Last week the OTC swaps market took a big step towards the creation of standardized interest rate swaps. Pushed by the buy-side, ISDA developed a “Market Agreed Coupon” or MAC contract with common, pre-agreed terms. From the ISDA press release:
The MAC confirmation features a range of pre-set terms in such areas as start and end dates, payment dates, fixed coupons, currencies and maturities. It is anticipated that coupons in the contract will be based on the three- or six-month forward curve and rounded to the nearest 25 basis point increments. Effective dates will be IMM dates, which are the third Wednesday of March, June, September and December. The initial currencies covered include the USD, EUR, GBP, JPY, CAD and AUD. Maturities will be 1, 2, 3, 5, 7, 10, 15, 20 and 30 years.
This is good for end-users. Dealers have long used superfluous customization as a tool to blunt competition and maintain margins. Creating a subset of contracts with standardized terms will make the interest rate swap market more efficient in many ways.
Some in the industry worry this just feeds the trend to futurization of swaps:
“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.” (RISK magazine, subscr. required)
But that ship had already sailed. The G20 specifically rejected the old model of faux customization, and mandated standardization in support of improved transparency and clearing. Whether standardization happens within the OTC swaps space, or via futurization is a detail.
Does JP Morgan’s derivative portfolio hedge its other lines of business? This picture says ‘no’.
Does JP Morgan’s use derivatives to make prop trade bets on interest rates. This picture suggests ‘yes.’
Let me explain.
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February 26, 2013 – 7:18 am
Last week we wrote about the financial contagion from Peugeot’s auto manufacturing business to its captive finance unit, Banque PSA Finance (PFA). The important question this raises for management is whether there are other ways to get the synergies associated with a captive finance unit without at the same time being susceptible to the contagion.
One set of alternatives keeps the unit as a captive, but tries to find financial structures that are not subject to the contagion. This includes separating funding sources and eliminating cross recourse. PFA is now considering offering deposits and making its liabilities separate from the Peugeot.
It is also possible to capture the synergies by some other means such as a strategic alliance with an otherwise independent bank. That’s what Fiat/Chrysler is doing with Banco Santander. The new venture, Chrysler Capital, will provide funds to consumers purchasing and leasing Chrysler’s cars and trucks, as well as loans to dealerships construction, real estate and working capital.
In the new venture with Santander, the automaker Chrysler will not even be listed as a shareholder. Chrysler decided against it because of its low credit rating (B1 by Moody’s and B+ by S&P), arguing that it would have damaged Chrysler Capital’s borrowing costs and ability to raise funds. Chrysler Group vice president of dealer network development and fleet operations, Peter Grady, is quoted in the Bloomberg story saying that “We were looking for a bank with some significant heft” that could “provide the financial backstop that would be needed in a downturn if another capital market disruption occurred.”
February 22, 2013 – 9:16 am
Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross.[1] Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.
What is at the root of the disagreement?
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February 14, 2013 – 9:10 am
The French automaker Peugeot is in trouble. Automobile sales in Europe saw a dramatic 8.6% slump in 2012. For Peugeot it was even worse: a 15% drop. Since the company relies overwhelmingly on sales in Europe, the company was burning through cash at a rate of €200 million per month, according to the Financial Times. Earlier today the company reported a loss of €5.01 billion in 2012. Already last March, Moody’s had downgraded the company’s credit rating to junk. To stabilize its finances, management last year initiated a program of asset sales, an issue of new equity, and the closure of one of its manufacturing plants near Paris.
Like many other manufacturers, Peugeot owns a captive finance arm, Banque PSA Finance (BPF). The bank has a special access to Peugeot-Citroen dealer networks and supports automobile sales by offering loans, leases and insurance to customers.
The bank gets its funds in the wholesale market, as shown in the figure below, taken from the bank’s 2012 annual report.
BPF’s captive relationship with Peugeot-Citroen exposes it to the risks of the car company. The sales volumes achieved on Peugeot and Citroën cars directly affect the bank’s own business opportunities. The ownership relationship, too, creates exposure. Accordingly, the credit rating agency Moody’s determined that its rating of the bank is constrained by its rating of the parent.
