Banks Prefer Mandatory CDS Clearing Over Exchange-Based Model

LONDON, Nov 20 - Some of the world's top banks are backing a proposal to develop a mandatory central clearing system for the $55 trillion credit default swap (CDS) market, a report in the Financial Times said on Thursday. Dealer banks are stepping up efforts to back CDS clearing to head off a more radical overhaul, which includes a proposal to move trading of over-the-counter CDS on to an exchange, the report said, citing an internal Morgan Stanley email.

Credit default swaps, which protect against a debt issuer's default, have been blamed for the worsening financial crisis, and banks fear that they might lose business if regulators insist on an exchange model for trading, the FT said.

"We have teamed up with a small group of dealers to put together a legal and regulatory proposal for CDS which we will propose to Congress and the Fed in an effort to address many of their concerns around CDS," said the internal email, sent by James Hill, a managing director at Morgan Stanley, according to the FT.

"This proposal will include mandatory clearing of CDS, margin rules, oversight of dealers and large market participants and SEC jurisdiction over anti-fraud and market manipulation activities," the email said.

Morgan Stanley could not immediately be reached for comment.

Publish Date:November 20, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=212101000

PWG Offers Initiatives to Strengthen OTC Derivatives Oversight and Infrastructure

The President's Working Group on Financial Markets is rolling out a series of initiatives to strengthen oversight and the infrastructure of the over-the-counter derivatives market.

Initiatives include the development of credit default swap central counterparties, some of which will commence operations before the end of 2008, and the establishment of a Memorandum of Understanding regarding CDS central counterparties among the Federal Reserve Board of Governors, the Securities and Exchange Commission and the Commodity Futures Trading Commission. The PWG also rolled out a broad set of policy objectives to guide efforts to address the full range of challenges associated with OTC derivatives and issued a progress summary to provide an overview of the results of ongoing efforts to strengthen the infrastructure of OTC derivatives markets.

The Treasury Secretary serves as Chair of the group, which includes the Chairs of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The PWG, working with the Office of the Comptroller of the Currency and the Federal Reserve Bank of New York, has been actively overseeing improvements underway in OTC derivatives markets and the reports issued today identify the progress already made and specific objectives for the relevant supervisors going forward.

Over-the-counter derivatives are integral to the smooth functioning of today's complex financial markets and, with appropriate regulatory oversight and prudent management can enhance the ability of market participants to manage risk. The rapid growth of OTC derivatives markets over the past several years reflects their increasing importance to market participants.

Publish Date:Nov 17, 2008
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=212100253

Cheque mate - How AIG got Uncle Sam over a barrel

JUST how concerned should American taxpayers be about American International Group (AIG), the insurance company brought to its knees by its escapades in the credit-derivatives market? On November 10th a revised rescue package was announced, comprising $153 billion of capital injections and loans. That is the largest bail-out for any firm, anywhere, during the crisis. Is the government being, as AIG’s new chairman says, “very, very smart”, or has it been taken for one of the most expensive rides in corporate history?

Even on September 16th, when the state first intervened, AIG was a controversial candidate for assistance. Its insurance businesses are ring-fenced by local regulators and individually capitalised, precisely so they can survive a collapse of the holding company. A bankruptcy was avoided only because of the size of the holding company’s book of toxic credit derivatives, which senior executives barely understood. These left AIG so intertwined with other financial firms that its failure was judged by the Federal Reserve and Treasury to endanger the financial system.

Whether that judgment was right remains unknowable. But it is now clear that the original plan was flawed. That may be understandable: panic was in the air, AIG faced crippling collateral calls and Lehman Brothers had just folded. And the authorities lacked the wide powers granted by the Troubled Asset Relief Programme (TARP) approved by Congress in October. Unorthodox options, such as splitting the systemically threatening credit derivatives from AIG, were not under discussion.

As a result, the original plan looked a lot like the traditional remedy for a liquidity crisis at a solvent bank. The Fed offered a two-year, $85 billion loan. AIG would pay a penal interest rate and cede to the state an equity stake of just under 80%. But as collateral calls mounted on the credit derivatives, and AIG admitted to new problems, it became plain that the loan was too small. It was also too expensive: in the first year it would have cost almost as much as AIG’s profits in 2006, its best year ever.

Meanwhile the chances of AIG being able to repay the loan also shrank. In the second quarter, it had only $59 billion of core equity capital (defined here as book equity less goodwill, tax assets and stock ceded to the state). By the third quarter, more losses had cut this to a meagre $23 billion. Worse, much if not all of AIG’s capital sits “stranded” in the ring-fenced insurance units. That makes it hard to funnel it up to a holding company that is otherwise almost certainly insolvent.

The original solution was to sell the insurance operations to raise cash, but with AIG’s competitors also reeling, this looked less and less realistic. The alternative, of AIG tapping credit markets to repay the state, became ridiculous by early November. AIG’s own credit spreads implied that the company was headed for default (see chart). Prospects of even rolling over the $64 billion of non-government borrowing due to mature by 2011 became increasingly bleak.

That forced the hand of the authorities. In one sense the new package does what, with the benefit of hindsight, should have happened all along. The Fed will provide $53 billion of funding for two vehicles which will, in effect, assume AIG’s most toxic credit derivatives and mortgage-backed securities. These positions have been marked to fairly conservative levels.

In an alternative universe the government could then walk away, confident that it had dealt with the worst of the systemically important credit derivatives and that the insurance operations remained safely ring-fenced. But in the real world the state is now the biggest lender to AIG, which has drawn down the bulk of the original $85 billion facility. AIG has Uncle Sam in a bind. As a result, the Treasury, through the TARP, has been forced to recapitalise the insurer by purchasing $40 billion of preference shares. Despite this its economic stake in the firm will remain just below 80%. The Fed will also maintain a loan facility, on more generous terms, of $60 billion. And if AIG struggles to refinance its debts, it is quite possible that the state will provide a formal guarantee.

The Treasury has secured crowd-pleasing concessions; for example limits on executives’ bonus payments. But the real question is whether the preference shares are safe. AIG has a trillion-dollar balance-sheet. There is now a thin buffer of core equity between the taxpayer’s preference shares and any further losses. The hope is still that as markets recover, AIG can sell the crown jewels of its insurance business at a premium to book value. That may well take years. Plenty of time to reflect on how an offer of a temporary loan, to a company that barely made the list of systemically vital firms, spiralled into one of the biggest corporate bail-outs ever.

Source URL: http://www.economist.com/finance/displaystory.cfm?story_id=12607251&fsrc=rss