Virtual Finance: Turning Things Right Side Up

Jun 22, 2012

Featured Products and Services by The Garfield Firm

NEW! 1/2 Day CLE Workshop for Paralegals and Lawyers with Neil Garfield: Building a case book for each client that saves time rather than takes time.

NEW! 2nd Edition Paralegal-Attorney Workbook,Treatise & Practice Manual

——–>SEE TABLE OF CONTENTS: WHOSE LIEN IS IT ANYWAY TOC

LivingLies Membership – If you are not already a member, this is the time to do it, when things are changing.

For Customer Service call 1-520-405-1688

Editor’s Comment:

The article below by Lisa Pollack in the Financial Times shows an amazing understanding of securitization, derivatives and the actual path of money. It also introduces a new term–“credit support annex (CSA). CSAs were discussed in this blog back in 2007 and 2008 which merely made the already incomprehensible financial structure even less understandable. But they are important because that is where actual assets, actual money and actual financial transactions are taking place.

The article below deserves several readings. Those that master it will understand completely the untenable position of the United States’ financial condition. The governments of each country are constantly engaged in trading and creating derivatives, insurance, credit default swaps and other credit enhancements as they hedge all perceived risks. The problem is that the dealer keeps on dealing whereas the original transaction remains unchanged. In our case the US government used taxpayer dollars and private companies used shareholder dollars to pay off the original transaction—the loan from the investor lenders to the homeowner borrowers.

The reason for the stream of fake securitization documents was to enable the dealers to keep on dealing, which they did. In some cases they leveraged the same loan or group of loans as many as 42 times that has been documented. Since most of these deals are undocumented we can comfortably assume that the actual figure is a multiple of 42 times given the current state of credibility of the 18 banks that dominated the mortgage securitization market.

With each deal, the margins kept spreading in virtual dollars, while the real money remained unchanged. When the real money was repaid to the creditor or the creditors agents (the dealers) the trunk of the tree disappeared. The acceptance of payment by a creditor from any obligor or co-obligor extinguishes the debt. This is black letter law in all 50 states and all federal decisions as well. But the dealer keeps on dealing as though the trunk of the tree was still there. In a 2-dimensional sense the dealers are drawing out branches and sub-branches of various “trades” based upon a nonexistent base (the original loan).

The reason the banks are so scared of discovery in litigation and why they settle any case in which a judge enters an order for them to open their books is that it would be obvious to a first year accounting student that there is no substance to the subsequent trades of the dealers and no substance to their current trades since the base transaction was no longer present.

The moment all was paid by the creditor, directly or indirectly through the investors creditors agents trading should have stopped. Any future trades after that point were pure fraud since they pretended that the loan still existed. All prior trades should have been required to settle immediately. Thus eliminating the appearance of branches on a tree with an invisible trunk.

Had the bankers been operating honestly (perhaps an oxymoron) the ground would have been clear, the paperwork exchanged, and the accounting complete, leaving some dealers “in the money” and some dealers “out of the money”. If they were dealing honestly the amount of money “in the money” would have been equal to the amount of money “out of the money”. The result would have been no loss, no federal bailout, no mortgages, no liens, no foreclosures, no notes, and no obligations on the original transaction.

What arises is the possibility of a case in which a party has paid money to satisfy the creditor, directly or indirectly (through the investor creditors agents) against the homeowner for money that they actually lost. But unless they actually purchased the loan which they did not (according to any of the paperwork I have seen or heard reported), there could be no foreclosure on any part of the debt. In fact, while the debt or obligation might continue to exist under the law, the absence of an actual creditor seeking payment might result in the homeowner receiving a windfall. This windfall is but a small percentage of the windfall made by the dealers who kept on dealing and were bailed out in an amount far exceeding the total of all money loaned during this 10 year period. Thus the dealers used investor lender money to fund 13 trillion dollars in loans, experiencing no more than 2.5 trillion in defaults, while claiming and receiving no less than 16.6 trillion dollars from the federal government plus settlements on insurance, credit default swaps and credit enhancements.

Somehow the windfall of the bankers has been made to appear more politically acceptable than the windfall to homeowners whose tax dollars paid for the windfall received by the dealers. What a country!!

The reason for the opportunity of a windfall to homeowners is that the dealers created a false chain of documents to enable them to achieve windfalls. The only way they could prevent homeowners from sharing in that windfall of multiple payments on the same debt was through the process of foreclosure. In foreclosure, the debt was made to appear as properly documented and owned by the investor lenders. In fact, the debt was made to appear as though it still existed when in fact it did not exist at all. Most judges, attorneys, and homeowners, cannot conceive of a scenario in which the mere application of law would provide an opportunity to homeowners to share in the windfalls of dealers who continued to make deals with the full intent of depriving both the investor lenders and the homeowner borrowers of any right to participate in this windfall. The rubber stamped order of the usual foreclosure judge seals one more deal. It pitches the bad loan over the fence and forces an investor to accept the bad loan even though he was expressly assured of receiving good loans that were properly underwritten. These judges do not realize that they are underwriting a windfall to the dealers of virtual money while the participants in the real money transaction both got screwed.

