And to this - is ethics - IMHO. If you are a closer, an attorney, a broker or a mortgage originator and your borrower, buyer, seller whatever is too unsophisticated to understand the transaction - why don't you stand up and stop it??? If the buyer/seller, borrower insists on proceeding with a transaction they don't understand have them sign a disclosure that you explained to them that this was not in their best interests and they chose to go forward.

This doesn't happen because people are afraid to stand up for what it is right or maybe they are just too greedy and don't want to lose their commission or bonus for doing the right thing. As I said before, there were plenty of people in a position to stop this, they just chose not to for their own personal benefit.

Here's a link to a very interesting 1999 New York Times article by Steven A. Holmes explaining some changes at Fannie Mae and basically prophesizing the current mess we are in: Fannie Mae Eases Credit To Aid Mortgage Lending

Late last year or very early this year, Dennis Lauria, senior vice president of Popular Mortgage Servicing in Cherry Hill, N.J., said a typical response from mortgagors (borrowers) with subprime loans is, “If I play my cards right, I can live here free for 12 months, maybe longer” before the lender can foreclose.” Lauris says, “Our challenge isn’t contacting borrower, I can talk to them, but they stick their tongue out at me.”

With all the media attention on preventing foreclosure by offering financial incentives to distressed borrowers, we've got to wonder what happens when the mortgagors, 96% - 98% of whom ultimately fulfill their mortgage obligation, become disgusted or disgruntled when they see other borrowers who failed to fulfill their contractual responsibilities “get all the goodies” or fail to suffer any consequences, while the prudent borrower may be working two jobs and cutting expenses to the bone to keep to keep their home.

Unlike Cal Ripken Jr., when asked during the major league baseball strike in 1994 why he crossed the picket lines, answered he was simply, “honoring his contract,” there appears to be serious erosion in the idea that one should be responsible for fulfilling their contractual obligations or suffer the penalty.

One of Secretary Paulson's favorite quotes has been for some time, “Any homeowner who can afford their mortgage payments, but chooses to walk away from an underwater property is simply a speculator – and one who is not honoring his or obligation.” Paulson also focuses on fraud by saying “Those who committed fraud or wrongdoing have contributed to the current problems; authorities need to and are prosecuting them. But poor judgment and poor market practices led to mistake by all participants.

The seemingly politically incorrect question to be asked during an election year may be whether, in the big picture, bailing out a small percentage of borrowers, even if foreclosure might devastating on an individual basis, could poison the housing industry’s historical reliance on the fact that most mortgagors pay honor their contracts.

The above is part of the problem, but the bigger problem was with the "Smartest Guys in the Room" making risky investments and commitments, that many of them did not even understand, with Enron-esque hubris. All the while collecting paychecks and negotiating golden parachutes that assured that they would not be affected by the economic fallout.

The many examples of greed, coupled with the ACORN push on Community Reinvestment Act (CRA), really did start us down this road.

There really is a psychological benefit to owning a home, a sense of community that tenants just don’t have. BUT – this is a classic situation of the law of unintended consequences, of thinking that if a little something is a good thing, then a lot of something must be better. Well, taking 1-2 aspirin will help ease pain and inflammation, but taking a bottle all at once will make you bleed to death. A lot of LOW down-payment loans ARE paying as agreed – that down-payment, however low, still creates that sense of ownership and commitment – but the no downpayment, the NINJA (no proof of income or asset value), the 125% loan-to-value, the option adjustable rate (pay as little as you want for awhile) and other weird loan arrangements – yikes. Then add all of the get-rich-quick home flipping schemes and related schemes in the mortgage securities market (even just the idea that gee, we made the loan, but we don’t have to keep it or its risk of non-payment), and here we are.

Isn't funny how our government said this was okay to let people qualify for loans with no proof of income or assets and yes you can get financing for zero down and we will even finance your closing cost.

I just can't believe that the American people fell for this! You would had thought they were smarter than that.

Hi Mr. Burnett could you please be so kind on helping me understand today's FDIC guarantee program:
• All newly issued senior unsecured debt issued by Eligible Entities on or before June 30, 2009, including promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. The amount of debt covered by the guarantee may not exceed 125 percent of debt that was outstanding as of September 30, 2008 that was scheduled to mature before June 30, 2009. For eligible debt issued on or before June 30, 2009, coverage would only be provided for three years beyond that date, even if the liability has not matured

Does this mean if we have a loan with a Bankers Bank, and that Banker's Bank fails, the FDIC will continue that loan?

