Someone with a suspicious frame of mind and a pencil could have figured that there were some perverse incentives possible in such a structure

TO BE NOTED: From the FT:

"Clash of interest between lenders and special servicers

By John Dizard

Published: May 17 2009 10:25 | Last updated: May 17 2009 10:25

“When I sit down with my friend, he is not sitting down with his friend.”

Intelligence profession maxim.

The fights around the commercial real estate waterhole are getting nastier as even the mud dries up. Defaults are rapidly increasing among the $850bn (£560bn, €627bn) or so of loans that were pooled into commercial mortgage-backed securities, and groups of lenders and mortgage servicers who started out as allies are now on the verge of open warfare.

It was always the case that different tranches in securitisations had divergent interests, but those were concealed, or elided, when property prices were rising and owner/developers had plenty of margin for their debt service. What has shocked some of the holders of senior debt is that the professionals they counted on to act as collection agents for troubled loans instead want to stretch out the terms as long as possible. The senior lenders, who thought they were well insulated from risk, even in the event of a default, are finding that their capital is being involuntarily locked up in loans for years longer than they counted on. Particularly for those who bought senior CMBS securities at a discount, this means not just illiquidity, but substantial reductions in yield – assuming that they get back their principal as promised.

I think I am on firm ground in thinking that many of the people who own “triple A” CMBS securities have not read every line of the pooling and servicing agreements that delineate their rights. And if they did, they did not game out what the other participants in the deal would do when trouble hit.

The senior certificate holders, the triple-A people, are now particularly angered by the “special servicers”. These are the companies called in to deal with troubled loans. They get typically 25 basis points in annual servicing fees on those loans, along with 1 per cent of principal and interest payments they collect, or 1 per cent of the recoveries in liquidations.

The special servicers were not, however, just fee-for-service people. In order to make sure their interests were aligned with those of the actual lenders, they were encouraged to buy junior pieces of debt, called the “B-piece”, so they would have an additional incentive to get those collections done.

Many of the special servicers also bought “interest only” or “i/o” slices of the securitised deals, which carried no rights to principal payments, but which paid a piece of any interest payments.

Someone with a suspicious frame of mind and a pencil could have figured that there were some perverse incentives possible in such a structure. In practice, it turns out, the special servicers have an incentive to stretch out loan repayments on the troubled commercial properties, while the senior lenders do better if foreclosure and recoveries proceed quickly. Most of the time, the impending defaults come about not because the owner/developer simply stops paying debt service, but because he cannot refinance a balloon repayment. It’s not just that credit is generally hard to come by, but because property values have dropped so much that a new loan would have to be smaller than the original loan.

Still, there is enough rent coming in to cover the interest payments. That means that the special servicer’s i/o “strip” could be covered, along with the interest payments on the junior tranches as well as the special servicer’s continuing fee income. However, the senior lenders, who may have bought the triple A tranche at a discount, suddenly have their duration lengthen and their returns drop.

So, to the now unconcealed rage of the seniors, the special servicers are incented, as they say, to extend the loans. Just to make it easier to do so, they have petitioned the Treasury to give tax-law cover for this and other forms of forbearance. I wouldn’t bet against them.

Those who defend the emerging role of special servicers as soft touches point out that they are governed by the requirements of the PSAs. These say the special servicers must maximise the net present value of the loans in work-out, and must protect the interests of all the classes. But net present value isn’t some invariant material truth; it depends on whether you assume that property values will rise or fall in value over time.

For some time now, those values have been falling, and falling fast for troubled properties. The assumption that this is just a temporary blip may turn out to be true, or it may just be a self-serving fiction on the part of the servicers, the junior security holders, and their lawyers that allows them to suck out payments for a few more years. We’ll find out some years from now.

There’s also a difference in philosophy. Are we better served by rapid recognition of losses, quick write-offs, and elimination of speculative lenders and weak owners? Or should we give everyone a second, third, or nth chance?

