The new issue of Risk should be on your desk now (if you're a subscriber. If you aren't, then it shouldn't, obviously). The cover story, as I mentioned last week, is by Jayne Jung and looks at the problems associated with subprime-based CDS in the US.
We also have:
Navroz Patel on solving counterparty credit risk with contingent CDS;
Rachel Wolcott on the cooling CLO market;
John Ferry on the continuing problems with Basel II;
and much more.

The 20th anniversary issue of Risk will look back at two decades of the derivatives market, through the memories of the people who shaped it. In no particular order, we will be publishing interviews with:
Ken Griffin, founder and CEO of Citadel Investment Group;
Merrill Lynch's derivatives legend Connie Voldstad;
former CSFB chairman Allen Wheat, and his former lieutenant Chris Goekjian;
Primus Financial CEO Tom Jasper;
Nobel laureates Robert Merton and Myron Scholes;
former Isda chairman Mark Brickell, who helped JP Morgan set up its derivatives business in the 1980s and 1990s;
TJ Lim, previously of Merrill Lynch, Dresdner Kleinwort Benson and UBS, and now CEO of the structured finance advisor NewSmith;
and many others.

The Risk 20th anniversary issue will also include our anniversary awards - the Pioneers for the original innovators who led the development of their particular markets, and the Modern Greats for the players who may not have been first into the game, but have pushed the markets to the next level in more recent times.
Awards will be presented at the Risk 20 event on July 10.

Hedge funds are getting bigger - both in the sense of larger market share, and individual size. Fitch points out in a new report that they are particularly poresent in the credit derivatives market, where they're responsible for 60% of trading, and assets - thanks to high levels of leverage - worth as much as $1.8 trillion. Not only that, but according to SG CIB's Bruno Lebre, head of hedge fund relations, whom I met earlier this week, they're increasingly consolidating.

"The entry costs are high; diversification into multiple asset classes requires large size". The shift towards institutional investors rather than rich private investors - institutions are now responsible for more than 50% of hedge fund assets - mean that compliance and back-office costs have gone way up in order to satisfy their greater demand for information.

"Concentration risk isn't an issue today, but it could be in five years' time", said Lebre's colleague Dan Fields, the bank's head of flow sales.

Fitch reckons the biggest problem this poses is liquidity risk - the trouble about having lots of highly mobile investors (like hedge funds) investing in your sector is that, when things go wrong, you may not see their highly mobile shapes for dust. Brace for reassessments of liquidity risk.

In her cover story in the latest issue of Risk, available online here, Jayne Jung looks at the problem with shorting subprime mortgage credit:

Under pressure to help prevent subprime borrowers from defaulting, mortgage servicers are modifying the terms of loans to a much greater extent than they have in the past - some bankers estimate that modification rates have increased fivefold, to as much as 10% of servicers' portfolios. That could have significant consequences for short trades: despite being correct in their view that subprime borrowers would struggle to repay loans, actual delinquency rates may not be as high as investors thought - and that, in turn, could cause short strategies to under-perform.

Also out, a Fitch report (registration necessary; summary here) on a similar problem. Fitch is about to cut its ratings on subprime RMBS, in recognition of the fact that loan renegotiation is artificially reducing the default rate.

Link via Tanta at Calculated Risk.

Kamakura, which tracks these things, reports a "significant" decline in world credit quality. 7.1% of companies worldwide are now officially "troubled", up from 6.6% last year.

"Credit quality in May remained strong by historical standards but the deterioration in credit quality since February is significant," said Warren Sherman, Kamakura President and Chief Operating Officer. "As we said in last month’s commentary, a substantial decline in credit quality is much more likely than an improvement from current levels."

The FT picks up on a letter of complaint from various unnamed hedge funds to Isda.

Some hedge funds say they are concerned that banks that both sell the derivatives contracts and handle mortgage payments could be involved in a form of market manipulation. The funds fear that banks are making concessions on the underlying mortgages to avoid making good on derivatives contracts that pay off in cases of default.

Evidently we have forgotten to spare a tear for those poor hedge funds, whose honest day's work of betting on failure, without having to pony up any real capital, apparently, is under threat. Yes, friends, there's a conspiracy afloat to put the interests of homeowners...and actual capital investors... ahead of the credit default swap punters. I don't know that I've ever been so moved."

UPDATE: now available online here.

The US Senate is looking into Amaranth, and so far it does not like what it sees. The staff report is already up here. Looks like more money for the CFTC (which should be welcome) and more regulation for ICE. It's fascinating to see the degree to which Amaranth dominated the market.

