Australian Insider Trading Case against Citigroup

There has been a lot of discussion in the press and in the blogs about an insider trading case launched by the Australian Securities and Investments Commission (ASIC) against Citigroup Global Markets Australia Pty Ltd. ASIC’s press release provides some details and soxfirst.com has published the full text of ASIC’s Statement of Claim

The facts are that while Citi’s investment bankers were advising a potential acquirer, its proprietary trading desk was buying the target’s stock. When the investment bankers came to know about this, they informally communicated to the traders that they should not be buying. The traders then stopped buying and in fact sold some shares. Since the shares rose sharply when the bid was announced, the traders would have made more money if they had continued buying or held on to what they had already bought.

Much of the comments that I have read are sceptical about whether ASIC has any case at all. Several authors have pointed out that Citi did not profit from its selling and that the client actually gained. But after reading the statutes that ASIC cites, it appears to me that ASIC has framed its claim very well.

• Section 912A(1)(aa)of the Australian Corporations Act states that a licensee must “have in place adequate arrangements for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken by the licensee or a representative of the licensee in the provision of financial services as part of the financial services business of the licensee or the representative”.
• Subsection 1043A(1) states that “the insider must not ... apply for, acquire, or dispose of, relevant ... financial products”. This is an absolute ban that does not refer to the direction of the trade, the profitability of the trade or even whether the trade was based on the inside information.
• Section 1043F provides a Chinese wall exemption to the absolute ban imposed by subsection 1043A(1). The requirements for obtaining this exemption are that:
  • (a) the decision to enter into the transaction or agreement was taken on its behalf by a person or persons other than [the officer or employee possessing inside information]; and
  • (b) it had in operation at that time arrangements that could reasonably be expected to ensure that the information was not communicated to the person or persons who made the decision and that no advice with respect to the transaction or agreement was given to that person or any of those persons by a person in possession of the information; and
  • (c) the information was not so communicated and no such advice was so given.

These statutory provisions seem to imply that in the absence of adequate Chinese Walls any trading in the securities concerned becomes insider trading regardless of whether Citi benefited from such trading or whether anybody suffered due to it.

Some commentators have suggested that modern financial conglomerates would find it impossible to function in such a situation. I think this is totally wrong. Conglomerates can still function freely provided they ensure that they have strong Chinese Walls and adequate mechanisms for managing conflicts of interest. If ASIC has its facts right, Citi’s systems were simply inadequate.

Posted at 2:39 pm IST on Tue, 4 Apr 2006         permanent link

Categories: regulation

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London and New York

Peter Weinberg, a former CEO of Goldman Sachs International has a piece in the Financial Times (“How London can close gap on Wall Street”, Financial Times, March 30, 2006) arguing why London could catch up with New York as the world’s leading financial centre. He believes that two factors give London a chance today:

1. The huge amount of Arab money that goes to or through London because of political reasons.
2. The preference for new issuers to list outside the United States due to Sarbanes-Oxley and other reasons.

Weinberg also suggests that an acquisition of the London Stock Exchange by a US exchange could facilitate this process.

We know that the United Kingdom has historically paid a big price for the success of London in the form of subordinating its domestic economic policies to the needs of the City. The United States has clearly shown that it is unwilling to do so. This would mean that even if London does gain, this will be a pyrrhic victory that does little good to the United Kingdom. See my post last year on whether financial centres are worthwhile.

Weinberg does however make an important point that New York’s dominance of global finance cannot be taken for granted. Those of us who had loosely interpreted Kindleberger as implying that a global centre is more or less secure in the absence of war or other serious upheaval should probably think again.

Posted at 3:08 pm IST on Sat, 1 Apr 2006         permanent link

Categories: regulation

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Informed trading or insider trading

Regulators seem to have great difficulty in distinguishing between informed trading and insider trading.

A study published in the Occasional Paper Series of the Financial Services Authority of the UK demonstrates that there are large (and statistically significant) abnormal stock returns ahead of takeover announcements. This is clearly evidence of informed trading but not necessarily of insider trading. After all, there is a lot of informed speculation ahead of any bid. The authors try to finesse the problem with an inappropriate definition of insider trading:

Throughout this paper the term “insider trading” is used to mean acting or causing others to act on material non-public information which could affect the value of an investment. This term is not a legal one but is intended to include the UK legal offences of insider dealing and misuse of information.

The financial press has been quoting the study extensively as evidence of insider trading. John Gapper writes in the Financial Times “Last week, [the FSA] said there were signs of insider trading before 29 per cent of UK mergers and acquisitions announcements.” Steve Goldstein wrote an article in marketwatch.com headlined “Insider trading rife in U.K. M&A: study ”. The opening sentence of the article uses the phrase “insider trading” while the second paragraph uses the phrase “informed trading”.

This confusion is unfortunate. Informed trading is the life blood of financial markets and if the only way to stop insider trading is to shut down informed trading, then it is far better to live with insider trading.

Posted at 1:37 pm IST on Tue, 21 Mar 2006         permanent link

Categories: insider trading, regulation

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Advantages of Single Regulator

An interesting IMF Working Paper by Martin Cihak and Richard Podpiera present evidence that single regulators (covering banking, securities and insurance) are associated with higher quality of supervision and with higher consistency of regulation across the three sectors. One of the problems that they face is that integrated regulators are typically found in more developed countries with more mature regulatory environments. They control for both of these in their study. Controlling for income reduces the effect a great deal but it remains positive and in many cases, it also remains statistically significant.

The authors measure quality of regulation by conformance to various international standards on core principles of regulation.

Posted at 6:36 pm IST on Mon, 20 Mar 2006         permanent link

Categories: regulation

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Tobin Tax and Capital Gains

In response to my comments on the Indian budget, Prof. Ramesh Gupta states that the securities transaction tax can be justified as a kind of Tobin tax to discourage speculative transactions. I disagree on two counts. Frist, I do not like the Tobin tax, but I will not get into this in detail because there is a huge literature on the Tobin tax and I do not think I have anything original to say on this subject. My second point of disagreement is more subtle. A Tobin tax and a revenue maximizing transaction tax are very different in terms of the tax rate. As Tobin himself emphasized, the rate of the Tobin tax should be exceedingly small so as not to affect true price discovery. A revenue maximizing transaction tax on the other hand would be much higher.

In India, the transaction tax was introduced as a substitute for the capital gains tax. This I think is a mistake. It forces the government to progressively move the rate towards a revenue maximizing rate and thereby endanger price discovery in the market. I believe that the current rate of the transaction tax is much higher than what a Tobin tax would be. More important is the question of fairness. Ideally, the real returns on all investments should be taxed at the same rate. Today, the return earned on equities is taxed at a negligible rate. Return earned on bonds is taxed at much higher rates as is salary income (which is return earned on investment in human capital). This is unacceptable from a fairness point of view. From a merit point of view also, it is difficult to make out any case for preferring investment in equities to investment in human capital.

Posted at 5:30 pm IST on Tue, 7 Mar 2006         permanent link

Categories: equity markets, exchanges, taxation

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Capital gains tax

I wrote a piece in yesterday’s Financial Express about the budget proposal related to capital gains taxation and securities transaction tax. I wrote that the government seems to have realized that its decision two years ago to replace the capital gains tax on securities with a tax on securities transactions was a mistake. My article makes the following points:

• The capital gains tax is like a call option on the stock market index. If the market rises and people earn capital gains, the government gets a share of that gain. When the market goes down, the government does not share the loss, it only allows the loss to be carried forward.
• Call options are too precious to be just thrown away but back in 2004 when “prices of securities were much lower” as the Finance Minister points out now, the call option must have looked less valuable. Now, the Finance Minister wants to bring back capital gains tax in two different ways.
• The really imaginative solution is to exploit the Minimum Alternative Tax (MAT) to achieve a tax rate of 10% without indexation which is the same as what foreign investors pay.
• The cruder solution is to raise the securities transaction tax “with a view to raise additional resources and also plug the leakage of tax revenue”. In other words, at last the government admits that the substitution of capital gains tax with the STT is leading to a leakage of revenues.

Posted at 2:19 pm IST on Thu, 2 Mar 2006         permanent link

Categories: miscellaneous

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FSA Loses Minmet Insider Trading Case

The Independent pointed me to a very interesting decision by the Financial Services and Markets Tribunal overturning an insider trading decision of the Financial Services Authority in the United Kingdom.

The most damaging part of the tribunal’s decision is towards the end when it states:

We have kept in mind that the burden of proof lies on the Authority, and the standard of proof (the balance of probability) must take into account the gravity of the allegation made. But our decision in the applicants favour does not depend on the burden of proof. On consideration of the whole of the evidence we are satisfied that there was not a telephone conversation between Mr Nolan and Mr Baldwin on 29 July 2003, and are satisfied that WRT’s trading in Minmet and Tiger shares was innocently conducted.

Usually when courts and tribunals acquit somebody they are quite happy to take shelter under the assertion that the prosecution has not met the standard of proof. Here the tribunal goes beyond this to assert that the accused have proved that they are innocent. It is difficult to imagine a more comprehensive defeat for a regulator.

Interestingly, the tribunal avoids even a suggestion that the main prosecution witness was lying. Even while stating categorically that they preferred the evidence of the accused to that of the key prosecution witness, the tribunal states:

We found no reason to doubt the good faith of any of the witnesses, who we considered were all doing their best to assist us.

The experts that the FSA relied on are also treated kindly but the tribunal does find that the experts were “inappropriately constrained” by the remit that the FSA gave them. At the end of it all, only the FSA comes out as the loser in this decision.

Posted at 1:39 pm IST on Wed, 22 Feb 2006         permanent link

Categories: insider trading, investigation, law

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Reliance Demerger as Backdoor Delisting

I wrote an article in today’s Financial Express about the Reliance demerger.

In January 2006, Reliance Industries Limited demerged four companies accounting for about a quarter of its market capitalization. The delay in listing these new companies means that about a quarter of the original company (representing a market value of over $7 billion) have been effectively delisted since January 18, 2006.

This has three consequences

1. Millions of shareholders in these companies cannot trade these shares.
2. The corporate governance provisions regarding independent directors and investor protection do not apply to these companies.
3. These companies are under no obligation to provide the continuing material event disclosures to the exchange that a listed company is required to provide.

The result is that a company with a million shareholders is subject only to the disclosure and governance regime that applies to a mom and pop company with a dozen shareholders.

I argue that the exchanges and the regulator should not look at the listing of the demerged companies through the framework of initial public offerings that are obviously designed to make it difficult for a company to list. Rather they should use the framework of the delisting guidelines which are designed to make it difficult for a company to delist. The situation in a demerger or delisting is that the public has already put in its money and the regulator’s priority is to ensure that the company does not slip away from the clutches of the listing regulations.

