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In The News





·          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)





·          U. S. Banker

December  2005



[Article on incoming Fed Chair Ben Bernanke]



·          Bloomberg News Service

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 Asbury Park Press on 11/3/05





New Jersey didn't find it necessary to tell taxpayers that it was about to pay Wall Street banks almost $123 million of their money to end a bad bet on interest rates made on an otherwise routine government borrowing.


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 New Jersey homeowners.


The penalty New Jersey paid stemmed from an interest-rate gamble the state made in 2000 under then Gov. Christie Whitman, using complex and unregulated contracts called interest-rate swaps and options. While such tools are widely used by state and local borrowers across the United States, officials often don't disclose the risks or potential costs, and taxpayers don't get the details needed to evaluate them.


"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 New Jersey canceled in May were sold on the premise that they would lower the cost of a $375 million bond issue arranged to shore up state pension funds. Instead, they cost the state fees and a lost opportunity to refinance at lower rates that would have saved the state more than $136 million in interest payments, Bloomberg data show.


Lehman Bros. spokeswoman Kerrie Cohen and Morgan Stanley spokesman Mark Lake declined to comment.


More swaps


New Jersey will face decisions on whether to pay to terminate other swaps if interest rates don't rise. The state had 34 active swaps totaling $5.1 billion on Sept. 1, according to a report by Beverly Hills, Calif.-based CDR Financial Products Inc., which was hired by the state two years ago to advise on its 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. "New Jersey has locked in historically low interest rates for many long-term borrowing needs, and its swaps strategy has already yielded debt service savings to state taxpayers."


"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 New Jersey can manage them better.


"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 Trenton. Falling interest rates this year allowed the state to charge investors a $123 million fee for converting the pension debt into so-called premium bonds that paid 7.4 percent interest, a rate lower than the state paid under the terms of the swap.


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 New Jersey's McCormac.


Looked safe


The swap agreements, known as swap options, looked like safe bets when they were made, says James DiEleuterio, who was New Jersey's treasurer from July 1997 to August 1999, when many of the decisions about the options were being made.


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 New Jersey cancellation of the swap options.


The development authority is required under New Jersey law to give notice to two state newspapers and the Secretary of State's Office, which keeps records of all public meetings, at least 48 hours before a meeting. It isn't required to publicize an agenda and didn't do so before the board met to vote to cancel the swap.


One-line notice


A one-line notice of the meeting, held at the authority's headquarters in the state capital of Trenton, was faxed to newspapers on May 13. The notice doesn't mention the swaps.


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 California and New York City, according to New York-based Thomson Financial.


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. Poole now works for the Schools Construction Corp., which oversees $8.6 billion in state school construction projects.


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 Florida school districts in Orange, Hillsborough, Pasco and Lee counties, says he wouldn't recommend them to all his customers.


"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," Moore says.


"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.



·          BBC Radio

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 US stock market.


So is the trading of derivatives policed well enough? And does this scandal prove that America's legal reforms are failing to stamp out corporate fraud?


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:





·          CBS MarketWatch


Refco's woes worry markets at nervous time


By Alistair Barr


10/14/2005 8:04:54 PM 


SAN FRANCISCO (MarketWatch) -- Before this week, Refco Inc. wasn't a household name.


But now the possible collapse of the largest independent commodities and futures broker in the U.S. has top investment banks, regulators and exchanges scurrying to save a company that's quietly become an integral part of the nation's financial markets.


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 U.S.


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.




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 Manhattan. See full story.


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."




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.




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."



·          News Analysis

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 Ferguson, whose style of both football and management has gone by the boards. Martin O'Neill is waiting by the phone


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 England's Premier League. It was a team that was disciplined and consistent, and thathad unshakeable confidence. Most days, it was not a team that could beat a good European outfit, but that was not necessary toprevail in England. So that formula worked until the European invasion of English football


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 Chelsea, building a European powerhouse in West London that romped over the others to win the domestic league handily. And a Spanish intellectual took over Liverpool, recreating Valencia on the Mersey and winning the Champions League. So it's been three years since Man U won the Premier League. Doesn't sound so bad, except that the team's yuppie dilettante fans fully expect it to win the domestic league every year


