Shares pledges by Satyam promoters
The farce at Satyam Computers gets worse and worse with the company announcing that “The promoters informed Satyam that all their shares in the company were pledged with institutional lenders, and that some lenders may exercise or may have exercised their option to liquidate shares at their discretion to cover margin calls.”. This bizarre announcement highlights a deficiency in the disclosure requirements in India regarding transactions by directors and other insiders.
In the United Kingdom, earlier this month, David Ross resigned from the boards of all four public companies of which he was a director after admitting his “unintentional” failure to disclose that he had pledged his stake in one of the companies (Carphone Warehouse) as collateral for personal loans. The model code on insider trading in the UK listing rules states that “dealing” in shares includes “using as security, or otherwise granting a charge, lien or other encumbrance over the securities of the company;”. Thus pledge of shares is subject to the same disclosure requirements as other dealings in shares. Interestingly, at the time when Ross resigned from the boards, none of his personal loans were in default – the situation in the Satyam case appears to be much worse.
In the US, Regulation S-K Item 403(b) was amended in 2007 to provide that while disclosing their beneficial interest in the shares of the company, directors must also “indicate, by footnote or otherwise, the amount of shares that are pledged as security.”
In India, the Prohibition of Insider Trading Regulations do not to the best of my knowledge deal with pledge of shares. In the Substantial Acquisition of Shares and Takeover Regulations, a pledgee of shares is regarded as an acquirer of shares, but banks and financial institutions are exempt from this clause. In any case, even these regulations do not say that the pledger is regarded as a seller.
Posted at 11:43 am IST on Tue, 30 Dec 2008 permanent link
Categories: corporate governance
Teaching finance the hard way
I was recently asked for my views on whether and how we should change the way we teach finance after all that we have seen in 2007 and 2008. Some of my thoughts are as follows.
- Quantitative models based on non normal fat tailed distributions with non linear dependence structures (copulas) are hard, but we must not shirk hard mathematics. It is much easier to talk about 2.33 standard deviations and simple correlations, but much of this is a delusion when applied to financial markets. It is even easier to adopt the viewpoint of some of Taleb’s followers that models are useless, but this is the path of nihilism. I think there is no place in finance teaching either for delusions or for nihilism. It is the creativity and subtlety of Mandelbrot that attracts me.
- Fat tailed distributions also required us to re-examine the use of historical data in financial modeling and simulation. Five or even ten years of historical data tell us very little about the true distribution if it is fat tailed. A lot of what happened during 2008 would have appeared ex ante impossible to anyone looking at several years or even a few decades of history. But one can see many parallels if one is prepared to go back several decades or a few centuries. Since we do not usually have high quality data going that far back, the implication is that historical simulation should be de-emphasized in favour of robust models that are qualitatively consistent with decades if not centuries of historical experience and extrapolate far beyond recent experience. I have long been fond of saying that one must approach the study of finance with Ito’s lemma in one hand and Kindleberger’s book in the other. Needless to say, the version of Ito’s lemma that I like to have in one hand is the one for semimartingales and not the one for Brownian motion alone!
- There is a need to shift from behavioural traits to hard nosed rational models. It is amazing but true that so much of what happened during 2007 and 2008 can be explained as the rational response of economic actors to altered fundamentals. I think that the crisis has taught us that finance is not a branch of psychology. For example, reliance on credit history (FICO scores) during credit appraisal assumes that default is a behavioural trait that can be measured using past track record. Rational models (Merton style models) assume that people default when it is rational to do so and focuses attention on modeling the fundamentals (for example home prices). Clearly lenders would have been much better relying on rational models rather than presumed behavioural traits. Unfortunately, during the lending boom, behavioural models held sway and these were supported by the short historical time series data that was then available.
- Much of modern finance deviated too far from its micro foundations in terms of well defined fundamentals. Derivative models allow us to compute implied volatility and implied correlations (and if necessary the entire implied risk neutral distribution) and start valuing anything without any regard to fundamentals at all. Models then become over calibrated to markets and under grounded in fundamentals. For example, quite often derivative textbooks and courses do not encourage us to ask questions like: what is the fair value of an option if we assume that the underlying is 10% overvalued in the marketplace. Just as finance is not a branch of psychology, it is not a branch of mathematics either.
- We need to teach more about the limits to arbitrage not in terms of behavioural finance, but in terms of well specified market micro structure with proper attention paid to transaction costs, leverage, and collateral requirements. The important stream of literature linking funding liquidity and market liquidity needs to be part of the core courses in financial markets.
- Perhaps we teach too much of ephemeral institutional detail. A lot of the details which we taught to our students during the last 3-5 years has been obsoleted by changes in the market structure. Investment banks are gone, the Libor market is barely recognizable and risk free government paper is no longer risk free. When we are preparing students for a career and not for their first job, we must emphasize functions and not institutions; concepts and not context.
In short, I believe finance teaching particularly in MBA courses during the early and mid 2000s became too soft and easy to cater to the needs of an ever growing body of students who sought a career in finance without any real aptitude for the subject. We dumbed finance down for the mass market. The time has come to go back to teaching finance the hard way – and perhaps there will be fewer students in the classroom.
Posted at 2:39 pm IST on Mon, 29 Dec 2008 permanent link
Categories: Bayesian probability, post crisis finance
Credit losses and the Mandelbrot parable of the receding shore
During the last year and a half, expected credit losses have always been around twice the actual credit losses recognized by the banks. Long ago, banks had recorded only $100 billion of losses and people estimated that total losses would be $200 billion. Now that a trillion dollars of writedowns have taken place, estimates of total losses seem to be around two trillion dollars.
This reminded me of Benoit Mandelbrot’s parable of the receding shore (“Forecasts of Future Prices, Unbiased Markets, and Martingale Models”, The Journal of Business, 39(1), 242-255, January 1966):
Once upon a time, there was a country called the Land of Ten Thousand Lakes ... The widest was a sea 100 miles across, the width of the rth Biggest was 100/√r, so that the smallest had a width of only 1 mile. But each lake was always covered with a haze that made it impossible to see across and thus identify its width. ... The people of that land were expert at measuring distances, however; they also knew all about the computation of averages ... They knew, therefore, that as one of them stood on an unknown shore, he had before him a stretch of water of expected width equal to 2 miles. He could very well travel 1 mile to reach the center of “the” expected lake; but he could never go beyond this point! Suppose, indeed, that he succeeded in sailing forth to a new total distance just short of 100/√r miles. In the meantime, the other shore would have “moved on,” to a new mean distance from him equal precisely to 100/√r. It is clear therefore that those Lakes were ruled by Spirits who would never let them be crossed by a stranger. However far the traveler might sail, the Spirits would spread the lake ever farther, and the stranger would always remain right in the middle of water; his boldness should eventually be punished by death, but all travelers were eventually reprieved by a special grace.
I learnt more about fat tailed distributions and power laws from reading Mandelbrot than from reading anybody else (including Embrechts), and after four decades, the parable of the receding shore is still perhaps the best introduction to the subject. This parable also seems to be a good explanation of what is going on today. We are all now waiting to be “reprieved by a special grace.”
Posted at 3:14 pm IST on Sun, 21 Dec 2008 permanent link
Categories: crisis, statistics
Madoff, Markopolos and the SEC
The Wall Street Journal has a bland story (subscription required) about the efforts made by a rival hedge fund manager named Markopolos to convince the SEC back in 2005 that Madoff was running a Ponzi scheme. Much more interesting are two documents that the WSJ has put up on its public pages (no subscription required) on this subject: Markopolos’ nineteen page submission to the SEC describing all the red flags about the Madoff operation and extracts from the SEC’s Case Opening Report and Case Closing Recommendation.
I found the Markopolos submission extremely persuasive and well argued. It appears to me to be a good example of forensic economics – the difference being that this is done not by academics (like the Nasdaq market making study) but by one of Madoff’s rivals.
Markopolos’ theoretical argument that Madoff’s alleged option trading strategy would deliver T-bill like returns is absolutely correct. This is what we teach in all derivative courses.
Markopolos also makes a valid argument about the open interest in the exchange traded options being too small to support Madoff’s alleged strategy given the large funds under management. He also points out that OTC option trades on this scale would breach counterparty limits and therefore explicitly requests the SEC to seek trade confirmation directly from the trading and operations teams at the counterparty.
What I found most interesting is Markopolos’s analysis of why Madoff did not set up a hedge fund himself but instead chose to be a white label agent for hedge fund of funds. Markopolos argues that it does not make sense for Madoff to give up the attractive 2/20 fees of a hedge fund unless he has something to hide. He also argues that the arrangement is best described as Madoff borrowing money at 16% interest. It is worthwhile understanding this part of the submission in detail, because the moment one accepts this analysis, it becomes clear that it can only be a Ponzi scheme.
Why then did the SEC miss all this? I could not get away from the feeling that the SEC bungled this investigation very badly. But I also suspect that regulators are much more geared towards dealing with complaints from whistleblowers or other complaints with a “smoking gun” proof rather than some forensic economics that most regulators probably do not understand. Perhaps also the fact that a complaint comes from a rival automatically devalues its credibility in the eyes of many regulators.
I believe that in financial regulation, both these attitudes are completely mistaken. Forensic economics is usually more valuable than “smoking guns” and complaints by rivals and other interested parties are the best leads that a regulator can get. Regulators should perhaps hire some PhDs in market microstructure and derivative pricing in their surveillance and enforcement departments. Under normal times, PhDs in these fields would probably not want to work in these departments of a regulator, but these are unusual times.
Posted at 7:33 pm IST on Sat, 20 Dec 2008 permanent link
Categories: fraud, investigation, regulation
Satyam and Maytas
Sandeep Parekh has two posts and and T T Rammohan has a post on the corporate governance issues raised by the aborted acquisition (bailout?) by Satyam of Maytas – a company owned by Satyam’s promoters. Sandeep Parekh concludes: “I think this is a clear case of violation of fiduciary duties by the executive and independent directors of the company and I would go so far as to state that they have violated all three duties imposed upon them as fiduciaries – the duty of care, the duty of diligence and the duty of loyalty.”
Posted at 8:28 pm IST on Wed, 17 Dec 2008 permanent link
Categories: corporate governance
Irish takeover panel snubs its own government
FT Alphaville pointed me to this fascinating ruling by the Irish Takeover Panel. The panel says that when the government is a shareholder of the target company, any concessions made by the acquirer to the government in the area of public policy (lower consumer prices) is tantamount to giving one shareholder (the government) more favourable terms than the other shareholders.
I am not a lawyer, but I think this is a complete game changer in takeover law. Any agreement with the promoters that gives them any kind of favourable terms even if it is not at all in their capacity as shareholders seems to be forbidden by this ruling. I blogged about this kind of issue nearly three years ago, but the Irish solution goes beyong anything that I imagined at that time.
Posted at 4:33 pm IST on Sun, 14 Dec 2008 permanent link
Categories: corporate governance, equity markets, regulation
Sovereign Limitations
I wrote a column in the Financial Express this week about the limitations of the government in dealing with financial crises:
The ongoing global crisis has seen the government assume an ever increasing burden to keep the financial system afloat. But governments are not omnipotent, and emerging market governments are even more constrained. Investment bankers who thought they were omniscient during the boom have turned out to be clueless. It is perfectly possible that governments that appear omnipotent today will begin to look powerless before we are finished with this crisis.
The first signal regarding this is coming from the credit default swap market where one can buy insurance against default by corporate or sovereign borrowers. As of end–November, this market quoted a premium of ½% per annum to insure against a default by the US government. This is comparable to the premium that one would pay to insure a building against fire. Of course, all insurance premia reflect not only the actuarial probability of loss, but also a compensation for risk and the CDS premium does so to an even greater extent than in normal insurance. Yet, a ½% CDS premium indicates a frighteningly high probability of a default by the world’s sole superpower.
Another point of comparison is that ½% was roughly the CDS premium for insuring against default by India and several other major emerging markets in mid 2007. In other words, the US is perceived to be as risky today as India was in mid 2007. Before the crisis began, the CDS premium for the US was less than 0.1%. A five fold increase in the CDS premium clearly indicates that the risk perception has increased dramatically as the US government has taken more and more risk on to its own balance sheet.
We see a similar phenomenon in other countries as well. The cost of insuring against a default by the UK is as high as 1%. On the other hand, a country like Germany which still retains a conservative fiscal balance sheet enjoys significantly lower spreads than the US, UK or Japan.
In 2002, Japan encountered the same problem as it went on a fiscal binge to try and support its ailing economy. The rating agency Moodys downgraded the world’s second largest economy which was then the biggest creditor nation on earth to a single A rating placing it below Botswana which was then receiving foreign aid from Japan.
This time around, the ratings agencies have confined themselves to acting against small countries like Iceland which used to have a AA+ rating not too long ago, but has had its sovereign rating cut to BBB- (just one notch above junk). This has happened mainly because Iceland has assumed most of the liabilities of its banking system. The rating agencies are hesitant to take harsh action against major countries like the US or the UK since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonise the government that holds the regulatory sword of Damocles over them. The doubts about sovereign creditworthiness are instead being expressed by impersonal markets in the form of CDS premia.
In emerging markets like India, the worries about creditworthiness are even greater for a variety of reasons including foreign currency external debt and weaker institutional structures. Since the Indian government itself does not have foreign currency bonds outstanding, the CDS market relies on sovereign proxies like the State Bank of India. Using this sovereign proxy, the CDS premium for insuring against default by India has widened from about ½% in mid 2007 to about 4% by end November 2008. At its peak during the panic of October 2008, this premium was over 7½%.
We must also keep in mind the fact that India entered the crisis with a weak fiscal situation. Falling oil prices may reduce some of the off balance sheet obligations of the government, but a slowing economy will also reduce tax revenues. The fiscal position will thus remain precarious if not worsen further. What this means is that the Indian government must perforce be highly selective in terms of the bailouts that it provides. It has to distinguish between systemically important financial intermediaries, other financial entities and the general corporate sector. If the state expends its scarce fiscal resources supporting everybody that seeks help, then it might find itself too weak if and when the more systemically important entities need assistance.
