Away on vacation
I am away on vacation for about seven weeks. I will not be posting on my blog till mid-June
Posted at 7:12 pm IST on Fri, 25 Apr 2008 permanent link
Categories: miscellaneous
UBS thought subprime was safer than Japanese Government Bonds
The Shareholder Report on UBS Write-Downs is very informative and interesting, but what I found most striking was the fact that UBS started buying US asset backed securities in 2002 because it thought that Japanese Government Bonds were too risky. This switch took place in the Relative Value Trading (RVT) portfolio used by central treasury to manage the liquidity buffer for the entire UBS Group. This portfolio was run by Foreign Exchange / Cash Collateral Trading (FX/CCT) within the investment banking business of UBS. The report states:
UBS created the ABS Trading Portfolio in late 2002 / early 2003 after Credit Risk Control (“CRC”) downgraded its country rating for Japan. This meant that FX/CCT had to reduce its then substantial holding of Japanese Government Bonds (“JGB”). Because FX/CCT retained the same level of funding liabilities and an unchanged revenue budget, it proposed to build up a portfolio of US ABS. In order for the assets to be a suitable replacement for the holdings of JGB that were to be liquidated, any replacement securities had to be:
- REPO-able;
- Highly rated - i.e. AA or AAA;
- Capable of being pledged to (one or more of) the primary Central Banks as collateral for UBS’s own borrowings; and
- Capable of being sold in the short term.
There were also a number of other advantages of ABS perceived at the time, including small spreads, USD denomination and no interest rate dependencies (floating rate instruments only in the portfolio). Because they had a higher yield (e.g. than government bonds), including ABS in the RVT Portfolio meant that there was no negative carry trade in the RVT Portfolio.
This reminds me of the famous statement by Mirabeau during the French Revolution: “I would rather have a mortgage on a garden than a mortgage on a kingdom”. The fate of UBS’ subprime assets has been only marginally better than that of Mirabeau’s assignats.
Posted at 9:44 pm IST on Tue, 22 Apr 2008 permanent link
Categories: bond markets, risk management, sovereign risk
Doubts on LIBOR
Yesterday’s Wall Street Journal has a story about bankers questioning the reliability of Libor. Last month, the BIS Quarterly Review discussed the issue at length with lots of data and some amount of econometrics:
- Interbank rate fixings during the recent turmoil by Jacob Gyntelberg and Philip Wooldridge, and
- What drives interbank rates? Evidence from the Libor panel by Francois-Louis Michaud and Christian Upper)
Gyntelberg and Wooldridge find that: “The US dollar market stands out for being the one market where Libor rose by substantially less than similar fixings during the stress period. The average spread between Sibor and Libor widened from about zero in the normal period to 2 basis points in the stress period, and the spread between H.15 and Libor widened from -1 to 7 basis points.” Of these, Libor is the only one that is used as a reference rate for swaps and other derivatives while H.15 (named after the table number in which the Federal Reserve publishes the data) is the only one which is based on actual transactions.
Since H.15 was 7 basis points above Libor, it does confirm that banks were actually paying more than what the Libor panel was quoting during the Libor fixing. Though 7 basis points is not a trivial difference when trillions of dollars of debt is referenced to this rate, it is much less than the 30 basis points being mentioned in the WSJ article. Moreover, there is a different way of looking at whether Libor is too high or too low and that is by comparing it to the Overnight Index Swap based on overnight rates. Under the expectations hypothesis, the OIS and Libor must be equal. Michaud and Upper find that during the crisis, Libor exceeded the OIS by 50 to 90 basis points. From this perspective, the problem is that Libor was too high, not that it was too low.
Gyntelberg and Wooldridge re-estimated Libor using a bootstrap technique instead of the trimmed mean used by the BBA and found that the bootstrapped estimate is not significantly different from Libor. “Moreover, the 95% confidence interval around the bootstrapped mean loosely corresponds to the interquartile range in the Libor panel ... In other words, the bootstrap technique indicates that 19 days out of 20, the design of the Libor fixing produces an estimate that is close to the true interbank rate. This is the case even during the stress period.”
They also argue that “many of the banks on the US dollar Libor panel are also on the euro Libor panel, and there are no signs that signalling distorted the latter fixing.” I do not find this argument convincing because Chapter 2 of the same issue of the BIS Quarterly Review provides a chart on page 21 which highlights how lopsided the US dollar interbank market has become. The data suggest that US banks have raised more dollar deposits from non banks than they have lent to non banks while the position is the reverse for European banks. The result is that European banks have probably borrowed about half a trillion dollars from US banks in the short term inter bank market. In times of heightened concerns about counter party risk, positions of this size become difficult to roll over and poses huge systemic risk. The incentives for strategic quoting are much higher in the dollar market than in the euro market.
All this has a bearing on the common assumption made in recent years in the credit derivative market (both in the theoretical literature and in the practicing world) that the correct risk free rate is the swap rate (essentially Libor) and that the TED spread is essentially a liquidity premium and not a credit spread. Since the crisis of 2007 and 2008 is simultaneously about liquidity and about counterparty risk in the inter bank market, all the turmoil fails to throw light on this hugely important issue.