Also the other statement:

• Funds in non-interest-bearing transaction deposit accounts held by FDIC-insured banks until December 31, 2009.

I do not understand what does this mean? Why would a bank be interested on additional coverage from the current coverage?

Thank you in advance for your assistance with these questions.

One of the best articles I've read on the history of the [lack of] regulation of credit default swaps, even-now little addressed aspect of this mess: http://www.washingtonpost.com/wp-dyn/con...3344&s_pos=

Excellent article. Unfortunately, I am not sure much will change with the recent actions by the Treasury,the Fed and Congress and an election looming. IMHO, this financial crisis will be with us for quite awhile.

What bothers me is that you don't hear anyone in the media talking about how the banks that sold loans to the secondary market abided by the underwriting guidelines of Fannie - which, by the way, were pretty ridiculous. Six months ago, it would not be out of the ordinary to see someone with a 550 credit score get approved under "refer eligible." These are some of the same borrowers who are now in default.

FinCEN has reported mortgage fraud SARs were up over 1,400% between 2006 and 2006 and up 47% in 2007. How can anyone say they did not know there was a problem?

And the real estate agents not only got their commission from selling the house at the top of the market to someone who could not afford it, they will get another commission when the market bottoms out and the house is sold again. There should be a law that the real estate agent can't benefit from this or flipping a house.

Lengthy, scary, perhaps prophetic article, copied in full (link at end):

November 24: Commentary - What Barack Obama Needs to Know About Tim Geithner, the AIG Fiasco and Citigroup

Location: New York
Author: IRA Staff
Date: Monday, November 24, 2008


On Friday, the FDIC closed and facilitated the sale of two CA savings banks, Downey Savings and Loan, the bank unit of Downey Financial Corp (NYSE:DSL) and PFF Bank and Trust, Pomona, CA. All deposit accounts and all loans of both banks have been transferred to U.S. Bank, NA, lead bank unit of US Bancorp (NYSE:USB). All former Downey and PFF Bank branches reopen for business today as branches of U.S. Bank.

Earlier this year we wrote positively about Downey and the funding advantages it had over larger thrifts such as Washington Mutual due to the solid deposit base and strong capital. Indeed, as of Q3 2008, the bank's Tier One leverage ratio was over 7.5%, more than two points over the minimum, and its charge offs had actually fallen compared with the gruesome 400 basis points of default reported in the previous period.

But since the September resolution of WaMu and Wachovia, the FDIC, it seems, is not willing to wait to resolve institutions, even banks that are apparently solvent and not below any of the traditional regulatory triggers for closure. The visible public metrics indicating soundness did not dissuade the Office of Thrift Supervision and FDIC from seizing both banks and selling them to USB.

The purchase of Downey and PFF is good news for the depositors and borrowers, who will all be offered the FDIC's prepackaged IndyMac mortgage modification program as a condition of the USB acquisition. Bad news for the investors and creditors, who now see their already impaired investments wiped out.

The resolution of Downey illustrates both the best and the worst aspects of the government's remediation efforts. On the one hand, we have argued that the government should be pushing bad banks into the arms of stronger banks to improve the overall condition of the system. The good people at the FDIC do that very well - when politics does not intervene.

In the case of Downey and PFF, it appears that the OTS and FDIC projected forward from the current above-peer loss rates and concluded that a prompt resolution was required. Reasonable people can argue whether this is the right call. But when we see the equity and debt holders of DSL, Washington Mutual or Lehman Brothers taking a total loss, we have to ask a basic question: why is it that the debt holders of Bear Stearns and AIG (NYSE:AIG) are granted salvation by the Federal Reserve Board and the US Treasury, but other investors are not?

If the rule of driving money to the strong banks (see "View from the Top: A Prime Solution to the US Banking Crisis") safety and soundness is to be effective, it must be applied to all. And now you know why we have questions about the nomination of Tim Geithner to be the next Treasury Secretary.

If you look at how the Fed and Treasury have handled the bailouts of Bear Stearns and AIG, a reasonable conclusion might be that the Paulson/Geithner model of political economy is rule by plutocrat. Facilitate a Fed bailout of the speculative elements of the financial world and their sponsors among the larger derivatives dealer banks, but leave the real economy to deal with the crisis via bankruptcy and liquidation. Thus Lehman, WaMu, Wachovia and Downey shareholders and creditors get the axe, but the bondholders and institutional counterparties of Bear and AIG do not.