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 America's stupid residence rules should be changed, but that is not the subject of this article. For purposes of this article, we assume that hedge funds are the nonresidents that they claim to be


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 United States, causing them to have effectively connected income taxable in the United States. As this article will discuss, the threshold for being considered to be in the trade or business of lending in the United States is not high, and the rules that hedge funds depend on to avoid U.S. taxation on their other activities will not protect their lending


Basically, the law says the opposite of what hedge funds want it to say. The law says that a lending business in the United States can have the effect of making securities trading an additional trade or business, but not that lending can be an adjunct to the securities trading safe harbor


The Ten Commandments

A hedge fund is an unregulated investment partnership that, though managed out of Greenwich, Conn., or New York City or some other domestic location, claims to be nonresident merely by virtue of having been organized as a corporation in a tax and banking haven. Management is carried on in the United States, while records may be maintained offshore. (There are many hedge funds run out of London, but we are concerned with the American ones.) Hedge funds' nonresident status is tolerated because of foolish American residence rules that define a partnership as resident where it is organized, rather than where it is managed and controlled. (For discussion, see Doc 2002-7945 [PDF], 2002 TNT 63-2 .)


Hedge funds typically organize the partnership that constitutes the fund itself in a tax haven. The management company, another related partnership, operates in the United States. If the activities of the management company are confined to investing and trading for the fund's own account, the fund will not be considered to have a trade or business in the United States because of the securities trading safe harbor. The management company would be the fund's dependent agent and office in the United States


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 U.S. sources that is effectively connected with a trade or business within the United States. What is a "trade or business within the United States" is defined in section 864(b) by excluding certain activities


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 United States by allowing foreign investors to pool their money and hire American managers. The exception's main effect is to absolve foreign investors from tax on U.S.-source capital gains, since interest and dividends are subject to withholding, albeit at reduced treaty rates


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 United States without tax consequences. Before its liberalization, the securities trading safe harbor was called "the Ten Commandments" because it had 10 criteria for staying out of U.S. tax jurisdiction, among which was that the investor could nothave an office. Foreign investors found that those criteria were inconvenient and cramping their activities, so the Clinton administration and Congress obliged. (Doc 97-25873, 97 TNT 178-8 .)The regulations were not amended to reflect the legislative change. According to reg. section 1.864-2(c)(2) and proposed reg section 1.864(b)-1, trading in securities encompasses all sorts of active portfolio management, but it does not include the active business of lending. "Securities" are broadly defined to include loans under reg. section 1.864-2(c)(2)(i)(c). That means that a hedge fund can buy loans or pieces of loans after someone else has made them. The question becomes whether the early entry of a hedge fund into a loan syndicate or a credit derivative is an extension of credit or an assumption of credit risk that is tantamount to making a loan. (For discussion, see Doc 2005-4376 [PDF], 2005 TNT 69- 30 .)Credit derivatives are part of the debate about how much lending a hedge fund can do without being engaged in a lending trade or business in the United States. Proposed reg. section 1.864(b)-1 would provide that foreign taxpayers who enter into derivative contracts for their own account are not engaged in a trade or business in the United States solely by reason of those contracts, provided that they are not dealers in derivatives or otherwise dealers in securities or commodities. Entering into derivatives contracts (including hedging) would not constitute a U.S. trade or business if the taxpayer met the definition of an eligible non-dealer. Given the broad definition of derivatives, that would be a sweeping rule


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 U.S. income tax liability. The basic argument is that lending should be treated no differently from buying a debt security. That argument is being pressed most vigorously by Stuart Leblang of Akin Gump Strauss Hauer & Feld and Rebecca Rosenberg of Caplin & Drysdale (Leblang and Rosenberg, "Toward an Active Finance Standard for Inbound Lenders," Caplin & Drysdale Tax ManagementInternational Journal, March 8, 2002. http://www.akingump.com/docs/publication/402.pdf.)


