Only One Way Forward for Growth Corporations: Securitization of Assets

The turmoil in the global economy has serious implications for growth corporations in the emerging markets. Rather than assessing corporate capital raising exercises from within the rational prism of the credibility (or otherwise) of business models, the markets are simply assigning sharply widened, and unreasonable, risk spreads on an across-the-board basis.

                       

The challenge for strategically placed companies is obvious. Managements requiring equity or debt capital need to prove that the quality of underlying assets (hard assets or receivables) overrides negatives attributed to country rating downgrades, currency forecasts, domestic interest rate fluctuations and sharp falls in stock markets.

 

This process of highlighting (and capturing) the current and future behaviour of assets supporting business models can only achieve success via asset securitizations. Given that a huge number of professional and retail investors have exited traditional investments in recent weeks, there is a record amount of money sitting on the sidelines, globally. Attracting that money demands a combination of (1) a fair reflection of asset values and (2) an acceptance of the revised pricing environment.

 

In terms of equity, this means higher dilution, and equity may be the only route open for venture-type companies with no assets in place at this juncture. In terms of debt, this implies relatively higher interest rates; for example, a departure from the Libor+150 basis points to Libor+300 basis points, or a fixed dollar-denominated 5-year loan at 10% rather than 7.5%.

 

According to recent feedbacks from significant private equity pools in Asia and the Middle East, the applicable yield must follow close asset scrutiny, and the determination of the debt service capability of the asset itself. But there is no doubt that dynamic business models will be funded, as long as debt buyers do not have to concern themselves with the actions of governments, central banks and other policy makers.

 

Furthermore, debt buyers now desire that their risk-reward profiles are determined exclusively by the assets incorporated in the business models, not by the corporations controlling the assets prior to securitization. On this note, it is important to recognize that international investors have no appetite to chase down managements with respect to their expansion plans and their discretion to adjust business models at any time, both of which have the real potential to dilute the asset offered as security.

 

www.creditdefaultswapslimited.com

derivatives@shaw.ca, crossborderreports@shaw.ca

 

Xtreme CDO Leverage to Create Another Deleveraging Storm

There is widespread apprehension about the imminent, and potentially disastrous, impact on the credit risk environment of the forced liquidation of synthetic collateralized debt obligations (CDOs). The 10:1 and 15:1 leverage ratios usually applied to synthetic CDO trades are obvious causes for concern. But beyond the synthetic CDO arena lies the shadowy world of 80:1 (and higher) leverage: speciality funds, called Credit Derivative Product companies (CDPCs), dedicated to shorting default risk on a basket of highly rated debt securities.

 

Three such funds, Theta Corp., Primus and Athilion, have already been the subject of recent rating downgrades; they will be forced to liquidate their positions if the rating agencies start placing an increasing number of S&P 500 index components on negative watch in forthcoming weeks. In fact, all highly leveraged sellers of CDO default risk must be preparing to face the inevitable: an across-the-board abandoning of commitments in the face of a broad-based recession. Such an event, according to a Citigroup study, “could wreck havoc on the marketplace.”

 

Theta Corp., managed by a rather appropriately named UK-based firm Gordian Knot, was last reported to hold $10 billion in client funds. How could that $10 billion be leveraged eighty times, or even higher?

 

At one end of the leverage spectrum, a leverage-free position would allow a CDPC to sell a maximum of $10 billion notional worth of credit default insurance, akin to a credit default swap, and to receive an income (premium) stream linked to the yields on the components (corporate issuers) of an underlying synthetic CDO. But far from being leverage-free, CDPCs owed their potential to offer exponential rewards to investors by employing the type of leverage which would make the average Wall Street hedge fund manager look like a bit player.  

 

If, to simplify an example, investor money was utilized exclusively to service initial margin deposits and margin calls, the leverage ratio on $10 billion would only be conditioned by the rating matrix of the underlying CDO on one hand and by the related margin requirements on the other. An unchanged rating matrix over a period of time (the third dimension of credit default insurance), would enable the booking of premium inflows as profits and the simultaneous release of margin security; the leverage ratio capability, in that event, could easily breach 100:1.

 

The problem today is that the rating matrices for the overwhelming majority of the synthetic CDOs are under serious threat. Given their leverage methodologies, CDPCs are subject to cash calls even if a limited number of CDO constituents are downgraded. And as cash calls increase, the CDPC leverage structure begins to contract.

