Monday, June 22, 2015

ForEx Settlements Nearing $12 Billion

Settlements are coming out in droves for the alleged manipulation of foreign exchange benchmark rates since either 2008 or 2009 (depending on the settlement).  

These have primarily been concentrated on settlements with or fines imposed by regulatory bodies in the US and Europe, in two sets of November 2014 and May 2015*.  But private litigation settlements are growing too, fast approaching the $2 billion mark. 

Importantly, the civil proceedings may yet be in their earlier stages, as other class actions have since been filed, with those new plaintiffs** arguing that they would not fall within the scope of the existing behemoth, In re Foreign Exchange Benchmark Rates Antitrust Litigation Case No. 1:13-cv-07789-LGS (S.D.N.Y.).

We'll keep you posted.  And as always, help us out if you think we're missing anything!  ~PF2

* For more on this, visit our prior commentary at

** See for example Taylor et al v. Bank of America et al, 15-cv-1350 (S.D.N.Y)

Monday, June 1, 2015

FX Settlements — New Admissions on Bank Misconduct

Another day, another FX settlement. What’s new? Well, actually a lot. The recent settlements, when you dig into them, provide a whole new array of material. First we will explore the background, and then we’ll get you to the new… 

The latest settlements between FX banks and regulators were filed on May 20. Five banks agreed to pay approximately $5.6 billion in fines to US and UK regulators relating to the rigging of FX rates, including several fix benchmark rates. JPMorgan, Citi, Barclays and RBS plead guilty to criminal charges for having “entered into and engaged in a combination and conspiracy to fix, stabilize, maintain, increase or decrease the price of, and rig bids and offers … in the foreign currency exchange spot market.” UBS avoided a guilty plea, and was only fined for breaking a prior non-prosecution agreement relating to LIBOR misconduct, as a reward for being the first to inform regulators of these FX activities. 

A Bloomberg news story in June 2013 provided the initial public information that there was a potential problem with FX benchmark fixes, particularly the WM Reuters London Fix. Since then numerous news stories and the November 2014 settlements with the CFTC, OCC, FCA (UK regulator) and FINMA (Swiss regulator) have described the communications between bankers at several major banks, conniving to rig FX benchmark rates -- including their use of group chats to share information on the fix trades that they would need to execute. These traders would communicate each other’s currency positions and customer orders for the upcoming fix and then determine the means to trade off of this information so that the banks could make profits at the expense of their customers. Some of the settlements provide examples of chat room conversations in which traders from multiple banks collude to manipulate the fix. 

This collusion at the London Fix is the focus of news reports and the regulators’ settlements with banks for good reason: fix trading constitutes a major portion of daily FX spot trading; fix rates are used world-wide to price many widely-held assets including mutual and pension funds; collusion is illegal and easily shown to have occurred based upon chat room communications; and the names of the chatrooms (e.g., the Cartel, the Mafia), and the lingo used within, make for entertaining media. 

New Revelations 

New areas of misbehavior are revealed in the new set of settlements and pleas. There is much less awareness of these than the fix-specific misconduct, so we’d like to underscore some of the more egregious patterns of behavior. 

This time around, the New York State Department of Financial Services (NY DFS) gets in on the act as well, tagging Barclays with a Consent Order. The NY DFS sheds light on some areas that are not covered in other plea agreements or settlements. For example, it stipulates that “Barclays conspired with other banks in order to coordinate trading … coordinate bid/ask spreads charged.” [1] 

The DFS also highlights Barclays’ “misleading sales practices”[2] , as well as the fact that “The misconduct described in this Order was not confined to a small group of individuals; it involved more than a dozen employees, who acted with the knowledge and oversight of some senior desk managers, and spanned geographically across numerous countries.”[3]  Moreover, the DoJ and DFS agreements include broader time ranges of misconduct than some of the earlier settlements, such as the CFTC’s.[4] 

So…what other wrongdoings were these FX trading engaged in? 

Manipulation of Spot Market to Profit from Client Orders 

Clients leave orders with their FX banks to execute FX spot trades, in order to manage their risks from future spot moves. 

Banks have admitted to manipulating FX rates when near the order levels, in order to increase the banks’ profit at the customer’s expense. For example, banks admitted to “accepting limit orders from customers and then informing those customers that their orders could not be filled … when in fact the defendant was able to fill the order but decided not to do so because the defendant expected it would be more profitable not to do so….”[5]

Likewise, NY DFS notes that Barclays told “clients that their orders had been only partially filled, when in fact the FX Sales employees were holding back a portion of the fill as the market moved in Barclays’ favor….”[6]  

Providing Quotes with Dealer Markup to Clients Expecting to Hear “Direct Trader Quotes” 

On large trades, some clients insist on hearing quotes not from their salesperson (who might add a spread to a trader quote), but directly from the bank trader over a phone line. Clients would expect these to be market-based -- and not shaded in one direction based upon the direction of the client’s intended trade. However, bank traders shaded the quotes either based upon hand signals from the salesperson indicating the direction and the size of the markup to include, or based upon earlier agreements made between the two bank employees. 