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 United States. (Readers will recognize these questions as similar to the questions posed by CDOs discussed inDoc 2001-13623 [PDF], 2001 TNT 94-3 .)Back to the first question -- the existence of a trade or business in the United States. To have a trade or business in the UnitedStates, a taxpayer would have to have an office in the United States. The trade or business case law does assign relevance tofacilities and actions within the United States that would be excused under the securities trading safe harbor. In short, if hedgefunds go as far as the securities trading safe harbor allows, they would have too much presence in the United States whenquestions arise about other trades or businesses


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 United States. All it takes, really, is extensive trading and the presence of an agent in the United States. Here it isuseful to remember that trading securities is a trade or business and that, but for the safe harbor, income effectively connectedwith it would be subject to U.S. taxation. This becomes relevant when the taxpayer has other U.S. activities. Whether the taxpayerhas a trade or business in the United States is a factual question. (Rev. Rul. 88-3, 1988-1 C.B. 268.)It is well established in the case law that a taxpayer need not be acting directly to be considered to be in a particular trade orbusiness. An agent acting on the taxpayer's behalf will put the taxpayer in a trade or business in the United States, according tothe case law


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 United States himself


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 United States was supposed to be their resident brokers. The "advantage of taxpayer's presence in this country,which was an important element in his trading here, may not be ignored and the case treated as though it involved nothing morethan sales and purchases by brokers for a principal across the seas," said the court


A Chinese investor who used a resident commission agent was somewhat luckier in avoiding U.S. tax in Liang v. Commissioner,23 T.C. 1040 (1955). The taxpayer's resident agent did not work for anyone else and had discretionary authority over the account


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 United States, so they were filing U.S. tax returns for income that was clearly the product of a trade orbusiness conducted in the United States. They were also making loans into the United States from their Canadian headquarters


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 United States. Because separate corporations are respected, that trade or business would have to be the trade or business of the Canadian parent, not the U.S. branch. So there had to be a very low threshold of activity that would put the parent in the active conduct of a trade or business of lending in the United States by virtue of the actions of the branch as agent. It is that very low threshold that hedge funds are now arguing against


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 United States, in whole or in part, will put a foreign taxpayer in a lending business in the United States. The sixactivities listed in the regulation are:􀁺 (a) receiving deposits of funds from the public;􀁺 (b) making personal, mortgage, industrial, or other loans to the public;􀁺 (c) purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange,acceptances, or other evidences of indebtedness;􀁺 (d) issuing letters of credit to the public and negotiating drafts drawn thereunder;􀁺 (e) providing trust services for the public; or􀁺 (f) financing foreign exchange transactions for the public


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 United States. That is the opposite of what the rule clearly says


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 United States. Some tax advisers strive to make those relationships indirect on the view that onlydirect relationships constitute lending


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 United States


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 United States. Practitioners argue that everydeal is individually negotiated and sui generis. But so is every loan, and uniqueness of deals does not preclude lender status


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 Financial Policy Forum Derivatives Study Center told Investment Dealers' Digest. (Investment Dealers' Digest, May 16, 2005, p. 26.) Unregulated market participants that are notsubject to capital requirements are able to take risks that participants subject to capital requirements cannot, increasing risk and vulnerability in the system. (See http://www.financialpolicy.org/fpfspr8.pdf.)


Sometimes banks, usually foreign banks, are partners in hedge funds that make loans to U.S. borrowers. Many of those foreign banks are already engaged in a banking trade or business in the United States, according to reg. section 1.864-4(c)(5). They would just rather park the loans in a hedge fund or somewhere other than on their own balance sheets. Moreover, those banks are ineligible for the securities trading safe harbor because they are dealers -- there is no such thing as a universal bank that is not also a dealer. So this group of hedge fund investors has no reason to care whether the hedge fund is also in a lending trade or business in the United States


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 United States is determined at partnership level. (See reg. section 1.701-2(f),examples 1 and 2, and Ruppel v. Commissioner, T.C. Memo. 1987-248.)The key to interpreting the application of the banking rule to hedge funds lies in a special little rule that once allowed foreign banksto avoid withholding on some portfolio securities. That'd be reg. section 1.864-4(c)(5)(ii), the so-called 10 percent rule, whichallows banks to piggyback a small amount of securities portfolio activity on to their effectively connected banking business. Thatrule was made to accommodate the banks, which were in the habit of keeping a small percentage of their U.S. assets invested insecurities. The rule is confined to investing; it does not cover trading


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 U.S. office to satisfy reserverequirements, or are short-term or government securities, or meet other stated criteria. But income and gain from debt securitieswill not be treated as effectively connected to the extent that debt securities exceed 10 percent of the total value of the assets of the taxpayer's U.S. office.



