By Marla Singer and Geoffrey Batt
One of the central tenants of Farcism as a doctrine is the promotion and use of layers of opacity and complexity to empower regulators via their ability to mitigate red tape and compliance costs and to conceal this power under a cloak of (for example) promoting the "American Dream of Home Ownership." It will be seen that Farcism has imbued the halls of regulatory power, particularly in financial services, for decades. Zero Hedge readers are invited to opine on the impact this realization has on prospects for a financial reform bill that puts more power in the hands of these parties.
In this connection, back in November of last year we explored the nuances of the "foreign regulatory capital" credit default swap portfolio of the besieged Financial Products group at AIG. We pointed out that $172 billion in notional exposure (well, it seemed like a big number for a potential loss before Fannie Mae actually lost $145 billion in eleven consecutive quarterly losses, wiping out its combined profits for the prior 35 years and still leaving about $80 billion in red ink to spare) remained outstanding, that deteriorating credit markets may force AIG to recognize additional losses on the portfolio, but that AIG expected the swaps mostly to be terminated by the first quarter of 2010 (please please please please?). We also noted that the implicit backing of the Federal Reserve might be one of the key (only?) elements permitting these swaps to perform their desired function: permitting European banks to reduce their regulatory capital requirements (read: boost their leverage).
We had several questions last year. Including:
- If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
- Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
- If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength? (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report). Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
- Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
- If so, why keep them on the books now, instead of unwinding them?
- Since it doesn't seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
- Does this mean that the Fed is effectively underwriting these swap agreements?
- Will the Fed post collateral if deteriorating credit conditions at AIG (today's -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it? Or are we missing something significant? By September 30, 2008 AIG had already posted $974 million in collateral for its "Foreign Regulatory Capital" portfolio.
- What if European banks are hit with more losses from, oh, we don't know, say... Dubai? Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe. Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
- Could it be that the Fed, once again, might have to bail out the world?
So what became of these issues?
Well, it seems most banks managed to skate by without enough realized Dubai exposure to cause problems, but those were the days of the $1.50 Euro. With nearly a 20% EUR/USD slide since then, perhaps we should revisit the ticking time bomb of AIGFP's "foreign regulatory capital" swap portfolio.
In the spirit of review, recall that the purpose of "foreign regulatory capital credit default swaps" is tied up in the structural rigging of the markets to support a housing market bubble and encourage foreign financial institutions to be among the greater fools when the music stops in the United States. (Score!) Perhaps unsurprisingly, the role played by the United States' elite Regulatori caste in detonating multiple 300 kiloton W87 warheards over the American Dream of Home Ownership (in order to save the American Dream of Home Ownership) is almost never reported. Key to understanding this perverse dynamic is the realization that regulators rarely manipulate bank behavior through the direct prohibition or mandate of certain behavior. Instead, banks are rewarded, somewhat nefariously, via policies that amount to massive subsidies. Arguably the two most substantial, and damaging, of these are:
- The implied and/or explicit guarantee against loss by the United States government or its proxies.
- Deliberate rigging of capital requirements to manipulate banks to hold assets favored by policy makers.
In the first case, government guarantees can be seen as a combination of price fixing and subsidies. Price fixing in that the intent of the guarantee is to pull the perceived risk out of the asset and lower its price. Subsidies in that the government does not extract a fee from the investor in exchange for assuming the risk. Amusingly, while commentators are prone to liken guarantees to put options, they are more properly described as default swaps. The government is assuming (swapping) the risk of loss or default in the instrument. In this context it is beyond comic to watch some of the most profligate used car salesmen of government guarantees denouncing the sinister and evil nature of, for example, credit default swaps.
No one expects to pay a guarantee when it is made. That's why it is made. It is a bit of "free" political payoff for loyal supporters. The more cynical among us might point out that the maturity mismatch between guarantees and their potential implosions (political capital right now, outsized loss in many decades time after elected official has retired to the private sector) is probably seen and leveraged by the more clever and greedy political animals. But this is the siren song of taxpayer funded subsidies. They look "free."
Of course, any Zero Hedge reader with even a passing understanding of options understands that a guarantee against loss is valuable, and that when such guarantees are made without compensation the recipient is getting a subsidy and taxpayers get to carry the risk (read: pay for it). In fact the risk need not even materialize for taxpayers to have been cheated here. They have given something (the security of risk mitigation) for nothing.
The situation is nearly identical when the FDIC so radically underprices deposit insurance premiums to member banks that it chronically bankrupts the DIF and regularly has to go to the taxpayer well to make up the difference. This, of course, is a subsidy from taxpayers to banks in the form of underpriced insurance. How free do those subsidies look now?
