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Tuesday, 30 September 2008


A week ago I wrote about an Exchange-bsed solution to take OTC structured products that are illiquid and toxic on-exchange (writing here and in FT Economists Forum and to some influencers in the US to take fuller advantage of TARP on top of the Fed's and Treasury's admin takeover of Freddie, Fannie, and AIG, and the reduction of CDS that is going on as firms merge and eliminated exposures to each other - part of the M&A/takeover price, including Citi AND Wachovia or JPM and Bear). I expand below on the original idea:
1. Establish a regulated EXCHANGE (owned by the Fed & US Treasury, with possibly BoE and ECB, and operated by the CME/CBOT/CBOE or equivalent) to trade structured products transparently (with protocols for tradability of commoditised asset backed products) based on cyclical (hold-to-maturity) economic cash-flow (IFRS-7) valuations plus tranche-based risk-hedging. Absolutely no trading would be allowed over-the-counter or otherwise on any of the eligible-securities specific pricing models or indexes. Products must be easily valued and rated on an exchange using for MBS sovereign ratings models to reflect national economy variations in mortgage protection and borrowers’ rights. Create a class of "eligible (mortgage-related only) securities" that are ‘toxic’, leaving all eligible securities on the books of existing holders. Central banks can buy in ABS (RMBS, CDOs etc.) or sell ABS holdings to maintain a target over the cycle price floor as per the TARP objective.
2. Have eligible security holders identify to the Exchange every eligible security by CUSIP and face amount. Only the Exchange will know institutional and investor positions. This will allow the Exchange internally to correctly assess the risks at hedge funds and others with "significant operations" without exposing their positions to competitors. Create a new accounting domain in-between "held-to-maturity" and "available-to-trade" where only eligible securities, as of a predetermined valuation date, can be accounted for at their value on the predetermined valuation date and not further subject to fair-value (marked-to-market) accounting while held for trading (something short of held to maturity).
2. Establish standard ratings on a "pooled-income revenue basis," whereby all issuers and holders that want (or are required) to be rated, pool funds on a per-volume, pro-rata basis and ratings providers are paid blindly for rating services.
3. Immediately stop issuance of CDS (credit default swaps) without mandatory reserve requirements and safeguards typical of what regulations already require of legitimate (Solvency II regulated) insurers. Netting of all existing CDS to tighten counterparty risk and unwind positions not secured by issuers meeting reserve requirements, and to eliminate virtual insurers. Allow issuance of CDS only up to the actual outstanding value of the underlying to ensure legitimate hedging only (eliminating undue pressure on debt issuers).
4. Mandate all holders of eligible securities mark-to-market inventories on a predetermined valuation date, the date that the Exchange expects all eligible securities to be registered with it. Those who recently marked their securities have already taken write-downs; those who haven’t will have to. If the results match bona-fide peer-group comparisons, investors and speculators may bid up eligible securities to own them before the predetermined valuation date, using new accounting definition(IFRS-7) advantages for holding eligible securities.
5. Reduce the haircut on the reserve requirements for all eligible securities covered. Since valuations have already fallen steeply, reducing reserve requirements on eligible securities additionally enhances their value as balance-sheet assets with upside potential. The Exchange may buy distressed assets at the behest of the Fed, Treasury (FDIC), or other authorities who have determined an administration outcome for holders suffering insolvency as a result of accurate mark-to-market values whereby their holdings on the predetermined valuation date (in the event of bankruptcy) may result in systemic problems. This scenario would meet TARP objectives of preventing exposing the financial system to disruptions.
6. The Exchange (backed by central financial authorities) will have a firm quality of market handle on all eligible securities and a transparent-pricing process through which any and all eligible securities may be accepted as collateral against Fed and other central bank discount windows and/or dealer and swap facilities.
7. "Servicers," (usually the originators) who manage the underlying asset pools (mortgage books etc.) on behalf of conduits (trust entities) under which securitised pools are issued, must be empowered to alter and modify terms and conditions of underlying mortgages as (or in conjunction with) the originating banks or lending institutions on the same risk mitigating (prudential + customer service) basis as their on balance sheet books with actions reported to and by the Exchange (and/or secured by first loss contracts) to incentivise banks and lending institutions to modify existing mortgages and to incentivize homeowners to stay in homes with negative equity or high LtV, taxing all capital gains on appreciation of newly appraised homes if and when they are sold by either homeowners, banks or lending institutions. And create tax-advantage scenarios for banks and homeowners partnering in the orderly reduction of delinquent obligations whenever loans can be brought back into a performing status. Lenders have various techniques for minimizing delinquency such as mortgage payment holidays, equity release and insurance cover (including Federal or other equivalents).
* with inspiration from R. Shah Gilani (trader, 29 Sept), Ronald P. O’Hanley, Vice Chairman, The Bank of New York Mellon and Charles. J. Jacklin, PhD, President and CEO, Mellon Capital Management (FT 26 Sept.) and Prof. Gilad Livne, and Prof. Alistair Milne at Cass Business School, City University London (FT 24 Sept.), and others writing in the FT mainly.

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