Investors said they were convinced institutions were reporting incorrect Libor figures to keep from appearing that they were in difficulties

TO BE NOTED: From Bloomberg:

"BBA May Increase Number of Banks in Daily Setting of Libor

By Shannon D. Harrington and Liz Capo McCormick

June 19 (Bloomberg) -- The British Bankers’ Association may expand the pool of banks that set the London interbank offered rate in a bid to bolster confidence in the benchmark for more than $360 trillion of financial products around the world.

Banks without a physical presence in London may apply to join the panel of members that contribute to the Libor-setting process, the BBA said yesterday. Banks will have to be “material participants” in the London market, said the BBA, which a year ago said it would look to expand the panel of contributors and possibly add a second daily survey.

The London-based BBA began a review of the 25-year-old system for setting Libor rates last year amid speculation that some banks may have understated their funding costs to avoid being seen as having difficulty raising financing amid a seizure in the credit markets. The rates banks say they pay for three- month dollar-denominated loans fell to 0.61 percent yesterday, from 4.82 percent on Oct. 10.

“Longer-term this change should create more depth and credibility to Libor,” said George Goncalves, chief fixed- income rates strategist at Cantor Fitzgerald LP, one of 17 primary dealers that trade with the Federal Reserve. “More people will trust it. Shorter-term it creates uncertainty in the process and that is what feeds into more volatility, and possibly an uptick in Libor.”

Gaining Attention

Libor, a benchmark rate for everything from mortgages to corporate borrowing costs, gained attention in August 2007 as losses from subprime-contaminated securities made banks wary of lending to each other.

Investors said they were convinced institutions were reporting incorrect Libor figures to keep from appearing that they were in difficulties. The BBA threatened to ban members that deliberately understated rates before beginning a consultation process to discuss improvements.

“The more names you add to the survey the more you dampen the volatility of the results and that’s a good thing,” said Chris Ahrens, Stamford, Connecticut-based head of interest-rate strategy at primary dealer UBS Securities LLC. “But we need to see” which banks join the survey, he said.

The BBA, which isn’t regulated, asks member banks once a day how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages and publishes them before noon in London. Sixteen banks contribute to the dollar setting, three of which are U.S.-based.

BBA Clarification

“This clarification will not affect the way in which current contributors formulate their rate submissions,” Brian Mairs, a spokesman for the BBA in London, said by e-mail. “It may allow banks that participate in the London markets, whose eligibility for inclusion in the fixing was not previously clear, to apply to join the panels.”

The BBA has “no expectation of the numbers of banks who might apply,” Mairs said. The BBA said it will make a further statement today, he said.

“Most of the banks that are in the panel would tell you that right now it’s not necessarily worth the trouble,” said Carl Lantz, an interest-rate strategist in New York at primary dealer Credit Suisse Securities LLC. “It just brings scrutiny on you. If you put in a high fixing people are saying you’re having problems. If you put in a low fixing people are saying that you’re trying to distort the fixing.”

The BBA first said in June 2008 that it may increase the number of banks that set the rates and was considering the addition of a second daily survey to reflect U.S. trading. London-based ICAP Plc, the biggest broker of transactions between lenders, introduced a new measure of U.S. bank rates last year as an alternative to Libor.

“One can always argue that you’ll get a better fix if you have a larger sample of relative players in the market,” said Laurence Meyer, vice-chairman of Macroeconomic Advisers LLC and a former Fed governor. “There was the somewhat discrediting of Libor earlier and some even suggested that we get a New York sample. This sort of pre-empts something like that.”

To contact the reporters on this story: Shannon Harrington in New York at sharrington6@bloomberg.net; Liz Capo McCormick in New York at emccormick7@bloomberg.net."

It’s worth remembering that these are the only two US financial institutions where senior lenders took a haircut

From Reuters:

"Felix Salmon

is summer arriving?

« Previous Post

May 26th, 2009

Revisiting WaMu

Post a comment (2)

Posted by: Felix Salmon

Tags: banking, regulation

JP Morgan, having lopped $29.4 billion off the value of WaMu’s loans when it took over the troubled lender, now reckons it’s going to get the lion’s share of that money back:

When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

WaMu failed in the middle of the sleepless craziness following the Lehman collapse, and in hindsight might well have been at least as much of a factor in the scary gapping-out of Libor as Lehman was. It’s worth remembering that these are the only two US financial institutions where senior lenders took a haircut — and in both cases the senior lenders were pretty much wiped out. In other bank failures, even the junior lenders generally emerged unscathed.

It increasingly seems as though a panicked FDIC thrust WaMu into the arms of Jamie Dimon, who could — and did — ask for pretty much anything he liked, including the right not to have to pay back any of WaMu’s creditors. The result was that the bank wholesale-funding market went straight into crisis: one sui generis default (Lehman) might have been navigable, but when you have two in as many weeks, it’s pretty clear which way the wind is blowing.

We’ve had endless rehashings of the weekends leading to the Bear Stearns and Lehman Brothers failures, but I’ve seen much less on the subject of WaMu, which is equally if not more fascinating and just as systemically important. The news out of JP Morgan that it massively undervalued WaMu’s loan books certainly seems to indicate that the likes of John Hempton have a point when they say that Sheila Bair got this particular decision spectacularly wrong, and in doing so put the entire US retail banking system on a much more fragile footing than was necessary.

Bair also took a relatively consumer-friendly bank (WaMu) and forced it to adopt the practices of a relatively consumer-unfriendly bank (Chase) — with predictable results: Chase is now telling former WaMu customers that even if they have directed the bank not to let their accounts go overdrawn, the bank can still push the account into overdrawn territory anyway, and, of course, “will assess an Insufficient Funds Fee” for doing so.

It’s clear that the big winner here is JP Morgan, but the rest of us — taxpayers, WaMu account holders, WaMu creditors — increasingly look like very big losers."

Me:

I agree that the WaMu seizure and sale was a mistake, but I think that it follows from Lehman. Now being quite aware that mergers were the only option for large banks and financial entities, they didn’t want to wait and chance a Lehman like situation, where the B of A and Barclays deals didn’t work out. So, they proactively seized and merged, scaring the hell out of bondholders and creditors.

Oddly, Lehman had scared investors that the government wasn’t guaranteeing the unwind. Now, WaMu scared investors that, even if the government got involved, they were in for a hellish ride of possible losses.

