January 30, 2010

Fannie, Freddie Get Tough With Banks

This should be rich. 

Fannie, Freddie Get Tough With Banks

The mortgage-finance companies are forcing lenders to repurchase loans found to contain improper documentation about a borrower's income or outright lies.

January 26, 2010

(BN) Wall Street Reviving Synthetic Bets as Volcker Blasts Credit-Default Swaps

I really dislike derivatives. I agree with a statement Warren Buffet made, that they are the nuclear bomb of the economy. They allow and encourage rampant irresponsibility with a ridiculous amount of leverage. Excessive debt has ruined more individuals, companies and governments than anything else. 

Banks Reviving Synthetic Bets as Volcker Blasts Default Swaps

Jan. 26 (Bloomberg) -- Wall Street is marketing derivatives last seen before credit markets froze in 2007, as the record bond rally prompts investors to take more risks to boost returns.

Bank of America Corp. and Morgan Stanley are encouraging clients to buy swaps that pay higher yields for speculating on the extent of losses in corporate defaults. Trading in credit- default swap indexes rose in the fourth quarter for the first time since 2008, according to Depository Trust & Clearing Corp. data. Federal Reserve data show leverage, or borrowed money, is rising in capital markets.

Investors who retreated to the safety of government debt during the financial crisis are returning to the simplest forms of so-called synthetic collateralized debt obligations after last year's record 57.5 percent rally in junk bonds left money managers with fewer options. While President Barack Obama's adviser Paul Volcker has blamed credit swaps and CDOs for taking the financial system "to the brink of disaster," bankers say the instruments help companies raise capital.

"In a flight to quality you see investors fly away from anything exotic," said Moorad Choudhry, author of "Structured Credit Products: Credit Derivatives and Synthetic Securitisation" and head of treasury in London at Europe Arab Bank Plc. "It's now very slowly reversing, and if the recovery continues we will see it come back."

Betting on Indexes

Bets using credit-default swap indexes that speculate on bonds without buying them have jumped 13 percent in the past three months to $1.2 trillion, DTCC data show. The amount includes index tranches, which may offer higher returns than indexes, according to Morgan Stanley and BlueMountain Capital Management LLC.

Derivatives, contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather, may boost yields for managers as if they were borrowing to purchase debt securities.

Bank of America strategists led by Suraj Tanna in London recommended that investors "rethink" so-called first-to- default baskets that pay investors for the risk that any one of four to 10 companies default. The trades "can provide an attractive premium relative to the total default risk the investor is taking," the analysts said last month.

Morgan Stanley strategists suggested clients sell protection on a so-called mezzanine tranche of the Markit CDX North America Investment Grade Series 9 Index that would pay 3.8 percentage points annually for about five years. That's more than triple the payments for a trade on the index, which is linked to 125 companies and used to speculate on corporate creditworthiness or to hedge against losses.

'More Leverage'

In the mezzanine trade, holders start losing money after 7 percent of the investment's value has been eliminated and lose everything after 10 percent.

As yields over benchmarks tighten, "investors are using more leverage to achieve return expectations," said Bryce Markus, a money manager at New York-based BlueMountain, whose founders helped pioneer credit swaps. "These are very thin slices and a very junior part of the capital structure. If there is a misstep, the whole tranche could be wiped out."

Speculative-grade bond yields have narrowed 15.4 percentage points relative to benchmarks since Dec. 15, 2008, when spreads were at a record 21.8 percentage points, according to the Bank of America Merrill Lynch U.S. High Yield Master II Index. The index has gained 1.45 percent this year, after the record rally in 2009.

Debt rated below Baa3 by Moody's Investors Service and BBB- by Standard & Poor's is considered high yield, or below investment grade.

'Easier to Understand'

CreditSights Inc., a New York debt research firm, predicts investors will initially return to first-to-default baskets and other "simpler structures" including credit-linked notes, or floating-rate securities created by selling a credit-default swap on an individual company.

Such trades are "significantly easier to understand compared to more complex, portfolio-based structures like bespoke tranches," CreditSights strategist Atish Kakodkar wrote in a Dec. 9 note to clients.

One obstacle to the return of riskier derivatives is the dearth of experts after financial institutions fired more than 340,000 employees, including mathematicians who created these instruments.