During a downturn, many corporate entities will need to go through a debt restructuring if they have a liquidity or solvency problem. This debt restructuring may involve maturity extension, debt reduction or debt-equity swaps where creditors take significant losses, but shareholders suffer even more. If this causes losses to the the banks, their shareholders would also take a hit in the process. It is only after all this is exhausted that government support needs to be considered.
Posted at 11:00 am IST on Sun, 14 Dec 2008 permanent link
Categories: sovereign risk
Good Moves by SEBI
The Securities and Exchange Board of India made several good moves at its board meeting last week (their press release is here). The huge move towards transparency has been widely welcomed in the mainstream media and in the blogosphere.
I will therefore focus on the change that they have made to prohibit early exit from closed end mutual funds. This change appears to be directed towards Fixed Maturity Plans (debt funds) which were designed to eliminate interest rate risk for investors by investing in paper with the same maturity as the tenor of the scheme. The intention was to lock in the rate of return at inception and avoid any price risk at maturity. There could be a small reinvestment risk because of reinvestment of intermediate coupons, but this was negligible given the short maturity of most of these schemes.
This investor expectation about a predictable return has been rudely shaken because of large redemptions by big corporate investors during the liquidity crisis of October 2008. The mutual funds had to sell some investments at a loss and more importantly the residual portfolio quality also suffered because the best and most liquid investments were sold. The RBI’s scheme to lend to mutual funds does not solve this problem because the valuation of some assets is suspect and the liquidity window actually helps redeeming investors exit at an unrealistically high valuation.
SEBI’s move to simply prohibit premature exit restores the closed end debt scheme to its original function and design. With this in place, the RBI scheme for lending to mutual funds can be scrapped and can hopefully be replaced by a scheme to lend against units of mutual funds. This would provide liquidity to corporate investors who now face an unanticipated liquidity need. Evidently, liquidity is a privilege for which they should expect to pay a fair market price.
The SEBI press release also says that these Fixed Maturity Plans should not invest in paper with maturity beyond the tenor of the scheme. This too is necessary to ensure that these plan work as advertised. However, the language used refers to all closed ended schemes and would therefore appear to preclude a closed end equity fund since by definition an equity share is perpetual in nature. Hopefully, this will be fixed in the actual regulations.
I also think that SEBI needs to put in place a regulatory provision for suspending redemptions even from open end funds in extreme cases where it is impossible to determine the net asset value (NAV) of the fund reliably. The ongoing financial crisis continues to worsen. Earlier people like me worried mainly about defaults by real estate companies and NBFCs. Now the fear extends to the corporate sector as well with at least three of India’s largest business groups being perceived to be at risk of severe financial distress.
We still hope this distress will stop short of default, but a situation could arise where uncertainties about the financial situation of systemically important borrowers could lead to a situation where the NAV of mutual funds cannot be reliably determined.
As far as I am aware, there is no explicit requirement in the mutual fund regulations prohibiting redemption of units above net asset value or prohibiting redemption if the NAV cannot be reliably ascertained. (I think this is because the regulations were designed largely to protect the investors from the fund and not to protect the investors from each other.) I do not know whether a prohibition against such unfair redemptions (fraudulent preference?) can be inferred from general trust law. In any case, for complete clarity, it would be useful to write these into the regulations.
There is enough international experience in dealing with the impact of systemic defaults on mutual fund redemptions. I think Korea handled the DTC crisis after the Daewoo bankruptcy in an admirable way and there are lessons from there both for SEBI and for RBI. There are useful lessons from the Lehman bankruptcy in the US as well. Regulators should study these lessons and stand ready to apply them if such unfortunate situations arise in India.
Posted at 12:30 pm IST on Mon, 8 Dec 2008 permanent link
Categories: mutual funds, regulation
Who creates CDOs today?
While many think that CDOs and other complex instruments contributed to the crisis, the US government has been very enthusiastic in its use of these structures. In fact, if the behaviour of the US government is any indication, CDOs seem to be part of the solution. Let me give a couple of examples.
One of the best is the bail out of Citigroup. If one looks at the term sheet for this transaction, it is clearly a CDO structure:
- First loss tranche (10%) retained by Citigroup. Using typical CDO numbers, this would be all the pieces rated A and below. But if we assume that valuations are generous, then this would be just the equity piece or may be also a bit of the mezannine piece.
- Second loss tranche (1.6%) taken 90% by US Treasury (TARP) and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the BBB piece, the A piece or the AA piece. This is a thin tranche implying high loss given default.
- Third loss tranche (3.3%) taken 90% by the FDIC and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the A piece or the AA piece.
- Senior piece (85%) taken 90% by the Federal Reserve and 10% retained by Citigroup. Under good old CDO norms, this is the correct attachment point for a AAA tranche and if you are very gullible, you could consider this a AAA piece. Since the Fed took this piece, you would assume that either they were gullible, or that some valuers there are willing to turn a Nelson’s eye towards this transaction.
Now why is such a complex structure required when most of the parties involved are arms of the government itself and every reasonable person would agree that all pieces are clearly at significant risk? Clearly, the government is now abusing CDOs for the same reasons that Wall Street abused it – to fool oneself or to fool others.
As a second example, consider the terms of the restructuring of the loans to the AIG announced by the New York Fed yesterday. There is an LLC set up to buy CDOs and this has a complex structure.
- There is an equity tranche of a little under 15% contributed by AIG and the remaining 85% (senior tranche) is provided by the New York Fed. Note once again that the attachment point of the senior tranche is once again the magic number of 15% of the old days.
- There is a complex payment waterfall structure in which the Fed receives principal before it receives the interest (Libor + 100 basis points). To me this looks like make believe accounting where the Fed would be able to claim that there was no loss of principal and only the interest was lost.
- The profits are shared between AIG (33%)and the Fed (67%). Since AIG provided all the equity, one can think of this as an implied IO (Interest Only) tranche that is owned by the Fed.
- The term sheet glosses over the fact that the only source of cash for AIG to provide the equity piece of $5 billion is borrowing from the various schemes of the Fed and the Treasury. So the Fed is now playing the role of a prime broker lending to a hedge fund that picks up the equity piece of a CDO. What can the Fed do when there are so few prime brokers still left?
My last example has nothing to do with CDOs and is not a recently designed instrument, but the consequences of some needless complexity in the design is showing up only now. Long ago the US Treasury introduced inflation indexed bonds (TIPS) whose coupons and redemptions are indexed to the consumer price index. This is close to a real risk free bond and is a useful asset class for many investors. It is also useful in creating a market implied estimate of expected inflation (simply subtract the TIPS yield from the nominal yield of an ordinary government bond).
The US Treasury however fouled up this simple and elegant instrument by adding a totally unnecessary complexity when it stated that the redemption will not drop below par even if inflation over the term of the bond turns out to be negative. This adds a European put option exercisable at par at maturity to the instrument. Under normal conditions, this option is far out of the money and can be ignored. If one wanted to be more accurate, one could assume a volatility for the inflation rate, value this put and compute the option adjusted spread (OAS) for the TIPS.
The problem is that these are not normal times. Some people believe that the risk neutral distribution of the CPI at maturity is bimodal with one peak at 80% of current levels and another at 140% of current levels. Black Scholes valuation is hardly appropriate and nobody knows what the true value is. What we do know is that the yields on two TIPS with the same residual maturity have vastly different yields (a spread of 200 basis points) depending on when they were issued and therefore how much of inflation adjustment is already impounded in the principal. Mankiw blog has an excellent discussion on this issue. Econbrowser also discusses this and I have drawn on ndk’s comments in that post for the bimodal distribution mentioned above.
There is an old joke which asks what is the difference between the godfather and the investment banker. The answer is supposed to be that the godfather makes you an offer that you cannot refuse while the investment banker makes you an offer that you cannot understand. The US government is now very clearly in the business of making offers to the rich and well connected that the tax payer cannot understand.
Posted at 6:18 pm IST on Thu, 4 Dec 2008 permanent link
Categories: derivatives
Sovereign defaults
According to data from Markit regarding the five year credit default swap (CDS) market on November 27, 2008, the cost of insuring against default by the US government was 0.5% per annum and the cost of insuring against a UK government default was almost 1%. The CDS market is now attaching a slightly higher probability to a default by the US than by Japan. Germany is seen as significantly less risky than any of these countries.
For comparison, 0.5% is the kind of premium that one might normally pay to insure a decent building against fire. But one must keep in mind that the CDS premium measures the risk neutral probability of default which could be several times the real world probability while for fire insurance, the risk neutral and real world probabilities are much closer to each other.
The sharp rise in the US CDS premium from the single digit levels prevailing before the crisis has left some people wondering whether all this makes any sense at all. Can a government default on debt in its own currency when it can print unlimited amounts of that currency? Above all, how can any entity provide protection against default by the government itself?
These same questions arose and were adequately answered years ago when the major ratings agencies downgraded Japan at a time when it was the largest creditor nation on earth running a large current account surplus. I therefore find it strange that the same questions are arising again now when the creditworthiness of the US is being doubted.
This time, the rating agencies dare not express doubts about the creditworthiness of the US since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonize the government that holds the regulatory sword of Damocles over them. The doubts are instead being expressed by impersonal markets in the form of CDS spreads.
So, let us once again remind ourselves that governments can and do default on debt denominated in their own currency. Creditworthiness is not only about ability to pay, but also about willingness to pay. It is reasonable to assume that governments have the ability to pay by printing currency though occasionally a government (Zimbabwe for example) has run out of ink and paper to print notes. The principal problem is about willingness to pay.
The Russian default of 1998 on its ruble debt is a good place to begin understanding the issue. I like to imagine the Russian government being forced to choose between paying its soldiers and paying its creditors. Obviously, it chooses to pay its soldiers – if it makes the wrong choice, it does not survive to tell the tale. Unlike creditors, soldiers cannot be paid in worthless paper. They have to be paid in something that can buy food and other essentials.
The government must therefore print notes on a scale that produces the maximum seigniorage revenues to the government. There is a very simple formula which states that in real terms seigniorage revenues are equal to the stock of real money times the rate of growth of nominal money. If it prints money on so large a scale as to create hyper inflation, then the stock of real money declines (and ultimately collapses to zero) and the government cannot earn any seigniorage revenues regardless of how fast it grows the nominal money supply by printing money.
A point is therefore reached where a government concerned about seigniorage revenues decides to default rather than print more notes. Stating the issue in terms of soldiers versus creditors dramatizes the issue, but we can as well think of it in terms of voters versus creditors and the analysis would be the same.
When one looks at the matter in historical perspective, the idea of government debt being risk free is a twentieth century illusion that is of as little relevance in the twenty first century as it was in the nineteenth century.
Let me now turn to the second question. Is it reasonable to assume that anybody can actually insure against default by the US government? I think the answer is yes provided one takes care not to take out insurance on the Titanic from somebody who is on board the Titanic itself. If one is paranoid, one might want the CDS contract to be governed by say English law rather than New York law and to pay out in say Euros rather than dollars. One might also like the counterparty to be outside the US or at least to have substantial assets outside the US. If these elementary precautions are taken, the CDS can indeed do the intended job as well for defaults by the US government as for defaults by any other reference entity.
Posted at 5:16 pm IST on Sun, 30 Nov 2008 permanent link
Categories: sovereign risk
Wrong investors and market dislocation
I have been reading the transcripts of the US House of Representatives Oversight Committee hearing on hedge funds and the financial crisis.
Having enjoyed Andrew Lo’s excellent book on hedge funds, I read his testimony with particular care. I was particularly fascinated by the following statement that he made:
Dislocation comes not from losing money, but from the wrong investors losing money. (lines 725-726, p 34)
I mentioned earlier that dislocation happens not when losses occur, but when losses by individuals that are not prepared for those losses occur. The hedge funds that invest in the worst risk tranches, they are prepared for losses; but when money market funds, pension funds, mutual funds invest in AAA securities that then lose substantial value, that is really the cause for dislocation. (lines 1067-1073, p 49)
That diagnosis ties in well with a report at FT Alphaville about why Lehman’s demise was so devastating to the markets. During the run up to the Bear Stearns collapse, investors stopped rolling over its commercial paper and the amount of this paper outstanding fell by over 80% as far as I can make out from Figure 1 in the report. After the Bear bailout, investors assumed that a large investment bank would not be allowed to fail. As Lehman lurched towards bankruptcy, its commercial paper issuance not only did not fall but actually increased nearly five times.
This means that at the point of its failure, Lehman was being increasingly funded by what Lo called “wrong investors”. The tipping point in the post Lehman crisis was the closure of a prominent money market mutual fund due to losses on its investments in Lehman commercial paper. This in turn led to the collapse of the entire prime commercial paper market necessitating a bailout of that market and an ever widening range of other bailouts.
This is a very potent example of the moral hazard caused by government bailouts. Absent implicit government support, a weakening institution sees a withdrawal by risk averse investors and its funding comes increasingly from those who in Lo’s words are “prepared for losses”. The moral hazard caused by previous bailouts breaks this adjustment and makes subsequent failures a lot more painful than they would otherwise be.
This analysis also suggests that a “silent run” on a financial institution could actually be a good thing under certain circumstances if it is Lo’s “wrong investors” who are doing the running.
Posted at 2:04 pm IST on Fri, 28 Nov 2008 permanent link
Categories: crisis, risk management
Show me the balance sheet
I wrote a column in the Financial Express suggesting that quarterly financial disclosures should be improved. In particular, the balance sheet should be disclosed quarterly:
In the current regulatory regime, Indian investors get to see the balance sheet of their companies only once a year, while they get to see the profit and loss information once a quarter. In the context of the current crisis, we need to change this urgently because the investor today wants to see the balance sheet as much or even more than the profit and loss data.
For example, if an Indian real estate company or non bank finance company were today to give its investors the choice between receiving a quarterly balance sheet or a quarterly profit and loss account, many investors would choose to get the balance sheet. Investors are currently more concerned about declining liquidity and solvency than they are about declining profitability. Indeed, the maturity and currency composition of the debt and the debt covenants are very critical pieces of information in assessing the survival prospects of these companies.
