Tom Armistead

Geithner's Bad Judgment Leaves Taxpayers Holding the Bag

Personal attacks on Geithner are uselss and counter-productive. I followed the AIG situation as it developed, and have now read the SIGTARPs report, a pre-condition for intelligent discussion.

The outcome was inevitable once the decision was made to bailout AIG. The counterparties on the CDS had what were in effect market value guarantees, and once AIG was supported by the triple A credit of USG they cashed them in. Geithner had an extremely bad lie, created by more than a decade of negligent regulation in which Congress played a pivotal role.

Specifically, CFMA exempted CDS from regulation as insurance, and OTS was way overmatched as a regulator for AIGFP, or any financial institution for that matter. If CDS had been regulated as insurance, which is what they are, AIG would have written less coverage and what they did write would have been supported by adequate reserves and would not have included the requirement of collateral posting.

The request for an audit by SIGTARP was politicallly motivated: the resulting attacks on Giethner are politically motivated: meanwhile, these same members of Congress were asleep at the switch when they let CFMA get passed and voted into law. They were also remiss in that they watched and applauded and created the entire process of deregulation which got us where we are today.

Understanding the AIG Decision

There was another alternative - the USG could have guaranteed AIG's performance, asserted the right to reduce collateral in accordance with its AAA credit rating, and left the deals in place.

The supersenior CDOs that AIG insured were still performing well when last I heard. Much of the underlying CDOs are now in Maiden Lane and hopefully the USG will let us know what they are actually worth when ultimate performance becomes clear.

The issue was more about AIG having let itself be maneuvered into a position where it was in effect the guarantor of market values in an insane, panicked market.

Discretion and Financial Regulation: Always Doing the Wrong Thing

A very good description of the forces that make the regulation of financial institutions pro-cyclical. There are a number of common sense ways to reduce this tendancy.

Banks could be required to establish loan loss reserves concsistent with very long term averages. Instead of going from 1% in times of prosperity to 7% in times of economic stress they could be required to establish a 3 or 4 % reserve on each year's loans and relieve it only when the loans are actually paid off.

This would impact capital requirements. Capital requirements could be subject to periodic revision by the Fed or another central regulatory - as credit became to loose the banks could be reined in by raising capital requirements. That would reduce the creation of real estate bubbles.

Finally, regulation must rely on a bean by bean examination of loan terms, conditions, and collateral. Over this weekend I was reading the OTS examiners manual and the degree of oversight in this area was set so low that an incredible amount of fraudulent and imprudent lending activity went undetected. The sample size was set to accommodate 10% bad loans, and then anything that was located was treated as an exception. A bank regarded as low risk could get away with the examiner looking at 15 cases and then being talked into treating any problems fround as an exception.

This last type of laxity can be fixed by Legislation, set the sample requirements big enough to detect problems. The examinations in turn would be auditted by the FDIC, who have a stake in the accuracy of the results.

CDS Regulation: Just One Simple Rule

KD, some thoughts on insurable interest. Insurance case law on the subject does not see expectations as a grounds for insurable interest, so the possiblity that GS might expect to do business with someone in the future would not create an insurable interest.

The important thing is that the insurance buyer be exposed to loss caused by default of the reference entity, and that the amount payable in the event of loss place him in the same situation he would have been in if no loss had occurred. A direct debtor/creditor relationship would be ideal, counterparty is potentially a debtor/creditor situation.

It's farily easy to construct hypothetical cases, like an auto parts supplier that had an a/r exposure to GM, if you owned the stock of the supplier you were exposed to credit risk from GM, so on and so forth. I personally would lean toward something more limited.

A very common practice that would be eliminated, and I think rightly so, would be the whole synthetic and credit linked note business. These transactions create excess supply of bonds, sometimes are less costly to assemble than acquiring the actual bonds, and have been used in dishonest ways. My favorite example I found on the Irish market was credit linked notes referencing Icelandic banks, 2 weeks before they blew up. The product is fundamentally dishonest and would be illegal if insurable interest were a requirement.

AIG's problem was that they had to post collateral. MBIA and Ambac generally did not issue CDS where they were required to do this, and they are still around in spite of having written worse business. By posting collateral, AIG placed itself in the position of guaranteeing market value, and created a situation where GS and others were able to profit by making the collateral requirement define the loss. The residue sits in Maiden Lane and is performing well and appreciating in value. The is about defining loss in such as way that the insurance buyer does not profit from loss.

That's what it's about, insurance transfers a pre-existing exposure to risk or loss: gambling creates a possiblity of gain or loss where none existed before the transaction.

CDS Regulation: Just One Simple Rule

I forgot to mentin that naked CDS is the equivalent of the naked short sale of a bond. Just like naked short selling of equities, it is a tool for manipulation.

