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Counterparty Risk Data Gathering Trumps Basel II
September 7, 2006

Counterparty Risk Data Gathering Trumps Basel II

In the dog days of August, the House Committee on Financial Services tentatively announced hearings regarding the long-delayed implementation of the New Basel Capital Accord or Basel II. In a letter, some legislators asked that US bank regulators hold off on issuing a new rule for public comment regarding Basel II until after the hearings, but yesterday the FDIC board did the right thing and approved the proposal for public comment.

Fact is, regulators, legislators and even the bankers feel an increasing sense of urgency regarding Basel II, if for no other reason than there are so many other pressing issues requiring attention -- issues which the delay of Basel II implementation in the US has effectively blocked. Important as Basel II may be to the industry and to the US national interest, the approaching trough in the credit cycle is stoking concerns about credit quality and collateral values. We hear that top of the list for the financial services industry is the generic question of how to get better counterparty risk data, especially for organizations involved in Complex Structured Financial Transactions (CSFT) and Over-the-Counter (OTC) derivatives.

For months now, Washington's focus has quietly been shifting away from the theoretical constructs of Basel II and towards the very real risk issues of counterparty credit risk and liquidity. One hint came over our transom when a certain regulatory agency in DC called to ask about applying structured data collection methods such as XBRL to gathering counterparty risk data a la the suggestions made by the Corrigan Group. XBRL is a machine readable language for the communicating business and financial data which has been adopted by the Federal Deposit Insurance Corporation for gathering bank call reports and is being assessed by the Securities and Exchange Commission for enhancing public company reporting.

It is remarkable and encouraging to us that political appointees are focused on gathering counterparty risk data at this level of detail and at this time. Perhaps Moody's illustrated the policy driver when it reported that sales of U.S. collateralized debt obligations or CDOs soared to a record $115.7 billion in the first half of this year, a 72 percent increase from the same period last year. Many CDO deals come with credit derivative enhancements and ratings from the major agencies of the overall riskiness of the deal. These ratings, in turn, are used to justify pricing. But does the sum of the parts analysis suport the yield to commission for the CSFT dealer?

Fact is, a growing number of senior people in government are pondering the use of XML-based technology solutions to address the issues like those raised by the Corrigan Group (aka the "Counterparty Risk Management Policy Group II" --http://www.crmpolicygroup.org/report), in particular the issue of gathering sufficient financial statement data about hedge funds and other lightly regulated entities to understand counterparty risk. And the FDIC's use of XBRL for gathering bank data is only one example.

Notice, for instance, that the Federal Reserve Board has just added bank charge-off and delinquency rates to their SDMX-ML data download series (http://www.federalreserve.gov/datadownload/). In a matter of months, most if not all of the public data gathered by the various bank regulators will be available for free online, in "as filed" form and in an industry standard format that you can easily import onto a spreadsheet or to power a database analytics application.

By no coincidence, Michael Rasmussen at Forrester just asked us, on behalf of a client, whether banks are using metadata to organize counterparty risk data for Basel II applications. Specifically, the client described a "current focus around Basel II" driven by interest "in a Metadata Repository (MDR)" and was said to be interested in learning whether or not an MDR is being used by the largest banks effectively to manage Basel II data requirements.

Answer: Yes. Give us a call, Michael.

And finally, last week the major rating agencies announced a laudable new effort to draw up financial criteria for rating hedge funds. Just as the rating agencies have been the enablers of CSFTs, providing credit ratings of these unique asset structures which have been absolutely crucial to acceptance on the Buy Side, now they purport to be able to assess the credit risk worthiness of specific funds, a reflection of just how important hedge funds have become to providing liquidity in the global markets.

Part of the reason for the rating agency initiative regarding hedge funds is self interest (that is, a fee), part the insatiable desire of investors for designer assets, but most risk pros we know still rely on collateral to "rate" fund counterparties. One liquidity maven at a top bank trading desk in NY tells an apocryphal tale of how a certain hedge fund went down because of a squabble between two principals, ending in messy litigation and uncertainty for the fund's counterparties. The funds financials, which were sterling, said nothing about the operation risk embedded inside these individual members of the hedge fund maggotry.