Another problem is that many companies have adopted the ugly practice of taking foreign exchange losses to the balance sheet in defiance of the accounting standards by taking refuge in some anachronistic arguments of doubtful legality. This means that the balance sheet is essential even to understand the true profitability of companies.
In the 1990s, when Sebi mandated quarterly disclosures of abridged profit and loss data, it was a huge step forward. It moved the Indian market to higher levels of informational efficiency and greatly improved price discovery. It would also be fair to say that quarterly disclosures have done more to reduce insider trading in India than the insider trading regulations themselves.
The time has now come to build on this and take it forward to its logical conclusion. In the 1990s, the only feasible mode of disclosure was a newspaper advertisement, and cost considerations severely constrained the amount of disclosure that could be mandated. The regulators therefore chose a minimal set of line items (all from the profit and loss account) for the quarterly disclosure.
Today online disclosure through the website of the stock exchange has become the primary means of information dissemination. The stock exchange data is then republished by several commercial and media web sites as well as by many online trading platforms. The online medium is not subject to the severe cost constraints that restricted the amount of information that could be published through newspaper advertisements. It is now feasible to mandate comprehensive quarterly disclosure of information.
In the US, Form 10K for annual disclosure and Form 10Q for quarterly disclosure are almost identical in terms of the basic financial data (income statement, balance sheet, cash flows, notes and other disclosures). India should also move to the same system where the quarterly disclosure contains all the information required for annual disclosures under Schedule VI of the Companies Act as well as the listing agreement.
Under normal conditions, this disclosure regime would be phased in gradually after extensive consultations and debate. But these are not ordinary times. The ongoing crisis puts a premium on the availability of information. I believe therefore that Sebi should take extraordinary measures to implement this on an emergency basis.
I propose that the top 500 companies (say the BSE 500) should be required to disclose the complete financial statements (balance sheet, profit and loss account and cash flow statement along with notes and schedules) through the stock exchange website beginning with the October-December 2008 quarter in January 2009. There is nothing to be done in the January-March quarter because it is coterminous with the year end. Therefore the remaining companies should be asked to disclose the extra information from the April-June 2009 quarter.
This disclosure requirement should not pose any problems for the companies. No sensible accountant prepares a profit and loss account without preparing the balance sheet and so my proposal would only require the companies to disclose what they have already prepared internally.
The stock exchanges may need software changes to upload all this extra information to their website. But if only 500 companies are subject to this regime in January 2009, it is quite feasible to upload the information manually in the worst case. The exchanges should undertake the extra effort involved in doing this while making software changes to allow them to handle everything automatically from July 2009.
On a related note, I also think RBI should require banks and financial institutions to disclose vastly more information regarding non performing assets and valuation of financial assets. Accelerated adoption of accounting standard AS 30 for financial instruments should also be considered. Current practices allow banks and finance companies to hide losses by improperly parking assets in the held to maturity category. This should be stopped. At the very least, voluntary early adoption of AS 30 should be encouraged. The market can be counted upon to penalise those companies that choose not to do so.
Posted at 11:39 am IST on Thu, 27 Nov 2008 permanent link
Categories: accounting, corporate governance, crisis, regulation
Liquidity or solvency?
I wrote a column in the Financial Express about the potential solvency problems in the Indian financial sector today.
During the last month, Indian policymakers have responded with a series of measures including cuts in interest rates and in cash reserve ratios to improve liquidity in the financial sector. These measures were certainly necessary, and I believe we would and should get more such measures.
However, lurking behind the current liquidity problems is a deeper problem of solvency that needs to be addressed quickly and decisively. It appears to me that India is now where the US was a year ago – the measures that we saw in India in October 2008 were broadly similar to what the US and Europe undertook in August and September 2007. In terms of the deflation of the real estate bubble also, India seems roughly where the US was a year ago.
One difference is that the US had early warning signals in the form of house price futures and ABX indices that provided valuable information on asset prices and credit quality. These measures combined with stringent mark to market accounting enabled analysts to make reasonable guesses about which financial institutions would be hit severely and which were likely to remain solvent. In India, we do not have these markets and the health of financial intermediaries has become the subject matter of rumours and gossip rather than reasoned analysis.
The only market signal of solvency that is available in India is the stock price. The majority of the 17 listed private sector banks for which information is available in the CMIE database are today quoting at a price to book ratio of 1.0 or below which is a crude signal of potential solvency issues. Of the same set of 17 banks, only two traded at a price to book of 1.0 or below at the beginning of last year.
At this point of time, accounting data is not quite reliable because the carrying values of assets do not reflect their fair value. This is a serious problem for banks and non-bank finance companies that have exposures to real estate and to other stressed borrowers. It is also difficult to assess the exposure of banks to troubled non-bank finance companies and weak banks. But the problem is much wider and extends also to debt mutual funds that have exposures to real estate, banks and non-bank finance companies.
Mutual fund net asset values have become unreliable for two reasons. First in respect of short-term financial instruments, mutual funds have the ability to carry the assets at amortised cost rather than market value. Second, some of the really distressed paper does not trade at all and this makes the valuation judgmental. SEBI has allowed greater freedom to mutual funds to mark down the valuation of debt paper by using higher discount rates rather than the rating based spreads that were mandated in the past. This is a good step, but its usefulness depends on the voluntary decisions by funds to mark down the net asset values of their funds.
Solvency problems should be addressed at the earliest possible stage because the longer the corrective action is delayed, the greater the eventual costs of solving the problem. It is necessary to move swiftly to triage financial intermediaries into three categories: those that are financially sound, those that need to be recapitalised or restructured and those that should be shut down. This requires price discovery for stressed assets. Indian policy makers should therefore move swiftly to put in place structures similar to what the Americans and Europeans have done in the last couple of months to restore the health of the financial sector.
A strong financial sector is essential to confront the challenges of a slowing world economy. Unlike during the Asian crisis, this time, emerging economies face a shrinking world market for their exports. The threat of a “beggar thy neighbour” policy of competitive currency depreciation is very real.
The Korean won today trades lower than it did as it was emerging out of the Asian crisis in 1999. The news coming out of China is also quite bad, and the Chinese seem determined to boost their economy through all possible measures. At some stage, these measures will probably include a depreciation of their currency. To make matters worse, many East European currencies are also in danger of going into free fall, and some of them could be formidable competitors in the IT and BPO industries despite a language handicap.
All of this could make the economic slowdown even worse than it would be otherwise. A slowing economy increases non-performing assets and induces financial sector weakness that in turn impacts credit availability and weakens the economy further. The way to stop this vicious spiral is through aggressive recapitalisation and restructuring of the financial sector. We have a window of a few months to do this before India enters election mode.
Posted at 6:00 am IST on Wed, 12 Nov 2008 permanent link
Categories: crisis
Land as an asset
The doyen of Indian housing finance, Deepak Parekh is today quoted as saying that land is no longer an asset (“There is no need for irrational pessimism”, Business Standard, November 7, 2008). Parekh says “Land prices have collapsed, land is no longer an asset – people don’t want land as a security. Today, there is surplus land, low demand ... the value of land is probably half of what it was ...”
This explains why real estate companies reportedly have to pay 35% interest after providing collateral (land) notionally equal to three times the value of the loan.
Another interesting statement in this context is in a speech by Fed Governor Kevin Warsh (hat tip Calculated Risk) “We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world.”
Posted at 2:58 pm IST on Fri, 7 Nov 2008 permanent link
Categories: miscellaneous
Credit Default Swaps on Indian Entities
The Depository Trust and Clearing Corporation has published what is perhaps the first comprehensive official numbers on the global credit default swap market including the top 1000 reference names. The top 1000 names accounts for over 95% of the market by gross notional value and a little less than 90% by net notional value. Entry into this list is a measure of how important an entity is in global fixed income markets, but this is not a list that entities are eager to get into (many of the top names on this list are shaky sovereigns and shakier financials!).
I could spot four Indian entities in this list (ICICI, Reliance Industries, State Bank of India and Corus) in the middle of the list (ICICI is actually in the top 500). The top Indian names also serve as sovereign proxies and therefore the numbers must be interpreted with some care.
Posted at 10:57 am IST on Wed, 5 Nov 2008 permanent link
Categories: crisis, derivatives
Policy Choices for India
Most of my posts in recent days have focused on the risks that I see for the Indian economy and the financial system rather than on the policy responses. Jahangir Aziz, Ila Patnaik and Ajay Shah (APS) address the question of policy responses in a paper that I mentioned in an earlier post. They recommend among other things that the policy makers should undertake the following measures:
- Increase rupee liquidity substantially with the CRR being cut to 5% and the SLR to 20% with a further de facto reduction in SLR by allowing oil bonds to be counted as SLR.
- Provide substantial dollar liquidity to the market in the form of currency swaps.
- Let go of the currency and allow it to fall.
I agree with the broad thrust of most of these recommendations. Unlike APS, I do not worry that these proposals would amount to over reaction, rather I fear that they would not be enough. I look at what Korea has done and believe that India’s responses can be only mildly milder than theirs. Neither India nor Korea needs to go to the IMF for dollar funds, but the good news really stops there.
Our reserves are sufficient to finance the current account deficit for a couple of years and to take care of the dollar needs of the banking system and a few systemically important entities. As in the case of Korea, the reserves are not enough for anything more ambitious, and we will have to take harsh decisions beyond that. Meeting the dollar needs of the entire corporate sector as APS appear to suggest would risk depleting the reserves to alarming levels. Defending the currency as the RBI has been doing is of course plainly unsustainable.
My main complaint with the APS paper is its title which makes it appear as if we are faced with only a liquidity crunch. No, I think we are faced with a much bigger threat to our economy than during the Asian crisis of 1997. As I have written in earlier posts, in terms of the evolution of the current crisis, we are only where the US was in September 2007. The big shocks are yet to come.
We have not yet had our Bear Stearns moment, but that moment will surely come. We have not yet had a collapse of the real estate market. The big real estate companies have been borrowing at 35-40% interest rates in the hope that the festive season (Diwali) will bring much needed home sales. This has clearly not happened, and November will perhaps see the first distress sales of property. Non performing assets in the financial system will probably start climb rapidly from then on. At least some banks, mutual funds and systemically important non bank finance companies will need some kind of bail out.
For the corporate sector, the real distress is still in the future as the large capacity expansion of recent years encounters a slowing economy. We are also yet to see the flood of cheap imports from countries like Korea that have let their currencies fall sharply. I fear that some East European currencies could collapse to the point where they become competitive with Indian IT and BPO companies unless the rupee itself goes into free fall. It is likely that aggregate Indian corporate earnings will decline significantly. A wave of corporate defaults will of course put further strains on the financial system.
As in the US and Europe, our government too cannot stop the carnage. The government can only try to mitigate its worst ill effects. Moreover the Indian government will have to be even more selective than other governments because it enters the battle with a rather weak fiscal position. If it tries to save everybody, then it will be in need of succour itself. Moreover, the government will face intense pressure for fiscal measures to boost the economy if necessary by monetizing the deficit.
Posted at 3:47 pm IST on Mon, 27 Oct 2008 permanent link
Categories: crisis
Will Asia go on a fiscal binge?
In my last post, I argued that Asian currencies are likely to witness a round of competitive devaluations. The purpose of this post is to consider whether this could be accompanied by a fiscal binge as well.
But first some elaboration of my two fold argument for Asian devaluations. The first part of the argument is that reserves are large but not infinite – reserves may be drained rather quickly if the country tries to defend the currency. The Koreans found this out quickly. (My definition of Asia does not include Russia, but the Russians may also be in the same boat right now. Their half trillion dollar reserves are the third largest in the world, but they have already lost a tenth of it and clearly, this rate of reserve loss can not last forever).
Faced with this reality many countries will let the currency find its level and let the rest of the world deal with its consequences. Korea is today telling the rest of Asia what US Treasury Secretary, Jim Connally told his European counterparts back in the 1970s: “The dollar may be our currency, but it is your problem.” The added twist is that Korea is also telling its own corporate sector that the won is their problem, not that of the government. Many Asian companies will hear the same message. Any emerging market company with lots of foreign currency debt will lilkely find itself staring into the abyss.
The second part of the argument was that faced with a global recession that threatens to be a global deflation, currency depreciation becomes a desparate attempt to maintain exports. Commentators on my earlier post asked whether this can succeed. Of course, beggar thy neighbour cannot succeed if everybody tries it as the world found in the great depression, but that does not prevent everybody from trying it.
There will therefore be two kinds of currencies – those that are taken down by the markets and those that are taken down by their own governments. Some currencies will be somewhere in between – the markets will begin the job and the governments will finish it.
Now back to the fiscal implications. During the 1997 crisis, the discipline of currency markets was a strong factor in favour of fiscal restraint. This time around, that restraint will be lacking. In fact, the governments will be tempted to use fiscal boosts to lift the economy out of recession. Two statements from the just concluded Seventh Asia-Europe Meeting were interesting in this regard:
- Indian Prime Minister Manmohan Singh stated quite bluntly: “As a counter cyclical device, increased infrastructure investments in developing countries, if backed by increased resources flows from multilateral financial institutions such as the IBRD and Regional Development Banks, can act as a powerful stabilizer.” India has still not let go of its currency and so the call for support from the world bank makes sense. But the day the government decides that the rupee is somebody else’s problem, this support will be less important. Elsewhere in his speech, Dr Singh also quoted Keynes with approval.
- The statement of the Seventh Asia-Europe Meeting on the International Financial Situation contains this line: “Leaders called on all countries to pursue responsible and sound monetary, fiscal and financial regulatory policies, enhance transparency, inclusiveness, strengthen oversight, and improve crisis management mechanisms so as to maintain their own economic development and the stability of the financial markets.” This was remarkable for not talking about price stability or orderly exchange rates. One could argue that financial markets include currency markets, but in today’s context, the terms refers more to credit markets.
The fiscal binge (particularly when financed by the printing press) is just the currency debasement strategy applied internally rather than externally. It is a very powerful weapon against “debt deflation”, but the remedy can sometimes be worse than the disease.