The Bank of England gets economical with its derivatives

by Lisa Pollack

Isn’t it annoying when particular clients insist on being treated differently to everyone else? Like, just because your client is well, England, or Italy, or some other sovereign nation, doesn’t make them ‘special’. It’s also kind of annoying when they make regulations that make business tougher for banks and then still expect to be treated differently.

Interestingly though, the Bank of England just stopped asking for one such special exception when it comes to certain derivatives that it enters into on behalf of the nation in order to best manage its balance sheet and the Treasury’s foreign exchange reserves.

With any such derivatives contract, it’s a zero sum game. When marking the transactions to market, if one party is up £1m (“in-the-money”), that means the other party is down £1m (“out-of-the-money”).

In the normal course of things, the out-of-the-money counterparty would post collateral with the in-the-money-counterparty. This keeps everyone happy because it guarantees performance under the contract. The exact rules around posting collateralare determined by an agreement between them called a “credit support annex” (CSA). The majority of CSAs are “two-way”, meaning that both parties have to post collateral as and when they are out-of-the-money.

But, sovereigns never really went for that. Instead, they have “one-way” CSAs. They expect their counterparties to post collateral with them, but they don’t expect to have to post collateral themselves. Banks were, more-or-less, willing to put up with this when counterparty risk was less of a concern and things were going a lot better for them generally. Before, say, the latest wave of regulation that takes an especially dim view of uncollateralised exposures.

Regulations aside though, there has always been something of a funding problem with trades like these (with sovereigns) since banks tend to hedge their trades.

In the above, we show that the Bank of England has entered into a swap with a dealer, e.g. an interest rate swap to hedge rates exposure. The dealer does another trade, or series of trades, with the dealer on the far left of the diagram to hedge the swap with the Bank of England.

Some time later, the dealer is in-the-money on the trade with the Bank of England, and out-of-the-money on the trade with the other dealer. This puts the dealer in a really uncomfortable position — collateral has to be posted with the other dealer, but the Bank of England doesn’t post any collateral.

The news release from the Bank of England on Thursday indicates that it will start to post such collateral in the future.

Up until now, the only other examples of sovereign nations we know of that do something similar are Ireland and Portugal.

So why did the central bank decide on this change?

It seems they primarily did it to get better pricing on the derivatives contracts. It’s quite simple — the costs to the banks of putting the swaps together for sovereigns rose. It’s more expensive for banks to fund themselves, i.e. to get that collateral to post to their counterparties. It’s also more expensive to have uncollateralised exposure in terms of regulatory capital. The banks have been passing on these costs to their sovereign clients.

The Bank of England therefore concluded that it was cheaper to start posting collateral, as it should make the prices they are offered come down.

In Risk’s coverage of the announcement, they had this rough estimate of the price differential:

The UK bank’s swaps trader says the funding charge associated with one-way CSAs could add as much as 10 basis points to a longer-dated trade. The head of the sovereign, supranational and agency (SSA) desk at one large European bank says it could reach 20bp.

And well, seeing as the central bank has a lot of bonds sitting in its reserves anyway, hell, why not?

The best part of the Risk article, in FT Alphaville’s opinion, is that they asked Alan Sheppard, the Bank of England’s head of risk management, about what he thought of the likely interpretation that the move is a kind of “back-door state support”. In response:

The BoE’s Sheppard doesn’t see it that way. “That would be a very strange interpretation. There is some value in the funding option implicit in a one-way CSA, but the way the market has developed, the price has gone beyond the value it has for us. What we’re actually doing is stopping paying the banks for an option that we don’t value as highly as it costs them to provide, so we’re giving them less money rather than more,” he says.

In other words: this works for the Bank of England cause they’re thinking it’ll save them money.

Good for them, then… right?

The likely point of contention will be that there are central banks out there that are way more into their derivatives use than the Bank of England is, and they have made no such indication that they will post collateral in the future, despite a lot of lobbying by banks on the matter.

Italy, for example, has a huge swap portfolio. This is a big issue not just because of the funding issue we mentioned above, but also because banks usually hedge their uncollateralised exposure by buying credit default swaps on the sovereign, which causes the spreads to widen further (with all that protection buying pressure), and then can feedback to the price the sovereign pays to fund itself in the bond market.

Or, at least, that’s one of the rallying cries of banks… who may well have a point, unfortunately. Arguably, some not-so-well thought out regulation drives quite a lot of this.

In any case, the last time FT Alphaville took a thorough look at this, we produced this table using data from the European Banking Authority’s 2011 stress test (with end-2010 data, click to expand):

This shows the “direct sovereign exposures in derivatives” measured in fair values (millions). When the number is positive, the bank (listed on the left) is in-the-money and would like to get some collateral from the sovereign (in the columns). As can be seen, Italy is seriously out-of-the-money to the banks and yet the banks are in the painful position of not receiving collateral.

Now look at the UK exposures. There isn’t much, is there?

These figures aren’t current (end-2010) and they don’t include non-European banks. But the general point that we wish to make is this: the Bank of England doesn’t have too much riding on this, the reserves are just sitting there, and it is likely to bring down the cost of transactions. In other words, it might not be as big a deal as it may be made out to be.

Sorry if the lack of drama disappoints you…