The BIS put out its annual report today - the full version is here (pdf, 260pp) and a five-page summary here. Malcolm Knight, the bank's CEO (last day today!) gave a speech about it - text here.

So, UBS is being sued in Massachusetts over mis-selling auction rate securities. We wrote about the ARS market in relation to the Jefferson County business and the big multi-state enforcement push in April.

And there's this profile of the prosecutor in the Bear Stearns fund case.

Also, the SEC has decided to start distrusting credit ratings. (join the club)

...thanks to Calculated Risk which links to this rather worrying graph - while the TED spread (of which we have heard before) starting to rise again. Caution, though - it's still only just above 1.0, well below crisis peak levels.

Meanwhile, the Fed is in something of a dilemma; it could lower rates, thus increasing the risk of inflation, or raise them and deepen a recession. It has therefore chosen masterly inactivity.

The Federal Open Market Committee left its benchmark rate at 2 percent yesterday and said ``upside risks'' to prices have picked up. The statement also said consumer spending is ``firming,'' while acknowledging that rising energy prices will curb growth into 2009.

The FOMC cited ``the elevated state'' of some measures of inflation expectations and dropped an April forecast of a ``leveling out'' in commodity prices. The officials want to keep their options open on rate changes in case the credit crisis worsens and the economy deteriorates after consumers spend their tax rebates, Fed watchers said.

Hauled up before Congress on Monday, CFTC chairman Walter Lukken seems to be adding his weight to the anti-speculator movement - citing "public concern" about commodity index future trading, especially in the energy market, he's promised a report by September 15 on the extent of this practice and "recommendation for improved practices and controls".
This is, of course, all about the oil price. The FT quotes one senior congressman uttering the immortal cry "Something must be done. This is something, therefore let us do it":

Speculative trading is being blamed by many politicians for the rise in the price of crude oil, which in turn has caused the price of petrol in the US to rise above $4 a gallon.
"Make no mistake about it, the excessive speculation in commodity markets is having a devastating effect at the gas pump that is rippling throughout our entire economy," said Bart Stupak, the Michigan Democrat who chairs the committee's oversight and investigations panel.
"If we do not act now with swift diligence, we risk having our economy brought to its knees."

The latest Risk VAR survey will appear in the next issue of the magazine - here are the previous surveys from February this year, January this year and August 2006.

In the meantime, Chris Finger at Risk Metrics comments on the SSG report:

Before refrigeration, what did you do if you wanted ice cubes in your drinks? You used an ice-house - a well-insulated hut which you filled with blocks of ice cut from a nearby lake or river during winter, and then drew on during the summer - or an icebox, a fridge-sized version of the same.
What if you lived somewhere (like Bengal) where there wasn't a nearby source of ice at any time of year? You imported it by the ton. From Boston.

Apparently this trade made sense - it continued for decades. Possibly relevant today, in the light of plans to retrofit oil tankers to haul fresh water around the world.

Which leads fairly neatly on to the extraordinary story of the late Saudi wheat industry . (via Aqoul)...

There's copious praise for Goldman Sachs today, Wall Street's "shiniest sausage machine", from the FT's Lex.

No, the bank hasn't started its own proprietary trading platform for pork bellies. Instead, it made $2.09 billion in its second-quarter results yesterday. That's down 11% on last year, but in the context of shockingly poor performances across the rest of the Street, not bad.

Lex notes:

Goldman made just less than $20 in net revenue from its fixed income, currency and commodities and equities trading businesses for every $1 of net VAR exposure – down almost 30 per cent quarter-on-quarter and down 45 per cent on the average for the previous 12 months.

Part of this is beyond the bank's control, of course. VAR models are reactive to recent market conditions, as historical data is used to calibrate them. So when markets were placid last year, some risk managers complained that VAR models were understating risk. Conversely, with market volatility now much higher in most cases, some say VAR models may well be overstating it.

Nonetheless, some bankers say these changed market conditions have led to increasing pressure upon them to reduce risk across business lines. But the way VAR models calculate risk means this too can lead to perverse incentives.

One London-based senior currency options trader recently mentioned an example to me involving credit prices and the level of the dollar-yen exchange rate. As recollected in Risk during May, yen carry trades were particularly popular among hedge funds before the credit and liquidity crisis took hold last year. As many funds looked to reduce risk in its wake by buying back yen, the Japanese currency began on an upward trend against the dollar while credit prices tumbled. If this correlation were taken into account in VAR models, he asserted, bank risk managers could look to, say, offset group-wide long credit exposures by buying the yen against the dollar.

