The Smartest Guys in the Room.....are crooks

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Postby admin » Sun Feb 17, 2008 12:36 am

go to this link for a humorous, yet accurate portrayal of the "rocket science" behind the smartest guys in the room
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Postby admin » Sun Feb 17, 2008 12:27 am


February 17, 2008
Arcane Market Is Next to Face Big Credit Test
Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated. But because swaps have proliferated so rapidly, experts say that a hiccup in this market could set off a chain reaction of losses at financial institutions, making it even harder for borrowers to get loans that grease economic activity.

It is entirely possible that this market can withstand a big jump in corporate defaults, if it comes. But an inkling of trouble emerged in a recent report from the Office of the Comptroller of the Currency, a federal banking regulator. It warned that a significant increase in trading in swaps during the third quarter of last year “put a strain on processing systems” used by banks to handle these trades and make sure they match up.

And last week, the American International Group said that it had incorrectly valued some of the swaps it had written and that sharp declines in some of these instruments had translated to $3.6 billion more in losses than the company had previously estimated. Its stock dropped 12 percent on the news but edged up in the days after.

A.I.G. says it expects to file its year-end financial statements on time by the end of this month with appropriate valuations.

Placing accurate values on these contracts is just one of the uncertainties facing the big banks, insurance companies and hedge funds that create and trade these instruments.

In a credit default swap, two parties enter a private contract in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default. These instruments can be sold, on either end of the contract, by the insurer or the insured.

But during the credit market upheaval in August, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold.

As investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claims.

“This is just a giant insurance industry that is underregulated and not very well reserved for and does not have very good standards as a result,” said Michael A. J. Farrell, chief executive of Annaly Capital Management in New York. “I think unregulated markets that overshadow, in terms of size, the regulated ones are a real question mark.”

Because these contracts are sold and resold among financial institutions, an original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay a claim.

In late 2005, at the urging of the Federal Reserve Bank of New York, market participants agreed to advise their trading partners in a swap when they assigned contracts to others. But it is unclear how closely participants adhere to this practice.

It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.

Credit default swaps were invented by major banks in the mid-1990s as a way to offset risk in their lending or bond portfolios. At the outset, each contract was different, volume in the market was small and participants knew whom they were dealing with.

Years of a healthy economy and few corporate defaults led many banks to write more credit insurance, finding it a low-risk way to earn income because failures were few. Speculators have also flooded into the credit insurance market recently because these securities make it easier to bet on the health of a company than using corporate bonds.

Both factors have resulted in a market of credit swaps that now far exceeds the face value of corporate bonds underlying it. Commercial banks are among the biggest participants — at the end of the third quarter of 2007, the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter.

JPMorgan Chase, with $7.8 trillion, is the largest player; Citibank and Bank of America are behind it with $3 trillion and $1.6 trillion respectively.

But many speculators, particularly hedge funds, have flocked to these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer.

The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations.

“The theme had been that derivatives are an instrument that helps diversify risk and stabilize risk-taking,” said Henry Kaufman, the economist at Henry Kaufman & Company in New York and an authority on the ways of Wall Street. “My own view of that has always been highly questionable — those instruments also encourage significant risk-taking and looking at risk modestly rather than incisively.”

Officials at the International Swaps and Derivatives Association, a trade group, say they are confident that the market will stand up, even under stress.

“During the volatility we have seen in the last eight months, credit default swaps continue to trade, unlike other parts of the credit market that have shut down,” said Robert G. Pickel, chief executive of the association. “Even if we have a series of credit events at the same time, we have the processes in place to enable the market to deliver.”

Such credit problems have been rare recently. The default rate among high-yield junk bonds fell to 0.9 percent in December, a record low.

But financial history is rife with examples of market breakdowns that followed the creation of complex securities. Financial innovation often gets ahead of the mechanics necessary to track trades or regulators’ ability to monitor the market for safety and soundness.

The market for default insurance, like the subprime mortgage securities market, is a product of good economic times and has boomed in recent years. In 2000, $900 billion of credit insurance contracts changed hands. Since then, the face value of the contracts outstanding has doubled every year as new contracts have been written. In the first six months of 2007, the figure rose 75 percent; the market now dwarfs the value of United States Treasuries outstanding.

