Interbank lending woes or...

Derivatives Traders Signal Bank Woes Likely to Worsen (Update3)

By Liz Capo McCormick

June 4 (Bloomberg) -- Interest-rate derivatives traders are betting banks' difficulties obtaining cash to fund holdings and shore up balance sheets will worsen.

The difference, or spread, between the three-month dollar London interbank offered rate and the overnight index swap rate on contracts beginning in three months and trading now in the forwards market is greater than spreads on those starting this month, according to data tracked by Credit Suisse Holdings Inc.

``The movement in the forward Libor-OIS spreads is telling you that the market is concerned that things can get even worse before they get better,'' said Carl Lantz, an interest-rate strategist in New York at Credit Suisse, one of the 20 primary dealers of U.S. government securities that trade with the Federal Reserve. ``Until all banks' balance sheets are cleaned up and they've re-capitalized, there is going to be funding pressure.''

Derivatives trades show that while global markets have rebounded since March, the worst may not be over for banks after racking up $387 billion of losses and writedowns from mortgage- related securities since the start of last year. Lehman Brothers Holdings Inc. has tumbled about 19 percent this week on concern it needs outside funding to shore up its balance sheet.

The three-month Libor-OIS spread traded forward to June 16, the date the June Eurodollar futures contract expires, is 68.5 basis points, while the forward spread corresponding to the September Eurodollar expiration is 70 basis points, or 0.7 percentage point. Eurodollar futures are priced at expiration to three-month dollar Libor.

Availability of Funds

Overnight indexed swaps are over-the-counter traded derivatives in which one party agrees to pay a fixed rate in exchange for the average of a floating central-bank rate over the life of the swap. For U.S. dollar swaps, the floating rate is the daily effective federal funds rate.

The difference between Libor, which is an average rate based on a daily survey of 16 banks by the British Bankers' Association, and the OIS rate indirectly measures the availability of funds in the money market. Forwards give expectations for the future.

Wider Libor-OIS September spreads may reflect traders exiting ``soon-to-expire'' positions earlier than usual, given potential volatility in Libor amid questions over its veracity, according to Laurence Mutkin, London-based head of European fixed-income strategy at Morgan Stanley, another primary dealer.

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events, such as changes in the weather.

Widening Forward Spreads

The market has grown more pessimistic since April 30, when the September spread was 6 basis points less than June, according to Credit Suisse.

The spot three-month dollar Libor-OIS spread is 67 basis points today, after ranging from 24 basis points to 90 basis points this year and peaking last year at 106 basis points in December. The spread averaged 11 basis points for the 10 years prior to August, when the global credit crunch began.

Concern institutions are having difficulty accessing financing increased this week after Standard & Poor's lowered credit ratings for Morgan Stanley, Merrill Lynch & Co. and Lehman Brothers on June 2, citing the possibility that the investment banks will have further writedowns on devalued assets.

Lehman Options

Lehman, the fourth-biggest U.S. securities firm, may report this month its first quarterly loss since going public in 1994, increasing pressure on the company to raise capital, according to analysts at Oppenheimer & Co. and Bank of America Corp. Lehman may be forced either to sell all or part of itself to a bigger financial firm or sell a large quantity of new shares to bolster its finances, the Wall Street Journal reported today.

Options trading shows bearish positions on Lehman exceeded bullish ones by 1.6-to-1 yesterday, a two-month high. The cost of protecting debt sold by Lehman from default rose to 240 basis points from 150 basis points in the credit-default swaps market during the past week, data compiled by UniCredit SpA show.

The British Bankers' Association has been under fire since the Bank for International Settlements said in March the banks that set Libor understated their borrowing costs to avoid speculation they were in financial straits as losses in credit markets mounted.

Libor Oversight

The London-based BBA completed a review of Libor on May 30, saying it will strengthen ``oversight'' of the system. Details will be revealed ``in due course,'' it said.

Three-month Libor-OIS forward spreads through December maturities are in line with each other, indicating the problems with Libor will be longer lasting, according Mustafa Chowdhury, head of U.S. interest-rate research in New York at Deutsche Bank AG, also a primary dealer.

``Instead of being an immediate bank-liquidity problem, Libor is now being affected by a longer-term capital problem,'' Chowdhury said. The market ``had previously expected the liquidity problems that had boosted the Libor-OIS spread to dissipate relatively quickly.''

The Libor-OIS forward spread that corresponds with the Dec. 15 Eurodollar futures expiration date was 67.5 basis points.

Getting creative in accounting -- Decrease in expected liabilties --> Gains (booked as profit)

Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math

By Bradley Keoun

June 2 (Bloomberg) -- Leave it to Wall Street to profit from its own distress.