On this count, banks admitted to “including sales markup, through the use of live hand signals or undisclosed prior internal arrangements or communications, to prices given to customers that communicated with sales staff on open phone lines….”[7]  

Disclosure of (Confidential) Customer Identities and Trade Activity to Other Market Participants 

Banks provided this information to other banks and even other customers, on both large fix and non-fix trades. According to the plea agreements, the banks disclosed “non-public information regarding the identity and trading activity of the defendant’s customers to other banks or other market participants….”[8]  

Trade Platform Provided Altered Rates to Certain Customers 

The settlements were unclear on the relationship between the platforms and the bank, but platform rates provided to certain customers were systematically favorable to the bank versus the unaltered rates. RBS engaged in “intentionally altering the rates provided to certain of its customers transacting FX over a trading platform disclosed to the United States in order to generate rates that were systematically more favorable to the defendant and less favorable to customers….”[9]  

Trading Ahead of a Corporate Transaction 

We find a new anecdote of RBS trying to move the currency rate ahead of a corporate transaction so as to favor the bank at the client’s expense. This is commonly known as front running. 

From the plea agreement: “… in connection with the FX component of a single corporate transaction, trading ahead of a client transaction so as to artificially affect the price of a currency pair and generate revenue for the defendant, and to affect or attempt to affect FX rates, and in addition misrepresenting market conditions and trading to the client….”[10]  

Manipulation of Emerging Markets Currency Pricing 

 “Barclays FX traders exchanged information about customer orders with FX traders at other banks…”[11]  For example, “a Barclays FX trader explicitly discussed with a JP Morgan trader coordinating the prices offered for USD/South African Rand to a particular customer, stating, … ‘if you win this we should coordinate you can show a real low one and will still mark it little lower haha.’”[12]  


These regulatory investigations have uncovered several different means used by traders to increase bank profits to the detriment of their customers, including by “providing false and misleading information to customers and markets.”[13]  

As opposed to the FX market convention of adding a spread on each trade to generate bank profit (controllable by customer scrutiny of the rates), these investigations opened the window to the various layers of deceptive practices prevalent in the FX market, and the abuse of client confidentiality and trust. While the FX market has begun adjusting to the misconduct around the 4pm WM/R London fix, it is not yet clear whether banks have begun (internally) investigating some of the newly highlighted misbehavior. 

One additional feature of these settlements is the demand by regulators for additional compliance scrutiny of FX trading which will hopefully limit potential future misconduct. May we return all the stronger for it, and more robust! 

About the Author 

Jonathan Wetreich has spent 20 years in the foreign exchange markets, beginning on the buy side with the Treasury Group at Honeywell International. There he was responsible for managing the foreign exchange risk to this multinational firm, which included trading in spot, forwards and options. At Brown Brothers Harriman, a private bank, his sell side positions included consulting with the senior management of corporations to improve their foreign exchange risk management and execution. Jonathan also spent several years there on the foreign exchange trading desk, working primarily with asset management firms, as well as spending time as an FX strategist. Jonathan also assisted asset management firms in managing their passive hedge programs. Since 2012 Jonathan has been an independent consultant, primarily to corporations on matters of foreign exchange risk management. In addition, he has consulted on FX litigation and to organizations attempting to further their understanding of corporate hedge programs. Jonathan received an MBA from Columbia Business School.


[1] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.1
[2] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.2
[3] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.6 ¶14
[4] FCA “Relevant Period”: 1/1/2008 – 10/15/2013; CFTC “Relevant Period”: 2009 – 2012; FINMA “Period under Investigation”: 1/1/2008 – 9/30/2013; OCC “Relevant Period”: 2008 – 2013; Fed “Review Period”: 2008 – 2013; DoJ: 1/1/2008 and 1/1/2009 – 5/20/2015
[5] See for example: Plea Agreement USA vs JPMorgan Chase & Co. p.17 ¶13
[6] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.16 ¶ 56
[7] See for example: Plea Agreement USA vs Citicorp p.16 ¶13
[8] See for example: Plea Agreement USA vs Barclays PLC p.18 ¶16
[9] Plea Agreement USA vs The Royal Bank of Scotland PLC p.17 ¶13
[10] Plea Agreement USA vs The Royal Bank of Scotland PLC p.17 ¶13
[11] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.11¶33
[12] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.11 ¶34
[13] NY DFS Consent Order, In the Matter of: Barclays Bank PLC, p.2

