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In
The News
2005
·
US Banker, December
2005
·
Bloomberg,
November 3, 2005
·
BBC Radio, October 21,
2005
·
News Analysis, October
16, 2005
·
CBS MarketWatch,
October 14, 2005
(also
in Investors Business Daily)
·
International
Herald Tribune, October 8, 2005
·
US Banker, October 2005
·
Global Finance,
September 2005
·
HoweStreet.com,
September 12, 2005
·
Bloomberg, July 12,
2005
·
The Treasurer (Association of Corporate Treasurers),
July/August, 2005
·
Bloomberg, June 24,
2005
·
New York Daily News,
May 21, 2005
·
Investment
Dealers Digest, May 16, 2005
·
Canadian Broadcasting Corporation,
May11, 2005
·
CBS MarketWatch, May 10, 2005
(also
in AFX Asia newswire, May 10 and 11)
·
Financial
Engineering News, May, 2005
·
Chicago Sun Times,
May 1, 2005
·
Bloomberg,
March 18, 2005
·
South China
Morning Post, February 26, 2005
·
BBC
radio, February 25, 2005 (no transcript)
December 2005
USBANKER
[Article
on incoming Fed Chair Ben Bernanke]
November 3, 2005
RATE
GAMBLE: Two banks decline to comment
NO
NOTICE: Meeting's agenda not publicized
Bad
bet by state cost $123 million
Posted
by the
BY
ANDREW PRATT
BLOOMBERG
NEWS SERVICE
The
state gave no public notice that board members of its Economic Development
Authority would be deciding on May 17 whether to end the interest-rate wager by
paying Lehman Bros. Holdings Inc. and Morgan Stanley enough money to wipe out
the average property tax bill of 22,000
The
penalty
"Democracy depends on
transparency," said Randall Dodd, president of the Financial Policy Forum,
a Washington-based institute that studies government borrowing. "There are
no reporting requirements, and information is hard to get on derivatives — very
hard if not impossible."
Derivatives,
which include swaps, are financial obligations derived from debt and equity securities,
currencies and commodities. Federal disclosure rules that govern municipal bond
sales don't apply to derivatives.
The
swap contracts that
Lehman
Bros. spokeswoman Kerrie Cohen and Morgan Stanley spokesman
More
swaps
The
agreements include $3.75 billion of derivatives tied to debt of the state's
Schools Construction Corp., which was set up in 2003 to oversee public school
construction.
The
majority of the swaps lock the state into debt at borrowing costs higher than
current rates. If interest rates don't rise, the state faces a choice of either
buying out the contracts and refinancing at lower rates, or locking in debt at
higher than market rates.
Cost
to cancel
The
state would have had to pay $425.7 million to cancel those swaps in September,
according to a CDR report. That figure will rise and fall with interest rates.
Kelley
Heck, a spokeswoman for acting Gov. Codey, a Democrat
who isn't running in next week's election, referred all questions about the
state's swaps to Thomas Vincz, spokesman for state
Treasurer John McCormac. Vincz
says the state uses swaps to provide certainty about its debt expense, and that
cost of canceling a swap is relevant only if the state decides to end it.
"Market
values of swaps change on a daily basis, so snapshot portfolio assessments have
no shelf life when measuring an issuer's long-term goals, history and position
with this financial tool," Vincz says. "
"Inadequate
disclosure"
Doug
Forrester, 52, the Republican candidate for governor on the Tuesday ballot,
says he wants to create an elected, independent office of state auditor that
would monitor borrowing practices, including swaps. The state auditor is now an
appointee of the Legislature.
"The
current problems are a result of inadequate disclosure requirements that have
masked the true cost of public borrowing," says Sherry Sylvester, a
spokeswoman for the Forrester campaign.
U.S.
Sen. Jon S. Corzine, 58, the Democratic candidate for
governor, says swaps are complicated, and he would hire the best people
possible to see if
"Until
I can look at it closely, I can't tell you what the state should do," says
Corzine, a former chairman and chief executive
officer of New York-based investment bank Goldman Sachs & Co.
Canceling
the pension swaps didn't raise the state's cost of borrowing, says Caren Franzini, chief executive
officer of the Economic Development Authority in
Best
way?
Using
premium bonds was the best way to cancel the swap without taking money from
other state programs, McCormac said.
Cancellation
won't bring back the opportunity to refinance the debt at the lowest possible
rates, Franzini says.
The
state could have gotten a rate of 5.7 percent to 6 percent in 2003 had it been
able to sell conventional fixed-rate debt instead of refinancing with
variable-rate debt and the swap, according to a Bloomberg index of taxable municipal
bond rates. A rate of 6 percent would have saved the state $136 million in
interest payments over the rates the state is now paying on the debt.
"It
was a risky swap because the pension bonds were issued with such a high
interest rate, and rates went down significantly after that," says
Looked
safe
The
swap agreements, known as swap options, looked like safe bets when they were
made, says James DiEleuterio, who was
The
options locked the state into a rate that was considered a low cost of debt,
says DiEleuterio, 52. The state took bids to make
sure it got the largest possible payments for the options, and netted $65.8
million from the sales, DiEleuterio says.
"When
it was presented to me based on the potential of $65.8 million in upfront cash,
we did evaluate it as a good deal," DiEleuterio
says.
Taxpayers
had little opportunity to learn about the
The
development authority is required under
One-line
notice
A
one-line notice of the meeting, held at the authority's headquarters in the
state capital of
Any
members of the public who attended the meeting couldn't get background material
explaining the swaps cancellation until after the 12-to-0 vote. The authority
posts minutes on its Web site within a few weeks of its regular gatherings.
Minutes of the May 17 special meeting weren't posted until mid-October, and
were available only by request before then.
Approval
of the cancellation was rushed because state finance officials under McCormac and the banks wanted to get the transaction
completed before interest rates rose, says Franzini. Franzini, who isn't a voting board member, heads the staff
that evaluates the proposals that go before members.
The
authority never hands out background documents until board members can review
them and make changes during the meeting, Franzini
says.
Big
borrower
The
development authority sold more than $4.5 billion in debt last year, making it
the third-largest municipal borrower in the nation, behind
Taxpayers
who want to learn about authority borrowing or the state's derivatives will
have to do extensive research.
Getting
access to reports by swap adviser CDR on the performance of the state's swaps,
contracts detailing the terms of the pension swaps and options, and memos and
meeting minutes explaining why the agreements were canceled required filing
requests under New Jersey's Open Public Records Act with both the state and the
Economic Development Authority.
Bloomberg
News filed its first request for information about the state's swaps on Aug.
22. On Oct. 17, it received the last documents it requested, including CDR's financial analysis of the decision to cancel the
pension swaps and minutes of the May 17 meeting where the authority's board
voted to cancel them.
Not
for all
James
Poole, a former state finance director who helped make the decision to sell the
swap options in 1998 and 2000, wouldn't comment on the agreement.
Roland
Machold, 69, who took over when DiEleuterio
quit as treasurer and signed the agreement authorizing the swap options, says
he doesn't recall the details of the transaction. Machold
is now retired.
David
Moore, an Orlando, Fla.-based managing director at financial advisory firm
Public Financial Management who has arranged swaps for
"Swaps
are a good financial tool that can significantly benefit our clients but must
always be entered into by clients that have been educated and understand all of
the features,"
"There
are many of my clients that at this point in time I would not encourage to
enter into swaps," he says.
With
reporting by Eddie Baeb in Chicago, Martin Z. Braun
in New York and Judith Mathewson in Washington.
October 21, 2005
This
week, we examine the latest scandal which has sent ripples through the world's
financial centres and ask, has anything changed since
the infamous frauds at Enron and Worldcom?
Phillip
Bennett, the former boss of Refco, a leading US-based
broker of commodities and futures, is facing fraud charges alleging he hid up
to 430 million dollars of debts from investors.
Refco traded in derivatives, complicated financial instruments which lay bets
on the movement of markets.
In
the past they've played a part in crises at Barings Bank and the investment
fund LongTerm Capital Management.
In
the last two weeks it's emerged that there was a discrepancy of more than 400
hundred million dollars in Refco's accounts.
Confidence
plummetted, part of the business has been sold off
and the rest has gone into bankruptcy protection. But only two months ago Refco's shares had been successfully launched on the
So
is the trading of derivatives policed well enough? And does this scandal prove
that
Joining
Lesley Curwen to discuss this are from Washington,
Randall Dodd, director of the Financial Policy Forum, and from New York,
Charles Crow, member of the Managed Funds Association representing the
derivatives industry and Jenny Anderson from the New York Times.
Link
to recording:
http://www.bbc.co.uk/worldservice/programmes/world_business_review.shtml
Refco's woes worry markets at nervous time
By
Alistair Barr
10/14/2005
8:04:54 PM
But
now the possible collapse of the largest independent commodities and futures
broker in the
Experts
said Refco's failure won't threaten global financial
markets in the way Enron's collapse did in 2001 and the demise of hedge fund
Long-Term Capital Management did in 1998. Still, the company's troubled
tentacles stretch far and wide, from pork bellies to futures on stocks and
bonds.
"Refco's big enough and it owes enough money to major
financial companies to raise doubts about markets at a time when we really
don't need it," said Randall Dodd, director of the Financial Policy Forum
in Washington D.C., a non-profit research institute that studies markets to try
to make them work better.
Market presence
Refco's (RFX) future is important because it's a leading broker in many
different markets.
In
2004, the company handled the most customer trades on the Chicago Mercantile
Exchange (CME), the largest derivatives exchange in the
Refco processed 461 million derivatives contracts in its 2004 fiscal year,
about the same amount traded on the Chicago Board of Trade and more than the
volume traded on the Chicago Board Options Exchange and the New York Mercantile
Exchange.
The
company also cleared more than $9 trillion worth of U.S. Treasury bond
repurchase, or repo, transactions and processed over $680 billion in the
foreign exchange markets for clients.
The
broker has more than 200,000 customers, including corporations, government
agencies, hedge funds, pension funds, financial institutions and retail and
professional traders.
Crisis
Refco was rocked this past week by a scandal that allegedly involves its
chief executive and at least $430 in hidden debt he may have owed the company.
Refco said on Monday it had suspended Phillip Bennett as CEO and added that
he had repaid the company $430 million.
Bennett
was arrested late Tuesday and charged on Wednesday with securities fraud
related to Refco's Aug. 22 initial public offering by
the U.S. Attorney for the Southern District of New York in
On
Thursday, Refco said it was shutting Refco Capital Markets for 15 days. Some analysts speculated
that the division, which handles foreign-exchange and fixed-income over-the-counter
transactions and offers prime brokerage, trading and stock-lending services,
was losing customers. See full story.
The
crisis accelerated on Friday when Refco announced it
was unwinding trades at its Refco Securities LLC
broker dealer, a move several observers said was a preliminary step to shutting
down its largest unit.
Refco shares lost almost two-thirds of their value in the two days before
the New York Stock Exchange halted trading indefinitely on Wednesday. On
Thursday, the NYSE warned it's considering delisting the stock. The stock last
traded at $7.90, down more than 70% from its IPO less than two months ago.
Refco's bonds slumped as agencies such as Standard & Poor's and Moody's
Investors Service chopped their credit and debt ratings on the company, with
S&P saying on Friday that a technical default by one of the company's units
was "almost certain."
Ripples
Refco's troubles may have already sent ripples through some markets.
Declines
in crude and gasoline prices on Friday "could've been exacerbated by some
traders at Refco liquidating their positions in
preparation for moving their accounts," said Phil Flynn, a senior analyst
at Alaron Trading.
Traders
said the dollar was also pressured by institutions shifting accounts away from Refco.
"The
Refco scandal is putting some pressure on the
dollar," said Michael Woolfolk, senior currency
strategist at The Bank of New York. "There has been some clearing out of
positions in the futures market."
Customers leaving
Amid
concern Refco may not be able to meet all its
financial obligations, some experts said customers are probably leaving the
broker.
Horizon
Cash Management LLC, a firm that advises investors on their cash positions, is
helping some clients who are taking money out of Refco
accounts and have yet to pick another broker and clearing firm.
The
response has been very similar to what Horizon saw when other financial firms
failed, such as Barings, Drexel Burnham and Long-Term Capital Management, Diane
Mix, president of Horizon, said.
"Clients
may just walk away from Refco," said Peter Fusaro, chairman of Global Change Associates Inc., a New
York-based energy risk advisory firm. "If they can't honor their
commitments people get nervous and go elsewhere very quickly."
Regulators rush
Refco's regulators have rushed to try to save the broker or at least soften
the impact if the company collapses.
The
Wall Street Journal reported late Friday that senior regulators at the Chicago
Mercantile Exchange and the Commodity Futures Trading Commission asked Goldman
Sachs (GS) and other banks to buy Refco to calm fears
among investors, lenders and trading partners who have become increasingly
concerned about the future of the company.
Goldman,
which was appointed as Refco's advisor this week,
isn't interested, the newspaper added, citing a person familiar with the
company's thinking. A Goldman spokesman declined to comment.
CFTC
spokesman David Gary said the regulator hasn't asked Goldman or any other firm
to intervene to save Refco.
A
spokeswoman at the CME declined to comment.
The
Securities and Exchange Commission on Friday barred the company from
withdrawing equity capital for 20 business days and restricted it from making
unsecured loans or advances to stockholders and affiliates if those loans
exceed 30% of the firm's excess net capital.