Posted at 1:10 pm IST on Thu, 17 Apr 2008 permanent link
Categories: benchmarks, derivatives
Thoughts on Global Financial Turmoil
What follows are the comments that I posted on Ajay Shah’s interesting blog post on understanding the global financial disturbance of 2007 and 2008.
Q1: Why was there a surge in demand for a yield pickup?
Ajay Shah is absolutely right in saying that monetary policy was loose, but then the question is why did it feed into asset prices rather than goods prices. It is the answer to this question that takes us to finance as opposed to economics. I often say that we must approach the study of finance with Ito’s Lemma in one hand and a copy of Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises in the other.
Q2: Why did dodgy practices on home loan origination and securitisation flourish?
This is question 1 in a different form: greater tolerance for operational risk instead of market risk.
Q3: Why did liquidity collapse in key markets thus doing damage to Finance?
I would argue that liquidity collapses when prices are not allowed to fall. Why are the ABX contracts liquid? Because they have been allowed to undershoot. The ultimate providers of liquidity in any market are the value investors and they do not enter until prices have undershot.
On what Ajay Shah regards as the “well understood” questions, my answers are slightly different from his:
Why did a modest rate of default in a relatively small part of finance lead to such a crisis?
My answer: The real problem is not sub prime (which is only the canary in the mine), but falling real estate prices. Real estate is a huge part of finance. See also my earlier blog entry on real estate finance.
Did the Fed do right in rescuing Bear Stearns?
In my opinion, No.
First, as Kindleberger used to say, "A lender of last resort should exist, but his presence should be doubted." Even after LTCM, there could be doubts. After Bear Stearns, there can be none. This is a great tragedy.
Second, I can understand LOLR (lender of last resort), I can even understand outright nationalization (Northern Rock). I cannot understand buying a second loss credit linked note on $30 billion of hard to value securities.
See also my earlier blog entry on the rise of Mahathirism in the US and UK.
Why has the impact on the real economy of these events been relatively modest?
My answer: Canary in the mine again. I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.
It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.
Posted at 12:42 pm IST on Tue, 15 Apr 2008 permanent link
Categories: crisis
Mahathirism thriving in US and UK
Mahathir was Prime Minister of Malaysia during the Asian Crisis a decade ago and shocked the world with controversial responses that stretched the limits about how responsible governments are supposed to behave. Looking around the world today, it is clear that Mahathirism is alive and kicking in the heart of the developed world. The actions of the US in the Bear Stearns bail out and of the UK in pursuing the enemies of HBOS smack of the same intolerance of market forces and preference for crony capitalism that characterized Mahathir.
The legal problems with the Bear Stearns deal have been analysed very ably by Prof. Davidoff in a series of articles in his Deal Professor column in the New York Times Dealbook (one, two, three, four, five, six, seven, eight, and nine.) Davidoff argues that the deal violates NYSE listing regulations (but the worst that NYSE can do is to delist Bear Stearns and this is going to happen anyway after the merger) and probably violates Delaware corporate law too. The circumstantial evidence certainly points to a deal that was imposed by the government with scant concern for the requirements of good corporate governance. Davidoff is also right in raising questions about the Bear Stearns directors selling their shares in the market rather than tendering it to the acquirer under the deal that they have approved. It is also evident that the creditors of Bear Stearns (and to a lesser extent, its shareholders) have been bailed out.
The story about HBOS in the UK is Mahathirism of a different kind. Since HBOS is known to have considerable exposure to the mortgage market, it has attracted considerable short interest. After rumours spread about liquidity problems at HBOS, the Bank of England took the extra-ordinary step of denying problems at this bank. The Bank of England does not usually talk about individual institutions. For example, during the Northern Rock hearings, the Chairman of the Treasury Committee of the Parliament had the following exchange with the Governor and another Director of the Bank of England:
Q129 Chairman: ... Are there any others in potential trouble? You do not need to name them!
Mr King: I think you know perfectly well that central bank governors cannot go ---
Q130 Chairman: Governor, I was not even talking to you; I was talking to Paul Tucker.
Mr Tucker: Central bank directors take the same approach.
Yet, the Bank of England went out of its way to deny the HBOS rumours. Moreover, though the BOE statement has been reported very widely in the press, I cannot find the text of the statement at the web site of the Bank of England despite searching its web site and also running down its list of press releases. So much about transparency.
The Financial Services Authority went further with a probe into the short selling episode. Its statement is quite bland, but press reports clearly indicate that the FSA is taking the probe very seriously. The FT Alphaville blog describes an imaginary conversation between the FSA and speculator showing how silly this whole idea of probing the short sales really is:
FSA: Why did you short this bank?
Speculator: Because I thought it might have liquidity problems.
FSA: Why did you then tell the salesman at X broker that you thought this bank had liquidity problems.
Speculator: Because I thought it might have liquidity problems.
FSA: But it doesn’t have liquidity problems.
Speculator: Really?
Posted at 6:52 pm IST on Mon, 14 Apr 2008 permanent link
Categories: international finance
Modernizing real estate finance
I believe that real estate finance today is where corporate finance was a hundred years ago, and the current global financial turmoil is the beginning of its transformation into something similar to modern corporate finance. About a century ago, corporate finance adopted its modern form where equity is owned by large diversified pools of capital with low levels of leverage. Real estate as an asset class is of the same size as the equity market, but it is still dominated by small undiversified owners with large amounts of leverage.
