PrefBlog

OK – found it!

It’s section 2128.03.3.1 Liquidity Facilities Supporting ABCP of the Fed Supervision Manual – 2007:

The Board’s risk-based capital guidelines impose a 10 percent credit-conversion factor on unused portions of eligible short-term liquidity facilities supporting ABCP. A 50 percent creditconversion factor applies to eligible ABCP liquidity facilities having a maturity of greater than one year. To be an eligible ABCP liquidity facility and qualify for the 10 or 50 percent credit-conversion factor, the facility must be subject to an asset-quality test at the time of inception that does not permit funding against (1) assets that are 90 days or more past due, (2) assets that are in default, and (3) assets or exposures that are externally rated below investment grade at the time of funding if the assets or exposures were externally rated at the inception of the facility. However, a liquidity facility may also be an eligible liquidity facility if it funds against assets that are guaranteed—either conditionally or unconditionally—by the U.S. government, U.S. government agencies, or by an OECD central government, regardless of whether the assets are 90 days past due, in default, or externally rated investment grade.

This rule appears to be similar to the Canadian requirements. There was a note in the source for this post that changes in the international rules were expected, but that these might not impact Canada. I will be checking to see whether the relevant section of the Fed manual was changed in the intervening period.

Update: Got it! Notice of Final Rule, Liquidity Facilities Supporting ABCP:

Under the current risk-based capital standards, liquidity facilities with an original maturity of over one year (that is, long-term liquidity facilities) are converted to an on-balance sheet credit equivalent amount using the 50 percent credit conversion factor. Prior to this final rule, liquidity facilities with an original maturity of one year or less (that is, short-term liquidity facilities) were converted to an on-balance sheet credit equivalent amount utilizing the zero percent credit conversion factor. As a result, such short-term liquidity facilities were not subject to any risk-based capital charge prior to this rule.
…
After consideration of the comments, the agencies have decided to impose a 10 percent credit conversion factor on eligible short-term liquidity facilities supporting ABCP, as opposed to the 20 percent credit conversion factor set forth in the NPR. A 50 percent credit conversion factor will continue to apply to eligible long-term ABCP liquidity facilities. These credit conversion factors will apply regardless of whether the structure issuing the ABCP meets the definition of an “ABCP program” under the final rule. For example, a capital charge would apply to an eligible short-term liquidity facility that provides liquidity support to ABCP where the ABCP constitutes less than 50 percent of the securities issued causing the issuing structure not to meet this final rule’s definition of an “ABCP program.” However, if a banking organization (1) does not meet this final rule’s definition of an “ABCP program” and must include the program’s assets in its risk-weighted asset base, or (2) otherwise chooses to include the program’s assets in risk-weighted assets, then there will be no risk-based capital requirement assessed against any liquidity facilities that support that program’s ABCP. In addition, ineligible liquidity facilities will be treated as recourse obligations or direct credit substitutes.

The resulting credit equivalent amount would then be risk-weighted according to the underlying assets or the obligor, after considering any collateral or guarantees, or external credit ratings, if applicable. For example, if an eligible short-term liquidity facility providing liquidity support to ABCP covered an asset-backed security (ABS) externally rated AAA, then the notional amount of the liquidity facility would be converted at 10 percent to an on-balance sheet credit equivalent amount and assigned to the 20 percent risk weight category appropriate for AAA-rated ABS.6

I love the internet!

Update, 2007-10-4: CFO magazine published a very good article, Longer Paper Routes dealing with the issues. The relationship to the Financial Accounting Standards Board’s  Financial Interpretation No. 46 (FIN 46) was discussed in The Securitization Conduit in 2002.

Some people – normal people – may be curious as to why I’m spending so much time on this, when it doesn’t have anything much to do with preferred shares or bonds … it’s banking regulation that has mainly an effect on the money market. Well, it’s all background, and I’ll study it for the same reason as I study banking panics and bankruptcies. The better I understand it, the more likely I am to avoid related pitfalls in the future … and all pitfalls in the financial markets are related.

