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June 18, 2009
Meeting Notes on Reforming CDS Event in Washington DC
Last week we held a well attended meeting at OTS to discuss the issue of "Regulation of Credit Default Swaps & Collateralized Debt Obligations." Click here to view the event page and see the presentations and other attachments. The OTS did video record the event and hopefully PRMA HQ will make this valuable content available to sustaining members. Many thanks to Tom Day and the people at OTS for making this fine facility available.
Key take aways from the June 10, 2009, chapter meeting:
The presentation by our friend Ann Rutledge of RR Consulting was perhaps the most sobering because it visually displays the deviation in terms of ratings performance/cash flow between conventional ABS and the late-stage production by CFC, WM, etc. Some chapter members who read the IRA comment will recall our discussion of the effect of rising option adjusted duration on the mortgage complex in a rising rate environment. Her discussion went to a far more basic issue, namely that many ABS deals were designed so poorly that they never performed as advertised in terms of cash flow from day one. And the FASB rule change on SPEs comes just in time to add further risk to the calculus for securitizations.
Ann notes that “Trading the ABS CDS without a reference spot market is nonsense,” a direct refutation of the conventional wisdom on Wall Street that models can accurately rate and track the actual cash flow performance of even ABS. But Ann’s slides also illustrate the more fundamental issue of how many securitizations were constructed in a legal and financial sense. Slides 13-17 show the difference between a classic conventional Ford ABS and a late-stage deal from CFC, which never even begins to converge on “AAA” performance in a cash flow sense. The lawyers for BAC and other sponsors have job security.
The next epiphany came when LSU professor Joe Mason reminded all that the major dealers had effectively ended substitution of collateral in many ABS deals at the end of 2006, meaning that they key players in the origination channel clearly knew that the game was over in terms of window dressing deals to mask the defects described by Ann’s presentation. Given the litigation with Angelo Mozillo et al from CFC, it may be time for BAC to raise its loss rate estimates for remediating the CFC litigation waste pile.
More significant, however, was the conciliatory posture taken by Tim Ryan of SIFMA. The veteran JPM banker made no bones about the fact that the dealer community must take responsibility for what has occurred in the world of structured finance. He also made very clear that a great deal of the pressure for change is coming from the Buy Side firms who are unhappy with some aspects of the Geithner proposal. The SIFMA line is clearly to embrace the Geithner proposal, although Ryan acknowledges that the discussion on Capitol Hill is probably not going to be limited to that template.
CALPERS, PIMCO, BlackRock, other activist Buy Side firms are key players in this evolving discussion. Members of Congress have absolutely no idea about this particular subject matter, thus the lobbyists/regulators will determine the ultimate deal. Yet the criticism of the OTC model coming from various quarters and, more ominously, the retreat of the Washington political class back to the exchange model, has complicated life for SIFMA, which represents both Buy and Sell Side firms.
The treat of the day was listening to Michael Greenberger of the University of Maryland, who formerly worked for Brooksley Born at the CFTC. Greenberger views the Geithner proposal, in its totality, as a huge step forward in the sense that it includes all OTC derivatives in the framework. While there is no explicit suggestion for a move to multilateral exchange models, Greenberger believes that this is the direction that the debate will take.
More, Greenberger apparently believes that it is likely that by leaving CFTC independent of the SEC, there is a high likelihood that all OTC swaps will be considered futures contracts for the purpose of law and regulation, even if they remain in an OTC market. If this change were to come to pass, and we are not at all sure that it will, giving the CFTC the power to regulate OTC swaps as futures contracts would reverse the decision of more than a decade ago by Greenspan-Summers-Rubin et al to prevent just that result. Brooksley Born may have been right after all.
While the prospects for more radical reforms, such as prohibiting naked short selling of CDS, are seen by Greenberger and the other participants as unlikely to survive the negotiation process, there clearly will be greater costs and risk limits placed on the zombie banks. The wild card: If another “surprise” loss event occurs in the OTC markets, then more radical solutions will have a chance to make it into law.
Final note: The Senate Banking Committee will be holding hearings on reforming the OTC derivatives markets on Monday June 22, 2009, thus our event was very timely indeed. Entitled "Over-the-Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks," the hearing will begin at 3PM in 538 DSOB.
Posted by whalenc at June 18, 2009 01:28 AM