Other
regulators imposed similar restrictions on Refco
units earlier in the week.
Lenders
Beyond
Refco's market reach and large roster of clients,
what's likely perturbing regulators is that fact that the broker needs to
borrow money to process trades for clients, said Dodd of the Financial Policy
Forum.
Bank
of America (BAC) arranged a $800 million loan and a $600 million debt offering
for Refco last year, along with Credit Suisse (CSR)
and Deutsche Bank (DB).
The
banks met on Friday to discuss whether to send Refco
a letter of default, according to Wall Street Journal Online.
Because
the scandal has caused Refco to say its financial
statements can't be relied upon, the banks could claim the company has broken
its loan agreements and debt covenants "by virtue of material
misrepresentation," Kevin Starke, senior equity analyst at Weeden & Co., said in a note to clients on Thursday.
If
Refco files for bankruptcy, it could take years for
the company's lenders to get their money back, Dodd said.
"This
may make these banks look like less financially sound counterparties to trade
with," Dodd explained. "If fewer people want to trade with them, that
could have a knock-on effect throughout markets."
That
worst-case scenario happened after Long-Term Capital collapsed, Dodd added.
"Everyone
knew LTCM had big exposures with the major derivatives dealers, but no one knew
who was safe to trade with, so the markets froze up," he said.
"That's also what happened in the energy markets after Enron."
Not like Enron
Still,
Dodd and other experts said Refco's demise wouldn't
spark so-called systemic problems that plagued global markets after the LTCM
and Enron debacles.
Refco doesn't act as a principal on major transactions, unlike Enron and
LTCM, said Brett Friedman, a partner at Risk Capital Management, a New York
firm that advises energy companies and banks on credit and counterparty risks.
"Refco's a broker, so this isn't like the Enron crisis when
a major counterparty on lots of trades suddenly disappeared," Friedman
explained. "Their demise wouldn't pose a systemic threat."
Refco also wasn't a broker to a lot of major financial institutions, but instead
focused on individual traders and smaller, institutional investors, he added.
That should limit the impact on broader markets.
Refco's
future
Still,
the future of Refco remains in doubt.
If
a lot of Refco's clients move their accounts to
competitors, the company's lenders may decide it's not worth pumping money back
into the broker, said Thomas Lord, president of Volatility Managers LLC, which
advises companies on risk management in commodity markets.
Selling
a brokerage business without clients would also be difficult, he added.
"If
the clients have gone, what have they got to sell?" Lord said.
"They'd be selling an empty Rolodex."
Aug. 16, 2005
News Analysis -- Neither a
Dealer Nor a Lender Be, Part 2: Hedge Fund Lending
by
Lee A. Sheppard
In news analysis, Lee A. Sheppard dissects
hedge funds and says that the rules hedge funds rely on to avoid U.S
taxation on their other activities will not
protect their lending
A
majority interest in the Manchester United Football Club was recently sold to
American investor Malcolm Glazer, who also owns the Tampa Bay Buccaneers. For
all the gnashing of teeth and rending of garments that occurred in Blighty, one would think that the company being sold was a
piece of the national patrimony rather than a profitable, publicly traded
entertainment enterprise
Man
U's fans, who own 17 percent of the shares, are still protesting outside Old
Trafford, and more importantly, boycotting ticket sales. Glazer, who during the
acquisition process had been burned in effigy, had to promise up and down that
nothing would change, including the manager, who gratefully explained to fans
in program notes that the team is a publicly traded company
Man
U is changing, as it must, as the two Irishmen who controlled the majority of
the shares appear to have recognized. Amid all the bleating, very little
attention was paid to why the pair might be motivated to sell. Our theory is
that the Irishmen didn't want to have to fire manager Sir Alex Ferguson, who is
their buddy. The next owner will have to. Why? Because the team has gone as far
as it's going to go under
The
Man U team that racked up a decade's worth of trophies was a homegrown, mostly
English team that played English long-ball football better than the bottom 15
teams in
Mostly
French Arsenal, managed by a cool-headed French intellectual, started playing
consistently and won the domestic league twice. Then a Russian billionaire
poured money into
There
has also been much bleating about the fact that Glazer borrowed the money to
make the purchase. Now, we like to think of bankers as sober types who don't
throw money at uncertain propositions like entertainment enterprises in which
the talent competes with the owners for the profits. Nonetheless, some banks
did lend money to Glazer. Who else lent money to Glazer? Three American hedge funds, Citadel
Investment Group, Perry Capital, and Och-Ziff Capital
Management, lent 275 million pounds of the 790 million pounds that Glazer paid
for the team
By
so aggressively jumping into lending, hedge funds, which are running short of
new investment and arbitrage opportunities, maybe making a tactical mistake
that would be highly detrimental to their goal of escaping U.S. taxation as
nonresident investors
They
should not be indulged as nonresidents, and
Hedge
funds may be lending too much, and taking the risks of loans too much, putting
themselves in the active trade or business of lending in the
Basically,
the law says the opposite of what hedge funds want it to say. The law says that
a lending business in the
The
Ten Commandments
A
hedge fund is an unregulated investment partnership that, though managed out of
Hedge
funds typically organize the partnership that constitutes the fund itself in a
tax haven. The management company, another related partnership, operates in the
The
securities trading safe harbor excuses those factors, but they remain highly
relevant for other trade or business questions, as this article will show
Foreign
investors are taxed on income from
Otherwise,
what constitutes a trade or business is defined by the case law
Section
864(b)(2)(A)(ii) makes an exception for trading in securities and commodities
for one's own account. The objective of the exception, installed in 1966, was
to encourage foreign portfolio investment in the
The
legislative history of the securities trading safe harbor shows that Congress,
rather than wanting to attract foreign capital, had simply given up on
collecting tax on capital gains realized by foreign investors, and had decided
that making brokers rich would be a good way to make up the lost revenue. That
is why foreigners have to transact through a resident broker. Said the
Senate:[A] nonresident alien will not be subject to the tax on capital gains,
including so-called gains from hedging transactions, as at present, it having
been found administratively impossible effectually to collect this latter tax.
It is believed this exemption from tax will result in considerable additional
revenue from the transfer taxes and from the income tax in the case of persons
carrying on the brokerage business. (Senate Report No. 2156, 74th Cong., 2d sess., p. 21.)Hedge funds are in a state of constant
argument with the tax administrator over whether various forms of income they
receive is effectively connected. They depend utterly on the section
864(b)(2)(A)(ii) safe harbor for trading for one's own account, an important
part of the longstanding policy of being very nice to foreign investors
The
standards for the securities trading safe harbor were significantly loosened in
1997 to permit maintenance of a principal office in the
The
proposed regulation tries to shoehorn derivatives into the trading safe harbor
by analogizing them to the underlying securities and commodities. Credit
derivatives, under this approach, would logically be analogous to loans. Prop.
reg. section 1.864(b)- 1(b)(2)(ii)(E) would define derivatives to include an
evidence of an interest or derivative contract in any note, bond, debenture, or
other evidence of indebtedness
As
the following discussion will show, hedge funds essentially want to stretch the
securities trading safe harbor to cover all of their dabbling in lending,
beyond credit derivatives. The law doesn't permit that, but that doesn't stop
tax practitioners from making the argument. The law basically says that if
hedge funds go into a trade or business of lending, all of their securities
trading income would become effectively connected with a lending business or a
securities trading business, with the effect that the securities trading safe
harbor goes away
Hedge
Fund Lending
What
kind of lending are hedge funds doing? Hedge funds often participate in lending
syndicates. "Big name hedge funds like Soros
Fund Management LLC, Cerberus Capital Management, Och-Ziff
Capital Management Group, Black Diamond Capital Management LLC, Citadel
Investment Group and Satellite Capital Management have now become names to
reckon with in syndicated loans and are playing a key role in loan market
dynamics," said Investment Dealers' Digest. Bankers are happy about the
money hedge funds bring, but other institutional investors regard them as opportunistic.
A year ago, hedge funds accounted for 9 percent of primary loan investments, a
portion that is growing. (Investment Dealers' Digest, June 14, 2004.)The lead
bank in a syndicate negotiates the loan as the agent of all of the other banks
in the syndicate. When a lead bank syndicates a loan, there are two tranches of
money. One tranche of money is immediately advanced by the other members of the
syndicate; that is, the lead bank never had credit risk for that amount.
Another tranche is "warehoused" by the lead bank, meaning that it
advances the money, and assumes credit risk until it can find other
participants to take that part of the loan off its hands
The
point is that the syndicate member banks minimize the period of their exposure
to the borrower, which becomes relevant to hedge fund participation
For
a hedge fund to participate in a syndicated loan, it is not necessary to join
the syndicate. A hedge fund may buy a participation from a syndicate member or enter
into a derivative contract with a syndicate member that transfers the risk of
the loan. As the following discussion will show, some tax practitioners want
hedge funds to keep their distance from the syndicate, with the aim that the
tax law treat the hedge fund as a mere investor in the loan, rather than as a
lender
Hedge
funds also make cash advances on letters of credit, make debtor-in-possession
loans, enter into repos, and purchase public interest private equity securities
(PIPES). Hedge funds are making bridge loans as well, competing with banks and
investment banks for business, and apparently preferring riskier deals.
"Precisely because of their lack of transparency, there is concern about
their ability to handle both the risks and obligations of lenders," said
The Wall Street Journal, while noting that hedge funds may be more
sophisticated about some kinds of risks than banks. (The Wall Street Journal,
May 26, 2005, p. C1.)Hedge funds are engaging in forms of debtor-in-possession
financing that banks have eschewed. Hedge funds are thought to "loan to
own"; that is, taking riskier loan bets with the view that they can take
over the borrower on a default. (The Wall Street Journal, July 18, 2005, p.
C1.) Hedge funds account for 70 percent of the market for second-lien loans to
borrowers of questionable creditworthiness. As the name implies, second liens
don't have much of a claim to the borrower's collateral, but they have a high
yield and could be satisfied with equity in bankruptcy. They are replacements
for junk debt, which hedge funds also buy and lend directly on. (Investment
Dealers' Digest, July 25, 2005, p. 26.) Second liens have not been tested in
bankruptcy court. (Investment Dealers' Digest, Jan. 25, 2005.)Hedge funds use
loan participations and synthetic loans to hedge their other exposures to the
borrower's credit. Indeed, credit derivatives are being designed with hedge
funds in mind, since they make up 20 percent of the market. Hedge funds are
also fond of synthetic collateralized debt obligations (CDOs), that is,
derivatives backed by credit derivatives. A CDO is a derivative backed by debt
securities. A synthetic CDO is a double layer of derivatives. There are also
triple layers, which have the effect of obscuring where the risk went. (Investment
Dealers' Digest, May 16, 2005, p. 26.)Hedge funds seem to mostly want to use
synthetic CDOs for trading or offsetting the risk of other investments, rather
than for explicitly absorbing the risk of the underlying loans. The notional
amount of credit derivatives can easily exceed the underlying loans.
(Investment Dealers' Digest, Nov. 15, 2004.)Hedge funds would have it that
everything they do should fit under the securities trading safe harbor, so that
they would not be deemed to have a lending or financial trade or business in
the United States, and would not be taxed on effectively connected income. The
general view of practitioners is that much in the way of loan participation and
credit derivatives fits into the safe harbor, and that hedge funds should keep
their distance from negotiations
Hedge
funds further argue that the existing rules should be reinterpreted or changed
to meet their desire to avoid
Trade
or Business
Case
law and administrative law both make it very easy to be in the trade or
business of regular and continuous lending in theUnited
States, regardless of whether the taxpayer has a banking license or would be
regulated as a bank by any government
First,
the taxpayer has to be in a trade or business. The relevant case law is the
securities trading case law that predates thesecurities
trading safe harbor. Second, the taxpayer's trade or business has to be lending
or banking or financing. (We use thoseterms
interchangeably, while practitioners fuss that banking can only be done by
banks.) For that question, reg. section 1.864-4(c)(5) has a bias in favor of
finding that a foreign taxpayer is engaged in the active conduct of a banking,
financing, or similarbusiness in the
Setting
aside the securities trading safe harbor, it doesn't take much more than hedge
funds routinely do to have a trade orbusiness in the
In
Adda v. Commissioner, 10 T.C. 273 (1948), affirmed,
171 F.2d 457 (4th Cir. 1948), cert. denied, 336 U.S. 552, the questionwas whether an Egyptian resident of France could be
considered to be engaged in the commodities trading that his brother in theUnited States was carrying out under his orders. The
brother had discretionary authority over the taxpayer's accounts. It wasundisputed that the trading was extensive enough to
constitute a trade or business. If the taxpayer had used a broker, he wouldhave been exempt from taxation as a passive foreign investor
under the predecessor of section 864(b)(2). But by using his brotheras his agent, he became liable for tax as though he
had conducted the trading business in the
Commissioner
v. Nubar, 185 F.2d 584 (4th Cir. 1950), reversing 13
T. C. 566, cert. denied, 341 U.S. 925, involved anotherEgyptian
who was present in the United States managing his own securities and
commodities trading, which he did quitesuccessfully.