Tuesday, May 26, 2015

Illinois’ Candidates for Municipal Bankruptcy

House Bill 298 would allow Illinois municipalities to adjust their debts through the Chapter 9 municipal bankruptcy process. The bill, endorsed by Governor Bruce Rauner, is currently in the house rules com-mittee.
If HB298 was enacted, which local governments might use the new bankruptcy option? To help answer this question, our team reviewed audited financial statements that (all but the smallest) municipalities must file. Most of these financial audits can be found on the state comptroller’s local government finance warehouse.
This article lists five municipalities that appear vulnerable based on information found in their audits. Among the indicators we considered were government-wide unrestricted net position and general fund balance. The first indicator shows the degree to which assets held by the government entity as a whole exceed its liabilities and are not locked up in buildings and other illiquid forms. The second indicator, general fund balance, focuses more narrowly on the government’s main fund – which is roughly analogous to an individual’s checking account. Low or negative general fund balances were cited in the bankruptcies of Vallejo and Stockton, California. It is worth noting that the five municipalities we identified are all located in Cook County, which also faces fiscal challenges. Our list does not include Chicago. Although that city’s financial struggles have made frequent headlines, several of its smaller suburbs appear to be in much greater fiscal distress. The five communities we identified are: Maywood, Sauk Village, Blue Island, Country Club Hills and Dalton.
In its 2013 financial statements, The Village of Maywood reported an unrestricted net position of -$47.4 million, and a general fund balance of -$8.2 million. While we found a number of jurisdictions with negative balances, these levels are quite pronounced for a relatively small municipality.  With general fund revenues of only $23.3 million and government-wide revenues of $44.1 million, it will take the village a long time to eliminate these shortfalls.
The Village’s 2014 financials should have been available by now, but, its reporting has been chronically late. Moody’s withdrew the Village’s credit rating in 2011 citing a “lack of sufficient current financial and operating information”. Despite the lack of credit ratings, Maywood was able to sell $16.3 million of bonds earlier this year.
In its 2014 financial statements, Sauk Village reported an unrestricted net position of -$36.7 million – a very large negative position considering that the village had only $29.6 million in assets and government-wide revenues of $13.4 million. Sauk Village also showed a negative general fund balance and unusually high interest costs. The village’s $2.1 million of interest expense accounted for over 15% of total revenue. In most of the Illinois municipalities we reviewed, the interest/revenue ratio was below 10%. To the extent that interest expenses crowd out spending on resident priorities, political leaders have an incentive to default on debt obligations as a way to shift spending to more popular purposes. Furthermore, the Village received an adverse audit opinion for its reporting of “Aggregate Remaining Fund Information” and a qualified opinion for its reporting of “Governmental Activities.”  The Police Pension Fund information was not included and has not been subject to an actuarial evaluation since May 1, 2011.
The City of Blue Island reported an unrestricted net position of -$15.2 million and a general fund balance of -$10.5 million in its 2013 financial statements – the latest available. The negative general fund balance is especially pronounced because the city only recorded $16.3 million in general fund revenue during fiscal year 2013. The city’s negative net unrestricted position appears to be understated because Blue Island did not report an Other Post-Employment Benefit (OPEB) liability. Government accounting standards require that municipalities report the present value of unfunded OPEB obligations on their balance sheets. This failure to report OPEB obligations resulted in the city receiving a qualified opinion from its independent auditor.
The City of Country Club Hills has yet to file audited financial statements for the 2013 fiscal year – making it the most delinquent filer among the municipalities we reviewed.  The city’s 2012 financial statements show a slightly negative unrestricted net position and a large negative general fund balance. Further, the city’s auditor was unable to render an opinion on the accuracy of these statements, saying:
Since the City did not maintain an accurate accounting of its revenue, expense/expenditure, bank reconciliations, and other assets and liability accounts, and we were not able to apply other auditing procedures to satisfy ourselves as to those balances, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements.
WGN Television has repeatedly unearthed financial irregularities in Country Club Hills.  Most recently, the station reported that Mayor Dwight Welch was being audited by the IRS for not declaring as income his personal use of a city vehicle. The station also reported that the mayor incurred large restaurant bills on a city credit card, and that the city mistakenly retained $6 million in tax revenue that was supposed to be remitted to Cook County.
The Village of Dolton reported a small negative net unrestricted position in its 2013 financial statements – the latest available. Although its general fund balance was positive, the amount was well below Government Finance Officers Association guidelines. GFOA recommends that a government maintain a balance equal to two months of expenditures. Dolton’s $1.3 million general fund balance would cover less than a month of general fund expenditures, which were $22.1 million for the 2013 fiscal year. Further, the village reported a $5.2 million general fund deficit. If this deficit persisted into 2014, Dolton may now be facing a negative general fund balance. Finally, the village also received an adverse audit opinion. According to the city’s independent auditor:
We were unable to examine supporting documentation for numerous expenditures out of various funds of the Village. We were unable to test the Village’s allocation of certain revenues collected by the water fund but belonging to the general fund and sewer fund. We were unable to obtain an aged trial balance supporting the receivable balances in the water and sewer funds. We were unable to obtain sufficient support for certain local revenues. We were unable to determine whether a net pension obligation should have been recorded in the government wide statements with respect to the police and firefighters’ pension funds. We were unable to obtain supporting documentation for certain payroll related liabilities such as compensated absences. We were unable to determine whether a lack of infrastructure assets was the result of a failure to include such information on the financial statements or whether the infrastructure had been fully depreciated in prior years. Due to the omission of financial statements for the discretely presented component unit, we were unable to determine whether the omission is material to the financial statements of the Village nor were we able to perform any auditing procedures on the component unit. We were unable to obtain confirmation from legal counsel as to whether any known actual or possible litigation, claims and assessments should be recorded or disclosed in the financial statements. Finally, we were unable to determine whether bond proceeds from a prior year were spent in accordance with applicable ordinances and requirements.
If HB 298 becomes law, these five communities may be among the first to utilize the municipal bankruptcy option. Regardless we hope that local leaders and active members of each community review the financial records we have referenced, and begin to pursue policies that bring their municipalities back from the brink. As Detroit and other cities filing Chapter 9 have found, municipal bankruptcy is an expensive process that transfers community resources to lawyers and financial advisors. While it may be unavoidable, bankruptcy should always be treated as the least best option.