Of course, if you believe as I do, that the government needed to guarantee everything right off, like Geithner, then both of these actions are terrible mistakes.However, in both cases, Lehman and WaMu, I can understand why the government acted as it did. Too bad that’s not going to stop them from looking like idiots in the history books, because a good plot needs dunces by which to measure the ultimate heroes intellect.

- Posted by Don the libertarian Democrat

To get a run out of bonds into hard assets, first people must want to own hard assets rather than locked-in cash flows

TO BE NOTED: From Inner Workings:

"How serious was yeseterday’s Treasury auction? May 8th, 2009
By David Goldman

A prominent economist writes today that he has taken his personal money out of dollars and put it into Australian and Canadian dollars, the commodity currencies. The sloppy 30-year auction today, he believes, is a true crack in the dam.

I am less certain: my core view is that America will undergo something closer to the Japanese scenario, in which economic growth stays extremely low, asset price deflation does not reverse, short-term rates stay close to zero, savings rates remain elevated, and bond yields stay low. All that has happened since March is that the end-of-the-world premium has been taken out of the Treasury market.

Remember that credit protection on the United State of America reached 75 basis points in early March — that’s where protection on Brazil was trading pre-crisis. It’s now down to “only” 35 basis points, given the success of the Fed’s and Treasury’s efforts to refloat bank equity with a few trillions of dollars of liquidity.

What the Federal Reserve and Treasury have set in motion is the mother of all crowdings-out. The Fed is compelled to buy substantial amounts of Treasuries to prevent the federal deficit from turning into a $1.8 trillion black hole that sucks in all the free savings of the world and then sum. The moment that yields start to rise, the stock market reacts negatively. There is no “give” in the economy for any substantial rise in yields: the penalty to growth expectations is exacted immediately.

By ballooning the deficit and tying the credit of the United States to the balance sheet of the banking system, the Fed has avoided panic, but has crippled the economy for the long term. There is no way to finance the deficit except by suppressing financing for everyone else. The massive amount of liquidity created by the Fed has no inflationary effect as long as the market does not wan to hold real assets — and it will not as long as the federal government sucks up the available savings. The most like scenario is a paralytic, zombie-like stasis.

The major commodity indices still remain close to their lows with an modest uptick reflecting the mildest hopes for recovery.

Red=UBS, Yellow=GSCI, Green=CRB, Blue=ROgers

source: Bloomberg

To get a run out of bonds into hard assets, first people must want to own hard assets rather than locked-in cash flows. I just don’t see it for the next couple of years.

Tags: fEDTR"

And:

"Addendum on the Treasury auction: Sovereign credit continues to improve May 8th, 2009
By David Goldman

Credit protection on the US sovereign continues to improve in tandem with the banks. We had been out to +75; now we are back to LIBOR +27 for five-year credit protection on the US sovereign.

The risk to the credit of the US Treasury comes from the link to the banking system, and as long as the frame holds (and the Fed doesn’t have to take hundreds of billions of dollars of losses on its multi-trillion-dolalr portfolio, all will appear well. All isn’t well, to be sure; since Alexander Hamilton funded the public debt in the 1790s has the credit of the US been at this kind of risk. But the frame is likely to hold, which means that the credit of the US will hold, along with the Treasury market.

From Markit Partners:

G7 Industrialised Countries CDS

Ticker CLIP Name 5Y Today Daily Chg (bp) Weekly Chg (bp) 28 Day Chg (bp) USGB 9A3AAA Utd Sts Amer 27 -8 -9 -20 JAPAN 4B818G Japan 57 -10 -13 -21 DBR 3AB549 Fed Rep Germany 25 -9 -13 -19 UKIN 9A17DE Utd Kdom Gt Britn & Nthn Irlnd 71 -11 -26 -23 FRTR 3I68EE French Rep 27 -8 -16 -19 ITALY 4AB951 Rep Italy 78 -13 -29 -41

I am sticking to my story: stocks will chop sideways forever

TO BE NOTED: From Inner Workings:

"US Credit Protection at “Only” 44 bps May 5th, 2009
By David Goldman

Now it costs only LIBOR +44 bps to buy credit protection for five years against a default by the United States of America. That’s slightly more than half of the peak level of March, when the prospective collapse of the banking system persuaded the market that the US Treasury and Fed might go down with the banking system.

It’s hard to be angry at Ben Bernanke for diving into the water to rescue the US economy when it seemed to be drowning. The Fed extended nearly $4 trillion of its balance sheet to buy dicey mortgage and credit risks, and kept the financial system afloat. By shoving mortgage money into the banking system it helped established a minimum bid for depreciated houses. On the other hand, it is now joined at the hip to a zombie banking system. That’s why the credit of the United States of America fluctuates with bank stocks, a phenomenon few of us could have imagined only a year ago.

What we have in response is neither a bull market, nor a bear market rally, but exactly the opposite: it is nothing in particular. The US economy has nowhere to go. The Fed will not let the financial system dissolve. It is in too far already. It has to keep throwing good money after bad because the weight of the Fed’s balance sheet will drag it down if the rest of the system goes. But the ever-present demand for savings by aging boomers, the depressant wealth effect, and the zombie character of the financial system all militate against a real recovery.

I am sticking to my story: stocks will chop sideways forever, as I wrote on Jan. 8 when the S&P was exactly where it is now. I didn’t believe the crash, and I don’t believe in the upside. What I expect to continue is the volatility implosion.

I expect VIX to settle down into the high ’20s during the next several weeks. Zombies aren’t volatile.

The collapse of volatility is most noticeable in the most volatile stocks, e.g., Citigroup;

The above chart from ivolatility.com shows the plunge in implied volatility on C by roughly half.

For those unclear about how to trade volatility under these circumstances, this instructional video is recommended."

All of these indicators are still too high, but there has been progress.

TO BE NOTED: From Calculated Risk:

"Credit Crisis Indicators

by CalculatedRisk on 5/03/2009 03:53:00 PM

It has been some time, so here is a look at few credit indicators:

First, the British Bankers' Association reported Friday that the three-month dollar Libor rates were fixed at 1.007%. The LIBOR was at 1.30% a few weeks ago, and peaked at 4.81875% on Oct 10, 2008. The dollar LIBOR might break below 1.0% this week.