 

Estimates of the total worth of outstanding synthetic CDO contracts vary, ranging from a low of $1.5 trillion to a high of $6 trillion. These figures do not include the size of the outstanding deals on synthetic CDO option trades and do not capture the real risk inherent in existing CDPC leverage ratios, which are, in most cases, determined by relatively inefficient mark-to-market mechanisms.

 

Note that CDPCs are not subject to any solvency ratios (AIG) or, for that matter, capital adequacy ratios (LEH, C) when picking the limits of leverage.

 

www.creditdefaultswapslimited.com

derivatives@shaw.ca

 

Sovereigns-IG CDS Arbitrage Window Opens this Week

Countries do not default, as the common wisdom goes; they only restructure, in a worse case scenario. Now balance that wisdom with recent government actions to backstop corporate debt and what you get is an unprecedented arbitrage window: sell sovereign risk insurance and buy investment grade indexes today or, perhaps, execute a reverse trade at some point in the foreseeable future.

                                 

In a more limited form, there are distinct arbitrage plays within the CDX and iTraxx matrix itself, for example the fluctuations in the gap between the 3-year IG-11 and the 3-year HY-11 (currently 910 basis points-plus). But with yields on a number of sovereigns expected to breach the 25% mark before the end of the year, the bigger opportunity is in the IG-11/sovereign credit default swap spreads, or even in HY-11/sovereign. Bring in treasuries and Libor into the equations and this arbitrage window expands exponentially.

 

The arbitrage foundations are firmly rooted in the “international” nature of the global economy, and the founding proposition in this regard can be simply stated via two questions. Firstly, will the IMF or World Bank allow a total “non-restructuring” default on Pakistan, Argentina, Hungary, Ukraine or even Russia? Secondly, can the industrialized world afford a complete dislocation in trade and investment in about two dozen emerging markets? If the answer to both questions is in the negative, then sovereign-driven arbitrage trades become an imperative for hedge fund portfolios, more so if leverage can be enhanced through CDS options.

 

There is no other comparable arbitrage format for professionals today. Granted, there is money in the traditional, in the trading of currency, interest rate and commodity-price movements; but those institutions seeking real money need to find it in the “risk insurance” arbitrage game.  

 

Besides the real potential for unprecedented sovereign yields as we enter 2009, the series of government bailouts, which are rapidly becoming a moving target, will create renewed volatility (and price-related confusion) in the CDS indexes themselves. The Fed’s commercial paper programme has indeed extended a much-needed lifeline for the better rated American corporations. But will the Fed be forced to start buying non-investment-grade risk if the recession turns out to be exceptionally nasty? How much government interference will we see in the mortgage debt market? And how will the results of the presidential elections impact credit spreads in general?

 

The building blocks defining both ends of the default insurance arbitrage spectrum (indexes/sovereigns) promise exceptional profits; they also point towards the scope of exceptional losses, particularly when the arbitrage ingredients are contextualized in a relatively low-liquidity environment, in the midst of genuine fears governing counterparty risk. But, that said, the building blocks are already lend themselves to compelling risk-reward arbitrage profiles.

 

First recommendation: long IG/short India & Mexico; the Argentina trade is perhaps fully priced at this time.

 

www.creditdefaultswapslimited.com

derivatives@shaw.ca

 

DARK CLOUDS GATHERING AGAIN: INSURERS EVERYWHERE SEEKING BAILOUTS

The $700 billion bailout package was intended to save the American banking system. But at least three insurance companies have reportedly been working with Treasury officials over the weekend to figure out if they can tap some of that money. Yesterday, AEGON, the giant European insurance group, disclosed that it was in talks with the Dutch government to see if it could join the $26 billion state capitalization scheme originally launched in the wake of the crisis at ING and Fortis. And Nordic countries are racing to implement support plans for banks and insurers within days.

                      

Without doubt, if insurance companies in America and Europe come under pressure this week, equities and bonds worldwide could easily be hit with another wave of selling. For all material purposes, the insurance industry is even more “international” than banking, given the extensive, long-standing reinsurance agreements between domestic policy writers on one hand and specialist risk buyers in the major financial centres on the other.

