Iceland Under Siege; Corrigan Group Redux

Eventually, I believe, as do others, that over-the-counter derivatives such as credit default swaps will have to be cleared and settled through central clearing houses such as those used by the futures exchanges. For all the chicanery of speculators and hedgers on the exchanges, there have been no fears of contagion, of one participant's failure leading to others, of the sort that led to the Bear Stearns bail-out/ takeover/near collapse. Tragically, though, this would reduce the profitability of the banks' derivative businesses or, rather, the profitability in good times. In bad times, it would reduce potential or realised losses from counterparty risk.
John Dizard
Financial Times
4/15/08

First, we want to thank our readers for the kudos we've been receiving regarding the ability of Economic Capital simulation in The IRA Bank Monitor to predict degradations in bank business models, most recently in the case of State Street Bank (NYSE:STT).

Henry writes: "Looks like your EC to Tier 1 ratio of STT was extremely prescient. STT is being put on 'Negative Ratings Watch' by Fitch today, which means a possible downgrade next. JPMorgan Chase (NYSE:JPM) is definitely the next one to watch. May your analysis come true."

Thanks Henry. BTW, STT has a ratio of EC to Tier 1 RBC of 7:1. JPM is just shy of 5:1. EC/Tier 1 RBC ratios for all US banks are available in The IRA Bank Risk Compendium.

The IRA traveled to Iceland this week to address that nation's banking, pension fund and regulatory communities on our favorite subject, namely OTC credit default swaps or CDS. Click here to read our presentation, "Credit Derivatives and Other Acts of Satan."

We must give credit for the delicious satanic reference to our friend John Dizard, who writes one of the more interesting and informative weekly columns in the Financial Times. It is quite a comment on the state of the news business when a skilled stylist like Dizard is able to convey more facts and insights in his weekly essay than most of the "hard news" reports in the FT.

Our critical views regarding the sad state of financial news reporting are reinforced by our visit to Iceland. Just as the word�"Iceland" describes a country that in fact has very little snow and ice, this due to the warm waters of the Gulf Stream, the dismal news reports about financial travails of this courageous nation of 300,000 people seem at odds�with the actual reality on the ground.

The Icelandic currency has been pounded in recent months as worries about the nation's trade balance and the banking system caused offshore investors to run for cover. The economy is expected to slow to little or no growth in 2008 and sharp recession in 2009, this as the central bank tries to control�inflation with double digit interest rates a la Paul Volcker. Yet unlike the US, Iceland has little external public debt and a dynamic, entrepreneurial business community which is intent upon building long-term wealth via direct investment around the world.

Spreads on credit default swaps for Icelandic banks currently trade in the 800-1,000bp range or more than 10x year-ago levels, but the volumes traded at these spread levels are thin, reflecting reluctance to buy protection at such levels. The sharp rise in CDS spreads for Iceland's three largest banks vastly exaggerate the economic situation, local observers tell The IRA.

Bankers and regulators in that country insist that, despite the tough macro picture, the junk level CDS spreads are the result of persecution by a vicious group of hedge funds; unregulated entities which are not afraid to evade securities laws, sometimes in multiple venues, to achieve their ends, the Icelanders complain. And the Icelanders blame the laziness of the global financial news media for not reporting both sides of this story.

Several Icelandic bankers tell The IRA that a handful of US and UK-based hedge funds, joined by Norway's State Oil Fund, are employing illiquid CDS markets to drive the apparent cost of funds for the three major banks to ridiculous levels - this in the hope of creating a liquidity crisis and perhaps even a national financial meltdown. Despite their common heritage, apparently there is no love between Norway and Iceland.

The Icelanders claim the hedge funds act in collusion and are conducting a concerted campaign of lies and vilification against their banks and the Icelandic economy. They cite repeated false statements made to the media about the financial condition of Iceland's commercial banks, attempts to suborn journalists and researchers into broadcasting these falsities, and threats of legal action by hedge fund employees against researchers and journalists who dare criticize these hedge funds by name.