This article was written by Marc Joffe on behalf of CivicPartner LLC.  CivicPartner is a Chicago-based startup that collects and analyzes government financial disclosures. Joffe is an independent researcher studying state and municipal fiscal conditions.

Monday, May 18, 2015

Is Chicago Really a "Junk" Issuer?

Last week, Moody’s downgraded Chicago general obligation bonds into speculative (i.e., “junk”) territory. As a critic of low municipal bond ratings, I saw a good opportunity to take Moody’s to task. But after diving into Chicago’s financial data, I’m not so sure. The data I compiled are in this Google sheet and my analysis follows.

In April 2012, Moody’s affirmed Chicago’s general obligation municipal bond rating at Aa3. Just over three years later, this rating stands at Ba1 - a cumulative reduction of seven notches. Since Moody’s entire rating scale, which ranges from Aaa to C, contains a total of 21 notches, the Chicago ratings changes have been quite dramatic. The magnitude of this downgrade does not appear justified by changes in the city’s finances..

When it affirmed Chicago’s Aa3 rating three years ago, Moody’s wrote the following:

The affirmation of the Aa3 rating on Chicago's general obligation debt is supported by the city's long-standing role as the center of one of the nation's largest and most diverse economies; a tax base that remains very sizeable despite several consecutive years of estimated full valuation declines; significant revenue raising ability afforded by the city's status as an Illinois home rule community; and its closely managed use of variable rate debt and interest rate derivatives. These strengths are somewhat moderated by the city's persistent economic challenges, including elevated unemployment levels and a large foreclosure backlog; narrow, though improving, General Fund reserves; relatively low levels of expenditure flexibility, as a high percentage of the city's operating budget is dedicated to personnel costs for a heavily unionized workforce; and above average levels of slowly amortizing debt.

Three years later, Chicago’s situation is about the same or slightly better. The city is still the center of a large and diverse economy and it continues to benefit from a strong revenue base. Although official property valuations (EAVs) are lower, both Zillow and the Case-Shiller Index show substantial property price gains since bottoming in early 2012. The city’s unemployment rate has also fallen substantially.

Gradual economic improvement has brought rising revenues. According to the city’s CAFR, its largest fund saw revenue grow from $2.8 billion in 2011, to $2.9 billion in 2012 and $3.0 billion in 2013. Unaudited figures in the city’s latest budget show further growth to $3.1 billion in 2014 and a projected $3.5 billion in 2015.

Although expenditure flexibility continues to be limited, Chicago has cut its retiree health insurance costs by reducing premium support and shifting beneficiaries onto Obamacare. These cost saving moves are still being litigated, but have yet to be overturned.

Chicago’s pension funds are seriously underfunded, but that is nothing new. At the end of 2011, Chicago’s four pension funds had a composite funded ratio of 37.9% - based on market value of assets. At the end of 2013 (the latest date for which complete statistics), the funded ratio was little changed at 37.0%.

That said, Chicago’s pension costs are quite large relative to city revenues. In 2013, actuarially required pension contributions totaled $1.74 billion, or 22.3% of the city’s total revenues of $7.82 billion.  This proportion is very high by national standards - higher, for example, than every single city in California.

I am skeptical of Actuarially Required Contributions (ARC) as a solvency measure, because a city can, in theory, meet its pension obligations on a pay-as-you-go basis. In other words, the city’s pension funds can all have a zero percent funded ratio, and all pension benefits and administrative expenses can be paid out of revenues.

But a review of Chicago’s benefit costs does not offer solace. In 2013, expenditures by the city’s four pension funds, totaled $1.84 billion, or 23.5% of total revenue. (Under current Illinois law, the city will have to pay much more than this in future years because it will be mandated to both meet existing pension obligations and raise its funded ratio to 90% by 2040).