 

Metlife, Prudential Financial and New York Life are the three insurers believed to have been meeting with Hank Paulson and Neel Kashkari. Without doubt, falling markets are pressurizing solvency ratios across the board; in certain instances, solvency ratios may already have been compromised. To make matters worse, sharp currency fluctuations are turning the assessments of such ratios into day-to-day moving targets. Furthermore, though no precise figures are available at this point, it is fair to assume that a number of insurance companies in America and Europe are exposed to hefty losses from the synthetic collatoralized debt obligations (CDOs) market.

 

Rating agencies have placed the entire life-insurance sector on “negative” watch in anticipation of one- to two-notch downgrades triggered primarily by investment losses, the true extent of which may finally justify a dedicated bailout package altogether. But will recapitalization programmes solve the challenge of insurance premium flexibility and competitiveness, both of which have been closely linked to investment profits?

 

Of course, recapitalization of any kind is ultimately meaningless unless the historical, and obviously intricate, relationship between the insurers, the derivatives players and the hedge funds is understood in a comprehensive manner. If AIG’s portfolio was simply a reflection of established practice, then the amount of money required to support the insurance industry could well exceed the Treasury’s budget for banks and financial institutions.

 

Earlier this month, upon hearing that AIG was granted another $38 billion (beyond the initial rescue amount of $85 billion), Rep. Barney Frank, chairman of the House Financial Services Committee, vowed to initiate legislation to regulate the credit default swap market when Congress reconvenes in January. By that time, however, Rep. Frank may have a much more complex problem on his hands, the problem of leverage of the very highest order: Constant-proportion debt obligations (CPDOs, leverage standard 15:1) and credit derivative product companies (CDPCs, leverage standard 80:1).

 

The Wall Street Journal (Oct 21 2008), citing a Citigroup report, warned that the liquidation of CDPCs “could wreck havoc on the marketplace.” CDPC names mentioned included Theta Corp., Primus Financial and Athilon Capital. Moody’s slashed Theta’s credit rating to Aa2 (from AAA) two weeks ago. But since the creation of 80:1 leverage is predicated on a rigid application of the mark-to-market rule, the rating agencies are obviously finding it hard to keep pace with ground events which are changing by the hour.

East European credit default swap prices in nervous state of flux

Hungary is in crisis mode today. While an IMF lifeline is negotiated, credit default swap prices for Hungary sovereign debt are set to fluctuate wildly, from a low of 420 basis points to a high of 600, and beyond. The rest of Eastern Europe waits with bated breath, hoping that Hungary default insurance costs will not follow the path shown by Ukraine (1,900 basis points, 3 years).

                                

The Forint has dropped a whopping 30%-plus against the dollar since June. Hungary’s benchmark interest rate has risen by 3% last week. The domestic bond market is virtually frozen. And, as official statistics tell the sorry tale, foreign currency loans make up almost 62% of all Hungarian household debt!

 

The CDX emerging market credit default swap index rose to 1,100 basis points this week and levels of 1,300 basis points are well within the realm of reality in forthcoming days. If index spreads do widen as anticipated, the impact on East European prices will be devastating.

 

Bond yields for all former Soviet states are rising, and market-makers are, in any event, currently revising their assessments of the relationship between yields on bonds and default probabilities implied by those yields. By all accounts, a serious collapse in the emerging market default insurance market, following the Argentine debacle, has been prevented (for now) by announcements that Iceland, Belarus, Pakistan, Ukraine and Hungary were lining up for IMF subsidies for “initial” requests totalling $20 billion.

 

The common, and perhaps dangerous, perception today is that IMF bailouts will serve to create a cap on default risk for Hungary (rated BBB+ S&P, negative watch), Romania (BBB-), Bulgaria (BBB+), Ukraine (B) and Serbia (BB-). That perception might well turn out to be an illusion, depending on what conditions the IMF imposes. The restructuring terms themselves could create credit events, rating events or even a fundamental revision in the underlying reference instruments for outstanding credit default swap contracts.

 

Most worrying of all is the willingness of traders to allow swap prices for a resource-rich country like Russia to approach 900 basis points. Last quotes for Bulgaria (430 basis points, mid-rate, 3 years), Romania (485 basis points), Estonia (460 basis points), Latvia (725 basis points) and Lithuania (450 basis points) revealed an acute shortage of genuine bids.