Roughly one-third of the credit default swaps provided insurance against a default by a specific corporate debt issuer in 2006, according to the British Bankers’ Association. Around 30 percent of the contracts were written against indexes representing baskets of debt from numerous issuers.

But 16 percent were created to protect holders of collateralized debt obligations, complex pools of bonds that have recently experienced problems because of mortgage holdings.

There is no exchange where these insurance contracts trade, and their prices are not reported to the public. Because of this, institutions typically value them based on computer models rather than prices set by the market.

Neither are the participants overseen by regulators verifying that the parties to the transactions can meet their obligations.

The potential for problems in sizing up the financial health of buyers of these securities leads to questions about how these insurance contracts are being valued on banks’ books. A bank that has bought protection to cover its corporate bond exposure thinks it is hedged and therefore does not write off paper losses it may incur on those bond holdings. If the party who sold the insurance cannot pay on its claim in the event of a default, however, the bank’s losses would have to be reflected on its books.

Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive.

To be sure, the $45 trillion in credit default swaps is not an exact reflection of what would be lost or won if all the underlying securities defaulted. That figure is impossible to pinpoint since the amounts that are recovered in default situations vary.

But one of the challenges facing participants in the credit default swap market is that the market value amount of the contracts outstanding far exceeds the $5.7 trillion of the corporate bonds whose defaults the swaps were created to protect against.

To the uninitiated trying to understand this complex market, its size might initially seem a comfort, as if there were far more insurance covering the bonds than could ever be needed. But because each contract must be settled between buyer and seller if a default occurs, this imbalance can present a problem.

Typically, settling the agreements has required the delivery of defaulted bonds if the insurance buyer wants to be fully covered. If the insurance contracts exceed the bonds that are available for delivery, problems arise.

For example, when Delphi, the auto parts maker, filed for bankruptcy in October 2005, the credit default swaps on the company’s debt exceeded the value of underlying bonds tenfold. Buyers of credit insurance scrambled to buy the bonds, driving up their price to around 70 cents on the dollar, a startlingly high value for defaulted debt.

Market participants worked out an auction system where settlements of Delphi contracts could be made even if the bonds could not be physically delivered. This arrangement was done at just over 36 cents on the dollar; so buyers of protection on Delphi who did not have the bonds received $366.25 for every $1,000 in coverage they had bought. Had they been valuing their Delphi insurance coverage at $1,000 per bond, they would have had to write off that position by $633.75 per $1,000 bond.

That is why the valuation of these contracts is of such concern to some participants.

As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in.

“The insurance business is very difficult to quantify risk in,” said Mr. Farrell of Annaly Capital Management. “You have to really read the contract to make sure you are covered. That is going to be the test of the market this year. As defaults kick in and as these events unfold, you are going to find out who has managed this well.”

And who hasn’t.
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Postby admin » Mon Feb 04, 2008 12:07 am

Are investment products lacking transparency?

If transparency is essential to preserve investor confidence, why isn’t there more of it?

By Laura Bobak Investment Exectutive Magazine
January 2008

Let’s face it: many financial products leave clients perplexed.
The fees behind principal-protected notes are confusing;
mutual funds can be elaborate;
the details of hedge funds are vague and opaque;
then there’s the complexity of asset-backed commercial paper.
Although some efforts are being made to clarify fees and the structure of widely used products such as mutual funds (which are also the subject of increased regulation), investor advocates and industry analysts say there’s still a long way to go on the road to industry transparency.

Indeed, in a speech in Toronto this past month, outgoing Bank of Canada Governor David Dodge laid part of the blame for the past summer’s market turmoil on lack of information: “Problems related to information contributed to the market turbulence. We have seen the emergence of increasingly complex structured products, which were developed in response to the demand for higher returns.

“And as these securities have become more complex and opaque, in many cases, it has become harder to assemble and understand all the information needed to determine what kinds of assets are backing the security, the quality of those assets and the counterparty risk involved.”

