Has the subprime crisis undermined Basel II? Willem Buiter (ex-MPC, now a professor at the LSE) thinks so, in fairly direct terms:

Two crucial inputs into Pillar 1... have been severely compromised by the recent financial markets turmoil...It is clear that, as regard rating complex structured products, the three internationally recognised rating agencies have done a terrible job... There appears to be a systematic bias in the ratings. If rating were merely difficult, you would expect as many over-ratings as under-ratings. What we see instead, is a persistent bias: ratings seem to systematically over-estimate the creditworthiness of the rated instrument or structure...I am not asserting that the rating process of complex financial instrument is unavoidably utterly corrupt and useless, although some of it probably is...

I can see no way the crippling conflict of interest can ever be resolved for anything other than the simplest structured products - those for which even the CEO can understand the principles underlying the model and the numbers going in and coming out... In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value.

Quant hedge funds have been suffering from the rise in volatility - as Risk wrote last month here. Now an EFN article suggests that the funds are not only flourishing, but could be stimulated to improve their algorithms:

He added: “We are seeing algorithmic trading spread across asset classes – from equities to futures and options and foreign exchange – as people look at cross-asset trading to hedge a position. We are also seeing real-time compliance being incorporated into the underlying model.”

The Bank of England doesn't mince its words in the latest Financial Stability Report - Risk News here, the full document (78 page pdf) here. The main theme seems to be one of complacency... of course, it's still being argued how much of that should attach to the Bank too. Alea highlights the report's recommendations on rating agencies (or see page 58 of the report).

And Alistair Darling says that the regulatory system needs refining:

The chancellor also said that there needed to be “better regulation to stop banks hiding things off balance sheet,” a reference to international efforts to inject more transparency into the financial system.

It'll be very interesting to see what happens - especially to the FSA, which seems to be in the weakest position of the three UK regulators (FSA, Bank and Treasury). Some sort of reform, even if only cosmetic, will be unavoidable.

King County, WA, in a startling stroke of bad luck, had invested in Rhinebridge. And Cheyne Finance. And Mainsail. Not an ideal set of decisions (a total of 3.8% of their investments).
The county's finance director speaks for many:

"That is the frustrating aspect about all this: you have these highly rated investments that have been downgraded simply overnight," he said.

1. Some more information about the rescue vehicle would be nice - estimates of the size of the fund are anything from $60 billion to $100 billion. HSBC and Dresdner have now (reportedly) joined.

2. The first public refusal has been issued - Pimco was supposedly interested, but has now pulled back. It'd be very interesting to see exactly how much the fund has raised so far in terms of commitments.

3. One really shouldn't call it the "Superfund" given that, in the US, a Superfund site is an area of ground so horribly contaminated by toxic waste that the federal government has been forced to step in to clean it up, or at any rate to stop the blight spreading. Or maybe one should call it the "Superfund" for exactly that reason.

4. Paul Krugman is sceptical about the whatever it is:

Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles” — basically hedge funds that borrow from the public and invest the proceeds in mortgage-backed securities. The new plan would create a “super-fund,” the Master Liquidity Enhancement Conduit, which would seek to restore confidence by, um, borrowing from the public and investing the proceeds in mortgage-backed securities.

The plan, in other words, looks like an attempt to solve the problem with smoke and mirrors.

That might work if there were no good reason for investors to be worried. But in this case, investors have very good reasons to worry: the bursting of the housing bubble means that someone, somewhere, has to accept several trillion dollars in losses. A significant part of these losses will fall on mortgage-backed securities. And given this reality, the “conduit” looks like a really bad idea...Mr. Greenspan’s take... seems broadly similar... this rescue scheme could be seen as an attempt to hide the bad debts everyone knows are out there, and as a result could delay any return of trust to the markets.

Alan Greenspan is making sense.

WTI oil broke $87 this week and is expected to go on rising (though it's now dropped back to a mere $86.78...) And, in broader terms, the last four years in particular have been a demand-driven commodity bull market of a sort seldom seen before - and matched by an explosion in the size and diversity of the commodity derivatives market.
Risk Books' latest publication is Intelligent Commodity Investing, edited by the founders of Premia Capital Management, Hilary Till and Joseph Eagleeye. The book covers research into the dynamics of the commodity market, the perspectives of index providers, active managers, investors and risk managers, and concludes with an exploration of the future - electronic markets, structured products, carbon trading and the Chinese commodity market.

Via Felix Salmon, Richard Murphy explores the convoluted structure of one of Northern Rock's funding vehicles...

It does seem clear that in this case a relatively normal bank with a relatively normal set of funding vehicles turned out, on close examination, to be fiendishly complex and opaque; it would be naive to assume that any other financial institution was very different. There is a regulatory lesson here... it's hopeless to expect regulators to stay on top of the complexity which is endemic to the global financial system... Basel II is likely to turn into a license for unscrupulous banks to structure their way into difficulties which might have very nasty systemic consequences indeed.