Click on graph for larger image in new window.

There has been improvement in the A2P2 spread. This has declined to 0.56. This is far below the record (for this cycle) of 5.86 after Thanksgiving, but still above the normal spread.

This is the spread between high and low quality 30 day nonfinancial commercial paper.

Meanwhile the TED spread has decreased further over the last week, and is now at 86.39. This is the difference between the interbank rate for three month loans and the three month Treasury. The peak was 463 on Oct 10th and a normal spread is around 50 bps.

The third graph shows the spread between 30 year Moody's Aaa and Baa rated bonds and the 30 year treasury.

The spread has decreased sharply over the last couple of weeks. The spreads are still very high, especially for lower rated paper.

The Moody's data is from the St. Louis Fed:

Moody's tries to include bonds with remaining maturities as close as possible to 30 years. Moody's drops bonds if the remaining life falls below 20 years, if the bond is susceptible to redemption, or if the rating changes.

This graph shows the at the Merrill Lynch Corporate Master Index OAS (Option adjusted spread) for the last 2 years.

This is a broad index of investment grade corporate debt:

The Merrill Lynch US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.

Back in early March, Warren Buffett mentioned that credit conditions were tightening again - and this was probably one of the indexes he was looking at. Since March, the index has declined.

All of these indicators are still too high, but there has been progress.

Posted by CalculatedRisk "

double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other

TO BE NOTED: From The Growth Blog:

"The Financial and Economic Crisis and the Developing World: Where We Are and Where We Are Going

By Michael Spence

Created 04/14/2009 - 16:46

The financial system in the USA and much of Europe had a heart attack in September 2008. As in the case of a real heart attack, the highest priority has gone to the emergency response and to stabilizing the patient. Once that is done and the crisis is abating and even to some extent as it is going on, it will be important (economically and politically) for some to focus on two related issues: What created the rising risk of an attack? And what combination of actions post-crisis will reduce the risk of a repeat in the future.

There are related issues. Are there lessons in the current crisis (and past ones) or is each one sufficiently idiosyncratic so that reregulating with reference to the past does little to limit the potential future damage. Globally, what is the appropriate tradeoff between risk reduction on the one hand and higher costs of capital and lower growth on the other? Is the financial sector different from most others in that when it malfunctions, the rest of the economy malfunctions along with it, and if so should it be treated differently? Will investors learn from this crisis to a point that much of the “re-regulation” will come from adjusted investor behavior and risk assessment procedures? Or are there inherently large divergences between private and social objectives that need to be aligned through regulatory and oversight structures? Are the answers the same for domestic economies and financial systems and for the global aggregate, or are they fundamentally different?

In climate change there are issues of mitigation (prevention or risk reduction) and adaptation. Good policy is a mix of the two. Corner solutions are unlikely to be the right answer. A similar issue arises in the present case. Whether or not regulation and oversight are adequate depends upon the risks and the consequences of financial instability and distress and the latter depends on the existence and effectiveness of response mechanisms. We will need to talk about both in a coordinated way.

The Crisis of September 2008

Credit locked up, interbank lending stopped, and the payments systems' started to malfunction in the US and much of Europe. The TED spread (The interest rate differential between t-bill rates and LIBOR) and related measures of risk at the heart of the financial, payments and credit system rose from its normal 100 basis points to between 4 and 5 hundred basis points. Asset prices declined rapidly, balance sheets in the financial sector further deteriorated and the household sector experienced a massive wealth loss, triggering a reduction in consumption. The double downward spiral involving the financial sector and balance sheets and asset prices on the one hand and the real economy on the other accelerated and has only recently shown evidence of deceleration.

The financial crisis quickly became an economic problem and then a crisis. Asset price declines (equities globally lost $25-30 trillion or more in a four month period) and very tight credit caused investors and consumers to become extremely cautious, causing consumption to fall and the real economy to turn downward. There was no near-term bottom and few brakes to slow the downward momentum.

A complete credit lock-up (and a depression-like scenario in which businesses that rely on credit simply fail) was averted through rapid action by central banks using a growing variety of programs to increase liquidity or directly supply credit, thereby circumventing the normal channels that were damaged and not functioning. The balance sheet of the Fed more than doubled in size from less than a trillion to more than two trillion and with recent commitments is on its way to 3 trillion dollars.

There were two further issues of central importance. First, the markets in a variety of securitized assets stopped functioning. The shadow banking system through which a substantial portion of credit is provided in the US, froze up. Second, because of a combination of leverage and damaged assets, there was and is a potentially large solvency problem in a significant number of large and systemically important institutions. The solvency and related transparency issues continue to be with us today.

The effects on the developing world were immediately felt, though the awareness of the magnitude increased over time. The two important channels were aggregate demand (globally), and the availability and cost of credit and financing. A third channel, rapid shifts in relative prices apart from credit spreads, were important but on balance beneficial.

The financial channel was dramatic. Credit tightened pretty much instantly in the developing world as capital either rushed back to the advanced countries or stopped flowing out, to deal with damaged balance sheets and capital adequacy problems in the advanced countries. The currencies of all major developing countries except for China depreciated against the dollar. Developing countries with reserves used them to stabilize the net capital flows and to partially restore credit and financing. Trade financing dried up and other capital flows diminished or disappeared. The IMF intervened in several cases while financing and bilateral swap arrangements of a variety of kinds were made by the US and China. Credit remains tight and high priced and there is a continuing need for additional financing on a broad front. The IMF did not have the resources in the fall of 2008. Expanding those resources significantly was part of the G20 agenda. At the G20 summit in early April, an important commitment was made to expand IMF resources by over $1 trillion to restore the availability of trade and other forms of finance on an interim basis to developing countries that need it.

The second channel was aggregate demand and trade. As aggregate demand in the advanced countries dropped for the aforementioned reasons, global aggregate demand fell and with it trade: exports and imports. The trade data show a stunning drop in exports, considerably more than in aggregate demand. In many developing countries that rely on external demand and exports as an engine of growth, the immediate negative effect was lower growth, reduced employment and reduced consumption triggering the usual domestic recessionary dynamics.