I have developed a hypothesis regarding the collapse of the Canadian non-bank ABCP market that I am now attempting to falsify:

• When the ABCP market was in its development stages, Canadian banking regulation was more strict than the international norms.
• This strictness made it uneconomic to issue ABCP with a global liquidity guarantee.
• Hence, the market developed with a Market Disruption guarantee.
• The US market banking regulation was looser; it was cheaper for the banks to offer global liquidity; they did so.
• Enron happened.
• US banking regulations became much closer to Canadian levels of strictness. By this time the ABCP market was well entrenched and was able to bear the additional cost.
• The Canadian market was also well entrenched. ABCP was selling just fine and there was no pressure to change the liquidity provision
• Liquidity provisions suddenly became important. Kablooie!

I’m going to keep gnawing away at this one …

Another Update, 2007-10-4: How much does Global Liquidity cost? Let’s make the following assumptions:

• The underlying assets of the ABCP have a 100% risk-weight
• There’s a 10% Credit Conversion Factor
• The guaranteeing bank (“Bank”) wishes to maintain Tier 1 Capital Ratios at 10%
• The Bank does not consider it necessary to change anything else
• The Bank wants return on equity of 15%
• There are no other costs to the Bank related to the guarantee.
• There is no overcollateralization in the conduit.

There are probably other assumptions inherent in the following calculation, but I’ll work them out eventually! So we calculate:

• $1.00 is to be financed
• If on the books of the bank, this would be $1.00 of risk-weighted assets
• At a CCF of 10%, the liquidity guarantee adds $0.10 to risk-weighted assets
• To maintain Tier 1 Capital at 10%, the Bank needs an additional $0.01 of capital
• To get a return on equity of 15%, this $0.01 needs to earn $0.0015
• Therefore, the cost of the guarantee is 15bp

15bp! That’s a lot! And this calculation is making some fairly generous assumptions as well. The 15bp has to come out of somebody’s pocket:

• An additional cost to the borrower
• Reduced profit for the sponsor
• Reduced spread earned by the investors

Considering that the Commercial Paper / T-Bill 90-day spread was only about 30bp last March, 15bp is an enormous cost.

So how, assuming I’m not barking up the completely wrong tree here, was the US market able to absorb it?

The article Developments and Issues in the Canadian Market for Asset-Backed Commercial Paper, published in the Bank of Canada Financial System Review in 2003 is most interesting. broken link fixed 2019-5-22

Because the assets are typically of longer maturity than the ABCP financing them, some sort of liquidity buffer is required to protect against rollover risk and timing mismatches. Hence, ABCP issuance programs purchase liquidity protection. At a minimum, such protection must safeguard against what the Office of the Superintendent of Financial Institutions (OSFI) calls a “general market disruption,” which is defined by market participants as a situation in which “not a single dollar of corporate or assetbacked commercial paper can be placed in the market—at any price.”9

A general market disruption is a highly unlikely event, and Canadian liquidity facilities, which do not cover anything beyond this minimum criterion, have never been triggered. According to OSFI (1994), a bank providing liquidity protection that embeds protection against other risks, like credit risk, would incur regulatory capital charges that, when passed on to the issuance program, could make the ABCP less economical.

U.S. regulatory charges have, however, been lighter on liquidity facilities that offer some degree of credit protection. Hence, liquidity enhancement for U.S. ABCP programs typically covers more than just general market disruptions, offering some elements of protection against credit risk.10

I was happy to find a definitive reference to the capital requirement for liquidity support – it is OSFI guideline B5:

An eligible liquidity facility that is in compliance with the conditions and scenarios described in sections 4.3.1, 4.3.2, and 4.3.3 is subject to the following capital treatment:
• for a facility that is available in the event of a general market disruption, a 0% credit conversion factor (CCF) applies;
• for a facility with an original maturity of one year or less or that is unconditionally cancellable at any time without prior notice, a 10% CCF applies; or
• for a facility with an original maturity of more than one year, a 50% CCF applies

Update, 2007-10-4: I note that the capitalization rules were mentioned by Dodge in a September, 2007 speech:

Another issue related to securitization concerns the capitalization of banks. If banks are moving securitized loans off their balance sheets, but still providing liquidity guarantees for these securities, how much capital should they be required to set aside? The authorities at the Basel Committee may need to revisit this issue in light of recent experiences.

As reported today by Bloomberg:

The IMF, which is charged with promoting global economic stability and lends to financially distressed nations, blamed the crisis on “benign economic and financial conditions” which “weakened incentives to conduct due diligence on borrowers and counterparties.”The fund also said the methodology of credit-rating companies, some of which gave high ratings to subprime mortgage securities that have plummeted in value, needs to be examined. The complexity of many of these securities may have made it difficult for investors to assess their worth based on the assigned ratings.

