Tuesday, June 26, 2012

Moody's down-grades 15 banks

On June 21, 2012, Moody's has downgraded 15 financial groups with global capital markets operations.


The central reasoning for the above down-gradings of the financial institutions is their capital market activities and, thereby, their significant exposure to the volatility and risk of outsized losses, i.e tail risk.

More specifically, Moody’s analysis is carried out in 3 major steps:

1. Appreciation of standalone credit worthiness

According to Moody’s methodology, the standalone credit worthiness of a financial institution depends on 6 key factors:

  • Size of capital markets activities: Both relative and absolute sizes count here. Firms that have a particular high portion of capital market revenues as compared to its total revenues include Barclays (40 %), Crédit Suisse (53 %), Deutsche Bank (54 %), Goldman Sachs (87 %), and Morgan Stanley (52 %).
  • Volatility of firm-wide earnings (incorporating earnings from non-capital markets businesses): Firms showing a particularly high volatility of earnings include Crédit Suisse (roughly 600 %), UBS (700 %), Citigroup (700 %), and Royal Bank of Scotland (700 %).
  • Size and resilience of shock absorbers such as pre-tax earnings, capital buffers, retail and commercial banking franchises, global wealth management or asset management businesses, and specialized businesses such as payment services and transaction processing.
  • Relative strength and or weakness of funding profiles: Moody’s analyzes the degree to which a firm relies on wholesale funding, the firm’s liquidity position (namely the average maturity of its liabilities), the firm’s net stable funding ratio (= core funding / illiquid assets), and the firm’s absolute wholesale funding requirements. To give an example, Moody’s points out that the major French banks BNP, Crédit Agricole, and Société Générale have, compared to their major competitors, a relatively weak funding position as their net stable funding ratios are 75 %, 79 %, and 79 % respectively 
  • Exposure to the ongoing Euro crisis and the weak European operating environment
  • Other considerations such as legacy assets, risk management and control, and strategy

2. Appreciation of systemic government support

In a nutshell, Moody’s considers that government support is likely to become less certain and predictable over time, due to ongoing regulatory reform projects in many developed countries. As a matter of fact, the analysts identify a tendency towards more flexibility and limited support in a stress scenario.

However, the rating agency also recognizes that today’s weak economic environment makes many countries still stick to governmental support schemes for its financial sector.

3. Appreciation of firm-specific considerations

In this section, Moody’s applies the above criteria to each financial institution and assesses the criteria in favor of a rating downgrade against any mitigating elements.


  • Moody's Press Release – Moody's downgrades firms with global capital markets operations – June 21, 2012
  • Moody's Special Comment – Key Drivers of Rating Actions on Firms with Global Capital Markets Operations – June 21, 2012

Friday, June 15, 2012

The OPEC Intergovernmental Organization

Holding its bi-annual conference in Vienna on June 13, 2012, OPEC has been pretty much in the news in the last days. In light of dramatically falling oil prices, the member states are discussing about the output level of its member states, more specifically the question whether they are producing too much crude oil. In addition, the countries are worried about potential falling crude oil demand due to the Eurozone sovereign debt crisis and a slowdown in economic growth in China and India.

“[...] the Conference decides to form a permanent Organization called the Organization of the Petroleum Exporting Countries, for regular consultation among its Members with a view to coordinating and unifying the policies of the Members […].“

OPEC is a permanent intergovernmental organization of oil-exporting countries founded by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Its headquarters are located in Vienna. The founding conference was held from September 10 – 14, 1960 in Baghdad, upon invitation of Iraq.

It has currently 12 member states.

According to the OPEC agreement, the reasons for the foundation of OPEC were the following:

  • Importance of petroleum income for the member states' budgets, namely the financing of their development programs;
  • Importance of oil price fluctuations not only for the member states' economies but also for the consuming nations' economies;
  • Character of petroleum as a wasting asset and the necessity to replace it in the future by other assets that follows from this characteristic.

As per resolution I.2.4 of the OPEC agreement, „the principal aim of the Organization shall be the unification of petroleum policies for the Member Countries and the determination of the best means for safeguarding the interests of Member Countries individually and collectively“.

More specifically, the resolutions passed by the OPEC member countries specify 6 goals for OPEC:

  • Counter oil price modifications effectuated by oil companies and maintain steady oil prices, free from unnecessary fluctuations.
  • Ensure the stabilization of oil prices, namely through the regulation of production.
  • Secure a steady income to the oil producing countries.
  • Secure an efficient, economic, and regular supply of oil to consuming countries.
  • Guarantee a fair return on capital to those investing in the petroleum industry.
  • Upon unanimous decision of the OPEC conference, every member country shall show solidarity with a member country which sees itself sanctioned by an oil company.