Globally, the intent is to counter this loss of aggregate demand with coordinated fiscal stimulus programs in the advanced countries and in developing countries to the extent it can be done without jeopardizing fiscal sustainability. The latter capacity varies considerably across countries. There is dissension in the G20 as to what the right order of magnitude is. There are also issues of free riding and protectionism. It is understandable that citizens in various countries facing fiscal deficits and large future debt service obligations prefer to have the benefits of a stimulus program land domestically.

I have described this incentive structure elsewhere as akin to a prisoner’s dilemma with the non-cooperative dominant strategies being either stimulus with some protectionism or free-riding depending on the size and openness of the economy. One can think of that portion of the G20 effort, the part devoted to openness, as attempting to shift policies away from the non-cooperative Nash equilibrium. Evidently, from data on increases in protectionist measures, this will be only partially successful, but partial success is probably much better than no effort at all. Realistically we may not have the option of choosing the first best, coordinated stimulus with openness, but rather have to be satisfied with an effort at coordinated stimulus with some protectionism, as opposed to openness with feeble stimulus commitments.

More generally there is confusion and disagreement about the role of government in the context of a crisis. I have written at somewhat great length about this issue here [1]. This disagreement complicates the politics of timely and effective intervention and has to be factored into the risk assessments for policy makers and private investors and consumers alike. One thing is clear. Government has become a major player in the financial system and the economy. In the financial system it has morphed from regulator to regulator and participant. Predictability of government action has therefore become a major determinant of risk.

The third channel was relative price changes. The dramatic spike in commodity prices (especially food and energy) was reversed. This ameliorated a twin challenge in most developing countries of dealing with the impact of the commodity price spike on the poor and on inflation. Beyond that, at the country level, those who have gained and lost depends on whether a particular country is a net importer or exporter of commodities.

The commodity price spike and fall brought into focus an important policy issue. Large relative price swings have very important distributional consequences across countries and across subsets of the population within countries. These need to be addressed as part of creating a better managed and more stable global economic system that people will support. [for further reference, see part IV of the Commission on Growth and Development: The Growth Report [2]].

Where Are We Now?

On the real economy side, in the advanced countries and globally, growth has gone negative or slowed dramatically. Global growth is projected to be negative in 2009 for the first time since World War II. Trade has collapsed. While there are some signs that the downward momentum may be slowing, the real economies have not bottomed out and are unlikely to do so in 2009 and perhaps well into 2010.

The advanced countries financial systems have shown some recent signs of improvement, though they are still functioning on life support. There are signs that credit is easing and risk spreads are declining somewhat from very high levels. But that is certainly because the government and central banks have a major and expanding role in the financial system. It is too early to say that the system is starting to return to normal. In the US, the Fed and the Treasury have launched a series of initiatives designed to restart the markets in securitized assets, clarify values, remove the transparency fog surrounding the balance sheets of major financial institutions, and as necessary recapitalize banks and other systemically important institutions, probably by becoming a major (or the sole) owner of some of them. Progress on this front from a policy point of view is relatively recent and it is too early to tell the extent to which they will be sufficient to jump start the sequential healing process and a return to normal functioning.

The US savings rate is rising, a part of the disorderly unwinding of global imbalances. Asset prices remain volatile and it is too early to tell if they have stabilized. It is clear however, that the financial system and the real economy will not return to their previous configurations. Even absent major and likely changes in regulation and oversight, there will be a “new normal”. Global growth in the future will be driven by a different portfolio of saving and investment rates and levels across countries.

The Growth Commission Workshop Meeting And Supplementary Report On The Financial And Economic Crisis

The Commission on Growth and Development is meeting one more time in late April in conjunction with a two day workshop, to consider issues related to the financial and economic crisis and its aftermath. The intent is to produce a special report, additional to the Commission report [3] which came out in May 2008. This special report will likely deal with three broad sets of issues.

One set has to do with post-crisis, the challenge of creating more effective regulatory and oversight structures (domestically and internationally) that reduce the risk of instability and the likelihood that the instability spreads quickly to the entire global system. A second set of issues has to do with crisis response. Are there ways when instability and malfunction occur, to limit the damage and disrupt the transmission channels? Further, can some of this capability be created in advance so that it can be deployed quickly? There is obviously a third issue: are the conditions needed to bring the patient back to health and prosperity being met? And if not, what else do we need to do?

The Commission anticipates that there will be a process overseen by the G20 designed to develop proposals for a different global financial architecture, regulatory and oversight structure. Our intention is to have the augmented Commission report contribute to that process with particular attention to the needs and interests of developing countries, some of whom are represented in the G20 itself and most of whom are not.

As we approach the workshop and the Commission meeting and discussion of these issues, we invite broader comment, input and discussion on the BLOG.

Like many members of the Commission and participants in the workshop, I have been thinking and writing about the financial and economic crisis under the headings of causes, crisis dynamics and policy responses, and post crisis reform. A link to my articles will be published on this blog, and I look forward to your comments."

Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank

TO BE NOTED: From Accrued Interest:

"Muni Swaps: Let's hope we don't have a burnout

Regular reader and sometimes commenter Gingcorp asked me to comment on this article in the New York Times about some, shall we say, questionable practices at Morgan Keegan's muni department.

I happen to know a fair amount about the problem of swapped muni VRDB's as I had a two clients threatened by similar circumstances. Unfortunately, the NYT article makes it sound like the municipalities were betting on interest rates which simply isn't the case. So I feel compelled to tell the world what's really going on here. Bear in mind that I can't speak to the situation in Tennessee specifically, because every situation can be a little different, but this should give you the general picture.

First, let's say its five years ago and you are one of these poor unsuspecting municipal authorities. Let's assume you are the authority who manages the local airport, the Bumpkin Airport Authority. You'd like to issue debt, and like any responsible financial steward, you want to minimize your interest cost.

Your banker suggests that a variable rate bond would lower your expected interest cost, because demand for short-term bonds is extremely strong. In 2004, the typical rate on variable rate muni debt (either auction rate or VRDN) was around 1.5%. (There are some additional fees involved, which we'll get to in a minute.)

First, a quick lesson on muni variable rate bonds. In a VRDN, the investor has the option to "put" the bond back to the municipality on any interest rate reset date, usually every 7 days, at par value. With an auction rate, investors can choose to "sell" at any auction, assuming the auction doesn't fail. Remember that until 2007, auctions almost never failed, so this wasn't seen as a big risk.

In both cases, the interest rate isn't based on some reference index, like LIBOR, but whatever interest rate clears the market.