I think you could make an argument for compassion for honest civilians down on their luck. But developers? Junk lenders? Collection agencies – sorry, I mean special servicers? Come on.

johndizard@hotmail.com"

If the administration and the union had just richened the deal offered the bondholders from 4-5 cents to maybe 10-12-15 cents on the dollar

TO BE NOTED: From the FT:

"Long road to a ‘good GM’ filing

By John Dizard

Published: May 10 2009 11:07 | Last updated: May 10 2009 11:07

Flushed with the immediate tactical success of the Chrysler bankruptcy, the US administration’s plans for the subsequent GM filing are moving forward, along the lines laid out a couple of weeks ago. The White House’s auto task force, with the UAW, the car workers’ union, behind it, could have had a quick, consensual trip in and out of court, but apparently that wasn’t what they wanted.

The “363” plan (a provision under the Bankruptcy Act that allows the company to sell assets), is the means for a “good GM” funded by the government to buy assets from the existing company, or “bad GM”. The plan, based on a review of some fairly clear precedents from past cases, is a legally flawed way to disregard the rights of certain creditors – in GM’s case, their public bondholders.

The unsecured bondholders are being offered somewhere between 4 and 5 cents on the dollar for their claims. In contrast, unsecured claims (with equal legal rank) by the union retirees’ healthcare plan are being offered a recovery of 74 cents on the dollar.

Nevertheless, the plan will probably work, in the sense of achieving the intended short-term effect. The key to the tactic’s success is not its integrity, but the current lack of available exit financing for companies emerging from bankruptcy.

The 363 loophole, (really 363(b)), was intended to give a judge the authority to allow for the quick disposal of wasting assets, or assets that are not part of the core business, without waiting for creditors to vote their permission. It was not intended as a way to impose what is called a “sub rosa plan of reorganisation”. That is a plan of reorganisation of the entire company on which creditors do not get a vote.

In GM’s case, the “sub rosa plan” is to sell the valuable assets, with accompanying union contracts, to a new, “good” GM, and leave the money-losing assets in the original company, which is left in the street to bleed cash and die.

GM’s law firm, Weil Gotschal, has attempted to use this section of the bankruptcy code in the past, and had only mixed success in doing so. For example, a bankruptcy judge in New York ruled against a similar Weil Gotschal tactic in the Westpoint Stevens case, saying: “The fact that a transaction including a 363(b) sale of assets may ultimately be in the best economic interests of a debtor’s various constituencies does not authorise the court to ignore the creditors’ rights and procedural requirements of Chapter 11.”

Here’s how I believe the GM bankruptcy case will play out. The government, the UAW and GM are in a good position to “forum shop”, or find a bankruptcy judge who will be sympathetic to the government-UAW plan. That judge may be in New York (convenient for Weil Gotschal, headquartered in New York’s GM building), or Michigan (hometown advantage for GM). That judge will almost certainly grant the request of GM, the union and the government for the 363(b) sale.

Then the bondholders do some forum shopping of their own. They could well find a judge in a Federal district court (one level up from bankruptcy court) willing to grant a temporary restraining order blocking the 363(b) sale.

Given the facts of the case, and the precedent on the side of the bondholders, I think it’s quite possible that the judge will issue a TRO, and set a hearing on a motion by the bondholders to enjoin the sale.

That will be the end of the good news for the bondholders. The judge will read through the law, and the facts, and then ask an unpleasant question of the bondholders: what’s your alternative?

They won’t have one. There will be a great deal of back and forth, but at the end of the day the bondholders need – not just the law – but a big cheque book on their side, and the money isn’t there. Not for the $35bn (£23bn, €26bn) or so they would need to pay off the government and step into its commanding position.

Their problem is that the US government will be offering not just working capital for GM during its bankruptcy, but “exit financing” for GM’s emergence from Chapter 11. That is hard to get now on commercial terms, even on a smaller scale than would be needed for GM.

There are other problems with the government/union plan. The suppliers to the remaining “good” brands will need to spread their fixed costs over fewer parts, and transferring and revising all the contracts is logistically very difficult. Getting effective, decisive management, when the major shareholders have made unconvincing pledges to be hands off and avoid conflicts . . . very uncertain.