 

Pakistan, for information purposes, is now quoted at 1,050 basis points, from a low of 150 in February! Pakistan is, in turn, impacting upon India, where buyers around 425 basis points have disappeared altogether.

 

www.creditdefaultinsurancelimited.com

derivatives@shaw.ca

 

Sovereign Default Outlook Causes Panic in CDS market

Pakistan needs $15 billion within days to avoid defaulting on its foreign loans. Yields on Argentina long term bonds soared above 30% yesterday, from a mere 12.15% just a month ago. Hungary, which has already received an emergency loan of 5 billion Euros from the European Central Bank, is now tapping the IMF for more money. Most disturbing of all, perhaps, is the fact that credit default swap prices for Russia have breached 800 basis points in limited trades in the Asian time zone Thursday.

                                                           

Naturally, the International Swaps & Derivatives Association (ISDA) and The Depository Trust & Clearing Corporation (DTCC), both of whom created confusion pertaining to the Lehman CDS settlement on Tuesday, are thus far maintaining a stoic silence with respect to the emerging market bond complex. Neither organization is prepared for the chaos and panic which is destined to continue well into 2009.

 

CDS pricing specialists had assumed that the development (and supposed upgrading) of credit risk assessment methodologies in recent years had generated error-free arbitrage windows, essentially characterized by the risk neutral gap between emerging market yields, credit default insurance and US treasuries (or Libor). The shift from probability-based pricing models derived from the works of Black, Scholes and Merton (1974) to arbitrage-driven risk premium calculations created the generally accepted notion that sophistication had, at last, succeeded in capturing the consequences of credit and rating events within credit default swap contracts.

 

In reality, hard facts from the global economy prove that neither probability nor arbitrage is a valid methodological premise, at the very outset. On the one hand, the two-dozen-plus sovereign issuers (potential defaulters) are unable to state when and if they can comply with their debt service obligations. On the other hand, there is no credible analysis surrounding the root causes of the crisis in domestic economies.

 

Pakistan, for example, blames its crisis on higher food prices; but reliable information from Pakistan’s market towns confirms that the problem is more due to hoarding and smuggling rather than any genuine shortage of grains and lentils (and onions, of all items). The East European financial systems are merely paying, somewhat belatedly, for the failed communism-to-democracy transition which, for all practical purposes, began in 1991, and which was never secured in economic terms: industrial development, agricultural productivity, job creation and welfare benefits.  

 

If any further evidence of the serious flaws in pricing credit insurance for sovereign debt is required, then Latin America has that in abundance. Rating events are due to pick up momentum shortly. And to compound rating downgrades will be the steady stream of credit events, leading to inevitable debt restructurings. In other words, two years from today, the underlying reference instruments (sovereign bonds) in a significant proportion of credit default swaps might well be replaced altogether!

 

 

While the total outstanding emerging market sovereign debt is a matter of public record, estimates of the size of the related credit default swap market range from a low of $4 trillion to a high of $12 trillion. But, size apart, it is important to recognize that low liquidity levels in the emerging market debt matrix must have severely constrained counterparty risk integrity in credit default swaps: i.e. the applicability (or, rather, the inapplicability) of the much-touted (by the ISDA and DTCC) mark-to-market rule on an ongoing basis.

 

Where will credit default swaps be priced in an environment where emerging market bonds offer yields of 25 and 30 percent, and beyond?

 

Short Russia risk at 800 basis points appears a highly attractive proposition. Other recommended bets: short Nicaragua and short Venezuela, depending upon the availability of a quote. The biggest gains, however, will be made in short positions on sovereigns which, as of today, are on the fringes of the investment grade category—check the S&P and Moody’s websites for specifics.

Cyclical Argument for Stocks is Invalid

Recent facts from the emerging markets demand that American corporations conduct a fundamental review of the nature, quality and behaviour of their offshore assets. And stock analysts recommending long positions in American companies with significant overseas income flows need to recognize that the “cyclical” case for equities is no longer a valid proposition. In brief, economic conditions in Latin America, Asia and Africa are guiding profound political changes which, in turn, are influencing new legislation (as opposed to mere policy statements) governing asset ownership, profit repatriation, production margins and currency controls.