But you, as the municipal airport authority, aren't interested in taking variable interest rate risk, as you don't have any natural variable rate assets. You'd rather lock in a certain interest rate today and have a known cost for whatever you are selling the debt to construct.

Your friendly banker has a solution. Sell the debt variable rate, and at the same time enter into a pay fixed, received floating swap. On its face, this can hardly be called creative finance. Its really finance 101. You have a floating liability, you want a fixed liability, just enter into a swap. Simple.

The Sith Lord was in the details. First of all, in order to do a VRDN, you needed to get a letter of credit from a bank. See, investors needed to know that the municipality had the cash to fund that put option I described above. The bank LOC allowed for that. So let's say the bank was charging 0.25% for the LOC. In the case of an airport authority, the bank would probably require that the municipality also buy a monoline insurance (e.g. Ambac) policy to protect the bank in the event the municipality defaults and the bank gets hit with a wave of puts. Let's say that costs about 0.10%.

But even in the face of those extra fees, the issue floating/swap to fixed still saves you a lot of money, because the fixed side of the swap is actually below where you could sell fixed rate debt. Everything is peachy.

The only remaining hitch is that, as I said above, muni VRDNs don't reset based on a specific index, but on whatever rate clears the market. This left the possibility that issuer A might pay a slightly higher rater than issuer B one week, but then issuer B would be higher the next week. Not because of anything about the issuers themselves, but just because of random variations in supply and demand at any point in time.

Unfortunately, the floating side of the swap had to be based on some predetermined index. Bankers usually picked one of two options. Either the SIFMA index, which is a published index of muni VRDN rates. Or they used 67% of LIBOR. E.g., if 1-week LIBOR was 3%, the the swap rate would be 2%. The 67% number was intended to reflect the typical gap between taxable and tax-exempt money market instruments. I believe the LIBOR version was more popular than the SIFMA version, and I have also heard swaps struck at 80% of LIBOR.

Right there was the red flag. What happens if the VRDN rate set by market forces isn't equal to the 67% of LIBOR level? This is known as basis risk, and it did happen under normal times. But it was always short lived. For example VRDN rates always rose during times when retail investors were pulling money out of muni money market funds, such as tax time. But those periods of elevated rates was always short-lived. The huge savings from the synthetic fixed rate structure overwhelmed these short-term costs.

Let's go back to the bank providing the LOC. Remember they required you to have a monoline insurance policy from Ambac to protect themselves. The actual legal language probably says something to the effect of...

"ABC Bank requires that Bumpkin Airport Authority acquire an insurance policy from a monoline insurer rated in the top ratings category from Standard & Poors and Moody's Investor Service. Should the authority be unable to acquire such a policy or should the monoline insurer be downgraded below Baa3/BBB- ABC Bank may withdraw the letter of credit."

Of course, don't need to worry about Ambac being downgraded right? Er... From the investor's perspective, you didn't wait around for Ambac to actually be downgraded. You were allowed to put these bonds back to the issuer at par! You hit that bid as hard as you could as fast as you could.

So now what happens? Remember that the interest rate that the Bumpkin Airport Authority actually pays is set by supply and demand. Now that the LOC is threatened, there is no demand, all supply. In order to actually entice some buyers, they had to set the rate at 7%, 8%, 9%, etc. Note that these weren't the failing auction rate bonds we heard so much about, although a similar story would apply have Bumpkin decided to go ARS.

Now Bumpkin is paying 9% on their VRDN, while the floating end of the swap is only paying you 67% of LIBOR, currently a glorious 0.25%. On top of the 9% you are paying investors, you are also paying your swap provider whatever the fixed leg of the swap is, probably something in the 4% area. Ugly.

But wait... it get worse. The interest rates are actually set by some dealer, called the remarketing agent. In normal times, the dealers would set the rate at something reasonable, and if they couldn't sell all their bonds right away, they'd just inventory them. So if it happened to be that a big holder of the Bumpkin Airport bonds wanted to put their bonds back on a given day, it was no big deal. The investment bank was willing to just hold the bonds waiting for the right investor to come along. It was considered a good use of balance sheet because it justified the remarketing fees the bank was collecting.

Once dealer balance sheets became crunched, nicities like this went right out the window. Instead of holding the unsold inventory, the dealers were exercising their rights to push bonds they couldn't remarket back to the LOC bank. These then because so-called bank bonds, and Bumpkin was charged some pre-determined rate on these, I think it was set off Prime.

But wait... it gets worse. Remember that the swap was intended to be a hedge against rising interest rates. It is therefore effectively a short position on long-term fixed rate bonds. In fact, long-term bonds have skyrocketed in value. Thus your swap is getting crushed. A 30-year swap struck on January 1, 2008 for $10 million notional value would currently be down $3 million in market value. Put another way, if you want out of this swap, you need to pay the investment bank $3 million.

Had the swap remained an effective hedge, this wouldn't be a problem, because Bumpkin Airport would be saving an equivalent amount of money on plummeting short-term rates. But in fact, Bumpkin is paying a usurious 9%.

So the VRDN itself is killing you. The swap is killing you. Basically, you're dead unless something changes.

What most municipalities did was refinance the Ambac-backed deal with a new VRDN without that stipulation. Except for a brief period in September and October 2008, the VRDN market has been pretty healthy. So once you refinance the VRDN, then the swap goes back to being a decent hedge. Everything works out just fine.

But even if you do a new VRDN deal, you still need a LOC from a bank. Guess what? Banks aren't so keen on tieing up their capital to make 25bps on muni LOCs. Instead, they've been picking carefully who they deal with, and charging a lot more to do it.

Even if the municipality can restructure, it isn't out of the woods entirely. If the swap is deeply underwater in nominal market value, the municipality probably has to post additional collateral. Think of it similar to margin posting on a futures contract. In some cases, this is no big deal, because the municipality has a decent sized general fund and simply must set aside certain securities as collateral. But in other cases, the municipality has little safety net. In fact, its more likely an issuer like Bumpkin Airport Authority has a sizeable investment portfolio compared with some county or school district which collects taxes directly. A lot of times, issuers with full taxing authority keep less in general funds. Politically, if the voters see that their county has a big investment balance they start wondering why tax rates aren't being lowered and/or why the money isn't being spent on new projects. An issuer with more volatile revenue, like a airport, toll road, hospital, etc., is more likely to build a reserve. It tends to be less politically sensitive if there aren't any direct taxes involved.

