Sovereign Limitations

I wrote a column in the Financial Express this week about the limitations of the government in dealing with financial crises:

The ongoing global crisis has seen the government assume an ever increasing burden to keep the financial system afloat. But governments are not omnipotent, and emerging market governments are even more constrained. Investment bankers who thought they were omniscient during the boom have turned out to be clueless. It is perfectly possible that governments that appear omnipotent today will begin to look powerless before we are finished with this crisis.

The first signal regarding this is coming from the credit default swap market where one can buy insurance against default by corporate or sovereign borrowers. As of end–November, this market quoted a premium of ½% per annum to insure against a default by the US government. This is comparable to the premium that one would pay to insure a building against fire. Of course, all insurance premia reflect not only the actuarial probability of loss, but also a compensation for risk and the CDS premium does so to an even greater extent than in normal insurance. Yet, a ½% CDS premium indicates a frighteningly high probability of a default by the world’s sole superpower.

Another point of comparison is that ½% was roughly the CDS premium for insuring against default by India and several other major emerging markets in mid 2007. In other words, the US is perceived to be as risky today as India was in mid 2007. Before the crisis began, the CDS premium for the US was less than 0.1%. A five fold increase in the CDS premium clearly indicates that the risk perception has increased dramatically as the US government has taken more and more risk on to its own balance sheet.

We see a similar phenomenon in other countries as well. The cost of insuring against a default by the UK is as high as 1%. On the other hand, a country like Germany which still retains a conservative fiscal balance sheet enjoys significantly lower spreads than the US, UK or Japan.

In 2002, Japan encountered the same problem as it went on a fiscal binge to try and support its ailing economy. The rating agency Moodys downgraded the world’s second largest economy which was then the biggest creditor nation on earth to a single A rating placing it below Botswana which was then receiving foreign aid from Japan.

This time around, the ratings agencies have confined themselves to acting against small countries like Iceland which used to have a AA+ rating not too long ago, but has had its sovereign rating cut to BBB- (just one notch above junk). This has happened mainly because Iceland has assumed most of the liabilities of its banking system. The rating agencies are hesitant to take harsh action against major countries like the US or the UK since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonise the government that holds the regulatory sword of Damocles over them. The doubts about sovereign creditworthiness are instead being expressed by impersonal markets in the form of CDS premia.

In emerging markets like India, the worries about creditworthiness are even greater for a variety of reasons including foreign currency external debt and weaker institutional structures. Since the Indian government itself does not have foreign currency bonds outstanding, the CDS market relies on sovereign proxies like the State Bank of India. Using this sovereign proxy, the CDS premium for insuring against default by India has widened from about ½% in mid 2007 to about 4% by end November 2008. At its peak during the panic of October 2008, this premium was over 7½%.

We must also keep in mind the fact that India entered the crisis with a weak fiscal situation. Falling oil prices may reduce some of the off balance sheet obligations of the government, but a slowing economy will also reduce tax revenues. The fiscal position will thus remain precarious if not worsen further. What this means is that the Indian government must perforce be highly selective in terms of the bailouts that it provides. It has to distinguish between systemically important financial intermediaries, other financial entities and the general corporate sector. If the state expends its scarce fiscal resources supporting everybody that seeks help, then it might find itself too weak if and when the more systemically important entities need assistance.

During a downturn, many corporate entities will need to go through a debt restructuring if they have a liquidity or solvency problem. This debt restructuring may involve maturity extension, debt reduction or debt-equity swaps where creditors take significant losses, but shareholders suffer even more. If this causes losses to the the banks, their shareholders would also take a hit in the process. It is only after all this is exhausted that government support needs to be considered.

Posted at 11:00 am IST on Sun, 14 Dec 2008         permanent link

Categories: sovereign risk

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Good Moves by SEBI

The Securities and Exchange Board of India made several good moves at its board meeting last week (their press release is here). The huge move towards transparency has been widely welcomed in the mainstream media and in the blogosphere.