Most houses are owned by individuals who finance them with mortgage debt. A high quality mortgage might have a loan to value ratio of 80% while very few modern businesses are run with 80% debt to total capitalization. In lower quality mortgages, the loan to value ratio could be in excess of 90%. This is a prescription for financial fragility. While modern economies can easily absorb the stock market dropping by 50% in a year, their financial systems are devastated by even a 20% drop in real estate prices.
This is also a problem from the investor view point. Since real estate is as large an asset class as equities, an institutional investment portfolio should ideally have a large holding of real estate, but this cannot be achieved because ownership interests in real estate are not available in sufficient quantity (see for example, Hoesli, Lekander and Witkiewicz, “Real Estate in the Institutional Portfolio: A Comparison of Suggested and Actual Weights”, Journal of Alternative Investments, Winter 2003.) Almost all real estate is user owned and therefore the only exposure that you can buy to real estate in the financial markets is mortgage debt (residential or commercial).
Corporate finance was also like this centuries ago. Bond markets existed long before stock markets, and for the first couple of centuries of their existence, stock exchanges like the London Stock Exchange traded bonds more than stocks. Apart from their own money and that of their friends, businessmen had to rely largely on debt to finance their businesses. But all this changed in the late nineteenth century as Mitchell has described in his fascinating book The Speculation Economy: How Finance Triumphed Over Industry, BK Currents, 2007. The joint stock corporation meant that anybody anywhere in the world could own a piece of any business.
The equivalent transformation in real estate has yet to happen. For most individuals today, their home is the most undiversified investment that they have (even more undiversified than their human capital), and it is a heavily levered investment. If an individual were to buy shares worth several times his annual income on margin, we would doubt his sanity. But when he does the same thing in real estate, governments encourage the imprudence by giving generous tax breaks.
This fragile financial structure where everybody buys real estate on margin with a downpayment of only 10% or 20% is a prescription for huge systemic risk. By contrast, in the equity market, pension funds and mutual funds have negligible levels of leverage; very few individuals buy stock on margin; and corporate investments in stocks (strategic investments) are also financed with relatively low levels of debt.
The fragility of real estate finance is less of a problem so long as people irrationally keep paying mortgages even when they have negative equity in their homes. Standard valuation models of mortgage securities (whether it is prepayment modelling or default modelling) assume that the home owner is irrational and will neither exercise the prepayment option (call option) optimally nor exercise the default option (put option) optimally. As financial systems get more sophisticated, these assumptions are bound to be falsified. As this happens and jingle-mail becomes more prevalent, the business of selling near money put options on real estate (which is what mortgages are all about) is bound to be less and less viable.
In the period of transition, large portions of the financial system will doubtless lose much of their capital. This is what one is seeing in the global financial turmoil. It is a necessary part of the process of creative destruction through which hopefully real estate finance will be transformed just as corporate finance was transformed a century ago.
Posted at 6:13 pm IST on Fri, 11 Apr 2008 permanent link
Categories: crisis
Google stock screener
Google Finance has launched a stock screener that allows the user to screen stocks based on several criteria including a number of balance sheet and profitability variables, several valuation metrics as well as variables related to stock price performance. This tool makes possible a variety of analyses that could earlier be done only by those with an expensive Bloomberg or Reuters terminal. However, the universe is limited to about four thousand stocks which is much less than you would get if you subscribe to one of the commercial services.
For example, one can list the stocks with a market capitalization of more than a billion dollars that have a negative beta. There are fifteen of them, but several are bond funds or ETFs.
It is also interesting to just list the tops stocks by market capitalization and observe that three of the top five stocks are from China and Brazil.
I wish they would also allow screening by industry and geography. The query string in the URL clearly shows that sector and exchange are potential search fields, but these do not appear to be enabled as of now.
Posted at 9:48 pm IST on Thu, 3 Apr 2008 permanent link
Categories: miscellaneous
FSA Review of Northern Rock Supervision
The Financial Services Authority of the UK has published an executive summary of a review carried out by its internal audit division into its supervision of Northern Rock. It has also published the recommendations of this review as well as a high level summary of the Supervisory Enhancement Programme that it has undertaken in response to the Internal Audit Report.
It is possible that the executive summary is a somewhat sanitized version of the report, but I did not find anything interesting in it. It is always possible to criticize the original supervisory process with the benefit of hindsight; the published summary does not to my mind rise above this to any clear evidence of supervisory lapses. Moreover if it is true that “the supervision of Northern Rock was at the extreme end of the spectrum within the firms reviewed in respect of these failings and that its supervision did not reflect the general practice of supervision of high-impact firms at the FSA,” then it does not make sense to embark on a major supervisory enhancement.
The decision that in future, “High-impact firms will be a key area of supervisory focus, regardless of probability of failure” is also a little puzzling to me. Impact and probability of failure should jointly guide the supervisory effort and the decision does not make sense unless it is believed that it is not possible to make a reliable assessment of the probability of failure.