  • Agreement concerning the creation of the Organization of Petroleum Exporting Countries (OPEC) dated September 14, 1960
  • OPEC Statute 2008
  • Financial Times, „Opec’s price hawks press Saudis on output”, June 12, 2012
  • Financial Times, „Opec warns of risks facing oil demand“, June 13, 2012

Friday, June 8, 2012

The TNK-BP Joint Venture and its Confidentiality Dispute

The dispute

As reported by the financial press, BP intends to sell its stake in the TNK BP joint venture which displeases its partner AAR. AAR claims the violation of its existing shareholder agreement with BP which, according to AAR, does not allow to give any confidential information about the joint venture to third parties.

AAR Advisory Board members Leonard Blavatnik, Mikhael Fridman, and Viktor Vekselberg

AAR Advirsor Board member German Khan

An in-depth analysis of this litigation necessitates the analysis of the shareholder agreement and the joint venture, both in light of Russian (or any other applicable) law. However, what I would like to do today, without having access to this detailed information, is to write about the major issues that play a role in this litigation:

Confidentiality clauses

Let's first start with some general comments on confidentiality clauses and their main content:

To show you what lawyers are able to do when you leave them without control, please read the following example of a typical definition of confidential information.

Confidential Information shall mean, with respect to a party, all information (and all tangible and intangible embodiments thereof), which is owned or controlled by such party, is disclosed by such party to the other party pursuant to this Agreement, and (if disclosed in writing or by another tangible medium) is marked or identified as confidential at the time of disclosure to the receiving party, or (if otherwise disclosed) is identified as confidential at the time of disclosure to the receiving party and described as such in writing within thirty (30) days after such disclosure. Notwithstanding the foregoing, Confidential Information of a party shall not include information which, and only to the extent that, the receiving party can establish by written documentation (a) has been generally known prior to the disclosure of such information by the disclosing party to the receiving party ; (b) has become generally known, without fault on the part of the receiving party ; (c) has been received by the receiving party at any time from a source, other than the disclosing party, rightfully having possession of and the right to disclose such information free of confidentiality obligations ; (d) has been otherwise known by the receiving party free of confidentiality obligations prior to the disclosure of such information by the disclosing party to the receiving party ; or (e) has been independently developed by employees or others on behalf of the receiving party without access to or use of such information disclosed by the disclosing party to the receiving party as evidenced in writing (each, a Confidentiality Exception).

262 words in 2 sentences! This is a score of 24.49 on the Gunning Fox index and means that you need 24 years of formal education to understand the text on a first reading. Good luck!

By the the way, did you know that Goethe was a lawyer? Obviously, the profession has changed since his death in 1832.

Confidentiality vs. prohibition of assignment

The details of the confidentiality clauses agreed upon by BP and AAR are not public. However, I doubt that the “real” litigation is about confidentiality issues here. It seems to be more about preventing BP to sell its stake in the joint venture and, if BP succeeds nevertheless, to obtain maximum damages. However, can you forbid your partner in a shareholder agreement to sell his shares in the future?

The first obvious answer to this question would be “Why not? After all, if he signs, it is his own fault because he knew it before.” This line of reasoning is called freedom of contract and is actually a fundamental civil law principle in most jurisdictions.

However, the problem here is that forbidding someone to sell his own shares impairs his property rights. As property rights and their design are part of people's fundamental rights, the above described agreement conflicts possibly with the state's constitution which usually contains people's fundamental rights.

In in the particular case of shareholder agreements, it is widely accepted that,

  • on the one hand, a joint venture often necessitates a binding engagement of the partners over a specific period of time (If everybody can step out immediately, it is no more a joint venture!);
  • on the other hand, you cannot bind your partner forever.

Having said that, the balance between freedom of contract and the fundamental property rights will usually involve 2 main aspects:

  • Time (Depending on the project, an engagement period of 10 years may be a good benchmark for the validity of a prohibition of assignment.)
  • Serious and legitimate reason (To limit a person's property rights you need such a reason. Examples include social welfare, other interests of the community, and the profitability of the project.)