Few observers outside Wall Street understand that the hundreds of billions of dollars pumped into AIG by the Fed of NY and Treasury, funds used to keep the creditors from a default, has been used to fund the payout at face value of credit default swap contracts or "CDS," insurance written by AIG against senior traunches of collateralized debt obligations or "CDOs." The Paulson/Geithner model for dealing with troubled financial institutions such as AIG with net unfunded obligations to pay CDS contracts seems to be to simply provide the needed liquidity and hope for the best. Fed and AIG officials have even been attempting to purchase the CDOs insured by AIG in an attempt to tear up the CDS contracts. But these efforts only focus on a small part of AIG's CDS book.

The Paulson/Geithner bailout model as manifest by the AIG situation is untenable and illustrates why President-elect Obama badly needs a new face at Treasury. A face with real financial credentials, somebody like Fannie Mae CEO Herb Allison. A banker with real world transactional experience, somebody who will know precisely how to deal with the last bubble that needs to be lanced - CDS.

Last Thursday, we gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same. You can read a copy of the slides by clicking here.

As part of the presentation (Page 17-21), IRA co-founder Chris Whalen argued the case made by a reader of The IRA a week before (see "New Hope for Financial Economics: Interview with Bill Janeway,") that until we rid the markets of CDS, there will be no restoring investor confidence in financial institutions. Here is how we presented the situation to about 200 finance and risk professionals in the auditorium of JPM last week. Of note, nobody in the audience argued.

1) Start with the $50 trillion or so in extant CDS.

2) Assume that as default rates for all types of collateral rise over next 24-36 months, 40% of the $50 trillion in CDS goes into the money. That is $20 trillion gross notional of CDS which must be funded.

3) Now assume a 25% recovery rate against that portion of all CDS that goes into the money.

4) That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS. And remember, a 40% in the money assumption for CDS is VERY conservative. The rise in loss rates for all type of collateral over the next 24 months could easily make the portion of CDS in the money grow to more like 60-70%. That is $40 plus trillion in notional payments vs. a recovery rate in single digits.

Q: Does anybody really believe that the global central banks and the politicians that stand behind them are going to provide the liquidity to fund $15 trillion or more in CDS payouts? Remember, only a small portion of these positions are actually hedging exposure in the form of the underlying securities. The rest are speculative, in some cases 10, 20 of 30 times the underlying basis. Yet the position taken by Treasury Secretary Paulson and implemented by Tim Geithner (and the Fed Board in Washington, to be fair) is that these leveraged wagers should be paid in full.

Our answer to this cowardly view is that AIG needs to be put into bankruptcy. As we wrote on TheBigPicture over the weekend, we'll take our queue from NY State Insurance Commissioner Eric Dinalo and stipulate that we pay true hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches and pitchforks catch up to them.

President-elect Obama and the American people have a choice: embrace financial sanity and safety and soundness by deflating the last, biggest speculative bubble using the time-tested mechanism of insolvency. Or we can muddle along for the next decade or more, using the Paulson/Geithner model of financial rescue for the AIG CDS Ponzi scheme and embrace the Japanese model of economic stagnation.

And, yes, we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into a quick and final extinction. Remember, when AIG goes bankrupt the insurance units are taken over by NY, WI and put into statutory receiverships. Only the rancid CDS positions and financial engineering unit of AIG end up in bankruptcy. And fortunately we have a fine example of just how to do it in the bankruptcy of Lehman Brothers.

Our friends at Katten Muchin Rosenman in Chicago wrote last week in their excellent Client Advisory: "On November 13, 2008, Lehman Brothers Holdings Inc. and its U.S. affiliates in bankruptcy, including Lehman Brothers Special Financing and Lehman Brothers Commercial Paper (collectively, "Lehman") filed a motion asking that certain expedited procedures be put in place to allow Lehman to assume, assign or terminate the thousands of executory derivative contracts to which they are a party. If Lehman's motion is granted, counterparties to transactions that have not been terminated will have very little time to react and will likely find themselves with new counterparties and no further recourse to Lehman because, by assigning contracts to third parties, Lehman will effectively receive, by normal operation of the Bankruptcy Code, a novation."

The bankruptcy court process also allows for parties to terminate or "rip up" CDS contracts, something that has also been fully enabled by the DTCC. The bankruptcy can dispose and the DTCC will confirm.