I will therefore focus on the change that they have made to prohibit early exit from closed end mutual funds. This change appears to be directed towards Fixed Maturity Plans (debt funds) which were designed to eliminate interest rate risk for investors by investing in paper with the same maturity as the tenor of the scheme. The intention was to lock in the rate of return at inception and avoid any price risk at maturity. There could be a small reinvestment risk because of reinvestment of intermediate coupons, but this was negligible given the short maturity of most of these schemes.

This investor expectation about a predictable return has been rudely shaken because of large redemptions by big corporate investors during the liquidity crisis of October 2008. The mutual funds had to sell some investments at a loss and more importantly the residual portfolio quality also suffered because the best and most liquid investments were sold. The RBI’s scheme to lend to mutual funds does not solve this problem because the valuation of some assets is suspect and the liquidity window actually helps redeeming investors exit at an unrealistically high valuation.

SEBI’s move to simply prohibit premature exit restores the closed end debt scheme to its original function and design. With this in place, the RBI scheme for lending to mutual funds can be scrapped and can hopefully be replaced by a scheme to lend against units of mutual funds. This would provide liquidity to corporate investors who now face an unanticipated liquidity need. Evidently, liquidity is a privilege for which they should expect to pay a fair market price.

The SEBI press release also says that these Fixed Maturity Plans should not invest in paper with maturity beyond the tenor of the scheme. This too is necessary to ensure that these plan work as advertised. However, the language used refers to all closed ended schemes and would therefore appear to preclude a closed end equity fund since by definition an equity share is perpetual in nature. Hopefully, this will be fixed in the actual regulations.

I also think that SEBI needs to put in place a regulatory provision for suspending redemptions even from open end funds in extreme cases where it is impossible to determine the net asset value (NAV) of the fund reliably. The ongoing financial crisis continues to worsen. Earlier people like me worried mainly about defaults by real estate companies and NBFCs. Now the fear extends to the corporate sector as well with at least three of India’s largest business groups being perceived to be at risk of severe financial distress.

We still hope this distress will stop short of default, but a situation could arise where uncertainties about the financial situation of systemically important borrowers could lead to a situation where the NAV of mutual funds cannot be reliably determined.

As far as I am aware, there is no explicit requirement in the mutual fund regulations prohibiting redemption of units above net asset value or prohibiting redemption if the NAV cannot be reliably ascertained. (I think this is because the regulations were designed largely to protect the investors from the fund and not to protect the investors from each other.) I do not know whether a prohibition against such unfair redemptions (fraudulent preference?) can be inferred from general trust law. In any case, for complete clarity, it would be useful to write these into the regulations.

There is enough international experience in dealing with the impact of systemic defaults on mutual fund redemptions. I think Korea handled the DTC crisis after the Daewoo bankruptcy in an admirable way and there are lessons from there both for SEBI and for RBI. There are useful lessons from the Lehman bankruptcy in the US as well. Regulators should study these lessons and stand ready to apply them if such unfortunate situations arise in India.

Posted at 12:30 pm IST on Mon, 8 Dec 2008         permanent link

Categories: mutual funds, regulation

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Who creates CDOs today?

While many think that CDOs and other complex instruments contributed to the crisis, the US government has been very enthusiastic in its use of these structures. In fact, if the behaviour of the US government is any indication, CDOs seem to be part of the solution. Let me give a couple of examples.

One of the best is the bail out of Citigroup. If one looks at the term sheet for this transaction, it is clearly a CDO structure:

• First loss tranche (10%) retained by Citigroup. Using typical CDO numbers, this would be all the pieces rated A and below. But if we assume that valuations are generous, then this would be just the equity piece or may be also a bit of the mezannine piece.
• Second loss tranche (1.6%) taken 90% by US Treasury (TARP) and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the BBB piece, the A piece or the AA piece. This is a thin tranche implying high loss given default.
• Third loss tranche (3.3%) taken 90% by the FDIC and 10% retained by Citigroup. Depending on one's valuation assumptions, this could be the A piece or the AA piece.
• Senior piece (85%) taken 90% by the Federal Reserve and 10% retained by Citigroup. Under good old CDO norms, this is the correct attachment point for a AAA tranche and if you are very gullible, you could consider this a AAA piece. Since the Fed took this piece, you would assume that either they were gullible, or that some valuers there are willing to turn a Nelson’s eye towards this transaction.