In the second case, the power to reduce the capital requirements for financial institutions permits a small and mostly obscure group of the Regulatori to wield control over literally trillions of dollars. Lowering capital requirements on banks has the immediate and naturally consequent effect of boosting their available leverage. This, of course, permits banks to boost their profits and thereby looks like a bit of "free" graft. Of course, to the extent these banks are insured by underfunded depository insurance schemes designed to keep premiums low rather than to build appropriate reserves for resolution, taxpayers are footing the subsidy bill, even before any failures crash the scheme.
Add failures in a "too big to fail" environment and the subsidy looks larger still. With GSEs and FHA now backing 96.5% of all mortgages in the United States (that's not a typo... and the figure approaches 100% of US 2009 GDP- let that sink in for a minute) sketching out the nature of this subsidy is left as an exercise for the reader.
In addition, and often overlooked, complex, interlocking and even Byzantine regulatory mazes provide ample opportunity for a bit of taxpayer funded, no-control-group sociology experimentation by elected representatives who are about as likely to have spent time in the private sector as Robert Byrd.[fn]Total tenure, 57 years, 142 days, 9 hours and is (at the sprightly age of 92) third in the line of succession for the presidency. (Sleep well, dear readers).[/fn]
It should come as no surprise at all to the astute Zero Hedge reader that foreign banks investing in United States treasuries and certain (favored) mortgage backed securities (guess which ones) received favorable treatment with respect to the capital requirements (read: allowed leverage) imposed on them. Further, it should surprise such readers exactly "not at all" to learn that European banks in particular (but also US banks with international presence) could use provisions of Basel I to duck the 8% of "risk weighted assets" capital requirement by using credit default swaps to insure MBS and other securities against loss. Using this method, banks could reduce their effective capital requirement to below 2% of risk weighted assets, provided they held the right assets.
Obviously, being able to control the list of "favored assets" entitled to preferential treatment permits regulators to funnel massive amounts of capital into risky assets out of all proportion to their actual economic value. AIGFP's "foreign regulatory capital" portfolio of credit default swaps served exactly this market by writing billions of dollars in notional credit default swaps that created trillions of dollars in additional leverage. Suddenly, the foreign appetite for U.S. MBS securities seems just a bit less a consequence of the "invisible hand" and a bit more related to the "political handout."
When last we left our heroes at AIGFP, they expected a large portion of their foreign regulatory capital credit default swap portfolio to be subject to early termination by counter-parties (as the phase out of Basel I removed the incentives to maintain the swaps). The SIGTARP report on AIGFP quipped:
AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II. Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets. However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio. AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected.[fn]Special Inspector General for the Troubled Asset Relief Program's (SIGTARP's) November 17, 2009 report "Factors Affecting Efforts to Limit Payments to AIG Counterparties".[/fn]
So how's that working out for them do we think? Well, fortunately we have AIG's latest quarterly to give us timely updates:
The regulatory benefit of these transactions for AIGFP's financial institution counterparties is generally derived from the terms of Basel I that existed through the end of 2007 and which is in the process of being replaced by Basel II. It was expected that financial institution counterparties would have transitioned from Basel I to Basel II by the end of the two-year adoption period on December 31, 2009, after which they would have received little or no additional regulatory benefit from these CDS transactions, except in a small number of specific instances. However, in 2009, the Basel Committee announced that it had agreed to keep in place the Basel I capital floors beyond the end of 2009, although it remains to be seen how this extension will be implemented by the various European Central Banking districts. Should certain counterparties continue to receive favorable regulatory capital benefits from these transactions, those counterparties may not exercise their options to terminate the transactions in the expected time frame.
In addition, as of March 31, 2010, AIG had expected $304 million of Regulatory Capital CDS transactions to terminate early between April 1, 2010 and April 30, 2010. Of that amount, none had been called. The counterparties to these transactions continue to receive favorable regulatory benefits as a result of the extension of the Basel I capital floor. Since all of these counterparties retain the right to terminate the transactions early, the expected maturity for these transactions has been extended by one year.
