Toomre Capital Markets LLC ("TCM") has previously written favorably of New York Federal Reserve President Timothy Geithner in the posts Bear Stearns: U.S. Banking Committee Starts Looking At Regulatory Change and Suggested Reading: Timothy F. Geithner Speech on Credit Derivatives. New York Fed President Timothy Geithner has been the Federal Reserve's point person dealing with Wall Street during the on-going credit crisis that seemingly started last year with the collapse of two Bear Stearns hedge funds that were highly leveraged and highly exposed to sub-prime mortgages and Collateralized Debt Obligations ("CDOs"). His active involvement in trying to stabilize the bursting of the housing bubble culminated with his prominent involvement with the March 2008 rescue of Bear Stearns which is expected to formally taken over by J.P. Morgan Chase & Co. on Friday, May 30^th 2008.

Since the Bear Stearns rescue effort unfolded in mid-March, there has been considerable criticism of the Federal Reserve and Treasury Department brokered sale of Bear Stearns to JP Morgan, particularly around the issues of moral hazard and the Federal Reserve's ability to act as an 'honest broker' in future financial crises. On the front page of the May 30^th 2008 edition of The Wall Street Journal, there is an article written by Greg Ip entitled Fed's Fireman On Wall Street Feels Some Heat that summarizes some of the criticism still being directed at Timothy Geithner. The article contains the interesting reference that "As early criticism of the rescue swirled, the president of the Dallas Fed, Richard Fisher, sent Mr. Geithner an email in Latin: 'Illigitimum non carborundum,' along with his translation, 'Don't let the bastards get you down.' Mr. Geithner replied that his grandfather had the same slogan on his kitchen wall."

Toomre Capital Markets LLC for one is glad that Mr. Geithner pushed for the Federal Reserve to lend $29 billion to JP Morgan to facilitate the latter's takeover of Bear Stearns on Sunday, March 16^th 2008. Although some rather ignorant Congressmen claimed that the Federal Reserve's participation "exposed the American taxpayers to unknown amounts of financial loss", TCM is sure that such politicians would have been singing a much different self-serving tune had Bear Stearns filed for bankruptcy early the next Monday morning. Many people who are not intimately involved with the Capital Markets do not appreciate how intricately the various investment and global commercial banks have become through derivative contracts and particularly what are known as Credit Default Swaps ("CDS").

On April 16^th 2008, the International Swaps and Derivatives Association, Inc. ("ISDA") released the results of its Year-End 2007 Market Survey of privately negotiated derivatives. In that report, IDSA reports "The notional amount outstanding of credit default swaps (CDS) grew 37 percent to $62.2 trillion in the second half of 2007 from $45.5 trillion at mid-year. Further CDS notional growth for the whole of 2007 was 81 percent from $34.5 trillion at year-end 2006. The survey monitors credit default swaps on single names and obligations, baskets and portfolios of credits and index trades." [Emphasis added]

Holy crap! No wonder there was so much concern about counter-party risk a month ago when a "run on the bank" which led to the acquisition of Bear Stearns by JPMorgan. Toomre Capital Markets LLC ("TCM") now even more appreciates the efforts of the President of New York Federal Reserve, Timothy Geithner, to clean up the credit default swap middle and back office operational issues. With growth this explosive, the major investment and global banks are particularly interconnected. From a moral hazard perspective, due to their derivatives exposures, are not all of these banks "too big to fail"? Or does this explosive growth suggest that the Capital Markets finally needs a global clearing mechanism so that there is more price transparency on what specific derivatives are worth and that there is less counter-party risk in the financial system?

On Thursday April 3^rd 2008, there was enlightening testimony before the United States Senate Banking Committee regarding the acquisition of Bear Stearns by JPMorgan with the assistance of the New York Federal Reserve (and potentially ultimately the U.S. Treasury and common taxpayers). The first panel was composed of Federal Reserve Ben Bernanke, SEC Chairman Christopher Cox, Federal Reserve Bank of New York President Timothy Geithner and Treasury Undersecretary Robert Steel. The second panel consisted of JPMorgan Chase CEO Jamie Diamond and Bear Stearns CEO Alan Schwartz. Toomre Capital Markets LLC ("TCM") thought that a couple of key items emerged from the testimony of these two panels:

• Bear Stearn's liquidity disappeared virtually overnight declining from $12 plus billion to about two billion on Thursday, March 13^th.