The bondholders still fight a hard, continuing, rearguard action, since they have little or nothing to lose, and want to preserve their rights and legal precedents for future reorganisations.

If the administration and the union had just richened the deal offered the bondholders from 4-5 cents to maybe 10-12-15 cents on the dollar, they might have got an agreed, prepackaged deal, and avoided a lot of sturm und drang.

johndizard@hotmail.com"

And as this blog has stressed, there does not seem to be a Plan B

From Naked Capitalism:

"Saturday, April 25, 2009

Markets Cheer Stress Test Double Speak

Forgive me for sounding even crankier than usual, but the reason deception sells is that so many people line up for it.

The release claiming to describe how the stress tests were conducted in fact provided no new information. Some analysts were more than a tad dismissive:

The central bank released a so-called white paper today describing methods used by examiners from the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency to calculate the capital buffer the banks will require through 2011 under two economic scenarios.

“The anticipation over the white paper appears to be much ado about nothing,” said Josh Rosner, an analyst at independent research firm Graham Fisher & Co. in New York. “The most significant numbers provided by the Fed in the paper appear to be the page numbers.”

Financial stocks did well on the belief that most of the big banks would get clean bills of health. But that was the plan from the outset, to validate that the system was more or less OK so that if the poor chump taxpayer had to stump up more money, it could be positioned as due to completely unforeseen events (thanks to having put on very big blinkers) yet still a good risk.

The cheer seems a naive view. Citi is far from out of the woods, with a half trillion of foreign deposits, plus roughly $1 trillion in off balance sheet exposures (remember those SIVs, the watchword of late 2007?). Dislocation there would have far bigger ramifications.

The Financial Times, looking at more or less the same fact set, comes to less upbeat conclusions. Is this the result of being further from the spinmeisters?

From the Financial Times:

Some of the country’s biggest banks will be asked to raise more capital by US authorities following the completion of bank stress tests, senior Federal Reserve officials said on Friday.

A second, larger, group of leading banks will be asked to improve the quality of their capital by increasing their amount of common equity, the officials indicated.

Yves here. A surprisingly large number of market participants are of the view that the current rally is at least in part the result of market manipulation. I can't recall ever seeing so much commentary to that effect. It amounts to an open secret. Even during the commodities run-up of last year, if you dared suggest there was a speculative component, you were treated as a conspiracy theorist. Now a fair number of commentators are making more aggressive claims, and they don't seem terribly far out.

The latest sign of something out of whack is via Jesse, who tells us that insider sales are at high levels. When did that last happen? October 2007. Admittedly, not long ago, but nevertheless not a sign of confidence.

Now back to the FT. The officialdom has wanted banks to raise more equity since the Bear collapse. They fantasized that the banks would be able to get enough done in that recovery to stave off disaster. But as John Dizard pointed out at the time, the needs were so massive that (and he was serious) that central bankers would need to help conduct road shows.

That didn't happen, needless to say. A year later, same problem, bank stocks much cheaper even post rally, so any equity raise more dilutive. And the powers that be have to hope all these banks that need more capital (admittedly reduced considerably thanks to the kindness of taxpayers) raise funds in this window.

The best of breed (for now) Goldman offering was a bit sloppy. Think all these banks, particularly with the stigma of a stress test forced raise, will get their deals done? The vast majority will be back at the government feed bucket, yet Mr. Market is acting as if everything is all for the best in this best of all possible worlds. Back to the FT:

Meanwhile, people familiar with the situation said regulators indicated that Citigroup might need more capital beyond a planned conversion of preferred shares into common stock that will give the government a 36 per cent shareholding.

If Citi has to raise more funds from the government, the authorities might force out Vikram Pandit, its chief executive. However, they added that no decision had been made and each bank had a week to discuss the results of the tests with regulators. Citi declined to comment.

While banks will be encouraged to raise the equity needed from the market, those unable to do so may have to ask the government to convert the preferred shares it holds in them into common equity. This could result in the US government ending up owning – at least temporarily – stakes in a number of the top US financial institutions.