“In the case of complex structured credit products, investors need to look behind the ratings,” the report said.

Regulators and investors will have to work together to strengthen financial markets to prevent a recurrence, and develop ways to improve the spread of accurate and timely information to help markets assess risk, the report said.

Parts of this report are available at the IMF site. In Chapter 1 they urge:

The need for a differentiated scale of credit ratings has
again been made apparent.
The fallout in the mortgage market has drawn attention to the role of credit ratings agencies in structured credit markets. Less sophisticated investors, who were content to delegate the risk assessment of their positions to the credit ratings agencies, were negatively surprised by the intensity of downgrades. Previous GFSRs have pointed out that structured credit products are likely to suffer more severe, multiple-notch downgrades relative to the typically smoother downgrade paths of corporate bonds (IMF, 2006). The experience of the past year has underscored the need for further efforts to inform investors of these risks, but better still would be the introduction by ratings agencies of a more differentiated scale for structured credit products. For example, a special rating scale for structured credits could be introduced to highlight to investors that they should expect a higher speed of migration between ratings than on a traditional corporate bond.

The section (page 37 of the PDF) ends with some sound advice for institutional investors; sadly, it does not advocate that institutional investors who bought CDOs without understanding them seek retraining as ditch diggers. The closest they get to advocating this urgently needed market reform is elsewhere in the document:

Finally, credit ratings evaluate only default risk, and not market or liquidity risks, and this seems to have been underappreciated by many investors.

Which isn’t really very close, is it? Ah, well, perhaps someday.

Update: Accrued Interest has some explanations and suggestions for the CDO market.

The Globe and Mail astonished me today by publishing a reasonably balanced review of what ratings agencies do and why they do it. They also published a precis of Levitt’s op-ed in the Wall Street Journal.

There were three snippets in the G&M piece worthy of comment, the first from Brian Neysmith, former head of DBRS (and boy, I bet he’s happy he’s retired!):

Pretend you’re a park ranger, and a camper wants to cross a big lake. He tells you he’s got a canoe, a paddle and a lifejacket, and asks what his chances are of crossing safely. You ask him what his canoeing experience is, and conclude that his chances are decent.

But then the camper asks what he would have to do for you to conclude that his chances were excellent. And so you tell him that he needs to add a flotation device, heavy weather gear and an extra set of paddles, just in case one falls out. And you say that if he does all that, you’ll give him a 100 per cent chance of success.

This is, essentially, what the ratings agencies are doing when they are retained by issuers to consult on the structure of new securities – with the notable exception that they never, ever give anybody a 100% chance of success. All they will ever do is (as the reporter noted at the beginning of the paragraph, but forgot by the end) conclude that the chances are excellent.

The second snippet comes courtesy of an ABCP investor:

“When you’ve got cash sitting around, you phone your banker, or you phone your money desk, and you say ‘I’ve got cash, what can you show me?’ ” said Richard Gusella, chairman of Calgary-based Petrolifera Petroleum Ltd. “And they tell you, ‘I’ve got 30-day Apsley Trust R1-high rated paper, per DBRS, and other people are buying it.’ And they say this is better than bank paper, and so you buy it,” he said.

The company had invested about $37.7-million, or more than half its total cash, in asset-backed securities. Its cash management policy had been to invest in short-term securities with DBRS’s highest rating, R1-High. On Aug. 15, $31.4-million of the notes became due but were not repaid. Mr. Gusella says the company is not in financial difficulty now – but he wants his money.

More than half its total cash in this stuff? Mr. Gusella may well be a very skilled oil & gas operator – and the front-line decision to gamble may not have been his, but rather his treasury group’s – but if I were a shareholder in Petrolifera, I’d be asking some rather pointed questions about prudent cash management.

A relatively small company such as Petrolifera (shareholders’ equity of about $120-million, according to its most recent financials) should not be doing its own money market investing anyway. Pay the fee and concentrate on what you’re good at … most (if not all) of the banks have institutional money market funds; some investment counsellors do; it’s not really all that expensive.