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

The new math, while legal, defies common sense. Merrill, the third-biggest U.S. securities firm, added $4 billion of revenue during the past three quarters as the market value of its debt fell. That was the result of higher yields demanded by investors spooked by the New York-based company's $37 billion of writedowns from assets hurt by the collapse of the subprime mortgage market.

``They can post substantial gains as a result of a decline in their own creditworthiness,'' said James Cataldo, a former director of treasury risk management for the Federal Home Loan Bank of Boston and now an assistant professor of accounting at Suffolk University in Boston. ``It's completely legitimate, but it doesn't make sense by any way we currently have of thinking of net income.''

The paper profits have helped offset more than $160 billion of writedowns taken by U.S. financial-services companies during the past year. Now some investors and analysts say the winnings are illusory and may have to be reversed.

``The piper will have to paid eventually,'' said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst who left the New York-based firm earlier this year to become an independent consultant.

Statement 159

The debate over what is known as Statement 159 adds to the number of accounting techniques called into question as the U.S. debt market unravels. Investors have criticized banks for booking some writedowns in an accounting category called ``other comprehensive income'' that bypasses their income statements. Accounting rulemakers are now proposing changes to standards that let banks use off-balance-sheet vehicles to juice earnings without tying up precious capital.

Statement 159, formally known as the ``Fair Value Option for Financial Assets and Financial Liabilities,'' was issued in February 2007 by the Financial Accounting Standards Board, or FASB, which sets U.S. accounting rules. It was adopted by most large Wall Street firms in the first quarter of last year and becomes mandatory for all U.S. companies this year, although they have wide latitude in how to apply it, if at all.

Lobbying Effort

The rule was enacted after lobbying by New York-based companies, led by Merrill, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup, which wrote letters to FASB arguing that it wasn't fair to make them mark their assets to market value if they couldn't also mark their liabilities.

``We do not believe it would be appropriate'' to let investors consider creditworthiness when valuing bonds if the issuing company couldn't do the same, wrote Matthew Schroeder, managing director of accounting policy at Goldman, the largest U.S. securities firm by market value, in an April 2006 letter.

Companies are allowed to decide for themselves which of their outstanding bonds, loans and other liabilities will get mark-to- market treatment. That's an unprecedented degree of leeway, said Willens, who is also an adjunct professor at Columbia University in New York.

``It's kind of a dumb rule,'' Willens said. ``In the entire panoply of accounting, this is the most flexible and elective and optional rule that we have.''

The Fed Objects

Here's how it works, according to Richard Bove, an analyst at New York-based Ladenburg Thalmann & Co. A company decides to designate $100 million of its subordinated bonds as subject to mark-to-market accounting. The price of the bonds drops to 80 cents on the dollar from 100 cents. So the firm books $20 million on the ``presumed savings that you have on your liabilities,'' Bove said.

``In the real world you didn't save a dime,'' he said. ``You still owe the $100 million. It's another one of these accounting rules that basically takes you further and further away from reality.''

The Federal Reserve, Federal Deposit Insurance Corp., Office of the Comptroller of the Currency and Office of Thrift Supervision objected to the rule before its passage, saying in a joint 2006 letter to the FASB that it would ``have the contrary effect'' of increasing a bank's net worth at the same time its ``financial condition is deteriorating.''

Split at FASB

The regulators remain so skeptical that they refuse to let banks apply the phantom revenue toward minimum capital requirements, according to reporting rules posted on the Web site of the Federal Financial Institutions Examination Council. Deborah Lagomarsino, a Washington-based spokeswoman for the Federal Reserve, declined to comment.

Not even the FASB was united on the new standard. Two of its seven board members -- Thomas Linsmeier and Donald Young -- voted against it, according to the February 2007 statement. Linsmeier said the rule ``will provide an opportunity for entities to report significantly less earnings volatility than they are exposed to,'' according to the statement.

The FASB tried to limit abuses by forcing companies to designate their ``fair value'' liabilities when they adopt the new standard. Subsequently, they can't change their minds. Liabilities added after adoption can only be designated at inception.

``The statement was thoroughly discussed with users and preparers'' in advance of its publication, said Neal McGarity, a spokesman for Norwalk, Connecticut-based FASB. A March survey by the CFA Institute, a Charlottesville, Virginia-based group that administers a financial-analyst designation program, showed that 74 percent of investors believe the standard ``has improved market integrity,'' he said.

Merrill's Liabilities

Merrill designated about $166 billion of liabilities, or 17 percent of its total, as fair-value instruments subject to mark- to-market accounting at the end of 2007, according to its annual report. Included in the amount were $76.3 billion of long-term borrowings and $89.7 billion of payables under securities- financing transactions.

Prices for the firm's bonds tumbled over the past year: Its floating-rate notes due in January 2015 are trading at about 87 cents on the dollar, compared with about 100 cents last June.