Posted at 6:36 pm IST on Mon, 13 Feb 2006         permanent link

Categories: corporate governance, equity markets, exchanges, regulation

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Leverage in banks and derivatives

Commenting on my blog about an Economist column on CDOs, Ajay Shah wrote in his blog that the comparison between derivatives and banks is equally instructive when looking at leverage. He points out that leverage in banking is more than in derivatives and correctly argues that the (inverse of the) capital adequacy ratio is not the correct measure of leverage for a like-for-like comparison with derivatives leverage.

I completely agree with Ajay on this. I present below a few like-for-like comparisons of varying levels of sophistication all of which point to the same reality that banks embody high levels of risk:

• Globally, most derivative exchange clearing houses are AAA rated while hardly any major bank has this coveted rating today.
• Even the AA and A ratings that large banks enjoy today depend on implicit support by the lender of the last resort. S & P states quite bluntly “Generally speaking, the regulated nature of banking serves as a positive rating factor, one that helps to offset concerns about the extraordinary leverage and high liquidity risk that characterize the industry. Indeed, without the benefits provided by regulation, examination, and liquidity support, bank ratings would not be as high as they are.” (S & P, Government Support in Bank Ratings, Ratings Direct, October 2004)
• Many large global banks have been to the brink of failure and have survived only with some form of support from the central bank. Only a few relatively insignificant derivatives clearing houses have gone broke.
• The Basel II credit risk formula uses the 99.9% normal tail or approximately three standard deviations in a single factor Merton model for capital adequacy for corporate exposures. (Paragraph 272 of Basel II). Under the fat tails typical of asset prices (say Student t with 6 degrees of freedom), this actually provides only 99% risk protection and not the alleged 99.9% protection. Moodys and S & P default data clearly show that a 1% default probability is not consistent with an investment grade rating. In other words, the latest regulatory framework for large internationally active banks is designed to produce a bank with a junk bond rating if we do not take into account the implicit sovereign support.
• During the days of free banking in Scotland, banks used much less leverage than they do today. They typically had capital in the range of 20-25%.
• Leading non bank finance companies around the world today have much lower levels of leverage than banks.

Posted at 3:38 pm IST on Tue, 7 Feb 2006         permanent link

Categories: banks, leverage, regulation

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Economist Buttonwood on CDOs

When I first read the Buttonwood column on Collateral Debt Obligations (“Of Scorpions and Starfighters”, Economist, January 31, 2006), I disagreed strongly with it but put it aside without much further thought. But then Anuradha suggested that I should blog about it; so here I go.

Buttonwood paints a picture of CDOs as being dark and mysterious things and so I began to wonder what is it about CDOs that creates unease in the minds of many. A CDO is a fairly straightforward and legitimate instrument. After all, a commercial bank is at bottom nothing but a CDO — though doubtless it is a rather crude and old fashioned way of creating a CDO.

I therefore went through the Buttonwood column replacing CDOs by banks and bank loans. A large part of the column goes through quite nicely. This is a sample of a few paragraphs:

If most of the borrowers stay solvent, the bank makes good money. If more than a handful default, then depositors and investors begin to take a hit ... The precise mixture of risks and payouts depends on how the bank is managed.

Moreover, the value of a bank loan portfolio depends not just on expected rates of default, but also on what might be recovered from defaulting companies’ assets. ... Bank loan portfolios are dynamic: they are in the hands of managers who can weed out the exposure to companies before they default, or trade credit risk with the aim of improving the portfolio.... Banks slice themselves into tranches of differing risk — deposits, (subordinated) debt and equity. Thus in theory investors can pick the collection of risks that suits them. They are helped by the existence of credit ratings, at least for the safer tranches (the riskiest equity tranches, which bear the first loss in the event of default, usually have no rating). But they must also consider the likely market price of the tranche they invest in, both for accounting reasons and in case they want to sell before maturity.

Bank loans are not that actively traded .... So it is often near impossible to establish a market price for them. Accountants have a horrible time when auditing books of illiquid bank loans, being forced to use numbers that they know are nearly meaningless.

One can go on with much of the rest of the column. For example, Buttonwood decries CDOs of CDOs, but in reality a CDO squared is not very different from a bank lending to another bank or investing in the subordinated debt of another bank. But let me not belabour the point.

Buttonwood also seems to think that cash settlement of credit derivatives is a bad thing that somehow disconnects them from reality. This is not true at all — the only difference between cash and physical settlement is one of transaction costs. Buttonwood is also worried about the notional vlaue of credit derivatives exceeding the total amount of debt that the company has issued. Again this is quite common in derivative markets. People are quite willing to take a little basis risk to operate in a more liquid market and therefore the largest derivative contracts usually attract a volume and open interest that is much larger than the direct risk exposure to the underlying of this contract. It is natural for people to use Delphi related CDSs or CDOs to hedge exposures to the entire auto component industry and also to cross hedge some General Motors or even auto industry risk. It is not at all surprising that the notional far exceeds the outstanding debt of Delphi

Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?

Posted at 9:54 pm IST on Thu, 2 Feb 2006         permanent link

Categories: banks, derivatives

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FASB may kill fair value accounting by permitting it

I have long argued that the alternative to fair value accounting is unfair value accounting and so I should normally be cheering the proposal by the Financial Accounting Standards Board (FASB) to permit fair value accounting for financial assets and liabilities. But actually, I am not happy at all.

The FASB’s Exposure Draft entitled The Fair Value Option for Financial Assets and Financial Liabilities “would create a fair value option under which an entity may irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities on a contract-by-contract basis, with changes in fair value recognized in earnings as those changes occur.” There are two problems with this exposure draft. First is that the fair value option can be exercised on a contract by contract basis allowing the company to chery pick profitable contracts to show on fair value basis while showing the loss making contracts on historical cost basis. The requirement that the fair value election is irrevocable provides only partial protection against this. The second problem that aggravates the cherry picking danger is that there are no safeguards at all on how this option can be exercised. Comparing its proposal with International Accounting Standard 39 (IAS 39), the FASB states:

This Statement has no eligibility criteria for financial assets and financial liabilities, whereas IAS 39 (as revised in 2005) indicates that, for other than hybrid instruments, the fair value option can be applied only when doing so results in more relevant information either because it eliminates or significantly reduces a measurement or recognition inconsistency (that is, an accounting mismatch) that would otherwise arise from measuring assets or liabilities or recognizing the gains and losses on them on different bases, or because a group of financial assets, financial liabilities, or both is managed and its performance is evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and information about the group is provided internally on that basis to the entity’s key management personnel.

The FASB proposal thus threatens to make fair value accounting very attractive to the scoundrels. The market recognizing this would penalize any entity that exercises this option. Thus fair value accounting would be killed by a proposal that professes to permit it.

I think fair value accounting should be the default method for all financial assets and liabilities. Companies should be allowed to irrevocably elect historical cost accounting (on an asset class by asset class basis) if they can show that this is more relevant and reliable because (a) market prices are not readily available and (b) fair values estimates have too much subjectivity.

Posted at 4:54 pm IST on Mon, 30 Jan 2006         permanent link

Categories: accounting, derivatives

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Exchange Software Bugs Yet Again

Three instance of software glitches from Japan, United Staes and India during the last two months have convinced me that exchange software must go open source. This software is too important to be kept under wraps. The complete source code must be disclosed to the whole market to prevent recurrence of such problems.

Today’s Business Standard (N Mahalakshmi, “Sebi to audit NSE systems”, Business Standard, January 25, 2006) reports that the Securities and Exchange Board of India intends to conduct a systems audit of the National Stock Exchange (NSE) in response to the software bug in the computation of the index last week.

The NSE’s description of the error is as follows:

The special session for Reliance Industries Ltd was held from 8 a.m. to 9 a.m. so as to discover the price after the demerger. ... After the close of the special session the volume weighted average price for Reliance Industries Limited was Rs. 714.35. The adjustments to the base index value were suitably carried out to compute the index value so as to give effect to the demerger of Reliance Industries Ltd.

Trading was resumed as per normal market timings ... The market opened and the correct adjusted index value of NIFTY was also displayed to the market at the opening trade. The activity of NIFTY index computation was closely monitored after market opening and it was seen that the first few NIFTY index values were computed correctly taking into account the adjusted base index value. However once the first trade in Reliance Industries Ltd. was executed, it was observed that the NIFTY Index reflected incorrect value. The problem was analysed and found that due to memory initialization failure the last traded price being reckoned for index computation purpose was carrying an incorrect value. This resulted in a wrong NIFTY index value being displayed. The problem was identified and changes were carried out to reflect the correct value of the NIFTY index. The NIFTY index dissemination was stopped at 10.30 a.m and the correct display of NIFTY index value was made available to the market from 10.56 a.m onwards. The other indices remained unaffected.

This is the third serious exchange software bug that I have come across in the last two months. The other two errors happened in the two largest capital markets of the world:

1. Last month, a software bug at the Tokyo Stock Exchange prevented a trader from cancelling a large erroneous order. I blogged about it here and here.
2. Last week, a computer glitch at the Nasdaq casued closing prices of NYSE listed stocks to be misreported. Yahoo! News reported that “at approximately 5:50 p.m. Eastern time Wednesday, ... 16,669 transactions involving NYSE- and AMEX-listed stocks that had been made at 9:50 a.m. were reposted to the consolidated list. In many computer systems, those transactions overwrote the final closing price posted earlier that afternoon.

I am therefore completely convinced that exchange software must go open source. Alternatively, exchanges must take out large insurance policies to compensate any aggrieved party. By large, I mean something like 10% or 15% of the daily trading volume. For the NSE this may be therefore be in the range of a billion dollars.

Posted at 12:30 pm IST on Wed, 25 Jan 2006         permanent link

Categories: exchanges, technology

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UK Indexed Bond Bubble

John Plender has an interesting article in the FT (Risk aversion and panic buying, Financial Times, January 23, 2006) on the bubble in the UK inflation indexed bonds. Yields on the 50 year indexed bond have fallen to the extraordinarily low level of 0.38%. Plender argues that unlike other asset classes where bubbles arise from irrational exuberance, here it arises from panic or high risk aversion.

Compared to typical estimates of the historical average real long term interest rate of around 3%, the yield of 0.38% does appear ridiculously low. However, the situation is not so bad when we compare 0.38% with the historical average real short term interest rate of around 1%.

Morgan Stanley economists Richard Berner and David Miles discuss the issue of low long term yields in the US. They refer to the interesting FEDS paper by Don Kim and Jonathan Wright of the US Federal Reserve which decomposes the long horizon forward rate into four components. Recasting that analysis in terms of the real interest rate of a long term nominal bond we get three components:

• the expected short term real interest rate
• the real term structure premium
• the inflation risk premium.

The last of these is not present in an indexed bond and therefore the yield on an inflation indexed bond is likely to be lower than the real yield on a nominal bond. The interesting part is the real term structure premium. Kim and Wright show that this premium has collapsed from 2% in 1990 to 0.5% in 2005. From a theoretical point of view this premium can fall further and can in fact be negative. Only the liquidity preference theory of the term structure predicts a positive term structure premium. The expectations theory predicts a zero premium and the preferred habitat theory is agnostic about the sign of this premium.

