCloet’s conclusion: National Policy 51-201 (and Regulation FD) should be revised, to eliminate the insider advantage held by CRAs that freely distribute the fruits of their labours. The current (April) edition of Advisor’s Edge Report has an article by me on this very subject … the article is currently embargoed for republishing purposes, but will be made available on PrefBlog in the near future.

Update, 2008-5-21: For the article, see Opinion: Credit Ratings – Investors in a Bind.

Derek DeCloet wrote a column in today’s Globe, Watchdog could use more Bay Street bite, which has the major theme of arguing for higher salaries and more direct financial services involvement for senior staff:

Salaries for deputy ministers – Ms. Dickson is paid in line with them – begin at $174,000 and top out at less than $300,000. Even the higher figure is less than one-thirtieth of what Scotiabank CEO Rick Waugh earned last year (nearly $10-million). The Finance Minister earns about $230,000, plus perks. The top of the pay scale for the Governor of the Bank of Canada was $429,600 last year. So there you have it: the three people with the most to say about banking policy and oversight in this country earn a combined salary that’s less than a decent stock analyst or mutual fund manager would make. OSFI’s entire budget is equivalent to nine Rick Waughs.

It’s not all about money, of course – but rare is the person like Mark Carney, willing to forgo millions in riches at Goldman Sachs to become a public servant. And it wouldn’t hurt to have more Bay Street brainpower in Ottawa, even if the banks, who fund OSFI through fees, and taxpayers have to pay for it.

The public can hardly expect five-star regulation on a dime-store budget.

It’s not particularly convincing and DeCloet doesn’t spend a lot of his 750-odd words arguing the case. As far as pay scales are concerned, I don’t consider the salaries of portfolio managers or bank CEOs to be a particularly solid benchmark. The benchmark is: can you get people of the quality you want at the pay offered? There is no evidence introduced to suggest that the OSFI bureaucracy is befuddled at the clever stuff involved in banking; at any rate, should particulars be lacking, there is no consideration of the alternative – from time to time, consultants could be brought in, if expertise in a particular area is found wanting.

Apart from that … well, it’s not particularly apparent to me just how brainy Bay Street brainpower really is, but apart from that, such a staffing objective could very quickly segue into revolving door regulation. While I have no reason to believe that James Gilleran is anything other than a rock of integrity, is his career path something that should be held up for emulation?

However, my main objective in posting this is to take issue with Mr. DeCloet’s justification for addressing issues of staffing and remuneration:

To sum up Ms. Dickson: not my cow, not my farm. Take your complaints and ring the doorbell of the Ontario Securities Commission.

Technically, she may be right. Nothing says that the good superintendent must be overly technical about it, though. The “primary job” may be to watch out for bank customers, but the OSFI Act gives her agency broad responsibility for watching “system-wide or sectoral issues” that may hurt banks and other regulated deposit-takers. And to have a $32-billion frozen blob floating through the financial system, it’s clear enough now, is a pretty major negative. ABCP forced at least one bank, the Dundee Bank of Canada, into a fast sale to Bank of Nova Scotia. It caused a $365-million writedown at another, National Bank. OSFI regulates both.

Let’s look at the Dundee Bank of Canada first:

In the 2007 they lost a total of $146.7-million after tax effects – about half their capital, after ‘fessing up to holdings of about $400-million as reported by Mr. DeCloet last August.

Try as I might, I don’t see anything wrong in any major way with this. Dundee was quite agressive with their ABCP holdings, putting slightly more than their total capital into the sector … were I a shareholder, I would be most upset! But I am not a shareholder, and I am not looking at their financials from the perspective of a shareholder. It does not appear to me that the OSFI can be faulted here, which is the main thing. The bank took risks – large risks – risks larger than they preferred to have taken, in fact, due to their lack of distribution (whereby their money could have been invested in, for instance, mortgages and credit card receivables, like the big banks).

But that’s what businesses do. That’s what common shareholders want. And there was enough value on the balance sheet after this debacle for the bank to be taken over.

Mr. DeCloet has stated a problem – ABCP – and a potential solution – pay OSFI regulators more money – but these points are not adequately connected. What are all these Bay Street wunderkind supposed to do once they complete their hostile takeover of the OSFI? Outlaw leverage? Outlaw commercial paper that doesn’t meet some kind of test? Outlaw risk? Ensure that no investor, anywhere, ever gets hurt for any reason? Details are sadly lacking.

