CFC reported some bad news regarding the bank's ability to sell loans, but this is hardly a surprise to those of you fortunate enough to have access of the IRA Bank Monitor and the SEC's EDGAR portal. The CFC filing with the SEC confirms our view that the adjustment in risk spreads and thus valuations for derivative securities is just started, and that bank earnings will suffer accordingly. But please don't tell anyone you are "surprised" by CFC's announcement.
In fact, we like CFC CEO Angelo Mozillo and his team to survive the widening mess in the credit markets for the same reasons we like our friends and former colleagues at Bear, Stearns (BSC). First movers who deal with problems promptly will be the ones to make it through the credit crisis looming over the US markets. It's the names you have not yet heard from that you really should worry about.
As we told the New York Times last Friday, the trouble at present is not only the spectacle of hedge funds and banks reporting losses from over-the-counter derivative securities, but that many market participants still pretend that there is no problem, hiding behind the pretence of "mark to dealer."
With 13% total capital, CFC can navigate even an extreme credit correction, the only question is how big is the oncoming wave? If the size of the "mark to market" process does not exceed 1991 levels, then firms like CFC and BSC will easily ride the waves.
But if the vile combination of derivatives, leverage and hedge funds creates a credit risk tsunami that is both larger and faster moving than previous credit default cycles, then traditional levels of capital may not be sufficient to maintain the solvency of many global financial institutions. Don't count CFC out of the game just yet, but this time round could see Mozillo played by George Clooney in The Perfect Storm.
A tidal wave of defaults and repricing of assets in coming months could engulf CFC and many other banks, forcing Uncle Sam to ride to the rescue to fix a systemic problem created by the Fed in the first place -- such is the magnitude of the mountain of fiat paper dollars printed by the Fed under former Chairman Alan Greenspan.
Greenspan's culpability in the latest credit fiasco stems not just from his easy money monetary policy, but from the Fed's consistent advocacy of derivatives as an appropriate vehicle for banks and investors to take risk. Under the guise of improved risk management, the Fed led the charge in Washington to lend legal and regulatory support for the development of the OTC derivatives markets, in part because other sources of profitability to the largest banks were diminishing.
Derivatives did boost profits at larger banks and dealers, but at the cost of decreased transparency and increased risk to the financial system as a whole. The Fed blithely accepted Sell Side arguments that trading derivatives over-the-counter, rather than on exchanges, represented an improvement for the safety of financial markets. Recent events now show that allowing Wall Street to migrate trading flows off exchange is an idiotic development, one that goes against the national interest.
Even Greenspan himself was forced to eventually ridicule OTC derivatives in his statement about the use of "19th Century" technology to clear credit default "swaps." Specifically, the Fed and other global regulators pretend:
That gaming via complex OTC derivatives is the same thing as classical cash investing, with or without a credit rating; That unique, OTC vehicles like collateralized debt obligations or CDOs are as liquid as standardized, exchange traded contracts and cash securities; and That statistical models such as "Value at Risk" or VAR can accurately predict the risk of OTC vehicles and derivatives markets generally.
It seems obvious to us that a breakdown in prudential guidelines on Wall Street and among federal regulators has led to the confusion that financial markets face today. Over the past decade, the Fed, SEC, other financial regulators and the managers of many private financial institutions, threw away a century worth of prudential rules and best practices for ensuring the safety and soundness of US banks, and instead embraced a culture of speculation.
The gaming metaphor is appropriate to understand the true nature of derivatives. When IRA CEO Dennis Santiago was a VP at Interactive Data Corp (IDC), one IDC unit actually calculated odds for fantasy sports leagues. A sports bet transaction is all about setting the odds so that you get equal piles of money on each side of the bet. As with OTC derivatives and most financial industry operations, the real money is made not by taking risk, but on the transaction and servicing fees.
Realized loss happens if the odds are miscalculated and an imbalance of collateral manifests. The lessons being (1) watch the balance between collateral piles scrupulously and (2) money is ultimately empirical; that is, each individual transaction is part of making or breaking the deal. These realities that apply to gaming instruments are no less true for mortgage and asset securities and the derivatives created from them. Gaming contracts and derivatives both allow risk to expand exponentially.
The cash flows from the individual loans in mortgage servicing pools are no less empirical than putting a dollar on who wins the Super Bowl. But the key to effective risk management is actually being able to measure the piles. Or as we also told the NYT last week, given that few market participants are able to value derivative securities such as CDOs, regulators in the US and elsewhere probably do not have an accurate picture of the "net" risks in the system or who holds those risks.
Part of the legacy of the lengthy debate over the New Basel Capital Accord or Basel II was to delay other urgently needed changes in the US regulatory infrastructure, particularly the update of the survey known as Shared National Credits ("SNC") to a quarterly reporting exercise for the larger, more complex banks and dealers. More than three years ago, in November 2004, the regulators outlined changes to the SNC survey that would have included information on exposure to hedge funds and other counterparties in derivative securities.
With Basel II apparently finalized, projects like modernizing the SNC survey and related tasks, like making it possible for regulators to relate regulatory and market data on the fly, are getting intense attention. But wouldn't the national interest be better served if the changes to SNC and other improvements to supervisory infrastructure were in place now and regulators today were able to see things like concentrations of exposure to high risk hedge funds?
Indeed, looking over the wreckage on Wall Street, should regulators even proceed with Basel II at all? The very same VAR models which have proven so ineffective (or maybe were moribund all along and nobody noticed) by the CDO market collapse are enshrined in the proposed Basel II regulation. Along with an official embrace of the major ratings agencies, Basel II depends on discredited "contemporary risk management" methods such as VAR to protect the safety and soundness of global banks.
Would it not be more than a little ironic if global bank regulators were forced to repudiate Basel II because the very VAR models and "derivative" ratings agency methods upon which the new regime depends have caused the collapse of the credit markets?
Consider the dilemma facing global financial regulators.
Do you move forward with a Basel II accord which has been discredited by actual events and is clearly unworkable from a risk analytics perspective? Or do you hold your nose and try to pretend that the CDO meltdown has nothing to do with the Basel II agreement?
Our answer to the above question: go ahead with Basel II, but begin immediate discussion about modifications. Meanwhile, convene a global discussion on non-quantitative methods and focus all available resources on gathering better data about actual exposures.
It's time to start watching the cash flow strength underneath OTC deals more visibly. It's also now quite clear that relying on modeled risk is no longer a good idea -- unless one wishes to be a feature in the next debacle story. Investors and regulators alike need a way to monitor risk via real market pricing, not ersatz derivative models.
To provide an intermediate cost surveillance option, IRA has begun to tune pieces of our surveillance analytics to focus on monitoring the loan portfolio performance of banks on the theory that their operational profiles may provide an indicator of whether the cash flow strength for their contributions to a given pool remains strong or are sliding towards the hazardous.
New regulatory initiatives like the update to SNC will help to fill in more of the data blanks in the global risk management puzzle. But during the next few months, regulators face a near-impossible task trying to determine where and how much risk is concentrated in the global financial system, all this thanks to the wonder of derivatives and other financial innovations.
