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Archive for the ‘Structured Finance’ Category

From Bloomberg:

Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said. The new policy applies only to managing directors and directors, the two most senior ranks at the Zurich-based company, according to a memo sent to employees today.

“While the solution we have come up with may not be ideal for everyone, we believe it strikes the appropriate balance among the interests of our employees, shareholders and regulators and helps position us well for 2009,” Chief Executive Officer Brady Dougan and Paul Calello, CEO of the investment bank, said in the memo.

The securities will be placed into a so-called Partner Asset Facility, and affected employees at the bank, Switzerland’s second biggest, will be given stakes in the facility as part of their pay. Bonuses will take the first hit should the securities decline further in value.

“It’s monstrously clever,” said Dirk Hoffman-Becking, an analyst at Sanford C. Bernstein Ltd. in London who has a “market perform” rating on Credit Suisse stock. “From a shareholders’ perspective it’s great because you’ve got rid of some of the assets and regulators will be pleased because you’ve organized a risk transfer.”

Interesting approach; stick the originators of toxic assets with the toxic assets as bonuses…Credit Suisse must subscribe to the phrase “What goes around comes around.”

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First, here’s a little history about the Glass-Steagall act, courtesy of PBS‘s Frontline:

Following the Great Crash of 1929, one of every five banks in America failed. In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduced historic legislation which sought to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds.

The new law banned commercial banks from underwriting securities, forcing them to choose between being a simple lender or an underwriter (brokerage). The act also established the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthened the Federal Reserve’s control over credit.

In retrospect, this ideology was the right prognosis for America; we had just had a nasty stock market crash, and were in the midst of the great depression. Years later, we would exit the depression only to achieve the greatest period of economic growth in our history…yet in 1986, we weren’t so sure:

In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argued that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. Volcker was unconvinced, and expressed his fear that lenders would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.

Sorry, I can’t help myself…the very argument for repealing Glass-Steagall is monumentally flawed – let’s review each of the three “outside checks” one-by-one, since we have the benefit of hindsight being 20/20:

  1. Was the SEC “effective” in granting Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers permission to exceed the market mandated level of leverage from 10:1 to 40:1? (Notice 3 of these brokers no longer exist, and 2 of them have become holding banks)
  2. “Knowledgeable investors”…not exactly true. Collateralized Debt Obligations, Credit Default Swaps, Mortgage Backed Securities, Credit Linked Notes….we could spend a day running off all of the instruments of structured finance, which is esoteric by nature – and understood by very few.
  3. “Sophisticated Rating Agencies” might be the most laughable of all; not only did they incorrectly gauge the health of the components in our financial system, but they were also stubbornly late in making adjustments to their ratings. In recent months they have only exacerbated problems in the credit markets, because by downgrading a company’s debt in the peak of a credit crisis, they are causing investors to demand a higher yield at the very point when the company is most vulnerable; if the damage is done, they shouldn’t push companies to the edge of bankruptcy – if you disagree or don’t know what I’m talking about, click the link above for more about this point (it’s actually really funny to watch the CNBC anchor rip apart S&P’s head of financial institution’s ratings).

Greenspan, who was appointed FED chairman in 1987, favored the repeal because he felt that deregulation would help U.S. banks compete with big foreign institutions. Leaving the lack of truth aside, his agenda is what developed our financial system into what it is today; Citigroup immediately merged with Travelers Corp., something which never could have happened under Glass-Steagall; a combination of insurance underwriting, securities underwriting, and commercial banking.

So to answer the question above, I say yes.

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There’s really 1 reason that’s important, and the others don’t matter when considering this (from “The New Republic”):

“Bankruptcy need not mean that the company disappears.” But, while it’s worked out that way for the airlines, among others, it’s unlikely a GM business failure would play out in the same fashion. In order to seek so-called Chapter 11 status, a distressed company must find some way to operate while the bankruptcy court keeps creditors at bay. But GM can’t build cars without parts, and it can’t get parts without credit. Chapter 11 companies typically get that sort of credit from something called Debtor-in-Possession (DIP) loans. But the same Wall Street meltdown that has dragged down the economy and GM sales has also dried up the DIP money GM would need to operate.That’s why many analysts and scholars believe GM would likely end up in Chapter 7 bankruptcy, which would entail total liquidation. The company would close its doors, immediately throwing more than 100,000 people out of work. And, according to experts, the damage would spread quickly.

When poorly run ‘too big to fail’ companies went bankrupt in the past, there was ample credit to tide them over through the process of solving some of their inefficiencies. If one thing is clear, it’s they don’t have enough money to run their business this time around, and we cannot allow them go bankrupt and hope they fix this one on their own.

While the effect on the real economy would be devastating, the effect of a big 3 default on the credit markets is talked about much less. Credit default swaps make up a $62 trillion market – how many of these contracts were sold to protect GM and Ford bond investors against default (or bankruptcy)? That is a huge question, because AIG along with all of the bulge bracket banks sold this kind of insurance (where their reward from this side of the bet is limited to the price of the insurance, while the risk is having to cover the entire value of the losses on a defaulted bond – something they do not count on happening). If GM defaults, we could certainly count on more bleeding out of AIG who is undoubtedly intricately involved in this.

bond-defaultGM is rated ‘Caa2’ which is junk status, meaning that Wall Street brokered bets using the riskiest instruments (CDS’s) on the riskiest products (junk bonds).

Like with everything these days, no one really knows what will happen. So as usual, we’ll have to wait and see.

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So I thought I should post something relevant to my internship before I finish up this week…the two types of instruments which are dealt with on a most regular basis, are Interest-rate swaps and credit-default swaps:

An interest rate swap is a contractual agreement to exchange a stream of periodic payments with a counterparty. The traditional interest rate swap agreement is an exchange of fixed interest payments for floating rate payments:

(Click to enlarge)

A Credit default swap (CDS) is a swap designed to transfer the credit exposure of the reference obligation between parties.

It is an agreement between a protection buyer and a protection seller whereby the buyer pays a periodic fee in return for a contingent payment by the seller upon a credit event (such as a certain default) happening in the reference entity

§ A pension fund owns USD 10 million worth of a 5 year bond issued by Risky Corporation;

§ In order to manage their risk of losing money if Risky Corporation defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of 10 million dollars which trades at 200 basis points;

§ In return for this credit protection, the pension fund pays 2% of 10 million (200,000 euro) in quarterly installments of 50,000 euro to Derivative Bank;

§ If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its 10 millions loan back after 5 years from the Risky Corporation;

§ Though the protection payments reduce investment returns for the pension fund, its risk of loss in a default scenario is eliminated;

§ If Risky Corporation defaults on its debt 3 years into the CDS contract then the premium payments would stop and Derivative Bank would ensure that the pension fund is refunded for its loss of USD 10 million

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