Can the fisc substitute for the lost foreign demand? The fisc is ill suited to buying the stuff that Asia is used to selling to the now retrenching American consumer. The fisc is best suited to building roads to nowhere providing some support to the steel and cement industries which are now gasping for breath.
Posted at 9:41 am IST on Mon, 27 Oct 2008 permanent link
Categories: crisis, international finance
The coming wave of competitive devaluations in Asia
We are today seeing a significantly altered re-run of the 1997 crisis in large parts of Asia. Once again, there is a “sudden stop” and reversal of capital flows. The big difference is the the large reserves that Asian countries accumulated during the crisis.
Korea was the first to realize a few weeks ago that unless they threw the reserves away in a futile defence of the currency, the reserves were large enough to cover the sovereign debts as well as the debts of the banking system. A crashing currency could bankrupt reckless companies, but the country would be safe. They have therefore let the currency collapse and have been free to use the reserves to lend to their over extended banks. In 1997, Asians did not have this option. They thought that the only way to prevent a run on the country was to defend the currency and signal to the rest of the world that they were sound.
I believe that the Korean currency depreciation of recent weeks is going to be the new pattern in Asia. Under normal conditions, most Asian governments are suborned by their corporate sectors, but under conditions like this, these same governments would let reckless companies stew in their own brew. An added incentive this time is that with a slowing global economy, the Asians are going to be fighting for a share of a shrinking export pie. We will therefore see more of the beggar thy neighbour game that the Europeans and Americans played during the great depression. This time around, the western world does not seem inclined to play this game leaving the field wide open to the Asians.
We in India know how ten years ago the Koreans used their depreciated currency to capture the white goods market in India. Now that the won is again at 1400 (closer to 1450 as I write) to the dollar, I see an even bigger onslaught by the Koreans because the best run conglomerates are in far better shape than they were in 1998. It will not just be white goods but every industry where there is global excess capacity (which probably means just about everything).
The won will also put pressure on Japan to embark on large scale intervention (possibly half a trillion dollars over the next year or so) to keep the yen down. The Japanese are possibly more concerned about the euro-yen cross today and their intervention could indirectly help the Europeans. But the Chinese would feel the heat of a declining won and yen.
For a couple of months now, the smart money has been shorting the renminbi (what a change a few months makes!). As Chinese exports slow down, a depreciation of the renminbi would be just what the doctor ordered. Since probably as much as half a trillion dollars of hot money flowed into China in the last couple of years, the Chinese government would just have to sit back and watch this money flow out and pull the renminbi down as it leaves. I would not be surprised if a year from today, Japan once again has the world’s largest foreign currency reserves.
Competitive devaluation by Korea, Japan and China would leave India with no choice but to let the rupee fall to levels which would be frightening (if not bankruptcy threatening) to those who have been stupid enough to borrow in dollars. Beggar thy neighbour is a very ugly game when countries start playing it in right earnest.
Posted at 11:35 am IST on Fri, 24 Oct 2008 permanent link
Categories: crisis, international finance
More on India being in September 2007
I received several comments on my post yesterday in which I argued that India is now where the US was in September 2007. Several focused on the large correction that has taken place in the equity markets and argued that in this sense, much of the pain is over. I disagree. India had a most outlandish bubble in the equity market and a partial correction of this is not what I mean by pain. At this point, only momentum investors in Indian equities are suffering; longer term buy and hold investors are in the money.
Two reference dates that allow stock markets across the world to be compared are the highs that most markets reached in early 2000 at the height of the dot com bubble and the low points that many markets reached after the 9/11 event in 2001.
- The Sensex close of yesterday was over 70% above the dot com peak. In comparison, the Dow in September 2007 was 18.5% above its dot com peak while its close yesterday was 27% below that peak.
- The Sensex close of yesterday was almost four times the post 9/11 low. In comparison, the Dow in September 2007 was about 69% above its 2001 low while its close yesterday was pretty close to this low (a mere 3.4% above it).
Let us for the moment put aside the possibility of the Sensex returning to its post 9/11 low – that would be a drop of almost 75% from yesterday’s levels. But what about the Sensex returning to its dot com highs (a 40% fall from yesterday’s level)? Is that possible? Well if aggregate corporate earnings were to fall as they well might in a recession and if the PE multiples were to shrink in line with slower global growth opportunities, this is by no means beyond the realm of possiblity.
India and China are essentially leveraged bets on the global economy. When the global economy goes into recession, stock markets in these two countries will fall much more than global markets just as they rose much more than global markets on the way up.
Other commentators argue that India will not see much pain because we did not have the wild excesses of the US. The UK has had very little of the teaser rate mortgages and other such toxic stuff that we talk about in the US context, but the picture that the Governor of the Bank of England painted in his speech earlier this week was quite dismal. And did we not have excesses in India? Did we not reach a point last year where many companies found that it was cheaper to hire a senior manager in the US than in India, that it was cheaper to rent office space almost anywhere in the world than in India?
Posted at 3:43 pm IST on Thu, 23 Oct 2008 permanent link
Categories: crisis
Comments have been enabled again
I am happy to inform my readers that I have finally enabled comments once again on my main blog site. I had to disable comments temporarily last month after somebody starting spamming me at the rate of one spam comment every minute. It took me 45 minutes to realize what was happening and disable comments. It took much longer to manually take out the offending comments. Had he done it at a time when I was not watching, he might have had a comment spam on every one of my blog posts!. I used to think that my CAPTCHA’s will stop spam, but they stop only automated spam. They do not stop somebody who starts spamming manually.
It took me a lot longer to write some code in my blogging software to allow comments to be moderated. I have now done this and tested it out. It seems to work. Please email me if there are any problems.
It is my intention to use moderation only to filter out spam. I do not mince words on my blog and I do not expect you to mince words in the comments. Comments are also moderated on my Wordpress mirror.
Posted at 5:40 pm IST on Wed, 22 Oct 2008 permanent link
Categories: miscellaneous
India is now in September 2007
In terms of the financial crisis in India, I believe we are where the US and Europe were in August/September 2007. This is how the comparative chronology stacks up.
| US and Europe: August/September 2007 | India: October 2008 |
|---|---|
| August 9/10, 2007. Liquidity strains in the money market becomes acute. ECB injects liquidity of € 95 billion. Fed injects $ 38 billion. | October 10, 2008. Liquidity strains in the money market become acute. RBI injects liquidity of Rs 600 billion by cutting the cash reserve ratio (CRR). |
| September 18, 2007. Fed cuts Fed funds target by 50 basis points (0.5%). It also cuts discount rate by 100 basis points (1%) including a cut a month earlier. | October 20, 2008. RBI cuts repo rate by 100 basis points (1%). |
| Q3 2007. Real estate prices (Case Shiller index) after peaking in the second quarter of 2006 has been declining for five quarters but has fallen by only 5% from the peak. | October 2008. Real estate prices in India probably peaked in late 2006 or early 2007 and has also been declining unofficially for several quarters, but the sticker price has not yet fallen significantly. |
| Q3 2007. The ABX index of AAA rated sub prime securities indicates losses of only 5-10% of par value. Actual defaults and even downgrades of AAA securities are yet to come: the infamous downgrade of nearly 2,000 AAA securities over a mere two days came only in April 2008. | October 2008. Lenders still believe that the best real estate lending will hold up reasonably well and think that losses will be confined to the really low quality loans. |
If we assume that the peak to trough decline in real estate prices in India will be comparable to what we have seen in the US, then it is clear that most of the pain still lies ahead.
Posted at 11:11 am IST on Wed, 22 Oct 2008 permanent link
Categories: crisis
India and its two giant hedge funds
I like to think of what has been happening to India on the external front in recent months in terms of the two giant hedge funds that we as a country have been running. The first hedge fund is the product of our (Foreign Institutional Investors) FII regime and the Reserve Bank of India’s policy of reserve accumulation. Up to 1997, FIIs bought stocks in India and the RBI stashed away the dollar inflows in its foreign exchange reserves in the form of US Treasuries and other assets. As a nation therefore we were short Indian stocks and long US Treasuries.
During the past year or so this has been an immensely profitable trade for India. Think of an FII that brought a billion dollars into India when the exchange rate was say Rs 40/$ and the stock market index (Sensex) was say 20,000. The billion dollars fetched Rs 40 billion and these rupees in turn fetched 2 millions “units” of the Sensex. Today, the FIIs are stampeding out of the exits when the Sensex is say 10,000 and the exchange rate is say Rs 50/$ (let us choose nice round numbers). The 2 million Sensex “units” can now be sold for Rs 20 billion and these rupees fetch $400 million. The RBI sells $400 million of US Treasuries and pays off the FIIs. The remaining $600 million of US Treasuries are now ours to keep as they will never have to be paid back. India as a nation makes a cool profit of $600 million through our “FII hedge fund”. And that is not counting the profits that we made on the US Treasuries as the global turmoil pushed their yields down to ridiculously low levels. This is a fabulous return and any hedge fund anywhere in the world would give an arm and a leg for this kind of performance.
But India has been running another giant hedge fund which is doing very badly indeed. Unlike the open door policy that we had towards FII investments in Indian equity, we kept our corporate bond markets largely closed to foreigners. In a policy regime which can only be described as incredibly perverse, we did however allow the Indian corporate sector to borrow practically unlimited amounts in foreign currency in global markets. We did have a cap on External Commercial Borrowings (ECBs), but in practice, this cap was simply raised whenever it was approached. This coupled with the inefficiency of the domestic financial system (because of incomplete deregulation) drove the Indian corporate sector to borrow large amounts overseas. Consumed by some amount of hubris, Indian companies splurged billions of dollars on buying marquee companies around the world even when the domestic stock market told them in clear terms that they were overpaying.
This is the second giant hedge fund (the “ECB hedge fund”) that we as a nation have been running – long cyclically sensitive assets in India and around the world, short US dollars. A large part of the dollar borrowings were also in relatively short term funding which has to be renewed at today’s punitive interest rates. The credit spread on Indian paper has risen by around 500 basis points (5 percentage points), the dollar has risen, cyclical assets have been hammered down due to global recessionary fears – the “ECB hedge fund” has been living through a nightmare. Aziz, Patnaik and Shah estimate that the Indian corporate sector will require at least $50 billion of dollar liquidity in the coming year. This is one reason why there is so much shortage of liquidity in India today: with dollar borrowing next to impossible, dollar borrowings are being repaid our of rupee borrowings.
So all in all, the “ECB hedge fund” has performed disastrously and could conceivably end up losing more money for us as a nation than the “FII hedge fund” makes for us.
In the fullness of time, when we come around to reviewing our capital account policy frameworks, we will hopefully keep this in mind.
Posted at 11:21 am IST on Tue, 21 Oct 2008 permanent link
Categories: international finance
Mutual funds cannot borrow their way out of redemption trouble
Indian mutual funds have been facing redemption pressure for some time now and the policy response to this was to allow them to borrow more easily. The Reserve Bank of India early this week created a special repo facility of Rs 200 billion to enable banks to meet the liquidity needs of banks. This facility has thankfully not been very popular so far and I hope that it does not become popular because it is a prescription for disaster.
A mutual fund is very different from a bank. When a bank borrows to repay depositors, there is a capital cushion that can take losses on the assets side. When this capital is gone, the bank also needs to be recapitalized and cannot solve its problems by borrowing from the central bank. A mutual fund does not have any capital separate from the unit holders. This means that the only prudent way for a mutual fund to repay unit holders is by selling assets. If it borrows, then it is exposing remaining unit holders to leveraged losses.
Imagine a mutual fund with assets of Rs 1,000 (worth par) and 100 units of Rs 10 outstanding. The net asset value (NAV) of the fund is Rs 10.00 at this point. Suppose now that some of the assets deteriorate in quality and the true value of the assets is only 88% of par value. If the instruments were liquid and well traded, the mutual fund would mark its holdings down to market value, and the NAV would drop to 880/100 = Rs 8.80 per unit. But because the instrument is illiquid and not well traded, the mutual fund would avoid doing this by pretending that the assets are all good. The NAV would on paper remain as 10.00 instead of 8.80. If the mutual fund borrows 200 to meet a redemption request at the old NAV then only 80 units are remaining to absorb the loss on the assets. The true NAV at this point is only (880-200)/80 = 680/80 = Rs 8.50. Every unit holder who remains in the fund has lost Rs 0.30 in order to allow the redeeming unit holder to exit without a loss.
What this means is that every intelligent unit holder now has the incentive to redeem and exit at 10.00 rather than wait and be left with only 8.50. It is far better to force the fund to sell assets at distress prices if necessary. Suppose in the above example, the market prices are distressed and the assets which are truly worth 88% of par can be sold only at 80% of par. In this case, the NAV of the fund drops to 8.00 by being marked to market. Suppose 20 units want to redeem and the fund sells assets with a face value of Rs 200 at 80% to pay out the NAV of 8.00 x 20 or 160. Suppose the remaining unit holders sit out the distress and hold on to their units till the assets rise to their fundamental value of 88% of par, the assets of the fund at this point would be Rs 800 of face value which are worth 88% x 800 = 704. The NAV of the remaining 80 units would then be 704/80 = 8.80. Thus the remaining unit holders have a gain of 0.30 per unit at the expense of the redeeming unit holders. This is as it should be. Those who demand liquidity during troubled times should pay for it and the patient capital that sits out the storm should be rewarded. What this would also do is to reduce the incentive to redeem. Only those with pressing liquidity needs would redeeem.
The questions therefore is whether Indian mutual funds are facing only a liquidity pressure or whether they are also facing the problem of hidden non performing assets. I think the latter is clearly the case today. The liquid funds and fixed maturity plans that are facing redemption pressure today have broadly four clases of assets in the portfolio:
- Bank Certificates of Deposit: Under the current global scenario where exposure to banks is effectively sovereign exposure, it is reasonable to assume that these assets are not impaired.
- Securitized paper mainly pertaining to auto loans. The underlying loans are witnessing high delinquencies and it is fair to assume that this paper is impaired significantly beyond their carrying values.
- Securities of Real Estate Companies. It is fair to assume that this paper is impaired significantly beyond their carrying values.