If you are an investor in munis, the best thing to do is hunt down how much VRDN exposure your bond issuers have, whether they have any monoline contracts attached, and what their plan for dealing with both is. You will probably find that you have nothing to worry about, but if you are sloppy, you could wind up with the next Jefferson County."

saying its members “strongly believe” that TALF loans should be at least five years.

TO BE NOTED: From Bloomberg:

"Fed Said to Weigh Charging Higher Rates for Longer TALF Loans

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By Scott Lanman

April 7 (Bloomberg) -- The Federal Reserve may offer investors longer-term loans at higher interest rates to buy commercial mortgage-backed securities, aiming to protect the central bank’s balance sheet while acceding to an industry plea.

Lobbyists in the commercial mortgage-backed securities industry say the Fed needs to provide loans of at least five years, rather than the current three-year limit, to avert a meltdown in the market. Fed officials, wary of granting the request outright, are considering a compromise in altering terms of its $1 trillion emergency-lending program.

Fed policy makers are wary of loosening limits on the Term Asset-Backed Securities Loan Facility because longer loans would make it more difficult to tighten credit when inflation picks up. At the same time, rejecting the industry’s request may further stymie the TALF after a slow start that’s hindering Chairman Ben S. Bernanke’s efforts to revive the economy.

Charging higher rates for longer terms, “as a compromise, seems like it meets the needs of both sides,” said Louis Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. “It’s the certainty of the funding, and providing certainty goes a long way to address those concerns.”

Today, the Fed received applications to borrow $1.7 billion in the TALF’s second monthly round, down 64 percent from $4.7 billion in March. Hedge funds and other investors are balking because of visa limits on workers and possible efforts to tax earnings, undermining Bernanke’s attempt to further drive down borrowing costs.

TALF Expansion

The Fed started the TALF last month, lending to investors purchasing securities backed by auto, credit-card, education and small-business loans. In coming months, the program will expand to include securities backed by commercial real-estate loans.

“We have been advocating strongly for a term of at least five years,” said Christopher Hoeffel, president of the Commercial Mortgage Securities Association, a trade group. “The most important thing is the term of the loan. If the cost of the financing and the equity requirement increased with the length of the loan, that would be a workable solution.”

Investor participation would be curtailed by a loan term of less than five years, said Hoeffel, who is also a managing director at Investcorp.

Fed officials are still devising terms for the expanded facility, which may reach $1 trillion. No decisions have been reached yet on the loan length. Sales of CMBS plummeted to $12.2 billion last year from a record $237 billion in 2007, according to estimates by JPMorgan Chase & Co.

Risk of Default

That raises the risk of increasing defaults on commercial mortgages, making it tougher for borrowers to refinance maturing debt and avoid delinquency or foreclosure, industry officials say.

Charging higher fees after three years would be a compromise aimed at giving more incentive for investors to borrow from the Fed and helping restart markets for commercial mortgage-backed securities, while protecting the Fed’s flexibility to raise interest rates in the broader economy once consumer demand recovers.

The Fed normally raises the benchmark federal funds rate by selling Treasuries on its balance sheet, draining reserves from the banking system. That task is tougher with the Fed’s commitment last month to buy more than $1 trillion in mortgage- backed securities, which are harder to sell quickly without roiling markets or potentially attracting political scrutiny. TALF loans in particular would be difficult for the Fed to move.

Loan Rates

Investors can take out a fixed-rate TALF loan to buy newly issued auto-loan securities at the one-month London interbank offered rate, or Libor, plus 1 percentage point. For today’s loan applications, that comes to 2.87 percent, the Fed said.

One potential solution under consideration would be to increase the spread over Libor to, for example, 200 basis points after three years and 300 basis points after the fourth year. The thinking is that rates for private-market financing would decline enough in the next three years to make Fed loans too pricey for investors to keep.

Commercial Mortgage Securities Association officials said last month that the government’s effort to boost bids for the commercial-mortgage bonds may fail unless the length of TALF financing is increased.

The group posted on its Web site a summary of recommendations dated March 25, saying its members “strongly believe” that TALF loans should be at least five years."

He met the mathematicians at the heart of the City - and found out why some say they are to blame for the financial crisis.

Via Alea, another excellent BBC post:

"The maths of the credit crunch

More or Less BBC Radio 4 and iPlayer Subscribe to the podcast

As the downturn takes hold, BBC Radio 4's More or Less programme looks at the maths behind the credit crunch.

Since 2007, presenter and economist Tim Harford( HE'S VERY GOOD IN THE FT ) has been exploring and explaining the numbers which have contributed to - and have characterised - the global economic downturn.

He met the mathematicians at the heart of the City - and found out why some say they are to blame for the financial crisis.

He uncovered the flaws of the bankers' bonus system, and discovered a mathematical error which might have led the banks into trouble.

He interviewed quantitative finance expert Paul Willmott and The Financial Times journalist Gillian Tett.

And he met the guardians of what could be the financial world's most important number.

You can listen to all of Tim's reports here.

PAUL WILMOTT, QUANTITATIVE FINANCE EXPERT

Paul Wilmott is a lecturer in financial mathematics and runs the profession's most popular website. ( HE'S TERRIFIC )

He is a fan of quantitative finance( AS AM I ) - but he thinks that its misuse( YES ) has played a part in creating the current banking crisis.

In November 2007, More or Less asked whether the financial mathematicians known as "quants" - short for quantitative analysts - were to blame for what was then being termed "the credit squeeze".

WHO ARE THE QUANTS?

Paul Wilmott discussed his concerns with Professor William Perraudin of the Tanaka Business School at Imperial College London.

Tim Harford chaired the discussion.

The risks of risk management

In December 2008, Tim invited Paul Wilmott back to talk about the problems in more detail.

Banks and hedge funds rely on highly-paid mathematicians and economists - "quants" - to evaluate risk.

So why did they not they see the credit crunch coming?

Paul Wilmott says some mathematicians have a tendency to get fixated on the numbers, failing to think about the big picture.

RISKY RISK MANAGEMENT

He posed a scenario.

Imagine you are at a magic show. The magician takes an ordinary pack of 52 playing cards, and gives it to a man in the audience to shuffle. He then asks a volunteer to think of a card. "The ace of spades," she replies.