Picture Perfect

Suffice to say that we perceive that the twin issues of counterparty risk and collateral valuation are rising to the top of the proverbial hops kettle in Washington. These inputs, added to contacts in the channel, suggest to us that modeling future capital needs for the purpose of Basel II has lost some priority compared to estimating the present day capital needs of banks and other obligors. It also confirms our suspicion that the new rule on Shared National Credits (SNC), including enhanced disclosure by hedge funds and other counterparties of CSFTs, is going to move soon, probably with a new comment period to update the December 2004 request.

Why do we believe that "Snick," as SNC is pronounced inside the beltway, is about to finally move after almost two years of torpor and long after the various regulatory agencies requested comment? Because the mounting threat of a serious systemic event in the opaque marketplace for custom built assets -- or, more specifically, the lack thereof -- has begun to really worry some people in the world of risk analysis.

Consider by way of example the profile of a notional institution whose financial performance has been "enhanced" via the use of OTC derivatives and CSFTs. Our subject is a good sized regional bank, an institution which has grown more sophisticated in terms of the use of the trading book and more willing to purchase as well as go short OTC products for both interest rate and credit risk management. The bank was once a mediocre performer, but now has above average asset and equity returns. Over the past five years, our subject also progressively improved default experience. It's so good, in fact, that the bank is now in the bottom quartile of the peer group in terms of charge offs. Volumes in purchased funds and derivatives have increased over the period, but the bank's earnings are more stable than its peer, picture perfect in fact. Almost too good to be true.

The worst nightmare of the regulatory community today is not the visible threat looming on the horizon, but rather the eerily tranquil scene in the marketplace for everything from loans to credit derivative swaps. Despite the growing list of anecdotal horror stories we hear from the Buy Side about sharply discounted secondary market valuations for CSFTs, structures, mind you, which often carry investment grade ratings from the major credit rating agencies, the data for loan defaults and related losses at banks remain well-below historical norms. As the FDIC just reported, in Q2 levels of non-current commercial & industrial loans were still near 16-year lows, albeit up now two quarters in a row.

Are we looking at the bend in the hockey stick?

As we've noted before, part of the reason for the calm picture still visible in the credit markets is the Fed's generosity between 2000 and 2003. Easy monetary policy covers a lot of economic and political sins. John Dizard writes in the Financial Times : "If the founding Austrians had Marxists and Keynesians as their opposition theorists, the present-day Austrians have Alan Greenspan and Ben Bernanke and their enablers in the US political system."

To us, the chief obstacles preventing regulators and risk managers from understanding the nature of the next systemic tsunamis are 1) over-reliance on statistical modeling methods and 2) the use of derivatives to shift and multiply risk. Of note, continued reliance on VaR models and Monte Carlo simulations is enshrined in the Basel II proposal, the pending rule revision on CSFTs and the SNC proposal. All share an explicit and common reliance on statistical methods for estimating the probability of a default or P(D), for example. These ratings, in turn, depend heavily upon stability in the assumptions about the likely size and frequency of risk events. None of these proposed rules focus great attention or resources on assessing specific obligor behavior.

Thus the urgency in some corners of Washington regarding revisions to SNC, including a quarterly reporting schedule and enhanced disclosure of counterparty financial data. Remember that one of the goals of the SNC enhancements is to gather private obligor P(D) ratings by banks and to aggregate same to build a composite rating system for regulators to use to assess counterparty risk. That is, the creation of a privileged data rating matrix which could be used to assess the efficacy of both bank internal ratings and third party agency P(D) ratings alike. More on this and the effect of derivatives on visible bank loan default rates in a future comment.

Bankers, after all, are not very good at understanding future risks, no matter how many ERM consultants they hire, default risk software implementations they direct, or meetings they attend at the Federal Reserve Bank of New York. Even making accurate observations about the present day risk events seems to be a challenge. Witness the fact that commercial bankers as a group managed to direct more than $2 out of every $3 in political contributions this year to Republican members of Congress, even as the GOP looks ready to lose control over the House and perhaps even the Senate. When Barney Frank (D-MA) is Chairman of the House Committee on Financial Services, perhaps the industry will take notice of this operational risk event and adjust accordingly.

Questions? Comments? [email protected]

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