- Securities of Non Bank Financial Companies: These companies in turn have large exposure to real estate, home loans, auto loans and other retail assets. It is fair to assume that this paper is impaired significantly beyond their carrying values.
In the current scenario, therefore, the NAVs of many debt oriented mutual funds today are not very credible. The only way to establish true NAVs is if the underlying paper is sold. Giving the mutual funds a credit line delays this day of reckoning. The danger is that the sophisticated corporates who are redeeming today get a good deal and the unsophisticated retail investors still holding on to their units will be left with all the rotten assets.
All of this is not to deny that a policy response is needed to the liquidity problem of mutual funds. If lending them money is not the answer, then what is the solution? There are two models available.
- The US solution of providing a sovereign guarantee to liquid mutual funds is one alternative. Part of the costs of this guarantee can be recovered by simultaneously withdrawing the tax break that the debt mutual funds get today.
- The solution adopted by Korea during the 1999 crisis in their mutual funds (ITCs) after the bankruptcy of Daewoo. This involved purchase of bonds from the ITCs by government entities (this was a purchase and not a loan), recapitalization of the ITCs and partial redemption freezes.
At the very least what is required today is a partial redemption freeze to ensure that nobody is able to redeem units of mutual funds at above the true NAV of the fund. Anybody who wants to redeem should be paid 70% or 80% of the published NAV under the assumption that the true NAV would not be below this. The balance should be paid only after the true NAV is credibly determined through asset sales. If this is done, then the Rs 200 billion line of credit would make sense to avoid distress sale of assets.
Posted at 5:18 pm IST on Fri, 17 Oct 2008 permanent link
Categories: crisis, mutual funds, regulation
Bubble in our backyard
I wrote a piece in the Financial Express on Saturday about India’s home grown financial bubble.
While Indians have been worrying about the spillover from the global financial crisis, a homegrown crisis has been brewing gradually. Like in the US, this crisis has its origins in a bursting real estate bubble and its effects are likely to be similar.
It is a mistake to assume that the US financial crisis was caused by the kind of securitisation and financial innovation that has been repressed in India. The deadliest financial innovation at the heart of the global financial crisis is a millennia-old innovation called the mortgage loan. We have had plenty of that in India.
During the last few years, India experienced a bubble in both residential and commercial real estate fuelled by easy availability of credit. Indians have been buying expensive houses almost completely financed by banks. The cumulative loan to value ratio including “furniture loans” and other forms of financing has been close to (and has sometimes exceeded) 100%. Unlike in the past, many of these transactions have been largely free of black money and therefore there is no hidden cushion in the loan to value ratio. Moreover, our young upwardly mobile professionals have been taking on large mortgage payments (EMIs) assuming that these would be affordable on the basis of projected salaries one or two years down the line. With declining salary growth, the affordability of these mortgages is now questionable.
Commercial real estate has been equally if not more frothy. Much of recent corporate lending by the banks has been to sectors like infrastructure, SEZs and retailing that have been essentially real estate plays. The real estate bubble has also helped banks to reduce non performing assets as companies have been eager to settle old problem dues in order to monetise their real estate.
The real estate bubble in India is clearly bursting. Anecdotal evidence points to declines of 20% or more in key markets. But this understates the severity of the problem. Real estate prices are sticky and they fall only gradually. Hidden discounts are more common than public price cuts. Evidence from the stock prices of real estate companies indicates that the value of their land bank has fallen by over 50%. Even if this is exaggerated, it is clear that a 30-40% nationwide fall in real estate prices from peak to trough is very likely.
Under this assumption, a large fraction of recent home buyers would have negative equity in their homes. They would also face increasingly unaffordable mortgage payments as the job market deteriorates. As in the US, we too have witnessed a significant easing of credit standards in retail lending in the last few years. We have anecdotal evidence that the retail unsecured lending portfolio of some large finance companies (including some foreign owned ones) received exit valuations of as little as 30% of face value early this year, and are probably worth even less currently. If credit standards in mortgages were similar, the home loan portfolio of the banking system could see severe losses as home prices fall.
I do hear people argue that while property loans in the US are without recourse, this is not the case in India. Actually, only in a few states of the US is it true that mortgages are without recourse to the borrower by law. However, elsewhere in the US and in other countries, where legally the lender has recourse to the other assets of the borrower, this makes very little difference in practice. The part of the loan that is in excess of the sale value of the house is an unsecured personal loan whose recovery in default is quite low and often lower than the costs of litigation.
Globally, therefore prudent lenders regard mortgages as being without recourse in practice. The lenders’ best bet is to modify the mortgage terms to persuade the borrower to stay on in the house and keep paying the reduced EMIs. This is because a house is typically worth more to the existing owner than to a potential buyer.
The picture in Indian commercial real estate is even worse because of the greater possibility of negative cash flows and acute liquidity stresses. There is of course a lag between dropping footfalls in malls to rising vacancy rates and then to negative cash flows, but the trends are clearly in evidence. It does appear that the situation in Indian commercial real estate is worse than that in the US.
Indian banks, mutual funds and other intermediaries have large exposures to residential and commercial real estate and there is a significant risk of their facing liquidity and solvency stresses similar to those faced by global banks. A “quiet run” is already beginning on some of these institutions. The question is whether Indian policy makers would respond to these stresses with the same speed and flexibility that the Americans and Europeans have exhibited.
Posted at 3:46 pm IST on Wed, 15 Oct 2008 permanent link
Categories: bubbles, crisis
Securitization has little to do with crisis
I have been arguing for sometime now that the global financial crisis has little to do with securitization and CDOs and everything to do with real estate lending. The data in the IMF Global Financial Stability Review released this week confirms this view. Of the estimated losses (Table 1.1) of $1.4 trillion, as much as 30% are in unsecuritized loans. The corresponding percentage was only 24% in March 2008 and as little as 17% in October 2007. During the last year, the percentage of losses attributable to unsecuritized loans has almost doubled.
What we see is that because of the mark to market approach, securitized assets show losses earlier while the held to maturity approach allows losses on loans to be concealed and deferred. In this sense, the securitized paper was the canary in the mine that alerted us to problems quite early. Policy makers are completely mistaken in believing that absent securitization, we would not have had any problem. All that would have happened is that banks would have been in a state of denial longer.
Another interesting thing that we have seen in recent days is that the global stock markets can take something like a trillion dollars of losses in a single day without stock exchanges collapsing. When banks take less than a trillion dollars of losses over more than a year, it looks like the end of the world. This tells us something about the inherent fragility of a bank dominated financial system and the need to move towards a world dominated by liquid financial markets. We also see that under conditions of extreme stress, liquidity collapses in inter bank markets, but not in stock markets and other non bank markets. Yet another reason to reduce the dependence on banks in the long run.
Posted at 1:57 pm IST on Sat, 11 Oct 2008 permanent link
Categories: bond markets, crisis, derivatives
SEC Audit Report on Bear Stearns
At the beginning of this week, the SEC released two reports of its Inspector General on the Bear Stearns failure and more generally the SEC’s supervision of the broker dealers. I am quite disappointed about this report which I approached with high expectations. This was a report requested by the US congress and the Inspector General had retained the services of one of the world’s leading authorities on market microstructure as an outside expert. The redactions in this report are not very large and I do not believe that the unredacted report would contain anything more useful.
The critical question in the SEC’s supervision of the broker dealers relates to the capital and liquidity regulations. On this the audit report states:
Bear Stearns was compliant with the CSE program’s capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements;
One expects an audit report to go beyond such an inane statement.
I read the audit report once again in the light of the management response by the SEC’s Division of Trading and Markets. I found myself agreeing more with the management response than with the audit report.
I remember being quite critical of the UK FSA’s internal audit report on Northern Rock, but today I must confess that the FSA report was definitely superior to this SEC report. We are reconciled to regulators being reactive rather than proactive, but if a regulator cannot do even a proper post mortem, then it is a matter of serious concern.
Posted at 1:41 pm IST on Sat, 4 Oct 2008 permanent link
Categories: crisis, investigation, regulation
More on financial crunch potential in India
I received several comments (some by email and some on the Wordpress blog) in response to my post about the possibility of a home grown financial crunch in India. Let me respond to some of them.
- Several comments asserted that there is a lot of black money in Indian real estate and this protects the lenders. It is difficult to make a categorical statement about black money which is by definition not publicly disclosed. My impression is that the prevalence of black money in real estate has been declining over time. The young upwardly mobile professionals have been demanding and getting white money transactions that can be almost completely financed by banks. I believe that much of the banking system’s real estate exposure involves transactions with negligible black money or structures which achieved high LTVs even after accounting for the black money.
- One comment asserted that the decline in property prices in India is confined to big cities and that the rest of the market is unaffected. This was true in the United States several months ago and is still partly true today – California and Florida account for a lot of the problems. Gradually, in India too, the problems could spread nationwide as they did in the US.
- Another comment highlighted the fact that while property loans in the US are without recourse, this is not the case in India. Actually, only in a few states of the US is it true that mortgages are without recourse by law. However, elsewhere in the US and in other countries, mortgages are in practice without recourse because of the difficulty of collecting. As we all know, when an unsecured retail loan defaults, recovery is quite low. Normally, what happens is that the banks modify the mortgage terms to persuade the borrower to keep paying the loan. But if the borrower defaults, the bank is left with whatever it can get for the collateral.
Posted at 10:21 pm IST on Tue, 30 Sep 2008 permanent link
Categories: crisis
Can a US style financial crunch happen in India?
When people ask me what impact the global turmoil would have on India, my response is that the relevant question to ask is whether a similar crunch could happen in India. The first point to emphasize is that the US turmoil has nothing to do with CDOs and securitization and everything to do with the bursting of a real estate bubble (see for example this, this, this and this).
Real estate prices are sticky (particularly downward) and therefore the bursting of the bubble is a very slow process – it is more like a leaking balloon than a bursting balloon. On the other hand, a liquid financial asset whose value is linked to real estate prices will decline sharply reflecting not merely the current fall in real estate prices but also the entire anticipated fall in real estate prices. This is why the first signal of problems in the US real estate came in the derivative markets (the ABX Index contracts). From there, the problems spread to the mortgage securities and CDO tranches that were most sensitive to real estate prices. To blame CDOs for this crisis is really no different from blaming the messengers for the bad news that they bring. I am fond of saying that the deadliest financial innovation that brought about the global turmoil is a millenia-old innovation called the mortgage loan. We have had plenty of that in India.
In India, the only liquid financial market related to real estate is the stock market. If we want to throw light on the boom and bust in real estate prices, it is to the stock market that we must turn. The stocks comprising the BSE Realty Index lost over 65% of their value between December 2007 and September 2008 while the broader market lost only 35-40% of value. Since the market value based debt-equity ratio of the realty companies was quite small (of the order of 10%), and the realty companies were valued in the stock market on the basis of the estimated value of their land bank, it is clear that the implied drop in nation-wide land prices is very steep. The implied drop is much higher than the 20% drop in selected pockets that is often mentioned anecdotally.
Just as the ABX Index prices (and housing futures prices at CME) have been the beacon of light in the US market in assessing the true state of US real estate, the realty stock prices are the beacon of light in understanding the true state of Indian real estate. The broad picture that we see is of an ultimate drop in real estate prices that is comparable to what is expected in the US. Since Indian mortgage loans are not marked to market (unlike the US mortgage securities) the impact of the problems in Indian real estate are hidden from the public view and are likely to manifest themselves in financial sector balance sheets only over a period of time.
Another way of looking at the Indian situation comes from reading Ellis’ paper “The housing meltdown: Why did it happen in the United States?”, BIS Working Paper 259. Many of the factors mentioned by Ellis are equally applicable to India:
- The supply elasticity of real estate construction has been very high in the current boom (compared to the past) and this supply overhang has the potential to deepen the correction that is required.
- There has been a significant easing of credit standards in retail lending in the last few years. We have anecdotal evidence that the retail unsecured lending portfolio of some large finance companies (including some foreign owned ones) received exit valuations of as little as 30% of face value early this year, and are probably worth even less currently.
- The cumulative loan to value ratio (CLTV) has been around 100% in many cases because of furniture loans and other similar loans that were added on to the basic housing loan.
- The tax system in India encourages mortgages in the same way as in the US.
- By affordability measures, Indian housing would be more expensive than in the US particularly but not only in cities like Mumbai.
All this implies that the housing price correction and associated mortgage defaults could be a serious problem in India. The key imponderable is the trajectory of monetary policy as well as GDP growth in India.
What is worse is that unlike in the United States, commercial real estate (CRE) is probably as badly (or even more badly) affected than residential real estate. There is of course a lag between dropping footfalls in malls to rising vacancy rates and falling CRE prices, but the trends are clearly in evidence.
Problems in commercial real estate are a serious problem for the banking system because a great deal of the improvement in non performing assets in recent years has been due to rising real estate prices. Many corporate defaulters queued up for settling the defaulted loans because the real estate value exceeded the value of the debt.
Moreover, the entire infrastructure sector which has received a lot of bank credit in recent years is largely a real estate play. If commercial real estate collapses, the viability of many of these projects would be seriously in doubt.
In a modern economy, lending of 80% of the value of real estate is a prescription for disaster when real estate prices come down. Real estate finance globally is in serious need for reform as I argued in a blog post several months ago. Real estate leverage ratios need to be brought down to more realistic “corporate finance” levels. (It is possible to achieve 80% or higher debt levels in repo markets and margin trading, but that requires the discipline of daily mark to market which is impossible in illiquid assets like real estate.)
Posted at 8:36 pm IST on Thu, 25 Sep 2008 permanent link
Categories: crisis
More on market for buyers only
Ankit Sharma sent me detailed short selling restrictions from various countries around the world. I have summarized the picture as follows:
- Short selling (naked or covered) prohibited in all stocks: Australia
- Naked short selling prohibited in all stocks: Switzerland
- Short selling (naked or covered) prohibited in key financial stocks: UK, US, Canada, Ireland
- Naked shorting prohibited in key financial stocks: Belgium, France, Germany, Luxembourg, Netherlands
Needless to say, this is a crude summary which glosses over exemptions and a lot of fine print.