In 2012, the automaker’s financial problems infected the bank. As the parent was downgraded, Moody’s also reviewed the rating of the bank, and it was downgraded. In July, the parent was downgraded to junk, and Moody’s announced that the bank’s credit rating was in review for possible downgrade to junk status.
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January 31, 2013 – 7:49 am
Today, the CFTC is hosting a Roundtable on the “Futurization of Swaps.” More than 30 people from various parts of the industry are speaking. I’m on the first panel. Here are 3 points I’ll be making:
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January 25, 2013 – 9:19 am
Representative Dave Camp, Republican Chairman of the House Ways and Means Committee, has released a discussion draft on new rules for the taxation of derivatives. The press release is here. Detail material is found here.
In the draft, derivatives used for hedging are excluded. The criteria proposed here for determining whether a derivative is used for hedging in tax accounting are similar to the criteria already applied in financial accounting. However, a large fraction of derivatives held by non-financial companies are not accounted for using hedge accounting. So, it seems to me that this proposal would probably affect the tax treatment of those holdings.
It will be interesting to see how this discussion unfolds.
January 16, 2013 – 5:54 pm
JPMorgan’s management released its Task Force Report (Report) on the trading losses at its Chief Investment Office (CIO). It’s very clearly written tick-tock and provides a good account of how various controls broke down. Taking for granted the task assigned to the traders running the CIO’s Synthetic Credit Portfolio, the report outlines where things went wrong.
As an accident of timing, the losses were first disclosed in the midst of a public debate about the Volcker Rule’s prohibition on proprietary trading at banks. So, for the public, the case became a test of whether the proposed regulations implementing the Volcker Rule had any teeth: would they prohibit the trades being done at JPMorgan’s CIO once they came into force? Management has always contended that the Synthetic Credit Portfolio was run to hedge the bank’s natural long position in credit risk, and that it was not proprietary trading and would not be prohibited under the Volcker Rule. That contention is repeated summarily in the Report when it gives an introductory overview of the Portfolio’s origin and operation. But, the contention is never actually substantiated: indeed, the Report does not purport to address the prop trading question directly.
There is much in the Report that would lead a reader to doubt management’s contention and to conclude instead that the Synthetic Credit Portfolio was a classic example of prop trading.
A key forensic test for distinguishing prop trading from hedging is the compensation criteria. A hedger’s success is not measured by his or her own profit and loss on the hedge trades. Instead, a hedger’s success is measured by how well his or her own profits and losses track and set off the losses and profits on the assets being hedged. The metrics for performance on hedging should incentivize minimizing net risk. The metrics should measure net risk reduction. When the desk reports big profits — after netting out the matched positions — that’s a bad sign, not a good one. The JPMorgan Report strongly suggests that the traders on the Synthetic Credit Portfolio expected to be rewarded on their own profit and loss, not on how successfully they hedged the bank’s natural long position. That compensation system fits prop trading, not hedging.
The Report does briefly consider the wisdom of the compensation scheme, but not from the perspective of the Volcker Rule and identifying prohibited activities. Instead, the Task Force was just concerned with the question of whether the profit and loss criterion was overvalued to the exclusion of other criteria management imposed on the unit.
So, it looks as if JPMorgan’s CIO, and its Synthetic Credit Portfolio provide a useful test case for the Volcker Rule going forward. The original regulations proposed for implementing the Rule did include an assessment of compensation criteria. Whether that will continue in a final rule is yet to be seen. And then comes the question of enforcement.
January 16, 2013 – 7:42 am
Finally, a journalist has located a real cost of futurization, as opposed to the many imagined ones.
December 13, 2012 – 11:55 am
The Capital Markets subcommittee of the House Financial Services Committee held a hearing yesterday on the derivatives portion of the Dodd-Frank Act — Title VII. The question of the futurization of swaps captured a good bit of attention.
Representative Bachus, who chairs the full Committee, said (at 14:04 in the video),
If all derivatives were supposed to be traded on an exchange, then they would all be futures. [Swaps] are differeent from exchange listed products, and imposing the listed futures or equity market model on [swaps] is not the mandate of Title VII.
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