Recall that banks (Citi et al.) that can't raise the needed capital in six months then have to take more TARP funding. And recall further that the "stress" scenario is increasing looking like the mainstream forecast.

The Wall Street Journal has a similar report, with the addition than three of the 19 are to bolster their equity levels:

The identities of the banks, among the 19 institutions that were subjected to federal "stress tests," couldn't be learned. Analysts believe they likely include regional banks with large exposures to commercial real estate in the Midwest and Southeast. Three people familiar with the matter said at least three banks are in this position.

As we said, if the stress test fingers Fifth Third (clean reporting, well managed God-awful geographic footprint) and not Citi, you know the the priority is finding examples to validate its seriousness, and not really discovering real risks.

The problem with the tests is that the focus on the loan books (as reported by the AP) is missing the fact that loans decay more gracefully than bad structured debt or derivatives exposure. Outlier events will hit the big capital markets players far worse than traditional banks. But those scenarios have been deliberately omitted.

And per Bill Black, the emphasis on loans is a charade without inspection of the underlying loan files. And the number of inspectors was clearly insufficient for that to have happened.

The strategy is TinkerBell: if enough people applaud, belief alone will restore goners. That may work in theater, but I'm loath to rely on mere faith in matters of consequence. And as this blog has stressed, there does not seem to be a Plan B (the ideas of Paul Volcker and others not in the Summers/Geithner camp have been relegated to a policy gulag).

More on this topic (What's this?)

Cuomo Letter Exposing Paulson's and Bernanke's (In)visible Hand In The Merrill Deal (Zero Hedge, 4/23/09)

The Evaporating Collateral Of The United States (Zero Hedge, 4/18/09)

Fed Admits "Stress Tests" Are a Sham (George Washington's Blog, 4/24/09)

Read more on Federal Reserve, Stress Test at Wikinvest

Posted by Yves Smith "

Me:

Don said...

Yves. Thanks for bringing up the Dizard. It allows me to comment on Bears and its importance for this crisis. I could just write it up, but I'm a commenter, and by nature passive. I'm passive with women as well. In fact, passivity is the theme of my second novel.

So, let's look at Dizard:

"The Fed itself would have to be a co-sponsor in some form."

"For all the chicanery of speculators and hedgers on the exchanges, there have been no fears of contagion, of one participant's failure leading to others, of the sort that led to the Bear Stearns bail-out/ takeover/near collapse."

So, I made the following assumptions from Bear:
1) The govt fears Debt-Deflation
2) The govt fears we're in a bubble
3) There's no Plan B
4) There's no free market plan
5) The govt will have to guarantee everything
I couldn't explain the bailout without these assumptions.

Now, I could be wrong, but I thought that I read at the time that Bernanke was a follower of Fisher and that explained his view on Bear. Of course, since then, there are a number of commenters who say that Bernanke doesn't understand Fisher. In any case, I have to admit being fooled, and assuming that we could handle this crisis well.

Here's Paulson in March 2008:

"We are working to get through the current period of market turmoil while minimizing its impact on our economy. And, as we do so, risk is being re-priced and markets are de-leveraging. This is creating liquidity challenges and, as a result, credit markets are not functioning as normal. We are encouraging financial institutions to continue to strengthen balance sheets by raising capital and revisiting dividend policies; we need these institutions to continue to lend and facilitate economic growth."

I take the risk of the de-leveraging to be Debt-Deflation. So, again, I thought that everybody understood where we were. Consequently, I'm having a hard time understanding the govt's responses since Bear.

Okay. Let's go to Fannie/Freddie:

"Assumed guarantees

There is a wide belief that FNMA securities are backed by some sort of implied federal guarantee, and a majority of investors believe that the government would prevent a disastrous default. Vernon L. Smith, 2002 Nobel Laureate in economics, has called FHLMC and FNMA "implicitly taxpayer-backed agencies".[27] The Economist has referred to "[t]he implicit government guarantee"[28] of FHLMC and FNMA. In testimony before the House and Senate Banking Committee in 2004, Alan Greenspan expressed the belief that Fannie Mae's (weak) financial position was the result of markets believing that the U.S. Government would never allow Fannie Mae (or Freddie Mac) to fail.[29]"

My assumption:
1) The govt will bailout Fannie/Freddie, with 5 above still in place.
And it did, but it did so in a way that led investors to believe that the govt was not going to guarantee everything. If you look at when China started selling Agencies, you'll see that it's August 2008.