"These are very complex and exotic products," said Sasha Rozenberg, global head of credit products at SuperDerivatives Inc. in New York. "It's going to take time to build up teams," said Rozenberg, who joined the pricing provider in 2007 from Morgan Stanley, where he worked in the credit derivatives structuring group.

Lehman, Washington Mutual

UBS AG hired more than 200 people for its debt unit last year, including traders specializing in credit structures, to rebuild the fixed-income business after $57.5 billion in writedowns and losses at the Zurich-based bank, Switzerland's largest. UBS spokesman Doug Morris in New York declined to comment.

While banks are recommending these trades, investors aren't seeking out the riskiest derivatives that led to losses of as much as 90 percent after Lehman Brothers Holdings Inc. failed, said Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York.

The investments included customized synthetic CDOs that during 2006 and 2007 loaded their holdings with credit swaps linked to the debt of financial companies such as Lehman, Washington Mutual Inc. and bond insurers MBIA Inc. and Ambac Financial Group Inc.

$62 Trillion

Insurance companies, hedge funds and money managers seeking investments with the highest ratings and bigger returns than corporate bonds pushed the amount of credit protection sold through such synthetic CDOs in that period to about $1 trillion, according to a Morgan Stanley estimate in February 2008. Credit- default swaps rose to more than $62 trillion at the end of 2007, a 100-fold increase in seven years, surveys by the New York- based International Swaps and Derivatives Association show.

As Wall Street recommends more complex trades, investors are also augmenting bets with borrowed money. Some banks are offering as much as 10-to-1 leverage on securities backed by prime-jumbo home loans, said Scott Eichel, global co-head of asset- and mortgage-backed securities at RBS Securities Inc. in Stamford, Connecticut, a Royal Bank of Scotland Group Plc unit.

Fed data show that as of Jan. 6, the 18 primary dealers required to bid at Treasury auctions held $32.7 billion of securities aside from government, agency and agency mortgage bonds as collateral for financings lasting more than one day. On May 6, the amount was $15.8 billion and in 2007 the figure reached as high as $113.9 billion.

Obama Proposal

"There is added liquidity and greater price transparency than 12 months ago," said Ashish Shah, a credit strategist at Barclays Capital in New York. "Leverage is coming back into the system, and that's a good thing."

Former Fed Chairman Volcker said last month there's no clear link between financial innovations to limit risk, such as credit-default swaps, and increased economic productivity. Obama called for limiting the size and trading activities of banks to reduce risk-taking and avert another financial crisis.

"We intend to close loopholes that allowed big financial firms to trade risky financial products like credit-default swaps and other derivatives without oversight," Obama said Jan. 21 in Washington.

Legislation is being debated in Congress designed to prevent the type of derivatives bets that pushed American International Group Inc. to the brink of bankruptcy in September 2008, threatening the global financial system. The proposed rules would require dealers and major market participants to process trades through a clearinghouse designed to contain losses if a firm fails. More capital would also need to be set aside for derivatives that aren't cleared.

New rules may prevent a return to the riskiest bets in structured credit, said Kakodkar at CreditSights.

"Regulatory changes are likely to increase capital charges for bespoke or customized tranche trades," he wrote in a report last month. That will force investors to focus on less risky versions of the swaps, he said.

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net Pierre Paulden in New York at ppaulden@bloomberg.net

(BN) Fed Officials Consider Adopting Interest on Reserves as New Benchmark Rate

I'm not sure what to make of this my brain is still wrapping itself
around this idea. My first blush response is that it will be positive
for the dollar. But it could get complicated and make the overall
economic recovery a little messier as banks adjust prime rates.
Fed Weighs Interest on Reserves as New Benchmark Rate

Jan. 26 (Bloomberg) -- Federal Reserve policy makers are considering
adopting a new benchmark interest rate to replace the one they've
used for the last two decades.

The central bank has been unable to control the federal funds rate
since the September 2008 bankruptcy of Lehman Brothers Holdings Inc.,
when it began flooding financial markets with $1 trillion to prevent
the economy from collapsing. Officials, who start a two-day meeting
today, have said they may replace or supplement the fed funds rate
with interest paid on excess bank reserves.

"One option you might want to consider is that our policy rate is the
interest rate on excess reserves and we let the fed funds rate trade
with some spread to that," Richmond Fed President Jeffrey Lacker told
reporters on Jan. 8 in Linthicum, Maryland.