Merrill has said its gains from the liabilities don't add to true earnings power. In a spreadsheet posted on its Web site, Merrill says that investors who want a ``more meaningful period- to-period comparison'' should exclude the $2.1 billion of revenue recorded in the first quarter.

Merrill spokeswoman Jessica Oppenheim declined to comment. The company owns a passive 20 percent stake in Bloomberg LP, the parent of Bloomberg News.

Lehman to Goldman

Lehman, the fourth-biggest securities firm, has reported $1.9 billion of gains related to a widening of its own bond spreads. Citigroup, the largest U.S. bank by assets, has booked $1.7 billion; Morgan Stanley $1.7 billion; JPMorgan Chase & Co., the third-biggest bank, $1.7 billion; and Goldman Sachs $550 million.

There may be more to come, JPMorgan analyst Kenneth Worthington wrote in a May 28 report. Lehman may book $325 million for the second fiscal quarter ended in May, and Morgan Stanley, the second-biggest U.S. securities firm, may report $470 million, Worthington estimates.

Spokesmen for Lehman, Morgan Stanley, Goldman, Citigroup and JPMorgan in New York declined to comment.

`Shell Game'

So far, most banks' writedowns are ``unrealized,'' meaning they've been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.

The same is true for the liabilities. Companies can't ``realize'' the mark-to-market gains on their debt unless they buy it back at the discounted price. They're unlikely to do so, because the deterioration in creditworthiness means they'd have to replace the debt with higher-cost borrowings, Willens said.

``No one's going out in the market and actually retiring this debt,'' Willens said. ``It's a shell game.''

David Moser, Merrill's managing director for accounting policy, acknowledged that concern in an April 10, 2006, letter to the FASB.

``It seems counterintuitive that when a company's credit spreads are widening, it would recognize a gain in earnings,'' Moser wrote. ``The amounts are typically not realizable and therefore less relevant.''

He nevertheless supported the new accounting standard because it ``mitigates some of the uneconomic volatility in earnings'' that results from marking assets to market without doing the same for liabilities.

Market Reversal

Bear Stearns Cos., which adopted the new standard this year, reported a $305 million windfall in the fiscal first quarter, which ended in February, as bond spreads widened on concerns the company might face a funding shortage. Then in March, after the New York-based securities firm was forced to sell itself to JPMorgan, Bear Stearns's bond spreads tightened, resulting in a $372 million loss, according to a regulatory filing in April.

Worthington estimates that similar tightening of bond spreads at Merrill, Morgan Stanley, Lehman and Goldman Sachs may cause them to reverse $5.96 billion of revenue by the end of the year.

``It could very well hurt earnings,'' said Jeffery Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, in an interview. On the flip side, a recovery may result in asset write- ups, he said.

Standard & Poor's, which relies on banks' financial statements to issue credit ratings, said in April 2006 that the new rule might lead to ``diminished analytical transparency.''

``Equity may be overstated as a result of these illusory gains that may never be realized, hindering the analysis of the equity cushion to absorb losses,'' S&P Chief Accountant Neri Bukspan wrote in a letter to the FASB.

If and when the ``illusory'' revenue is reversed as losses, the banks and brokers may have to work harder to convince investors to ignore them, Willens said.

Lying about LIBOR

Libor Cracks Widen as Bankers Struggle With Reforms (Update2)

By Gavin Finch and Ben Livesey

May 27 (Bloomberg) -- Few companies have suffered from the subprime mortgage collapse more than UBS AG, which has taken $38 billion of writedowns and losses, replaced its chief executive officer and chairman and saw its stock tumble 60 percent.

Yet on 85 percent of the days between July and mid-April, the Zurich-based bank told the British Bankers' Association that it could borrow in the money markets at lower interest rates than its rivals. Not even the U.K.'s Lloyds TSB Group Plc, which only wrote down $1.4 billion, could obtain the rates UBS said it was able to get, according to data compiled by Bloomberg.

``Even when the market knew UBS was massively exposed and Lloyds wasn't, that was not reflected in Libor,'' said Antony Broadbent, an independent banking consultant and former analyst at Sanford C. Bernstein & Co. in London.

Such discrepancies are creating a crisis of confidence in the London interbank offered rate published daily by the London- based BBA and taken from the contributions of UBS, Lloyds TSB and 14 other banks. Rates on corporate bonds, leveraged buyouts loans, derivatives and even U.S. mortgages are pegged to Libor.

The criticism has prompted the BBA to accelerate a review of the 24-year-old system of setting rates. The findings, due May 30, may determine how fast the banking industry recovers from the credit crisis.

`People Get Hurt'

``You've got to fix Libor,'' said Tim Bond, head of asset allocation strategy in London at Barclays Capital, a unit of Barclays Plc, one of the banks that provide quotes to the BBA. ``You don't ever want to be in a situation like this again, where people can get away with quoting whatever rate they like. Real people get hurt like this.''