And then Lehman. The real question is why did this happen? Did the govt think it would be a disaster? From Swagel:

"Free Markets Day
The way Congressman Barney Frank put it at a hearing at which I testified on
Wednesday, September 17 was that we should celebrate, Monday, September 15, as
“Free Market Day”— Lehman Brothers was allowed to fail and the free market to work
on that day. Now, the next day, Chairman Frank continued, AIG had been bailed out so
“the national commitment to the free market lasted one day,”3 (as quoted by WSJ.com),
but we should celebrate that day.
The decision not to save Lehman Brothers is no doubt the most hotly debated decision of
during the crisis. Secretary Paulson and Chairman Bernanke have made the point that
with the firm evidently insolvent, they did not have the authority save it—the Treasury
outright had no authority, while the Fed could provide liquidity, not capital. The Fed can
lend, however, against collateral to its satisfaction, so in principle the Fed could have lent
against unencumbered Lehman’s assets—essentially what it did with AIG. This would
not have saved the Lehman—indeed, it would have concentrated losses on the rest of the
firm—but it is possible such lending could have provided time for a more orderly
dissolution of the firm (indeed, there are estimates that the disorder bankruptcy reduced
the recovery value of the firm by billions of dollars). The feeling at Treasury, however,
was that Lehman’s management had been given abundant warning that no federal
assistance was in the offing, and market participants were aware of this and had time to
prepare. It was almost as if Lehman management was in a game of chicken and
determined not to swerve."

China's actions in August should have signaled trouble. I think that he understands this. As to being prepared, this is the main problem I have with his essay. Things had gotten worse, not better. Nor was this a short term problem.

Here again:

"A number of lessons of that weekend have received extensive discussion in the financial
press and in the academic literature, including the role of liquidity (as discussed by Allen
and Carletti (2008)), fragilities arising from counterparty risks embedded in the tri-party
repo system and the over the counter derivative markets, and the need for a resolution
mechanism for non-bank financial institutions. At Treasury, two additional lessons were
learned: (1) we had better get to work on plans in case things got worse, and (2) many
people (at least in Washington, DC) did not understand the implications of non-recourse
lending from the Fed. This latter lesson was somewhat fortuitous, in that it took some
time before the political class realized that the Fed had not just lent JP Morgan money to
26
buy Bear Stearns, but in effect now owned the downside of a portfolio of $29 billion of
dodgy assets. This discovery of the lack of transparency of non-recourse lending by the
Fed was to figure prominently in the financial rescue plans adopted in the first part of
2009.
The Fed’s announcement of the primary dealer credit facility (PDCF) immediately after
the collapse of Bear Stearns seemed to us and many Wall Street economists to remove
the tail risk of another large financial institution suffering a sudden and catastrophic
collapse. This was a time to plan for further events.
Part of the planning was for the long-term, on which Treasury on March 31, 2008
released a Blueprint for a Modernized Financial Regulatory Structure with a vision for a
long-term reshaping of financial sector regulation. This had long been in the works—
indeed, Treasury had requested public comments on the topic in October 2007—but the
timing of the report led to press reports that this was Treasury’s “response” to the crisis.
More near term in vision was work being done on so-called “break the glass” options—
the reference being to what to do in case of an emergency. This work evolved from a
recurring theme of the input we received from market participants over the prior year,
which was that the solution to the financial crisis was for Treasury to simply buy up and
hold the “toxic” assets on bank balance sheets. Indeed, this suggestion found its way into
some versions of the Frank-Dodd bill. Eventually a memo was written that listed options
to deal with a financial sector crisis arising from an undercapitalized system—indeed, the
memo went through more than a dozen iterations in discussions around Treasury and
with other agencies between March and April. The options ended up being to buy the
toxic assets, turn the Treasury into a monoline and insure the assets, directly buy stakes in
banks to inject capital, or use a massive scheme to refinance risky mortgages into
government-guaranteed loans and thus improve asset performance and firms’ capital
positions from the bottom up. With estimates in mind that U.S. financial institutions
would suffer $250 billion of losses from mortgage securities, we envisioned a
government fund of $500 billion. A mix of asset purchases, capital injections, and
additional private capital raising by banks would allow this amount to roughly offset the
forthcoming losses.
All of these options, however, would require Congressional action—this would move the
focus of financial markets policy back from the Fed to the Treasury, which would be
appropriate in what was a problem reflecting inadequate capital rather than insufficient
liquidity. But there was no prospect of getting approval for any of this. With growth
positive and the stimulus rebates only just beginning to go out in late-April, it was just
unimaginable then that Congress would give the Treasury Secretary such a fund. And it
was doubly unimaginable that the fund could be enacted without being used. Such a
massive intervention in financial markets could only be propose if Secretary Paulson and
Chairman Bernanke went up to Congress and told them that the financial system and
economy were on the verge of collapse. And we understood that by then it could well be
too late."