So bold are these funds, say the Icelanders, that they even employ public relations firms to act as paid propagandists. Is this the brave new world of modern finance? Orchestrate a financial crisis then profit from it using cash settlement derivative gaming contracts?�� Perhaps it is no coincidence that these very same tactics were used by hedge funds during the partially successful bear raid against Bear, Stearns (NYSE:BSC). BSC, after all, did not actually default, depriving the hedge funds with long-CDS positions of the big payoff. Yet one reason that hedge funds are able to successfully attack victims like BSC or even an entire country like Iceland is the lack of liquidity and transparency in the OTC derivatives markets.

Icelandic banks are vulnerable to external market pressures due to the large percentage of liabilities not funded with core deposits, but unlike US banks, their balance sheets are unpolluted with highly leveraged structured assets, subprime loans and OTC derivatives. Given a choice between a short CDS position in say Kaupthing Bank, Iceland's largest, and JPM, we would take the former every time despite the huge difference in CDS spreads in favor of the later -- at the moment. Iceland's banks have none of the OTC market risk that weighs upon the top US names. Indeed, did you know that the largest US banks generated $2.6 billion in losses from CDS in Q3 2007 (latest data available from the OCC).

CDS spreads are more a function of speculative momentum than an indicator of default probability, thus the current wide spreads will soon attract investor attention. Since, in our view at least, the actual P(D) of the three major Icelandic banks is just about nil, in part because neither the Icelandic�pension funds nor the central bank would ever allow them to default, enlightened investors able to write CDS on these names should be taking all of the bids available at current spread levels. The state pension system in Iceland is fully funded and around the same size as that of Norway's State Oil Fund on a per capita basis.

As we told the IFSA, the best way to deal with troublesome hedge funds wielding illiquid CDS is to bury them in same. To us,buy side investors who own Icelandic bank debt should start hitting bids in CDS and take advantage of the ridiculous spreads before they disappear.

Corrigan Group Redux

Meanwhile, back in the US, news reports indicate that The Corrigan Group will be reconvening, led exclusively by representatives of the largest banks, to study the crisis affecting the financial markets. Limiting the participation in the Corrigan group solely to representatives of the largest banks almost ensures that the Group's recommendations will be entirely inadequate and irrelevant.

Back in June 2006, IRA co-founder Christopher Whalen interviewed his former boss, NY Fed President Gerald Corrigan, for an editorial in Barron's (See "A New Form for Risk Are these derivatives over-the-counter, or under it?," Barron's, June 5, 2006) regarding the counterparty risk inherent in OTC derivatives. At the time, the Goldman Sachs (NYSE:GS) risk honcho rejected the idea that OTC instruments like CDS eventually must be traded on exchanges in order to avoid precisely the systemic risk event which led to the failure of BSC earlier this year.

Two years ago, Corrigan argued that CDS must be traded OTC in order to ensure that clients can customize the structures to meet their particular needs. We disagree. Mandating an exchange-based market for CDS and other OTC derivatives would not preclude an OTC market entirely.� But for the vast majority of investors, who simply need to be able to manage single name default risk via a liquid and transparent market instrument, an exchange traded CDS contract represents a huge improvement over today's deliberately inefficient markets.� In particular, moving most of the volume in OTC derivatives contracts onto exchanges would eliminate much of the bilateral counterparty risk that killed BSC, almost killed Lehman Brothers (NYSE:LEH) now threatens Iceland and other nations in the global marketplace with systemic disaster.

Given that Corrigan has spent much of his professional life warning the financial markets about the systemic risks menacing institutions and markets, we find it inexplicable that he would ignore the lessons of the BSC debacle and continue to take a position which seems to us, at least, entirely retrograde. Obviously all of the major dealer firms benefit from the wider spreads and bigger profits in an OTC market structure, but at enormous risk.� Does anybody really believe that the RAROC of being a dealer in OTC derivatives is positive?

Could it be that Corrigan's position at GS and that's firm's vested interest in the OTC�status quo has clouded the vision of this dedicated public servant? No, we don't believe that. At the end of the day, we think Gerry Corrigan will put aside personal interest and do the right thing. But he may need some help.

So next week, we shall publish an open letter to Corrigan and Douglas Flint, Vice Chair of the Corrigan Group and Group Finance Director of HSBC (NYSE:HBC), asking them to open the Corrigan Group's deliberations to a wider group of experts on OTC markets, including representatives of Buy Side firms, commercial companies and the academic world. We'll let you know what happens.