BTW, while you folks in the Big Media churned out hundreds of thousands of words last week waxing euphoric about the prospect for enhanced back office clearing of CDS contracts, the real issue is the festering credit situation in the front office. Truth is that the DTCC and the other dealers, working at the behest of Mr. Geithner, Gerry Corrigan and many others, have largely fixed the operational issues dogging the CDS markets. The danger of CDS is not a systemic blowup - though that will come soon enough. It is the normal operation of the now electronically enabled CDS market wherein lies the threat to the entire global financial system, this via the huge drain in liquidity illustrated above as CDS contracts are triggered by default events.

The only way to deal with this ridiculous Ponzi scheme is bankruptcy. The way to start that healing process, in our view, is by the Fed emulating the FDIC's treatment of DSL, withdrawing financial support for AIG and pushing the company into the arms of the bankruptcy court. The eager buyers for the AIG insurance units, cleansed of liability via a receivership, will stretch around the block.

By embracing Geithner, President-elect Barack Obama is endorsing the ill-advised scheme to support AIG directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. News reports have already documented the ties between GS and AIG, and the backroom machinations by Paulson to get the deal done. This scheme to stay AIG's resolution cannot possibly work and when it does collapse, Barak Obama and his administration will wear the blame due through their endorsement of Tim Geithner.

The bailout of AIG represents the last desperate rearguard action by the CDS dealers and the happy squirrels at ISDA, the keepers of the flame of Wall Street financial engineering. Hopefully somebody will pull President-elect Obama aside and give him the facts on this mess before reality bites us all in the collective arse with, say, a bankruptcy filing by GM (NYSE:GM).

You see, there are trillions of dollars in outstanding CDS contracts for the Big Three automakers, their suppliers and financing vehicles. A filing by GM is not only going to put the real economy into cardiac arrest but will also start a chain reaction meltdown in the CDS markets as other automakers, vendors and finance units like GMAC are also sucked into the quicksand of bankruptcy. You knew when the vendor insurers pulled back from GM a few weeks ago that the jig was up.

And many of these CDS contracts were written two, three and four years ago, at annual spreads and upfront fees far smaller than the 90 plus percent payouts that will likely be required upon a GM default. That's the dirty little secret we peripherally discussed in our interview last week with Bill Janeway, namely that most of these CDS contracts were never priced correctly to reflect the true probability of default. In a true insurance market with capital and reserve requirements, the spreads on CDS would be multiples of those demanded today for such highly correlated risks. Or to put it in fair value accounting terms, pricing CDS vs. the current yield on the underlying basis is a fool's game. Truth is not beauty, price is not value.

If you assume a recovery value of say 20% against all of the CDS tied to the auto industry, directly and indirectly, that is a really big number. The spreads on GM today suggest recovery rates in single digits, making the potential cash payout on the CDS even larger.

As Bloomberg News reported in August: "A default by one of the automakers would trigger writedowns and losses in the $1.2 trillion market for collateralized debt obligations that pool derivatives linked to corporate debt… Credit-default swaps on GM and Ford were included in more than 80 percent of CDOs created before they lost their investment-grade debt rankings in 2005, according to data compiled by Standard & Poor's."

At some point, Washington is going to be forced to accept that bankruptcy and liquidation, the harsh medicine used with other financial insolvencies, are the best ways to deal with the last, greatest bubble, namely the CDS market. When the end comes, it will effect some of the largest financial institutions in the world, chief among them Citigroup (NYSE:C), JPMorganChase (NYSE:JPM), GS and MS, as well as some large Euroland banks.

The impending blowback from a CDS unwind at less than face amount is one of the reasons that the financial markets have been pummeling the equity values of the larger banks last week. Any bank with a large derivatives trading book is likely to be mortally wounded as the CDS markets finally collapse. We don't see problems with interest rate or currency contracts, by the way, only the great CDS Ponzi scheme is at issue - hopefully, if authorities around the world act with purpose on rendering extinct CDS contracts as they exist today. Call it a Christmas present to the entire world.

Indeed, as this issue of The IRA goes to press, news reports indicate that C is in talks with the Treasury for further financial support under the TARP, including a "bad bank" option to offload assets. A bad bank approach may be a good model for applying the principle of receivership to the too-big-too fail mega institutions, but the cost is government control of these banks.

Q: Does a "bad bank" bailout for C by Treasury and FDIC qualify as a default under the ISDA protocols!?