The magician turns to the man with the pack of cards and removes a single card from the deck. What is the probability that the card is the ace of spaces?

To hear the answer listen to the interview, or read Paul Wilmott's article on the risks of risk management.

A fundamental mathematical error

Paul Wilmott says an additional cause of the credit crunch is that people simply got their sums wrong.

GETTING THE SUMS WRONG

He told More or Less these errors might have contributed to the mispricing of financial derivatives, and thus to the travails of the banks, the credit crunch, and the economic downturn.

The maths of the bonus system

Many traders were paid bonuses if they made money.

And yet, collectively, their trades bankrupted some banks and nearly bankrupted many more.

THE TRADER'S DILEMMA

Why did traders, paid for performance, all make the same mistake at the same time?

Paul Wilmott set out the trader's dilemma.

AT HOME WITH THE QUANTS

In October 2007, Tim Harford got a glimpse into the world of the quants.

The most successful of these talented mathematicians will come up with mathematical formulae that make them and their bank or hedge fund employers millions of pounds per year.

They are highly secretive about their work, not wanting others to know the details of their systems.

MEET THE QUANTS

But one of them, William Hooper, invited Tim Harford into his beautiful London home.

Read more about quantitative analysts

A trader's apology

William Hooper has since left the world of finance to start his own business.

He has been reflecting on the global economic problems and the question of who is to blame - read A trader's apology.

GILLIAN TETT, THE FINANCIAL TIMES

Gillian Tett is an assistant editor of the Financial Times and oversees the global coverage of the financial markets.( SHE'S VERY GOOD )

Five years ago, she was shocked to discover what she says could best be described as an iceberg in the middle of the City.

The role of the media

She was studying media coverage of the City and began to realise journalists were doing lots of stories on stocks and shares, mergers and acquisitions, but nothing on what had become a much bigger part of finance - the credit and derivative markets.

She says business journalists were simply not covering the City in a representative way.

THE FINANCIAL ICEBERG

You had a small part of the financial system bobbing above the water but a vast shadowy mass of activity pretty much hidden beneath the waves.

And hidden not just from ordinary people, but hidden from politicians, from many regulators, and unfortunately from much of the media too.

UNDERSTANDING LIBOR

The London Interbank Offered Rate - LIBOR - has been dubbed the financial world's most important number.

Published each day in the UK, it is the rate at which the banks lend to each other and it influences over $150 trillion (£100 trillion) of funds worldwide.

The Libor number is compiled by putting together the estimates of the cost of borrowing from at least eight banks, and then discarding the highest and lowest of the sample to leave an average rate which then becomes the daily 'Libor Fix'.

LIBOR

But the figure's validity is being questioned, with critics dubbing it "the rate at which banks won't lend".

Tim Harford was granted exclusive access to the operations centre where the daily rate is compiled.

More or Less is broadcast on BBC Radio 4. To find out more, visit the programme website, or subscribe to the More or Less podcast."

"In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index."

A story on Bloomberg with lots of interesting points:

"By Michael McDonald and Michael Quint

Dec. 24 (Bloomberg) -- Six years after embarking on an effort to lower borrowing costs using derivatives, New York is watching those savings evaporate.

The state( THAT'S CORRECT, THE GOVERNMENT BOUGHT SWAPS ) says it paid bankrupt( NOW YOU KNOW WHY THIS WAS A DISASTER. IT TRIGGERED A WHOLE INFINITY OF PEOPLE HAVING TO GET CASH. IT'S LIKE A BANK RUN ) Lehman Brothers Holdings Inc. and other Wall Street banks at least $75.9 million since March to end interest-rate swap contracts that were supposed to lock in below-market rates. That money and the costs of issuing new debt to replace bonds linked to swaps( IN THIS ENVIRONMENT ) gone awry are eroding the $207 million in savings New York budget officials say the derivatives produced since 2002.

New York isn’t alone. Lehman’s bankruptcy filing on Sept. 15 triggered the termination of similar contracts across the country, forcing state and local governments and other borrowers in the $2.67 trillion municipal-debt market to buy out the agreements( PAY MONEY BACK ). They suddenly find themselves making unexpected payments at a time when their revenue is already under pressure from the worst recession since World War II ( A TERRIBLE TIME TO HAVE TO COME UP WITH CASH ).

“People are fixing problems right now,” said Nat Singer, managing partner at Swap Financial Group in South Orange, New Jersey, and the former head of municipal derivatives at Bear Stearns Cos. The number of new deals has shrunk to a “fraction” of the amount a year ago as issuers unwind failed swaps( BECAUSE OF THE BANKRUPTCY ) with Lehman, Singer said.

Bentley University in Waltham, Massachusetts, and a school district in Pennsylvania vowed never to use swaps again after losing money. The added costs in New York come as the state faces a record $15.4 billion budget deficit over the coming 15 months.

Lowering Costs

In a swap, parties agree to exchange interest payments, usually a fixed payment for one that varies based on an index. Borrowers may benefit by using swaps to lower interest expenses or lock in rates for future bond sales."

Here's a definition:

"An exchange of interest payments on a specific principal amount. This is a counterparty agreement, and so can be standardized to the requirements of the parties involved. An interest rate swap usually involves just two parties, but occasionally involves more. Often, an interest rate swap involves exchanging a fixed amount per payment period for a payment that is not fixed (the floating side of the swap would usually be linked to another interest rate, often the LIBOR). In an interest rate swap, the principal amount is never exchanged, it is just a notional principal amount. Also, on a payment date, it is normally the case that only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts. Thus, an interest rate swap usually involves very little cash outlay."

