Financial Arms of Mass Destruction (Part 2)

By Sean Hayes (Korea Times 01/08/09)

In last week's article I noted that ``Warren Buffett, who used to utilize credit-default swaps (CDS), called them financial weapons of mass destruction (WMDs). I love Warren Buffett and was a student of his every word during my pre-attorney stockbroker days, but blaming CDS for our present financial difficulties is as logical as blaming the Iraq War on oil or skin cancer on the sun."

The heart of our current difficulties was not `complex financial instruments but many governments the world over, particularly the American government, being hell-bent on distorting markets.

Their policies led to distorted interest rates and asset prices, loans to un-creditworthy borrowers and, eventually, the destruction of our markets.

The first culprit was Alan Greenspan and his serfs at the Federal Reserve. Since 2001, it has drastically increased the money supply while reducing the federal funds rate.

The drastic increase in the money supply led to the increased availability of credit, which overwhelmingly went into real estate. This Fed-induced, credit-fueled artificial demand led to an overheated real estate market and a drastic increase in the construction of new homes.

The dramatic decrease in the federal funds rate from 6.25 percent to 1.75 present led to a negative rate, in real terms. The interest rates were lower than the inflation rate, leading to more adjustable-rate mortgages (ARMs), since short-term interest rates were much lower than long-term interest rates.

The Fed-induced low short-term interest rates led to almost 40 percent of homebuyers choosing ARMs by 2004. When short-term rates began to climb and mortgages adjusted up, many of these new homeowners were unable to pay their mortgages.

The second culprit was a government that encouraged and even mandated the writing of risky mortgages. In 2006, over 23 percent of them were classified as ``nonprime.'' The vast majority included only a small down payment.

The culprits in the government include an administration that extended the Community Reinvestment Act and the Home Mortgage Disclosure Act, the Department of Housing and Urban Development, the Federal Housing Administration, and Fannie Mae and Freddie Mac.

The Community Reinvestment Act and related acts made it more difficult for lenders to receive acceptable bank ratings, which, after the amendments, were heavily influenced by how well a lender ``served'' low, moderate income and minority borrowers.

Without acceptable ratings, banks did not receive permission to merge or establish new branches.

Secondly, the Department of Housing and Urban Development (HUD) lowered payment requirements to only 3 percent. Many private lenders, in order to compete, followed suit. These low down payment mortgages were some of the first to fail.

The Department of Housing and Urban Development also strong-armed lenders to offer loans to ``nonprime'' borrowers by suing lenders who declined higher percentages of minority applicants, leading to many lenders not only evaluating credit risk but evaluating lawsuit risk.

Finally, Fannie and Freddie Mac grew to hold over half of the U.S. mortgage market. HUD set ``affordable housing'' goals; 52 percent of borrowers had to be below-median income earners.
Institutional investors were more than willing to feed these goliaths since they had the implicit guarantee of the U.S. government.

Many in D.C. tried to reign in on them but they had the strong backing of some of the most powerful people in Washington, including our usually regulation-friendly Barney Frank, chairman of the House Financial Services Committee, who strongly opposed plans to monitor Fannie and Freddie Mac, noting that the agencies ``are not facing any kind of financial crisis … The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''

He added, in a House hearing, that ``there has been more alarm raised about potential unsafety and unsoundness than, in fact exists … I want to roll the dice a little bit more in this situation toward subsidized housing.''

Hopefully, we can give credit where credit is due and learn, as Professor Lawrence White has noted, that ``Cheap-money policies by the Federal Reserve system do not produce a sustainable prosperity. Hiding the cost of mortgage subsidies off-budget, as by imposing `affordable housing' regulatory mandates on banks and by providing implicit taxpayer guarantees on Fannie and Freddie Mac bonds, does not give us more housing at nobody's expense.''

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SeanHayes@ipglegal.com

Seoul Bar Association Implements Assessment of Judges

Seoul Bar Association announced that it will begin assessing 700 judges in almost all Seoul courts including Seoul High Court, Seoul Administrative Court, Seoul Family Court, and all Seoul district courts.

The results, according to the Seoul Bar Association, will be kept confidential. A report on the outcome of the evaluations will be given to the Supreme Court. However, the Seoul Bar Association noted, according to Law Times, that the evaluations could be made public if the evaluations are not reflected in judicial evaluations conducted by the Supreme Court next February.

I was quoted by Asian Legal Business as being opposed to the plan.

But there are several problems this poses for the judiciary, said Sean Hayes, a lawyer at Logos Attorneys at Law and the only foreign lawyer to be hired by the Korean Constitutional Court. Hayes said that evaluations may put pressure on the decisions of the judge, especially in a criminal case which could sway the decision towards a more defendant-friendly sentence.

"Korean lawyers often get paid based on contingency fees, even in criminal cases. So a judge might be perceived as a good judge when that judge rules in favour of defendants, since lawyers are getting paid based on the outcome of the case."