We've been predicting that Treasury will eventually be in charge of C. On the day the government formally takes control, we say that Treasury should and hire FDIC to start selling branches and assets. Thus does the liquidation continue and we get closer to the bottom of the great unwind. Stay tuned.

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of RiskCenter or any other party. RiskCenter has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to info@institutionalriskanalytics.com. (www.institutionalriskanalytics.com)

http://www.riskcenter.com/story.php?id=17438#rating

another interesting opinion piece: http://www.bmorenews.com/opEd/oped-lessons-of-the-1970s-international-credit-cri.shtml

"....In the current crisis, the U.S. has become the ‘lender of last resort,' bailing out financial institutions in the hope of them re-lending to Americans. At the risk of oversimplifying these events, here is what I believe: (1) the bailout after the international lending crisis of the 1970's directly led to the savings and loan crisis of the 1980's; (2) the bailout of the savings and loan crisis led to the dot.com bubble of the 1990's; and (3) the bailout of the dot.com bubble led to the housing crisis and the reckless lending problems of today. And inevitably, the current bailouts will cause further, severe and unintended negative consequences. .... U.S. growth since 1982 has been illusionary; asset prices have climbed on the ability of the banks willingness to lend. With credit soon a thing of the past, U.S. stocks, growth and standard of living will continue their tumble until credit is priced out. The government, by printing more money and propping the markets up, is simply delaying the inevitable hit we must take, which is living without credit.

In conclusion, the current banking system and the banking system of the 1970's would have collapsed without the intervention of global authorities. What this tells us is that the banks have never considered themselves responsible for the soundness of the system; it has been the job of the central banks to prevent shortages and excesses. Commercial banks have a strict view towards maximizing profits and have proven unable to police themselves. Realistically, financial markets must be supervised. A forewarning from central banks could prevent these cycles, or at least minimize their harm before it's too late, by responsibly managing access to credit."

It will be interesting to see if any comprehensive, international agreements come from the meeting in Davos, Switzerland.

I have read most of the posts here and skimmed the rest. It sounds like a bankers convention...oh yeah, it basically is. I think most of the ideas are right on, but I think it needs a little different presentation for the laymen. Here is my take, I have a degree in economics and have been in collections, banking and lending for over 10 years. I am actually giving a presentation on this at the local high school in a couple of weeks.

We got in this mess for a number of reasons.
1. We came into a belief that living beyond our means was ok. We justified borrowing money to supplement our income to get the stuff we wanted. This is noted in the rise of consumer debt in general. This mentality drove the economy through the possible recession when the tech bubble burst. Remember? The reports were saying that the tech bubble burst, but consumer spending is carrying the economy. Mainly mortgage related debt and home buying.
2. The mortgage industry had Private Mortgage Insurance (PMI) and other programs (FHA insurance) to help homeowners purchase homes for little or no money down. Historically, the borrower needed 20% for a down payment, or had to pay PMI.

3. During the Clinton adminsitration, Fannie and Freddie Mac, two government sponsored companies were asked to increase home ownership. They thought by easing credit standards (credit history quality, ability to repay the loan, down payment requirements, and other criteria) they could drive up or increase home ownership. It worked.

It is important to note that traditional, prudent lending would possibly give way on one standard, if the others were very strong. For instance, you would loosen the standard for credit history, if there was good down payment, good ability to repay, job stability and so forth. However, the industry deviated from that and loosened the requirements on all standards. Then they allowed borrowers to avoid PMI by being creative and doing multiple loans to avoid the PMI requirement. PMI had traditionally been a barrier to home ownership by way of price. Now it was not AND lenders were taking all the risk.

This went on for some time, and as long as the economy was cooking hot everything was fine because house values were rising and the belief was that no down payment homes would increase in value and the bank could always get their money out if needed. Plus, everyone was making money.

Then it all unraveled. Many of the Low down payment homes had rates on them that would change, many borrowers believed they could refinance out of them at the rate change time because they would have equity or just jump lenders. Suddenly, rate changes forced payments to be unaffordable, defaults rose, then a large supply of homes entered the market for sale, they couldn't sell them all and prices dropped as owners were competing on price to sell their homes. Then the layoffs as perceptions of a recession crept in and employers started scaling back payrolls.

And here we are...politics aside, in my opinion this is how it happened. I am not so sure everyone reading the article wants the blame as much as the mechanics. I can cite for days the political machinations that paints both sides of the aisle guilty and innocent...that is the beauty of politics. Like economics, politics is as much about perception as economics is.