·          International Herald Tribune



Little guys in the big leagues

By Erika Kinetz International Herald Tribune



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 U.S. defined-benefit plans now invest in hedge funds, according to Empirical Research Partners; the numbers are even higher for Europe (more than 30 percent) and Japan (about 60 percent).


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 U.S. investors will have to register with the U.S. Securities and Exchange Commission by February. Regulators in Europe and Asia are also taking a fresh look at the funds.


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 U.S. benchmark, the Standard & Poor's 500 index, lost 43.8 percent, according to Van Hedge Fund Advisors International.


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. U.S. venture capital investments, a subcategory of private equity, have yielded, on average, more than 25 percent a year for the last decade, compared with 9 percent for the S&P 500, according to Thomson Venture Economics and the National Venture Capital Association, a U.S. trade group. Over the last five years, while the S&P 500 declined, on average, by about 2.71 percent a year, the MSCI Hedge Invest Index gained by about 8.27 percent a year.


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 London firm of financial advisers, wrote in an e-mail. "They benefit the managers more often than they benefit investors. They should be entirely reserved for wealthy clients."


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 France and Monaco. The fund, which matures in 2013, was closed in May.


The number of U.S. mutual funds that use hedge fund strategies, like shorting stocks, has also grown. Morningstar now counts 36 such funds, up from 12 in 1998. Unlike hedge funds, they are liquid and regulated, have low investment minimums, and are widely available. They also have not performed very well.


"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 United States, comes from pension funds.


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 U.S. venture capital and private equity firms.


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 U.S. mutual fund companies. "And their recent performance was very much dependent on the best three years to short stocks since the Depression."


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 U.S. private equity firm. "The exponential growth in private equity and hedge funds in the last decade is mind-boggling. There's a bubble here that's going to bust. There's too much money. That's true in venture capital and it's true of hedge funds as well."


Wilson added: "Hedge funds are contrarian players by their nature, who go the opposite way from the herd, who have niche strategies. How do you have a contrarian strategy when you have $200 billion trying to do similar things? How do you outperform the market to justify the fees?"


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 New School for Social Research in New York. "Hedge funds make it cheaper for companies to borrow overall. If profits go up, earnings go up, and because of this, everybody wins."


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."



·          U. S. Banker

October  2005




October 2005


Washington's Power Brokers



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 Washington, D.C., think tank.


Also important is Sen. Dianne Feinstein, the California Democrat, who has been a pit bull on the ID-theft front, and who is now pressing for consumers to be able to choose to keep their records out of databases. She also "has done some very good work in bringing some sense of sanity back to the derivatives market," notes Randall Dodd, director of the Financial Policy Forum, a think tank in Washington, D.C.   Her 2002 bill, passed in the wake of the Enron debacle, provides the Commodity Futures Trading Commission with regulatory oversight of derivative transactions of energy commodities, and had to be introduced three times before it passed.


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 [New York state attorney general Eliot] Spitzer on consumer affairs, calling it "a very gutsy move for someone in government. ...But unless you're making enemies, you're not doing anything."


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 Stanford University professor who became the first female deputy managing director at the International Monetary Fund, has also won high marks for her stewardship since 2001. The vice president of the World Bank in the 1980s, Krueger is no stranger to Washington, where she has long pushed for trade liberalization, accompanied by sound macroeconomic policies, including an appropriate exchange rate and tariff reduction. All, she says, are vital to spur to economic growth in developing countries.


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 Central America.


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 Washington to understand the way banks work. Her lobbying acumen recently helped push through the Check Clearing For the 21st Century Act, which established a substitute-check provision to facilitate electronic check processing. In testimony this April before the House Subcommittee on Financial Institutions and Consumer Credit, she noted that her own bank, Wachovia, where she is an evp, would process only two percent to three percent of all checks via image exchange by the end of 2005. However, what processing the bank has done to date has been an unqualified success: Of the two million substitute checks processed, the bank has received not one expedited recredit request.