That was held sufficient to constitute the conduct of a trade or business. The
court was unsympathetic to thetaxpayer's position
that he should be considered a nonresident eligible for the securities trading
safe harbor while he lived in thecountry, in
violation of the immigration laws, and made a fortune
The
court believed that the purpose of the exemption "was to exempt from
taxation, except as to taxes which could be collected atthe
source, aliens over whom no effective jurisdiction in enforcement of the tax
laws could be exercised." These investors' onlycontact
with the
A
Chinese investor who used a resident commission agent was somewhat luckier in
avoiding
The
court found that there was not enough activity in the taxpayer's account to
raise it from investment to trading. The courtbelieved
that the agent "did no more than was required to preserve an investment
account for his principal." Under Higgins v
Commissioner,
312 U.S. 212 (1941), continuity and regularity are not enough to establish a
trade or business when the activity isessentially
personal investment management
The
Banking Rule
Once
the taxpayer has been determined to be in a trade or business, the special
banking rule of reg. section 1.864-4(c)(5) kicks into determine whether that
business is lending or financing or a similar business. This rule is
essentially a limited revival of the"force of
attraction" doctrine that went out the door when the securities trading
safe harbor was enacted in 1966. The regulationcontains
both a definition of "active conduct of a banking, financing, or similar
business" and an effectively connected income rulefor
income derived from the conduct of that business
The
banking rule was written on behalf of banks -- no surprise there --
specifically Canadian banks. Those banks were operatingthrough
branches in the
In
the normal course of the operation of the rules before most interest was
exempted from withholding, interest paid by anAmerican
borrower to the bank's Canadian headquarters would have had tax withheld from
it
The
banks didn't want withholding because it would endanger their profit margins.
So they lobbied to have the interest paid by American borrowers to Canadian
headquarters considered income effectively connected with the conduct of a
trade or business in the
Reg.
section 1.864-4(c)(5)(i) lists activities that
constitute being in the lending business. Engaging in any one or more of those sixactivities in the
All
six activities require that the foreign taxpayer deal with the public. Hedge
funds sniff that they would never sully themselves by dealing with the great
unwashed public. Leblang and Rosenberg complain that
the regulation does not define "public." Leveraged hedge funds -- as
most are in these days of chasing meager returns -- borrow from banks and
investment banks. The regulation does not require that a lender accept deposits
from the public. The regulation specifically exempts foreign finance
subsidiaries from being considered to be lending to their own affiliates. The
necessity and the narrowness of that latter exception implies abroad notion of
what constitutes the public, that is, any unrelated borrower
The
regulation goes on to state that it is not necessary that the entity be subject
to bank regulation. Its activities are what matters
Hedge
funds are not subject to bank regulation or any other kind of regulation, a
result of negligence and politics. Some hedgefund
representatives advocate an interpretation of the regulation that would require
a banking license for the taxpayer to beconsidered to
have a lending trade or business in the
Banks
don't lend anymore. Banks negotiate loans and then immediately get rid of them,
either by selling the whole loan or fobbingoff the
risk by means of credit derivatives. (Investment Dealers' Digest, Nov. 15,
2004.) So what does it mean to make loans to thepublic?
What does it mean to originate a loan?Hedge funds
sometimes negotiate and originate the loans themselves -- it's going to be
their money anyway, so they want controlof the
process. Or they may join a syndicate of banks making a big loan. Those direct
lending activities would clearly put them in alending
trade or business in the
Practitioners
advising hedge funds take a very narrow view of what it means to originate a
loan. They take the position that onlythe bank that
negotiated the loan -- that'd be the lead bank in a syndicate on a big loan --
originated it. So no one else in thesyndicate did so,
and no hedge fund standing by to buy a piece of the loan from a syndicate
member did so, practitioners believe
The
view is that if the hedge fund does not join the syndicate, then the lead bank
in the syndicate -- clearly an agent for themembers
-- cannot be an agent for the hedge fund that would put it in the trade or
business of lending in the
Well,
gee, aren't hedge funds then just passive investors in old and cold loans? Sometimes
the ink is barely dry on the loandocuments. The
longest period any bank will wait to fob a loan off onto a hedge fund is 48
hours. The hedge fund's contract maycontain a
material adverse effect clause that allows it to back out within that period.
Bankers, of course, would like to be rid ofthose
clauses, but lawyers for hedge funds believe it keeps them out of an
origination position. More conservative advisers tellhedge
funds to wait a few days and then buy a piece of the loan in the secondary market
at market price
If
a hedge fund is on the bankers' speed dial, however, there could be a problem
with volume and regularity and continuity of loanparticipations.
The lead bank could be deemed to be the hedge fund's agent in the
Moreover,
the smaller the amount of the loan, the larger a hedge fund's proportionate
position could be. Taking a larger chunk of a loan could militate against the
hedge fund's mere investor posture
Why
don't regulated commercial banks have an interest in seeing their hedge fund
competitors pay U.S. tax on income from loans made into the United States? Hedge
funds are the best customers of commercial banks and investment banks. They
borrow heavily and pay a lot of fees for prime brokerage as they churn their
portfolios. More important, they stand ready to buy loans that banks want to
get rid of. All in all, there is no percentage for any regulated financial
intermediary in doing anything that would run counter to hedge funds'
well-being
Sometimes
hedge funds are not competitors. Many hedge funds have commercial banks as
investors. Seems that regulated commercial banks want to be able to make some
loans off their books
If
a bank makes a risky loan like the ones hedge funds have shown a taste for, it
has to reserve against it in case of default
Having
an equity interest in the hedge fund allows some banks to get a risky loan off
the balance sheet, so no capital need be reserved against it. Moreover, under
some countries' interpretations of the Basel capital rules, that same hedge
fund equity interest might even be shown on the balance sheet as positive capital,
even though the fund holds a risky loan. The Bank for International Settlements
is reviewing the definition of eligible capital.
(http://www.bis.org/publ/bcbs107.htm.) In the meantime, it is also worried
about credit risk transfer. (http://www.bis.org/publ/joint13.pdf.)
"Our
systemic fear is that our core banks and brokers are meeting their capital
requirements by moving their credit exposure into unregulated funds that don't
have capital requirements," Randall Dodd of the
Sometimes
banks, usually foreign banks, are partners in hedge funds that make loans to
If
banks doing business in the United States are partners in a hedge fund, would
the bank partners' lending trade or business alsoput
the hedge fund in a lending trade or business; that is, would the partners'
activities be ascribed to the partnership? Certainlythe
law deems a partner, as a member of partnership that is conceptually an
aggregate of its partners, to be conducting thebusiness
conducted by the partnership. If the partners are all banks, and were using the
hedge fund as a vehicle to do theirnormal business,
then the partnership would logically be viewed as an extension of the banks,
even though the test of thepartnership having a trade
or business in the
Reg.
section 1.864-4(c)(5)(ii) states that U.S.-source income and gain from
securities will be considered to be effectivelyconnected
to the taxpayer's lending business if the securities were acquired by the
taxpayer's
SATURDAY,
OCTOBER 8, 2005
Little guys in the big leagues
By
Erika Kinetz International Herald Tribune
SATURDAY,
OCTOBER 8, 2005
The
adage that it takes money to make money has never seemed more true. Some of the
best returns in the last decade have come from investments in areas most
individual investors cannot touch: private equity and hedge funds.
Bears
have, for some time now, been predicting an era of low returns; even sanguine
advisers warn that the double-digit returns of recent memory are not the norm.
Such
sobriety hurts, coming as it does while the global squeeze on pension funds,
among other things, means that individuals are being asked to take on more of
the responsibility and the risk for their financial future. Democracy in
financial markets or, at the very least, the perception of democracy, has never
seemed more pertinent.
Pragmatists
will point out that there has long been an overclass
and an underclass on Wall Street. But the growth of hedge funds and private
equity has brought an increasing proportion of market activity into an
unregulated, essentially private realm. There have been some recent signs of
democratization in hedge fund land, but it is far from clear whether public
offerings are on par with private ones. And issues of fairness aside, some
observers worry about the economic consequences of allowing so much unregulated
activity in financial markets.
"It's
never been a perfectly fair game," said Randall Dodd, the director of the
Financial Policy Forum, a nonprofit research institute in Washington that
studies the regulation of financial markets. "This makes it less
fair."
Today,
according to most estimates, there are 8,000 hedge funds globally, which manage
assets of about $1 trillion - and have borrowed perhaps an additional $1 trillion.
Much of that growth has occurred in the last five years as pension funds have
increased their exposure to the sector. More than a quarter of
Credit
Suisse First Boston has estimated that one-third to one-half of daily activity
on the New York Stock Exchange and the London Stock Exchange comes from hedge
funds, and that hedge funds racked up about $25 billion in banking fees in
2004.
All
this has caused regulators some concern. Most hedge fund managers with
Interest
in alternative investments has spiked for a number of reasons. First, hedge
funds weathered the bust well. During the bear market of April 2000 through
September 2002, hedge funds returned 2.1 percent, while the broadest
Second,
as global equity market movements have become more tightly correlated,
investors have sought out new sources of diversification.
Finally,
their promise of absolute returns is a glittering one. Surely it is better to
give one's money to a manager who, armed with a full complement of
sophisticated and occasionally high-risk strategies, at least tries to achieve
solid returns in both up and down markets, rather than simply trying to beat an
index.
And
returns have been enviable.
The
maundering performance of equity markets has lately made the division between
public and private more acute: In 2004, while the Dow Jones Stoxx
index of leading European stocks returned 10 percent, European buyouts returned
a whopping 22.8 percent, according to Thomson Venture Economics and the
European Private Equity and Venture Capital Association.
In
practice, however, hedge funds have several drawbacks. They are pricey, with
typical fees are 2 percent of assets plus 20 percent of profits; and, despite
some recent changes, they remain highly unregulated. This means that just about
anyone can start a hedge fund and that investors must do serious due diligence
themselves, which, as the recent collapse of the Bayou Group demonstrates, can
be difficult even for the rich and well connected.
"I
wish, frustratingly so, that hedge funds would be outlawed by the
regulators," Bill Blevins, a managing director of Blevins Franks
International, a
That,
however, is not the direction history is moving. Indeed, even as institutional
interest may be waning, hedge funds and hedge-fund-like products are starting
to go mass-market.
"We're
seeing a growing trend to bringing what were sophisticated investments only available
to a certain category of investor to the masses," said Paul Aaronson,
chief executive of PlusFunds Group, which holds an
exclusive license to develop investment products based on the S&P Hedge
Fund Index. "It's the McDonaldization of this
part of the investment world."
Investment
minimums have been falling. Funds of funds and principal-guaranteed products
have also given retail investors more access.
This
spring, for example, ABN AMRO and AXA Investment Managers started Patrimoine Obligation Croissance,
an actively managed, principal-protected credit-derivatives fund for retail
investors in
The
number of
"Our
overall assessment has been that in general these have not been particularly
attractive investments," said Todd Trubey, an
analyst at Morningstar. In the last three years, according to Morningstar, the
funds' returns have ranged from negative 4.48 percent to 20.17 percent; nine have
actually underperformed risk-free U.S. Treasury bills.
The
rise of hedge fund indexes, which are theoretically investible
and function much like funds of funds to distribute risk, has also opened new
possibilities for retail distribution. Standard & Poor's started a hedge
fund index in 2002, for example, and now there are investment vehicles that
track it, some of them publicly available.
In
contrast, private equity remains, for the most part, very private. Less than 10
percent of venture capital investment comes from wealthy individuals; the
largest share, 42 percent in the
There
are several structural issues that make private equity a hard sell to the
public. First, investors have to be willing and able to tie up considerable
amounts of money for more than five years. Second, it is a rare venture
capitalist who has the time and resources to answer to a mass of individual
investors.
"A
venture capitalist would rather work with three large institutional investors
who give him $50 million rather than 10 individuals who give him $5 million
each," said Mark Heesen, president of the
National Venture Capital Association, which represents almost 500
Also,
the timing of "democratization" in hedge funds could have been
better. Skeptics, a number of them mutual fund managers, maintain that the
funds' halcyon days are over. "Hedge funds are not the silver bullet
people are making them out to be," said James Riepe,
the vice chairman of T. Rowe Price Group and chairman of the Investment Company
Institute, a national association of
There
are some signs of a plateau in interest: Net inflow of new money to hedge funds
is predicted to grow by about 7.5 percent this year, triple the rate for the
rest of the money-management industry, but only about half the average of the
last five years, according to Empirical Research Partners.
"Usually
when the public gets admitted to something, it's the end of the bubble,"
said James Wilson, a founder of Boston Ventures, a
One
answer is: You don't. From January through August of this year, hedge fund
index returns ranged from negative 7.09 percent (the FTSE Hedge CTA-Managed
Futures Index) to 5.63 percent (the S&P Equity Long/Short Global Ex-US
Index). Investors could have made about 1.9 percent on Treasury bills and about
1.5 percent on a low-cost index fund that tracks the S&P 500.
Similarly,
interest in private equity has been rising, perhaps too much.
"We
are turning away money at this point," Heesen
said. "We will raise about $25 billion this year. In talking with many
venture capital firms, I think we could have raised $100 billion if we wanted
that money." Too much money can make deals harder to get and distort
prices upward, cutting into returns.
Fairness
aside, the economic wisdom of allowing large swaths of market activity to go
unregulated is a matter of debate. Hedge funds provide liquidity, but they also
have the potential to destabilize. The collapse of Long-Term Capital Management
in 1998 has caused lingering fears about the danger of highly leveraged,
unregulated managers, even very smart ones, at play in the market.
Opacity
is another big issue. The lack of information makes it hard to settle the
debate about whether hedge funds are agents of redemption or ruin.