If clients insist on greater transparency, they’ll get it, Dodge says. Credit-rating agencies should explain more clearly how they rate highly structured products and that their ratings should not be used with the same degree of certainty as ratings for conventional, single-name issuers. Investors [and members of pension funds, taxpayers who fund public treasuries, etc - JFR] also need to be told, Dodge says, that certain instruments do not trade with the same degree of liquidity as others.

There’s also the issue of some investors’ mistaken belief that they are well briefed about their choices. In fact, many do not have the financial literacy to grasp what’s being disclosed, let alone what’s not. And that can result in purchasing products that do more harm than good to their financial situations.

“The best way to deal with risk,” says investor advocate Ken Kivenko, who runs the Web site, “is really to understand what you are being sold, the fees involved, tax efficiency and how the fund fits into your portfolio’s asset allocation.” [Good advice - did PSP Management follow it in buting ABCP? - JFR]

Canadians are plagued by high fees and a shortage of straight facts, he says: “They’re stabbing you in the front, not in the back, with high fees (salaries in our case) and opaque disclosures (NONE in our case).”

Some investor advocates also say that simply flagging questionable products for investors isn’t good enough. “Transparency is not a substitute for the investment industry’s duty to design products with minimal red flags,” says investor activist Diane Urquhart. “The financial advisor needs to market products without deception. In the retail market, financial literacy is not high. The complexity is so high, people don’t understand transparency, in any case.”

Here’s a look at some of the red flags raised by some of the industry’s murkier products:

Principal-Protected Notes

The lack of transparency in PPNs has led the federal government to announce that, as of April 1, it will require more disclosure both before and after the sale of these interest-bearing deposit products. Clients should understand that fees are high relative to the return, which is linked to the performance of underlying assets such as funds linked to stock market indices or commodities, say investor advocates.

“By and large, even if the PPN has a few good years, those fees just eat away at you,” says Kivenko, who points out that often the underlying products linked to PPNs are Canadian mutual funds, which are themselves plagued with high fees. “If there are fees on top of that for the note, what chance do you have?” he asks.

And although the principal is guaranteed, PPNs are not as low-risk as a GIC because they are not covered by deposit insurance. In addition, clients may not be aware that only a relatively small portion of the amount invested is placed in products with upside potential: the rest is used to cover the principal returned at maturity.

“PPNs are opaque,” Kivenko says. “People don’t have a clue what they’re buying. The people selling them are not always professionals. If it were a mutual fund, you’d have to be a registrant. But we don’t know who is selling PPNs. It could be some guy in the branch in his office with no professional qualifications.”

Kivenko also says it’s unclear who regulates PPNs: “We wrote the government and we said: ‘Who is it?’ We didn’t get an answer — yet.”

Some firms have improved disclosure, Kivenko says, but he’s still concerned, especially since the new regulations proposed by the federal government are principles-based, not mandatory requirements.

“If there’s one product that needed absolute uniform ways of communicating to retail investors,” he adds, “this would be the one.”

Mutual Funds

In comparison to some other products, mutual funds are reasonably good about disclosure, says Dan Hallett, president of Windsor, Ont.-based fund analysis firm Dan Hallett & Associates Inc.

Unlike PPNs, which, Hallett says, have fee disclosure in irregular and illogical places such as in a section entitled “net asset value,” a mutual fund prospectus is easy to compare with documents from other funds.

“If you’ve gone through a few of them, it’s very easy to compare them,” Hallett says. “There’s a lot of irony that regulators continue to pound away at mutual funds and segregated funds, and they are just getting around to PPNs.”

However, Hallett complains that mutual funds no longer have to release statements of portfolio transactions, which in the past could be requested by an investor or through the System for Electronic Document Analysis and Retrieval online at Hallett argues that without this information, it’s hard to tell if a portfolio manager is actually sticking to his or her stated investment policy.

Recent regulatory efforts are also falling short, Hallett says. In his view, the proposed two-page Fund Facts document for mutual funds and segregated funds recommended by the Joint Forum of Financial Market Regulators, an umbrella group set up in 1999 to co-ordinate the regulation of financial products, doesn’t improve disclosure in a meaningful way in the areas of “risk” and “suitability.” Hallett says investors could understand their risk level better if shown a chart showing rolling returns or past declines in the fund’s benchmark; this would be preferable to the six-point scale rating risk from very low to high.

