Martin Meyer on Credit Default Swaps

The current state of the Credit Default Swaps market represents a risk similar in quality to that of portfolio insurance just prior to the market crash of 1987.

What is alarming that in terms of quantity there is no comparison, as the risks now are probably an order of magnitude greater in that the risk in concentrated at the heart of the US banking system. In 1987 the US was still at least partially protected by Glass-Steagall.


On Credit Default Swaps: Comments at AIER
By Martin Mayer
June 25, 2009

Let me open with a large thought you can carry with you when you leave. Note how we are no longer being told that the chairman of the Federal Reserve is the second most powerful man in America. Why do you think that is true?

One of the truly awful moments of my time in this business was the early evening of December 9, 1982, an incident not in any of the histories but highly revelatory. What happened that evening was that Banco do Brasil failed at CHIPS (the Clearing House Interbank Payments System). Neither National City Bank nor Chemical, which represented Banco d Brasil in New York, was willing to pony up the $300-plus million the Brazilians couldn't find. So they kept the window open until midnight, while the Fed worked its necromancy on its member banks and the money was found.

Subsequent examination revealed that after the Mexican collapse the previous summer, Banco do Brasil had found it increasingly difficult to roll over its loans, and had steadily switched a higher and higher share of its borrowings out of the conventional lending and borrowing market and into the overnight infrastructure market. For more than six months, the Brazilians had increased the size of its overnight position, until somebody at National City noticed and said, No more.

The Treasurer of Chemical was an exceedingly able young man who went on to a great career at AIG, oddly enough. I went to see him to help my understanding of what had happened. Finally, he said, "You have to understand. They were paying an extra eighth." A banker will turn himself absolutely inside out for what looks like a safe extra eighth of a point. The change over the quarter century is that now he will probably do it for five basis points. (And this is why banks must be regulated and their speculation firewalled from the public funds. Why? Because they are human. - Jesse)

Meanwhile, on a less cosmic scale, let us start with the thought that Wall Street gets in its worst trouble not by taking risks but by following false prophets who promise to make finance risk-free. The nomenclature and some of the equations change, but the truth is that there are only six scams, and each of these financial panics is rooted where the others were. (In defense of false prophets, Wall Street and others too often use them as a convenient excuse to do what they are already inclined to do in the first place. - Jesse)

What made the market break of 1987 so sharp and so deep was the widespread adoption of dynamic hedging, a mathematically proven plan to provide portfolio insurance by selling futures contracts on stock indexes if the stocks themselves fell hard. Dumbest idea ever accepted by any substantial part of mankind, said Howard Stein, who then ran the Dreyfus fund. How could anybody believe that everybody could sell at the same time?

It then took twenty years for the magnificently rewarded innovators of the new paradigm in banking to find an even dumber idea that everybody could safely and profitably hedge everybody else's risks through credit default swaps. (Quite so. The resemblance between portfolio insurance and the current state of Credit Default Swaps is apparent, but even worse, because they are so heavily written and held by the major money center banks, with their risk spread to the public compliments in part to Alan Greenspan and Phil Gramm - Jesse)

We make bad policy in this country because we do not inquire about how we got to where we are. There are every few second acts in American finance. Not one in a thousand of the people now commenting on the future or regulation of the CDS knows where the instrument comes from. The truth is that the CDS is one of many of what I shall call GSIs - "Government Supported Instruments" -- that would never have come into existence without dumb ideas from on high.

The Collateralized Debt Obligation or CDO, which came into existence in the late 1980s, is a single instrument expressing a garbage pail of loans and notes and bonds. It is all but impossible to value because it mixes together many disparate risks. Most people who think about it at all come to the conclusion that its not very useful for trading or for investing. In short, it is an excrescence that ought not to exist.

The CDO came about because Bill Seidman, when he was given control of the S&L workout in the late 1980s, wanted to sell whole banks rather than gather the tainted assets in FDIC control and auction them off in the usual FDIC procedure. Instead of taking, say, the real estate loans of six failed S&Ls and lumping them together as an offering on which real estate experts could paste a price, he wanted to take the entire portfolio of one or more failed thrifts and sell it off for what it would bring. (Marty is being a bit hard on Bill Seidman. There was nothing inherently fraudulent in the manner in which they packaged the sales related to the S&L crisis. It took Wall Street and the Rating Agencies to provide the real dose of fraud and larceny in the misrating and intentional mispricing of risk. - Jesse RIP Bill Seidman)

Note that this multiplied the amount of business Wall Street would get from the workout. The way you got people to bid on this sort of package was to give them the right to substitute other assets for assets in the package, or to guarantee the cash flow from the package.