Hayes noted that Korean sentences are very low compared to other developed nations. The issue is also surrounded by cultural dilemmas. Korean judges are often younger than the lawyers, since a Korean lawyer begins their career as a judge and then turns to private practice. Hayes questions whether the evaluation program will
have a significant effect, but maintains that the integrity of the judge's decision should be upheld.

"Order is something that should be kept. Sometimes a judge needs to be tough, especially a younger judge. I don't know if this will have a huge effect. But there will be certain judges red-flagged for bad reasons, for example being victim friendly, which could cost practising lawyers money."

KIKO: Injunction Granted Against SC First Bank

A Korean law firm has won a bellwether case (injucntion granted) for two medium- sized Korean companies with combined losses of over $21 million in KIKO contracts. Hundreds of other cases are in the pipeline.

The Seoul Central District Court issued a preliminary injunction holding that "The bank has not met its obligation to recommend additional measures to limit loses . . . and to clearly and sufficiently explain possible risks in the contracts." The preliminary injunction frees the companies from their obligations under the contract until the final ruling. The final ruling is unlikely to conflict with the injunction based on the strong language used by the court.

Knock-in Knock-out (KIKO) contracts are currency option contracts. The knock-in or knock-out events are tied to certain currency levels and are utilized by mainly exporters.

These option contracts were aggressively sold to small and medium size (SMEs) enterprises. These banks encouraged exporters to hedge against a stronger won, since it was nearly universally believed that the Korean currency would continue its appreciation against the dollar.

However, the won weakened to nearly 1,500 to the dollar from a level of less than 1,000 to a dollar. The won on January 2, 2009 was trading at 1,330 won to the dollar.

The final outcome of these cases will have great implications for the Korean banking sector, because of the amount of money in contest and the manner in which financial products are marketed.

A translation of the injunction decision can be found on this blog HERE.http://http://www.thekoreanlawblog.com/2009/01/kiko-win-by-logos-law-llc-against-sc.html

Financial Arms of Mass Destruction

Financial Arms of Mass Destruction (1)
By Sean Hayes (Korea Times 1/1/2009)

Warren Buffett, who used to utilize credit-default swaps (CDS), called them ``financial weapons of mass destruction (WMDs)."

I love Warren Buffett and was a student of his every word during my pre-attorney stockbroker days, but blaming CDS for our present financial difficulties is as logical as blaming the Iraq War on oil or skin cancer on the sun.

The $55 billion CDS market is certain to be regulated, since they are perceived by the vast majority of the public as the very epicenter of our problems and the cause for the spread of U.S. difficulties overseas.

This perception is far from the truth and probably originated from a fear and anathema, in America and throughout much of the world, of everything even remotely considered ``complex.''The CDS derivative market, however, is not the heart of the problem and if we leave the math out of it, is even not so complex.

For us to learn from our mistakes we need to put the credit where the credit is due and not vilify poorly understood financial tools.

The blame must be placed on our government; a government that was determined to facilitate the extension of every imaginable type of home loan to the most unqualified of borrowers.CDS, in essence, are nothing more than insurance policies on bonds and securities. CDS are not, as often noted, ``some kind of speculative wager by people who are betting money they don't have, it's an orderly process that provides a credit insurance to a market that uses it and needs it'' as stated by Prof. Roy Smith from NYU Stern School of Business to Reuters at the end of last month.

For example, at the end of 1997, JP Morgan pooled over 300 loans worth over $9.5 billion and cut the loans into different slices (tranches).

JP Morgan then sold the riskiest 10 percent tranche to investors. The tranche was entitled the Broad Index Securitization Trust Offering (Bistro).Most of the underlying loans were to financially secure companies such as IBM and Wal-Mart. Therefore, even Bistro was considered, by most, a safe investment.

The reason for the creation of this financial instrument was to increase liquidity in the credit market. Banks, because of government regulations, were mandated to reserve a percentage of their capital.Banks wishing to free up this reserve capital created CDS. These CDS were sold to investors, thus the third party investor would assume the risk of default, in exchange for regular payments from the banks.

The banks were able to free their books and thus were able to lend more.The problems in the CDS markets began when mortgages went south, not by ``complex'' financial instruments such as derivatives and securities, but the same bone-headed government that intends to fix these troubles with more regulation.

The government, hell-bent on distorting our markets, created distortions that motivated all to ignore market realities, which led to loans to credit unworthy borrowers.These market distortions were caused by the Federal Reserve, the unmitigated backing by Congress of Fannie Mae and Freddie Mac, the Federal Housing Administration loosening of down-payment requirements, the strengthening of the Community Reinvestment Act, and the Department of Housing asserting pressure on lenders to lend.

Without the government's hand in the markets few would have ever known, or even questioned, the soundness of these financial tools.