The central bank needs to have an effective policy rate in place when
it starts to raise interest rates from record lows to keep inflation
in check, said Marvin Goodfriend, a former Fed economist. Policy
makers are concerned that the Fed funds rate, at which banks borrow
from each other in the overnight market, may fail to meet the new
target, damaging their credibility and their ability to control
inflation as the economy recovers.

'Extended Period'

The choice of a benchmark is the "front line of defense against
inflation, and also it's at the heart of the central bank being able
to precisely and flexibly guide interest-rate policy in the
recovery," said Goodfriend, now a professor at Carnegie Mellon
University in Pittsburgh.

The Federal Open Market Committee is likely to maintain its pledge to
keep interest rates "exceptionally low" for an "extended
period" in a statement at about 2:15 p.m. tomorrow, economists said.
The Fed probably won't raise interest rates from record lows until
the November meeting, according to the median of 51 forecasts in a
Bloomberg survey of economists this month.

Fed Chairman Ben S. Bernanke, in July Congressional testimony, called
interest on reserves "perhaps the most important" tool for
tightening credit.

Inflation Concerns

Banks' excess reserves, or deposits held with the Fed above required
amounts, totaled $1 trillion in the two weeks ended Jan. 13, compared
with $2.2 billion at the start of 2007. The Fed created the reserves
through emergency loans and a $1.7 trillion purchase program of
mortgage-backed securities, federal agency and Treasury debt.

By raising the deposit rate, now at 0.25 percent, officials reckon
banks will keep money at the Fed and not stoke inflation by lending
out too much as the economy recovers.

The new policy may be similar to what the Bank of England does now,
said Philip Shaw, chief economist at Investec Securities in London.
The U.K. central bank's benchmark interest rate, now at 0.5 percent,
is the rate it pays on the reserves it holds for commercial banks. It
may drain excess liquidity from the system by selling back the gilts
it has purchased through its so-called quantitative easing program,
Shaw said.

Communications Strategy

Policy makers will need to adopt a communications strategy to explain
the new benchmark because "people might have had a hard time getting
their mind around the idea that the official rate had become the
interest on reserves rate," said Kenneth Kuttner, a former Fed
economist who has co-written research with Bernanke and now teaches at
Williams College in Williamstown, Massachusetts.

Without a federal funds target, banks might have to find a new way to
set the prime borrowing rate, the figure most familiar to consumers
that that is now pegged at three percentage points above the fed funds
target.

In the past, the Fed had controlled the rate by buying or selling
Treasury securities, adding or withdrawing cash from the system. That
mechanism broke down when the Fed started flooding the system with
cash after the bankruptcy of Lehman Brothers to prevent a financial
meltdown.

The deposit rate would help set a floor under the fed funds rate
because the Fed would lock up funds by offering a fixed rate of
interest for a defined period and prohibiting early withdrawals.

'Risk Free'

"In general, banks will not lend funds in the money market at an
interest rate lower than the rate they can earn risk-free at the
Federal Reserve," Bernanke said in an October speech in Washington.

The New York Fed has been testing another tool, reverse repurchase
agreements, as a way of pulling cash out of the financial system. In
that case, the Fed would sell securities and buy them back at an
agreed-upon later date.

There could be complications to using the deposit rate. Banks may be
able to generate more revenue by lending at prime rate rather than by
earning interest at the Fed, said William Ford, a former Atlanta Fed
president at Middle Tennessee State University in Murfreesboro.

Also, the Fed's direct control over a policy rate --instead of
targeting a market rate -- could skew trading and financing toward
short-term borrowing once investors know the rate won't change
between Fed meetings, said Vincent Reinhart, a former Fed monetary-
affairs director.

The new reliance on reserve interest could also increase the policy
clout of Fed governors in Washington at the expense of the 12 regional
Fed bank presidents, Reinhart said.

Congress gave only the Fed governors the authority to set the deposit
rate. The presidents have historically favored higher rates and voiced
more concern about inflation.

"The Federal Reserve Act puts a very high weight on comity," said
Reinhart, now a resident scholar at the American Enterprise Institute
in Washington. Using interest on reserves for setting policy "can
change the tenor of the discussions, and I don't know how they get
around it."

Elon Musk: Tesla Cybertruck Is Dead, $20,000 City Car Is Coming

I think Elon Musk is interesting, humble and arrogant all at the same time. I'm glad he is him. Neat guy.  Elon Musk: Tesla Cybertruck I...