I don't know if this is true, but, if it is, congress would bear some heavy responsibility for this crisis. In my opinion, from Lehman, we've been in a slow-motion Debt-Deflation. The govt's actions have done a lot, but we could have done a lot better. For one thing, we could have recognized that the govt has to guarantee everything in order to stop Debt-Deflation. Does that mean we want to spend a lot of money? Quite the contrary, it means that we expect the guarantee to stop the panic, the downward spiral, and allow:

"This would
not have saved the Lehman—indeed, it would have concentrated losses on the rest of the
firm—but it is possible such lending could have provided time for a more orderly
dissolution of the firm (indeed, there are estimates that the disorder bankruptcy reduced
the recovery value of the firm by billions of dollars)."

This could have saved an unknown amount of dollars and jobs. Now, I understand that many, if not most, people don't agree with me, and that's fine. But if you do, do you really believe that the blanket guarantees could have passed the congress or gotten our citizens behind it? From my point of view, we have a crony welfare state which caused and continues to hinder our solving the crisis, but we also have a system in which hard choices and tough news is constantly deferred and put off by everyone. We have the ghastly hybrid precisely because we disagree and have different solutions. Given that, it's amazing that we seem to be lurching towards some decent solutions. One minority view, and tentative supporter of Geithner.

Don the libertarian Democrat

PS Contra Dizard, the Pharisees and Money Changers were not evil people. The Pharisees allowed the average Jew to act like a priest in everyday life, honoring the average person. The money changer allowed average worshipers, who's offerings might be damaged in transport, to sell the offering locally, get cash for it at the Temple ( there were lots of currencies ) and buy an acceptable offering at the Temple. Again, a plan designed to help the average Jew.

April 25, 2009 4:52 PM

Their basic implied threat is to withhold any further capital investment in big banks, which example would be followed by foreigners.

TO BE NOTED: From the FT:

"Who can afford the next recovery plan?

By John Dizard

Published: April 12 2009 11:45 | Last updated: April 12 2009 11:45

“That piece of shit up there, I never liked him. I never trusted him... But that’s history, I’m here, he ain’t.” Tony Montana (Al Pacino), watching a colleague hanged from a helicopter.

Scarface (1981)

It’s nearly time for some Washington careers to get the helicopter-noose treatment, particularly among the crowd of unvetted advisers and the tiny group of confirmed appointees at the Treasury Department. Politicos and policy hustlers have a style that differs slightly from Tony’s, but they’re about as sentimental. Secretary Timothy Geithner, not a bad or dishonest person, just a mediocrity who picked the wrong friends and trusted them for too long, can probably hear the rotor blades in the distance. Sadly, the prospective compensation packages for his next career are more modest than they would have been even a year ago…

For the rest of us, the question is who can be the next to take the lead on the national workout. That is probably Sheila Bair, chairman of the Federal Deposit Insurance Corp. But the FDIC needs serious reinforcement of its talent, and a different capital structure, for this to work.

