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The central issue over capital adequacy related to risk exposure centers around the controversy of asset values mark-to-model against that mark-to-market.</strong> Basel II was instituted because marked-to-model value was considered inoperative, devoid of reality.</strong> Thus marked-to-market value was required at the close of each trading day. Yet mark-to-market is generally recognized as the detonator of the current credit crisis.</strong> Now, the Fed’s stress tests for banks have switched back to mark-to-model</strong> to calculate the capital adequacy of banks.

The differential between the two values in a market failure can amount to more than the total to cause the asset to become “toxic” because of the interconnectedness of structured finance instruments.</strong> In other words, a bank exposed to counter-party default on one single credit instrument can affect the mark-to-market value of all other credit instruments</strong> in its possession and also those held by other institutions, even those with no direct counter-party exposure.</strong>

Mark-to-market, sometimes known as fair value accounting</strong>, refers to the accounting standards of determining the value of  a position held in a financial instrument based on the current fair market price for the instrument or similar instruments. Fair value accounting has been a part of US Generally Accepted Accounting Principles (GAAP) since the early 1990s.</strong> The use of fair value measurements has increased steadily over the past decade, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions. Fair market value in a failed market (where there are no buyers at any price) can be zero, but could also recover to fair market value when the market starts functioning normally again.

The seeming innocuous rise in default rate of the riskier unbundled tranches of an inverted credit pyramid can affect the credit ratings of the upper “safe” tranches to cause the whole credit superstructure to crumble much like the way the dead weight of falling upper floors of the collapsing World Trade Towers in lower Manhattan caused the collapse of the lower floors in an unstoppable cascade of mounting structural failures.

Mark-to-market is real while mark-to-model has meaning only if the model reflects reality. Often while models are operative over the long term, the market can cause the model to fail at any one specific point for any number of reasons. As Keynes famously said: "the market can stay irrational longer than market participants can stay liquid."</strong>

Mark-to-market reporting has caused many banks to appear undercapitalized, or even to fail from illiquidity. The point is that if mark-to-model was considered inadequate for informing investors on the true financial health of a holder of financial instruments and only mark-to-market is truly reliable and meaningful, then the bank stress tests by reverting to mark-to-model do not yield reliable information on the capital adequacy of the tested banks. Indeed, several largest banks challenged the model use by the Fed and negotiated lower capital requirements. Other critic complained that the Fed model were too optimistic to be useful in a real worst case situation and that even banks that have passed the Fed's stress tests will require Fed bailout if reality should render the Fed model inoperative. Thus the stress tests were a meaningless exercise because at the end of the day, the positive tested banks will need government bailout anyway.

Credit Default Swaps (CDS)

The banking system in recent decades has morphed into one that is inherently risk-infested on account of its precarious dependence on unimpaired counterparty credibility. The shadow banking system has deviously evaded the reserve requirements of the traditional regulated banking regime and institutions and has promoted a chain-letter-like inverted pyramid scheme of escalating leverage, based in many cases on nonexistent reserve cushion. This was revealed by the AIG collapse in 2008 caused by its insurance on financial derivatives known as credit default swaps (CDS).</strong>

AIG Financial Products (AIGFP), based in London where the regulatory regime was less restrictive, took advantage of AIG statue categorization as an insurance company and therefore not subject to the same burdensome rules on capital reserves as banks</strong>. AIG would not need to set aside anything but a tiny sliver of capital if it would insure the super-senior risk tranches of CDOs in its holdings. Nor was the insurer likely to face hard questions from its own regulators because AIGFS had largely fallen through the interagency cracks of oversight.</strong> It was regulated by the US Office for Thrift Supervision, whose staff had inadequate expertise in the field of cutting-edge structured finance products.