The idea that a bank could be rid of its bad stuff through the device of a bad bank was then picked up by Mike Milken, and carried through with Mellon Bank in Pittsburgh, where the operation was funded through junk bonds. I wrote a piece for Barrons about how intelligent all this was. I spoke with some of the brilliant kids Milken assigned to this project.

The damage these CDS instruments do has not yet been exhausted. The publicized stress tests to which the federal bank examiners recently subjected the 19 largest banks was not really a serious enterprise, because all these banks rely on swaps to protect them against their losses on the toxic legacies they accumulated under the gaze of these same examiners -- and nobody knows whether or not these hedges will pay out if they are needed. (They will only pay out in full with government monies, which is the dirty little secret that the Treasury and Fed are desperate to hide from the public. And when they fail, they will bring down the top four or five banks in the United States. - Jesse)

Swaps, after all, are bilateral contracts, and if the loser under the contract can't pay, the fact that he has theoretically hedged his risk in a separate contract with a third party does not necessarily mean that the winner can collect. Hence the "systemic risk" when AIG or Lehman, signatories to tens of thousands of these contracts, blows up, leaving a paper litter of unimaginable dimensions.

Sixteen years ago, I testified before the House Banking Committee to urge that it should be public policy to discourage over-the-counter derivatives contracts and encourage the use of exchange-traded instruments instead. To assure that losers pay, exchange-traded contracts impose overnight deposits to meet margin requirements rather than collateral that may show up some day. The Treasury Department, after years of fighting on the other side, has now discovered the virtues of settling derivative contracts through clearing houses.

But what Treasury Secretary Timothy Geithner has proposed will not do the trick, because it leaves the actual trading of these instruments in the hands of inter-dealer brokers who do not publish the prices at which they arrange the deals (and may not offer the same prices to all bidders). And because it does not show the way to meeting the legitimate needs that spawned this illegitimate market, the Geithner proposals invite evasion of the rules. (Geither's solution was designed in large part by the banks themselves who do not wish the game to end just yet - Jesse)

The legitimate need is for a place where traders can short bonds.

Shares of stock scan be borrowed (fees for such borrowings are an important source of income for brokers) and delivered to buyers who don' know that what they have bought is borrowed stock. Much publicity has been given to traders who abuse these rules, sell what they have not borrowed and then fail to deliver and suffer no significant punishment for their failure. The SEC had been and remains asleep at the switch when it comes to this issue. And even when stock cannot be borrowed, there is an options market offering puts in a trading context where open interest is public knowledge. No such institutions exist in the bond market.

It was the difficulty of shorting bonds that produced the T-bond contract at the Chicago Board of Trade thirty years ago, permitting participants in the fixed-income markets to protect themselves against interest-rate fluctuations. Interest-rate futures are a legitimate instrument because there is a generic interest-rate risk, expressed in the market-determined yield curve.

It is easy to understand that traders once they have hedged interest-rate risks would seek to insure also against credit risks. But there is no such thing as a generic credit risk that can be traded. Like all instruments with a trigger option, they promote the illiquidity that drives markets out of the patterns the white swan people need.

Hat tip to Institutional Risk Analytics for the article

The Bull Market in Financial Fraud in the US

Does it, should it, surprise us that there is a bull market in financial fraud in the United States, to accompany the bubble economy and the deterioration in government and corporate financial statistics and accounting?

A society where the capital allocation in the bond and equity markets have become the domain of organized manipulation, theft, and insider trading? Where the major media is owned by a handful of corporations dedicated to selectively spinning the truth for their own benefit and point of view? A nation whose very money supply has become a thinly disguised Ponzi scheme?

A wise old hand of many years in government of our acquaintance told us once that he did not think there were more people of questionable virtue in the world today. Rather it is the tolerance of bad behaviour from the top down that emboldens those who are so inclined to lie, cheat, and steal in greater numbers than at other times.

All that is required for society to decline is for good people to do nothing. Those who tolerate or ignore such widespread deceit are enablers. The rest of the world must begin to stand up to the American Wall Street crowd, first in their own countries, their regions, and then in all free economies.