There will be more on the potential problems with VAR in July's edition of Risk. Meanwhile, as you ponder the voluminous tributes to Goldman Sachs in the press, you might also want to consider the reported layoffs.

Mark Pengelly is blogging while Alexander Campbell is away.

Closing at $22.70 today, Lehman stock is now plumbing levels not seen since October 2002.

Having recorded its first quarterly loss (of $2.8 billion) since it went public in 1994, the bank's been fending off worries that it might become the next major dealer to collapse as a result of the credit crunch. As Alexander Campbell reported in Risk during April:

Lehman Brothers pursues a similar business model to Bear Stearns, with sizeable exposure to US mortgages...

The bank has just sold $6 billion in new capital, comprising $4 billion in common stock and $2 billion in mandatory convertible preferred stock.

Meanwhile, the axe has fallen on president and chief operating officer, Joseph Gregory; along with chief financial officer Erin Callan. Although according to a statement from Lehman, Callan "will be rejoining the Investment Banking Division in a senior capacity". I'm sure investors will be breathing a sigh of relief at the news.

Lehman's cash injection and management reshuffle come on the back of another poor result for the firm earlier this week: on the lacrosse field, where they got whacked 11-4.

I'll leave it to you to find out who beat them.

Mark Pengelly is blogging while Alexander Campbell is away.

As Peter Madigan writes, Ambac and MBIA have finally joined peers ACA, FGIC and SCA, and succumbed to a downgrade by the rating agencies.

I'm sure I needn't go over the story of the monolines one more time; it's no doubt something regular readers of Risk will be thoroughly familiar with by now. Since it began with the onset of the subprime crisis last year, the monoline story has touched a wealth of asset classes -- from municipal credit, to inflation, and even life insurance securitisation.

It's also been keeping the lawyers busy, although perhaps fewer from today: Merrill Lynch has reportedly won a summary judgement from a US federal judge over SCA's failure to pay guarantees covering $3.1 billion of collateralised debt obligation (CDO) tranches. SCA's subsidiary, XL Capital Assurance, had argued the bank failed to honour a commitment giving it exclusive control rights over the tranches of CDO notes it insured -- making its guarantees null and void. More background on the story here.

Among the reasons it downgraded Ambac and MBIA, S&P notes "diminished public finance and structured finance new business flow". An interesting counterpoint came up while I was thumbing through yesterday's FT, in a letter from Jeremy Hosking, of Marathon Asset Management:

The inference that the bond insurance firms are not "going concerns" or that a Triple A rating is a business requirement for sales seems to ignore the abundant number of companies which do not innovate but remain in business, or which remain solvent despite lower tiered credit ratings. The negative comment should be limited to the suggestion that the option of writing new business has been temporarily lost; after all, a company such as MBIA cannot sell a Triple A rating that it does not possess.

However, the business value of a bond insurer consists of two components, not one: the aggregate of the existing book of business plus the option value of the new business opportunity. MBIA will remain in business for many years in order to stand behind its existing guarantees, if and when they are triggered. We believe the net present value represented by this book of business substantially exceeds MBIA's market capitalisation and that, unlike many banks, there is no requirement on MBIA to issue additional equity capital based on regulatory rules, rating agency opinions and unproven mark-to-market security values.

Mr. Hosking has his own reasons to be sanguine about MBIA's prospects, of course.

For more questioning of mark-to-market accounting, see here.

Mark Pengelly is blogging while Alexander Campbell is away.

Paul Krugman blows his own trumpet slightly as he resurrects a futurist piece he wrote in 1996. The conceit is that it's written in 2096, looking back...

When looking backward, you must always be prepared to make allowances: it is unfair to blame late-20th-century observers for their failure to foresee everything about the century to come...

The future, everyone insisted, would bring an ''information economy'' that would mainly produce intangibles...But even in 1996 it should have been obvious that this was silly...The billions of third-world families that finally began to have some purchasing power when the 20th century ended did not want to watch pretty graphics on the Internet. They wanted to live in nice houses, drive cars and eat meat...

Soaring Resource Prices

The first half of the 1990's was an era of extraordinarily low prices for raw materials. In retrospect, it is hard to see why anyone thought that situation would last. When two billion Asians began to aspire to Western levels of consumption, it was inevitable that they would set off a scramble for limited supplies of minerals, fossil fuels and even food...

The Environment as Property

... Today, of course, practically every environmentally harmful activity carries a hefty price tag... Once governments got serious about making people pay for pollution and congestion, income from environmental licenses soared. License fees now account for more than 30 percent of the gross domestic product, and have become the main source of Government revenue; after repeated reductions, the Federal income tax was finally abolished in 2043...