Posted at 6:28 pm IST on Wed, 26 Mar 2008 permanent link
Categories: crisis, investigation
Deliciously timed move to margin institutions
It was perhaps pure coincidence but the timing was still delicious – just two days after the collapse and bail-out of the US investment bank, Bear Stearns, the Securities and Exchange Board of India announced that even institutional investors in the Indian stock market would have to pay margins to back their trades. SEBI was careful to say that the move was designed to create a level playing field since non institutional investors already pay margins. But the fact remains that the move will also make the market safer. Exchanges are designed to eliminate counter party risk by interposing a central counter party which relies on collateral instead of making assumptions about the solvency of its counter parties. Traditionally, it has been assumed that margins are needed only in derivative markets and not in cash markets that settle in a couple of days. The speed with which Bear Stearns collapsed suggests that this assumption is dubious. SEBI is right to margin all investors in the cash market as well.
Posted at 10:52 am IST on Sun, 23 Mar 2008 permanent link
Categories: equity markets, exchanges, risk management
Is Warren Buffet's Berkshire Hathaway a hedge fund?
Aleablog reports that the market is worried about the default risk of Warren Buffet’s Berkshire Hathaway – CDS spreads have widened from 20 basis points in November 2007 to almost 120 basis points in mid March 2008. I spent some time reading Buffet’s letter to shareholders as well as Berkshire Hathaway’s annual report for 2007.
What struck me was that Berkshire Hathaway is becoming more and more like a hedge fund than a mutual fund. The transformation has been gradual. In his 2002 annual report, Buffet famously declared that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”. He also wrote that “When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.”
What a difference five years makes! In the 2007 letter, Buffet writes that Berkshire had 94 derivatives that he managed himself (up from 62 the previous year). Buffet does not use derivatives for hedging – in his 2006 letter, he wrote that he buys derivatives when he thinks they are wildly mispriced. As at the end of 2007, Hathaway had derivatives positions with a notional value of about $50 billion. The biggest chunk of these ($35 billion notional) are written put options on equity indices. That reminds me of LTCM which too had written large amounts of put options on equity indices. Berkshire has sold credit protection for $5 billion of notional value of junk bonds – too small to remind me of the bond insurers. During the last few years, Berkshire has speculated on a wide range of currencies, though it has unwound most of them at a profit. That reminds me of George Soros.
There does appear to be a big difference between the big hedge funds and Berkshire – the absence of leverage. But, probe a little deeper, and even this is not so obvious. A large part of Bekshire’s investment portfolio comes out of the $59 billion float of its huge insurance business of which $46 billion comes from the reinsurance companies. Reinsurance is best thought of as written put options on non traded or illiquid assets.
Berkshire today is not the simple investment company that it was a decade ago. Today it is in the business of writing put options (financial derivatives and reinsurance) and investing the proceeds in stocks. What Buffet wrote about the activities of major banks in 2002 is gradually becoming true of Berkshire. Rising CDS premiums are perhaps not so surprising.
Posted at 12:52 pm IST on Sat, 15 Mar 2008 permanent link
Categories: derivatives
Is this the beginning of the end of credit rating?
A report by the US President’s Working Group (PWG) on Financial Markets released on Thursday could well be the beginning of the end of credit rating. It says
Overseers should ensure that [institutional] investors (and their asset managers) develop an independent view of the risk characteristics of the instruments in their portfolios, rather than rely solely on credit ratings.
...
The PWG member agencies will reinforce steps taken by the CRAs through revisions to supervisory policy and regulation, including regulatory capital requirements that use ratings.
In a different context, the report also says that “U.S. authorities should encourage other supervisors of global firms to make complementary efforts to develop guidance along the same lines.”
There is therefore a serious possibility that global regulators would wean institutional investors away from the use of ratings and also reduce the regulatory role of ratings. If that were to happen, would the rating agencies survive only on the basis of retail investors relying on the ratings? I doubt that very much. Long ago when Eurobonds were bought by Belgian dentists, ratings were hardly influential. Bonds were bought on the basis of name recognition – companies like IBM, Coca Cola and Walt Disney could borrow easily because they and their products were well known.
It is true that when the rating agencies began life a century ago, they did not need a regulatory monopoly to prosper. But that was before Altman showed that creditworthiness could be easily measured using econometric models based on accounting information and before the Merton model showed that the stock price by itself provides adequate information.
Posted at 10:26 am IST on Sat, 15 Mar 2008 permanent link
Categories: credit rating, regulation
Theory building in real time
The global turmoil of 2007-08 has been a crisis in slow motion that has allowed an astonishing amount of theory building and conceptualization to happen in real time even as the crisis is evolving. I think that the theorization is much greater both quantitatively and qualitiatively than what I saw during the Asian (and LTCM) crisis of 1997-98 which was also a crisis in slow motion. I have spend the last several days reading and digesting a part of the huge literature that has emerged. That explains why there have been no posts on my blog for a long time now. The sense that I get is that, at a deeper theoretical level, what has happened is not quite so puzzling though financial market participants find the crisis inexplicable.
I will not attempt to summarize all the excellent work that I have been reading – they all deserve to be read in full. I shall just provide the links:
- Leveraged Losses: Lessons from the Mortgage Market Meltdown by David Greenlaw, Jan Hatzius, Anil K Kashyap and Hyun Song Shin provides several alternative estimates of the aggregate losses from the mortgage market and reconciles the huge differences between what the ABX market is telling us and what vintage-by-vintage analysis suggests.
