Stepwise Resolution of the Sub-Prime Crisis

Step 1:

For God’s sake, relax! Everyone is so uptight right now that we can’t even think. We will only get out of this mess by thinking, not by reacting prematurely with adolescent measures and childish pronouncements.

Step 2:

Suspend all further Treasury loans to Wall Street until the situation can be clarified by valuing all subject financial assets intrinsically (see below). How long will this take? Approximately six months if we stop taking ourselves so seriously and start working seriously. At most, it will take one year.

Step 3:

Immediately impose a moratorium on mark-to market accounting in its current form. It does not work anyway. Next, redefine “fair value” (see below) to mean the risk-neutral amount derived from primary market data. This eliminates the three “levels” now in use, which are confusing and non-analytical at best.

Step 4:

Redefine all CDS contracts as insurance to be regulated at the Federal level by the FDIC. Once you do this, all CDS writers are now supposedly insurance companies, and are subject to new capital rules. Similar to life insurance, this type of insurance should only be available when the purchaser owns the underlying exposure. This effectively ends all speculation in this market and enforces equilibrium between long and short positions. The lack of equilibrium is one of the main issues at this stage.

Give the CDS a new name. Our suggestion: enhanced recovery guarantee or ERG.

Why is a CDS not like a normal interest rate swap contract under ISDA rules? The answer is that it is not based on market risk, but credit risk. What’s the difference? The fact of the matter is that market risk is statistical, and credit risk is stochastic. This is the true economic rationale. ISDA rules are only intended to apply to statistical instruments, as is clear from reading any swap-confirm.

There is no need for a “Collateral Annex” in a standard ISDA swap agreement. This means that ISDA rules have been manipulated. How come? The answer is that collateral is property while a swap is an executory contract. ISDA swap confirms were never intended to apply to property contracts.

The net impact of this procedure will be to create a huge, national-level pool of credit risk-based instruments, operating on a smooth and linear time-scale and through which the FDIC will manage credit exposures the same way the Federal Reserve ought to manage liquidity exposures. If operated properly, it will prevent any future credit crisis from occurring.

Step 5:

Appoint the current head of the FDIC as the first Chairman of the Federal Credit Board or FCB. The FDIC is to relinquish all other responsibilities in favor of the OCC, who would take over all bank examinations nationwide. Rename the FDIC the FCB and merge all banking regulators into the OCC. The field of credit risk management is in dire need of a unified, monolithic approach. This also means that the Federal Reserve will be removed from oversight responsibility regarding credit risk in the country. The Federal Reserve was created to manage liquidity, not credit risk.

Step 6:

Engage one or many firms to value all subject financial assets using feedback from primary market data. The latter are available using servicer reports that are now produced by all servicers in the MBS market. The price and the value are incommensurate, and so the Bloomberg- or Reuters-quoted price is irrelevant to this exercise. Start with Countrywide deals, for they represent 20% of the MBS market and are the benchmark issues. This is the most efficient way to do the valuation.

Repeat the valuation every month until maturity, using new servicer data, and redefine the “fair value” used by accountants to be this number exclusively. Market prices are to be eliminated from GAAP accounting rules.

Investors should pay for the work since they own the risk. This intrinsic valuation would become the basis both for the fair-market insurance premium on all future ERG contracts and the Fair Value under GAAP. As soon as a Value is available with respect to any transaction’s securities, implement Step 7 below with respect to the target securities and related outstanding CDS contracts.

Step 7 (main step):

Invert all CDS contracts currently outstanding and redefine the basis of all future ERG contracts using the Value from Step 6 above. This means that all protection buyers will become protection sellers and vice versa. This also means that payments will be due at the same rate as they were made to the original protection-sellers. Thus, there is little bankruptcy risk and the entire system will be able to breathe again. The current fear is the fear of bankruptcy, i.e. of death.

Protection-buyers who held the underlying exposures when entering into the original CDS contract will receive both types of payments, the non-linear (time value) amount being calculated using the method from Step 6 above at the time of the inversion. Protection-buyers who did not hold the underlying exposures when entering into the original CDS contract will receive the intrinsic value only and will forfeit the time value. In this respect, we are talking mainly about hedge funds.

An insurance contract like a CDS has two types of value, a linear or “intrinsic” value and a non-linear or “time” value. The latter amount is also referred to as the “option value” embedded inside the contract. These two values are normally partitioned and computed separately as distinct percentages of the original principal amount, hence the expression “option-adjusted” spread or OAS. In this case, the intrinsic value will be defined as the cumulative premium already paid up to the inversion date.

In standard MBS, the time-dependent, so-called prepayment risk is never credit risk, but always market risk. In addition, it always works out to the detriment of the security buyer. The actual risk does not rest in the prepayment per se, but in the fact that the investor is faced with a less favorable investment set than the one prevailing at the time she made the original investment. Thus, what is commonly known as prepayment risk is really reinvestment risk. Analyzing credit risk as liquidity risk is the cardinal sin of finance.

Step 8:

Require the broker-dealer lobby [SIFMA] to institute, and pay for from member-fees, a two-tier certification program via which only certified individuals would be allowed to be involved in the creation of any structured security in any asset class. This program would teach how to define Value unambiguously and would prevent all non-deals from proceeding. Individuals who do not achieve the higher qualification (see below) would not be allowed to structure transactions, only sell or buy them. The two levels would be statistic (lower) and stochastic (higher), respectively. As an integral part of this Step, SEC Regulation AB would be strictly enforced. The unique valuation framework is disclosed in the book The Analysis of Structured Securities, Oxford University Press, 2003.

The above certification requirements will apply to all market participants. These include, among others, accountants, buy-side analysts and bank examiners, sell-side/research analysts and rating agencies. Lawyers are excluded because they do not structure securities. As a result, security valuations by rating agencies will lose their privileged status and will be no more credible than those stemming from any other independent firm. The common language of structured valuation will be spoken by all parties. Investors will also be required to retain their own valuation firm unless they have certified personnel on staff. Sarbanes-Oxley modalities will apply to investors too. The latter modalities will replace the existing requirement for NRSRO ratings. The “NRSRO” label will be abrogated.

All third-party valuation firms will be paid on a flat fee basis regardless of whether the deal closes or not. Success fees will be forbidden.


What would happen if one implemented the above steps consistently, without exception and maintained them over time via legislation?

a) A future credit crisis like the present one would never reoccur.

b) The mere announcement of a comprehensive resolution to the sub-prime crisis would restore confidence in the credit process and its institutions. Clearly, some of those institutions will not survive in their current incarnations (e.g. the rating agencies) while others (the FDIC) will assume their rightful place among the powers of the Earth.

c) Within one or two months, money would start going around again and the “crisis” would be effectively over. Thereafter, we would enter the post-mortem phase of reconciliation. The central purpose of cash (i.e. species, not Value) is to go around. Cash is the pump, not the water. Once cash stops going around, no matter how much water (credit) one has, one can still die of thirst (liquidity), which means that we have a credit crisis mistaken as a liquidity crisis. This is where we find ourselves right now.


Individual US citizens unable to retrieve their funds because of the current mess, such as auction-rate security holders, should be made collateralized, fixed-rate loans equal to the Value of their collateral as determined according to Step 6 above with a loan rate equal to the APR on the illiquid contract as of the loan date. All ARS ought to be termed out.

The collateral will be the underlying illiquid financial asset. This effectively ends the current contract. Although it is true that such people will receive a principal amount below par, they will most likely receive somewhere in the neighborhood of 80% of par. They would forfeit the difference as the price of their gullibility. If they wish, they can later sue their broker for misrepresentation.

— Sylvain Raynes