Duke, who became the first female to head the board since the ABA was founded in 1875, is like her Washington comrades when it comes to thanking those who have come before her. "I owe a debt of gratitude to the hundreds of thousands of women in this industry," Duke said when she was elected in 2004. "There never could have been a first woman chairman if there hadn't been so many talented, hard-working women challenging barriers every day."



·          HoweStreet.com

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 Indonesia? How would anyone know? After all, Fannie Mae doesn't even know what it itself has on its own books. How could anyone else possibly know? That, of course, begs the question: Is Fannie Mae "too big to fail" or "too big to bail"?


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.




Mike Shedlock ~ "Mish"



·          Bloomberg wire


Venezuela Proposes Debt Market for Emerging Countries


By Alex Kennedy and Peter Wilson

July 12 (Bloomberg) -- Venezuela proposed the creation of a debt market for emerging market countries, saying it may purchase bonds from Argentina, Bolivia, Brazil and Ecuador.


Finance Minister Nelson Merentes said at a news conference today in Caracas that countries joining the market would purchase one another's debt. The purchases, which may help bolster prices and diversify Venezuela's central bank holding, began earlier this year when the nation bought Argentine bonds.


Venezuela, the world's fifth-largest oil exporter, is seeking to boost its influence and reduce the role of the U.S. in Latin America through the plan, said Pablo Goldberg, Merrill Lynch & Co.'s co-head of Latin American fixed-income research. The proposal may backfire as some nations reject the assistance, said Nicholas Field, who oversees $800 million of emerging market assets at WestLB Asset Management in London.

``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.



Argentina's default in 2001 followed a default by Ecuador two years earlier and Russia's default in 1998. Standard & Poor's analyst Lisa Schineller said in an interview in May a scenario in Ecuador that includes default within 1 1/2 years can't be ruled out.

``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.''


Venezuela, which earlier purchased $300 million of Argentine debt, also plans to purchase $200 million more in Argentine debt, Merentes said. For other nations in the region, ``we could purchase their debt, and they could purchase ours,'' Merentes said.

Emerging market tradable debt totaled $3.4 trillion last year, according to Merrill.



·          BLOOMBERG wire

June 24, 2005


New York Ruling May Lead More Cities to Curb Private Debt Sales


June 24 (Bloomberg) -- An obscure ruling by New York's highest court has the potential to roil the $2 trillion market where Wall Street bankers typically arrange private financings for states, cities and other local governments. The legal decision may force elected officials to make such borrowings more accountable to the public.


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 U.S. have sold bonds almost daily to finance roads, sewers, stadiums and schools, with last year's total reaching $360 billion, following a record $383 billion the year before, according to Thomson Financial. More than 13,000 state and local governments borrow at lower rates than in other markets because the bonds have a feature attractive to wealthy investors: payments are exempt from federal taxes.


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 New York ruling is likely to force states and cities to sell more bonds through a competitive bidding process, said government officials and finance executives.


``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 New School University in New York, co-authored a study on hospital bonds that found debt sold by taking bids saved issuers more than half a percentage point in annual interest costs, or $500,000 per $100 million.


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 New York at a trial, the court ruled.


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 U.S. underwriters said they earned $4.7 billion last year helping sell stocks. That represented 2.5 percent of their total $190.5 billion in revenue.


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, Massachusetts' deputy treasurer for debt management. It's a negotiation, and the only way to do that right is to have knowledge of what you're doing.''


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 Connecticut's decision earlier this month to sell bonds by competitive bidding for the first time in six years, and legislation in Illinois last year that requires more bond sales by auction.


``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., New York Court of Appeals (Albany).




To contact the reporter on this story:

David Voreacos in Newark, New Jersey at  Or dvoreacos@bloomberg.net;

Eddie Baeb in Chicago at  ebaeb@bloomberg.net.


Last Updated: June 24, 2005 01:02 EDT



·          New York Daily News


Conflict shutters MTA bank search

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 Washington group that studies world financial markets. "If you give the contract to the best bidder, the damages from these kinds of relationships will be mitigated."


