PrefBlog

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.