                                   

What impact will these legislative changes have on corporations (like GE, C, AIG, BA, COP, CVX and RDS) whose investments in the developing world are critical to their business models? And if there is nothing “cyclical” about this trend towards socialism-oriented legislation, is a radical shift in the methodology applied to equity valuations overdue today?

 

Latin America has been leading the charge in redefining the role of American and other foreign capital in domestic economies well into the next decade and beyond. Due primarily to the failure of sixty years of anti-poverty initiatives, Rafael Correa (Ecuador), Evo Morales (Bolivia) and Daniel Ortega (Nicaragua) are now firmly in the Hugo Chavez-Fidel Castro camp, with a few more major Latin American politicians on the fringes. The continent’s message, to anyone who is listening, is fairly straightforward: proceed to implement laws which dramatically curtail the freedom of private capital, particularly foreign capital, to influence the upgrading of “national” assets and the distribution of profits generated from those assets.

 

Another perspective on the methodology to be applied to American equity valuations can be obtained from the state of the political risk insurance marketplace. In certain instances, like energy assets in the Gulf of Guinea or off the coast of Somalia, risk insurance is now simply unavailable. In certain other instances, like for a variety of assets located in South Africa and India, political risk insurance coverage can only be obtained on a year-by-year basis, mainly due to concerns that the state of the domestic economies might force new nationalization-type regulation in the foreseeable future. Then there are instances, like Pakistan, Bangladesh, Iraq, Iran, Burma and Zimbabwe, to name just a few examples, where the mere mention of political risk insurance invites nothing but laughter (and scorn) in risk placement dealing rooms. 

 

It should be pointed out that political risk insurance rates bear, at best, a minimal relationship to credit default swap quotes for emerging market sovereign bond issues. The former are indicators of specific asset (business) risks, while the pricing of the latter usually incorporates only the prospects of a country reneging on its debt service obligations.

 

Like corporate credit, political risk insurance remains frozen for the moment. But what the political risk marketplace has certainly acknowledged in recent weeks is that political movements firmly rooted in social conditions carry with them the real potential for sweeping constitutional amendments. Unlike in the second half of the 20^th century, when Latin America’s armed revolts were unable, with the exception of Cuba and Nicaragua, to achieve any level of government control, the modern-day political movements are engaging the electoral process, and winning. How should the new reality influence corporate valuations?

 

To further complicate emerging market asset valuations, far forward (medium and long term) currency risk-offset providers are hesitant to enter into any fresh commitments unless the crisis in counterparty risk shows signs of resolution; in fact, certain reports suggest that many American corporations are unable to obtain even short-term foreign exchange risk coverage.

 

The first task is not how to value equities in the changed international environment but whether the changes in that environment are cyclical, or non-cyclical, in nature.

 

Wall Street’s Investment Banking Model Collapses

Since equity market participants have been busy finding answers to the challenge of unprecedented volatility (VIX), the decision by Goldman Sachs (GS) and Morgan Stanley (MS) to seek banking licenses has gone largely unscrutinized. As the official talking points suggest, a change in status will provide “maximum flexibility” and “stability” to pursue new businesses; in reality, if the facts are properly contextualized, it is safe to assume that Wall Street’s elite institutions are abandoning the core components of the very business model which created the basis for phenomenal, sustained profits (and bonuses) over the previous three decades. And for good reason, one might add.

 

The widespread perception is that the more-than-impressive historical performance of New York’s investment banks was a result of a superior balancing of leverage and risk. But, risk aside, the leverage employed was never fully captured in their financial statements. The crisis in the credit default swap market, for example, may well be a consequence of counterparties assuming insurance-related risks without sufficient actuarial foundations; but more importantly, the leverage itself violated all standard capital adequacy ratios. It is easy to blame the trading community for this mess; but, in essence, it is the abject failure of the accountants and auditors, and lawyers in many instances, to highlight contingent risks (in the event of default) which enabled the dealers to continue pricing an entire series of derivatives, day in, day out.

 

In other words, the classic investment banking model was, in a fundamental respect, incapable of generating the type of profits which featured in news headlines for so many years if prudent accounting governance was in place. The multi-faceted business models of Citigroup (C) and Bank of America (BAC) prove that the relationship between traditional banking and leverage-driven investment banking is nebulous, at best; the more reasonable conclusion, in fact, is that the two activities are predicated on completely separate parameters of risk management, asset behaviour, counterparty mechanisms and mark-to-market principles.