Plender believes that indexed bond yields are depressed because pension funds are buying these assets for regulatory reasons and that the bubble could be pricked if either they turn to other assets or if the government could signal an intention to issue more long term indexed bonds. In the terminology of the preferred habitat theory, this merely states the truism that the term structure premium will change dramatically if some lenders or borrowers change their preferred habitat.

In the days when indexed bonds yielded say 3%, this yield would have decomposed into a expected short term real interest rate of say 1% and a term structure risk premium of say 2%. An yield of 0.38% would imply a term structure premium of -0.62% assuming that the short term real interest rate is unchanged. It is difficult to understand why a fall in the absolute value of the risk premium from 2% to 0.62% could be interpreted as a rise in risk aversion let alone as panic.

I share the view that there is a global asset market bubble and am quite sympathetic to the view that there is a bubble in UK indexed bonds as well. But I believe that Plender’s analysis is over simplified.

Posted at 12:44 pm IST on Tue, 24 Jan 2006         permanent link

Categories: bond markets, bubbles

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Best Price Rule in Takeovers

Two recent developments have brought into focus the right of all shareholders to receive the same price in a takeover (the “best price” rule). Many countries including India impose this requirement while the United States imposes it in a very narrow and almost meaningless way. One of the developments that I will talk about is that the United States is proposing to relax even further the already minimal best price rule that it has.

But I would like to begin with the United Kingdom. The Lex column in the Financial Times (“Lex: Virgin Mobile”, Financial Times, January 17, 2006) raises an interesting pricing issue in the proposed sale of Virgin Mobile to NTL in the United Kingdom. Lex calculates that if NTL rebrands its entire business as Virgin and pays the same royalty to Richard Branson as what Virgin Mobile pays currently, it would effectively add about 10% to what Richard Branson would get for selling his 72% stake in Virgin Mobile. Lex believes however that minority shareholders have no valid complaint:

Sir Richard does have more incentive than other shareholders to back the takeover, but under the City Code minorities do not have to sell out. They do not own the Virgin brand and have no independent entitlement to its value.

This is fair enough particularly because the Virgin brand is indeed separable from the cellular business. But in many other cases of this kind, there has been a problem in valuing the brand. Moreover, the brand is often inextricably intertwined with the business itself. There have been such instances in India as well.

The United States is proposing to cut right through this Gordian knot. Under its current regulations, the best price rule applies only to tender offers. If an acquirer takes a statutory merger route to an acquisition, the regulation does not apply at all. The two most important rules in tender offers are that:

1. “The tender offer is open to all security holders of the class of securities subject to the tender offer ” (the all holders rule)
2. “The consideration paid to any security holder pursuant to the tender offer is the highest consideration paid to any other security holder during such tender offer” (the best price rule)

Many (but not all) courts in the US have taken the view that the best-price rule applies to all integral elements of a tender offer, including employment compensation and other commercial arrangements that are deemed to be part of the tender offer, regardless of whether the arrangements are executed and performed outside of the time that the tender offer formally commences and expires. The US SEC believes that this interpretation has led many acquirers to disfavor tender offers in favor of statutory mergers where the best-price rule is inapplicable.

The SEC is therefore proposing amendments that establish that the best-price rule applies only to consideration “paid for securities tendered” instead of “during such tender offer” or “pursuant to such tender offer”. In addition, the SEC also proposes to introduce a blanket exemption for employment compensation, severance or other employee benefit arrangements.

The US regulations have always been fatally flawed because they provide almost no protection to minority shareholders in two step takeovers where large shareholders are bought at a high price and then other shareholders are bought out in a tender offer at a lower price. The best price rule looks only at price paid in the tender offer and does not look back to the price paid in transactions prior to the tender offer. Moreover, the ability to use the statutory mergers instead of tender offers has provided another loophole. It is strange that instead of plugging these glaring deficiencies in its regulations, the SEC is proposing to relax whatever little protections currently exist.

Posted at 1:46 pm IST on Wed, 18 Jan 2006         permanent link

Categories: corporate governance, equity markets, regulation

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Financial Repression in China and India

Raghuram Rajan, Economic Counselor and Director of Research, International Monetary Fund says that “uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown” and that the inadequacies of the Chinese financial system are to blame for this:

It is unlikely the chairman of a state owned corporation, cash rich because he no longer has to meet his social obligations to workers, will prefer to return cash to the state via dividends rather than retaining it in the firm, particularly when banks are under orders to restrain credit growth. And with financial investments returning so little, far better to reinvest cashflows in real assets. Indeed, liquidity plays a greater role than profits in determining real investments.

Similarly, the chairman of a private firm knows that financing from either the stock market or the state-owned banks is very uncertain. So he too will be unlikely to pay dividends, preferring instead to retain the capital for investment. Again, instead of storing this as financial assets and awaiting the right real investment opportunity, given the poor returns on financial assets, he has an incentive to invest right away.

These tendencies imply a lot of reinvestment in existing industries especially if cashflow in the industry is high, which inexorably drives down their profitability. And they imply relatively little investment in new industries. The inadequacies of the financial system would thus explain both the high correlation between savings and investment and the oft-heard claim that over 75 percent of China's industries are plagued by overcapacity. They also suggest why uniquely among fast-growing Asian economies, China has not raised its share of value added coming from high-skilled industries significantly, even as its per capita GDP has grown.

This is an interesting argument against financial repression. It is useful to remind ourselves once in a while that the occasional stock market scandal that we have seen in India since the beginning of economic reforms is a small price to pay for getting rid of financial repression. It is also necessary to recall that as a percentage of GPD, the annual losses to Indian households from financial repression were higher than the amount involved in even the biggest of the stock market frauds since 1991. For example, during 1980-81 to 1989-90, time deposits at commercial banks averaged over 25% of GDP. I have estimated that financial repression in the 1980s was about three percentage points. This implies that holders of time deposits at banks lost 0.75% of GDP annually. If we add the losses on other repressed financial assets (especially life insurance and provident funds), the total would certainly exceed 1% of GDP annually. By comparison, the total amount of fraud in the scam of 1991-92 (involving Harshad Mehta and others) was about 0.75% of GDP. The total amount of fraud in the scam of 2000-01 (involving Ketan Parekh) was less than 0.2% of GDP.

Posted at 2:26 pm IST on Mon, 16 Jan 2006         permanent link

Categories: corporate governance, equity markets

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Some interesting titbits

The new year has brought with it a number of interesting titbits related to financial markets

• Andrew Ross Sorkin (“To Battle, Armed With Shares”, New York Times, January 4, 2006) reports on the emergence of hedge funds as activist investors. I have long been convinced of the Michael Jensen thesis that the US got its takeover regulations badly wrong in the 1980s. In my posting early last year, I argued that the US still has to get its regulations right in this area. The emergence of hedge funds as major players in the market for corporate control may force me to change my view on this. Sorkin also states that large once-conservative mutual funds are now prepared to side with hedge funds and against incumbent managements. This has the potential to change corporate governance in a fundamental way.
• The Financial Times reports (“Korea becomes king of derivatives hill”, Anna Fifield, January 4, 2006) that Korea has overtaken the United States to become the largest equity derivative market in the world.
• Floyd Norris reports (“In 2005, Companies Set a Record for Sharing With Shareholders”, New York Times, January 7, 2006) that the amount that the companies in the S&P 500 returned to shareholders in the form of dividends and buyback in 2005 represented 4.6% of the market capitalization of the index at the end of the year. This was the same percentage as in 2004. The figures show that buybacks were about one and half times the dividends. Norris also points out that “the big surge in such buybacks came only after one major advantage of buybacks - in the tax code - was removed. Now the United States taxes both dividends and capital gains at a 15 percent rate.” This presents a challenge to corporate finance theory unless as Norris speculates “Or perhaps all those buybacks are simply an indication that corporate America has good profits now, but a dearth of attractive investment opportunities for all that cash.”
• Andrew Ross Sorkin (“Sometimes, Two Is Less Than One”, New York Times, January 8, 2006) quotes a Goldman Sachs study that looked at 10 big companies that split up between 1994 and 1999, and found that the average company's shares fell 6 percent between the announcement and the actual split. One reason offerd for this phenomenon is that big-cap investors no longer want to own a collection of small-cap or midcap companies. The other possible reason is that investors interested in one unit are unlikely to be interested in the other. Sorkin suggests that these are short term phenomena and that the jury is still out on whether split-ups add value in the longer term.

Posted at 1:16 pm IST on Mon, 9 Jan 2006         permanent link

Categories: miscellaneous

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Trading Error at BSE, India

Another new listing, another country, another trading error and a strange resolution. It is much smaller than the Mizuho trade that I have blogged about here and here. But its resolution is utterly strange.

On listing day a trader placed a sell order for about 400,000 shares of Tulip IT Services Limited at a price of Rs 0.25 at the BSE in Mumbai when the market price was around Rs 170. Since circuit filters do not apply on listing day in BSE, the trade executed causing a modest loss of about US $ 2.6 million.

What is interesting is the way that the exchange has resolved the issue. It says that:

1. The buy orders at a price higher than Rs.96/- and matched against the said order, shall be deemed to have been transacted at such prices at which the trades were executed. The cut-off price of Rs.96/- has been arrived at by applying circuit filter limit of 20% on the issue price of Rs.120/- on the lower side on the lines of the existing practice of application of standard Circuit Filter of 20% in the regular market.
2. All other existing orders below Rs.96/- and which got executed against the said sale order will be deemed to have been transacted at a price of Rs.171.15. The said price of Rs.171.15 has been arrived at by taking the weighted average price of the trades executed at or above Rs.96/- against the said sale order.
3. All other orders placed subsequent to said sale order and which were matched against the said sell order will be deemed to have been transacted at a price of Rs.171.15.

In response my first Mizuho blog, Piyush Mishra commented that an erroneous trade is due to “the lack of oversight on the part of the broker/dealer” I agreed with that and wrote that “By nullifying erroneous trades, exchanges may actually be reducing the incentives for traders to install and use such software checks.”

I have therefore little sympathy for the BSE bailing out the offending trader by changing the traded price at all. But putting that objection aside for the moment, the solution adopted is still perverse. A trader who bought at Rs 97 pays Rs 97 while another who bought at Rs 95, is asked to pay Rs 171.15. That two traders in very similar situations are treated so differently is manifestly absurd and unfair. That the person who bid a lower price pays higher makes the solution even more ridiculous.

I recall a similar situation in the US in 2001. A hedge fund offered to buy Axcelsis Technolgies at $95 instead of $9.50 on the Nasdaq. Nasdaq cancelled all trades at prices below an arbitrary threshold of $22 and let the other trades stand. Floyd Norris wrote (“At the Nasdaq Casino, the Winners Get Stiffed”, New York Times March 2, 2001) about a day trader who sold into the erroneous trade and then covered his short position at a profit of $145,908. When the Nasdaq cancelled the trades selectively, this trader found that his share sales had been cancelled while his purchases stood producing a loss of $130,065 instead of the profit of $145,908. That the offending hedge fund was bailed out while an innocent day trader was penalized was clearly absurd. In a scathing comment, Floyd Norris wrote ”Nasdaq looks a lot like a casino that values a customer's business only until he starts winning.”

Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.

Posted at 5:17 pm IST on Sat, 7 Jan 2006         permanent link

Categories: exchanges, failure, regulation, technology

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Tokyo Stock Exchange Trading System: Why Not Open Source?

The Financial Times reports that “The Tokyo Stock Exchange is considering replacing its trading system, even though it is merely a year old, following computer problems that have shattered the exchange's reputation and damaged Tokyo's status as a financial centre.”

Clearly the Mizuho trading error that I blogged about last month has been the main driving force behind this move. I would argue that open source is the better way to go if the goal is to make the trading system more robust.

I have been reading the official explanation that the Tokyo Stock Exchange (TSE) put out on the Mizuho incident. As I understand it the sequence of events was as follows.

• At the beginning of the first day of listing of J-COM (December 8, 2005), a special bid quote of 672,000 yen was being displayed in order to determine the initial listing price. Special quotes are used at the TSE during the call auction (Itayose method) that is used to determine the initial listing price of stocks that have never been traded before at the TSE or at any other exchange. The Guide to TSE Trading Methodologygives the details of this process.
• At 9:27 am while this special quote was being displayed, Mizuho mistakenly placed a sell order for 610,000 shares of J-COM at 1 yen, instead of the intended 1 share at 610,000 yen.
• The Mizuho order allowed the conditions for execution of the special bid quote to be fulfilled and the trade was completed. The call auction (Itayose method) requires that all market orders as well as all orders on one of the two sides of the order book should be executed and that the volume executed should be a minimum of 1000 trading units. The Mizuho order was large enough to meet all these conditions.
• This trade established the inital listing price of 672,000 yen as also the lower price limit for the day of 572,000 yen. The Tokyo Stock Exchange has computed that in the absence of the Mizuho order, a price of 912,000 yen per share would have prevailed.
• The remaining part of the Mizuho order was now deemed to be an order at the lower limit price of 572,000 yen (“deemed processing”) and started executing against various buy orders.
• “Meanwhile, Mizuho Sec. made several attempts to cancel the order, but as these cancel orders were made while executions were being processed, an irregularity occurred in which the target order was not canceled. This is an irregularity that arises when deemed processing is applied to an order, and a corresponding opposing order exists.”

Summing up the nature of the problem, the Tokyo Stock Exchange states:

“This is an incident that occurs when an issue is newly listed on the TSE directly and, as in this case, while a special bid quote is displayed, such a large amount of orders is placed that the net amount exceeds the number of the special quote order, and many sell orders still remain after the initial price is determined, to which deemed processing is then applied and then orders are placed at that price. As such, we are committed to strengthening supervision of newly listed issues in the near future and conduct extensive, detailed investigations of our system while considering the possibility of this and all other cases in the future, in ensuring irregularities such as this do not occur again. Also, the TSE will conduct a prompt, thorough analysis of the details of the cause of this recent irregularity in cooperation with the trading system developer, Fujitsu, Ltd.”

It appears that the irregularity that was observed would have occured only under very special circumstances that may never be repeated in future. It is also evident that in a complex trading system, the number of eventualities to be considered while testing the trading software is quite large. It is very likely that even a reasonable testing effort might not detect all bugs in the system.

Given the large externalities involved in bugs in such core systems, a better approach is needed. The open source model provides such an alternative. By exposing the source code to a large number of people, the chances of discovering any bugs increase significantly. Since there are many software developers building software that interacts with the exchange software, there would be a large developer community with the skill, incentive and knowledge required to analyse the trading software and verify its integrity. In my view, regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.

Also, there is a case for simplifying the trading system. The trading system at TSE is unnecessarily complex because of the existence of price limits and the complex combination of call auction (Itayose method) and continuous auction (Zaraba method). TSE needs to question the very need for special quotes.

Posted at 2:37 pm IST on Wed, 4 Jan 2006         permanent link

Categories: exchanges, technology

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Short selling in India

The Securities and Exchange Board of India has put out a discussion paper recommending that all market participants should be permitted to short sell shares and that a transparent system of securities lending should be introduced. These are recommendation that I enthusiastically agree with.

However, I see no reason why short selling should be restricted to stocks on which derivative contracts are permitted. Short selling should be seen as a defence against market manipulation and therefore a measure to improve market integrity. It is therefore more necessary in stocks that are prone to market manipulation. On the other hand, derivative contracts are typcially not permitted on precisely the stocks on stocks that are prone to market manipulation. The proposal is therefore best seen as a convenient resting point on the path to allowing short selling in all stocks.

The other critical issue is of regulatory risk that retail short sellers have faced in the past. Though short selling by individuals has been permissible most of the time, SEBI has on certain occasions banned short selling peremptorily in response to market fluctuations. An assurance that this would not happen again would be welcome. Any future restriction on short selling should only be after due process of consultation and with a reasonable transition arrangement

Posted at 2:16 pm IST on Fri, 30 Dec 2005         permanent link

Categories: regulation, short selling

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FSA Resilience Benchmarking

The Financial Services Authority of the United Kingdom has put out a discussion paper on its Resilience Benchmarking Project. This study seeks “to assess how the UK financial services sector would be able to cope in the event of major operational disruption (e.g. terrorist attacks, natural disasters) and how quickly it could recover afterwards”. It contains valuable guidance for those involved in preparing business continuity and disaster recovery plans in the financial sector anywhere in the world. For example:

“The data suggest that reasonable target ranges for the recovery of wholesale payments, trade clearing and settlement would be 60-80% of normal values and volumes within four hours, rising to 80-100% by the next working day. The overall aim within these targets would be to complete material pending transactions on the scheduled settlement date”. (emphasis in original)

My own sense is that these would be demanding targets for firms in most other countries. However, I also believe that these are reasonable goals to work towards even in emerging markets like India.

A broader question in this context is the relative importance of regulation and competition in ensuring the resilience of financial systems. The example of the London Stock Exchange during the Second World War is illuminating. Ranald Mischie (The London Stock Exchange; A History, Oxford University Press, 1999) tells us that the LSE closed on September 1, 1939 when the war broke out. But an outside market developed immediately and within a week, the exchange was forced to reopen. After that, during the rest of the war, the exchange was closed for only one day (on September 14, 1940) after physical damage to the stock exchange building itself in an air raid.

It is fascinating to read how the exchange coped with “the ever-present threat of fire due to bombing, which could have destroyed the Stock Exchange building completely”.

“As the enemy are now dropping incendiary bombs in the City it is more necessary that a careful watch must be kept on the roof and top floors of the Building, otherwise fires could start and gain hold before they were discovered. The only time when any discretion can be given is when aircraft are immediately overhead and shrapnel is falling, then cover should be taken in the Fireman's shelter which had been specially constructed for this purpose”. (London Stock Exchange: Trustees and Managers, September 18, 1940 quoted by Machie, p 290).

It is also interesting to observe that during the war, the stock exchange which normally believes in the indispensability of the trading floor and discourages trading methods that bypass the floor actively encouraged members to use the telephone to trade. Competition does indeed work wonders.

In this light, I do wonder whether regulators that are overly protective of their regulatees during periods of market disruption are inadvertently making markets less resilient. For example, after September 11, 2001, Instinet was in fact in a position to provide a trading facility for US stocks in London. However, regulators did not permit this. This allowed the New York Stock Exchange to be shut down for a few days. I still find it odd that the US government securities market which suffered the heaviest human casualties on September 11, 2001 reopened sooner than the stock exchange where the human casualties were proportionately far lower. Once the decisions regarding disaster recovery are moved from the markets to the regulators, the decisions clearly become more political and the end result is a market that is less resilient to operational disruption.

Perhaps therefore the best thing that the regulators could do is to leave things to the market with a clear signal that when disaster strikes, no market participant should look to the regulator for protection.

Posted at 1:38 pm IST on Tue, 27 Dec 2005         permanent link

Categories: risk management, technology

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Mizuho photographs

Underthecounter has an interesting set of photographs from Triple Witching Friday about the chaos at Mizuho securities after the trading error that cost the firm $335 million. If the photographs are genuine (one comment says that they are doctored photographs of the Taiwan parliament), some of our preconceptioms of Japanese cultural nuances need to be revised. Perhaps trading rooms around the world are the same regardless of the host culture. Financial markets are indeed a great leveller.

The trading error also led to the resignation of the head of Tokyo Stock Exchange. Photographs of the scene there would be interesting!

Posted at 11:10 am IST on Thu, 22 Dec 2005         permanent link

Categories: risk management

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IPO Frauds

IPO procedures were in the limelight again last week, this time in India (see my post last month about the United Kingdom).

In India, small investors (applying for shares worth less than Rs 50,000 in a share offering) are given preference in allotment when the issue is oversubscribed. In the case of the Yes Bank IPO, the portion reserved for these investors was oversubscribed 9.96 times while the portion available for larger non institutional investors was oversubscribed by 43.68 times. This meant that the proportionate allotment to an investor applying in the small investor category was four times more than the proportionate allotment to larger non institutional investors.

This of course presents an arbitrage opportunity to those who are willing to break the rules. The Securities and Exchange Board of India found that one investor had put in more than 6,000 different applications in different names in the small investor category. This allowed her to receive allotments of nearly a million shares worth about Rs 43 million at the issue price. On listing, the shares of Yes Bank traded at a price approximately 36% higher than the issue price. The profits earned by flipping the shares in the market immediately after listing were obviously quite large.

While an investor applying in 6,000 different names is rather exceptional, multiple applications on a less ambitious scale are quite common. The same IPO witnessed another investor putting in over 1,300 applications. Those who put in only a hundred or so applications were probably not detected at all.

Clearly, the system of cross subsidizing small investors in the allotment process is the root cause of this abuse. A month ago, when an official was murdered while trying to prevent the adulteration of diesel with subsidized kerosene, many commentators in India were quick to point out that the irrational cross subsidy in the pricing of petroleum products was the root of the problem. There seems to be less willingness to recognize that a similar cross subsidization is the root of the problem in the IPO abuse as well.

Today the technology exists to ensure that IPO allotments are made to all investors at the same market clearing price in a completely non discriminatory manner. There is no need to reserve shares for some categories of investors. Nor is there any need to give issuers or their investment banks any discretion in the process of allotments. There is no reason at all why the primary market should be any less efficient than the secondary market. The path that Google took in its IPO was clearly the right one. There is no need to permit any other way.

Posted at 3:47 pm IST on Tue, 20 Dec 2005         permanent link

Categories: equity markets, fraud

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Does the BIS care about insider trading?