One solvency ratio I find especially useful is the sum of pension costs and interest expenses to total revenues. In studying Depression-era government bond defaults, I found that when interest expense exceeded 30% of revenue, default often occurred. Back then, pension expenses were not that significant - now they are much larger and they enjoy similar or even preferential legal treatment to debt service.

In 2013, Chicago reported $478 million in interest payments, amounting to 6.1% of revenue. If we add this expense to the cost of providing constitutionally protected pension benefits, we get a composite ratio of 29.6% - dangerously close to the 30% threshold.

Even worse, the trend is not in the city’s favor.  Each plan’s actuarial valuation contains projected benefit payments through at least 2041. If we add up these future expenses, we find that they are projected to grow by about 4% annually through 2023. After that, benefit cost growth decelerates, as “Tier 2” beneficiaries - who are entitled to reduced pension benefits - begin to retire. The benefit growth rate from 2013-2023 is faster than the rate of revenue growth the city experienced in the previous decade. Between 2003 and 2013, revenue grew from $5.75 billion to $7.82 billion - an annual rate of 3.1%, significantly slower than projected

If its revenue growth trends continue, Chicago’s pension benefits and its interest expenses will exceed 30% of revenue later this decade. While this situation does not automatically trigger a default or bankruptcy, it leaves the city vulnerable in the event of an economic downturn. With so much of the city’s spending locked in, it would be faced with making deep service cuts or defaulting on its obligations in the event that revenue falls during a future recession.

So while Chicago’s situation is not much different than it was in 2012, the city’s fiscal status was and remains fairly dire. Although a seven notch cumulative downgrade seems inappropriate, the city’s current Ba1 rating does not seem very far off to me. Perhaps the problem lay with more with the city’s 2012 rating than the one it carries now.

Friday, May 15, 2015

Short Selling & the Squeeze

In the aftermath of the 2-minute Swiss franc movement earlier this year -- and with so much attention surrounding the Herbalife short-squeeze (on Bill Ackman's Pershing Square) -- we have put together a short & sweet presentation describing the concept of the short squeeze. 

We have included some examples towards the end, like Sears stock in November 2014 and that "exciting" day when Volkswagen suddenly became the world's most valuable company: thanks to its stock jumping over 300% in a day. 

Welcome to the world of short squeezes. May you never be on the wrong side!


A brief thank you goes out to our outgoing intern Mr. Ferreira for his helpful work preparing this set of slides.

Tuesday, May 12, 2015

Flash Spoofing, and "Normal" Market Operations

The criminal case filed by the DoJ against U.K. trader Navinder Sarao is the latest case to capture the media’s attention in what must be the early stages of a series of investigations into what we’ll broadly term “issues of market manipulation.”

 The potential for manipulative behavior has been garnering more attention over the past year since Michael Lewis’s “Flash Boys” more forcefully drew regulatory attention to issues around high frequency trading (HFT) activities and current market structures.

Regulators have received their fair share of criticism for taking nearly five years to investigate the Flash Crash, finally getting around to examining orders, and not just executions

While Mr. Flash Crash protests that he has “not done anything wrong apart from being good at my job,” regulators clearly have their sights on spoofing.  Just last week came news of the CFTC bringing civil charges against two prop traders in the UAE for allegedly spoofing in the gold and silver futures markets. All of this comes on the heels of several other low-profile players charged with spoofing over the past couple of years, such as Panther Trading

Spoofing, sometimes referred to as “hype & dump,” is basically when a trader enters orders with the sole purpose of influencing market prices and with no intention of actually executing those orders. 

Obviously the law does not require traders to openly state their intentions regarding whether they are buying or selling, and how much. Likewise, we don’t play poker with our cards face up. But what type of bluffing is kosher? To what lengths can one go to cloak his intentions so that others don’t run ahead, increasing transaction costs?

Kraft was recently hit with a CFTC complaint regarding its wheat futures trading, and this case seems to be more of a gray area.

But there's more to come, no doubt.

The general areas of interest concern front-running, spoofing, time advantages, and trading on insider information. Just a couple of weeks ago, we saw a situation which must fall smack in the middle of the realm of the regulatory whip: the Aussie dollar moved significantly just (milliseconds) before the announcement by the Reserve Bank of Australia (RBA). But even worse – this has now happened three consecutive times!

Let’s have a look at the overall movement, just before 3am, and then we’ll focus on the movement and its occurrence just before news came out.

Here's the movement, generally, at 00:30.

But the important note is the movement occurs just moments before (any) news is released.  See all the news items at the top?  Each news item corresponds to a blue box in the graph.

The first one, the rate decision, "flashes" into our screen, just AFTER the movement.

It's worth mentioning that we're not alone in discovering this market movement. The Australian Securities and Investment Commission is on top of things, having opened an investigation into these wild, yet accurate, swings.  Notices have purportedly "been sent to many financial institutions and platform providers to understand the basis of the trading on these markets at the point in time of interest." More troubling, however, is that preliminary findings have revealed to ASIC that:
"moves in the Australian Dollar ahead of the announcement to be as a result of normal market operations in an environment of lower liquidity immediately ahead of the RBA announcement. The reduction in liquidity providers is a usual occurrence prior to announcement in all markets. Much of the trading reviewed to date was linked to position unwinds by automated trading accounts linked to risk management logic and not misconduct." 
Call us skeptical (or sceptical, given they're in Australia).