Posted at 8:04 pm IST on Tue, 23 Sep 2008 permanent link
Categories: crisis, short selling
Towards a market only for buyers
The current state of progress towards a market where only buying is permitted is as follows:
- Pakistan: There is a floor price on the main index. “This Floor-Price-Level means that, KSE index cannot decrease below the closing level of [27th of August, 2008]: For KSE-100 index, the Floor-Price-Level is 9144.93 points. This action is taken because of the decline in KSE index to very low levels.”
- Russia: The stock market itself was closed for a couple of days.
- United Kingdom: Shorting of all financial stocks is banned: “The FSA stands ready to extend this approach to other sectors if it judges it to be necessary.”
- United States: Probably headed in the same direction. Updated: They are already there
Posted at 1:30 pm IST on Fri, 19 Sep 2008 permanent link
Categories: crisis, regulation, short selling
New blog feeds
I have been receiving several complaints about problems with my blog feeds particularly in Bloglines. People have also complained about the accessibility of my blog itself in terms of the uptime of the server on which it is hosted. I have done two things to make things better.
- I have started an atom feed in addition to the RSS feed. So if you have a problem reading my blog in Bloglines, you could unsubcribe from the old RSS feed and subscribe to the new atom feed: ../index.atomfeed
- I have also begun mirroring my blog at Wordpress. The blog address is http://jrvarma.wordpress.com/ and the RSS feed is http://jrvarma.wordpress.com/feed/. My reason for choosing Wordpress rather than Blogspot is that Wordpress allowed me to import all my old blog posts while Blogspot does not allow me to do so. As of now, I first post on my regular blog and then cross-post on Wordpress as soon as possible.
Posted at 5:47 pm IST on Mon, 15 Sep 2008 permanent link
Categories: miscellaneous
Visible benefits of margining FIIs
Foreign Institutional Investors (FIIs) resisted being margined in the Indian stock market, but the benefits of margining are now quite visible. Today, the Wall Street Journal reports that “Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.” Lehman may yet be rescued, but the report serves to remind all of us that a bankruptcy of a US firm leaves non US creditors totally in the lurch as explained by the London Banker in the Finance and Markets Monitor at RGE Monitor.
The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. ...
The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own.
The margining system ensures that there are enough assets within Indian borders to satisfy the needs of Indian counterparties. In this context, the unmargined OTC inter bank market leaves Indian counterparties at risk when foreign entities go bankrupt. That is an additional reason why the RBI should abandon its bias in favour of OTC markets and move more and more markets to an exchange traded and novated platform.
Posted at 12:02 pm IST on Sun, 14 Sep 2008 permanent link
Categories: exchanges, international finance, regulation
Governments can keep secrets if they want
Writing about the takeover of Fannie and Freddie in his Infectious Greed blog, Paul Kedrosky says: “Apparently the government is better at keeping secrets than anyone else in the capital markets. I’m not sure if that’s reassuring, or frightening.”
Kedrosky has a point. If the stories in the New York Times (“As Crisis Grew, a Few Options Shrank to One”, September 8, 2008) and the Wall Street Journal (“Mounting Woes Left Officials With Little Room to Maneuver”, September 8, 2008) are right, the decision to take a drastic action was taken more than a week before the announcement. The New York Times says that Treasury Secretary Paulson briefed President Bush over secure video on August 26, while the Wall Street Journal reports that the decision on conservatorship was taken on August 30/31 (the Labor day weekend). Yet, the markets did not get even a whiff about it until the government informed Fannie and Freddie about the decision on Friday, September 5 and asked them to get their boards to accept the terms of the rescue. From that point onwards, the media knew the broad contours of the rescue package and the announcement on Sunday morning was largely a formality.
In India also, we observe that the government is able to keep secrets if it wants to. Budget proposals are a wonderful example. Sometimes, the budget speech reserves its sting for the tail and then one an observe that until the closing minutes of the speech, the market has no clue about what is to come. And then within seconds, the market tanks as the finance minister reads out the nasty proposal.
The private sector by contrast finds it very difficult to keep secrets. It is very difficult anywhere in the world to even begin a merger discussion without the news leaking to the media.
Evidently, the incentive structures that the government can bring to bear are far more severe than anything that the private sector can muster. To answer Kedrosky’s question, I personally find it more frightening than reassuring – it suggests that governments simply cannot be trusted because their secrecy processes allow them to get away with blatant lying if they choose.
Posted at 2:51 pm IST on Tue, 9 Sep 2008 permanent link
Categories: miscellaneous
More on currency futures
I received some offline comments on my earlier blog post on currency futures in India and would therefore like to elaborate on my views.
I see this market evolving in three phases:
- In phase one, the market is largely retail. Retail traders simply did not have access to the forward market and assuming that they would like to use currency derivatives, the futures market is the only option for them. Some of the retail participation would be purely speculative, but there would be substantial hedging demand as well. The fact is that you can have an exposure to exchange rates even if all your economic transactions are with domestic participants and are denominated in Indian rupees. For example, a small pepper farmer who sells produce in the local market in Indian rupees is exposed to currency risk to the extent to which domestic pepper prices are linked to global prices denominated in dollars or other foreign currency. I believe that retail demand alone would be sufficient to take the market to the point where it has sufficient liquidity and depth for amounts of $50,000 to $200,000.
- This would bring the market to phase two where the liquidity and depth is enough to attract small and medium enterprises (SMEs). SMEs do not trade in the interbank market – they do forward contracts with their regular bank and face quite significant transaction costs. It is easy for the futures market to be competitive for this segment in terms of liquidity and depth. The futures market have the advantage of not tying up credit limits, but have the disadvantage of daily mark to market cash flows. Assuming that the broking business in India is more price competitive than the banking business, I expect brokers to find ways of meeting SME hedging demand at a lower all-in-cost than the banks do. Large SME participation would provide the market with good liquidity at a depth of around a million dollars.
- At this stage, the market is ready for phase three, where the market starts competing with the inter bank market for the smaller lots traded there. It is at this point (probably a year or more from today) that the restrictions on the futures market in terms of FII participation and client level position limits will start to bite. Assuming that these restrictions are lifted by then, the futures market could provide stiff competition to the inter bank market if the exchanges provide strong support for direct market access (DMA) and algorthmic trading and persuade agencies like Reuters and Bloomberg to give enough visibility to futures market quotes.
Posted at 1:23 pm IST on Mon, 8 Sep 2008 permanent link
Categories: derivatives, exchanges, international finance
Indian Currency Futures
Ajay Shah’s blog post yesterday provides a lot of interesting data about liquidity and trading in India’s nascent currency futures market. The contract is doing quite well for a newly introduced product, but clearly it is miniscule compared to the OTC market. What are the prospects of this market really becoming mainstream?
How does an illiquid market grow and take liquidity away from an established market? One important factor based on lessons from the well known battle for bund futures (see for example Cantillon and Yin) is the ability of the market to attract a different group of traders into the new market. New markets get their initial momentum from new entrants and not from switchers from old markets. This group of new entrants who value the liquidity of the old market less than the other characteristics that the new market offers start trading and gradually build up liquidity in the new market to the point where it can start attracting switchers.
For currency futures in India, there are several such groups available:
- Those who do not have the underlying exposure that the RBI requires for trading in the OTC market but are allowed to trade in the cash settled futures.
- Those who trade in lots smaller than the million dollar (or half-million dollar) lot required in the OTC market.
- Those who prefer the anonymity of the futures market as opposed to the bilateral trade that takes place in the OTC market.
- Those who prefer depositing margins or collateral in the futures exchange to tying up credit lines in the OTC market.
The restrictions in the currency futures market (position limit and absence of FIIs) do not bite at this stage because they do not by and large affect this group of new entrants.
The real battle for market share would begin when the market builds up reasonable depth and liquidity to attract participants from the inter-bank market (as opposed to the customer market from which the initial traders would come).
Globally, we know that the currency futures have a role in price discovery that is disproportinate to its share in trading (Rosenberg and Traub) though improved transparency in the OTC market has reduced this role quite sharply between 1996 and 2006. In India, the price discovery role of currency futures is potentially greater because of regulatory restrictions on the OTC market. An additional complication is that since covered interest parity does not yet hold in India, there is information content in the forward/futures market distinct from what is there in the spot market. Globally, one assumes that the information in futures and spot markets is the same.
Posted at 5:49 pm IST on Thu, 4 Sep 2008 permanent link
Categories: exchanges, international finance
Indian and Asian Money Markets
The September 2008 issue of the BIS Quarterly Review has an interesting article on Asian money markets by Loretan and Woolridge.
Their Graph 1 shows that as a percentage of GDP, the Indian Treasury Bill market is quite tiny. The Treasury and Central Bank Bill markets in countries like Malaysia, Phillipines, China and Taiwan are much larger as a percentage of GDP. India’s large fiscal deficit ensures that the government securities market as a percentage of GDP is reasonably large and I had not thought of this as a problem area. But Loretan and Woolridge data does suggest that there may be an issue with the maturity composition of the debt. A lot of the Asian T-Bill and CB-Bill market came out of sterilization operations and to my mind this makes sense. If a lot of the reserves are invested in short maturity assets, it makes sense to fund them with short matutirity liabilities as well. The question is why did India use Market Stabilization Bonds instead of Market Stabilization T-Bills.
The second thing that stands out in the paper is the volatility of the interbank interest rate. Indian rates are so volatile that in Graph 3 of the paper, Loretan and Woolridge plot India and Indonesia on a separate graph titled “Higher Volatility Markets”. Even between these two, it is the Indian interest rate that swings more wildly – even in a graph of the two most volatile rates, the Indian rate goes out of the graph. I can understand this happening when the central bank was targetting money supply rather than interest rates – even a monopolist cannot simultaneously control the quantity of money and its price. But this kind of volatility ought not to be present today.
Table 1 about turnover in derivatives market is distressing in terms of what India is missing out on, but at least here most of emerging Asia gives us company.
Posted at 3:53 pm IST on Mon, 1 Sep 2008 permanent link
Categories: bond markets, crisis, international finance
Catastrophe bonds to recapitalize banking system
Anil Kashyap, Raghuram Rajan and Jeremy Stein presented a fascinating paper at the Jackson Hole Symposium. This is my third post related to this symposium and yes, finally, the papers are available at the Kansas Fed website. The Buiter paper that I blogged about a few days ago after reading it on the WSJ website is also now available at the Kansas Fed website.
Kashyap, Rajan and Stein propose an instrument similar to a catastrophe bond which would automatically recapitalize the banking system when system wide losses cross a certain threshold. The starting premise of their paper is that the high level of leverage in banks is a rational response to governance problem of banks. If one accepts this premise, then their proposal for contingent capital makes a lot of sense. It gives banks capital to the banks when it is needed in the crisis, but does not give it to them in the boom when they might squander it.
It is a very clever idea, but I tend to be sceptical of the notion that there is something special about banks that exempt them from the Modigliani Miller arguments about capital structure. Rather I think Friedman was right in his statement in a different context that banks are not regulated because they are different, but banks are different because they are regulated. After all, many non bank financial firms run quite well with lower levels of leverage than banks, and the free banking era was also characterized by relatively low levels of leverage.
Kashyap, Rajan and Stein design their instrument very elegantly to deal with moral hazard problems at the level of the individual banks. My fear is that it will attract moral hazard on the part of the regulators. In fact, I think that their bond is best seen as non voting equity in a deposit insurance corporation. The governance implications of this are a nightmare.
Posted at 6:45 pm IST on Wed, 27 Aug 2008 permanent link
Categories: banks, crisis, leverage, regulation
Buiter on the central banks
Willem Buiter’s paper at the Jackson Hole Symposium castigating the major central banks of the world (and the Federal Reserve in particular) is worth reading in full (144 pages) even if one disagrees with what he has to say. I am surprised that as of today, I still cannot find the symposium papers at the web site of the Kansas Fed which organized the symposium, but the paper is available in the public section of the website of the Wall Street Journal.
Some people have been mis-characterizing the paper as dogmatically opposing central bank interventions on moral hazard grounds. That is not the impression that I got by reading the paper. The paper does accept that the central bank has to intervene in times of crises, but Buiter does oppose the particular forms that this intervention has taken.
Below are some interesting quotes from the paper:
- A case can even be made for taking the setting of the official policy rate out of the central bank completely ... the central bank is the only agency that can manage liquidity. It will also have to implement the official policy rate decision ... But it does not have to make the official policy rate decision. The knowledge, skills and personal qualities for setting the official policy rate would seem to be sufficiently different from those required for effective liquidity management, that assigning both tasks to the same body or housing them in the same institution is not at all self-evident. ... In the UK, the Governor of the Bank of England could be a member, or even the chair of the MPC, but need not be either. (p 36)
- The deviations between the official policy rate and the overnight interbank rate that we observe for the Fed, the ECB and the Bank of England are the result of bizarre operating procedures – the vain pursuit by the central bank of the pipe dream of setting the price (the official policy rate) while imposing certain restrictions on the quantity (the reserves of the banking system and/or the amount of overnight liquidity provided) ... Ideally, there would be a 24/7 fixed rate tender at the official policy rate during a maintenance period, and a 24/7 unlimited deposit facility at the official policy rate. (p 37-8)
- Libor now is the rate at which banks won’t engage in unsecured lending to each other. (p 25)
- ... those engaged in applied statistics should not leave their ears and eyes at home. Specifically, it pays to get up from the keyboard and monitor occasionally to open the window and look out to see whether a structural break might be in the works that is not foreshadowed in any of the sample data at the statistician’s disposal. (p 64-5)
- The UK ... a Net International Investment Position of around minus 27 percent of GDP in 2007 ... a primary deficit of almost five percent of GDP. ... both external assets and external liabilities are close to 500 percent of GDP. The characterisation of the UK as a hedge fund is only a mild exaggeration. (p 68)
- The decision to discontinue publication of the M3 series also smacks of intellectual hubris; effectively, the Fed is saying: we don’t find these data useful. Therefore you shall not have them free of charge any longer. (p 80)
- If we add together the statements by the world’s central bank heads (from the industrial countries, from the commodity-importing emerging markets and from the commodity exporting emerging markets) on the origins of their countries’ inflation during the past couple of years, we must conclude that interplanetary trade is now a fact: the world is importing inflation from somewhere else. (p 82)
- On August 17, 2007, there were no US financial institutions for whom the difference between able to borrow at the discount rate at 5.75 percent rather than at 6.25 percent represented the difference between survival and insolvency; neither would it make a material difference to banks considering retrenchment in their lending activity to the real economy or to other financial institutions. This reduction in the discount window penalty margin was of interest only to institutions already willing and able to borrow there (because they had the kind of collateral normally expected at the discount window). It was an infra-marginal subsidy to such banks – a straight transfer to their shareholders from the US tax payers. (p 97)
- Both the 1998 LTCM and the January 21/22, 2008 episodes suggest that the Fed has been co-opted by Wall Street - that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception of reality is unhealthy and dangerous. It can be called cognitive regulatory capture (or cognitive state capture), because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator or agency, like the Fed, but instead through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest. (p 101-2)
Posted at 4:00 pm IST on Mon, 25 Aug 2008 permanent link
Categories: monetary policy
Bernanke and his tag clouds
Paul Kedrosky’s Infectious Greed blog compares Bernanke’s speech at the Jackson Hole symposium this year with his speech at the same event last year. Using Wordle, Kedrosky produces nice tag clouds for the two speeches that highlight how sharply Bernnake’s concerns have moved from mortgage markets to the entire financial system.