I will point out as well that the quote makes him sound a little pompous (talking about ‘phoning his money desk’). Perhaps his remarks were misconstrued for brevity, but:

• all dealers will have a range of products
• if you don’t like one dealers offerings or prices, you call another
• it certainly sounds as if he bought whatever the friendly salesman told him to buy

I’ve emphasized in the past and will emphasize again: dealers are not your friends, no matter how many social functions they invite you to – or how much of a big-shot they make you feel like.

And one last snippet:

For instance, the Canada Marine Act sets minimum ratings on investments that port authorities can buy. And in a stroke of good luck or prescient planning, the act says authorities can only buy investments rated by two bond-rating companies – meaning that authorities couldn’t touch the asset-backed commercial paper that’s run into trouble because there was only one rating agency that graded it (DBRS).

No. Not “good luck”. Not “prescient planning”. Merely a reasonable, if rather mechanical, application of the Prudent Man Rule.

So, finally, we get to Arthur Levitt’s proposals (bolded, with my comments in italics).

• The SEC needs to set standards for agencies and punish transgressions. Too vague for much commentary! It makes my hackles rise a bit because it implies that the SEC should be regulating agencies, but I’m willing to wait for the specifies and will attempt to retain an open mind. Note that Mr. Levitt is a former head of the SEC … when you have a hammer, everything looks like a nail!
• Ratings agency employees shouldn’t be able to jump to investment banks they have helped to structure transactions.: This suggestion came up in the September 4 commentary. No! A thousand times, no! In the first place, there is no indication that this is, in fact, a problem. Secondly, it will enforce draconian restrictions on the career choices of analysts. And thirdly, it is inappropriate because agency analysts have no power to force anybody to do anything; they give advice. Full stop. This sort of restriction is appropriate for regulators but is not even applied to them. Regulation Services trumpetted the fact that their employees were jumping to the banks for fat paycheques as evidence of the impressive skill of their employees; let’s fix up this aspect of revolving-door regulation before going after mere advisors! I will, perhaps, give a certain amount of additional credence to a particular agency if they tell me that each analyst has “gardening leave” in their contracts; to give such a matter of judgement the full force of law would be abuse of regulatory authority. I would be much more impressed if the agencies reacted in the same way every single brokerage firm in the world reacts when an employee leaves: devote a lot of time to reviewing the employee’s work. In the brokerage’s case, this is in order to retain the clients for the firm; in an agency’s case, it should be to double-check the ratings assigned to the instruments reviewed by that employee. The ratings should never be the responsibility of a single employee in any event. I recently reported the DBRS downgrade of little rinky-dink ES.PR.B – that report has two names on it.
• Issuers should disclose any consulting services provided by ratings agencies. I’m of two minds about this one. Disclosure is a good thing, but too much disclosure leads to the voluminous and unread state of modern prospectuses. I’m more against it that for it, but don’t think it makes a lot of difference either way.
• Investors should be able to hold ratings agencies “liable for malfeasance that is more than mere negligence.” No! Investors do not pay ratings agencies any money; there is no fiduciary relationship between investors and agencies. I can buy something solely on the basis of its rating; I can buy something solely because I got an anonymous eMail telling me it was good. If investors want a fiduciary relationship, there are many shops out there (like CreditSights, discussed here recently) who are more than willing to fill that need.
• Investors must stop blindly relying on credit ratings, and instead do more research on structured products to determine their safety. Hey! Finally, something I agree with completely! I will also note that one or two errors won’t hurt you (much) as long as you’re well diversified.

Update, 2007-09-19: Douglas W. Elmendorf has published a commentary on current policy issues, in which he endorses

additional oversight by the SEC, a one-year waiting period for a ratings agency employee wanting to join a security issuer, and disclosure in debt-offering documents of any related advice provided by the rater to the issuer.

without further argument.

Update, 2007-09-24: The WSJ has reported on an interview of Greenspan by FAZ:

In an interview with Sunday’s Frankfurter Allgemeine Zeitung, one of Germany’s most prominent newspapers, former Federal Reserve Chairman Alan Greenspan sharply criticized ratings agencies for their role in the current credit crisis. “People believed they knew what they were doing,” Mr. Greenspan says in today’s FAZ. “And they don’t.”

Still, he doesn’t think it’s necessary to strengthen rating-agency regulation. Essentially, they’re “already regulated,” he says, because investors’ loss of trust means the agencies are likely to lose business. “There’s no point regulating this. The horse is out of the barn, as we like to say.” Greenspan also said he believes that the volume of structured-finance products will decrease. “What kept them in place is a belief on the part of those who invested in that, that they were properly priced. Now everyone knows that they weren’t. And they know that they can’t really be properly priced,” said Greenspan.