Regulatory capital portfolio: In the case of credit default swaps written to facilitate regulatory capital relief, AIGFP estimates the fair value of these derivatives by considering observable market transactions. The transactions with the most observability are the early terminations of these transactions by counterparties. AIGFP continues to reassess the expected maturity of the portfolio. AIGFP has not been required to make any payments as part of terminations initiated by counterparties. The regulatory benefit of these transactions for AIGFP's financial institution counterparties is generally derived from the terms of the Capital Accord of the Basel Committee on Banking Supervision (Basel I)....[fn]American International Group Form 10-Q, United States Securities and Exchange Commission (May 7, 2010).[/fn]
- The regulatory capital portfolio (politically renamed from the "foreign regulatory capital portfolio" in this quarterly) simply isn't shrinking as fast as AIG hoped.
- The only input to their model valuing the instruments in this portfolio seems to be the early cancellation of swaps, which is simply not happening at the rosy pace AIG predicted.
Another otherwise obscure detail caught our attention. Of about $7.6 billion in net notional credit default swaps in AIGFP's "multi-sector CDO" portfolio, some $1.5 billion are on "physical settlement terms." This means that, in the event the credit default swap is triggered by default or other credit events, AIGFP will pay the counterparty the protection (in cash) and the counterparty will deliver the debt instrument covered by the protection to AIGFP. Of these physical settlement swaps, more than 80% are Euro denominated.[fn]American International Group Form 10-Q, United States Securities and Exchange Commission (May 7, 2010).[/fn] This means that while AIGFP must deliver cash to the counterparty, all it gets in return are increasingly worthless debt instruments denominated in a crashing currency. Not only is this a major drain on cash, but the instruments would also have the effect of loading up AIGFP's balance sheet with more deteriorating sludge. Of course, cash settled swaps are 80% dollar denominated, meaning that the decline in the Euro hits AIGFP's portfolio coming and going.
When can we expect Basel II? Suffice it to say that, just like it was a year ago, the one year delay predicted by AIG seems quite silly. Already by late 2009 Italian banks were screaming bloody murder at the prospect of complying with Basel II. The tougher requirements would, they credibly complained, likely slap all of Italy with a massive credit crunch. None other than the Telegraph's Ambrose Evans-Pritchard quoted Giampaolo Galli, director-general of Italy’s business lobby Confindustria thusly:
“We must convince the authorities that it is not only necessary to postpone the changes until 2011-2012 but also to soften them,” he told Italy’s financial paper Il Sole.
“There are going to be very serious difficulties. Firms have a great need for credit and they are going to reveal awful books for 2009, with the result that their access to credit will suffer,” he said.[fn]Ambrose Evans-Pritchard, Italian Banks Fear Crunch from Basel II, (December 16, 2009).[/fn]
If it sounds like Galli is bemoaning the impact real disclosure would have in revealing the sludge hidden beneath the AstroTurf and calling for its continued concealment, well that is because he is.
It is difficult to imagine, given the kind of panic that prompts short-selling bans, Basel II seeing implementation in the next twelve (or twenty four) months. For perspective, the original deadline was in 2004. Indeed, the Committee itself seems vague on this point.
The fully calibrated set of standards will be developed by the end of 2010 to be phased in as financial conditions improve and the economic recovery is assured, with the aim of implementation by end-2012. The Committee will put in place appropriate phase-in measures and grandfathering arrangements for a sufficiently long period to ensure a smooth transition to the new standards.[fn]"Consultative Proposals to Strengthen the Resilience of the Banking Sector Announced by the Basel Committee," Bank for International Settlements (December 17, 2009).[/fn]
- The end of 2012
This makes it rather difficult to gauge the risk of AIGFP's swap portfolio, the likelihood that AIGFP will have to post additional collateral, or the possibility that technical insolvency at AIG or AIGFP will invalidate the beneficial effect of the swaps on foreign capital requirements- instantly branding these institutions as "undercapitalized" and (in some jurisdictions) legally mandating authorities to put them in receivership.[fn]Cf. Sheila Bair's assigning responsibility for enacting "Prompt Corrective Action" to this year's winner of the FDIC's Jeff Spicoli Award for Industry in Financial Regulation.[/fn]
Then remember that AIGFP is only one of these Farcist enablers that we are fortunate enough to have discovered. What other nastiness lurks beneath CDO^3 structures and SPVs?
The reality is that until transparency of the sort that casts the brightest sunlight on earmarks, guarantee giveaways, accounting games, dumbed down capital requirements and the kind of legal structure that expects subjects to comply with 150,000 pages of federal regulations on top of state and local statutes, effectively causing the average citizen to unwittingly commit three felonies per day,[fn]Did you make a personal call at work today? Are you going to declare that income from your employer to the IRS? If not, you too might be a felon.[/fn] the Wages of Obfuscation (read: Farcism) will drive the United States.
Get down with the sickness.