Governments are today extremely careful to ensure non discriminatory disclosure of sensitive data at the same time to all. Supranational bodies also normally observe this discipline. Even where they hold press conferences ahead of public disclosure, they are subject to clear embargoes that are complied with. In this context, the early disclosure of BIS data on petrodollars is quite disturbing. Steve Johnson reported the data in the Financial Times a day before it became public.

The following chronology would put things in perspective

• November 28, 2005. Stephen Roach, Chief Economist of Morgan Stanley, wrote a report stating that most OPEC current account surpluses were not being invested in dollars. This clearly pointed to possible dollar weakness,
• November 30, 2005. Brad Setzer contested this in his blog arguing that OPEC was parking dollars offshore
• December 2, 2005. Dr. Harm Bandholz of HVB analyzed data from several sources to come up with an analysis similar to that of Brad Setzer.
• December 4, 2005. Steve Johnson writing in the Financial Times quoted BIS data showing that "Middle Eastern oil exporters have rediscovered their love of the US dollar".
• December 4, 2005. Brad Setzer commenting on this report in his blog lamented that he could not find this data at the BIS web site. When I visited the BIS site, I also found that the December quarterly review was still not live on their site.
• December 5, 2005. The December quarterly review went live on the BIS web site. The web site clearly indicates December 5, 2005 as the date of the report.

This chronology establishes that the issue of what was happening to petrodollars was important to market participants, analysts and academics. This was an issue being debated quite earnestly. It is also clear that the BIS report contains data pieced together from a number of sources that adds materially to our understanding of the situation. By any standards, it constitutes "material price sensitive information" that should not have been disclosed in a selective manner. It is even more lamentable that the central bankers’ central banker should be guilty of such a lapse.

Posted at 2:38 pm IST on Tue, 6 Dec 2005         permanent link

Categories: insider trading

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Suing or Regulating Rating Agencies

Dr. Ajay Shah has provided some very interesting comments on my earlier post about Private Sector Watchdogs: Reputational Capital and Financial Capital.

While agreeing with my post in so far as it relates to auditors, he has a different point of view with which I agree only partly. Ajay says

In contrast, the work of a credit rating agency is necessarily gray. The Agency merely gives you it's opinion that the Pr(default) is (say) 10%. After that, it cannot be held accountable whether default takes place or not, because these outcomes do not serve as a performance evaluation upon the probability statement.

Even auditors do not guarantee that they will pick up any fraud. They can sued only for negligence in their attempt to fix fraud. Some aspects of credit rating are actually close to audit. For example, in many ABS transactions, the market is relying on the rating agency for a lot of things. Only the rating agency sees the actual pool of car loans underlying an ABS. If the statements about the pool are wrong, the rating agency has some responsibility. Similarly in ABS/CDO deals, the investor probably relies on the rating agency even for the legal validity of the SPV structures and possibly even the CDS transactions underlying the transaction. They should be amenable to a negligence suit.

Ajay goes to say:

I feel that a credit rating should have the status of an `analyst report' on the stock market. It's the view of an individual. You may want to chat about it in a cocktail party, but for the rest, it should have no special status.

For individual companies, I agree. But for securitization and other complex structures, I am not so sure.

I fully agree with what Ajay has to say about regulatory use of ratings:

Given the lack of accountability of credit ratings or (worse) corporate governance ratings, I am a big skeptic on their role in public policy. When credit ratings go into pension fund regulation or (worse) Basle II, I think we are merely setting up an expensive diversion of resources with no clear accountability.

I agree. Today, there is the ability to have a completely open and objective rating based on the Merton model for large issuers. It should be possible for SEC or SEBI to say that if the distance to default (computed by an open source software) is less x standard deviations, it is investment grade and otherwise not. The only difficulty is that there is no Merton model for sovereigns. But then sovereign ratings by S&P and Moodys are also of dubious value as can be seen from the sovereign default data complied by the rating agencies themselves. In any case, the single best predictor of sovereign rating is per capita income and so these ratings are not really capturing default probability at all. I think the regulators should work on the equivalent of the Altman Z score for sovereigns. Since the performance of the rating agencies is not very high, achieving a comparable level of accuracy with a scoring model should be feasible. Once this is done, the rating agencies can be completely eliminated from all regulatory frameworks.

Posted at 10:41 am IST on Fri, 2 Dec 2005         permanent link

Categories: credit rating, regulation

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Creditor Committees in US Bankruptcy

A recent SEC cease-and-desist order brings out some unpleasant facts about official bankruptcy committees and informal bondholders committees in the US. The order is against Mr. Van D. Greenfield and his securities brokerage firm, Blue River LLC. The facts as stated by the SEC are as follows:

18. WorldCom filed for bankruptcy protection on July 21, 2002 (the “Petition Date”). On the Petition Date, Blue River owned only $6 million in face value of WorldCom unsecured 7.5% notes due 2011 (the “Notes”) and $500,000 in face amount of WorldCom 6.25% Notes due 2003.

20. On July 26, 2002, Greenfield directed Reybold ... to execute, “as of” July 19, 2002, a short sale of $400 million in face value of the Notes in one Blue River proprietary account and a purchase of $400 million in face value of the Notes in a another Blue River proprietary account. ...

21. Also on July 26, Greenfield sent a letter to the U.S. Trustee for the Second Circuit requesting that Blue River be appointed to WorldCom’s official unsecured creditors’ committee. On a questionnaire attached to his letter, Greenfield represented that Blue River held a $400 million unsecured claim against WorldCom based upon the Notes. The letter did not disclose that Blue River had no net economic interest in the notes because it also held a $400 million short position in the Notes, that the transaction in the Notes had not yet settled, or that the purchase had occurred after the Petition Date but was backdated to a date prior to the Petition Date. A $400 million unsecured claim would have put Blue River among the top 20 unsecured creditors of WorldCom as disclosed in WorldCom’s schedule of the 50 largest unsecured claims against it that was filed on the Petition Date.

22. On July 29, 2002, the U.S. Trustee for the Second Circuit appointed Blue River to WorldCom’s official unsecured creditors’ committee and Greenfield became co-chair of the committee. On or about July 30, 2002, Greenfield directed Reybold to cancel the $400 million short sale and associated purchase of the Notes, leaving Blue River only with its original $6.5 million position in WorldCom debt. The $6.5 million face value claim was much smaller than the smallest unsecured claim listed by WorldCom in the schedule of the 50 largest unsecured claims against it, which exceeded $100 million.

The order goes on to raise issues about insider trading or as the SEC puts it “potential misuse of material, nonpublic information in light of the conflicts of interest arising from Greenfield’s serving as Blue River’s representative on the committees at the same time that he was also Blue River’s compliance officer, principal owner, and general securities principal.”

The more troubling question is the total lack of diligence in the appointment of creditor committees. Any bankruptcy process leads to a detailed listing of all creditors and their claims. That a co-chair of an official creditors’ committee can be appointed so casually on the basis of an unsubstantiated letter indicates either that there are no processes governing such appointments or that such processes broke down completely in the WorldCom case. Since WorldCom was the largest ever corporate bankruptcy in the US, one would have expected greater care in the appointment of official committees in this case.

The incident also highlights the need to reexamine the whole idea of providing confidential information to such committees. In the old days, when everything was on paper, the idea of making thousands of copies would have been infeasible. In this day of internet and email, it should be possible to provide information in a non discriminatory manner to all. The committees would still play a role in negotiating and designing a restructuring but they need not have privileged access to information other than any documents that the committee itself drafts. It is possible to specify that the moment the company submits a written proposal to the committee or the other way around, these documents would be publicly disclosed. The SEC states in relation to another creditor’s committee that “Greenfield on occasion had access to the terms of proposed offers by third parties to purchase Globalstar, L.P.’s assets before the terms of those offers were disclosed publicly.” There was no reason no justification at all for this to happen.

Posted at 2:29 pm IST on Thu, 1 Dec 2005         permanent link

Categories: bankruptcy, law, short selling

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Validating my RSS feeds causes old posts to reappear

Today some of my old posts reappeared as new posts in some RSS readers. This is because I have been validating my RSS feeds. While my blog has been valid XHTML for quite some time, I found yesterday that the RSS feed was not valid XML and therefore not valid RSS 2.0. I corrected the errors and have now made the feed a valid RSS feed. Because of these corrections the RSS aggregators regard the posts as different though I took care to ensure that the time stamp of the original post remains unchanged

Posted at 6:44 pm IST on Wed, 30 Nov 2005         permanent link

Categories: miscellaneous

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Private Sector Watchdogs: Reputational Capital and Financial Capital

In my earlier posting on private sector watchdogs, I argued that these watchdogs can be sued for negligence while government regulators cannot. Commenting on my post, Dr. Ajay Shah asked whether there are many private sector watchdogs who can pay serious money in the event of a lawsuit.

My initial response was that audit firms and investment banks have often paid large amounts of money to settle lawsuits against them. But this exchange set me thinking about the capitalization of private sector watch dogs. Information about the capital and financial position of audit firms is rather scanty. But some information is available from the July 2003 report of the US General Accounting Office ( “Public Accounting Firms: Mandated Study on Consolidation and Competition”) and the July 2004 report of the UK Office of Fair Trading (“An assessment of the implications for competition of a cap on auditors’ liability”).

The US data indicates that audit fees are about 0.15% of the revenues of the firms being audited while the UK data suggests that the audit firms have capital of about 4-5 times their annual audit fee income. Combining the two suggests that capital is less than 0.75% of the revenues of the companies being audited. To my mind, this is a very low amount of capital in relation to the potential liability. The low capital might be an important reason why the audit firms have lobbied hard for a cap on auditor liability.

The low capital might also explain the extremely high degree of concentration in the audit business with the Big Four accounting for practically the entire audit business of large companies. When audit firms rely on reputational capital rather than monetary capital, this becomes a very strong barrier to entry. A different approach to auditing would involve audit firms with large amounts of financial capital. Regulatory changes would be needed to allow audit to be done by public companies rather than private firms. Regulatory changes would also be required to allow audit firms to solicit business and advertise aggressively. This would dramatically ease entry into the audit business and make it highly competitive. For example, one could imagine a Warren Buffet starting a new audit company with say $10 billion of capital and gaining business by aggressively advertising more stringent auditing standards than the existing audit firms. Many institutional investors may then put pressure on companies to use the new audit firm even if it is significantly more expensive.

There is no reason why the same strategy of relying on financial rather than reputational capital cannot be applied to credit rating agencies and other private sector watchdogs.

Posted at 6:30 pm IST on Fri, 25 Nov 2005         permanent link

Categories: accounting, leverage, regulation

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FSA’s Concerns about Competitive IPOs

The Financial Services Authority of the United Kingdom has expressed its concerns about competitive Initial Public Offerings. It was in fact so worried about them that it highlighted them in a supplement to its quarterly newsletter List!. The FSA wrote that “we felt we needed to tell the market about [these issues] immediately, rather than waiting until our next full edition”.

The FSA expressed its concern about the new form of conducting Initial Public Offerings as follows.