- The BIS Quarterly Review, March 2008 has several special articles related to the current turmoil. In particular, I would point to Credit fundamentals, ratings and value-at-risk: CDOs versus corporate exposures by Ingo Fender, Nikola Tarashev and Haibin Zhu
- The Banque de France has an entire Special issue on Liquidity in its Financial Stability Review of February 2008. My mind goes back to 1999 when the BIS Committee on Global Financial Stability produced a collection Market Liquidity: Research Findings and Selected Policy Implications in response to the LTCM crisis. It is indeed heartening to find that our theoretical understanding of liquidity is far superior to what it was then.
- The Senior Supervisors Group consisting of banking regulators from France, Germany, Switzerland, UK and US presented a report titled Observations on Risk Management Practices during the Recent Market Turbulence on March 6, 2008 to the Financial Stability Forum. This provides an insightful comparison of risk management practices in firms that were badly affected by the crisis and those that avoided severe problems. Since it is based on an indepth study of eleven of the largest banks and securities firms in the world and not any silly check-box ticking survey, the report is extremely valuable.
- Is the 2007 U.S. Sub-Prime Financial Crisis so Different? An International Historical Comparison" by Reinhart and Rogoff provides a much needed historical perspective on what is going on.
- I would also like to mention a paper that is a little older but highly relevant to what is going on today: Market Liquidity and Funding Liquidity by Markus K. Brunnermeier and Lasse Heje Pedersen.
Posted at 3:43 pm IST on Tue, 11 Mar 2008 permanent link
Categories: crisis
Vulture funds restructuring sub prime home loans
Bloomberg has an interesting story (hat tip Aleablog) about how vulture funds are buying up delinquent mortgages and then reducing the interest rate to allow the borrower to resume payments.
A market solution like this appears to be a better strategy than the loan waivers that we are seeing in India and the government sponsored home loan restructuring that is being proposed in the United States.
Posted at 6:47 pm IST on Fri, 29 Feb 2008 permanent link
Categories: bankruptcy, bond markets, crisis
FICO scores and subprime defaults
Thomas Brown has an interesting article at bankstocks.com which indicates that US mortgage defaults might not be driven by low FICO scores at all. Brown compares the various mortgage pools underlying the widely tracked ABX index and shows that in many cases, the worst performing pools have higher FICO scores than the best performing pools. In some cases, the average FICO scores of the worst pools are around 640 so that they do not even count as subprime according to the standard definition. Until last year, subprime was generally defined as FICO scores below 620, but after the subprime turmoil began, some lenders have raised the cutoff to as high as 680.
In some sense, this is not surprising. FICO scores are not about creditworthiness as measured by income, assets or cash flows. They are simply about past credit histories. If a household with an impeccable credit history is given a housing loan that is well beyond what it can afford in terms of its income levels, the FICO score would be excellent, but the default risk would be high.
Brown’s data shows a clear pattern where pools originated by some lenders like Wells Fargo have the lowest default rates while those originated by other lenders like WMC have the highest default rates. Geography matters too – the worst pools have high exposure to some of the most frothy housing markets of 2006.
Brown interprets his data to mean that mortgage losses are not likely to be as high as feared because many subprime mortgages will not default. While I grant this, an equally valid conclusion from the data is that many non subprime mortgages will default because the trajectory of housing prices matters more than FICO scores.
All this has implications for India where many hopes are being pinned on the creation of credit registries and similar agencies that would make FICO-like scores possible in India as well. In a country where recovery is even harder than in the United States, excessive reliance on credit histories might not be such a good idea at all. The smartest crooks will build excellent credit histories with a series of small loans until they can take out a large loan. Long ago in the United States, the term Brazilian straddle was used to describe a huge market position which the trader intended to run away from if it proved unprofitable (the other leg of the straddle was supposed to be a one way air ticket to Brazil). What the equivalent straddle should be called in India is left to the imagination of the reader. I would confine myself to the observation that credit histories provide little protection against such straddles.
Posted at 5:01 pm IST on Thu, 21 Feb 2008 permanent link
Categories: bond markets, credit rating
XBRL - Is India missing the bus?
Nearly two months after the Securities and Exchange Board of India (SEBI) launched its XBRL enabled electronic filing platform, no XBRL tools are available on this platform, while the corresponding platform in the US continues to innovate in providing increasingly better and more powerful interactive tools to view and analyze the data. On Friday, the US SEC unveiled its new XBRL tool, Financial Explorer, which prompted me to do a quick comparison.
I looked up Infosys Technologies in the Indian filing system and got static tabular data with which one cannot do anything meaningful except by downloading it. Unfortunately, the site does not appear to allow the data to be downloaded in XBRL or any other usable format. I then went to the SEC’s Interactive Financial Viewer and could download the raw XBRL filing as well export the data into Excel. I could also compare the filing of Infosys with that of Satyam in parallel columns. The power of XBRL allows similar elements in the two filings to be lined up correctly in this tabulation while also providing data in each that is not present in the other. The site also allows the user to chart the data choosing the rows and columns of data that is to be charted.
I then went to the Financial Explorer page and saw how various interactive charts could be produced from the XBRL data. These charts rely on the semantic information embedded in XBRL. For example, since XBRL encapsulates knowledge of what are the elements of shareholder equity, it can generate a chart explaining the changes in shareholder equity in terms of the changes in its constituent elements.