  • “Oligarchs threaten BP's Russia sale plans” in FT dated June 3, 2012
  • “Russian watchdog targets TNK-BP dispute” in FT dated June 6, 2012

Friday, June 1, 2012

JP Morgan’s Synthetic Credit Portfolio Losses

On March 10, 2012, JP Morgan has announced a 2 BUSD trading loss on credit derivatives trading. Since then, JP Morgan’s top management in its Chief Investment Office (CIO) has changed and speculation is ongoing about the “real losses” incurred by JP Morgan’s investment.

Unfortunately, I have not yet found the explanation of what these positions are specifically about. The official information as of today is as follows:

JP Morgan's 10-Q filing dated 10 Mai 2012

Let’s first stick to JP Morgan’s 10-Q filing for the first quarter 2012. On page 9 of this filing we learn that

  • the loss has occurred in JP Morgan’s Corporate / Private Equity segment;
  • the loss has occurred as a consequence of marking to market a synthetic credit portfolio that was intended to work as an economic hedge for the firm.

The relevant passage reads as follows:

In Corporate, within the Corporate/Private Equity segment, net income (excluding Private Equity results and litigation expense) for the second quarter is currently estimated to be a loss of approximately $800 million. (Prior guidance for Corporate quarterly net income (excluding Private Equity results, litigation expense and nonrecurring significant items) was approximately $200 million.) Actual second quarter results could be substantially different from the current estimate and will depend on market levels and portfolio actions related to investments held by the Chief Investment Office (CIO), as well as other activities in Corporate during the remainder of the quarter.

Since March 31, 2012, CIO has had significant mark-to-market losses in its synthetic credit portfolio, and this portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the Firm previously believed. The losses in CIO's synthetic credit portfolio have been partially offset by realized gains from sales, predominantly of credit-related positions, in CIO's AFS securities portfolio. As of March 31, 2012, the value of CIO's total AFS securities portfolio exceeded its cost by approximately $8 billion. Since then, this portfolio (inclusive of the realized gains in the second quarter to date) has appreciated in value.

The Firm is currently repositioning CIO's synthetic credit portfolio. Accordingly, net income in Corporate likely will be more volatile in future periods than it has been in the past.”

As regards CIO's average VaR, its value has more than doubled in Q1 2012 (129 MUSD) as compared to Q1 2011 (60 MUSD). On March 31, 2012, CIO's VaR is 186 MUSD compared to 55 MUSD on March 31, 2011. (See JP Morgan's 10Q filing, pages 73 et seq.)

In plain English, this means that, on March 31, 2012, CIO's portfolio had a 5 % chance to devalue by 186 MUSD or, in other words, during 100 trading days, CIO's portfolio would loose at least 186 MUSD on 5 trading days. However, such VaR, first, does not correspond to an actual mark-to-market loss on a specific trading day and, second, does still not tell us anything about the type of positions taken by JP Morgan.

Business Update Call dated May 10, 2102

Second, we could analyze the business update call given to investors by Jamie Dimon on Mai 10, 2012:

The only passages where JP Morgan's CEO talks about the investment loss are the following:

Regarding what happened, the synthetic credit portfolio was a strategy to hedge the Firm's overall credit exposure, which is our largest risk overall in its trust credit environment. We're reducing that hedge. But in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective than economic hedge than we thought.

What have we done? We've had teams from audit, legal, risk and various control functions all from corporate involved in an extensive review of what happened. We have more work to do, but it's obvious at this point that there are many errors, sloppiness and bad judgment. I do remind you that none of this has anything to do with clients.”

The original premise of the synthetic credit exposure was to hedge the company in a stress credit environment. Our largest exposure is credit across all forms of credit. So we do look at the fat tails that would affect this company. That was the original proposition for this portfolio.

In re-hedging the portfolio, I've already said, it was a bad strategy. It was badly executed. It became more complex. It was poorly monitored. We don't – obviously, we don't have to do anything like this at all, if we don't want.”

The rest of the conference call consisted of general announcements and slogans which did not help understanding the actual investments carried out by JP Morgan. As an example, the hedge was described as follows:

This was a unique thing we did and obviously it had a lot of problems and we are changing appropriately as we are getting our hands around it, but we are going to have a CIO who is going to have talented people there, continue to do what they've always done.”

We are obviously not more intelligent after reading this. As Jamie Dimon said, JP Morgan will explain any details later on:

We will discuss all these matter and more and in fulsome detail on our second quarter analyst call and we are going to take some questions on this call. I do want to tell you now we are not going to take questions about specific risk positions, strategies or specific people.”

Let's wait for the next quarterly report then.


  • JP Morgan's 10-Q report dated May 10, 2012
  • Transcript of JP Morgan's business update call dated May 10, 2012