“In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’. In a standard IPO, the lead manager and other brokers involved in the IPO are appointed at a very early stage of the process, forming a syndicate of brokers. Under competitive IPOs, the syndicate members, their roles and remuneration are not defined until late on in the process. This maintains competitive pressure on the potential syndicate members as not all the firms involved in the competitive IPO process will be appointed to the syndicate after the initial ‘beauty parade’.. This may create ‘pressure points’ and new conflicts of interest — particularly around the preparation of pre-deal research and pre-marketing activities. We understand that one of the reasons issuers favour competitive IPOs is that it gives them greater control over the IPO process and greater leverage over the firms involved.

In a competitive IPO the issuer may be able to exert pressure on the competing firms, directly or indirectly, to produce research that is favourable or which justifies a higher valuation range. This is because firms could be providing their draft research to the issuer in circumstances where the firm is still trying to win a role in the syndicate. In a competitive market, firms may find it difficult to resist such pressure. Even where individual firms have some reservations about the process, they may feel compelled to participate so they are not excluded from transactions.”

This concern of the FSA appears quite strange to me. It suggests that regulators have not learnt the right lessons from the IPO scandals that took place during the dot com boom in the United States. Those scandals showed that the investment banks were not trying to get the best possible price for the shares in the IPO. Competition between investment banks was of the non price variety. Worse, in some cases, it took the form of allotting hot stocks of other underpriced IPOs to the CEO and other key decision makers in an attempt to win the IPO mandate. An IPO process that increases competition on the basis of price is a move in the right direction.

Regulators however continue to act as if anything unfamiliar is worse than the status quo even when it is potentially better. The US SEC did the same when Google decided to auction shares instead of doing a normal IPO. The risk factors that the SEC forced Google to incorporate in its offer document showed that the SEC too had not learnt any lessons from the IPO scandals that took place under its own watch.

Posted at 12:49 pm IST on Thu, 24 Nov 2005         permanent link

Categories: equity markets

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Negligence, Misfeasance and Private Sector Watchdogs

The collapse earlier this week of the misfeasance suit by the liquidators of BCCI against the Bank of England highlights the importance of private sector watchdogs. The key difference is that many private sector watchdogs can be sued for negligence, but regulators can usually be sued only for misfeasance.

In the case of Bank of Credit and Commerce International (BCCI), most observers believe that the Bank of England was negligent in the discharge of its regulatory duties. But the sovereign cannot be sued for mere negligence. The liquidators of BCCI therefore had to invoke the charge of misfeasance. Misfeasance consists essentially of an intentional misuse of public power. It required the liquidator to prove not merely that the actions of the Bank of England were improper but that they were malicious or dishonest (not necessarily in a financial sense). In most cases of regulatory failure, malice or dishonesty is very unlikely to exist. It is difficult to imagine why the officials of the Bank of England would act with malice against the depositors of BCCI. It is much easier to see why they might be negligent.

Another recent case of a failure of a misfeasance suit again in the United Kingdom was the suit by the shareholders of RailTrack against its renationalization. Here there was much greater plausibility to the claim that the sovereign acted with something approaching malice. But the claim could not be proved in court and the judge dismissed the claim completely.

If misfeasance is either unlikely or difficult to prove, then the victims of regulatory negligence are left with no recourse at all. This makes private sector watchdogs attractive. When they fail, it is possible to sue them for negligence and to recover monetary damages. It is noteworthy that in the Worldcom and other scandals in the United States, the major part of the financial recovery by investors has come from private sector gatekeepers and watchdogs.

Posted at 2:33 pm IST on Fri, 4 Nov 2005         permanent link

Categories: regulation

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Regulators Shooting Their Mouth Off

Last week the Chairman of the US Securities and Exchange Commission, Mr. Christopher Cox made a series of comments quite unbecoming of a regulator. On October 16, 2005, Mr. Cox made the following remarks before the US - China Joint Economic Committee at Hebei in China (http://www.sec.gov/news/speech/spch101605cc.htm):

“Let me illustrate this point by briefly considering the upcoming IPO for China Construction Bank, which has been very much in the news here. This is simultaneously an example of what’s going right, and what more remains to be done.

The roadshow that kicked off in Hong Kong a week and a half ago was a success. And there’s a strong likelihood that CCB will be heavily oversubscribed. For that, China deserves congratulations.

We’d be kidding ourselves, however, if we didn’t recognize that CCB could have done even better if it had been listed in New York rather than Hong Kong.

We’d also be foolish not to notice that even with the success of the CCB’s roadshow, there’s now speculation in the press about the health of its balance sheets; how many of CCB’s existing loans will become non-performing; and how much management has really changed.

Perhaps, the exacting process of listing on a U.S. exchange would have helped CCB avoid these concerns, which go directly to the question of investor confidence. Of course that process would be expensive and time consuming. But no one should pretend that the avoidance of strong securities laws and tough enforcement, which is admittedly cheaper on the front end, isn’t more expensive in the long run.”

Two days later, in remarks before the Securities Industries Association/Tsinghua University Conference on October 18, 2005 in Beijing, Mr. Cox was more circumspect in raising the same issue (http://www.sec.gov/news/speech/spch101805cc.htm):

“But it would appear that many other Chinese companies are seeking to avoid higher regulatory standards by not listing in the U.S.

This year, there has been a significant drop in the amount of money Chinese companies have raised in the United States as compared to last year.

The truth is, no honest company need worry that the bar is too high to list in America. It is precisely because our markets are the gold standard that listing in the U.S. remains the benchmark of investor confidence for companies around the world.

Going through the listing process in the U.S. will improve Chinese company disclosure practices. And this will serve to achieve China’s objective of upgrading the governance of its firms. That, in turn, will benefit every investor, saver, and worker in China.”

Even these later comments may appear too self laudatory to some, but they are not objectionable. The comments of October 16 on the other hand, are completely unbecoming of a regulator:

• Mr. Cox casts aspersions on a company about which he has no knowledge as a regulator. Since CCB never filed any documents with the SEC, whatever he says about it is mere hearsay.
• Mr. Cox is lending the SEC’s credibility to market gossip by saying that it would be foolish to ignore this gossip.
• Mr. Cox’s remarks are more like that of a trade envoy trying to persuade everybody to buy American goods and services than that of a fair and impartial regulator.

Posted at 4:21 pm IST on Mon, 24 Oct 2005         permanent link

Categories: regulation

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T+1 Settlement of Securities Trades

I wrote an article in the Financial Express today about T+1 settlement of securities trades. The argument in this article is that the separation of trading and settlement made sense when settlement was time consuming and laborious. Today with electronic settlement, trading and settlement must be brought closer together. T+1 is the way forward, but it is by no means the destination. The article can also be read at my website.

Posted at 5:40 pm IST on Mon, 17 Oct 2005         permanent link

Categories: exchanges, regulation

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Hedge Fund Frauds

In August 2005, investors in the Bayou Group of hedge funds in the United States discovered that the $400 million of assets that Bayou purported to have did not really exist. For several years, the accounts of the fund had been completely falsified. Since then there have been many proposals for tighter regulation of hedge funds.

Many of these proposals which try to make hedge funds look more like mutual funds do not make sense. Academic research going back several decades has consistently shown that buying an index funds (or perhaps even better, an Exchange Traded Fund or ETF) out performs actively managed mutual funds. Research has also generally shown that by and large those who beat the market in any single year are not likely to do so year after year on a consistent basis. In short (apart from ETFs) mutual funds provide a completely useless asset class - they do not expand the investment opportunity set for investors.

Basically, the regulatory restrictions on leverage, derivatives and short selling mean that all mutual funds are just more expensive versions of an ETF. Like branded gasoline, mutual funds are a branded commodity where one uses expensive marketing efforts to demonstrate that one’s product is somehow different from (and superior to) the competition.

Academic research on hedge funds is more recent and perhaps therefore less conclusive. But the limited evidence that is there suggests that hedge funds do expand the investment opportunity set. They provide absolute returns that are weakly correlated with the market. Risk compensation per unit of beta is therefore excellent, and risk compensation per unit of standard deviation is respectable. This makes them a useful addition to the portfolio of many investors.

If we defined investor protection in objective finance theory terms therefore we should make mutual funds more like hedge funds rather than the other way around.

So what is the right regulatory response to Bayou? Jenny Anderson has an interesting proposal on this subject (“A Modest Proposal to Prevent Hedge Fund Fraud”, New York Times, October 7, 2005) which requires only a simple modification to the SEC’s registration requirememt for hedge funds that comes to effect in February 2006.

“The [SEC] should ask for two other pieces of information: the name of the accountant responsible for auditing the fund and the name of the broker-dealer through which the hedge fund trades - including whether that broker-dealer is affiliated with the hedge fund.

These issues were critical red flags in the fraud at Bayou. Its auditor, Richmond-Fairfield Associates, was a fake accounting firm created to produce false audits of Bayou. Bayou Securities was the broker-dealer through which trades were made to create real commissions for Bayou’s principals, who used them as compensation on top of 20 percent incentive fee they made on their fraudulent returns.”

This is perhaps the most sensible response to Bayou.

Posted at 5:42 pm IST on Tue, 11 Oct 2005         permanent link

Categories: regulation

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Is a fraud an offence only if there is a foreign listing?

The Securities and Exchange Board of India (SEBI) has issued an order against Pentamedia Graphics Limited in respect of an issue of fake shares by the company. The order makes the perfectly valid statement that:

“Issuing fake shares is a major offence”

Since the days when Jay Gould and Vanderbilt fought for the control of the Eire Railroad in the United States in the nineteenth century, issuance of fake shares has been rightly seen as one of the worst capital market offences that a company can commit. A speedy and effective response from the regulator is therefore most welcome.

However, at the fag end of a perfectly unexceptionable order, SEBI goes on to make a very disturbing statement:

“the GDRs issued by the company are listed and traded in foreign countries. In case of such companies, it is all the more essential for companies to adhere to the highest standards of corporate governance in keeping with global benchmarks.”

This statement is disturbing in two ways. First it seems to put a fraud (issuance of fake shares) on par with a mere lapse from the highest standards of corporate governance. Second, it raises the distressing thought that SEBI might not have acted with equal alacrity if the company did not have a foreign listing.

Posted at 10:38 am IST on Tue, 4 Oct 2005         permanent link

Categories: fraud, regulation

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HealthSouth and Whistle Blower Protection

After the Enron debacle, the US enacted whistle blower protection into Section 806 of the Sarbanes-Oxley Act. Many companies around the world adopted whistle blower policies in accordance with the requirement of this law.

But much of this protection is quite useless if judges and prosecutors are insensitive to the organizational ground realities within which whistle blowers have to function. The verdicts in the HealthSouth case in the United States provide an excellent example of how things can go badly wrong. HealthSouth's founder Chairman and CEO was acquitted on all counts in June. A few other employees and former employees received mild sentences. As if to compensate for all these failures, the prosecution sought tough penalities against the whistle blower himself. Last week, the judge imposed the longest prison sentence in the case so far on the whistle blower Weston Smith!