"In
the run-up of energy prices, there was concern hedge funds were taking big open
long positions in energy, but people don't know," said Dodd, of the
Financial Policy Forum.
"Federal
energy regulators don't know. Maybe they're not responsible for high prices,
but we don't know. People are not being reassured. They are more fearful, and
it's affecting their investment and consumption decisions."
In
some corners of the market, like over-the-counter credit derivatives, the
consensus is that hedge funds add useful liquidity.
"You
are taking an important sector of the economy, credit risk, and making it more
liquid," said Salih Neftci,
an economics professor at the
But
others warn that lack of transparency could cause that liquidity to vanish as
quickly as it appeared.
"Once
you involve hedge funds, credit risk becomes a three-card monte
game," Dodd said. "A rumor of a credit problem, people withdraw from
the market. On a good day, hedge funds add liquidity to the market that can be
of economic benefit, but you've got to talk about the bad days, too."
Most
agree that the influence of hedge funds on mainstream equity markets is
considerably more muted than their impact on the more esoteric derivatives
markets.
"There's
probably a little more volatility in individual stock prices in those sectors
in which some of these more aggressive hedge funds have invested," said Riepe, of T. Rowe Price.
Whether
agents of liquidity or destabilization, hedge funds have produced one direct,
and caustic, reaction in many individual investors: envy. The best way to deal
with that, financial advisers say, is to stop trying to keep up with the
Joneses.
"A
lot of rich people buy things because they think they are different," Riepe said. "It doesn't mean they'll necessarily do
better. We see a lot of investors here who think they are smarter than everyone
else. Then we see investors who put their money in and don't do anything with
it for 10 years. You'd be surprised how many of them do better."
October 2005
USBANKER
October
2005
Some
are in public. Some are behind the scenes. Women in the banking industry are
wielding influence from every corner of the capital. And they're not afraid to
make noise.
By
Karen Krebsbach
Ask
any Beltway insider what oils the innards of the capital city and the answer
won't have a thing to do with the greenback. Of course, money helps oil the
wheels of progress more efficiently, but it can never surpass the premier power
of the relationship, this town's only true currency.
For
the women of financial services who operate in this high-profile fish bowl,
negotiating tank space requires equal parts diplomacy, financial acumen and
emotional intelligence. For bankers, more used to seeing the world in dollars
and cents, these alliances can take time to nurture, since they're more about
political-and personal-capital than financial.
Two
decades ago, the number of women effecting change in this epicenter of power
could be counted on the fingers of two hands. Today, there are hundreds of
women making a difference in Congress, in the White House and on Capitol Hill,
and hundreds more in the financial services regulatory agencies, lobbying
firms, international economic agencies, and think tanks. And their voices are
only growing louder.
In
Congress, the number of legislators influential in banking remains limited, but
certainly these have made a difference: Sen. Elizabeth Dole, the North Carolina
Republican who is a member of the Committee on Banking, Housing and Urban
Affairs, on July 28 pushed through legislation that aims to improve oversight
of government-sponsored enterprises, such as Fannie Mae and Freddie Mac. The
bill, which goes to the Senate for a vote this fall, would create an
independent regulator for the entities; Fannie Mae, for example was so
mismanaged that it had to restate earnings for the last four years. "The
Dole bill is very important and will go a long way in regulating Fannie Mae and
Freddie Mac," says Peter J. Wallison, resident
fellow at the American Enterprise Institute, a
Also important is Sen. Dianne Feinstein, the
Rep.
Nancy Pelosi, the California Democrat who is the minority leader in the House
of Representatives, has served on the Banking and House Committee on Financial
Services, and has been one of the most vocal opponents of the privatization of
Social Security. "The potentially most influential on this list is Nancy
Pelosi because she's the leader in the House and can presumably whip her party
into shape," Wallison says. "And that would
mean bad news for the banking industry." Pelosi hasn't tapped her full
potential, however. Also high-profile are Rep. Deborah Pryce, the Ohio
Republican who is the fourth-ranking member of the Financial Services
Committee, and chairs both the Subcommittee on Domestic and International
Monetary Policy and the House Republican Conference. She has been a loud
proponent of financial literacy.
Among
regulators, none is so highly regarded as Julie Williams, the chief counsel of
the Office of the Comptroller of the Currency, who twice served as acting
comptroller. "She has taken a very courageous stand, which has not been
popular with state bank supervisors on the [consumer affairs] preemption issue,
but has been very popular with national banks," points out Ricki Tigert Helfer,
chairman and CEO of Federal Deposit Insurance Corp. from 1994-1997, and who now
heads a New York City consultancy, Financial Regulation and Reform
International. "She's a strong lawyer and does her homework. For those who
plan to challenge her convictions, beware."
Observes
Wallison: "Julie Williams is a very powerful
person. And she's very modest, a wonderful person. Given the amount of
authority she has acquired, she doesn't throw her weight around. She's smart,
diligent and hard-working, one of the most highly respected officials in the
financial services industry, ever." He points to her decision to take on [
Susan
Schmidt Bies, a member of the Board of Governors of
the Federal Reserve since 2001, also draws high praise. "Susan Schmidt has
a long résumé of being involved in a lot issues and she's a big-picture
person," notes Denise Greenlaw Ramonas, who has worked for more than 20 years as a Senate
staff member. "She thinks globally." Notes Helfer:
"Susan is a very conscientious Fed board member who has given a lot of
thought and attention to matters she comments on. She brings a terrific breadth
and depth to the board."
Another
influential regulator is Securities and Exchange Commissioner Cynthia Glassman,
"who brings toughness and determination" as one of two
dissenters-including Paul Atkins-on the SEC, says Wallison.
"And that's a very tough thing to do." Known as an economist's
economist, Glassman was formerly at Ernst & Young and spent 12 years at the
Federal Reserve and one year at the Treasury Department. Dodd
credits her for "standing her ground on mutual fund regulation to stamp
out abuse in the industry. She's had some tough fights."
Henrietta
H. Fore, the outgoing director of the U.S. Mint at the Treasury Department,
"has brought her great skills as a manager and attacked the agency as if
it were a business," says one observer. She was recently named under
secretary for management at the State Department. Anne O. Krueger, the
But
behind the scenes, the most influential women help set banking policy. One
mover and shaker is Candida Wolff, director of the Office of Legislative
Affairs at the White House and President Bush's top legislative strategist. She
worked at both the Senate and for Vice President Dick Cheney, before becoming a
private-sector lobbyist. Bush tapped her to return to the White House after his
reelection. "She's the president's top lobbyist, so her sphere of
influence is everything," says Ramonas.
"That's her domain. She's very knowledgeable on the issues, good at
counting votes and counting coalitions." One of her key initiatives was
trying to sell Social Security private accounts to the masses, enacting
tax-code reform and pushing through the divisive trade pact with nations of the
Caribbean and
Lawranne
Stewart, senior counsel at the House Financial Services Committee, has been
instrumental in helping the financial markets run more smoothly. "She
really understands how they're regulated," says Dodd. "Some people
say the markets always work perfectly, but that's not true. Anyone who's smart
knows that they work better if they're properly policed. Chaos is not a good
thing. She understands where you need regulation and where you don't. She's got
good legal skills and economic understanding. That's rare."
Kathy
Casey, staff director of the Senate Banking Committee, is on many people's list
of skilled power brokers. "There's nobody smarter than Kathy Casey,"
says Ramonas. "She works really hard. She knows
the issues and drills down deep. She has a very keen intellect and is able to
collect all the data and the arguments and analyze the law-and then put it
together into a cogent and effective policy."
Lisa
S. McGreevy, evp of external affairs and president of
the Government Affairs Council at the Financial Services Roundtable, has drawn
praise from Democrats and Republicans alike as a successful lobbyist with a
good understanding of the opposition. "McGreevy is a really smart
accomplished woman," says Dodd. "McGreevy is knowledgeable of the
many pitfalls in the industry," adds Helfer,
while Ramonas says, "She has been very
effective."
Diane
Casey-Landry, president and CEO of America's Community Bankers also is
well-known for her effective lobbying for the issues of smaller banks.
"Diane is very savvy, very thoughtful," muses Helfer.
"She's very good at reading the tea leaves." On the front burner for
the group is support of the H.R. 3206, the Credit Union Charter Choice Act of
2005, which would make it easier for credit unions to convert to mutual savings
banks or associations, pay taxes, and comply with the Community Reinvestment
Act.
Elizabeth
Duke, the outgoing chairman of the board of the American Bankers Association,
has been instrumental in getting
Duke,
who became the first female to head the board since the
September
12, 2005
On
Aug. 5, Randall Dodd, director of the Financial Policy Forum, wrote an
interesting article on the GM debacle entitled "Credit Derivatives Trigger
Near System Meltdown":
"Rumors
started circulating two months ago concerning the possible failure of several
large hedge funds and massive losses by at least one major global bank. The
source of the troubles was a free fall in prices in the credit derivatives
market that was triggered by the downgrading of GM and Ford. The financial
system ended up dodging a systemic meltdown, but without proper coverage and
analysis of the events there will be no lessons for policymakers to learn.
"This
Special Policy Brief is an attempt to put these rumors together in order to
tell a coherent story. The purpose is to show how the events posed a severe
threat to the stability of our financial markets and overall economy. The
narrative also should help illustrate the market problems with these
nontransparent markets organized around dealers with no commitment to market
participants to maintain orderly and liquid markets...
"What
is the extent of the fallout? Exact amounts cannot be known with any clarity or
certainty. Actual losses at hedge funds and proprietary trading desks are not
reported, or at least not reported separately. The change in credit derivatives
prices can be estimated from the iTraxx index for
credit derivatives; however, there is no reported information on the volume of
trades and value of derivative and cash positions. Thus, estimates of gains and
losses to individual firms and the market cannot be determined."Some
anecdotal information can be gleaned from announced hedge fund closings. The
well-known Marin Capital hedge fund closed doors after big losses in
convertible arbitrage and credit arbitrage, and Aman
Capital also closed shop at the end of the midyear. GLG's
Neutral Group, which has credit derivative investments similar to that of Marin
Capital, lost $2.5 billion, or 17.2%, in the first half of the year. Cheyne Capital's hedge fund lost 4.8% in May alone. The
huge hedge fund Bailey Coates Cromwell Fund, after being named Hedge Fund of
the Year for 2004, announced in early June that it would close down."
Is
LTCM on the Fed's mind once again? Given some recent near misses with
derivatives, and given that no one has a clue with what might be trillions of
dollars worth of derivatives at Fannie Mae, the Fed should be concerned.
Actually, it should have been concerned long ago, but typically it waits until
there is a big problem, and then and only then does it think about addressing
it.
At any rate, I am sure LTCM and a derivatives
blowup is on the Fed's mind, since the "Fed Summons 14 Banks to Discuss
Credit Derivatives Controls":
"The
Federal Reserve Bank of New York invited 14 of the 'major participants' in the
credit-derivatives market to a meeting next month amid concern the
$8.4-trillion industry is rife with unconfirmed trades.
"The
credit-derivatives market more than doubled in the past year, giving companies,
investors, and governments the ability to bet on or protect against changes in
credit quality.
"JP
Morgan Chase & Co., Deutsche Bank AG, Goldman Sachs Group Inc., Morgan
Stanley, and Merrill Lynch & Co. dominate the credit derivatives market as
the five most-cited trading partners, according to Fitch Ratings."
The
Fed's letter said "a senior business representative and a senior risk
management person," should attend the meeting.
Of
course the Fed summons brings to mind some additional questions:
**
Was this an "invite" from the Fed or a demand to be there?
**
Why is the industry "rife with unconfirmed trades"?
**
If there are problems and lawsuits over Treasuries, the most liquid of all
futures, what the heck is going on with CDOs, CMOs,
and synthetic CDOs?
**
If it takes 1,500 consultants a year to straighten out Fannie Mae's hedge book,
how long would a complete audit of JPM's book take?
**
If all JPM's trades had to be unwound tomorrow, would
JPM even be solvent?
One
thing we do know is the derivatives bubble has become too large for
transparency of any kind. No one fully understands exactly what the counterpart
risk really is. Everybody has vast positions, most of which are "netted
out," but it's also a chain that no one has complete control over or even
knowledge about. What if the ultimate guarantor of a slew of contracts is
Madame Merriweather's Mud Hut in
Let's
now return to the original question: Are we headed for a "credit
derivatives event"?I do not see how we can
possibly avoid one, but timing it is the problem, since no one knows what event
might trigger the cascade.
Regards,
Mike
Shedlock ~ "Mish"
By
Alex Kennedy and Peter Wilson
July
12 (Bloomberg) --
Finance
Minister Nelson Merentes said at a news conference
today in
``While
some may welcome this, many countries in the region will not wish to see
Venezuelan influence extended,'' Field said.
The
proposal also carries risks without solving the problem of luring long-term investment
to the region, said Randall Dodd, director of the Financial Policy Forum, a
Washington-based institute that studies financial market regulation.
Defaults
``What
this doesn't seem to answer is how you will get net new lending into Bolivia,
Peru and other developing countries,'' said Dodd. ``You just can't do each
other's dirty laundry and then say we are all better off.''
Emerging
market tradable debt totaled $3.4 trillion last year, according to Merrill.