One more likely explanation is that the news was leaked, or sold, to one or more firms that could execute quickly based on an incredibly fast network connection, likely linked to an algorithm. (If not, why wait for the seconds or milliseconds before the announcement – why not execute a minute before, or two minutes before?) 

So that opens up the door to the question of “time advantages” – more specifically, whether some preferred clientele can buy early access to the news. Let’s just say, it’s a little like gambling on a football game, in which most people are watching on tape-delay, but some gamblers are allowed to see the game “real-time.” The real-time gamblers can add or remove bets once the game is really finished, while the other gamblers with the lagged connection don’t yet know the final result. Can we call that a rigged market? 

The next legal question becomes: do the ordinary gamblers know that the preferred gamblers have a time advantage, or whether they know that they’re on a lagged connection (and that others are not). In other words, there’s the question of proper disclosure. Whether or not the market is rigged in favor of some parties, should the “unfavored” parties have been made aware of their material disadvantage?


For more on Time Advantages in the Financial Markets, and corrective actions taking place, visit any of the following links:

The Crucial Piece of Information That Big Traders Get Before Everyone Else

Firm Stops Giving High-Speed Traders Direct Access to Releases: Warren Buffett Involved in Berkshire Unit Business Wire's Decision to End Practice

Traders May Have Gained Early Word on Fed Policy, Study Finds

Thomson Reuters ends early access to key market data

Behind One Second of Trading Mayhem
(Article chronicles impact of earnings results released to paid clients milliseconds before news services released earnings, while those results impacted closing price of shares.)


Tuesday, February 24, 2015

Ocwen Wins this Weekend

Shortly after our blog posting went out on Friday evening, Ocwen (OCN) and Nationstar (NSM) and affiliated companies announced two agreements that sent all of their shares higher.

It will be interesting to see if some of them come back today: the reasoning for the bounce isn't immediately clear -- certainly for some of the Ocwen affiliates (AAMC, ASPS and RESI) who might reasonably be expected to miss out on future revenue opportunities as a result of the sale of HLSS.

Or is this just a win-win-win-win-win-win-win?

Ocwen selling MSRs to Nationstar ($9.8 billion of loans). 

New Residential (NRZ) to buy HLSS:

Friday, February 20, 2015

Serving Up the Servicing Complaints

It's February 20th, and time to update our post from Feb. 20th last year, when we investigated state of the mortgage servicing arena.

Firstly the good news: overall, complaints for the year 2014 are down roughly 12% over 2013 levels.

Non-bank servicer Ocwen has been all the rage of late, and has risen to the most complained-about mortgage servicer out there in 2014.  Meanwhile many of the bank-servicers have decreased their servicing businesses and platforms -- often selling to non-bank servicers -- and with it their tally of complaints!

Notably, Ocwen has settled with the CFPB and related state AGs for alleged misdeeds between 2009 and 2012.  The settlement was to the tune of $2.1 bn, but much of this cost may well be absorbed by investors in RMBS trusts serviced by Ocwen.  Importantly, though, Ocwen's complaint count seems only to be rising, and is now roughly 70% higher than in was in 2012.

Also of interest, if you look in the list below at the five servicers whose complaints grew fastest between 2012 and 2013, all five of them continued to have complaint growth in 2014.  This unwelcome trends seems not to be abating.  For example, for Select Portfolio Servicing, Inc (SPS) complaints more than tripled from 2012 to 2013.  They're again up another 65% from 2013 to 2014.

For another take on this, see Tom Adams' interesting read in Naked Capitalism, entitled "Ocwen’s Servicing Meltdown Proves Failure of Obama’s Mortgage Settlements."

Tuesday, February 3, 2015

S&P Settles: Now How About that US Bond Rating?

In its settlement with the Department of Justice, S&P has backed off its assertion that the federal lawsuit was filed in retaliation for its 2011 downgrade of US Treasury debt. But the downgrade subjected S&P to a barrage of criticism both at the time and ever since, raising the question of whether the decision was appropriate. My view is that the downgrade was the correct credit decision in 2011, but that it is now time for S&P to restore the US to AAA status.

Since rating agencies earn minimal revenue from sovereign ratings, the downgrade was clearly not in the firm’s short term commercial interest. This speaks well for the sovereign group and senior management at the time: the analysts looked the numbers, decided that the US was no longer a triple-A credit and were allowed to implement and publicize their decision. While we often hear negative generalizations about rating agencies, it is worth noting that these firms are heavily siloed; the behavior of the structured finance group does not necessarily reflect on the work of the sovereign team.