Posted at 12:30 pm IST on Mon, 26 Sep 2005         permanent link

Categories: corporate governance, regulation

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Financial Development, Financial Fragility, and Growth

A recent IMF Working Paper by Norman Loayza and Romain Ranciere entitled Financial Development, Financial Fragility, and Growth (http://www.imf.org/external/pubs/ft/wp/2005/wp05170.pdf) tries to disentangle the short run and long run effects of financial development on economic growth.

In the process, the authors also seek to reconcile the apparent contradictions between two strands of the literature on the subject.

“On the one hand, the empirical growth literature finds a positive effect of financial depth as measured by, for instance, private domestic credit and liquid liabilities. On the other hand, the banking and currency crisis literature finds that monetary aggregates, such as domestic credit, are among the best predictors of crises and their related economic downturns. This paper accounts for these contrasting effects based on the distinction between the short- and long-run effects of financial intermediation.”

Essentially, Loayza and Ranciere measure financial development by the ratio of private credit to GDP. Using data for 75 countries from 1960 to 2000, they show that in the long run, a rise in this financial intermediation ratio increases economic growth. However, the short run effect is negative and this effect is several times the long term effect.

In their detailed analysis however the authors show that the short term effect is entirely due to the countries that have experienced a banking crisis. “In fact, for the non-crisis countries, the average short-run impact of intermediation on growth is statistically zero.”

This suggests that it is rather misleading to claim that financial development reduces economic growth even in the short term. First., while the title of the paper uses the term financial development and the text of the paper uses the term financial intermediation, the measure used is purely a measure of credit and ignores other financial claims. Second, the negative impact even in the short term is restricted to crisis countries where presumably the institutional structures required to support rapid credit growth were less well developed.

Posted at 1:21 pm IST on Mon, 12 Sep 2005         permanent link

Categories: banks, bond markets, bubbles, crisis

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Transparency in Bond Trading

The FSA has put out a discussion paper on Trading transparency in the UK secondary bond markets ( http://www.fsa.gov.uk/pages/library/policy/dp/2005/05_05.shtml). This paper is in response to the possibility that greater transparency may be mandated under MiFID, the European Union’s Market in Financial Instruments Directive. MiFID currently imposes transparency obligation on the equity market but Article 65 requires the Commission to report on whether the pre and post-trade transparency obligations should be extended to transactions in bonds as well.

The FSA discussion paper provides a nice review of the academic literature on the role of transparency and also provides a comprehenseive description of the bond market in the UK. It is onstensibly neutral on whether more transparency is needed, but on closer reading it is clearly biased towards maintaining the status quo. It argues that the basic question to be asked before imposing a transparency obligation is whether there is a market failure that needs to be corrected. The problem is that market failure is too strong a word to describe the effect of opaque markets. Opaque markets may be unfair to classes of investors and may also be inefficient, but these do not probably rise to the level of market failure.

For example, the discussion paper while pointing out that post trade information is not publicly available observes that this information is available to those who subscribe to the services of various vendors. The point is that this may well be enough to prevent market failure but not sufficient to meet the regulator’s obligations regarding investor protection.

Posted at 6:42 pm IST on Tue, 6 Sep 2005         permanent link

Categories: bond markets, regulation

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Henry Blodget’s Irreplaceable Exuberance

In the New York Times of August 30, 2005, Henry Blodget tries to justify some of the things that happened during the internet boom and bust of the late 1990s. Henry Blodget was a well known internet stock analyst of that era and his actions invited regulatory sanctions that cut short his career.

Blodget is not saying anything new when he says that “stock prices and strategic decisions are based on predictions, and predicting the future in an industry’s early days is hard”. What is more interesting is his point that “our exuberance helps build industries, however boneheaded it may later seem”.

This is true if we define exuberance as a temporary reduction in risk aversion. Such a reduction will lead to investments with higher expected returns and from the point of view of a risk neutral observer, this is more rational. Since we are always risk neutral about the past, posterity will be happy that those investments were made.

Unfortunately for him some of the investments that were made at that time were not justifiable even if we ignore risk aversion. Yet, it must be said that compared to some of the nonsense that Blodget wrote as an analyst, what he is writing now contains a grain of truth even when it is largely self serving.

Posted at 10:06 am IST on Thu, 1 Sep 2005         permanent link

Categories: bubbles

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Is the Feldstein Horioka puzzle dead or dying?

In today’s Financial Times, Martin Wolf writes that

“The principal determinant of the pattern of capital flows is, it turns out, divergent savings rates. ... because investment rates were closer together than savings rates, the world's capital exporters were countries with high savings rates and the importers were ones with low savings rates.” (Martin Wolf, “Capital flow must change course”, Financial Times, August 29, 2005.)

Does this mean that one of the oldest puzzles of international financial economics, the Feldstein Horioka puzzle is dead or dying? Feldstein and Horioka showed that the cross sectional regression coefficient of investment rates on savings rates was close to unity. (Feldstein, M. and C. Horioka, 1980, “Domestic savings and international capital flows”, Economic Journal, 90, 314-329). This coefficient has fallen since then. Obstfeld and Rogoff noted that the regression coefficient had fallen to 0.60 for the early and mid 1990s as opposed to the 0.89 obtained by Feldstein and Horioka for the 1960s and early 1970s (Obstfeld, M. and K. Rogoff, 2000, “The six major puzzles in international macroeconomics: Is there a common cause?”, NBER Working Paper 7777).

Perhaps, freer capital markets are destroying what is left of the puzzle?

Posted at 11:16 am IST on Mon, 29 Aug 2005         permanent link

Categories: international finance

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Institutional Investors

Granit San has an interesting paper at SSRN about institutional and individual trading (San, Granit, “Who Gains More by Trading - Individuals or Institutions?”, June 2005. http://ssrn.com/abstract=687415)

The conclusion of the paper is that institutions are momentum traders who buy stocks that have done well in the last few quarters and sell those that have not done well. On the other hand individual investors trade in a more contrarian manner and earn higher returns. The superior performance of individuals persists after adjusting for risk using (a) the CAPM or (b) the three factor model of Fama and French or (c) the four factor model of Carhart. The data is consistent with the hypothesis that institutions are noise traders while individuals are informed, rational traders.

What is more interesting is that the same conclusion is true even during the technology stock bubble of the late 1990s. Individual entered technology stocks and exited them more rationally than institutions and earned superior returns during the process as well.

In India, the regulatory regime for foreign portfolio investors has been that foreign institutional investors (FIIs) are welcome while foreign individuals and hedge funds are barely tolerated. San's results would suggest that this policy is completely misguided. If FIIs are momentum investors, then their presence would exacerbate the booms and busts in the stock market. Encouraging non institutional investors would be a far better idea.

Posted at 4:55 pm IST on Mon, 22 Aug 2005         permanent link

Categories: behavioural finance

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Markets, marketplaces and eBay

In a free-wheeling article on markets and market places, in today's Financial Times, columnist John Kay discusses the problems at the big exchanges in Chicago, London, Frankfurt and New York. He also finds time to talk about the Fulton fish market in New York and the world's largest produce market at Ringis near Paris (John Kay, “In search of a quiet courtier”, Financial Times, August 9, 2005). After that, he has this to say about eBay:

“The most successful for-profit marketplace today is eBay. But it has not yet made much money and the issue for its future is whether it can reconcile shareholder expectations with the iron law of natural monopoly - to exploit it is to lose it”.

Though Kay does not mention this, the big difference between eBay and the rest is that while eBay centralizes trading like the others, it does not centralize settlement. This allows eBay to handle millions of separate non fungible physical settlements - something that none of the big exchanges or clearers can even dream of.

Posted at 11:33 am IST on Tue, 9 Aug 2005         permanent link

Categories: exchanges

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Are Financial Centres Worthwhile?

The Times of London reported earlier this month that London was the most successful financial services industry in the world with record net exports of £19 billion ($33 billion).

I was struck by the smallness of this number. If this is what the world's premier financial centre can achieve, then is it at all worthwhile for a country to promote itself as a regional or global financial centre? For example, does it make any sense for India to build Mumbai up as a regional financial centre? Perhaps not.

It is reasonable to assume that in a few years time, India‘s software and BPO exports will be above $33 billion. On the other hand, any new financial centre will have a fraction of the net exports of London. Not only will it be smaller, it will most probably not have institutions like Lloyds of London which contribute significantly to those net exports (insurance accounted for a third of London's net exports). We might be better off importing financial services and exporting software!

My colleague, Prof. Sebastian Morris, points out however that the advantage from having a regional financial centre is likely to last for a very very long time. If London‘s experience is any guide, that is certainly true. If we present value all that, it might make the whole effort worthwhile. But Prof. Morris also adds that the real sector of the UK economy may have lost out in the pursuit of London‘s interest as a financial centre. If we subtract that, where does that leave us?

Posted at 12:05 pm IST on Thu, 28 Jul 2005         permanent link

Categories: international finance

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Overpricing of Emerging Market CDS?

A recent IMF working paper (Manmohan Singh and Jochen Andritzky (2005), “Overpricing in Emerging Market Credit-Default-Swap Contracts: Some Evidence from Recent Distress Cases”, IMF Working Paper 05/125) claims that there is significant overpricing of Credit-Default-Swaps on emerging market sovereigns.

The authors claim that the market prices CDS on an assumed recovery assumption of 20%. Under this assumption, the CDS spread can be used to compute an implied probability of default. The authors then show that even during periods of financial distress and restructuring (for example Argentina) the cash market price of the distressed bonds (even the cheapest to deliver bond) is well above 20% of par (it is typically 40% of par). The authors then compute an implied recovery rate from the cash market price of the cheapest to deliver bond by assuming the implied probability of default computed from the CDS spread under the 20% recovery assumption. They then compute the theoretical CDS spread using the implied probability of default from the CDS market and the implied recovery rate assumption from the cash market. This theoretical CDS spread is below the actual CDS spread.

It is difficult to understand what this whole exercise really proves. Yes, it does show that emerging market sovereign CDSs should not be priced under a 20% recovery assumption. Perhaps, it also shows that there was a divergence between the CDS market and the cash market — either the CDS was overpriced or the cash market was underpriced. To arbitrage this difference away, it would be necessary to short the cheapest to deliver bond in the cash market. This is where the first author’s earlier paper (Manmohan Singh (2003) “Are Credit Default Swap Spreads High in Emerging Markets? An Alternative Methodology for Proxying Recovery Value”, IMF Working Paper 03/242) throws some light. In that paper, Manmohan Singh explains that the cheapest to deliver bonds were squeezed and were on special repo. Moreover, the sovereign itself was trying to push up the price of the cheapest to deliver bond by buying up as much of it as possible. The price of the cheapest to deliver bond rose during the period of distress. All this points to a very different conclusion — that the cash bonds were overpriced. If so, it is not that the CDS spreads were too high but that the cash bond yields were too low.