I hope this helps.

Continuously harping on the value-less multi-trillion dollar CDS, because no one else seems to - here's another good article about counterparty risk - pretty well describes the bilateral CDS market as analogous to betting on a sports game - no underlying collateral, repayment based only on the good faith of the participants, with middlemen getting most of the $$$: http://www.riskcenter.com/story.php?id=17904

"Apart from the fact that CDS seems to increase the overall risk in the financial system by multiplying the actual legs of risk and, of course, the opportunities for gain and loss associated with a given cash basis – bonds, collateralized debt obligations, or any reference asset – the practical problems with CDS contracts come from several basic flaws in the regulatory, legal and business model for these instruments, deliberate flaws that include:

An archaic, bilateral clearing scheme that has only recently begun to be reformed,
A deliberate lack of standardization and price transparency that advantages the CDS dealer,
No common central counterparty to guarantee all trades and to hold collateral, and thus no effective limit on dealer leverage, and
A schizophrenic pricing methodology that has little connection to the several different types of underlying market and credit risk contained in CDS contracts ....

It is no small thing for a conservative libertarian to sit her an tell you that we need better regulation, but we need to remember that while efficiency and innovation are wonderful things, our Founders often embraced deliberate inefficiency and conflict in order to protect our nation from the short-term whim and caprice of a political majority, including wealthy interests that buy their way through Washington.

The prudential rules that are necessary to govern the safety and soundness of financial institutions or the clearing members of a multilateral exchange have the same origins as the checks and balances and transparency that is meant to support and protect our democratic process. All that I am suggesting today is that we bring the CDS market fully into the light of transparency by listing most of these contracts on exchanges, that we require adequate capital and collateral for all players in both exchange and OTC markets, for end users and dealers alike; and that we force parties writing default protection to show that they understand the risk implications of same."

Looks like some progress on those CDS - see http://www.ft.com/cms/s/0/1acadb8e-0ddc-11de-8ea3-0000779fd2ac.html?nclick_check=1

"....To address "counterparty risks" numerous steps have been taken, which culminated in the introduction of a central clearing counterparty this week.

Outstanding contracts offsetting each other were cancelled, a process called "compression" which has in recent months reduced the face value of outstanding credit default swaps contracts to an estimated $30,000bn.

....More broadly, new rules are being adopted such as those that determine payouts in the event of a default. All these moves will make clearing easier in the future, although the industry is still waiting for European regulators to decide on clearing rules there.

The International Swaps and Derivatives Association (ISDA), which represents the industry, has dubbed the new contract guidelines for CDS the "Big Bang", and they come as corporate defaults are expected to soar.

The most common US CDS will now be streamlined, and there is already more information available about the size of the market and the risks outstanding.

A few months ago, not even regulators were able to get some of this data. ...."

more on the Big Bang fix for CDS, from http://www.ft.com/cms/s/0/4b581dd0-23d4-11de-996a-00144feabdc0.html?nclick_check=1 :
"....This protocol, which has been adopted by some 1,500 players - mostly in recent days, if not hours - aims to introduce more consistency into the credit default swaps market by imposing a uniform procedure for settling CDS contracts when a company goes into default. It also tries to impose more standardisation by introducing set coupons for contracts - a measure that will initially be limited to the US, but could later spread into Europe....

Efforts are also intensifying to put CDS trades through a centralised platform in a bid to reduce counterparty risk - an endeavour which becomes much easier once standardised contracts are in place. The Intercontinental Exchange, for example, is running one clearing system in tandem with other banking groups, and has already managed to clear over $60bn worth of contracts.

Last, but not least, initiatives are intensifying to "tear up" (or cancel) outstanding CDS contracts which offset each other....

As the industry becomes more commoditised, it could well slash margins for the banks. The transformation of contracts to meet the new standards, or to simply "tear up" deals, will generate additional costs, which some banks have not budgeted properly for.

If the CDS sector continues to expand, that decline in margins might be offset by a rise in volumes. The interest rate swaps business, for example, continues to generate healthy profits for some banks, even though it has become commoditised in recent years...."

There's a related article in today's WSJ that I haven't read.

learning, slowly but surely....

from http://www.riskcenter.com/story.php?id=18259 "Use of collateral in privately negotiated derivatives transactions grew significantly in 2008, with the amount of collateral in circulation now estimated at $4.0 trillion. The International Swaps and Derivatives Association (ISDA) last Friday released results from its 2009 ISDA Margin Survey at its 24th Annual General Meeting in Beijing.