Above all, the SEC is providing the source code for most of its application at its XBRL viewers page and is encouraging software developers to take this and build other tools based on this. In a couple of years from today, I expect that financial data will be shared, analyzed and presented using XBRL tools. I have previously argued that one day financial statements will also be prepared using XBRL tools.
SEBI certainly needs to do far more than it has done so far to bring the power of these exciting tools to Indian investors.
Posted at 2:51 pm IST on Sun, 17 Feb 2008 permanent link
Categories: accounting, regulation, technology
Unbundling derivatives clearing from trading
The US Department of Justice has put out a very well argued and cogent paper arguing that unbundling derivatives clearing from trading would lead to greater competition in derivative trading with attendant benefits in terms of greater innovation and lower costs for the users of derivatives.
The DOJ’s theoretical reasoning is quite sound:
If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and it thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sustained head-to-head competition. A trader could open a position on one exchange and close it on another. In such a world, a trader could execute against the best price wherever offered without fear of being unable to exit the position because there is insufficient trading interest (or of being forced to exit at a poor price) on the new entrant trading venue when a trader chooses to exit.
In addition, if exchanges did not control clearing, an appropriately regulated clearinghouse could reduce member margin obligations by recognizing offsetting positions in correlated financial futures contracts traded on different exchanges. The ability to offset correlated positions in a futures clearinghouse can significantly reduce the capital required to trade.
This theoretical reasoning is backed up by some excellent discussion about the attempted entry of Eurex into US Treasury futures as well as of other competitive battles in the derivative industry.
But the most important confirmation came from the stock market: the share price of the CME Group that runs the largest derivative exchange in the US dropped by 18% after these comments were released and rose again after subsequent news reports suggested that the proposed changes were unlikely to happen anytime soon.
Posted at 5:00 pm IST on Tue, 12 Feb 2008 permanent link
Categories: derivatives, exchanges, regulation
Socgen scandal becomes murkier
My blog four days ago stated that there was perhaps more to the Socgen fraud than meets the eye, and the deluge of information since then confirms this first impression. It is pointless to even attempt to cite all the stories that have come out in the last few days and I will be very selective. Socgen’s own five page non explanation of what happened is of course mandatory reading, but the Aleablog, the Alphaville blog, the Financial Times and the Independent have been the best English sources – the truly best sources are obviously in French. Another quick observation is that the blogs have been better at covering this than the mainstream media.
The issues that emerge are the following:
- Was this a fraud at all or was this just a bet that went wrong? If it was the latter, it is similar to the subprime lending at many banks – blunders rather than frauds. There is a view that this was just a case of a trader exceeding his limits and that this kind of behaviour was common at Socgen and at other banks. There is some evidence that the prosecutor has not bought the entire Socgen story and that the courts have bought even less of it.
- Kerviel does not seem to have benefited from the frauds in as much as his bonuses were not clearly linked to the profits – the alleged bonus of €300,000 that he was offered for making profits of €1.5 billion does not suggest that a monetary motivation was at all important. The compensation proposals of Raghuram Rajan and Martin Wolf that I blogged about two weeks ago would not have helped in this case at all.
- Frank Partnoy pointed out in the Financial Times that the ranking of the losses announced by Socgen last week were as follows: (a) €3.4 billion from Socgen’s unwinding the positions abruptly into a falling market, (b) €2 billion of losses on CDOs and (c) €1.5 billion of accumulated losses on Kerviel’s positions as at the time when they were discovered. The last is clearly a small part of the total loss.
- Many obserers think that unwinding the positions abruptly during a period of market stress was not the best way of dealing with the problem.
- Socgen has been sued by shareholders for insider trading in respect of its unwinding of positions over a three day period without informing the market.
- Socgen’s statement on January 24, 2008 described Kervien’s role as “plain vanilla futures hedging”. Its detailed explanation of January 27, 2008 talked about proprietary trading and arbitrage which are quite different from what it was suggesting earlier.
- There are reports that the unauthorized trades go back to 2005 and that the derivatives exchange, Eurex, had raised a red flag in November 2007. The breakdown in controls is therefore much deeper than Socgen tries to make out.
- Socgen claimed that for his fictitious short positions, Kerviel “chose very specific operations with no cash movements or margin call and which did not require immediate confirmation” while the actual long positions “were subject to daily controls and in particular margin calls with the main clearing houses.” This implies that the €1.5 billion of accumulated losses on the positions before they were discovered would all have been cash losses which would have been funded by Socgen. That a low level trader could obtain funding on this scale without being investigated carefully is baffling to say the least.
- In my last blog entry I had speculated that the position would have been at least $50 billion in notional amount. Socgen has disclosed that the amount was much larger – it is was €50 billion. This was well in excess of the market capitalization of Socgen. Even if the fictitious trades did not require immediate confirmation, they would have require confirmation at some stage. How these positions could have evaded detection for so long is again puzzling.
Posted at 5:13 pm IST on Tue, 29 Jan 2008 permanent link
Categories: crisis, fraud
Margin Changes in Exchange Traded Derivatives
Surjit Bhalla wrote a provocative piece in the Business Standard yesterday describing the system of automatic revision of margins in Indian stock exchanges as ugly and insane – the first adjective is quite appropriate, but the second is not. Bhalla is right in saying that the Indian system is different from what the rest of the world does, but it does not follow that the system is wrong, much less that it is insane.