Posted at 2:05 pm IST on Mon, 11 Jul 2005         permanent link

Categories: derivatives, sovereign risk

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Reputational Cost of Cooking the Books

Karpoff, Jonathan M., Lee, Dale Scott and Martin, Gerald, “The Cost to firms of Cooking the Books” (June 14, 2005) http://ssrn.com/abstract=652121 provide an interesting analysis of the penalties for financial misreporting in the United States.

They claim that the legal penalties are dwarfed by what they call the reputational penalty imposed by the market: “the reputational penalty is twelve times the sum of all penalties imposed through legal and regulatory processes.”

The difficulty is in the way that the reputational penalty is estimated. The authors take the drop in market value of the firm when an investigation is announced and subtract from this the monetary penalty imposed by the regulator as well as the amount paid in any class action suit. They then proceed to subtract the valuation impact of the accounting write-off required to reverse the financial misreporting. What is left is the authors’ estimate of the reputational penalty imposed by the market. The authors assume that the valuation impact of the accounting write-off is captured by multiplying the amount of the write-off by the price to book ratio.

consider the hypothetical example of an all-equity firm that has book value of assets equal to $100 and a market-to-book ratio of 1.5. The market value of the firm’s assets, and its shares, is $150. Assume the company then issues a misleading financial statement that overstates its asset values by $10. If the firm's market-to-book ratio stays the same, its share values will increase temporarily by ($10 x 1.5) to $165. But when the financial misrepresentation is discovered, the book value will be restated by $10, back to $100. If there is no other impact, the market value will fall by $15, back to $150. Thus, a $10 restatement in the firm’s books implies a $15 change in the market. This $15 drop in market value is what we seek to capture with the accounting write-off effect.

This estimate can be badly wrong because the accounting restatement can change the price to book ratio itself. A restatement that is relatively small in relation to the net worth of a company can make a large difference to the growth rate in earnings. If this changes the estimate of future growth opportunities, then the price to book ratio can fall dramatically. This is because the price to book reflects the relative importance of the present value of growth opportunities (PVGO) in relation to the present value of continuing operations (PVCO) and a relatively small change in growth rates can make a large change to the PVGO.

This is best seen in the context of a constant dividend growth model. Under this model, the market capitalization of the company is given by E(1-b)/(k-g) where E is the earnings of the company next year, b is the fraction of earnings that is retained (1 minus the payout ratio), k is the cost of equity and g is the growth rate in earnings and dividends. In this model E/k is the present value of continuing operations (PVCO) and is a rough estimate of what the book value would be. The balance is the present value of growth opportunities (PVGO).

Let us consider a numerical example. If last year’s earnings are $108 million, the dividend payout ratio is 40%, the cost of equity is 10% and the growth rate is 8%, the dividend growth model predicts a market capitalization of about $2.3 billion since the projected earnings next year are $116 million and the price earnings multiple (1-b)/(k-g)is 20. Of this, the PVCO is only about half ($108 million discounted at 10%), while PVGO accounts for slightly more than half. Assuming that book value is a rough approximation to the PVCO, the price to book for this company would be about 2. Consider an accounting restatement that changes the earnings last year from $108 million to $106 million. as against $100 million the year before last. This reduces the observed growth rate from 8% to 6%. If the market regards 6% as the true estimate of future growth, then the price earnings multiple would fall to 10 and the price to book ratio would fall to 1 as the PVGO simply vanishes. (The 6% growth amounts to only the required 10% return on the 60% of earnings that is retained and ploughed back into the business every year.) The market capitalization would then halve from $2.3 billion to $1.1 billion or a loss of over $ 1 billion. As against this, the authors’ estimate of the valuation effect would be $2 million times the price to book ratio of 2 or $4 million. The true valuation effect is then about 250 times what the authors estimate it to be.

If this is so and the bulk of the alleged reputational penalty is actually a valuation effect of the restatement itself, then the author’ findings can be interpreted very differently. The legal penalties are only a small fraction (only 1/12 or around 8%) of the true losses suffered by investors. Considering that creditors recover about 60% of the value of a defaulted bond, this is a very poor track record

Posted at 4:38 pm IST on Fri, 1 Jul 2005         permanent link

Categories: accounting

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FSA Fine on Citigroup is total nonsense

The order that the Financial Services Authority (FSA) of the UK has passed against Citigroup Global Markets Limited (CGML) in the Euro MTS case imposing a fine of $25 million is total nonsense. Clearly, the FSA lacked either the evidence or the courage to say that Citigroup had manipulated the markets. At the same time, the FSA was unwilling to let them off without any penalty. What they have done therefore is to impose a penalty under regulations that have no bearing on the case at all. This means a penalty is imposed without having to prove any serious charges against Citigroup.

The event that led to the fine was quite simple. On 2 August 2004, Citigroup “executed a trading strategy on the European government bond markets which involved the building up and rapid exit from very substantial long positions. The centrepiece of the strategy was the simultaneous execution of a large number of trades on the MTS platform using specially configured technology.”

FSA claims that in executing these trades, Citigroup contravened the following two Principles of Business of the FSA:

• “A firm must conduct its business with due skill, care and diligence”
• “A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems.”

On the face of it, it is difficult to see how Citigroup's trading violated either of these principles. On the contrary, it would appear that its actions demonstrated a high degree of skill and sound risk containment systems.

FSA however believes that due skill and care were lacking because Citigroup did not consider the likely consequences of the execution of the trading strategy could have for the efficient and orderly operation of the MTS platform. This statement is absolute nonsense. The whole strategy was predicated on a clear understanding of these consequences which were highly beneficial to Citigroup. More importantly, Citigroup's understanding of these consequences was quite correct.

FSA also believes that there were

• “a failure within CGML to escalate the detailed trading strategy on 2 August 2004 adequately and in advance to senior management, and a failure to consult with applicable control functions” and
• “inadequate systems for the supervision of traders”.

This would be a perfectly valid argument provided the FSA had first established that the trading strategy itself violated the rules of market conduct. The FSA does not however want to assert that the trading strategy was manipulative. If it does not do so, then it is difficult to see why a trade, even if it is very large, needs clearance from senior management.

I think the FSA has simply taken the easy route out. Perhaps, for Citigroup too, paying a $25 million fine is an easy solution to its problems.

Posted at 12:56 pm IST on Wed, 29 Jun 2005         permanent link

Categories: manipulation, regulation, risk management

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Credit derivatives versus cash markets

In a recent paper (Packer, F.and Wooldridge, P. D. (2005), “Overview: repricing in credit markets”, BIS Quarterly Review, June 2005), the BIS compares the resilience of the credit derivative markets and the cash markets during the turbulence of May 2005 after the GM and Ford downgrades. They write:

“ the downgrade of the auto makers had the potential to cause dislocation in credit markets. In the event, cash markets appeared to adjust in an orderly way to the downgrade. Credit derivatives markets were more adversely affected, with CDS spreads ‘gapping’ higher on several days in the first half of May and lower in the second half ... Yet spillovers from credit derivatives markets to other markets were limited.”

They also contrast the lack of contagion to other markets in May 2005 with the massive contagion from the Russian default and the collapse of LTCM in 1998.

While the statements are factually correct, the implicit suggestions that the credit derivative market is less resilient and less important is misleading. As the paper itself points out, the major trigger for the turmoil of May 2005 was a sharp fall in default correlations. Since contagion is by definition a sharp rise in correlations, it is not surprising that a fall in default correlations is not accompanied by contagion. Similarly, it is correlated defaults that cause the greatest stress on the cash bond markets. Uncorrelated defaults are quite benign in their impact. It is only in the credit derivative markets - n‘th to default credit swaps and the lower tranches of a CDO - that a fall in default correlations can cause havoc. It is precisely in these markets that players lost a lot of money.

The relative resilience of the cash market and the credit derivative market can be truly tested when there is a credit event which is more symmetric in their impact on the two markets.

Posted at 6:39 pm IST on Thu, 23 Jun 2005         permanent link

Categories: bond markets, derivatives

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MCI-Verizon: Some shareholders are more equal than others

Verizon is buying out MCI’s largest shareholder at a higher price than what it is offering to others. Once again, we see a big flaw in US takeover regulations. Michael Jensen pointed out long ago that the US got its takeover regulations badly wrong in the 1980s. I think they are yet to get it right. All the corporate governance reforms post Enron have not touched this area at all. Interestingly, very little of the takeover regulation in the US comes out of the capital market regulator.

India’s takeover code has a number of deficiencies but in this respect at least it is a lot better.

Posted at 7:34 pm IST on Sun, 10 Apr 2005         permanent link

Categories: corporate governance, regulation

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More on who owns the bonds?

The issue of who owns the bonds is still not fully resolved. Bloomberg quotes the New York judge as saying ‘Both sides have raised serious issues, good faith issues’. The judge ruled that the creditor could not seize the defaulted bonds held by the the exchange agent for swap becuase these bonds still belong to the bondholders not to Argentina. But, he then went on to say that the creditor may be entitled to attach Argentina's right to receive the bonds, if not to attach the bonds themselves before the exchange takes place.

Posted at 4:23 pm IST on Thu, 31 Mar 2005         permanent link

Categories: bond markets, sovereign risk

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Do bonds belong to the lender or borrower?

A creditor of Argentina has got a New York court to attach bonds issued by Argentina. Normally one hears of assets being attached, but here it appears that a liability is being attached. This peculiar situation has arisen because Argentina is going through a debt restructuring. The bonds in question had defaulted and the bond holders had surrendered them for conversion into new bonds of reduced face value as part of this debt restructuring.

In this context, the surrendered bonds could conceivably be an asset. To compound the problem, the bonds are actually held by a custodian bank. The question will then be whether this custodian is an agent of the bond holder or of the issuer. If it is an agent of the issuer (Argentina) then the attachment may be tenable. Otherwise the bonds do not belong to Argentina and the attachment would not make sense. It is a strange legal situation and Argentina is trying hard to get the order vacated

Posted at 6:20 pm IST on Tue, 29 Mar 2005         permanent link

Categories: bond markets, law, sovereign risk

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This is a test

This is a test posting. Please ignore.

Posted at 3:39 pm IST on Tue, 29 Mar 2005         permanent link

Categories: miscellaneous

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Coming Soon

I am in the process of setting up my blog using Blosxom. Why Blosxom?

1. It is open source so that I can use and customize it the way I like
2. It does not use MySql or PHP. So I do not have to go to my web administrator to set up MySql accounts and other permissions. Yes, it needs CGI access, but I already have this and I would not dream of hosting my website on a server that does not give me this
3. It is written in Perl, so I do not have to learn yet another programming language
4. The core of Blosxom is small enough (less than 500 lines) so that it is easy enough to understand and modify. But, a large number of plugins are available to add whatever functionality is desired. This site uses the following plugins:
   • Calendar
   • Comments with this security patch
   • Interpolate Fancy
   • Foreshortened
   • WB Notify
   • WB Captcha
   • RSS 2.0

Posted at 12:15 pm IST on Sat, 26 Mar 2005         permanent link

Categories: miscellaneous

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