The results show an increase of almost 86 percent over the estimated $2.1 trillion of collateral in the 2008 Survey. Cash continues to grow in importance among most firms, and now stands at over 84 percent of collateral received and 83 percent of collateral delivered. ....

also from that Survey, from http://www.riskcenter.com/story.php?id=18255 : "....trade processing continues to improve, especially in regard to confirmations outstanding. Credit derivatives, for example, show an average across all respondents over 2008 of 3.8 business days’ worth of outstanding confirmations, compared with 6.6 days for 2007. Most other products showed similar improvements. ....Automation of processing functions also continues to progress, with credit derivatives showing by far the highest degree of automation of operational processes. Equity derivatives show the lowest degree of automation. This is due to the more customized nature of many equity derivatives transactions compared with other products as well as the more diverse nature of the market participants. Recognizing the opportunity for improvement, over 90 percent of respondents report that they plan to increase the automation of equity derivatives processing in the coming year, which will be supported by newly increased standardization of ISDA documentation."

Another interesting macro-economic article about some of the global consequences of our current situation:

http://www.ft.com/cms/s/0/918fe90c-351f-11de-940a-00144feabdc0.html?nclick_check=1

"....At the same time the recycling of the excess savings of current account surplus countries in Europe, the Middle East and Asia to finance the deficits of the high spending countries of the anglophone world is creating increasing tensions, with China initiating a debate on the creation of a super-sovereign reserve currency to replace the dollar. Against this background the future of financial globalisation looks more and more uncertain.

....A consequence, Charles Dumas of Lombard Street Research points out, is that the US requirement for foreign inflows is shrinking along with its current account deficit. The surplus countries' propensity to save nonetheless remains high. The result, adds Mr Dumas, is that the high savers are suffering a collapse in income, led by exports, which will continue until the belated shift to domestic spending reduces net saving.

....From a global perspective the desirable outcome is for the surplus countries to stimulate domestic demand and adopt exchange rate regimes that are less conducive to piling up trade surpluses and reserves. On present evidence, China is taking the domestic stimulus route by increasing investment rather than reducing saving, and Japan has been shocked by the trade collapse into a new and significant fiscal stimulus. For its part, Germany remains obdurately committed to the path of excess savings and relatively modest fiscal expansion...."

Actual email exchange between me and my better half:

Me: You don’t have to have technical knowledge, a neat article for us history buffs: http://www.ft.com/cms/s/2/51f425ac-351e-11de-940a-00144feabdc0.html

Better Half: What's a credit derivative?

Me:per http://dictionary.reference.com/search?q=credit+derivative&r=66 ): "Credit Derivative

Privately held negotiable bilateral contracts that allow users to manage their exposure to credit risk. Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments).

Investopedia Commentary

For example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss by transferring the credit risk to another party while keeping the loan on its books. …”

Of course, if you want the REAL explanation ; ) from http://www.amex.com/servlet/AmexFnDictionary?pageid=display&titleid=1634 :

Credit Derivative

A highly generic term often used to describe one or more of the following instruments or arrangements: (1) a put or a call with a payoff dependent on the interest rate spread between a specific corporate debt instrument and sovereign debt denominated in the same currency. The most common example is the Treasury EuroDollar, or TED spread. Alternately, an option with a payoff dependent on the spread between indexes of similar maturity debt instruments such as the five-year swap rate and a five-year government bond rate; (2) a swap or embedded swap with the payments on one side mirroring the interest and principal payments of a basket of bonds rated below investment grade. The payer of the bond return is the nominal holder of the low-rated bonds, but the receiver actually takes the credit risk. The payment on the other side can be a fixed or floating rate as the parties agree; (3) an asset swap in the form of a stand-alone swap or structured note where one party holds a below-investment-grade issue and pays the interest called for under the bond indenture, in exchange for a traditional fixed or floating rate. The fixed or floating rate is greater than usual in compensation for the acceptance of any losses from default by the holder of the below-investment-grade issue. See Credit Derivative Bond; (4) a total return swap with the “fixed” rate based on the total return of a corporate bond because the bond's issuer is overrepresented in the fixed-rate payer's credit portfolio.

If you can translate THAT, then Goldman Sachs wants to talk with you….Just remember, it’s still true that if you don’t understand an investment, don’t do it! Too bad a bunch of firms and people didn’t remember that….