I should also note that the Bank of Canada, despite its apparently inadequate pay-scale, was expressing surprise at ABCP’s popularity in 2003 … but nobody listened. It is now attempting to get the market re-started.

As I indicated on March 13, BoC Governor Mark Carney has delivered a speech reviewing the credit mess and “corresponding priorities for the official sector and market participants”. He commences:

The social and economic costs of the events in the subprime market are concentrated in the United States, while the financial costs are both widely dispersed and – relative to the scale of the system – readily absorbable. In short, as painful as they are to those affected, subprime losses have been important primarily because they have revealed deeper flaws in the financial system. While a number of underlying causes can be identified, I will concentrate on three in particular.

These three causes are:

• liquidity:
  • fed overconfidence in ability to sell holdings at model-derived valuations
  • encouraged “originate to distribute” securitization
  • when vanished with ABCP, forced long-term assets onto books of investors and liquidity-guaranteeing institutions
• lack of transparency and inadequate disclosure:
  • when problems emerged with structured instruments, it became apparent that many investors did not understand them
  • opacity makes them hard to value, reducing liquidity
  • uncertainty over holders feeds concerns on couterparty risk
  • trust in Credit Rating Agencies has been shaken, amplifying stresses
• misaligned incentives:
  • if (subprime) loan will be sold immediately, less emphasis on documentation and due diligence
  • timing of trader compensation
  • provision of funding at risk-free rates to trading desks
  • insufficient recognition and compensation of risk-management professionals
  • crowded trades result when, for instance, too many players have automatic signals based on credit ratings.

With respect to liquidity, Mr. Carney outlined the changes that Bank of Canada is making to increase its provision of such liquitidity on an emergency basis:

• Accepting ABCP as previously discussed
• Accepting Treasuries
• Possible formalization of term repos

He speaks approvingly of an IIF publication, Principles of Liquidity Risk Management:

The report noted that internal governance and controls are the keys to reducing liquidity risk for a firm since no formulaic approach will yield appropriate or prudential results across different firms. More specifically the Special Committee advocated that:

• Firms should have an agreed strategy for the day-to-day management of funding of all kinds of liquidity risks that they may need to manage.
• Such strategies should be approved by the Board of Directors and reviewed by it on a regular basis.
• Senior management should promote the firm-wide coordination of risk management frameworks.

The report also recommended that firms should have in place:

• Contingency plans to respond to the potential early warning signals of a crisis.
• Strategies and tactics in the normal course of business that prevent liquidity concerns from escalating.
• Possible strategies for dealing with the different levels of severity and types of liquidity events that could cause liquidity shortfalls, with the breadth and depth of these strategies incorporating recovery objectives that reflect the role each firm plays in the operation of the financial system.
• A clear understanding of the role of central bank facilities and the limits on these facilities.

With regard to regulation, the recommendations in the new report reflect approaches that could both facilitate liquidity management for firms and make the system more robust overall. These include issues of supervision concerned with:

• Home-host coordination.
• Harmonization of regulations.
• Principles-based” not “rules-based” liquidity regulations that, for example, focus on qualitative risk management guidance, rather than on prescriptive and quantitative requirements.
• Expansion and harmonization of the range of collateral accepted by central banks and settlement systems.

Frankly, the discussion of responses to liquidity and disclosure is little but platitudes, but he does indicate that regulators could reduce exemptions:

While issuers and arrangers have every incentive to improve the transparency of structured products, ultimately, disclosure guidelines are set – or not – by regulators. One lesson from the ABCP situation may be that blanket disclosure exemptions were too broad. At the same time, however, authorities should resist the temptation to bring forward overly prescriptive regulations. Rather, they should consider greater application of principles-based regulation. There is no point in regulators trying to anticipate every new product or to restrain their development. There is a point in encouraging issuers to ensure the adequacy of their disclosure within a principles-based framework and to bear the consequences if it is subsequently found wanting.