Not only was the downgrade principled, but it was also justified. In 2011, the US debt-to-GDP ratio was skyrocketing, the country had an unsustainable fiscal outlook and it lacked the political will to deal with the imbalance between future revenues and swelling entitlements arising from baby boomer retirements. While the British and Italian governments were able to address population aging by raising taxes and delaying eligibility for social insurance programs, divided government in the US prevented a grand bargain from occurring here.

Further evidence that the US did not merit a top credit rating emerged in October 2013 when both parties engaged in brinkmanship over raising the debt ceiling. Had the debt ceiling not been raised, the Treasury would been forced to prioritize payments. While I believe that the Treasury would have prioritized debt service over other obligations, my confidence in this belief does not approach the 99.9%+ level normally associated with AAA ratings.

So what has changed and why am I suggesting an upgrade? First, after taking widespread blame for the debt ceiling debacle, Republicans have changed tactics. It is now extremely unlikely that they will trigger a similar confrontation when the debt ceiling has to be raised again. Since failure to raise the debt ceiling and failure to prioritize debt service are both low probability events, the chances of both occurring seem to be within the AAA risk band.

More relevant to S&P’s original downgrade decision, the nation’s fiscal long term outlook has changed since 2011. When I say this, I am not referring to the marked decline in headline deficit numbers. The fact that the annual deficit declined from $1.3 trillion in fiscal 2011 to a projected $468 billion in fiscal 2015 is not a surprise. Looking back at CBO’s ten year projection from 2011, the agency estimated a $551 billion deficit for the current fiscal year – pretty close to what we are actually seeing. While politicians from both parties may be congratulating themselves for this improvement, the downward deficit trend is exactly what one would expect from an improving economy. Rising tax revenues and lower unemployment insurance costs – not any major reform – are reducing the deficit. There was no grand bargain, nor is there likely to be one anytime soon.

But two developments since 2011 have greatly altered the country’s longer term outlook: reduced healthcare cost inflation and persistently lower interest rates. Between 2000 and 2007, annual healthcare expenditure growth averaged 8.5%. Since 2009, the rate of growth has averaged only 3.9% and health expenditures have stopped rising as a percentage of GDP. Back in 2011, the decline in health cost inflation could be dismissed as a temporary effect of the Great Recession – but now that it has persisted into the recovery, we apparently have a lower baseline rate. Since healthcare costs are such a large component of future federal spending, less cost escalation in this sector is a very important factor in the long term fiscal outlook. 

Last year CBO projected that in 2039 the US debt/GDP ratio would reach 106% under current law and 183% under a likely set of alternative policies. As healthcare disinflation persists these forecast levels are likely to fall. 

Lower interest rates should also slow the accumulation of debt. After years of recovery and many months after the end of quantitative easing, Treasury rates remain near record lows. Rather than assume that rates will return to pre-recession levels, it now seems more reasonable to assume that we have entered a new normal of ultra-low rates just as Japan did after 1990.

While discussion around government solvency often revolves around a nation’s debt-to-GDP ratio, a better measure is the ratio of interest expense to revenue – because it focuses on the government’s ability to maintain debt service. Just after World War II, Britain reached a debt-to-GDP ratio of 250% but did not default because it faced very low interest rates. If interest rates remain low in the US, the federal government can comfortably service the 183% debt load envisaged by CBO’s most pessimistic scenario.

In 1991, the nation’s interest/revenue ratio peaked at 18% - but there was no discussion of a default. Currently, the ratio is below 8%. My study of fiscal history suggests that a Western style government becomes vulnerable to default once this ratio reaches 30%. While the US can always avoid a default by printing money, it is possible that an independent Fed Chair would refuse to do so, out of fear that the resulting price inflation would have worse consequences than a Treasury default. 

Under the CBO’s most pessimistic scenario, the interest/revenue ratio reaches 46% in 2039, well into the danger zone. But this outcome assumes an average interest rate on federal debt of 4.85%. Right now this average is below 2% and falling as higher coupon bonds mature and are replaced by new low-rate issues. Even if the government’s average financing rate drifts up to 3%, its interest/revenue ratio will remain below the critical threshold.

S&P had good reason to downgrade the US in 2011. If health cost inflation and interest rates had returned to pre-recession historical norms, the case for the lower rating would still be strong. But now that we have entered a new normal of quiescent healthcare cost escalation and low interest rates, it appears that the US is due for an upgrade.