An interesting profile of cloning specialist Harry Kat:

Kat had worked in the financial markets for almost fifteen years, but what he learned about hedge-fund fees shocked him. An investor who puts a million dollars in a fund of funds whose value goes up ten per cent in twelve months would face deductions of about sixty thousand dollars on the gains he makes. “Who wants to pay that kind of money?” Kat asked the executive who was interviewing him. “You can’t seriously expect there to be anything interesting left after somebody takes out three and thirty.” The executive was nonplussed. “I don’t know,” he said. “But they pay it.”

Read the whole thing here.

A quick roundup of links from the weekend:

Two pieces on the problem with credit rating agencies. John Succo warns of a huge conflict of interest problem in the CDO market:

in order to make the market work an “impartial” pricing mechanism must exist that the entire market relies upon. Enter the credit agencies. They use their models, which are not sensitive to current or expected economic activity, but are based almost entirely on past and current default rates and cash flow to price the risk. This of course raises two issues.

First, it is questionable whether "recent" experienced losses over the last few years really represent the worst of the credit market (conservative). But even more importantly, it raises a huge conflict of interest: the credit agency's customers are the very issuers of the tranches they rate.

More analysis of the same issue here.

All this is being looked at in the context of the Bear Stearns hedge funds - commentary everywhere, but most interestingly here.

So, a bunch of first-time homebuyers with no money made Angelo write a bunch of regrettable loans. Angelo undoubtedly made Bear Stearns buy those loans. A bunch of insane hedge fund investors who aren't happy with 12-18% annual returns from investing in the first loss position on the loans Angelo was forced to make got out their pitchforks and "clamored" until Bear Stearns gave them a new fund that used 10x leverage to sell protection to somebody who is exposed to the losses on the underlying reference securities (you want to bet me that'd be Fund 1?) that were valued by Bear's nifty models to start with.

Just to bring you up to date: the London Stock Exchange has almost succeeded in its pursuit of Borsa Italiana, despite a last-minute counterbid by NYSE Euronext. The Italian exchange also plans to take over the 51% of the MTS bond platform it doesn't already own (from NYSE Euronext, incidentally). The Chicago Merc and the Intercontinental Exchange continue to snipe at each other over the Chicago Board of Trade. Meanwhile, ICE has also snapped up the all-electronic Winnipeg Commodity Exchange. Not to mention continuing unrest over the NYSE-NASD regulatory merger.
Yes, this is all looking rather like the bit at the end of Act Two where everybody is frantically in love with the wrong people, disguised as someone else, etc. It also raises the question (addressed here before) of what the steady state exchange market will look like, once this wave of mergers is over.

The local financial industry group, IFSL, now believes that London is going to be the world's leading carbon trading centre. It makes a good case - the European emission trading scheme, the ETS, accounts for most of the carbon traded last year (1101 million tonnes equivalent, out of 1649 mte), and 82% of ETS trading happened on the London ICE Futures exchange.

This isn't entirely a surprise.

Of the three big emitters, China refuses to do anything very much (and continues to build highly-emitting coal-fired power stations at a rapid rate).
The US, as noted earlier, is only now coming round to the idea that climate change actually exists. That leaves the EU - and, that being the case, it's not very surprising that London ended up on top.

What if it stays there? It could; carbon is a global market in the way that equities, for example, aren't, so even the development of a thriving US emissions scheme shouldn't per se mean that London loses its lead. The head start means that the innovative second-generation carbon products are more likely to come from London than anywhere else. It's unlikely, at least, to lose its place as the preferred market for European emissions.

Moreover, expertise in emissions will be good for the City as a whole - with energy expected to be the biggest equity growth area of the next ten years, there will be plenty of interest in energy-related products - which means emissions.

Both suitors for the Chicago Board of Trade - ICE (the Southern outsider) and CME (the boy next door) - are ready to raise their bids yet again, it seems. As Risk wrote last week, ICE has the cash, but CME has the CBOT board on its side. But now CME could be raising its bid from $10.1 billion to $11.7 billion, close to ICE's $11.8 billion offer; ICE could respond by increasing its compensation payments for CBOE exercise rights (ICE is already offering up to $800,000 per member, compared with CME's $250,000).
But ICE could be suffering from the perception that it can't handle the load, according to this report.