CDS Regulation: Just One Simple Rule

Kid,
BSC, LEH, AIG, MBI, ABK, MER, AIG etc. were all brought down or severely damaged by the buy CDS, naked short, and put out the word short and distort crew. Have you every looked at the threshold lists from that point in time? A situation was created where no financial instituion had any access to capital. Finally, the failure of the Federal Government to stop the carnage brought Lehman down and with it very nearly the entire economy and financial system. Panic ensued, everybody started cutting production, canceling orders, firing workers, etc. So we nearly had a Depression because of CDS and you don't see a problem?

Your argument that hedging exposure to counterparty risk shows there is a need for CDS not supported by an insurable interest doesn't hold water, for the simple reason that a counterparty exposure creates a chance of loss due to the insolvency of the counterpary which in turn creates an insurable interest.

To deny the moral hazard created by CDS in the absence of insurable interest is absolutely naive: you clearly do not understand human nature. Arson and murder for profit are a fact of life: that's how people behave; that's why fire and life insurance have requirements of insurable interest.

Obviously, some of the institutions taken down were fragile. However to justify perpetrating the financial equivalent of arson on those firms is similar to reasoning that anybody who lives in a frame dwelling has no reason to complain if someone buys eight insurance policies on his house and then burns it down. The victim of arson is not responsible for his loss becasuse he did not live in a concrete bunker.

For that matter, a person who murders for the life insurance proceeds can't justify himself by saying: "the victim had cancer, he was going to die anyway."

I am not sure why you wish to bring mark to market into a discussion of CDS. What I have observed is that many of the securities that were the issue in mark to market have recovered much of their value. Similarly, many CDS spreads have come back down into contact with reality. But the damage done to the firms involved and to their shareholders has not yet been repaired.

The whole effect of permitting the sale of naked CDS was to give an irresponsible band of financial manipulators access to a huge amount of leverage which they promptly applied to every financial instituion they could finger as a remote possiblity for take-down. Finally we had the Fed guaranteeing the credit of GE and GS, and others, with Warren Buffett putting his money on the line, for huge profits.

That was the high point of the CDS bear raids, when the spread for GE ballooned out and it looked like they were gonig to bring down the big one.

CFMA, carefully engineered as an end run around regulation for the likes of Enron, and the perpetrators of CDS, was one of the most egregious examples of our legislators selling out to financial interests who have destroyed free market capitalism as it had been established following the Depression. One by one the protections created in the wake of that horrible time in the life of this country were taken down, cumulating with CFMA which brought the curse of unregulated CDS down on the country, destroying trillions of dollars of wealth.

To summarize, CDS should be regulated as insurance, with a requirement of insurable interest for the buyer and adequate capital for the seller.

CDS Regulation: Just One Simple Rule

CDS levels affect the perceived creditworthiness of a company and their cost of funds. Financial companies that rely on credit can literally be put out of business by these perceptions. CDS were widely used in conjunction with naked short-selling in short and distort manipulations to take down financial firms leading up to the meltdown.

Naked CDS are gambling contracts, and contrary to your apparent belief system Wall Street is an inappropriate location for a casino operation.

Lack of insurable interest creates a motive to cause a loss - something that can be done be spreading rumors. The exemption from regulation of CDS was a primary cause of the financial crisis.

The correct "one rule" is a requirement of insurable interest: you have to own the bond in order to buy the insurance.

Financial Regulation: How Would You Have It Work?

Bernanke has mentioned a number of times that the current regulatory regime is pro-cyclical, and suggested that this be changed. That would mean that capital requirements would go up in times of economic tranquility and down in times of stress. The Fed could have a target capital ratio and raise or lower it in judicious .25 point increments, with much fanfare and a carefully crafted statement for the press to parse.

There is no reason why CDS should have been allowed to be exempt from regulation and there is no reason why naked CDS should be bought and sold at all. Lehman would still be standing if CDS had been properly regulated rather than permitted as a casino on Wall Street.

Speculation by "banks" and others in the various markets could be supressed by setting punitive margin requirments in order to reduce leverage. Again the Fed could review the margin requirements frequently and change them incrementally with much
fanfare.

Banks could go back to accepting deposit and making loans, and the whole array of speculative and manipulative trading they are premitted to perpetrate on the investment community could be made illegal.

Bank of New York and Bank of America vs. AIG: No Winner in Sight

I spent a tedious half hour reading the decision. The transactions consisted of Master Policies under which individual certificates were issued for each loan.

UG was attempting to rescind the Master Policies in their entirety but did not have a very good case based on the wording of the policies or the conduct of the parties. UG had a right to audit or sample the underlying loans before issuing the Master Policies: however, they did not do so. So the Master Policies will stand. However, individual certificates can still be denied based on fraud.

UG was trying too hard to be "easy to do business with" on these bulk transactions and they didn't exercise due diligence. The Master Policies had provisions on how to handle fraud by the issuer so it was part of the deal.

THis is not going to blow up the MI system. All mortgage insurers routinely deny coverage in the event of fraud and that is going to continue and will be supported by the courts.