June 24, 2005
New York Ruling May Lead
More Cities to Curb Private Debt Sales
June
24 (Bloomberg) -- An obscure ruling by
Overlooked
in a June 7 ruling by the New York State Court of Appeals on a suit by
creditors of eToys Inc. was a decision that compels
securities underwriters ``not to conceal from the issuer private arrangements''
that stem from their dual role as agent for the buyer and seller of bonds.
``If
investment bankers had to tell issuers that they don't work for them, that
would shake underwriting to its very foundation,'' said William Kittredge, director of the Alexandria, Virginia-based
nonprofit Center for the Study of Capital Markets and Democracy. Kittredge, who taught public finance at the University of
Georgia in Athens and headed a public utility in Springfield, Oregon, said,
``The underwriter's customer is the investor. That's something the underwriting
community has finessed for a long time.''
For
more than a century, local government officials across the
Negotiated
Sales
Until
the 1970s, most local governments simply auctioned their bonds to the bank
whose bid produced the lowest cost to taxpayers. Now about 80 percent of
municipal bond sales are done by private arrangements with investment banks and
bond dealers who are paid fees by the borrower, and who count as customers the
investors buying the bonds.
This
process, a so-called negotiated sale, is little understood by taxpayers and
voters, partly because government officials themselves don't always understand
the role of the investment bank, finance experts say.
``There
is a conflict already in a municipal bond transaction,'' said Patrick Born,
chairman of the Government Finance Officers Association's Committee on
Governmental Debt Management and chief financial officer of Minneapolis. ``The
underwriter may be trying to get the lowest rate for the issuer and the highest
yields for the investors.''
Municipal
bond bankers say negotiating a financing helps issuers obtain low costs by
providing more flexibility on the timing of the sale and that their
relationships with buyers help them adjust the price in response to demand.
Lynnette
Hotchkiss, senior vice president and associate general counsel of the Bond
Market Association, the industry's trade group, said the group is ``reviewing
the decision and will be speaking with our members to assess the impact of this
ruling on their underwriting business.''
More
Bond Auctions
The
``If
the court asks underwriters to start saying that they represent buyers and are
looking out for their interests too, that would be a very interesting
disclosure,'' said Ed Alter, who is serving his 25th year as treasurer of Utah,
a state that has done 85 percent of its bond sales by competitive sale. ``It
strikes me as a way to bolster the argument that a competitive sale is the more
appropriate way to sell bonds.''
States,
cities, towns and schools usually ask for bids when purchasing goods and
services such as police cars, supplies and maintenance because experience has
shown it is cheaper. Academic studies say competitive bidding results in the
lowest cost for bond sales, too.
`Public
Interest'
Alec
Gershberg, a senior economist for the World Bank and
professor at
The
ruling ``does put the responsibility on the treasurers at municipalities,''
said Randall Dodd, president of the Financial Policy Forum, a Washington-based
nonprofit research institution dedicated to the study of markets, financial
regulation and economic policy. ``The first thing in the treasurer's mind has
to be public interest, which is getting the best price or the lowest rate of
interest on the securities that they're issuing.''
Court
Decision
The
Albany, New York-based court ruled on June 7, after hearing a suit by eToys creditors against Goldman Sachs Group Inc., the
underwriter of the Internet retailer's initial stock sale, that investment
bankers who advise clients on price, or offer other expert advice, must
disclose any potential conflicts of interest.
EToys creditors sued on behalf of the defunct company, alleging that Goldman
Sachs set the price of its initial public offering, a service that created a
relationship of trust known as a ``fiduciary duty,'' the court said. The
fiduciary duty requires disclosure of any conflicting relationship with other
customers, the court said.
Goldman
argued that by agreeing to buy eToys shares and
resell them, it had a commercial relationship with eToys,
not a fiduciary one. The appeals court rejected that by a 6-to-1 margin. The creditors
still must prove their breach of fiduciary duty claims in state court in
Goldman
spokesman Lucas van Praag, declined to comment on the
ruling. Goldman, the third-largest securities firm by market value, denies
claims by eToys creditors that the bank sold the
shares for less than the best possible price.
Reduced
Fees
The
ruling raises the possibility that customers will demand their underwriters
charge less for their services, finance experts said. The top five
Citigroup
Inc., the world's largest financial services firm, Morgan Stanley, Merrill
Lynch & Co., Goldman and JPMorgan Chase & Co.
earned $6.9 billion underwriting bonds in the same period, which was 3.6
percent of their revenue.
`Dramatic
Impact'
The
court decision is likely to prompt investment banks to include a disclaimer in
underwriting contracts saying they don't have a fiduciary duty to issuers,
which public officials may be reluctant to sign, said Harvey Pitt, former
chairman of the U.S. Securities and Exchange Commission, in a telephone
interview from the Washington consulting firm he now heads, Kalorama
Partners LLC.
``I
think it could have a dramatic impact,'' said Pitt. ``If you're a public
official, you may have a greater reticence agreeing to that kind of language
because municipal issuers are likely to feel they are more dependent on advice
from investment banks they've engaged.''
The
ruling wouldn't affect local governments that hire independent financial
advisers to assess the work of their of investment bank, lawyers said.
``We
are not relying on the good offices of any of our underwriters to make sure we
get the best deal,'' said Jeffrey Stearns,
States
and cites already are considering doing more competitive sales, said Kevin
Olson, a former bond trader who now runs a Web site, municipalbonds.com, that
reports instances of price discrepancies in trades. He cited
``This
will be just another thing along the way that will get issuers, and especially
elected officials, to think twice about negotiated bond sales,'' he said.
The
case is EBC I Inc. v. Goldman Sachs & Co.,
To
contact the reporter on this story:
David
Voreacos in
Eddie
Baeb in
Last
Updated: June 24, 2005 01:02 EDT
Conflict shutters MTA bank search
By MARTIN Z. BRAUN
May 21, 2005
The Metropolitan Transportation Authority scrapped a search for bond underwriters after learning that two people involved in the selection process owned stock in some of the 41 investment banks that applied for the work.
Tom Kelly, a spokesman for the MTA, said the operator of the subways and buses found out about the conflicts of interest from Executive Director Katherine Lapp. He declined to provide further details. No date for restarting the selection has been determined.
"It was early in the process and she felt the best thing to do was to just cancel it," Kelly said. "Just to make sure that nobody could come back later and say there was anything amiss."
The MTA is among thousands of public agencies, schools and cities that select investment banks to sell bonds instead of having them vie for the business by offering the lowest debt cost at an auction.
Patrick McCoy, the authority's finance director, last month said the MTA may consider taking bids on bonds, a process that would eliminate any chance for conflicts of interest, and which studies have shown saves taxpayers money.
"These
kinds of conflicts are regularly a problem," said Randall Dodd, president
of the Financial Policy Forum, a
The MTA's withdrawal of its bond underwriter selection process was previously reported by the Bond Buyer.
The MTA plans to sell $4.2 billion in
bonds over the next five years to help improve bus, rail and subway systems
around the city and pay for expansion projects such as a
The Synthetic CDO Shell
Game;
Could the hottest market in all of fixed income be a disaster in the making?
May 16, 2005
Bill Shepherd
When rumors of potential trouble at hedge funds roiled both the
Over the past year or so, nothing has grown faster than demand for synthetic
collateralized debt obligations. Far newer than their cash CDO brethren (backed
by actual bonds or loans), synthetic CDOs are complex structures that employ
wads of credit derivatives to build leverage on top of leverage-what some
skeptics call "imaginary" structures-and they've been raising a lot
of eyebrows. In the past several weeks, a drumbeat of warnings has emanated
from the likes of the International Monetary Fund, Standard & Poor's Corp.,
and a top official at the U.S. Federal Reserve.
Then, last week, on the heels of its dramatic downgrading of General Motors
Corp. and Ford Motor Co. to junk status, S&P, which is generally considered
the rating agency most skeptical of synthetic CDOs, downgraded several CDOs
arranged by Deutsche Bank-putting others on negative watch-because they were
exposed to GM debt. The subsequent hair-trigger unwinding of some CDO positions
showed how nervous CDO investors are these days. Merrill Lynch & Co.
immediately issued a fixed-income strategy report saying: "We expect a
rush to the door to be painful."
The concerns come at a time when
Worse, the arrangers of CDOs-which include all of Wall Street's leading
banks-often keep the riskiest chunks of synthetic CDOs on their own books, and
dealers, banks, funds and insurance companies are all enmeshed through
countless counterparty links. That means that major trouble, if it comes, could
have wide impact throughout the financial system.
Synthetic CDOs, like traditional CDOs, are normal securitizations, except that
the collateral lodged in the special purpose vehicle (SPV) is a portfolio of
credit default swaps instead of actual debt or loans. The SPV then issues three
or more tranches of debt securities (and sometimes as many as nine) rated from
triple-A on down the ratings ladder, and tailored for different investors with
different objectives or risk appetites. The premium income on the swaps
provides the cash flow to pay the coupons on the debt tranches.
Synthetic CDOs have become hugely popular because they offer almost infinite
ways for banks, insurers, hedge funds, and many other money managers to
speculate on credit spreads-the spreads between different debt markets, between
the debt of different issuers, between different classes of debt on a single
company's balance sheet, and so on.
That has sparked a boom in what's called credit risk transfer, and
"correlation trading desks" have sprouted all over Wall Street, as
well as at funds and at all kinds of European and Asian banks that are trying
to measure and capture anomalies in the spreads between credit instruments. As
Tanya Azarchs, an S&P managing director, puts it:
"Credit trading-that is, taking views on the direction of credit spreads
and correlations among spreads of various companies-has come into its own as an
asset class."
Exploiting anomalies in credit spreads is essentially what Long-Term Capital
Management, a huge hedge fund noted for the Nobel laureates on its staff, was
trying to do in more primitive ways when it nearly collapsed in 1998 and threw
the U.S. financial system into a tizzy until lenders organized by the New York
Federal Reserve Bank bailed the fund out. Today, the activity is more
sophisticated, more organized-and far more widely spread. Whether that is reducing
the risks sufficiently or creating vast new perils is a subject of much debate.
What happens, for instance, if something causes credit spreads suddenly to
widen far more than risk models anticipate or anyone expects? So far, there
isn't enough experience with synthetic CDOs to come up with definitive answers.
"One of the questions people have to ask themselves is, how will these
synthetic instruments behave in times of stress?" says Leslie Rahl, a former Citibank risk expert who now runs Capital Market
Risk Advisors, a risk consultancy in
Participants in credit derivative and CDO markets, of course, have their own
view. Some say that all the risks of these instruments are well known, that
risk management systems are adequate, and that critics simply don't understand
the new instruments. "People are naturally afraid of new
innovations," says a market participant. "They haven't taken the time
to understand synthetic CDOs."
That last observation may not apply to such critics as the IMF and S&P, but
it might apply to another, unintended party: investors. A Fed official said
last month that perhaps 10% of synthetic CDO investors "do not really
understand what they are getting into."
Skyrocketing growth
The market for synthetic CDOs has certainly grown very large, very fast, but
coming up with reliable numbers is chancy, as many deals are done privately and
are never reported to anyone. A rough proxy for synthetic CDOs is the figure
for credit default swaps proffered by the International Swaps & Derivatives
Association (ISDA) and adjusted to avoid double-counting. As measured by their
"notional" value (the par value of bonds and loans they represent),
outstanding credit default swaps have soared exponentially in the past three
years. Less than $1 trillion at the end of 2001, they increased more than
eightfold, to $8.4 trillion, by the end of last year, adding nearly $6 trillion
in the previous 18 months.
Guesses are that perhaps two-thirds of those swaps are going into synthetic
CDOs-and by all accounts the pace has quickened even more in the early months
of this year. JPMorgan, the leading dealer in credit
derivatives, sees a smaller universe than ISDA and takes a more conservative
view. By its tally, credit derivatives overall have merely quadrupled in the
past three years, to $4.8 trillion, of which only about a third, or $1.64
trillion, have so far gone into synthetic CDOs, but that may not reflect all
the synthetic CDOs arranged privately.
Whatever numbers one uses, it's a spectacular growth rate.
The main appeal of synthetic CDOs can be summed up with a single word:
leverage. Traditional cash CDOs are backed by actual bonds or loans, which
require real money to purchase. Synthetic CDOs are backed chiefly by credit
default swaps, which presumably "replicate" real bonds or loans. But
as in the case of interest-rate or currency swaps, no money changes hands to
set up a credit default swap. There is no buyer or seller of the contract, only
a "seller of protection" and a "buyer of protection," or,
conversely, a seller and buyer of credit risk. In that sense, credit default
swaps are the ultimate leverage tool.
Moreover, the CDO structure adds another layer of leverage in a different
manner. The SPV that holds the credit default swaps slices and dices the risks
into debt tranches ranging from triple-A down to an unrated tranche called
"equity" because it bears all the initial risks. (Investors pay real
money for the tranches.) By bearing the first risks, the junior tranches
protect the credit quality of the upper tranches. Moreover, the SPV is usually overcollateralized so that more money flows in than must be
paid out to investors in senior and mezzanine tranches, leaving fat profits for
the equity tranche holder if no company defaults. Throw in a lot of borrowed
money, and you have a lot of leverage, indeed.
The other great appeal of synthetic CDOs is that they're far easier to obtain
than the underlying debt securities. Finding enough bonds or loans to play
spreads is tough, and can take weeks to accumulate or unload, whereas credit
default swaps can be negotiated quickly. A common factoid in the business is
that only 5%, or around 250, of outstanding corporate bonds trade more
frequently than twice a day, and demand for them has so compressed spreads that
yields often no longer represent fair reward for risks.