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 Second Avenue subway and a rail link from Long Island to Grand Central station amid a growing debt burden and declining city and state subsidies.



·          Investment Dealers Digest


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 U.S. and international credit markets last week, the nervousness raised a serious question: Could the hottest market in all of fixed income become Wall Street's next catastrophe?

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 U.S. credit markets, after a generation of declining yields, appear to be churning through a long-term secular turning point. Though the junk market got creamed in April and spreads widened in anticipation of the auto makers' downgrades, it has mainly been a time when spreads have been extremely compressed, investors have been taking more and more risks for yield, and default rates are low and appear likely to rise in the coming year or two. At such times, it's natural to look for potential trouble spots ahead. And with all sorts of new players piling into the game, synthetic CDOs look suspiciously like a speculative bubble.

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 New York. Normal risk modeling only approximates normal markets-the real test comes in extreme markets. And as Rahl likes to say, "We have a once-in-a-lifetime crisis every three or four years."

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 Chicago firm, Tavakoli Structured Finance, advises investors and banks and whose latest book, published in 2003, is "Collateralized Debt Obligations and Structured Finance." "All of this credit derivative technology," she says, "allows us to obscure what's really going on."

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, Britain's securities regulator, and ISDA are practically flogging firms to bring their confirmation processes up to speed.

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 London tailors, and since there's only one investor, these deals often take the form of single-tranche instead of multiple-tranche issues.

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, Italy's Banca Popolare di Intra in March launched a legal claim against Bank of America over losses allegedly due to mispricing and misrepresentations of equity or quasi-equity tranches in CDOs, CDO-squareds, and CDOs of asset-backed securities. The Italian bank also accuses BofA of substituting different collateral in the collateral pool.

Reminiscent of the catastrophe that struck California's Orange County when it invested in derivatives in 1994, both cases indicate that many buyers of synthetic CDOs do not have adequate ability to assess risks and prices themselves. "A number of institutions are not so skilled at evaluating the risks, which means that many of the spreads being paid are insufficient," says McKinsey & Co.'s Arno Gerken, who consults for financial institutions out of McKinsey's Frankfurt office. And since the CDOs in both cases were set up before the current synthetic CDO boom, more such lawsuits are probably going to appear in the future.

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 Derivatives Study Center in Washington, D.C. He tells of a friend who's a "quant jock" at a major investment bank. "He told me, We can't accurately price [credit default swaps], although we're confident that we're getting a good price for them.'" Says Dodd: "That tells you what side the errors are on."

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 Derivatives Study Center. A big question is how reliable those counterparties will be if a crisis hits the credit markets. The concern is that if, in a period of severe market stress, the hedge funds back out of their commitments, an extraordinary number of banks and insurers could all be hit simultaneously.

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 London who is now at the Federal Deposit Insurance Corp.'s Center for Financial Research.

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.



·          CBC TV


May 11, 2005

Transcripts not yet available.



·          CBS MarketWatch, also Investors.Com and AFX


Markets shaken by hedge fund rumors

By Alistair Barr and Kathie O'Donnell
Last Updated: 5/10/2005 6:51:05 PM


SAN FRANCISCO (MarketWatch) - Rumors of trouble in hedge fund land gained enough momentum Tuesday to sway broader markets and pressure shares of some of the world's largest banks.


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 New York firm majority owned by J.P. Morgan (JPM).


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 U.S. companies. Moreover their use of hedging strategies occupies $1.6 of the $127 trillion outstanding contracts.


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, New York. “The current policies are supporting families who would buy anyway, getting the larger home with a fifth bedroom, second homes and increasing suburban sprawl.”


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 U.S. economy posed by the narrow ratios of total capital to assets and the concentration of mortgage-related assets. Fannie stood at 3.4 percent total capital to assets and Freddie at 3.9 percent, compared to FDIC-insured depository institutions ratios of 9.2. About 86 percent of the combined balance sheet of Fannie Mae and Freddie Mac constitutes mortgage-related assets, representing almost 50 percent of all the credit risk and 20 percent of all market risk associated with U.S. residential mortgage assets. “These are thinly capitalized large companies and there’s a real concern about what happens if they stumble or falter,” says White. “They’re good at what they do, but why do it with public backup?”