You can pick out the likely geographical spot where the present bail-out wave will recede: 399 Park Avenue, the Citigroup HQ. Already, the Federal Deposit Insurance Corp’s resolution planners are circling the holding company’s shareholders, bondholders, and – at last! – top management.

Even other Tarp financed Wall Streeters are getting tired of the pretence that the Treasury and its advisers are brilliant or that their schemes make sense. Vishwanath Tirupattur, a Morgan Stanley credit strategist, said on a conference call last week that “The policymakers think lack of liquidity and leverage is the main problem…they think prices are depressed more for technical than underlying reasons. There are clearly several asset classes where current prices are better explained by collateral performance.”

“Collateral performance” means that the banking system’s real losses, not temporary mark to market losses, are overwhelming the capital injections finance-able by Federal bail-out appropriations. Congress won’t vote for any more, because they want to safely return home to their districts and maybe get re-elected.

So who’s left? The receivers at the FDIC. They’re sort of like the Internal Revenue Service, though without the Service’s easygoing institutional nature and its agents’ good sense of humour.

When there is a seizure, or “resolution”, of a bank, they take over as owner, guarantee deposits, and fight to take control of any assets. They are not customer-centric, relationship lenders. The FDIC is a corporation owned by the US government, but its costs are paid through levies on member banks.

Before Sheila Bair puts up government buildings colour swatches on the wall of Mr Geithner’s office, though, she will want to decide whether it might make more sense to stay in her current position. Senate confirmation would not be a challenge for her. Maybe, though, having some other punching bag at the Treasury would be better, especially since the FDIC faces staff shortages. Managing that, as well as a leadership transition and a raft of resolutions, would be difficult.

Also, while the Wall Streeters in Mr Geithner’s corner are demoralised enough to be brushed aside, and the big bank shareholders are either playing some derivative arb or totally out of it, the bondholders of the banks aren’t going to run away crying like little girls. Their basic implied threat is to withhold any further capital investment in big banks, which example would be followed by foreigners. That is less scary than it was before Hank Paulson’s crash.

Chris Whalen of Institutional Risk Analytics, which, among other activities, profiles bank credit quality, says “The administration has said that all the senior debt of the banks is money good, but they don’t have the money to back that up. The fight with the bondholders is the political issue we face. Before the end of the second quarter, we have to come to a decision on Citibank. Government cannot write a cheque for $200bn, $300bn or $400bn to bail out the bondholders.” Mr Whalen, a Bair fan, has been right so far in his bearish calls on the bail-out.

Citi might buy some time with writeups on assets formerly marked to market. And even with bank bondholders sliced up and turned into mere stockholders, and with the FDIC backed with a $500bn (£341bn, €377bn) (or bigger) line of credit with the Treasury, a systemic workout will eventually need new law.

The key problem is this: if the cash the FDIC uses for big bank resolutions really is a loan from the Treasury, then it will have to be repaid with a usurious assessment on the rest of the insured banks. That would not leave sufficient operating cash flow, or capital accumulation, for the banks to finance recovery. So the loan must turn into an equity capital contribution from the taxpayers.

However, since the FDIC is owned by the same taxpayers, and insures their deposits, that will be an easier sell than any more capital “investments” in the banks or dealers. Also, FDIC managers have modest houses in the suburbs, and drive minivans rather than limos. Better optics.

johndizaard@hotmail.com"

"But there are lots of other things that credit default swaps are useful for."

Felix Salmon comes to the defense of CDSs. There's something strange about this constant focus on the products, and not on the people:

"John Dizard wants to kill off the entire CDS market. It does no good, he says, and quite a lot of harm, and we'd all be better off without it.

I disagree. Dizard says there are only "three possible defences for treating the CDS market as a going concern"; in fact, there are more than that, and he misses out the big one, which is that the CDS market has allowed investors, for the first time ever, to hedge their credit exposure. Yes, there's a downside to that -- which is that it becomes easier to simply buy credit protection than to do the hard work of fundamental credit analysis. But CDS by their nature are more liquid than bonds, and it will always be easier to buy credit protection than to sell a bond."