AIGFP insured bank-held super-senior risk CDOs in the broad CDS market. AIG would earn a relatively trifle fee for providing this coverage – just 0.02 cents for each dollar insured per year. For the buyer of such insurance, the cost is insignificant for the critical benefit, particularly in the financial advantage associated with a good credit rating, which the buyer receives not because the instruments are “safe” but only that the risk was insured by AIGFP. For AIG, with 0.02 cents multiplied a few hundred billion times, it adds up to an appreciable income stream, particularly if no reserves are required to cover the supposedly non-existent risk. Regulators were told by the banks that a way had been found to remove all credit risk from their CDO deals.</strong>

As an example, an investor buys a CDS contract from a triple-A-rated Bank to insure against the eventuality of a counterparty defaulting, by making regular insurance payments to the bank for the protection. If the counterparty defaults on its commitment anytime during the duration of the contract by missing an agreed interest payment or failed to repay the principle at maturity, the investor will be assured to receive a one-off payment of the insured amount from the bank whose credit rating is triple-A and the CDS contract is terminated. If the investor actually holds the debt from the counterparty, the CDS contract works as a hedge against counterparty default.. But investors can also buy CDS contracts on debts they do not hold, but as a speculative play, to bet against the solvency of one side of the any counterpary relationship in a gamble to make money if it fails, or to hedge investments in other parties whose fortunes are expected to be similar to those of target party.

If a counterparty defaults, one of two things can happen:
1) the insured investor delivers a defaulted asset to the insurer Bank for a payment at par value. This is known as physical settlement, or
2) the insuring Bank pays the investor the difference between the par value and the market price of a specified debt obligation after recovery to cover the loss. This is known as cash settlement.

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional value. For example, if the CDS spread of counterparty risk is 100  basis points (1%), then an investor buying $100 million worth of protection from the insuring Bank must pay the bank $1 million per year. These payments continue until either the CDS contract expires or the target counterparty defaults, at which point the insuring bank pays the insured of outstanding value owed by of the counterparty.
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a particular counterparty with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can impact the comparison. When spread skyrocket during a market seizure, insurers can fail  because they are not required to adjust  regular income statements to show balance sheet volatility. This was what happened to AIG which provided no reserves for its CDS contracts.

Systemic Risk and Credit Rating

There were two dimensions to the cause of the current credit crisis. The first was that unit risk was not eliminated</strong>, merely transferred to a larger pool</strong> to make it invisible statistically. The second, and more ominous, was that regulatory risks were defined by credit ratings, and the two fed on each other inversely.</strong> As credit rating rose, risk exposure fell to create an under-pricing of risk. But as risk exposure rose, credit rating fell to exacerbate further rise of risk exposure in a chain reaction that detonated a debt explosion of atomic dimension.

The Office of the Comptroller of the Currency and the Federal Reserve jointly allowed banks with credit default swaps (CDS) insurance to keep super-senior risk assets on their books without adding capital because the risk was insured. Normally, if the banks held the super-senior risk on their books, they would need to post capital at 8% of the liability. But capital could be reduced to one-fifth the normal amount (20% of 8%, meaning $160 for every $10,000 of risk on the books) if banks could prove to the regulators that the risk of default on the super-senior portion of the deals was truly negligible, and if the securities being issued via a collateral debt obligation (CDO) structure carried a Triple-A credit rating from a “nationally recognized credit rating agency”, such as Standard and Poor’s rating on AIG.

With CDS insurance, banks then could cut the normal $800 million capital for every $10 billion of corporate loans on their books to just $160 million, meaning banks with CDS insurance can loan up to five times more on the same capital. The CDS-insured CDO deals could then bypass international banking rules on capital.  To correct this bypass is a key reason why the government wanted to conduct stress tests on banks in 2009 to see if banks need to raise new capital in a Downward Loss Given Default.

CDS contracts are generally subject to mark-to-market accounting that introduces regular periodic income statements to show balance sheet volatility that would not be present in a regulated insurance contract. Further, the buyer of a CDS does not even need to own the underlying security or other form of credit exposure. In fact, the buyer does not even have to suffer an actual loss from the default event, only a virtual loss would suffice for collection of the insured notional amount. So, at 0.02 cents to a dollar (1 to 10,000 odd), speculators could place bets to collect astronomical payouts in billions with affordable losses. A $10,000 bet on a CDS default could stand to win $100,000,000 within a year. That was exactly what many hedge funds did because they could recoup all their lost bets even if they only won once in 10,000 years.  As it turns out, many only had to wait a a couple of years before winning a huge windfall. But until AIG was bailed out by the Fed, these hedge funds were not sure they could collect their winnings.

May 25, 2009