 

In specific terms, traditional banking incorporates counterparty risk on an asset-by-asset basis, while the investment banking model relies on the rating agencies to provide a broad evaluation of counterparty creditworthiness. Furthermore, to take the credit default swaps as a significant contrasting example, traditional banking effectively forbids short position on underlying assets or reference instruments. Finally, at the risk of being presumptuous, it is apparent that guiding (and indeed brilliant) minds at Goldman Sachs and Morgan Stanley have realized that the increasing demand to comply with rigid capital adequacy benchmarks will, inevitably, curtail the quantum of leverage, and reduce a large percentage of the related profit forecasts.

 

What impact will the adjustments in the investment banking model have on valuations? That is the question which investors should ask themselves in forthcoming weeks. It is simply not sufficient to say that free cash should be chasing Warren Buffett (GS) because, as the visionary himself has clarified more than once, his time horizons and objectives (and deep pockets) may well differ substantially from those of hedge fund managers, arbitrage traders and, for that matter, from the man on the street.

 

For starters, one still needs to wait for the losses to fully unfold. From that perspective, this freeze in the counterparty risk matrix has delayed a thorough and verifiable assessment of who lost, or is currently losing, how much from the tens of trillions of dollars worth of outstanding swaps, insurance contracts and structured products. What has also been postponed is the pressing need for another bailout by the Fed and the Treasury, not only for banks but also for corporations (like General Electric, GE) who populate the derivatives universe.

 

G-7 Watch. What happens next week?

Perhaps it is fitting that the key indicators of sanity in the credit markets closed at their most insane levels yesterday.

                                    

The TED spread (three-month treasuries to three-month Libor) closed at a record 4.64%. The Overnight-Index-Swap to Libor gap widened to 3.65%. The CDX Index (IG, Investment Grade, 11) finished the day at 220 basis points. IBM 10-year bond, issued at 388 basis points, briefly breached 400. The 2-year/10-year spread moved further out to 226 basis points. And, as far as equities were concerned, the volatility index (VIX) surged to a record intraday high of 76.94.

 

The indicators prove that investors crave both liquidity and safety, and are desperate for some semblance of a valuation consensus in equities. 

 

How exactly does the G-7 plan to address this contagion? The US Treasury Secretary wants to buy stakes in US financial institutions, and there are rumours that more than a few banks (including one or two big ones) do need help next week. Financial columnists and fund managers are urging that the G-7 move aggressively to bring down Libor rates on Monday morning, particular 3-month Libor which ended the day at 4.82%. Not to be outdone, politicians on both sides of the Atlantic have started to talk about eliminating the mark-to-market accounting rule and adjusting capital adequacy ratios.

 

Thus far, of course, all attempts to inject liquidity have simply resulted in the hoarding of cash; if by liquidity, the G-7 means the freeing up funds for lending to businesses, then it should be obvious that the problem is not going to be solved by forcing Libor lower, by bailing out failed business models or by buying preferred shares in ailing banks. If lending has to be conducted in accordance with rigid standards, then it will be imperative to order up an across-the-board valuation (or re-valuation) of the assets which are presumably the target of such lending.

 

This is where the G-7 must focus. Given the state of the global economy, the overwhelming majority of businesses need loans in order to survive. But how many businesses need loans to grow and prosper? There is a more than fine distinction between easy credit and good credit; in the current environment, the gap between the easy and the good is formidable. It is, in many respects, this gap which the credit market indicators are confirming. And the challenge to identify good credit, and properly priced credit, is extending itself to the equity markets where extreme divergences in the perception of value are creating unprecedented volatility.

 

What the G-7 should do is to issue unequivocal guidelines on asset valuations in the banking, insurance and general corporate sectors, and then let the debt and equity markets find their own levels over the next few months. What the individual members of the G-7 should do is to go back home and figure out how to raise family incomes and how to create quality jobs. There is a fundamental relationship between asset values and real wages.

 

The message of this weekend to the emerging markets should be equally emphatic: revamp banking and insurance institutions in line with international standards and ensure a high degree of integrity in national growth statistics. If hundreds and thousands of banks and corporations fold in the process, then so be it. If dozens of economies shrink as result, all the better. If virtually all corporate and sovereign bonds are re-priced in the process, then at least emerging market trading will become genuinely liquid.