The Key to Regulatory Reform: Flexibility

The "moral hazard" is ceated by the fact that any government that is confronted by speculative attacks on key financial institutions has no realistic alternative but to defend the institutions by issuing guarnatees or other capital support.

Speculative attacks normally occur when a country has excessive debt, whether located in the financial sector, the private sector, or the government.

The implication is that regulation will not be successful until debt in the overall system is brought down to manageble levels and contained there by fiscal discipline on the part of government and prudential regulation of those who grant credit, to prevent excessive lending.

Capital requirements for banks need to be flexible and contra-cyclical: they need to be strict when times are good and lenient when times are bad. Counter-intuitive but Bernanke has stated over and over again that the current regulatory regime is pro-cyclical and accordingly unstable.

What that means is that just as soon as the economy gets rolling sustainably capital requirements for banks need to be ratcheted up and kept up as long as conditions are prosperous. Then, when things get tough, there will be room to cut them some slack.

Bernanke Proposes New Oversight to Manage Risks to the Financial System

The government confiscated 80% of AIG as a fee for making loans that will be repaid and generate a profit. AIG was forced to take a loss on their assets now in Maiden Lane facilities, Ed Liddy couldn't stand the pressure, paid insured parties in full and then gave the assets to the USG at half price. That sorry scenario is a good reason to have a set of rules that officials must comply with to wind down or prop up questionable financial institutions.

As far as systemic risk oversight, the SEC was supposed to be regulating GS, ML, C, JPM and LEH as CSE's: the SEC bragged before Congress at how good their oversight of systemic risk was, how every month those under supervision reported their VAR and everything was under control. Regretfully this approach of having those who were supposedly being supervised set and report their own capital requirements and risk profile was a useless exercise in self-deception.

What is needed is hard and fast capital rules, rigidly applied, together with legislation outlawing financial gambling by the use of derivatives. That would get us back to where we were before all the trouble started.

Monoline Mania: MBIA and Ambac Included in the Dash to Trash

jimmy,

I was wondering about that myself. MBIA has stated that it is corporate policy to sue anyone whose fraudulent actions have harmed their shareholders. They have not sued any rating agency, although they have been pretty thorough about suing the other parties responsible.

As far as I can see the players in the securitization game seem to have this belief that the normal rules about fraud and so on, even when supported by contractual clauses, just do not apply to their situation. It's like the whole area is supposed to be outside of the reach of established business and contract law.

I found that also going over the financial statements of some of the players, they were aware of warranties and representatons liability and would mention it in passing but setting up meaningful reserves and publishing them just doesn't seem to happen. The belief seems to be that it will just go away if they ignore it long enough.

Jay Brown said it could take 4 years for all of this to be resolved.

On another topic, MBIA made a list of the 20 most concentrated hedge fund holdings, a list that has outperformed the S&P by 14% a year since 2001, the article was here on S-A.

On Sep 04 03:32 PM jimmy46 wrote:

> Hello Tom
> Here's something in the news yesterday:
>
> ""Investors who believe that major credit-rating firms should be
> held responsible for their disastrously optimistic ratings of subprime-mortgage
> bonds have won at least an interim victory.
>
> U.S. District Judge in New York ruled late Wednesday that Moody’s
> Investors Service and Standard & Poor’s can’t invoke the 1st
> Amendment to hide from subprime-related legal challenges.""
>
>
> Is this ruling likely to have significant benefit for MBA,
> or do the rating agencies have 10 more lines of defense?

Monoline Mania: MBIA and Ambac Included in the Dash to Trash

What I did was sell enought of the September 7 calls to cover the cost of establishing that part of the position, 14 calls I sold out of 80 I owned. So I got to play the game next month on house money, try to trade my way to owning some free lottery tickets.


On Aug 28 03:02 PM alajac wrote:

> Hope you sold the open, Tom (though by option exp I think we'll be
> higher). I think we are (next) going to work down for a retest of
> some moving averages and then get one last big rally starting September
> option expirations week, pretty much just like in 1938. That should
> pretty much be "it" for the major upside for the next few years.

Was the AIG Bailout a Goldman Bailout by Proxy?

The most damining information: Dinallo's assertion that Goldman Sach got to collect on an insurance policy without having a loss.

When last I heard the super senior CDOs insured by AIG had 3% that were not paying.

A misstatement that needs correcting is that Paulson spent 85 billion buying AIG. The US Government loaned the money to AIG and recieved promises of repayment and heavy commitment fees, together with warrants at a nominal price for common shares equal to 80% of the company.

Basically Paulson destroyed AIG to recue Goldman Sachs and other counterparties.

JPM and Maiden Lane: What the Fed Doesn't Want Us to Know

You are way off base on the AIG wrapped CDOs in ML III. So far, 3% of the CDOs are not paying: ie, 97% are paying. These were bought for market price, which was about half of par, and are probably worth much more when the smoke clears.

The situation is similar on MLII.

The Federal Reservie is not going to lose money on these transactions. AIG lost the money.