Sunday, January 25, 2015

SEC Shines a Light on Inflated CMBS Ratings

On January 21, S&P settled a number of complaints with the Securities and Exchange Commission as well as two states’ attorneys general.  The issues primarily involved ratings of Commercial Mortgage Backed Securities (CMBS), although the rating agency also paid a relatively small fine for a self-reported lapse in its RMBS monitoring.
The settlements show that the SEC making use of the new regulatory powers it gained under Dodd-Frank and the earlier Credit Rating Agency Reform Act of 2006. While the complaints illustrate the fact that commercial considerations continue to affect credit ratings in the post-crisis era, regulators were able to identify and address (some of) them before another disaster occurred.
The CMBS market is much smaller than RMBS market was in its heyday, so a wave of unanticipated CMBS defaults may not have been enough to trigger another financial crisis on its own.  Nonetheless, it is nice to know that (some) misbehavior was caught early -- so we won’t have to find out.
Another difference between the contemporary CMBS market and the RMBS market of yore is greater competition. Six rating agencies currently vie for CMBS ratings mandates:  the “Big Three” plus DBRS, Kroll and Morningstar.  Neither Kroll nor Morningstar was around when bankers were shopping for higher RMBS ratings a decade ago.
After S&P temporarily suspended CMBS ratings in 2011, its market share position was quickly captured by Kroll. S&P’s subsequent misstep - distorting a Great Depression data set to justify lower AAA credit enhancements – was likely motivated by the fear of being permanently dislodged from the top three in a highly profitable asset class.
Ironically, the SEC enforcement actions, which include a one year suspension of conduit CMBS ratings, will cement S&P’s also-ran status. A takeaway here is one we have warned of many times previously: that more competition results in more ratings shopping by issuers and more pressure on rating agencies to dumb down their criteria - the type of concern that had motivated the Franken Amendment.

Competition in the Market for Single-Asset CMBS
S&P can still compete with the other players in rating single asset CMBS – a category that should worry any observer of the rating agency business. As the name suggests, single asset CMBS deals are collateralized by a mortgage on just one commercial property. The property can be an office building, a hotel or a shopping mall.
Typically investors in AAA structured finance paper have at least two protections:  seniority and diversification. With AAA securities at the top of the heap, collateral defaults usually have to destroy most or all of the value of more junior securities before the AAA holders are impacted. The second protection afforded to AAA structured finance investors is diversification:  the fact that the collateral pool contains a large number of loans whose risk attributes can be expected to offset one another.
Single asset CMBS deals kick this second protection away.  If the one loan backing the deal stops performing and has to be liquidated at a large discount, all investors lose – including those holding AAA paper.  The question in rating these deals is thus a fairly simple one:  what are the odds that the property will suffer a catastrophic loss in value?
According to the Moody’s idealized default probability table, the default probability on Aaa securities should be 0.0001% annually.  For an instrument rated Aa1, the annual default probability should be 0.0006%.  Differentiating between an event that has a 1 in 100,000 probability from one that has a 1 in 16,667 probability is difficult for any mere mortal – even one that happens to be employed by a credit rating agency.
But is it really credible to believe that any given shopping mall has just a 0.0001% chance of a catastrophic decline in value?  A brief review of recent history should refute this notion.
We have already seen one shopping mall devastated by a terrorist incident.  Although this tragedy happened in Nairobi, similar events are possible in the US which has already seen mass shooting incidents at Florida and New Jersey shopping centers.  But shopping malls can easily be laid low without an act of violence.  The closing of an anchor store or the opening of a competing mall can decimate traffic in short order.  And these aren’t theoretical possibilities as one can see by perusing the Dead Malls website.  This site lists over 100 US shopping malls that have closed or become largely vacant in recent years. Indeed, the rise of standalone big box stores like Walmart and the increased popularity of online commerce have placed enormous pressure on the entire shopping mall business.  Earlier this month, large tenants Macy’s and J.C. Penney both announced the pending closure of tens of stores around the country.
With such obvious risks, it’s hard to understand how a security collateralized only by a single shopping mall loan could be rated AAA.  Yet despite previous defaults on AAA shopping mall loans (see below) we continue to see AAA single shopping mall deals in the aftermath of the financial crisis.
Interestingly, the two pre-crisis shopping mall transactions with defaulted AAA securities weren’t single loan transactions – but they were overly dependent on individual loans that went bad.  Bear Stearns Commercial Mortgage Securities Trust 2007-PWR15 contained a loan to Las Vegas’ World Market Center II that accounted for 12.3% of the deal’s collateral pool. The default on this loan, in 2010, together with a large loss on the Aiken Mall in Aiken, SC have proved sufficient to trigger losses on the Aaa-rated AJ class.
CSFB Commercial Mortgage Pass-Through Certificates Series 2005-C2 included an exposure to the Tri-County Mall in Cincinnati that accounted for nearly 10% of its collateral pool. The liquidation of this mortgage at a deep discount eventually inflicted losses on AAA investors.
Despite these cautionary tales, we now have at least seven post-recession deals, with 100% exposure to a single shopping center, carrying AAA senior ratings.  These deals and their associated malls are as follows:
Aventura Mall
Miami, FL
Tysons Galleria
McLean, VA
Fashion Show Mall
Las Vegas, NV
Santa Monica Place
Santa Monica, CA
Green Acres Shopping Center
Valley Stream, NY
North Star Mall
San Antonio, TX
Altamonte Mall
Altamonte Springs, CA

If readers are aware of others, please pass them along.