I'm not sure why insurance on mortgages and bonds is inherently indefensible. It seems sensible to me. Buying CDSs for other reasons than mimicking bonds bothers me, but only in the sense that I wouldn't personally come near them because they're risky, and more like a bet. All I ask is that buyers be clearly and truthfully explained the risks in buying them. That's it.

"What's more, CDS prices are a much better indication of credit risk than bond spreads are, for many reasons including the tax treatment of bond coupons and the fact that many bonds simply don't trade. In other words, not only are they more liquid, they're also more transparent. These are good things."

This seems true to me in theory, but I'd like to see more information on how these differences work out in practice.

"But Dizard doesn't concentrate on simple things like liquidity and transparency. Instead, he talks about CDS providing "support for capital raising", which was never something it was designed or even really used for. The whole point of credit default swaps is that they're derivatives: they're not cash instruments to be used for raising capital."

This is something I talked about on Derivative Dribble. Some people understand bonds because they're essentially loans for capital, but don't see the sense in investments that look like side bets.

"Dizard does have a good point that as spreads have widened, banks have seen increasing amounts of money tied up in CDS collateral. That's a concern, and it's a good reason to work hard on compression, netting, and rehypothecation. It's not a reason to kill the CDS market outright."

In other words, ways to free capital for other uses. However, I'd worry about this possibly lowering capital on these investments right now.

"Dizard's other big point, however, eludes me:

Price discovery is a useful economic function; that is the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books...
At high levels of default risk and equity volatility, if you hedge the one with the other you get frantic, self-defeating activity.

I'm not sure I understand this, but Dizard seems to be saying that there's a lot of capital-structure arbitrage going on: people hedging equity positions in the CDS market, and vice-versa. That's a strategy which has blown up quite consistently since the summer of 2007, and it tends to require quite a lot of leverage, so I'd be surprised if it was a major factor today. But even if it is, I still don't see why it means the CDS market should be abolished."

I actually don't understand the point at all. It sounds like a weird trading strategy, at best.

"I do understand, however, what Dizard is saying here:

If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.

He's wrong. I just had a long conversation with Kai Gilkes of CreditSights, who confirmed for me that it's pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it's impossible to isolate expected default probabilities. So I don't know what implied default rates Dizard is using, but I do know that they're unreliable to the point of uselessness, since right now CDS spreads tell us precisely nothing about expected default rates.

So yes, if you try to use CDS spreads as a guide to default probabilities, you're not going to get very far. But there are lots of other things that credit default swaps are useful for. So let's not abolish the entire market quite yet."

That's correct. Here's my comment:

Posted: Dec 09 2008 3:30pm ET

I too believe that CDSs can be useful. As to spreads on many bonds right now, the question is whether or not they are moved more by panic than clear analysis of a company's fundamentals. Right now, there's so much uncertainty, that it must contribute as well.

The real question is do you believe that these spreads are accurately predicting default rates, or simply overshooting in our current crisis.

James Grant had a good piece in the FT about default rates recently I believe.

By DonthelibertarianDemocrat

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Felix also posted a couple replies:

"Posted: Dec 09 2008 3:20pm ET

My point is that you need to combine default probabilities with an opaque risk-aversion function to get credit risk prices. We can use CDS prices as a great way of pricing risk. But how much of that is default probabilities and how much is something else, we don't know.

By Felix"

"Posted: Dec 10 2008 09:39am ET

Let me try one more time: the *price* of credit risk is a *very* important number in financial markets, and the CDS market is the best way of discovering it. The implied probability of default, on the other hand, is basically bullshit, and neither the CDS market nor anything else is going to help you very much on that front.

As for Whalen, his numbers make zero sense to me, sorry, and I think the reason that he's unable to explain them in English is that they just make zero sense, period. I do like the way though that when he stuns an audience into silence, he takes their lack of questions as assent.

By Felix"