"You don't have to own the loan or bond to sell protection on it,"
notes one market participant. "There is a great deal more liquidity for
the derivatives than there is for the bonds." And no doubt in many cases,
there are far more credit default swaps outstanding for a particular company's
bond or loan than the size of the bond or loan itself.
Basket of headaches
Synthetic CDOs and credit derivatives are helping to spread credit risks far
and wide, which helps keep the banking system strong. But as in any new
over-the-counter market, pricing is all over the lot, a fact that keen-eyed
professionals love to exploit. And discrepancies between pricing, hedging, and
actual risk may be lodging risk where it isn't currently discernible. "It
creates a kind of shell game-you don't know where the credit risk is
anymore," says one derivatives analyst.
"Are investors really getting paid enough for the risk?" asks Janet Tavakoli, whose
Questions abound, too, about how valid risk modeling is for credit
correlations: Not only do correlations change constantly, but historical
parallels may be invalid because new players, such as activist bond holders in
the 1990s and fast-trading hedge funds today, may be changing the behavior of
credit spreads and the correlations between them. And of course, models are
useless in market seizures, when all correlations go to 1.0-that is, everything
moves together.
Moreover, many of the new entrants rushing into credit risk transfer games
don't yet have the necessary back office and IT systems in place, which has
brought an element of operational risk to the market. Confirmation is sometimes
done by hand, with many foul-ups and delays. Gossip among market participants
is that some transactions have taken as long as two months to settle. Both the
Financial Services Authority,
Further complicating efforts to assess risks is an enormous burst of
innovation. Increasing numbers of synthetic CDOs, for instance, are custom
designed at the behest of a single investor, what are called
"bespoke" CDOs in the manner of fine
Other innovations include swaps on first-to-default and nth-to-default baskets,
swaps on credit derivative indexes, and highly complex (and expensive) swaps
that try to cover more than just default risks by incorporating amortization,
call, and prepayment provisions. To make matters worse, there are also
total-return swaps, which bundle a swap with its underlying debt security, and
combination notes, which package pieces of CDOs to create a new security.
Investors can also purchase over-the-counter credit options, and the Chicago
Board of Trade and the Chicago Mercantile Exchange are both considering
launching credit futures contracts.
Synthetic CDOs are also reaching down the ladder to incorporate lower and lower
credits in their collateral. And more and more synthetic CDOs are set up as
funds of funds investing in other synthetic CDOs-called CDO-squareds-making
the tracking of risk from tranche to tranche extremely difficult. There are
even a few CDO-cubeds, or CDOs of CDOs of CDOs. Some
CDO portfolios are combining swaps on bonds and loans, and many have been
pushing into swaps on asset-backed securities, backed by everything from
commercial and residential mortgages to aircraft leases. Both ISDA and the
rating agencies have been pressing to catch up with all the new wrinkles. ISDA,
for instance, is rushing to craft definitions for credit default swaps on ABS.
Two lawsuits have already appeared accusing banks of misrepresenting CDO
investments. German bank HSH Nordbank brought suits
against Barclays Bank over losses that it believed to be due to the mispricing of a CDO sold to a Nordbank
predecessor in 2000, and to Barclays' active management of the collateral pool.
The suits were settled in mid-February of this year.
In a similar case,
Reminiscent of the catastrophe that struck
Wave of anxiety
As a result, some heavyweight organizations have recently issued a series of
warnings. In summing up recent financial trends, Rodrigo de Rato
y Figaredo, head of the IMF, at the beginning of
April cited currency moves and the decline of the U.S. dollar as his first
concern. Then he stated: "...low short-term interest rates are encouraging
investors to move out along the risk spectrum in their search for absolute or
relative value. The search for yield has contributed to the compression of inflation
and credit risk premiums and encouraged the rapid growth of structured
products, including credit derivatives. The combination of compressed risk
premiums, and the rapid growth of complex and leveraged instruments that lack
transparency, is a potential source of vulnerability that merits
attention."
Four days later, Gerd Husler,
who heads the IMF's international capital markets division, followed suit in
remarks at the Bank of England. After noting a number of factors that could
cause bond yields to rise and credit spreads to widen, he zeroed in on
liquidity risks that could exacerbate losses in the credit markets. "The
liquidity risk is particularly acute in all areas with narrow markets,' but
particularly relevant in the area of complex and leveraged financial products,
including credit derivatives and structured products such as collateralized
debt obligations (CDOs)." Husler then ticked off
several specific problems, such as pricing anomalies, the opacity of the
market, the fact that risk management systems have "not been through a
live test," and whether counterparties would hang in and absorb the shocks
if investors suddenly all "rush to the exit at the same time."
During the same period, S&P warned that the same corporate credits are
reappearing in CDOs, an "overlap" that suggests insufficient
diversification and increased systemic risk if one or more of those companies
defaults. A week later, Michael Gibson, the U.S. Federal Reserve's chief of
trading risk analysis, weighed in with yet another concern. "What we are
hearing from market participants is that there is a minority of CDO
investors-perhaps 10%-who do not really understand what they are getting
into."
And 10% may be too conservative, says one market analyst. "I imagine the
number is higher. It's mind-boggling how much data you have to get a handle on
to measure your exposure."
But the knee-jerk defense of some market participants-that those who fear
innovations such as synthetic CDOs don't truly understand them-hardly applies
to the Fed and the IMF, both of which are beneficiaries of an excellent study
done under the auspices of the Financial Stability Forum. An international
group whose members include both the IMF and the Fed along with 23 other
financial authorities, from the Bank for International Settlements and the
World Bank to the European Central Bank, the FSF is chaired by Roger Ferguson
Jr., who is also vice chairman of the Fed's board of governors.
The FSF study is by far the best elucidation so far of the market for synthetic
CDOs. It carefully steers clear of any alarmist language, and in many ways it
counters some prevailing anxieties. For instance, the study finds no
"evidence of hidden concentrations' of credit risk," except perhaps
at the monoline insurers, such as MBIA Inc., that
provide credit guarantees and presumably know what they're doing. But the study
does highlight 29 specific areas of concern, from possible market illiquidity
and overconcentration of market making in a few Wall
Street banks to untested assumptions in risk models and an overreliance
on credit ratings in lieu of investors' own risk analysis.
Pricing problems
Insufficient risk analysis is at the heart of the pricing anomalies in
synthetic CDOs and credit default swaps, and stories abound about pricing
discrepancies. For instance, many buyers don't understand that a credit swap
premium or the coupon rate on a CDO tranche is negotiable.
"There's a lot of give [in pricing]," says Tavakoli
of Tavakoli Structured Finance. She tells of wanting
to buy a senior tranche rated triple-A, but she felt the subordination was
insufficient to warrant the triple-A rating. "I said, this wouldn't merit
a triple-A by Moody's,' and the salesman said, well, if you want more spread,
you can have it.' I said, yes, but I would want the spread at a double-A'-that
is, I wanted a higher coupon rate. And he said, you can give me a bid at a
double-A level." She advises clients to be tough on pricing.
Tavakoli also advises clients not to rely blindly on
credit ratings. "The rating agencies have a hard time keeping up with the
new products that we're creating," she says. "They do their best. But
even if they did keep up, the rating agencies themselves have different ways of
looking at the credit risk. You'll often find that Moody's, S&P and Fitch
have systemic differences between each other. It's wise for investors to
educate themselves well on what those differences are and what price they
should ask for."
Market makers in swaps don't always have a firm grip on correct pricing
themselves. That notion is borne out by an anecdote from Randall
Dodd, director of the Financial Policy Forum's
Credit default swaps "are very hard to price, because they're abstracting
away from a normal corporate bond, or some other credit instrument, just the
pure credit risk," Dodd says. And, he points out, risk models provide a
bell-shaped curve of probability distributions based on the past. If a company
such as GM has never defaulted, "you can't put a probability on it,"
Dodd notes.
And wonky pricing can be even worse getting out. "If you want to get out
early, it costs you," says CMRA's Rahl. "People don't fully understand the degree to
which, if over-the-counter markets freeze up, there could be substantial
differences between what a theoretical model tells you something is worth and
where a buyer and a seller are willing to transact."
The limitations of risk models apply in correlations, too. "Correlations
are changing all the time, rising, falling, going positive and negative. If you
know when the correlations will work and when they won't, you can
arbitrage," says a market analyst. Do people have a good grip on how
correlations change? "I think people are sorting them out," she says.
"We don't have a huge historical experience."
Hedge fund impact
Even the skimpy historical record may be distorted by the ways that new
entrants change market behavior. "There have been significant changes in
how the credit markets work," notes Rahl. For instance,
"the role of banks in working out bad credits has changed dramatically.
Bondholders now play a much more significant role. So looking at data from the
1980s, probably there's little resemblance to the workout patterns and partners
of today."
The major new entrants today are hedge funds, whose active trading and high
leverage may be changing the character of the market. In theory, at least,
"spreads on credit default swaps should be highly correlated and linked to
the underlying bond yield," says McKinsey's Gerken,
and the market "should be driven by banks and institutions focused on
hedging credit exposure." Instead, he says, spreads jump about
"because hedge funds and other institutions are playing correlation
games."
Hedge funds are not yet the biggest players in credit default swaps and
synthetic CDOs, but by some guesstimates, their activity in the market may
surpass that of investment banks by next year.
"One systemic fear is that our core banks and brokers are meeting their
capital requirements by moving their credit exposure into unregulated funds
that don't have capital requirements," points out Dodd at the
Another salient issue looming over the market is how the leverage of CDOs may
be altering, shifting, or adding to the risks inherent in the credit
derivatives that form the collateral in a synthetic CDO. "How all these
components work together has not been studied much in detail," says
Andreas Jobst, a former securitization expert at
Deutsche Bank in
For example, the Fed's Gibson, in a study of his own of synthetic CDO risks, is
concerned that using "notional" amounts for credit derivatives, rather
than mark-to-market values, may be misleading investors. As he sees it,
"even though mezzanine tranches are typically rated investment-grade, the
leverage they possess implies their risk (and expected return) can be many
times that of an investment-grade corporate bond." Moreover, a mezzanine
tranche may be more sensitive to business-cycle risk that investors realize,
Gibson says.
Taking a different slant, Jobst believes that the
structure of synthetic CDOs, which lodge expected risk in the lowest tranche,
actually pushes unexpected losses up to the more senior tranches. By unexpected
risk, Jobst means the risks of high-stress
events-"volatility above the historical average"-not the day-to-day
volatility of normal markets and normal risk models. "What is not well
understood is that a senior investor is almost entirely exposed to unexpected
loss," he says, "and the risk is much higher for senior investors
than for equity tranche investors. The more senior tranches are more
susceptible to risk volatility."
If true, then CDO senior tranche holders are bearing a lot more risk than they
realize and probably aren't being adequately compensated for it. That means
that indeed, no one knows exactly where the risk is anymore-and probably won't
find out until a tsunami of some sort hits the credit markets. After everyone
picks up the pieces, then the risk modelers will have something tangible to
work with.
May 11, 2005
Transcripts not yet available.
Markets shaken by hedge fund rumors
By Alistair Barr and Kathie O'Donnell
Last Updated: 5/10/2005 6:51:05 PM
Speculation
swirled that a couple of hedge funds were facing trouble as a result of their
exposure to General Motors Corp. (GM) bonds. Last week,
Standard & Poor's cut its credit rating on the world's largest automaker to
"junk" status.
The
implications of the downgrade on hedge fund positions in credit derivatives
also weighed on the minds of investors and traders.
Equities
and the U.S. dollar fell while Treasury bonds and gold climbed as investors
looked for relatively safe places for their money.
A
Wall Street Journal report Tuesday highlighting recent troubles in the hedge
fund industry also fueled concerns. See full story at WSJ.com.
Deutsche
Bank (DB) slid
3.3% amid talk that the bank is the prime broker for QVT Financial L.P., one of
the hedge funds rumored to be in distress. A London-based spokeswoman wouldn't
comment.
Other
investment banks with sizeable hedge fund brokerage businesses also dipped:
Bear Stearns (BSC)
slid 3.4%; Goldman Sachs (GS) shed 3.2% and
Morgan Stanley (MWD)
declined 2.6%.
QVT
Financial, investment manager of the QVT Funds, said speculation that a QVT
hedge fund was one of those in trouble is "categorically untrue."
"We
were up 2.6% year-to-date through April, and we are up even slightly more in
May at present," said Dan Gold, chief executive of QVT. "We welcome
further difficult market conditions because we think they will present buying
opportunities to strong funds such as ourselves."
Gold
added, however, that QVT believes "the current conditions in convertible
and structured credit markets will pose difficulties for many of our
competitors."
Other
hedge funds mentioned by market professionals were GLG Partners, a London-based
hedge fund, and Highbridge Capital, a $7 billion
Spokesmen
for Highbridge and J.P. Morgan declined to comment.
GLG,
which has reportedly been in talks with Lehman Bros. (LEH) about being
acquired, also wouldn't comment.
Tim
Ghriskey, chief investment officer at Solaris Asset
Management, a New York-based investment firm that offers hedge funds, said he
heard speculation Tuesday morning that a large hedge fund was unwinding
positions in GM bonds and may have taken losses in those positions.
Still,
Ghriskey said rumors of hedge fund blowups are
"very common."