• Federal Reserve Bank of New York President Timothy Geithner is really impressive and clearly a heavy-weight. Toomre Capital Markets LLC previously highlighted his speech on the credit derivatives issue in the post Suggested Reading: Timothy F. Geithner Speech on Credit Derivatives. TCM is quite reassured that this regulator is at the helm of the Federal Reserve Bank of New York during this time of credit crisis.

• The various regulators were not prepared to deal with a liquidity crisis at one of the primary dealers (and it is not clear if they have the authority to do so going forward).

• At the invitation of the SEC, Federal Reserve examiners are now on site daily at the top five investment banks: Merrill Lynch, Goldman Sachs, Lehman Brothers, Morgan Stanley and Bear Stearns. While the Federal Reserve officials do not have the authority to direct the investment banks to follow its directives, one can be assured that the Federal Reserve holds one very critically key trump card: The Federal Reserve is not required to lend to any institution and critically is unlikely to do so to any institution that it deems as "unsafe". Hence, if the investment banks want access to the Federal Reserve discount window, one can be rest assured that they will be following the Federal Reserve's "suggestions."

Toomre Capital Markets LLC ("TCM") has long been concerned about the opaqueness of the Credit Default Swap market. As this market sector has exploded in size in the past decade, TCM has feared that some losses from these credit derivative instruments may be hidden from investors, regulators and counterparties. Hence, the soundness of the global financial system might well be less sound than what international regulators, rating agencies and large financial institutions might think.

Others have been concerned too. The Australian has started off the 2008 New Year with a rather ominously entitled article Forget CDOs, Is is Time for CDSs. The article starts with "If 2007 was the year of the CDO, the latest acronym to loom dark and large on the financial markets' horizon for 2008 is the CDS. And the CDS (credit default swap) is shaping up to be far more noxious than its little derivative brother, the CDO - a spliced and diced bundle of mortgages known as a collateralized debt obligation that sent Wall Street into a tailspin last August when the market for low-grade US mortgages froze over. At least Warren Buffett seems to think so. After the world's top two bond insurers were scolded with [the threat of] a ratings downgrade last month and told to go and raise some capital, the visionary Buffett revealed last Friday that he was to set up a bond insurance business." [emphasis added]

The key point of this article is that "the murmur among the cognoscenti is that an implosion in the CDS market could do serious damage to the international banking system." They have slightly misquoted Warren Buffett who did say "We felt that, in many cases, the prices that people were charging were inappropriate." What Mr. Buffett was referring to was the cost of credit enhancement insurance to ensure that a municipality's debt was paid on a timely and ultimate basis that is part and parcel of a AAA/Aaa rating. He was not referring to the prices of CDS transactions. However, the article authors were correct that the crux of the problem is that there is not only price transparency but there also are problems about reserving and regulation.

Toomre Capital Markets LLC ("TCM") made a post back on November 3rd 2007 entitled UBS Has a "SMALL" VaR Risk Modeling Problem. A key point in that post regarded how badly the UBS investment bank' risk management area missed in the calculation of the bank's economic risks. For instance, the third-quarter UBS economic report card revealed that the bank's trading areas had sixteen trading days out of sixty-three or so where the daily losses exceeded that projected by the daily Value-at-Risk ("VaR") at the 99% confidence interval level. With the December 10th 2007 announcement of its additional $10 billlion in losses at UBS, no doubt there will be a number of days during the fourth quarter where the actual losses will exceed the calculated VaR. An interesting question still to be answered is how many days did they miss on?

Probably the most key parameter for any VaR model is volatility, both in the size of positions and in the prices at which those positions are marked. Likely, a key reason why the UBS risk management area missed on so many days during the third quarter is that their volatility estimates of prices were simply averages of the last five years of observations and did not give extra weight to the recent period when prices began to deviate significantly from the near par prices. CDO prices have now been declining for several months and there is considerable question about what the heck CDOs are worth and what should be used in various analytical risk models.

For counter-parties and investors, a key question remains after the $10 billion write-down announcement at UBS. What amount of subprime investments and CDOs does UBS still own, and perhaps even more importantly, where are they now valued?