Krugman's five also include the rebirth of the big city, the devaluation of higher education and the birth of the celebrity economy. What other big trends would you add to the list? Ubiquitous surveillance, novel power sources and increasing longevity would be my picks.

"The future's already here", said William Gibson; "it's just unevenly distributed".

I'm off for the next two weeks, but the rest of the Risk team will be picking up the slack in my absence.

Ambac and MBIA, of course. The estimate of downgrades comes from Bloomberg.
(Moodys will no doubt follow suit soon.)

And the FT (among others) points out that weren't we all panicking about the apocalyptic consequences of a monoline downgrade back in Q1, and what about that then? Well, yes we were; and since then we've had the ARS shutdown . But there's an argument that the effect of the downgrade has already been priced in - in which case, yesterday's decisions simply emphasise how far behind the curve the rating agencies are.

Recently we covered the shutdown of the auction rate securities market here. Risk's Peter Madigan wrote:

The apparent explanation for the rapid seizing up of the market was the almost simultaneous decision by every auction agent to pull out of their back-stop role in taking unwanted securities on to their balance sheets. In the weeks that followed, broker-dealers have remained silent on why they chose to withdraw from the market, leading local authorities, saddled with significantly higher interest rates, to cite this as the latest example of Wall Street protecting itself at the expense of Main Street...

Trouble is, of course, with no ARS market, student loan companies are finding it difficult to keep distributing the loans they originate. Solution - stop lending so much. Specifically, stop lending to poor people.

Some of the nation’s biggest banks have closed their doors to students at community colleges, for-profit universities and other less competitive institutions, even as they continue to extend federally backed loans to students at the nation’s top universities...By splitting out community colleges and less-selective four-year institutions, some remaining lenders seem to be breaking the marketplace into tiers. Students attending elite, expensive, public and private four-year universities can expect loans to remain plentiful. The banks generally say these loans are bigger, more profitable and less risky, in part perhaps because the banks expect the universities’ graduates to earn more....

Now, according to Alea, there is a plan: a conduit set up with the support of the Treasury to buy student loan ARS and issue short-term commercial paper. Note that the underlyings (unlike mortgages!) have a 97% or 95% federal guarantee.
The two banks involved are Goldman Sachs and Lehman Brothers. (Treasury might want to think about a substitute, just in case.)

Unrelated interesting link: Inside a bank failure

The biggest problem with having non-engineers run things is their inability to speak proper English. "Redundancy" to an engineer is a good thing - it means taking precautions against failure. To a non-engineer it generally means "you are about to get fired". Mergers may lead to efficiencies of scale (though mostly they don't) but they also lead to banks which are "too big to fail" because the collapse of any one of them could bring down the financial system.

Nor is a tightly-integrated, fast-moving international network always a good thing - ask any epidemiologist about how (say) AIDS spread around the world.

The BIS is looking at this problem with regard to payment systems. In a paper published this week it warns that there could be problems with the payment and settlement system:

interdependencies have increased the potential for disruptions to spread quickly and widely across multiple systems.
To address the potential for a disruption to spread quickly to many systems, the report suggests that system operators, financial institutions, and service providers take several actions in order to adapt their existing risk management practices to the more complex, integrated environment resulting from tighter interdependencies...

The report's frustratingly light on actual recommendations (especially given its 84 page length!) but with any luck its presence in the BIS bully pulpit will lead to something more concrete soon.

Meanwhile, this analysis (subscriber only, but presented here)
on the effects of capital levels and connectivity on stability. The model predicts thresholds beyond which more connections actually help stability rather than spreading contagion. Of course translating that into real-world policy will be tricky.
Worth a read.

No changes to Libor, according to the BBA - apparently there wasn't that much of a need for reform after all. This from the Wall Street Journal blamed "Citigroup Inc., WestLB, HBOS PLC, J.P. Morgan Chase & Co. and UBS AG" for reporting falsely low borrowing rates and skewing Libor down. Defending Libor are Alea and Felix Salmon.
The FT isn't happy, writing "...some officials hoped this might quell the current controversy about this crucial daily benchmark of money market behaviour.

Such hopes, however, seem naive. For while the BBA might have backed away from radical reform, unease about this benchmark remains high – not least because money market tensions are continuing to plague the system.

Consequently, bankers are now watching to see whether these frustrations will prompt some institutions to actively press ahead with creating alternatives to the BBA measure..."