GM trade
So-called
arbitrage hedge funds may have been hurt the most by General Motors's recent
troubles. Arbitrage involves ironing out
price anomalies between related securities.
One common type of trade is to short the equity and buy the bonds of a
company that's been downgraded to junk status.
In
theory, if the company files for bankruptcy, its stock would be worth nothing,
while its bond holders may be entitled to a portion of the firm's assets.
Last
week, this type of trade involving GM stocks and bonds would have suffered a
double hit. When S&P cut its rating
on the carmaker's debt, GM bonds fell. But the company's shares also rose when
Kirk Kerkorian announced he would bid for a stake in
the firm.
Convertible troubles
As
the largest issuer of convertible bonds, GM's troubles highlighted the recent
struggles of hedge funds operating in that market.
Convertibles
pay a coupon like traditional corporate debt notes, but also give investors the
chance to convert their holdings into stock of the company at a set price in
the future.
Hedge
funds are big players in this market and many follow strategies known as
convertible arbitrage, which involves ironing out differences between the value
of convertible bonds and the stocks to which the debt is linked.
Hedge
funds that trade convertible bonds lost 3.5% in April on average, leaving them
down 6.3% so far this year, according to Hennessee
Group, an industry consultant which tracks performance.
Overall,
hedge funds lost 1.8% in the first four months of 2005, according to Hennessee's Hedge Fund Index, which tracks the performance
of about 900 managers overseeing at least half of the capital in the industry.
Several
convertible arbitrage managers took a beating in April as a result of widening
credit spreads, problems at General Motors and redemptions from hedge fund
investors, Hennessee said.
That's
created "the worst convertible arbitrage environment since 1994," the
consultant added.
Structured credit
GM's
credit downgrade may have triggered problems in structured credit markets
too. Structured credit products use
derivatives to shift credit risk from a person or entity looking to buy
protection onto sellers of protection. The products include collateralized debt
obligations and credit default swaps that can cover a basket of different
companies, according to Randall Dodd, director of the Financial Policy Forum, a
non-profit research institute set up to study the regulation of financial
markets.
Credit default swaps are a form of insurance
against corporate debt default.
Providers of this credit insurance have to pay in the event of a default
or bankruptcy. However, depending on how products are structured, they may also
have to pay if there's a credit downgrade or credit spreads widen beyond a
certain point, Dodd said.
Because GM has sold so many bonds, it's
usually a part of these baskets of credit risks, he added.
"People that have sold protection now
are taking a beating because they have GM all over the place," Dodd said.
Standard & Poor's cut its ratings Tuesday
on six synthetic collateralized debt obligations arranged by Deutsche Bank
after "negative credit rating migration within the underlying reference
portfolios of each transaction."
S&P didn't say what credit rating changes
triggered the move, however Dodd said it was likely related to GM and Ford debt
being cut last week to "junk" status.
Surging assets
Hedge
funds are private investment partnerships that can bet on falling as well as
rising prices. Sporting track records of steady annual returns in both up and
down markets, the funds have attracted billions of dollars in new money in
recent years and now oversee about $1 trillion.
Surging
assets and the proliferation of new managers have sparked concerns that returns
may fall as more traders chase a finite number of investment vehicles.
In
recent years, hedge funds have faced further challenges as interest rates
languished near record lows, credit spreads narrowed and market volatility declined.
With
fewer opportunities, some managers have taken on more risk in search of higher
yields, said Kevin Mirable, a partner at S3 Asset
Management, which provides prime brokerage services to the industry.
Now
that interest rates are rising, credit spreads have widened and volatility has
picked up, some hedge funds may not be able to handle the change, he added.
"These
things are historically handled very well by hedge funds," said Mirable, former head of Barclays Capital's hedge fund
services group. "But there are a lot more hedge funds doing this now and
there'll be some that may have come into business in the past 5 years that will
really be challenged."
Troubles at Fannie and
Freddie May Impact Capital Markets and
Companies’ Response to New
Accounting Regulations
by
Cynthia Harrington, CFA
Fannie
and Freddie occupy headlines recently because of the challenges to their
methods of accounting. But simply the size of Fannie Mae and Freddie Mac attracts
attention. The two companies’ activities involve nearly half of $7.7 trillion
residential mortgage debt. Their combined $1.8 trillion assets rank the
mortgage companies in second and third place as largest
Cries
to diminish the companies’ influence have grown louder as the companies rapidly
expanded over the past three decades. Diverse interests wish to privatize,
break up and restrict the way the two do business. The outcome of the current
accounting hoopla might have a broad impact on both the capital markets and the
way that companies deal with the new accounting regulations.
Forces
for Change
Calls
to shrink Fannie and Freddie come from diverse corners. Some think policies
that encourage home ownership have succeeded and should be changed. The
interest and local property tax deductions, as well as the implicit government
backing of Fannie and Freddie, have met their goals. Now these policies drain
capital from development of human and production capital and should be
narrowed. “Home ownership is something to be encouraged but government support
should be focused toward households on the cusp,” says Lawrence J. White,
Arthur E. Imperatore Professor of Economics,
Department of Economics, Leonard N. Stern School of Business, New York
University,
White
and his coauthor W. Scott Frame, a financial economist and associate policy
advisor at the Federal Reserve Bank of Atlanta, call for privatizing both
companies in their forthcoming article “Fussing and Fuming over Fannie and
Freddie: How Much Smoke, How Much Fire?” They point to the systemic risk to the
“The
prepayment option make 30-year mortgages the toxic waste of fixed income
securities”
The
concentration of assets concentrates interest rate risk as well. Dwight M. Jaffee makes a case for spreading out the concentrations in
“The Interest Rate Risk of Fannie Mae and Freddie Mac” published in 2003. “The
prepayment option make 30-year mortgages the toxic waste of fixed income
securities,” says Jaffee, who is the Willis Booth
Professor of Banking and Finance at the Haas School of Business,
The
big mortgage companies incur additional risk in their methods of financing.
According to Jaffe, all the hedging done by Fannie and Freddie is done off
LIBOR but they borrow off agency rates. “Since the two institutions create the
agency rates, there could be serious basis point risk in the hedge,” says Jaffee. “Because of the concentration of assets the impact
would be huge if they got into trouble.”
Jaffee presented his plan for shrinking Fannie and Freddie before the
American Enterprise Institute. The proposal calls for liquidating the $2
trillion mortgage-backed securities portfolio, or phase out over a few years by
just not buying new ones. “We really need to disassemble Fannie and Freddie and
have 100 like them only 1/100th the size,” says Jaffee.
“Let the interest rate risk be spread over a larger number of people instead of
focused on the U.S. Treasury.”
Restating
Earnings
The
accounting irregularities spark even louder expressions of privatizing or
breaking up Fannie and Freddie. Greenspan recently suggested to Congress that
the two shrink dramatically. He proposed a reduction to $100 to $200 billion in
mortgage holdings from the current $905 billion at Fannie and $654 billion at
Freddie. Support for the two seems to be weakening on Capitol Hill. “We will
probably get some sort of regulatory reform to increase safety and soundness
but I expect we’ll be a far cry from privatization,” says White.
“Fannie
is going to have to go back and very carefully apply the new regulations
retroactively”
The
spark to the renewed argument is the ongoing inquiry into Fannie’s methods of
accounting, primarily its adherence to the new fair value accounting for
derivatives. According to FAS 133, derivatives must be marked to market each
quarter after January 1, 2001, except for a variety of exceptions. Fannie has
announced that as much as $9 billion worth of earnings from 2001-2003 might be
restated. “Fannie is going to have to go back and very carefully apply the new
regulations retroactively,” says Randall Dodd, director of the Washington,
D.C.-based Financial Policy Forum. “Running a very large business through a new
accounting framework is a substantial effort and Fannie did not implement the
changes well.”
Dodd
emphasizes that Fannie broke the law and needs to make amends but that the
economic affect of the changes is near zero. While quarterly numbers will
fluctuate, gains or losses in one quarter can come out in the wash in future
quarters’ fluctuations. “Fannie Mae is not Enron,” says Dodd. “Across time past
losses become future gains.”
Even
proponents of a smaller Fannie and Freddie don’t expect the challenges to
accounting practices to amount to much in the long run. “Fannie Mae simply
broke the technical rules and should be badly punished,” says Jaffee. “But if they had published truthful numbers the
economic impact would not be much different.”
The
companies will change in response to the questionable accounting, however.
While Freddie Mac’s name melted from the headlines as its 2000-2003 accounting
problems were settled, Fannie’s problems continue. The CEO and CFO stepped down
last December, the company is working to accurately implement fair value
accounting for its derivatives positions, and changed auditors from KPMG LLP to
Deloitte & Touche LLP. Fannie has until September
30, 2005, to increase its capital surplus to 30 percent, and regulator Office
of Federal Housing Enterprise Oversight continues its probe into accounting
practices under no fewer than five additional accounting standards.
The
The
current questioning clearly opens the dialogue about grander changes. Privatizing
and taking away the government backing incite the threat that mortgage rates
would rise. “Congress runs scared of that but it’s a false threat,” says Jaffee.
Rates
wouldn’t rise because nearly the same players would form the market. In an
application of replication theory, Jaffee points out
that while Fannie and Freddie hold significant mortgage backed securities
today, they sold agency bonds to raise capital for the purchases. The companies
hedged the interest rates on the portfolio through derivatives held by Wall
Street firms and other investors. If Fannie and Freddie liquidated their
holdings, the new buyers of mortgages would sell bonds to raise capital and
hedge with the same investors. The only difference would be the treasury
backing. “If mortgage rates go up by four basis points and risk gets spread
around, that’s a good deal for the treasury and a good deal for taxpayers,”
says Jaffee.
The
full impact of privatization rests on additional variables. “Fannie’s borrowing
costs would probably increase by around 40 basis points because now the
AA-company borrows at AAA rates,” says White. “But if they’re private they’re
no longer limited to the conforming end of the market, or even solely to the
residential mortgage business.”
As
private companies, Fannie and Freddie would need to manage governance issues in
order to maintain their credit ratings. “Any problems of safety and soundness
become worries of the SEC and not something the taxpayers would have to pay
for,” says White.
Change
the Rules
While
the financial impact of the change in the way derivatives must be accounted for
is immediate, the controversy over accounting rules may be far from over. Jaffee points out that for these mortgage lenders and other
companies, FAS may turn out to be unworkable. Establishing fair value adds what
some feel is unnecessary volatility to earnings, and the 800-page standard is
complicated to implement. “I could imagine unintended consequences,” says Jaffee. “Commercial banks could come out and say that
abiding by the rules raises the cost of hedging beyond the benefits. That way
FASB shoots itself in the foot.”
“It’s
the accounting that’s got to be fixed,”
Besides
the difficulty of applying the standard, the results don’t effectively report
the economic conditions for companies like Fannie and Freddie, according to
Dodd. “It’s the accounting that’s got to be fixed,” says Dodd. “These companies
hedge liabilities as opposed to assets yet they have to mark to market on
assets.”
Dodd
suggests that companies use pro forma earnings to show the best way to show the
business model and the firms’ way of looking at it, in addition to reporting
earning within the legal limits. These companies are successfully hedging
fluctuating liability costs. Strict adherence to accounting rules keeps them
within the law but may not accurately reflect the economic fundamentals of what
they’re doing. “For example, callable bonds aren’t recorded as derivatives,”
says Dodd. “Yet the borrowing cost of a three-year bond with a swaption for a seven-year fixed rate is the same as a
10-year bond callable in three years.”
Fair
value accounting poses challenges for both public companies and their external
auditors. Some party must be responsible for the validity of the numbers. “From
a policy standpoint, companies like Fannie and Freddie should have third-party
vendors to provide these numbers,” says Jaffee.
Whether
Fannie and Freddie shrink, are privatized, or carry on in their current status,
the story is far from over. The debate simmers at Congress, the SEC, FASB, in
academic circles and at think tanks around the country. Being too big to fail
may just mean being too big to not break up.
May 1, 2005 Sunday
Bond manager yields to muni temptation
David Roeder
With inflation a concern and the Federal Reserve on the prowl for it, it might
not seem the occasion to tinker with bond investments. But John Miller,
proprietor of Nuveen's $1.5 billion High Yield
Municipal Bond Fund (NHMCX) sees much to tempt the fixed-income investor.
Miller said AAA-rated municipal bonds are a good tax-free value when compared
with Treasury or corporate bonds. He said 30-year munis
with the AAA rating are achieving yields of about 4.37 percent, close to the
Treasury bond figure. Those munis also are roughly
equivalent to the taxable yields on corporate bonds with the riskier BBB
rating, he said.
Miller likes munis because local tax bases hold up
well regardless of whether or not the economy is humming.
He's more leery of the corporate market these days because concerns about big
debt issuers such as General Motors (GM) and Ford (F) have produced volatile
price swings. His investment choices in corporates
are the classic defensive plays such as utilities and health care. Miller said
a current favorite are bonds of Nevada Power, a unit of Sierra Pacific
Resources (SRP), whose territory includes
But above all, he counsels investors against jumping into and out of bonds
based on guesses about interest rates. "It's expensive to trade that way
and costly if you're wrong," he said.
OUCHES OF THE WEEK: "Jones Lang LaSalle (JLL) reports solid revenue
growth," said the headline on the earnings release. Uh-huh. The real estateservices firm also reported a sharply wider loss that
caused the stock to get pummeled. It fell $9.66 on Thursday, then recouped 90
cents Friday to close at $37.50. Makes one wonder about the big recovery in
commercial real estate that is often talked about but hasn't arrived.