 

Remember that the task at hand should be to rationalize the international debt and equity matrix, even if the process of rationalization becomes tantamount to an acknowledgement of the failures of the previous two decades.

 

There is one last contentious, and most critical, issue which deserves consideration: the nature of the derivatives markets, specifically the default insurance segment. Before trying to regulate derivatives, the G-7 must distinguish between plain hedge contracts on one hand and insurance-driven contracts on the other. Then the G-7 must decide if banks, investment banks and insurance companies should be allowed to insure business model-type risks at all. In other words, should the G-7 ban all insurance activity which is unrelated to credible actuarial foundations?

 

www.creditdefaultswapslimited.com      [Credit Insurance]

www.quoteplatform.com [Political Risk Insurance and Hedge Contracts]

www.uralmountainshedgegroup.com  [Securitized Debt Pricing]

 

 

Why central bank rate cuts are not working

 

Three-month Libor settled at 4.75% today, and as the spread between three-month treasuries and three-month Libor (TED spread) breached the 400bp barrier. Are these indicators of liquidity simply awaiting adjustment following the completion of the Lehman Brothers credit default swap auction tomorrow? Or, is the TED spread a true reflection of the quality of residual risk in the international and bank sector?

 

Rather than wasting their time wondering why the across-the-board cut in interest rates by central banks is failing to instil confidence amongst capital market participants, central bankers should be seeking answers in the status of the 60 trillion credit default swap market and, for that matter, in a few more tens of trillions of dollars worth of contracts governing interest rate swaps, basis swaps and currency swaps, and related options. In fact, the sheer immediacy of the problems inside the entire derivatives complex should be of much greater concern than trying to force downward revisions in benchmark rates for treasures and bills.

 

Of course, recent Libor levels may well be incorporating an overdue dynamic: the degradation, over the next few months, of financial and corporate balance sheets consequent to revaluations demanded by the dramatically changed global economic environment.

 

The common argument going around today is that the liquidity transfer mechanisms allowing for a central bank rate cut to have the desired impact on the broader marketplace are currently in suspension and that, with time,  lower benchmark rates will bring a semblance of normality to day-to-day business. That argument, however, is fundamentally flawed. The transfer mechanisms which worked so well in the previous decades are not suspended; they have, for all material purposes, been comprehensively destroyed. And one does not have to go far to find the reasons.

 

 Firstly, the maturity mismatches (long term assets compared with short term liabilities) are rampant right across the banking and corporate spectrum, and impaired capacity of assets to service debt obligations in the existing climate is acting as a formidable constraint to any activity designed to utilize central bank windows. Secondly, doubts relating to compliance with debt service obligations are casting dark shadows over valuations in all asset classes; therefore, the reluctance to lend and the willingness to hoard free cash.

 

Finally, despite wave after wave of regulation since the 1970s, most banking and corporate disclosures do not meet the standards required to make credible assessments of risk in the first place; the fear of the uncertain, as a consequence, is now being augmented by the dread of the unknown.

 

Even if only for tactical purposes, rate cuts are counterproductive today, since they only serve to accelerate the implied (adverse) readings obtained from key market indexes (the TED spread, the Overnight Index and basis swaps).

 

Rate cuts do not take into account the more-than-obvious fact that there has been a seismic shift in the very structure of the capital markets over the last two decades, a shift primarily characterized by the exponentially rising influence of risk-pricing in derivates contracts on traditional cash transactions.

 

The sad part of this mess is that central bankers today are assumed to possess sufficient resources (and, hopefully, expertise) to determine the impact of a rate cut well before making decisions on rates and liquidity, from data publicly available in the futures, options and benchmark-fixing markets. Why then are corporations and individuals being led to believe that these bailouts and rate cuts are going to bring near-term or long-term relief? Why is this rather complex credit crunch being explained away by reliance on the dubious virtues of brevity and simplicity?

 

Most importantly, why have the guardians of the bailouts (or rescues) in America and Europe not revealed the valuation methodologies which will guide their efforts in the foreseeable future? The answer to that question might tell us more about where Libor is headed than the results of the Lehman liquidation tomorrow.