There are pieces of http://www.riskcenter.com/story.php?id=18468 that seem worth studying....

from the basic concern of accrual-based accounting: "...- Yet another might book just $400K of gains currently. This would represent the NPV of the $500k over the five-year period based on an internal capital rate set by the bank's management. This is close to economic reality and is the form that most banks use to value this type of business. While it is the most appropriate and reasonable approach, it too is badly flawed.

The next day your bank announces quarterly earnings and says, "We made $400K. We are paying a dividend based on that and we are paying bonuses based on that. Net-net, retained earnings will go up by $250,000. It was a good quarter"

In this very simple example there is no cash from this profit. The cash will come to you over five years. So you have to borrow to pay the dividend and the bonus and all the other current expenses relating to this profit.

What you have done is 'borrow' retained earnings from future cash flow. You look like you have retained earnings to support your tier one capital ratios. But when there is a real 'cash call' on your equity (2008) you do not have the cash equity to survive. So you have a TARP party...."

to some key contentions in the interview that follows: "....all of the bailouts to date engineered by Treasury Secretary Tim Geithner and Fed Chairman Ben Bernanke, including the merger of Bear Stearns, the acquisition of WaMu and the rescue of American International Group (NYSE:AIG) were designed to prevent the trigger of CDS and the resultant evaporation of JPM. The bank is an afterthought compared to the OTC derivatives exchange that JPM has become. That is why JPM must ensure that any true reform of CDS is strangled with the proverbial umbilical cord.

....the Geithner plan marginalizes all of the non-banks corporates, funds and other players in the OTC derivatives markets in favor of the banks. There is a growing awareness of this fact and it may just take another default event to swing the political equation against JPM and the other dealers....

....As long as the authorities are willing to pump money into zombie firms, they are making bad bets. The incentives of the zombie firms, especially those with stock-based formulas for executive compensation, is to take longshot gambles even if the investments have negative present value. So-called toxic assets are precisely the type of exposures managers want to keep when their enterprise has no economic net worth and all of their resources are coming from the public safety net. Once the economy gets better, some of these assets will gain value sharply. Putting money into the zombie institutions is likely to make things worse in the long run .... "

Totally Agree!

The level of anger in this article is astonishing: http://www.riskcenter.com/story.php?id=18736

The tamer paragraphs include these:

"....Of interest, ...is the investigation by the Department of Justice into price fixing in the CDS markets. It's not so much price fixing as a complete and deliberate lack of a) price discovery and b) disclosure of even end-of-day pricing. That's why we've called it "deceptive by design" for the past several years and, with a Democrat in the White House, the DOJ is now at least pretending to enforce the laws prohibiting such behavior - even in the name of innovation.

....But there is virtually no "price discovery" in this market, as illustrated by the fact that the dealers still, even today, refuse to report all trades. This dealer monopoly model is one of the "innovations" that the Geithner proposal for regulating OTC contracts would set in concrete.

...most of the US Senate and a growing proportion of the House (excluding Chairman Frank, of course), seem to understand that there is a causal link between the unfettered leverage in OTC and the appearance of systemic risk. And a growing number of Members of both houses seem to understand that the only way to avoid further public expense and limit systemic risk is to limit risk in all derivatives instruments. So long as infinite leverage exists via OTC derivatives, systemic risk is also unlimited. ...

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. ..."

...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...."

The links to a letter and article about the need to limit the apparent power of ratings agencies are very good.

like we need something else to worry about - now it's today's version of program trading, one of the key causes of the 1987 stock market crash: http://www.nytimes.com/2009/07/29/opinion/29wilmott.html?_r=1

this is echoed in an article in today's Washington Post (the comments are as good to read as the article):
http://www.washingtonpost.com/wp-dyn/content/article/2009/07/30/AR2009073004115_Comments.html

summarized in today's daily summary of industry articles as "Business columnist Steven Pearlstein expressed his suspicions about high-frequency trading, which he said could plant the seeds for future turmoil in the financial markets. While traders tout the innovation as improving cost, transparency and liquidity, "those are the same justifications we heard for portfolio insurance, which prompted the 1987 stock market crash, and for the derivatives trading, securitization and naked short-selling that led to our recent crisis."

Looks like a really good introductory article about some trading techniques that, if overused, if done by too many, could lead to no one profiting or worse, the next financial bubble and burst: http://online.wsj.com/article/SB124908601669298293.html

as with the Post article in the previous entry, the comments are good reading too.