I liked the Wordle tag clouds so much that I created one for my own blog which appears at the end of this post. The tag cloud confirms my description of the blog as being about financial markets.
Coming back to Bernanke’s speech, I found a few interesting things.
First, there was the sentence “The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions.” This seems to vindicate those who have been arguing for quite some time now that the Bear Stearns rescue was a bail out of J P Morgan Chase. JPM had the largest derivative book by far of all the commercial banks and was a large counterparty of Bear Stearns.
Second, was the passage that has been widely quoted in the blogosphere: “A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.”
I wonder whether a new statutory framework is really necessary to achieve this. The monoline bond insurance companies have been able to negotiate cash settlement of the guarantees (which they had issued when they were AAA rated) at haircuts that reflect their current reduced credit worthiness. I would imagine that if Bear Stearns had not been bailed out, similar haircuts could have been negotiated with its counter parties as well. The Bear Stearns rescue was essentially a $29 billion loan under a second loss credit note collateralized by Bear Stearns assets. I do not see why the Fed could not have lent directly to Bear under a similar structure and adjusted the second loss trigger point to achieve any desired haircuts for the counter parties. I suspect that the alleged lack of legal frameworks is an excuse for lack of spine.
The Wordle tag cloud for my blog is shown below:
Posted at 2:12 pm IST on Sat, 23 Aug 2008 permanent link
Categories: crisis
Faster rights issues in India
The Securities and Exchange Board of India (SEBI) has announced “changes in timeline [that] would enable a right issue to be completed within about 43 days as against about 109 days currently available for a rights issue.” It is indeed very creditable that SEBI has chose to attack the problem decisively rather than tinker at the edges.
Just to provide perspective, the ill fated rights issue of HBOS in the UK took almost three months (from late April to late July) to complete and during this period a 45% discount to the market price turned into a premium. After this experience, the UK is also attempting to bring this period down.
Posted at 11:36 am IST on Fri, 15 Aug 2008 permanent link
Categories: equity markets, regulation
Insider Trading by Underwriters
Robert Preston at BBC News reports about the extraordinary insider trading that took place after the HBOS rights issue flopped miserably and the underwriters were left holding the bulk of the issue:
On Friday, Dresdner and Morgan Stanley both knew that existing shareholders had shunned the rights issue, since they were organising the share sale. But the market was only given the information this morning.
That information was - in theory at least - highly price sensitive. You’d think therefore that both Dresdner and Morgan Stanley would be banned from dealing in HBOS on their own account till the market had been told the extent of the rights take-up.
But apparently no such prohibition applied.
...
Well after the rights closed at 11am on Friday, they were both allowed to take a short position in HBOS, to cover themselves against a future fall in the HBOS share price.
So they duly shorted HBOS in massive size. I understand Morgan Stanley took a 2.4 per cent short position in the mortgage bank - which is huge.
If this story is true, it means that the UK Financial Services Authority (FSA) has given up all pretence of being a referee rather than a market player itself. The FSA’s stand against what it called abusive short selling now sounds truly hollow.
Posted at 1:17 pm IST on Tue, 22 Jul 2008 permanent link
Categories: equity markets, insider trading, regulation, short selling
US too turns against the shorts
The headline on FT Alphaville says “America suspends capitalism” while the Wall Street Journal’s Deal Journal suggests that the regulators would simply have put a bounty on a short seller’s head if only they knew that it could be done. They are both referring to the emergency order of the US SEC against naked short selling in 19 financial stocks including Lehman Brothers, Fannie Mae and Freddie Mac. These orders were issued under Section 12(k)(2) of the Securities Exchange Act which provides that the SEC “in an emergency, may by order summarily take such action ... as the Commission determines is necessary in the public interest and for the protection of investors ... to maintain or restore fair and orderly securities markets.”
I can well see that a ban shorting Fannie Mae and Freddie Mac might help the central banks of China, Russia and other countries which together hold close to a trillion dollars of these Agency bonds, but I fail to see how it protects the US investors whom the SEC was set up to protect.
It was only last month that I commended US regulators for not being as harsh on short sellers as the UK had been. My praise was clearly premature. In addition to the ban on naked shorting, the SEC was also talking loudly about “enforcement investigations into alleged intentional manipulation of securities prices through rumor-mongering and abusive short selling.”
Incidentally, Aleablog tells us that there is an ETF that allows one to short the US Financials Index without being naked short at all. That post also tells us June was the best month for short sellers since the dot com bust seven years ago.
Posted at 6:39 pm IST on Wed, 16 Jul 2008 permanent link
Categories: short selling
Y V Reddy on Indian Financial Stability
Reserve Bank of India Governor, Dr. Y V Reddy in a speech at the Meeting of the Task Force on Financial Markets Regulation in the United Kingdom earlier this month talked about how “India has by-and-large been spared of global financial contagion due to the sub-prime turmoil”:
The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by resident in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. As a result, while there are orderly conditions in financial markets, the financial institutions, especially banks, reflect strength and resilience.
First of all, I would have liked the word “yet” to be added while talking about India being spared the turmoil because it is too early to say whether India will emerge unscathed out of all this. It has been my view that the global turmoil is first and foremost about the bursting of an asset price bubble in real estate and secondly about excessive leverage. The specifics of the financial products involved – credit derivatives, financial guarantees, securitization, CDOs and SIVs – are relatively less important. India has not yet had an equally severe correction in property prices though correction in the share prices of real estate companies suggests that such a correction is in progress. I also think that there is a high degree of leverage in Indian real estate and a fair degree of sub prime lending too. One part of the sub prime lending (unsecured personal loans) has already witnessed severe losses mainly for finance companies. A 20% nation wide fall in real estate prices in India is not inconceivable, and if that were to happen, the consequences would be ugly for the financial sector.
Second, the idea that institutions in India are prevented from excessive risk taking is quite incorrect. Indian banks can make bad loans as easily as banks elsewhere in the world, and there is little evidence that the culture of credit appraisal is particularly strong in large parts of the banking system. Low levels of non performing assets in an (until recently) booming economy prove nothing.
Third, the assertion that financial markets in India do not become extremely volatile is plainly wrong. I would recall January 16, 1998 in the fixed income markets, August 20, 1998 in the currency markets and January 21, 2008 in our equity markets as evidence of what can happen in a single day in three different financial markets. Low volatility during benign periods is irrelevant; what matters is the volatility when things go wrong.
The speech refers to several counter cyclical policies of the RBI:
- encouraging banks to create an Investment Fluctuation Reserve
- permitting them to transfer bonds to the Held to Maturity category
- increasing the risk weight for real estate loans, consumer credit and capital market exposures.
The first and the third are valid points and highly creditable. The second is quite dubious as it only allowed banks to avoid mark to market losses.
Posted at 6:22 pm IST on Fri, 11 Jul 2008 permanent link
Categories: crisis, regulation
Crude oil spot and futures markets
There appears to be a lot of confusion about the relationship between spot and futures markets for crude oil after Paul Krugman set the ball rolling with his remark: “Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.” Krugman led up to this with an even more provocative example:
Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?
The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.
Such provocation was bound to elicit an extreme response and Peak Oil Bebunked did just that with the oppposite claim:
Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by ... adding a premium to, or subtracting a discount from, certain benchmark or marker crudes. ... Originally, the benchmark prices were spot prices, but over time ... many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark.
... Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren’t a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.
Peak Oil Bebunked left many commentators on his blog thoroughly confused. One commentator for example wrote:
I always wondered about this. I figured the futures prices had to adjust to the spot price (which was driven by actual oil) as the contract expired. If they didn’t, a arbitrage opportunity would exist that would correct the imbalance.
But given this explanation, I guess not. I guess the “spot” prices adjusts to the futures price.
The downside to this approach is that supply/demand fundamentals don’t necessarily determine the price.
Crude oil markets are pretty complex and Peak Oil Bebunked’s description of this market is actually quite correct, but there is a sense in which Krugman’s textbook model is not totally wrong either. It is worthwhile understanding this market in some detail. For concreteness, I will focus on the Brent Crude market.
The term Brent crude today refers to crude coming out of any of four oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk – collectively referred to as BFOE.
The most important market for physical Brent crude is the cash BFOE market which is essentially a forward market. It is based on 21 days advance declaration (though 15 day and other periods are also in vogue). In July, a buyer and seller may conclude a transaction for delivery in August without fixing even the approximate date within the month. The buyer can choose the date later but has to give 21 days advance declaration to the seller. It is the price of this contract that most participants would regard as the price of physical Brent crude oil. Price discovery does happen in this market though it is heavily influenced by the futures price. Moreover, though this is a market for physical crude, it is a forward rather than a true spot market.
Let us then move to the closest that we get to a spot transaction – the dated Brent crude market. The terms are usually FOB – the buyer brings the vessel and the seller provides the berth at the terminal and loads the cargo. Dated Brent is a market for a specific cargo (typically 600,000 barrels) to be loaded at the terminal close to Brent during say July 23-25. The middle day (July 24) is the scheduled day of loading, but the buyer can usually bring the vessel to the terminal at any time within the three day period known as the laydays. Dated Brent contracts are actively traded between oil industry participants. Also, when a buyer gives an advance declaration in the cash BFOE contract, it effectively becomes a dated Brent contract.
Since the laydays span three days and the loading period itself could be close to two days, there is considerable deviation in the precise day of loading of the cargo even in the dated Brent market. Similarly, if the buyer of an August cash BFOE contract gives declaration for a date late in August, it is possible that loading takes place only on say the 2nd of September. Contracts often allow for further exceptions even beyond this if there is a curtailment of production in the oilfield or for other reasons beyond the control of the buyer or seller. These complications are natural in any genuine spot market for a non financial asset.
The dated Brent market probably has very little impact on price discovery for Brent crude. This is because these transactions are concluded on a differential to the (forward) cash BFOE price. The dated Brent for July 23-35 might for example be traded at August cash BFOE plus 10 cents.
Finally, we come to what is by far the most important price of Brent crude – the Brent crude futures at ICE. The ICE Brent Futures is a deliverable contract based on EFP delivery with an option to cash settle. Cash settlement is based on the cash BFOE market as explained in the contract specifications:
[T]he ICE Futures Brent Index ... is the weighted average of the prices of all confirmed 21 day BFOE deals throughout the previous trading day for the appropriate delivery months. These prices are published by the independent price reporting services used by the oil industry. The ICE Futures Brent Index is calculated as an average of the following elements:
- First month trades in the 21 day BFOE market.
- Second month trades in the 21 day BFOE market plus or minus a straight average of the spread trades between the first and second months.
- A straight average of all the assessments published in media reports.
Essentially, therefore, the underlying for the Brent futures is the cash (21 day) BFOE market. The standard textbook model of cash-futures arbitrage implies that the futures price cannot deviate too much from this underlying “spot” price. Even if we regard cash BFOE as a forward rather than spot contract, it is linked to its underlying which is dated Brent. The moment the buyer of cash BFOE gives declaration, he effectively turns his contract into dated Brent crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At this level, Krugman’s argument that a futures contract is a bet about the future price is not without merit.
But things are much more complex than this because long term contracts for crude in regions far away from the North Sea are based on Brent futures price plus/minus a differential. ICE claims that the Brent contract “is used to price over 65% of the world's traded crude oil.” On the other hand, BFOE is only a miniscule part of the total crude oil production in the world. This is the point that Peak Oil Bebunked is making. Brent futures are far more important and influential than any of the markets for physical crude. Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.
Crude is a particularly nasty example, but similar phenomena exist even in financial assets. Much of the price discovery in stock markets happens in the index futures market. Individual stocks are priced taking the broader market index as given. If the index has fallen 5% on a day and a specific stock has not traded so far, a person contemplating placing a bid for this stock would implicitly price it off the index futures price taking into account the beta of the stock and any stock specific information. Yet the index futures contract is settled using the cash index value and is therefore itself tied down to the cash market through cash-futures arbitrage. This is not inconsistent with the fact that the major element of price discovery happens in the index futures market.
Posted at 3:32 pm IST on Fri, 4 Jul 2008 permanent link
Categories: commodities, derivatives
Non-use of ratings in SEC regulations
I am not fully satisfied with the 222 page proposal that the US SEC has put forward for eliminating the use of credit ratings in various regulations. It is certainly commendable that the SEC has done a comprehensive job of identifying all regulations that refer to ratings and then systematically eliminated every one of them. Moreover, in many cases, the SEC has also identified meaningful alternatives to the use of ratings. My disappointment is in relation to the two or three truly critical uses of rating in the SEC regulations.