``Is this a game of chicken? Sure,'' said Howard Simons, a former finance professor who is now president of Glenview, Illinois-based Rosewood Trading Inc. ``Whoever winds up buying the Board of Trade is going to have a moment of buyer's remorse because it's almost like they are forcing each other into overpaying.''

On a related note: it's well known that most mergers destroy shareholder value. In fact, even if a company manages one successful merger, its later ones are still likely to fail. Hence the "merger paradox".
One possible new explanation is here - "CEOs' worth increases even when poor acquisitions are made". It's a classic agency problem.

Rene Stulz lays out the facts about hedge funds. Summarised by economist Tyler Cowen:

1. Hedge funds have existed since at least 1949.

2. Hedge funds exist because mutual funds do not deliver "complex investment strategies." In part this is because mutual funds are regulated.

3. The largest mutual fund is about six times larger than the largest hedge fund. Marketing constraints also encourage very large funds to adopt simpler and easier-to-explain strategies.

4. Investment advisors with fewer than 15 clients do not have to register with the SEC.

5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty). That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance. This is not obviously efficient, and of course hedge funds pay for performance.

6. Hedge funds don't have to disclose information to investors, other than by contractual agreement.

7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.

8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.

9. Available data on hedge fund returns are nearly worthless.

Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations.

To read the full paper, click here, follow the link to "working papers" and then to "Hedge Funds: Past, Present, and Future".

Guest post today, from Douglas Long at Principia Partners, who has just returned from the Global ABS conference in Barcelona and kindly agreed to share his notes exclusively with OTC.

"Main days - Mon and Tue where the bulk of the people attended. Well over 4000 people attending.

"The main hot topics from the sessions I attended and talking to attendees were:

"1) ABCP conduits and the impact of Basel II.

"Several panels were discussing the impact of Basel II on ABCP conduits and more specifically the adoption of the IAA (internal assessment approach). Many of the conduit managers said that this IAA was similar to conduits internal credit assessment process anyway and most sponsoring banks are well into / completed the implementation of IAA. Additionally, the view that Basel II was not expected to have a significant impact on the market size was reiterated.
[Risk looked at the impact on ABCP in 2004 and 2005]

"2) ABCP conduits and alternative liquidity.

"Again partially driven by Basel II - many conduit managers are adopting alternative more active liquidity management techniques. Whether using extendible commercial paper, total return structures, market value and cashflow generated from assets, liquidity put options through to issuing more MTN structures. This was described in the context of increased convergence between the SIV and ABCP markets, with conduits adopting more SIV techniques and technologies to reduce the vehicles liquidity requirements.

"It is not believed that Basel II will increase the cost of liquidity (which is already high) as many of the liquidity providers already have internally priced the capital they hold against this from internal economic models.

"3) SIV market trends and growth.

"Interest in this sector was apparent from many different sessions. The market is exhibiting very strong growth - both in the number of SIVs (30% increase) last year and size of the existing SIVs (over 50% increase) to around $300bn assets under management.

"SIVs have increasingly been focused on providing a scalable business operation. The driver behind this is that the size of the SIV is key in the tight spread environment that we are operating within. The increase in SIV size, while keeping the overhead and operating costs static, allows them to achieve their desired returns.

"Another important trend was the increased use of a 3+ tier capital structure - with the main drivers being to diversify the SIV investor base and provide investors with greater liquidity.

[John Ferry examined developments in the SIV market last month.]

"4) Impact of subprime market on CDO.

"Obviously a big topic of discussion was not specifically the subprime RMBS market in the US but rather the impact that its performance will have within the CDO market. A large portion of CDO collateral is RMBS and a large portion of that represents subprime and home equity. Although there was some debate about whether the subprime market will deteriorate further, there was more general agreement that there will be trickle-down effects on the overall CDO market."

[Our recent cover story looked at the subprime market and its effects on CDOs.]

Dire warnings from the speakers at the Risk 07 event in London today; Credit Suisse's Robert Parker is worried about liquidity, and author Naseem Taleb warns that modern portfolio management theory is useless. We'll have more tomorrow on Risk News.

Meanwhile, another couple of links on the subprime business. Calculated Risk notes a letter to the FT today from Paulson & Co, clearing up some of the doubt around market manipulation allegations. And a thoughtful paper from the San Francisco Fed comes via Economist's View.

In a long and thoughtful post, Tanta at Calculated Risk asks: has the CDS market done any good, any good at all, for the subprime market? Or is it just a huge moral hazard problem?

Risk 07 starts tomorrow; we'll have live reports from the conference on Risk News.