I will also point out that there is no point in requiring disclosure if nobody reads it. And then, on Credit Rating Agencies:

Going forward, securities regulators will want to see agency incentives aligned more closely with those of investors, and will ensure that agencies are quicker and more thorough in reviewing past ratings. Other regulators must also take responsibility for looking at the extent to which the mandated use of ratings has encouraged credit outsourcing, led to pro-cyclical price movements, and encouraged discontinuous crowded trades.
…
In a mark-to-market world, with leveraged, collateralized positions, investors need to make their own judgments about the creditworthiness, liquidity, and price volatility of the securities they own.

He did not address the question of the exemption from Regulation FD (in the States) and from National Policy 51-201 (in Canada) … while I certainly agree that investors should do their own due diligence and understand the credit risk they are talking on, their ability to perform an independent check of credit ratings is constrained by this regulatory policy.

… and he manages to come down on both sides of the fence with respect to trader compensation …

Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking. Investors should take the lead in demanding compensation structures that are more aligned with their interests. Others have suggested that the regulators themselves should make these determinations. While I think regulation of compensation within private institutions is entirely inappropriate, I do think that regulators need to consider carefully the incentive impact of compensation arrangements as they assess the robustness of risk-management and internal control systems.

All in all, an interesting, but not particularly meaty, speech.

The Bank of Canada is attempting to re-start a market in Canadian ABCP … or, at least, that is my interpretation of the call for comments released today.

The Bank of Canada is seeking comments from direct participants in the Large Value Transfer System (LVTS) and other interested parties on the proposed eligibility criteria for accepting asset-backed commercial paper (ABCP) as collateral for the Bank of Canada’s Standing Liquidity Facility (SLF). Written comments are requested by 14 March 2008. The final terms and conditions for accepting ABCP as collateral for the SLF will be announced by 31 March 2008. Recognizing that the market for ABCP in Canada is still evolving, the Bank of Canada intends to review these criteria in a year’s time and announce the results of that review by 30 June 2009.

The proposed eligibility criteria require the sponsor to be “a deposit-taking institution that is federally or provincially regulated and that has a minimum stand-alone credit rating equivalent to at least A.” – which is to say, a bank or credit union. They may have good reasons for this requirement, but it’s not disclosed.

Other eligibility criteria are:

• The liquidity agreement(s) include an obligation to provide funding except in the event of insolvency of the conduit or near-default status of the underlying assets.
• The program must not contain any actual or potential exposure to securitized assets, with the exception of National Housing Act mortgage-backed securities.
• The program has received the highest possible short-term credit rating from at least two rating agencies.

Of perhaps even greater interest are the transparency requirements:

• The Bank must receive a single, concise document that is provided by and validated by the sponsor, and that includes all relevant investment information.
• This document must be easily accessible to all investors.
• The sponsor must agree to provide timely disclosure to all investors of any significant change to the information contained in this document.
• At a minimum, relevant investment information would include:
  • The identity of the sponsor, the financial services agent, and liquidity providers
  • The range of assets that may be held by the program, including maximum or minimum proportion, if applicable, and when/how asset composition could change
  • Characteristics of the asset pools, including at a minimum: composition, foreign currency exposures, performance measures, credit enhancements, and hedging methods. Other information such as average remaining term, current payment speeds, and geographic locations should be disclosed if relevant to the investor.
  • Where the investor could obtain updates of relevant investment information
  • The nature of the liquidity facilities, including the amount of support from each liquidity provider
  • The nature and amount of program-wide credit enhancements
  • The flow of funds, including payment allocations, rights, and distribution priorities

I maintain rather enormous doubts as to the number of investors who will actually make use of the transparency information, but at least the few who are sufficiently interested will have the ability to look.

From a practical perspective, how is the word “concise”, as in “The Bank must receive a single, concise document”  defined?

And as a last quote, here’s one in the eye for the conspiracy theorists:

The Bank will also consult other available documents, including credit-rating reports, to assess whether an ABCP program meets its criteria.

Golly, credit rating reports? From Credit Rating Agencies? Don’t they get paid by – gasp! – the issuers?

The bank is to be applauded for taking this action – securitization markets are a Good Thing. However, I remain concerned about the appropriate level of capital that the liquidity-guaranteeing bank must put up in respect of their guarantee … I suspect that the current credit conversion factor is simply too low. Additionally, it seems to me that the sponsoring bank (Bank!) should be putting up capital to reflect the reputational risk that it runs if there are actual credit problems in the vehicle.

These are not directly BoC concerns, however – determination of this matter belongs to OSFI and other BIS members.