Most exchanges around the world change margins infrequently and in a discretionary manner. Everywhere in the world, market turbulence does lead to a rise in margins. Last week itself when the Chicago Mercantile Exchange (CME) left margins unchanged on stock index futures, it raised margins on interest rate futures sharply in response to increased volatility. What the Indian system does is (a) to take the discretion out of the system completely and (b) to make the revisions more frequent.
The system adopted in India is similar to the internal models that banks and securities firms use to monitor and control the risk of their trading positions. Like any other sound margining system, it does have the potential to create a vicious cycle of falling prices, margin calls, unwinding of levered positions and further price falls. It is ugly but it can hardly be called insane.
It is also true that there is significant over-margining in the Indian system. Partly, this reflects a greater risk aversion on the part of Indian regulators and the broader political system. As Indian regulators and politicians become more comfortable with well functioning derivative markets, the risk aversion should decline. The over-margining is also due to the lower level of capitalization of securities firms in India which forces exchanges and brokers to rely almost entirely on margins to ensure solvency. As Indian brokerages consolidate and shore up their capital base, this problem should also get attenuated. Over a period of time, therefore, the margining system could become more relaxed – both in terms of lower quantum of margins and in terms of lower urgency in raising margins in response to volatility spikes.
What India does need urgently is an abandonment of informal and ad hoc margin tightening in times of crises. One keeps hearing anecdotes about members being asked to reduce positions or deposit more margins than is mandated by the regular margining system. A greater degree of transparency in this regard would also be welcome so that false rumours do not circulate about this.
Posted at 8:47 pm IST on Sun, 27 Jan 2008 permanent link
Categories: derivatives, regulation, risk management
How to lose $7.1 billion
The announcement by Societe Generale that a rogue trader had caused losses of $7.1 billion was cryptic and baffling. The press release says that the bank:
has uncovered a fraud, exceptional in its size and nature: one trader, responsible for plain vanilla futures hedging on European equity market indices, had taken massive fraudulent directional positions in 2007 and 2008 beyond his limited authority. Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle-office, he managed to conceal these positions through a scheme of elaborate fictitious transactions.
Assuming that the indices in question have fallen by about 20% in line with the broad European equity index, the notional value of the plain vanilla futures position must have been over $35 billion. That a trade of this size could be concealed by an isolated individual appears difficult to believe since most large banks have internalized the lessons from Leeson’s fraudulent trades at Barings more than a decade ago. I have a sense that there is more to this than meets the eye.
Posted at 1:41 pm IST on Fri, 25 Jan 2008 permanent link
Categories: crisis, fraud
Compensation of bankers (and their regulators)
Raghuram Rajan wrote a provocative article (“Bankers’ pay is deeply flawed,” Financial Times, January 9, 2008) arguing that “Significant portions of [bankers’] compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.” Martin Wolf agreed enthusiastically with this idea and went further “Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse. ” (“Why regulators should intervene in bankers’ pay,” Financial Times, January 16, 2008).
I agree with the basic idea that incentives are critically important but would like to go down a different fork. Why not link the pay of bank supervisors to the fate of the banks that they supervisors? If 50% of the pay of those who supervised Northern Rock were in escrow in an uninsured deposit in Northern Rock itself, I suspect that the stress tests that the supervisors carried out would have been a little tougher. I recall reading that long ago when private clearing houses performed some kind of deposit insurance and lender of last resort functions, they did sometimes hire supervisors on somewhat similar terms. The advantage is that this proposal requires regulators to change only their own HR practices and not of everybody else in the world.
In a similar vein, investors could put pressure on the rating agencies to invest a large percentage of their rating fees in the securities that they rate (with the percentage being higher for high ratings). If this had been in force, I very much doubt whether there would have been so many AAA ratings in the sub prime CDO space.
Posted at 1:43 pm IST on Fri, 18 Jan 2008 permanent link
Categories: banks, corporate governance, crisis
Will Stoneridge save the banks and the rating agencies?
The decision of the US Supreme Court in the Stoneridge case is doubtless a victory for business, but I doubt whether it will be enough to save the banks and the rating agencies when it comes to the inevitable sub prime related litigation. The court refused to allow investors to sue “entities who, acting both as customers and suppliers, agreed to arrangements that allowed the investors’ company to mislead its auditor and issue a misleading financial statement affecting the stock price.”
I am not a lawyer, but I think the penultimate paragraph of the opinion seems clear enough: “Unconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere. ... In these circumstances the investors cannot be said to have relied upon any of respondents’ deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability to petitioner under the implied right of action. ”
While agreeing that that the anti fraud provisions of securities law are not “limited to preserving the integrity of the securities markets,” the court asserts that these provisions do “not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.”
I do not see how any of this will help the originators and underwriters of sub prime securities or the agencies that rated them if their actions turn out to be fraudulent. It will take a lot of investigative effort to determine whether there was fraudulent behaviour (and even more effort to establish the fraud if any in a court of law), but private players have every incentive to expend this effort.