Libor is a benchmark for about $350 trillion of debt- related securities and derivatives, according to the Bank for International Settlements in Basel, Switzerland. The rate that San Antonio-based AT&T Inc., the biggest U.S. phone company, pays on $2 billion of notes it sold on March 27 floats at three- month Libor plus 0.45 percentage point.

``Libor is baked into the global financial system,'' analysts at JPMorgan Chase & Co. led by Terry Belton, global head of fixed-income and foreign-exchange research, wrote in a May 16 report. ``The question of whether a benchmark could be designed that is less flawed than Libor is debatable; whether such a benchmark could effectively replace Libor is not.''

Libor Exposed

Every morning the BBA, an unregulated trade group, asks member banks how much it would cost them to borrow from each other for 15 different periods, from overnight to one year, in currencies from dollars to euros and yen. It then calculates averages, throwing out the four highest and lowest quotes, and publishes them at about 11:30 a.m. in London. Three-month dollar Libor was set at 2.64 percent today.

Libor was thrust into the spotlight in August as the subprime-mortgage contagion spread and banks were suddenly wary of lending to each other because of mounting losses that reached $383 billion as of last week, data compiled by Bloomberg show.

Three-month Libor soared to 2.40 percentage points above yields on Treasury bills on Aug. 20, the widest margin since December 1987 and up from 0.39 percentage point a month earlier. The figure was 0.80 percentage point today.

The credit crisis exposed Libor's flaws, according to Peter Hahn, a London-based research fellow for Cass Business School and a former managing director at Citigroup Inc. That's because the BBA publishes the names of contributors and their rates, giving lenders an incentive to underestimate borrowing costs to keep from appearing like they are in financial straits.

Rates `a Lie'

In the first four months of 2007, the difference between the highest and lowest rates for three-month Libor didn't exceed 0.02 percentage point, according to JPMorgan. In the same period this year, it was as wide as 0.17 percentage point.

The BIS said in a March report that some lenders may have ``manipulated'' rates. Strategists such as Bond at Barclays went as far as calling the reported rates a ``lie.''

The BBA said on April 16 that any member deliberately understating rates would be banned. The cost of borrowing in dollars for three months rose 0.18 percentage point to 2.91 percent in the following two days, the biggest increase since the start of the credit squeeze in August.

Lesley McLeod, a BBA spokeswoman in London, would only say the association's review is ``ongoing'' and a ``robust process.''

Libor would be more reliable if banks offered rates anonymously, removing the stigma of appearing like they are having trouble accessing capital, said Bond at Barclays.

More U.S. Banks

For Brian Yelvington, a strategist at bond research firm CreditSights Inc. in New York, the solution is for the BBA to insist on proof that the rates quoted are based on real transactions. That way, there would be ``no way to hide since it goes from being a poll of sorts to a confirmed trade,'' he said.

The discrepancies wouldn't have been so pronounced if Libor were set at 10 a.m. New York time, making it less skewed toward Europe, JPMorgan wrote May 16. Only three U.S. banks contribute rates to the BBA: Citigroup, Bank of America Corp. and JPMorgan.

Any changes may be little more than cosmetic as a wholesale restructuring would disrupt the global financial system, said Barry Moran, a money-market trader at Bank of Ireland in Dublin.

``But the last thing you want to be doing in the middle of a financial crisis is implementing massive changes in the way the world's benchmark rate is set,'' Moran said.

UBS, the world's biggest wealth manager, and Lloyds TSB, the U.K.'s largest provider of checking accounts, underscore the wide range in rates quoted to the BBA since July.

HSBC, RBS

UBS's three-month offered rate in dollars averaged 1.3 basis points less than Libor from July through April 15. By contrast, Lloyds TSB quoted rates that were 0.04 basis point above Libor on average. A basis point is 0.01 percentage point.

In that period UBS ousted Peter Wuffli, 50, as chief executive officer after subprime-related losses at a hedge fund run by the bank, and Chairman Marcel Ospel, 58, who helped form UBS through a merger a decade ago, stepped down. UBS has slumped to 25.84 Swiss francs in Zurich from last year's high of 77.05 francs on Feb. 9, 2007. Dominik von Arx, a UBS spokesman in London, declined to comment.

HSBC Holdings Plc, Europe's largest bank by market value, gave rates that averaged 1.4 basis points less than Libor. The London-based bank has taken $19.5 billion in writedowns and charges. Royal Bank of Scotland Group Plc, the U.K.'s second- biggest bank, submitted rates that averaged 0.9 basis point below Libor. It has reported $15.3 billion in losses and writedowns.

HSBC spokesman Patrick McGuinness in London and RBS spokeswoman Carolyn McAdam in Edinburgh declined to comment.