Investors also need to know how the advisor is compensated through commissions and trailer fees; whether there is a deferred sales charge; and how high the management expense ratio is compared with other funds in the same category. Clients are also likely to have questions about non-MER expenses, which include trading fees, brokerage commissions and taxes on distributions.

Urquhart says there should be a Web site to which clients can go to see mutual fund portfolio transactions: “You should have the right to receive it if you choose.”

Hedge Funds

These funds should not be sold to retail investors unless these funds are prepared to issue a prospectus in the same manner as mutual funds, Urquhart says.

“It’s an absurdity for a country to allow that to occur,” she adds, speaking of the current regulations allowing minimal disclosure through an offering memorandum. “I don’t want accredited investors to have to play Where’s Waldo.”

Urquhart also suggests that clients who are not privy to the investments held by their funds need to ask questions. How long has the fund been in business? What are the qualifications of the fund managers? How much leverage will the fund take? To what extent will derivatives be used? What are the fees (which are usually 1%-2% plus 20% of the profits above a certain risk-free return, Urquhart estimates)?

“They get 20% of the upside,” she says of fees, “but are they going to pay you back when they lose your money?”

Income Trusts

These trusts are not required to disclose their calculations of distributable cash in a standardized format, an item normally dealt with in the publicly traded companies’ management discussion and analysis.

The murkiness of income trusts has been questioned by the Canadian Institute of Chartered Accountants, which has recommended that trusts be required to use standardized methods of reporting distributable cash. But as of November, only a few trusts have begun using the standard format. The CICA recommends that trusts disclose from what source distributable cash is coming (income, investor capital or debt), and whether the trust’s capital spending is adequate to maintain its operations.

Critics of trusts, such as forensic accountant Al Rosen of Accountability Research Corp. , have complained that many clients don’t understand that they are often merely getting their own money back when trusts make their distributions.

Another scenario, according to Urquhart, is the income trust mutual fund: in a hypothetical example, such a fund could be billed as having a 16% return, when in fact the real return — the amount that remains when the investor’s own money or funds from other sources of financing are subtracted from the amount being paid out — is 5%. And of that 5%, a further three percentage points might well be eaten up by MER fees.

“The customer would not buy that if they knew about the fees,” Urquhart says. “People construe it to be income, and they might be willing to pay higher fees than they should. You shouldn’t have to pay fees to get your own money back.”

Asset-Backed Commercial Paper

One of the reasons investors lost faith in ABCP is that the companies peddling the product released very little information about the underlying assets; this led some investors to stop rolling over their notes.

Hallett says that when he tried to find out about a few ABCP trusts being sold by Coventree Inc. , the firm at the heart of the summer liquidity crisis in Canada, he found very little about the creditworthiness of the underlying assets in the ABCP “information statements” released to investors.

“The disclosure is lacking significantly,” Hallett says. “There’s really no description of the assets.”

As with PPNs, there is also a troubling range in the quality of disclosure among ABCP notes. “It’s not that great,” Hallett says. “That’s the reason we hit this wall of liquidity — because there is no transparency.” IE
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The Smartest Guys in the Room.....are crooks

Postby admin » Mon Feb 04, 2008 12:05 am

As I sit on a sunday night, watching ENRON, THE SMARTEST GUYS IN THE ROOM on CBC, The Passionate Eye, I am allowed a few thoughts.

First is the thought that from Michael Milken's junk bonds in the 80's, to hedge funds in the '90's, to some of the worse Royalty Trusts, to current Asset Backed Commercial paper crisis, they all have one thing in common.

They all were synthetic schemes cooked up to play games with peoples money by folks who were "the smartest guys in the room" at that time.

They just keep rotating the guys. The game never changes. In the United States, at least the securities and judicial system is attempting to hold some of these guys accountable and responsible. In Canada, we actually have top regulators saying publicly that "we don't want to see our white collar criminals go to jail".

Enron appears in hindsight to be another case of letting the "Emperor with no clothes", pull the wool over everyone's eyes.

In Canada, with our current system of regulators, and private rental cop agencies we call "self regulators", we are providing a perfect breeding ground for the smartest, the richest and the most pathalogically deficient people in the world to work their magic here without consequence.
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