I can see that there is going to be a lot of debate over the next year (until the day after the US Presidential elections, anyway) about regulation, so I’ve started a new category in this blog for it.

Anyway … the forces of regulation are gathering and the issues need to be understood.

Menzie Chinn at Econbrowser abandons her usual highly technical approach to state:

While I haven’t drawn a particular conclusion regarding the right direction to move, one insight prompted by current commentary is that — if the Fed were to opt for looser monetary policy — greater regulation of the financial sector would make a lot of sense.

I don’t know. To me, that if-then logic looks like a complete non-sequiter, but I can’t really comment too much until there is something to comment about. Let’s hear some proposals – I’ll consider them!

Mark Thoma has written a piece titled Fed Intervention and Moral Hazard which, really, simply explains the concept of moral hazard in home-spun tones, but declares himself “in substantive agreement” with what must be deemed a polemic by Robert Reich, Stop the Hedge Fund Casinos:

Yet there’s precedent: in September 1998, despite growing evidence of inflation, the Fed lowered interest rates in order to forestall a global credit crisis after Russia defaulted on its loans (many had been underwritten, foolishly, by several large Wall Street investment banks).

No substantiation is offered for the word “foolishly”. Additionally, there is no acknowledgement of any role played by investors, as opposed to underwriters, in the process.

Oddly, private credit-rating agencies judged these “sub-prime” loans to be relatively good risks.

Mr. Reich does not substantiate his use of the word “Oddly”. Additionally, there is no indication of an awareness of a risk/return trade-off.

Meanwhile, hedge funds created what can only be described as giant betting pools — huge amalgamations of money from pension funds, university endowments, rich individuals, and corporations — whose assumptions about risk were derived from the assumed low risks of the home loans (hence the term “derivatives”).

This is a novel derivation of the word “derivatives”! One can, I suppose, characterize hedge funds as giant betting pools – but only to the extent that any investment that has ever been made in the history of the earth has been a bet.

Investors in these hedge funds had little or no understanding of what they were buying, because hedge funds don’t have to disclose much of anything.

No substantiation is offered for this rather surprising smear. In the first place, the fact that hedge funds don’t have to disclose much of anything to regulators doesn’t mean they don’t disclose anything to investors. It is up to investors to demand whatever they want to demand from those who want discretionary authority over their money – Mr. Reich does not make any sort of case that further disclosure to regulators is necessary.

An investor can do whatever he wants with his own money. If, however, someone is acting as a fiduciary (as will be the case with pension funds and university endowments) there is a standard of care required. There may well be cases in which the Prudent Man Rule has been violated – well, nail ’em to the wall, I say, and I’ll ask Mr. Reich to pass me the hammer; that is not only a separate issue, but it’s already regulated.

That doesn’t mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten.

Mr. Reich forgets that he has not, in fact, discussed even a single instance of irresponsibility.

Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need.

This is the first mention of credit-rating agencies in the entire essay. No supporting evidence or argument is brought forward to support this charge.

They’ve [the credit rating agencies] been too eager to make money off underwriting the new loans and other financial gimmicks on which they’re supposed to be objective judges.

I am not aware that any credit rating agency anywhere has acted as underwriter. I’m not even aware of any credit rating agency having a license to underwrite. Let’s have a few more details, Mr. Reich!

Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

Strong arm? Let’s have some evidence, or some argument at the very least. I suspect that any wrong-doing of this nature is already regulated.

For the financial market to work well — to ensure fair dealing and to prevent speculative excess — government must oversee it.

There are no arguments, no details and no evidence in this essay to make this assertion even worthy of consideration.

This mess occurred because nobody was watching.

Nonsense. There ain’t nuthin’, anywhere on earth, watched as carefully as the financial markets. Investors, traders and Mr. Reich’s beloved regulators watch it very carefully indeed.

Credit-rating agencies must not have any relationship with underwriters.

What? They shouldn’t even accept details of the issue so they can assign a provisional rating prior to its sale to investors? Mr. Reich betrays complete ignorance of the credit rating process with this slogan.

Finance is too important to be left to the speculators.

I’m … speechless.