“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, University of California, Berkeley. “The lack of call protection is the source of the vast majority of interest rate risk at Freddie and Fannie.”


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 Battle Continues


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.




·          Chicago Sun-Times

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 Las Vegas. Nevada Power had been forbidden to pass along rate hikes, but now "we see regulatory relief coming and that should help the credit to recover," Miller said.

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 Chicago markets portend danger for the country. Dodd's nonprofit group analyzes the futures markets and reports subsisting on money from the Ford Foundation, not any Wall Street firms.

He's even-handed. Dodd praises the Chicago exchanges for stabilizing the markets. They're getting a higher share of trading that used to occur exclusively in the Wild West of the financial world, the over-the-counter market. That puts the business in a regulated and transparent setting. He also said trading firms have found that if they use exchanges rather than OTC markets, they can assign reduced credit risks to their balance sheets for the same financial maneuvers.

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," Paris said, referring to studies that have shown it costs a firm $190,000 a year to provide research coverage on a company. Paris said government-forced reforms on Wall Street are driving up costs and forcing firms to concentrate on only the most liquid stocks.

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: U.S. equities." -- Bill Miller, Legg Mason Inc.



·          Bloomberg, March 18, 2005

Morgan, UBS Helped Parmalat Hide Costs, Study Alleges

March 18 (Bloomberg) -- Morgan Stanley and UBS AG helped Parmalat Finanziaria SpA, Italy's largest food company, hide the cost of selling 720 million euros ($962 million) of bonds six months before it collapsed in the country's biggest bankruptcy, according to a report prepared for Milan prosecutors.

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 Milan consultant Stefania Chiaruttini and obtained by Bloomberg. UBS, Europe's No. 1bank, advised Parmalat that it was possible to keep the market from knowing the cost of issuing 420 million euros in bonds by delaying disclosure, a bank memo attached to the report shows.

``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.


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 London said.

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 London. ``We believe that the transaction in question was legal and entirely valid and therefore any proceedings in connection with the transaction will be met by a vigorous defense by UBS.''

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 U.S. history. WorldCom emerged from bankruptcy last April as Ashburn, Virginia-based MCI Inc.

``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 Rome, said that the market didn't notice the term sheet and that it was unusual for a company not to disclose the discount and total return in a release.

``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 Walker. ``Parmalat's pricing supplement for the bonds was sent to the Luxembourg Stock Exchange approximately three weeks after the transaction was completed, and listing was granted on Aug. 14, 2003.''

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,'' Walker said.

Yesterday's Milan court filing said officials from Citigroup Inc., Credit Suisse First Boston, Deutsche Bank AG and Banca Intesa's Nextra unit may also face charges.

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 New Jersey state court seeking as much as $10 billion in damages from the world's biggest bank. Citigroup said it was a victim of fraud by Parmalat, had lost more than 500 million euros as a result, and was seeking damages from the dairy.

James Pressley in Brussels at  jpressley@bloomberg.net.



·          South China Morning Post

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), Singapore's financial regulators don't have all that much time to imbibe the aptly named Bank Breakers.

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 Singapore's role as a regional financial hub.

In early December last year, China Aviation Oil (Singapore) Corp (CAO) sought court protection after raking up losses of US$ 550 million through speculative trading in oil derivatives.

SGX and MAS officials have been quick to reassure CAO's 7,000 or so small shareholders that the Singapore government is prepared to change the law if that is what is required to protect their interests.

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 United States in the late 1990s.

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 Britain, the Barings Bank disaster led to the creation of the country's Financial Services Authority (FSA), which brought together nine separate regulators under one government agency.

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 Baltimore subsidiary involving forex trader John Rusnak.

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 Singapore, both the SGX and the MAS have been very defensive of their own regulatory record.

Singapore authorities point to the Securities and Futures Act (SFA) introduced in 2002, which has significantly strengthened disclosure, accounting and corporate governance rules.

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 Singapore lawmakers is that most of the transactions that have made it a regional hub for oil trading are conducted overthecounter (OTC) rather than through an official exchange.

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.