The Economist
Fraud reporting
Jul 21st 2009

The rise in financial crime in America

OVER 730,000 counts of suspected financial wrongdoing were recorded in America last year, according to recent data from the Treasury Department's Financial Crimes Enforcement Network.

Institutions such as banks, insurers and casinos are required by law to report suspicious activities to federal authorities under 20 categories. Financial institutions filed nearly 13% more reports of fraud compared with 2007, accounting for almost half of the increase in total filings.

The number of mortgage frauds alone rose by 23% to almost 65,000. But not all categories saw an increase: incidents suspected terrorist financing fell. Just under half of all filings are related to money laundering, a proportion that is little changed in over a decade.

Hat tip to Tim Dossman for the article.

"Build America Bonds" Paying a Shocking Premium to Corporates

The “Build America Bonds” were created by Bill S.238 called "The Build America Bonds Act of 2009 which provides $50 billion of federal taxpayer funds to subsidize state and local government tax free bonds in support of 'shovel ready' infrastructure projects.

The U.S. Government gives the issuing municipality or state a 35% rebate on the interest that the issuer pays to the bond holders. This is a huge benefit for local governments.

We have not yet found out why, but it is apparently giving a big benefit to the buyers of the bonds who are getting an income stream at well below market prices for comparable issues. In some cases the BAB bonds are pricing at 149 basis points over comparably rated corporate bonds.

Where is the inefficiency coming from in this bond offering? Who is taking the differential, the vigorish, being granted to the state and cities? Who are the underwriters and the market makers? Who are the big market makers besides Pimco? What are the fee structures being charged compared to the overall bond market?

Meredith Whitney, star analyst that she is, was the closest with her $4.65 prediction. She thinks the stock has lots of room to run, notes Fortune. Goldman, in her mind, will surf the economic woes now roiling the country. Goldman is a top underwriter of municipal bonds and the No. 1 underwriter of Build America Bonds. "These are a new type of municipal bond, part of the Obama administration's $787 billion stimulus plan. Cities, states, universities and government entities use BABs, as they're known, to finance infrastructure projects. This is a potential $50 billion annual market, Whitney says, and Goldman currently holds a 25 percent share," reports a Fortune article.

Oh now it all makes sense. Droit de Seigneur.

Bloomberg
Taxpayers Inferior to Shareholders With Obama Bonds
By Michael McDonald and Bryan Keogh

July 22 (Bloomberg) -- State and local governments, forced to close budget gaps by firing workers and shutting schools, may pay at least $4.2 billion more in interest than companies with similar credit ratings on Barack Obama’s Build America Bonds.

The $17.4 billion of Build America Bonds sold since April pay an average yield that’s 0.96 percentage point more than corporate securities with the same ratings, according to data compiled by Bloomberg and based on the 25 largest deals.

“Taxpayers are taking it on the chin,” said G. Joseph McLiney, president of Kansas City, Missouri-based McLiney & Co., a firm that specializes in selling municipal bonds that qualify for federal tax credits. “There should be no spread.”

While Build America Bonds opened credit markets to municipalities after the collapse of Lehman Brothers Holdings Inc., states and cities are being penalized compared with corporations, which are 90 times more likely to default than local governments, according to Moody’s Investors Service....

‘Disserving Their Constituents’

The difference in borrowing costs shows elected and appointed officials are failing taxpayers, said Stanley Langbein, a banking and tax law professor at the University of Miami and former counsel at the U.S. Treasury in Washington.

Issuers are “supposed to get the best rate available,” Langbein said. “To me they’re disserving their constituents. Their responsibility is to get the lowest rate available, which is the corporate rate.”

Congress included the Build America Bonds program in the $787 billion stimulus President Obama signed into law in February, after sales of fixed-rate municipal bonds fell 17 percent last year to $281.1 billion, according to Bloomberg data. Most of the drop followed Lehman’s bankruptcy in September.

The initiative, which expires at the end of next year, provides a federal subsidy for 35 percent of the interest costs on taxable bonds sold by states, local governments and universities to finance capital projects that create jobs. Borrowers say they save money compared with tax-exempt debt because the interest after the federal payments is lower than tax-exempt benchmarks.

‘Priced it Right’

“We feel like we priced it right,” Jennifer Alvey, Indiana’s public finance director, said of the June bond sale. Indiana is paying a rate of 4.28 percent after the subsidy, lower than on tax-exempt bonds, she said. “That’s the difference I care about.”