And an example:

Copyright ®2004 International Swaps and Derivatives Association, Inc.
Alfa Corp Strong
Financial
Floating rate payment
(3-month Libor)
Fixed rate payment
(5% s.a.)
Terms:
Fixed rate payer: Alfa Corp
Fixed rate: 5 percent, semiannual
Floating rate payer: Strong Financial Corp
Floating rate: 3-month USD Libor
Notional amount: US$ 100 million
Maturity: 5 years
Interest Rate Swap example
• Alfa Corp agrees to pay 5.0% of $100 million on a semiannual basis to
Strong Financial for the next five years
– That is, Alfa will pay 2.5% of $100 million, or $2.5 million, twice a year
• Strong Financial agrees to pay 3-month Libor (as a percent of the notional
amount) on a quarterly basis to Alfa Corp for the next five years
– That is, Strong will pay the 3-month Libor rate, divided by four and multiplied
by the notional amount, four times per year
• Example: If 3-month Libor is 2.4% on a reset date, Strong will be obligated to pay
2.4%/4 = 0.6% of the notional amount, or $600,000.
– Typically, the first floating rate payment is determined on the trade date
• In practice, the above fractions used to determine payment obligations
could differ according to the actual number of days in a period
– Example: If there are 91 days in the relevant quarter and market convention is to
use a 360-day year, the floating rate payment obligation in the above example
will be (91/360) × 2.4% × $100,000,000 = $606,666.67.
A fixed-for-floating interest rate swap is often referred to as a “plain vanilla” swap because it is the most commonly encountered structure"

"New York agencies used them to lower the cost of almost $7 billion in bonds sold between 2002 and 2005, according to an Oct. 30 report from the budget division. The average fixed rate the agencies agreed to pay Lehman and other banks was 3.78 percent, compared with 4.5 percent if they had sold conventional tax-exempt debt( THEY GOT A LOAN AT LOWER INTEREST ), officials calculated.

The state failed to comprehend the extent of the risks( TOO MUCH ) involved in entering into the long-term contracts, which often last more than 20 years, the report said. They included the likelihood an investment bank would go out of business, triggering the termination of the agreement ( THAT'S IT ).

930,000 Contracts

“One of the main risks with swaps, which is that a sudden bankruptcy of a counterparty could terminate a swap in unfavorable mark-to-market conditions( CURRENT PRICES ), was not effectively addressed in the existing laws and agreements,” the budget division wrote in its annual report.

A budget-division spokesman, Matt Anderson, said in an e- mail that “given the current volatility in the market, we currently don’t anticipate entering into further swap agreements at this time.”

Lehman had about 930,000 derivatives( OH MY ) contracts of all types when it collapsed, according to bankruptcy filings. About 30,000 remain open( THAT'S NOT BAD WORK ), Robert Lemons, a Weil, Gotshal & Manges lawyer representing Lehman, said last week. The contracts are worth billions of dollars to Lehman’s creditors, though their exact value isn’t clear, he said.

The cost of ending a contract depends on current interest rates. Since New York and other issuers agreed to pay a fixed rate to Lehman when borrowing costs were higher, they must pay the bank to end the deals( THAT'S IN THE CONTRACT ). The three-month dollar London interbank offered rate, or Libor, upon which many agreements are based has tumbled to 1.466 percent from 5.5725 percent in September 2007.

Swaps Approval

Because they are private agreements, no comprehensive data exist on how many municipalities( GOVERNMENTS ) are involved in the almost $400 trillion interest-rate derivatives market or the total paid to exit the contracts. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather( TRUE ).

New York passed a law in 2002 expanding the ability of state agencies and authorities to use swaps. It was signed by then-Governor George Pataki, a Republican. New Jersey, California and other states also use derivatives in their public financing.

Bentley University entered into swaps with Lehman and Charlotte, North Carolina-based Bank of America Corp. on $85 million of debt between 2003 and 2006. The school also had to pay a fee to end the swaps when Lehman collapsed, based on its contracts with the bank.

Upfront Cash

“It’s going to take awhile for people to get comfortable again, if ever,” said Paul Clemente, the chief financial officer at Bentley, who declined to disclose the amount of the fee. “As far as the future for interest-rate swaps, for me there is no future.”

Some borrowers also use swaps as a way to generate upfront cash, an attractive feature as the recession eats into municipal finances. At least 41 states and the District of Columbia face a combined budget shortfall of $42 billion this fiscal year, the Center on Budget and Policy Priorities in Washington, a non- partisan budget and tax analysis group, said Dec. 23. The estimate on Oct. 10 was $8.9 billion.

The Butler Area School District in Pennsylvania decided in August to pay JPMorgan Chase & Co. $5.2 million to back out of such a deal, more than seven times what it was paid to enter the agreement, rather than risk losing even more money over the 18- year contract. The district superintendent, Edward Fink, said he now thinks it’s inappropriate for school systems to dabble in such trades( NOT COMPETENT ), even though they were explicitly backed by the General Assembly in 2003.

Valuing Risk

JPMorgan said in September it would stop selling derivatives to states and local governments amid federal probes into financial advisers and investment bankers paying public officials for a role in swap agreements( COLLUSION ).

Borrowers “never put a value on the risks associated with the swaps( THE LENDERS SHOULD HAVE MADE IT PLAIN. THIS IS AT LEAST NEGLIGENCE ),” said Joseph Fichera, president of New York-based Saber Partners LLC, a financial adviser to corporate and public sector borrowers. They only estimated the savings investment bankers and advisers were telling them they would get, he said.

The use of swaps began faltering in February when the market for auction-rate securities collapsed. States, local governments and nonprofits sold about $166 billion of the debt, and as much as 85 percent of that was then swapped to fixed rates, according to Fichera.

Bond Insurers

The collapse of the auction-rate market left issuers such as the Port Authority of New York and New Jersey paying weekly or monthly rates of up to 20 percent. The swap agreements failed to adjust to swings in the underlying variable rates, leaving New York and others exposed to higher borrowing costs.

Interest rates on other types of municipal variable-rate debt also rose this year as investors boycotted bonds backed by MBIA Inc., Ambac Financial Group Inc. and other insurers that lost their AAA ratings because of their expansion into subprime- linked credit markets.

Some borrowers entered into new swaps after Lehman’s collapse, agreeing to pay higher than market rates in exchange for upfront payments to help cover the termination fees they owed Lehman( INTERESTING ), according to Swap Financial’s Singer. London-based Barclays Plc, which acquired Lehman’s brokerage, is among the banks bidding on this business, he said.

“The combined message from all of that is you cannot have complete confidence in your counterparty,” said Milton Wakschlag, a municipal finance lawyer in Chicago at Katten Muchin Rosenman LLP. “People will be taking a hard look at some of the conventions of the marketplace” after they finish cleaning up from Lehman’s bankruptcy."

I consider this negligence if the borrowers were not clearly explained the risk. You also see Fraud and Collusion in this post. Point taken.