Then there was Archer Daniels Midland (ADM), down $3.64 Friday to $17.99 after
its quarterly report missed analysts' marks. The stock is in for a rough haul
because a glut of ethanol will eventually force it to cut prices.
FUTURES SHOCK? I couldn't help it. While working on a quintessential "good
news" story last week about record volume and earnings at the Chicago
Mercantile Exchange (CME), a shiver went up my spine. It was when Merc CEO Craig Donohue explained the wonderful results with
the line, "Futures have gone mainstream." Fund managers, he said,
"have learned how to handle futures to enhance portfolio returns." He
also cited the sophistication of trading software that alerts the unwary to a
possible meltdown.
Where have we heard that before? Long-Term Capital Management, run by guys who
knew it all? Barings Bank? I sought out Randall Dodd, president of the Washington,
D.C.-based Financial Policy Forum, to find out if he thinks the great volumes
in the
He's even-handed. Dodd praises the
But Dodd said concern isn't misplaced. "You don't know who's out there
trying to execute a highly leveraged investment strategy," he said. Much
has been made of the shadowy power of hedge funds, but Dodd notes that the
investment banks such as Goldman Sachs (GS) and Merrill Lynch (ML) have
reported that their biggest profit gains are coming from proprietary trading,
where they risk their firms' own money. "They're really just becoming a
slightly better regulated hedge fund," he said.
BLIND SPOT: The daily chatter in the marketplace often gives short shrift to
small-cap stocks, the market's best sector in recent years. Alexander Paris,
president of Barrington Research Associates, looked at companies with market
capitalizations of $100 million or less and found that 75 percent have no
coverage by a research firm. "It's the economics,"
CLOSING QUOTE: "If oil declines in conjunction with a moderating pace of
economic growth, then not only will that encourage investors, it will remove
the inflationary impact of rising commodity prices. We are bullish on the
out-of-favor asset class:
Morgan, UBS Helped Parmalat
Hide Costs, Study Alleges
March 18 (Bloomberg) -- Morgan Stanley and UBS AG helped Parmalat Finanziaria SpA,
Morgan Stanley used derivatives to help Parmalat
sell 300 million euros of bonds that gave an investor a higher return than Parmalat stated in a release, according to the study by
``If the true conditions of the bond issues obtained by the
buyers were communicated to the market, it would have caused a serious drop in
the price of other bonds,'' Chiaruttini said in the
72-page report for magistrates probing the dairy's collapse.
Milan prosecutor Francesco Greco sent judicial notices to
attorneys of 13 executives at Morgan Stanley, the second-biggest securities
firm, UBS and four other financial groups yesterday, accusing them of
attempting to manipulate market prices for Parmalat
securities.
Collecchio, Italy-based Parmalat
inflated assets and racked up more than 14 billion euros in debt before filing
for bankruptcy protection in December 2003. Investors and Parmalat's
current chairman, Enrico Bondi,
have alleged that bankers knew the company's financial state when they arranged
funding for it.
`Polemical'
Morgan Stanley said there was no basis for indictments.
``We believe that the conduct of Morgan Stanley and its
employees was entirely correct and proper throughout our dealings with Parmalat,'' spokesman Carlos Melville in
UBS denied any wrongdoing, saying that Chiaruttini's
report was flawed and ``polemical'' and that the memo she cited was ``a
discussion paper'' dated almost two months before the bond sale closed in June.
``This document does not accurately reflect what was finally
agreed and what happened following that date,'' said spokesman David Walker in
Bondi and Greco declined to comment. Chiaruttini didn't immediately respond to two messages
seeking comment.
Greco's action comes at a time when former banks to
WorldCom Inc. have agreed to pay more than $6 billion to settle investor lawsuits
claiming they should have known the company's books were fraudulent when they
underwrote its bonds.
Effective Derivatives
Bank financing has come under increasing scrutiny since
WorldCom and Houston-based energy trader Enron Corp. filed for the two biggest
bankruptcies in
``Derivatives have become hugely effective as a way of
defrauding investors, or making things that appear to be one thing and are
actually another,'' said Randall Dodd, director of the nonprofit Derivatives
Study Center in Washington.
``You've got to go after the banks because they are
complicit'' in structuring the deals, said Dodd, a former economist for the
U.S. Commodity Futures Trading Commission, referring to financing done for Parmalat and Enron.
`Fast and Loose'
Banks and brokerages have been stepping up investments in
structured finance, where securities and derivatives are blended to fit the needs
of companies, as fee levels for services such as bond sales and stock trading
decline. Abuses have grown along with the business, say critics such as Raymond
Baker, a senior fellow at the Center for International Policy in Washington who
has studied how banks use tax havens and is working on a book about ``how
capitalism is trying to separate itself from the rule of law.''
``A lot of bankers are playing fast and loose with what
should be known banking products,'' Baker said. ``Enron revealed a great deal
of this, and Parmalat did, too.''
``What we are seeing is the construction of a parallel
financial system that is designed to work in an obscure way,'' Baker said.
``Every bank here is active in this.''
Morgan Stanley and UBS began arranging the two debt deals
after Parmalat failed to find enough investors for a
sale of as much as 500 million euros of 30-year bonds. When the dairy scrapped
the sale Feb. 27, its shares slumped and its bond yields soared.
Morgan Stanley was one of the banks hired to underwrite
those bonds. A month later, the brokerage offered to help Parmalat
break the ``vicious circle'' in the market, suggesting actions including a
buyback of convertible bonds to restore investor confidence, according to a
copy of a March 24, 2003, presentation attached to Chiaruttini's
72-page study.
Nextra Demands
By then, Morgan Stanley was brokering the sale of 300
million euros of floating-rate Parmalat notes to Nextra Investment Management SGR, a unit of Milan-based Banca Intesa SpA,
according to internal Morgan Stanley e-mail attached to Chiaruttini's
report.
Nextra demanded an interest rate of 350
basis points above money-market rates, which was in line with the cost at the
time of insuring Parmalat debt against default in the
derivatives market, according to bank documents attached to Chiaruttini's
report.
Parmalat was trying to lower those
premiums and wanted to tell the market that it had sold the bonds at 305 basis
points, Chiaruttini wrote. A basis point is 0.01
percentage point.
In a deal signed in June, Nextra
paid 294.1 million euros for the 300 million euros in notes, boosting the
fund's return to 350 basis points. Morgan Stanley then used an interest-rate
swap to bridge the 5.9 million euro gap between the proceeds of the discounted
sale and the face value of the notes, the study says.
Credit Default Swaps
Parmalat didn't mention Nextra's discount in a June 18, 2003, release announcing
the placement, saying only that the 300 million- euro bond was ``indexed to Euribor plus 305 basis points.''
Nextra spokesman Volfango
Portaluppi didn't return phone calls seeking comment.
Parmalat's cost of insuring its debt
against default tumbled after the sale was announced. The dairy's default swaps
traded at about 300,000 euros to insure 10 million euros of debt for five
years, down from about 360,000 euros at the start of June 2003, according to
data compiled by Bloomberg. Chiaruttini described
this as ``closing the gap'' between how investors priced Parmalat
risk before and after the sale.
Term Sheet
Nextra's discount could have been deduced
from a bond term sheet received by Bloomberg that June. It said Parmalat's net proceeds were 97.626 percent of the 300
million-euro face value.
Marco Elser, principal of Advicorp Plc in
``They were trying to pull a fast one, which they did,''
said Elser, who said he sold all of his Parmalat bonds when the company issued the release because
the dairy had previously promised not to sell more debt. He currently trades in
and out of the bonds.
In discussions on a second Parmalat
debt deal agreed upon that June, UBS had written a memo to the company dated April
16, 2003, that discussed ways the dairy could delay a listing of the bonds and
avoid disclosing how much money it netted from the deal.
``With a late listing, the pricing information would be
deemed to be old and irrelevant,'' UBS told Parmalat
in outlining ``a solution to the disclosure aspect of the transaction,''
according to a copy of the memo attached to Chiaruttini's
report.
Late Listing?
The memo showed that Parmalat
wanted to keep the market from knowing the full cost of the financing, which
raised a net 110 million euros for the dairy from the sale of two bonds with a
nominal value of 420 million euros.
``We understand the importance for you that persons not
party to this transaction do not have full details of the all-in cost of Parmalat's bond issue,'' UBS wrote.
This created a difficulty for UBS, which wrote that it
could only buy listed securities. After talks with the Luxembourg Stock
Exchange, the bank offered a solution under which the securities could be
listed ``3 months after the Closing Date,'' said the memo, which also proposed
putting ``minimal pricing details on Bloomberg'' only ``a couple of months
after the listing.''
With a late listing, the memo said, ``it may also be
possible to omit the Net Proceeds from the pricing supplement.''
In the end, half of the bonds, or 210 million euros of 5.1
percent notes, were listed on the Luxembourg Stock Exchange on Aug. 14, 2003.
That was two months after the sale closed on June 9 and more than a month after
the issue date of July 3.
No Delay
``UBS did not delay the listing by Parmalat
of the relevant bonds on the Luxembourg Stock Exchange,'' said
The supplement did state the net proceeds from the sale,
200 million euros, according to a copy provided by exchange official Carlo Oly. The second bond, or 210 million euros of 5.2 percent notes,
was never listed on the exchange, Oly said.
Parmalat didn't tell the market about the
deal until the following September, when Chief Financial Officer Alberto
Ferraris told investors that UBS had underwritten a bond sale generating 130
million euros in net financing at below market rates.
Bloomberg didn't receive a pricing supplement on the listed
bonds until Dec. 22, 2003 -- three days after Parmalat
disclosed it had lied to investors about having a 3.95 billion-euro bank
account and two days before the dairy filed for bankruptcy protection.
UBS said disclosure of the sale was Parmalat's
responsibility. ``They had their own advisers in this regard,''
Yesterday's
Citigroup, CSFB and Deutsche Bank, which are also
defendants in lawsuits by Parmalat Chairman Bondi, have all denied wrongdoing. Banca
Intesa, which also has denied wrongdoing, agreed in
October to pay Parmalat 160 million euros to avoid
legal action over its role in the 2003 bond sale.
Last night, Citigroup filed a counterclaim to a suit by Bondi in a
James Pressley in
February 26, 2005
Caught
between risk and a hard place
Nick Leeson broke Barings but 10 years on, Michael
Dwyer reports, Singapore is still under a cloud
The bartenders at Harry's Bar, a popular pub on the banks of the Singapore
River, serve up a mean cocktail named after rogue trader and former regular
Nick Leeson.
But 10 years after Leeson brought down Britain's
oldest merchant bank by gambling away ¬n862 million ($ 12.83 billion),
Officials from both the Singapore Exchange (SGX) and the Monetary Authority of
Singapore (MAS) have instead spent most of the past three months dealing with
another financial scandal that could jeopardise
In early December last year, China Aviation Oil (
SGX and MAS officials have been quick to reassure CAO's
7,000 or so small shareholders that the
Yet, a far more difficult task will be the creation of a regulatory environment
that would prevent financial scandals like the collapse of Barings Bank and CAO's massive derivatives losses.
Randall Dodd, who runs the Derivatives Study Centre at the
Washington-based think tank Financial Policy Forum, says it can be very
difficult for governments to regulate against such rogue trading.
"The rogue trader problem must be solved by having proper internal
controls," said Mr Dodd, who served as a senior
official with the Commodity Futures Trading Commission (CFTC) in the
He said that trading just made poor internal controls a much greater potential
danger: "Most participants in the derivatives markets are sophisticated,
although some are significantly more sophisticated than others.
"The difference can create problems from fraud and market manipulation.
Regulators are savvy to some issues but do not have the resources and access to
information to do a thorough job."
The collapse of the 230-year-old Barings Bank a decade ago certainly brought a
quick response from both national governments and companies that were
potentially at risk.
In
Investment banks also significantly beefed up their compliance departments and
set in place far more rigorous risk management.
Yet, even with the most rigorous of risk management systems in place, it seems
highly unlikely that financial scandals caused by rogue trading will ever go
away.
In February 2002, Allied Irish Banks revealed that it was investigating a US$
690 million currency fraud at its
In late 2003, the National Australia Bank also admitted it was facing losses of
about A$ 185 million ($ 1.13 billion) as a result of unauthorised
foreign currency trades.
In the aftermath of the CAO scandal in
But critics argue that the SFA still lacks teeth. "We do have the
necessary framework in place in terms of updated securities legislation dealing
with false or misleading statements, continuous disclosure of material
information by listed companies and insider trading," said Mak Yuen Teen, the co-director of the Corporate Governance Centre
at the National University of Singapore.
"There are civil penalties, criminal penalties and civil liability for
contravention of provisions in the SFA," Mr Mak said.
"But strong enforcement is necessary, not only in cases that reach the
status of a corporate scandal like CAO, but in other cases of lax or misleading
disclosures that do not result in corporate failure."
Another potentially big problem facing
The government has in the past been actively encouraging this type of OTC
derivatives trading.
"OTC markets are largely unregulated," said Mr
Dodd. "No one knows the open interest. No one has full knowledge of
prices."
By comparison, exchange-traded derivatives were well-supervised and there were
reporting requirements that could help detect and deter manipulation, he said.