The regulators in question were in front of the House of Commons' Treasury Select Committee yesterday. Video here (if you have the time to spare; FT account if you don't). Interesting points - the FSA appears to have spent more time wargaming individual institutional failures than a general collapse of liquidity - which I suppose makes sense, given its institutional objectives. But shouldn't someone have the job of macroeconomic stability management? This seems to be another issue that has got stuck in the Bank/FSA gap...

The FT reports gloomy news from outgoing (as in "about to leave", that is) IMF head Rodrigo Rato:

Mr Rato said the credit squeeze was a “serious crisis” that was not over yet and would curtail growth worldwide.

“Policymakers should not think that the problems will stay at the desk of the bankers,” he said. “Problems are going to come to the real sector, come to the budgets – that is something we keep telling people.”

Bad news too for readers in London, with a survey (not online but reported here) predicting 6500 net job losses in the City next year. Bonuses will be down 16% - so bad news too for people like Olivier Millex, ING's head of yacht finance, who may have fewer customers. (Yes, that is a real job. Read the link.)

An interesting sidenote in the survey - London's growth is expected to suffer from the post-Olympic lull in Beijing. I'm not surprised that such a thing exists: it's due to start in January, at least for Chinese builders, because the city government has banned all construction in 2008 not related to the Olympics in an effort to clean up the city. London is then expected to start seeing its own Olympic boom in the leadup to 2012. The survey stops there - but is London, too, set for a post-Olympic lull? Given how much Olympic infrastructure will not be productively used after the games finish (I can't see much coming of the enormous velodrome, for example) we could be in for a big debt plus "broken window spending"- driven slowdown. Any work been done on the economic impact of the Games?

And finally, from the FT again - Citigroup is shifting some of the leveraged loans off its balance sheet. How? It's selling them to KKR. Where's KKR getting the money? It's borrowing it from Citigroup. So Citi is swapping exposure to a bunch of leveraged loans for exposure to KKR, which in turn is exposed to, er, exactly the same bunch of leveraged loans. But there is method to this: KKR's investors, not Citi, will take the first shock of a default. It'll also free up Citi's capacity and allow them to make - yes! - more loans. Hopefully slightly better ones.

It's spring in the Southern Hemisphere, and the spring issue of Risk Australia is now out - see here. For the first time, it included the Risk Australia Rankings. And while the top place was taken by Deutsche Bank, with Citi runner-up, local banks also made a strong showing: Commonwealth Bank of Australia (CBA), National Australia Bank (NAB), ANZ and Westpac came third, fourth, fifth and sixth respectively, and dominated the currency sector.

The awards were presented by Risk editor Nick Sawyer on September 25 at the Westin Hotel in Sydney. Our photographer was on the scene and the results are here (the morning session) and here (the awards). (Please feel free to browse through the photos and refer friends and colleagues to them - if you want to reproduce them, contact us first.)

The new issue of Risk will be available online (and in print) next week - check back here for Jayne Jung's account of how hedge funds' equity quant models went awry, the background to the (recently malfunctioning) hedge fund derivatives business, why banks are selling off their head offices, what to do with Fannie Mae and Freddie Mac, and what happened to the SIV market. Also special reports on equity derivatives and South Africa, and an interview with ISDA second-in-command George Handjinicolaou.
We'll also have the first in the new series of Class Notes (last seen in 2005) - Charles Smithson looks at the concept of economic capital.

Some lighter reading while you wait: long-standing econopessimist Nouriel Roubini announces "I Was Way Too Optimistic on the Housing Recession"; a look at predictions and reality on the US crisis... and (via Felix Salmon) the Wall Street Journal describes the travails of possibly-soon-to-quit Sprint Nextel CEO Gary Forsee, before writing:

A Sprint spokeswoman declined to comment. She said Mr. Forsee was traveling and couldn't be reached.

Modelling modern financial products is beyond the ability of regulators, Bill Gross says. "If the Fed was so slow to grasp the role that subprime mortgages played in the housing boom and bust, do the Fed and the Treasury of today totally comprehend what happens when the nonbanking private system suddenly stops flooding the market with credit? Do they recognize that such a shutdown puts spending for housing and business investment at risk, and job growth as well? The Fed will have to adapt its monetary policy, and the Bush Treasury will have to adjust its fiscal policy to this brazen new world dominated more and more by private rather than public policies..."
The problem is that the world now includes two banking systems - the traditional banks, which are (as always) open to the guiding hand of the Fed, and the "shadow banks" of the structured finance world, which aren't. The Fed is going to have problems...
Alan Greenspan, meanwhile, has turned against CDOs. "There's going to be some rethinking about collateralized debt obligations," he told a London conference today. "The pricing which in too many cases has been, by some model derivation, four times removed from actual market prices, just doesn't work.''

It's at times like this that one turns to consider the government debt market in 14th-century England. Adrian Bell and Chris Brooks at Reading University are studying the use of credit finance by the kings of England... "Evidence suggests that English monarchs were sub-prime borrowers, allegedly causing the Frescobaldi of Florence to suffer a 'run on the bank' at the turn of the 14th century. This arose precisely as a consequence of a lack of investor confidence due to the bank's loans to the unreliable Edward I, the then King of England." Should be interesting to read the final report...