The first is in capital requirements for broker dealers where the existing regulations specify different levels of haircuts for their proprietary positions in debt securities with different levels of credit rating. A good solution to this problem could have provided the template for eliminating the use of ratings in Basle 2 as well. Instead what the SEC proposes is:
We are proposing the substitution of two new subjective standards for the NRSRO ratings currently relied upon under the Net Capital Rule. For the purposes of determining the haircut on commercial paper, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the three highest rating categories by at least two NRSROs -- with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For the purposes of determining haircuts on nonconvertible debt securities as well as on preferred stock, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the four highest rating categories by at least two NRSROs with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.
We further believe that broker-dealers have the financial sophistication and the resources necessary to make the basic determinations of whether or not a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments.
Notwithstanding our belief that broker-dealers have the financial sophistication and the resources to make these determinations, we believe it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the Net Capital Rule.
The last paragraph above means that while technically the SEC gets ratings out of its rule book, for all practical purposes nothing really changes. Broker dealers would use ratings exactly as before with the full blessings of the SEC.
The SEC has a similar non solution in the second place where ratings play a critical role. Money market funds are allowed to value their holdings at amortized cost rather than fair value on the ground that regulations restrict their investments to short term debt securities in the two highest short-term rating categories. The proposal is to rely on a determination of “minimal credit risk” by the board of directors of the fund. In the context of the large losses that many money mutual funds have taken during the sub prime crisis, I would have thought that the logical thing to do would have been to mandate fair value accounting for money market funds and treat them like any other mutual fund.
The third critical use of rating and rating agencies is in the field of disclosure. Rating agencies are exempted from the prohibition of selective disclosure under Regulation FD. The SEC proposes to maintain this exemption. I think this exemption is inconsistent with the stand of the ratings agencies that their ratings are “editorials”. Similarly, the SEC permits but does not require issuers to disclose credit ratings in their offer documents. The SEC’s proposal leaves this substantially unchanged. My problem here is that if ratings are editorials, then they should be permitted to be disclosed in offer documents only in the same way and to the same extent that other editorials, research reports or expert opinions are permitted to be disclosed.
Posted at 5:09 pm IST on Wed, 2 Jul 2008 permanent link
Categories: credit rating, regulation
Where is London's alleged light touch?
At least when it comes to short selling in today’s troubled markets, the UK Financial Services Authority’s vaunted light touch has given way to a heavy handed approach that makes the US regulators appear light touch. The US regulators have been content to be silent spectators while outspoken short sellers attack key financial institutions. Ackman has brought the bond insurer MBIA to its knees and Einhort has put enormous pressure on Lehman without any rebuke from any regulator.
By contrast, the FSA in the UK has ham handedly pursued those who shorted the leading UK banks particularly HBOS. In April, I blogged about the FSA initiating a probe into short selling in HBOS shares. Since then, HBOS shares have fallen by almost 50% as a stream of bad news has come out of the bank. In late April, HBOS launched a rights issue at what was then a deeply discounted price of 275p. On a couple of occasions recently, the share price has dropped below the rights issue price threatening the success of this capital raising effort. The FSA stepped in earlier this month with fresh regulations against short selling in companies which are conducting rights issues. The new regulations require public disclosures of any short position exceeding 0.25% of the issued capital of a company that is conducting a rights issue. The FSA stated:
The FSA views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. ...
In addition to the new disclosure regime, we are also giving consideration to whether it might be necessary to take further measures in this area. We are currently examining a number of options including the following: restricting the lending of stock of securities in rights issues for the purposes of enabling short selling; and restricting short sellers from covering their positions by acquiring the rights to the newly issued shares.
Much of this is silly. It is precisely when a company is raising billions of pounds of new capital from the public that investors need the genuine price discovery that is promoted by short selling. As it is, the FSA is dangerously close to complicity in a scheme to sell overpriced shares to the public on the basis of an artificially elevated share price. The FSA has been saved from this only by the ineffectiveness of its measures in propping up the share price on a sustained basis. After a short spike, the price has again been testing the 275 level.
Meanwhile, press reports state that the FSA is ending the probe that it launched in April – apparently, it is unable to put together a case against anybody in that case. If true, this vindicates all those who thought that the investigation itself was misguided.
I think what we are seeing is a clear regulatory conflict of interest. In its role as the supervisor of HBOS, the FSA seems to be putting the health of HBOS above the health of the capital market which it regulates.
Posted at 2:56 pm IST on Tue, 24 Jun 2008 permanent link
Categories: crisis, regulation
Offmarket transactions on the exchange for tax reasons
We have been discussing order matching and market microstructure in class during the last two weeks and this morning, students brought up the report in the Economic Times today about whether Ranbaxy promoters could use bulk trades on the exchange to sell their holdings to the Japanese acquirers. The reason for doing this is that India does not levy capital gains tax on transactions done on the exchange – the Securities Transactions Tax (STT) levied on exchange transactions is supposed to be in lieu of capital gains tax.
The price that the Ranbaxy promoters have negotiated with the acquirer is at a premium of about 27% to the current market price and SEBI regulations allow block trades negotiated outside the exchange to be put through the exchange only within a price band of 1% of the market price. It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.
Obviously, a transaction of this kind would be done on the least liquid exchange on which Ranbaxy is quoted and it would be done at a time when the sell side of the order book is as thin as possible. There are two problems with this however.
The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens. There is nothing to be lost and everything to be gained by doing so. The acquirer has to make a tender offer at 127, but this is only for 20% of the issued shares and selling one’s entire holding at 125 is better than tendering into that open offer and taking one’s chances. If enough people put limit orders at 125 or so, then the cost of eating through the entire order book can quickly become prohibitive. This possibility is very real because people who have the ability to borrow stock can place these limit orders even if they do not own the stock. Immediately after the bulk deal, the price will drop back to normal levels and the short seller can buy back from the market and close out the position.
The second problem is the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003 (endearingly known as FUTP). I am not a lawyer, but I think FUTP raises some very interesting issues that have not I believe been tested in this context. The question is whether executing a bulk trade in this manner would amount to market manipulation. Regulation 4(2) of the FUTP states that:
Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-
- (d) paying, offering or agreeing to pay or offer, directly or indirectly, to any person any money or money’s worth for inducing such person for dealing in any security with the object of inflating, depressing, maintaining or causing fluctuation in the price of such security;
- (e) any act or omission amounting to manipulation of the price of a security;
I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative. I know we do not have OTC equity derivative markets in India, but imagine what the situation would be if there were large OTC barrier options at 125 that got trigerred by this trade. Would they not think that there was market manipulation?
In class today, we also considered the possibility of pushing the price only upto say 125.75 with a market order that just burns through the sell side of the order book and then using a block trade negotiated outside the exchange at 127 (within 1% of the market price). This would perhaps be even more manipulative and might not have any significant advantages over executing the entire transaction through the order book.
I think the most important lesson in all this is that the idea of treating the Securities Transactions Tax as a substitute for the capital gains tax is a huge mistake. It is not only inequitable in allowing very large untaxed incomes, but it also distorts markets and creates perverse incentives for many market participants.
Posted at 2:12 pm IST on Wed, 18 Jun 2008 permanent link
Categories: corporate governance, equity markets, regulation, taxation
Takeover disclosures and cash settled derivatives
The New York District Court ruled earlier this week that the hedge fund TCI should have disclosed its cash settled derivatives (total return swaps) on CSX stock under the takeover rules of the US SEC (Rule 13d-3). Hitherto, it was believed that cash settled derivatives do not convey a “beneficial ownership of any equity security” as required by the statute. Rule 13d-3 defines the beneficial owner essentially as one who has or shares voting power and/or investment power over the security.
The New York District Court took a different line. Based largely on the expert report of Prof. Marty Subrahmanyam, the Court came to the conclusion that the only practical way for the swap counterparty to hedge its position was to buy the underlying stock. It also found that this was what they actually did:
But the evidence is overwhelming that these counterparties in fact hedged the short positions created by the TRSs with TCI by purchasing shares of CSX common stock. ... they did so on virtually a share-for-share basis and in each case on the day or the day following the commencement of each swap.
This is precisely what TCI contemplated and, indeed, intended. None of these counterparties is in the business, so far as running its swap desk is concerned, of taking on the stupendous risks entailed in holding unhedged short (or long) positions in significant percentages of the shares of listed companies. As a practical matter, the Court finds that their positions could not be hedged through the use of other derivatives. Thus, it was inevitable that they would hedge the TCI swaps by purchasing CSX shares.
The Court interpreted this as investment power. Moreover, it determined that TCI chose counterparties who were more likely to vote the shares in accordance with its wishes. The Court relied on the SEC position that “ability to control or influence the voting . . . of the securities” constitutes voting power.
The Court also referred to provisions in UK law based on economic interest rather than legal ownership and stated that “Yet there is no reason to believe that the sky has fallen, or is likely to fall, in London” as a result of such provisions.
Having come close to saying that cash settled derivatives meet the definition of beneficial ownership under Rule 13d-3(a), however, the Court refused to rule on this point at all, but proceeded to decide the case under Rule 13d-3(b) which deals with “contract, arrangement, or device ... as part of a plan or scheme to evade the reporting requirements”. The Court also allowed TCI to vote the stock after making the requisite disclosures.
The Deal Professor is of the view that everything now depends on how the the Second Circuit Court of Appeals deals with this case on appeal.
All this discussion is of great relevance in India because of the large cash settled single stock futures market in India. Indian law talks about acquisition of shares and voting rights. Shares “includes any security which would entitle the holder to receive shares with voting rights”, but this clearly does not cover cash settled derivatives. Another issue that comes to mind in the context of the US ruling is the issue of participatory notes as well as that of the non voting ADRs and GDRs issued by Indian companies.
Posted at 6:12 pm IST on Sat, 14 Jun 2008 permanent link
Categories: corporate governance, derivatives, regulation
Reforming the rating agencies
In my last blog on my vacation reading, I was rather contemptuous of the efforts of the New York Attorney General and of IOSCO to reform the rating agencies, but Joshua Rosner goes much further. He says that the Attorney General’s proposal will actually reward the rating agencies, and I think he is right.
Rosner also has some very sensible suggestions for genuine reforms at the end of his post. I agree with all of them and also think that they are genuinely workable:
- Requiring that any regulated institution that was required to invest only in highly rated securities should generally hold only securities listed on a major exchange. They would be allowed to hold non-exchange traded securities only if they were able to demonstrate to examiners their own independent analysis in support of rating agency assessments.
- Reducing the structured finance liability exemptions for rating agencies
- When a rating agency finds that their model needs to be updated or corrected the rating agency should be required to, on a timely basis, re-rate all existing securities that were rated using the prior model.
- [For structured products], the rating agencies should be required to automate an objective method of utilizing the originally modeled assumptions and re-rating the security monthly using the original assumptions, originally assumed loss curve and tied to the monthly servicer remittance reports.
- A qualified team that is fire-walled from revenue line pressures and reports directly to a committee of independent Board members should create ratings models.
Posted at 1:55 pm IST on Tue, 10 Jun 2008 permanent link
Categories: credit rating, regulation
My vacation reading
I am back from my vacation. I did not read email and newspapers while on vacation, but I did read some blogs and web sites selectively. I also used the opportunity to catch up on some reading material that I had not been able to finish before I began my vacation. As could be expected, my vacation reading was dominated by the global financial turmoil. Some of the more interesting stuff that I read:
- Socgen put out the final report (Part 1, 2 and 3) of its internal investigations. This report is more sensible than Socgen’s earlier “non explanations” as I called them in my blog.
- The Financial Services Authority (FSA) in the UK put out a heavily redacted version of its internal review on the supervision of Northern Rock. This is certainly more informative than the executive summary that I dismissed as uninteresting in March. I still disagree with much of what they are saying.
- Davidoff’s Deal Professor column in the New York Times Dealbook calls for a complete rethink of the SEC’s takeover regulations in the US. He is absolutely right and a similar rethink is required in many other jurisdictions including India.
- The gloom surrounding the sub prime crisis calls for some humour and I enjoyed Macroman’s modern nursery rhyme on the house that Jack built.
- David Murphy’s draft paper on the credit crunch was enlightening. I especially liked his description of SIVs as the “The New Way of Doing Old Style Banking”.
- FT Alphaville reported at length on the computer bug in Moodys rating of CPDOs and their attempt to cover this up.
- In this light, the agreement arrived at by the New York Attorney General with the rating agencies on rating securities based on residential mortgages appeared to many observers too little too late.
- However, the New York Attorney General did make almost irrelevant IOSCO’s consultation report on “The role of credit rating agencies in structured finance markets” and the subsequent changes in the code of conduct. IOSCO also published a report on the subprime crisis.
- The OECD’s Financial Markets Trends published a revised estimate of the size of the subprime crisis.
- Reinhart and Rogoff’s study of eight centuries of financial crises is most useful. The 12-page bibliography itself will keep many of us busy for a while.
- Andrew Kuritzkes and Til Schuermann wrote a fascinating paper on “What we know, don’t know and can’t know about bank risk” using quarterly earnings data for 20 years for 300+ U.S. bank holding companies that had total assets of at least $1bn. I suspect that earnings volatility understates default risk, but the relative contribution of different kinds of risk is still highly valuable.
- Many blogs referred to an interesting story in the Wall Street Journal that provided a rare behind the scenes view of how the US FDIC handled the closure of First Integrity Bank. Many of us had marvelled at the FDIC’s ability to do bank closures quickly and smoothly, and the WSJ story unravelled this mystery to some extent.
- Andrew Clavell at Financial Crookery provided an interesting analysis of Warren Buffet’s huge derivative trades that I blogged about in March. He points out quite unsurprisingly that the position is basically a vega play as the delta is extremely low. The interesting twist is the sensitivity to the dividend yield (known as phi or lambda). Clavell suggests a a fixed for floating dividend swap to offset the negative dividend growth rate locked into the option price. The very fact that somebody can suggest such a swap to Buffet tells us something interesting about how Buffet is perceived in the markets today. Incidentally, the market attaches a higher default probability to Berkshire Hathaway than to Brazil. In May 2008, Brazil priced a 10-year bond at 15 basis points tighter than a deal of the same maturity launched by Berkshire Hathaway Finance at nearly the same time.
Posted at 8:46 pm IST on Sun, 8 Jun 2008 permanent link
Categories: miscellaneous