Investors demand higher rates from municipal borrowers because Build America Bonds are 91 percent smaller than company offerings on average, according to data compiled by Bloomberg.

While California sold $5.23 billion in April, the largest issue so far, Avondale, Arizona, offered $29.8 million on July 6 for sewer and other public improvements. The average par amount for Build America Bonds is $102.5 million, compared with $1.16 billion for the 611 U.S. investment-grade corporate bond offerings this year, according to Bloomberg data.

‘Pricing Power’

Investors also require higher yields because they say the securities may become difficult to trade if the program isn’t extended past 2010, said Natalie Trevithick, a senior vice president at Pacific Investment Management Co. The Newport Beach, California-based firm runs the world’s biggest bond fund, the $161 billion Total Return Fund.

“We do have much more pricing power in these deals,” Trevithick said.

Endowments, foundations and pension funds are overlooking the securities because unlike Pimco, they don’t have expertise to analyze municipalities, said Peter Coffin, president of Boston-based Breckinridge Capital Advisors, which oversees $10 billion in bonds.

“You have a lot of big buyers so there’s less price competitiveness,” said Scott Minerd, the chief investment officer at Santa Monica, California-based Guggenheim Partners, which manages $100 billion.

Alan Krueger, the Treasury’s chief economist in Washington, said Build America Bonds succeeded in reviving the municipal market by lowering debt costs. He said municipal and corporate securities are different, so they are difficult to compare.

‘Good Start’

“Build America Bonds are doing what they were designed to do, which is lower the cost of capital for municipalities and increase access to capital markets,” Krueger said in a July 15 telephone interview. “That’s what Build America Bonds are intended to do, and they’re off to a good start doing that.”

State tax collections fell 11.7 percent to $160 billion in the first quarter compared with the same period in 2008, the largest drop in at least 46 years, the Rockefeller Institute of Government in Albany, said in a July 17 report.

Congress’s Joint Tax Committee estimated in February that the Treasury would spend $9.8 billion through 2019 subsidizing the bonds. Matt Fabian, a managing director at Municipal Market Advisors in Westport, Connecticut, said in a June 22 report that the program’s price tag may reach $27.3 billion by the time all such securities mature in 2044...

The spread is even wider when considering more of the smaller Build America Bond deals, according to Philip Fischer, a strategist in New York at Merrill Lynch & Co., a unit of Charlotte, North Carolina-based Bank of America. He found that on July 15 the average yield on bonds of more than $100 million compared with an index of AA corporate rates was 1.49 percentage point.

“Munis and corporates are apples and oranges in terms of the credit, but does that justify that kind of spread? Not for me,” said Ben Watkins, the director of Florida’s state bond division. Investors in the corporate bond market are “taking advantage of an opportunity.”

SP Futures Hourly Chart at 2:30 EDT

Some short term indicators are flashing that we are nearing at least a short term top. There is also indication of distribution of stock here by insiders to the public, which is also an indication of a possible top. This judgement is based on many charts and indicators not shown here.

Having said that, our discipline will not prompt us to do any seriously non-hedged shorting until the 'trendline' Key Pivot is violated at least on a daily close, and then confirmed by a move lower.

The market is rising on thin volumes, and unless the sellers come back in, it can continue to drift higher on program trading and short squeezes.

We are within two weeks of a potential 'crash window' where a final top will be made, and a selloff with a significant leg lower will be seen into the end of year. The window is a bit wide for now, a six week period starting around August 17th. We will hope to tighten that up by the end of July.

This is only a probability, not a hard forecast. But it has us edgy to be on the long side, even in precious metals miners, without hedging a general market decline. The Cashflow in the market is looking a bit stretched. We may have to wait until later in earnings season for this to shake out.

In sum, the markets seem 'precarious' and unstable to us, but not enough to jump in front of the market to the bear side yet.

As an aside, we are seeing quite an increase in 'screwy fills' on the bid ask level II where fills on the retail side seem to be made 'out of bounds' of the usual bid/ask action.

We do not use market orders normally and would not suggest them here for those that do. The market makers are shaving fills and front running perhaps although that is harder to spot except on the thinly traded stocks where other issues may come into play.

But we are seeing far too many fills BELOW our limit bids on some stocks to believe this market is functioning normally.