Posted at 12:21 pm IST on Thu, 17 Jan 2008 permanent link
Categories: accounting, credit rating, fraud, law, regulation
SEBI loses case on misleading recommendations
Last week, the Securities and Exchange Board of India (SEBI) lost a high profile case regarding misleading investment recommendations: the Securities Appelate Tribunal (SAT) set aside the SEBI order against Mathew Easow.
SEBI’s order in September 2006 stated that “While Mathew Easow has been advising the market to buy a stock, he himself has taken contrary positions. This indicates an obvious attempt to mislead the investors through investment recommendations, in a striking posture of ambivalence coupled with interest. ”
On appeal, SAT was scathing in its criticism:
We cannot uphold any of these findings which are based on a complete misreading of the recommendations made through the e-mails. ... We are amazed that the adjudicating officer could not understand this basic concept. Unfortunately, the adjudicating officer did not apply his mind to the merits of the recommendations made by Mathew. He did not even make an attempt to understand what the recommendations meant.
...
In view of the aforesaid discussion, we allow the appeal, reverse the findings recorded by the adjudicating officer and set aside the impugned order. The damage caused to the reputation of Mathew cannot be undone. However, he will have his costs which are assessed at Rs.1 lac.
There is an enormous conflict of interest inherent in a person making investment recommendations while also trading in the same securities. Disclosures and disclaimers coupled with investor education are meant to address this conflict of interest. The facts that SEBI has brought on record do not appear to be sufficient to elevate this inherent conflict of interest to the level of a “a fraudulent or an unfair trade practice”. We do not know whether a more thorough investigation and a deeper analysis would have led to a different set of facts and a different set of conclusions. However, based only on the facts that are available in the SEBI order and the SAT judgement, I find it difficult to disagree with the SAT.
Posted at 7:17 pm IST on Wed, 16 Jan 2008 permanent link
Categories: regulation
Moody's archaeology is quite unconvincing
Last week, Moody’s published a report on the global credit crisis (Archaeology of the Crisis) that I found totally unconvincing. To begin with, the word “archaeology” in relation to such a recent event is perplexing, but that is a minor issue.
My most serious disagreement is with the section in the report on “Reduced risk traceability in the financial innovation process”. Moody’s argue:
Rating agencies were supposed to bridge some of the information asymmetries, but this proved to be some-what unrealistic when the incentive structure of (sub-prime) loan originators, subprime loan borrowers, and market intermediaries also shifted in favour of less information.
... The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards.
Risk traceability has declined, probably forever. It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies.
This leads to two conclusions. First, more capital buffers will be needed or required by counterparties and regulators. Second, not just more but more intelligible information is needed ...
Moody’ is trying to argue that rating agencies failed because the task that they were asked to do was impossible. The first problem with this argument is that they should have thought about this before they accepted the rating assignment and collected their fees. The second problem is that the solution of greater capital buffers (higher attachment points for various rated tranches) was available to the rating agencies all along, but they chose not to go this route.
The third problem with Moody’ argument is that it is becoming increasingly clear that the credit crisis that we are seeing today has nothing to do with financial innovation but is more like the familiar credit and banking crises of the past. For example, it is quite similar to the Japanese banking crisis of the 1990s which also had its origins in a property market collapse.
In August of 2007, it was possible to argue that the credit crisis was somehow related to the difficulty of valuing complex financial instruments like CDOs. One might have thought that credit correlations (which are difficult to estimate) might have been underestimated but there was no problem with the core credit assessment. However, the fall in prices of sub prime linked instruments has been so steep and persistent that it is now clear that the issue is not about correlations but about the value of the underlying credit. A good deal of this underlying value depends on macroeconomic variables like housing prices and GDP growth where there is little if any information asymmetry.
Today, the rating agencies can really take one of only two positions. Either they can admit that they made a grave error in estimating credit risk in a whole large class of credits without any significant attenuating circumstances. Or they can argue that the markets have got it all wrong and the credit quality of sub prime and alt-A housing loans is not as bad as the market thinks. With every passing week of new data coming in from the US, the second position looks increasingly untenable.
In 2001, when the rating agencies were severely criticized for their failures in relation to Enron, I argued that the most that one could accuse them of was some degree of complacence. I wrote: “Any criticism about the rating agencies must keep in mind that the agencies gave Enron a rating that reflected a high level of risk.” Moreover, there were significant information asymmetries between the rating agencies and Enron. The asymmetries in sub prime lending were much lower and the rating agencies had the law of large numbers on their side. I think therefore that a mea culpa would be more appropriate than the kind of archaeological sophistry that Moody’s has dished out to us.
Posted at 4:23 pm IST on Mon, 14 Jan 2008 permanent link
Categories: credit rating
Change in my phone numbers
My telephone numbers will change around January 15, 2008. The first digit will change from 2 to 6. The office number will become 6632 4867 and the residence number will become 6632 5318.
Posted at 1:39 pm IST on Tue, 8 Jan 2008 permanent link
Categories: miscellaneous
Short selling moves closer to reality
RBI’s new year gift on December 31, 2007 approving short selling by FIIs moved short selling one step closer to reality in India. The financial press reports that February 1, 2008 would be the launch date for short selling and securities lending, but there is no confirmation about this on the web site of SEBI.
Posted at 7:15 pm IST on Sun, 6 Jan 2008 permanent link
Categories: crisis, regulation, short selling