Now why is such a complex structure required when most of the parties involved are arms of the government itself and every reasonable person would agree that all pieces are clearly at significant risk? Clearly, the government is now abusing CDOs for the same reasons that Wall Street abused it – to fool oneself or to fool others.

As a second example, consider the terms of the restructuring of the loans to the AIG announced by the New York Fed yesterday. There is an LLC set up to buy CDOs and this has a complex structure.

• There is an equity tranche of a little under 15% contributed by AIG and the remaining 85% (senior tranche) is provided by the New York Fed. Note once again that the attachment point of the senior tranche is once again the magic number of 15% of the old days.
• There is a complex payment waterfall structure in which the Fed receives principal before it receives the interest (Libor + 100 basis points). To me this looks like make believe accounting where the Fed would be able to claim that there was no loss of principal and only the interest was lost.
• The profits are shared between AIG (33%)and the Fed (67%). Since AIG provided all the equity, one can think of this as an implied IO (Interest Only) tranche that is owned by the Fed.
• The term sheet glosses over the fact that the only source of cash for AIG to provide the equity piece of $5 billion is borrowing from the various schemes of the Fed and the Treasury. So the Fed is now playing the role of a prime broker lending to a hedge fund that picks up the equity piece of a CDO. What can the Fed do when there are so few prime brokers still left?

My last example has nothing to do with CDOs and is not a recently designed instrument, but the consequences of some needless complexity in the design is showing up only now. Long ago the US Treasury introduced inflation indexed bonds (TIPS) whose coupons and redemptions are indexed to the consumer price index. This is close to a real risk free bond and is a useful asset class for many investors. It is also useful in creating a market implied estimate of expected inflation (simply subtract the TIPS yield from the nominal yield of an ordinary government bond).

The US Treasury however fouled up this simple and elegant instrument by adding a totally unnecessary complexity when it stated that the redemption will not drop below par even if inflation over the term of the bond turns out to be negative. This adds a European put option exercisable at par at maturity to the instrument. Under normal conditions, this option is far out of the money and can be ignored. If one wanted to be more accurate, one could assume a volatility for the inflation rate, value this put and compute the option adjusted spread (OAS) for the TIPS.

The problem is that these are not normal times. Some people believe that the risk neutral distribution of the CPI at maturity is bimodal with one peak at 80% of current levels and another at 140% of current levels. Black Scholes valuation is hardly appropriate and nobody knows what the true value is. What we do know is that the yields on two TIPS with the same residual maturity have vastly different yields (a spread of 200 basis points) depending on when they were issued and therefore how much of inflation adjustment is already impounded in the principal. Mankiw blog has an excellent discussion on this issue. Econbrowser also discusses this and I have drawn on ndk’s comments in that post for the bimodal distribution mentioned above.

There is an old joke which asks what is the difference between the godfather and the investment banker. The answer is supposed to be that the godfather makes you an offer that you cannot refuse while the investment banker makes you an offer that you cannot understand. The US government is now very clearly in the business of making offers to the rich and well connected that the tax payer cannot understand.

Posted at 6:18 pm IST on Thu, 4 Dec 2008         permanent link

Categories: derivatives

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Sovereign defaults

According to data from Markit regarding the five year credit default swap (CDS) market on November 27, 2008, the cost of insuring against default by the US government was 0.5% per annum and the cost of insuring against a UK government default was almost 1%. The CDS market is now attaching a slightly higher probability to a default by the US than by Japan. Germany is seen as significantly less risky than any of these countries.

For comparison, 0.5% is the kind of premium that one might normally pay to insure a decent building against fire. But one must keep in mind that the CDS premium measures the risk neutral probability of default which could be several times the real world probability while for fire insurance, the risk neutral and real world probabilities are much closer to each other.

The sharp rise in the US CDS premium from the single digit levels prevailing before the crisis has left some people wondering whether all this makes any sense at all. Can a government default on debt in its own currency when it can print unlimited amounts of that currency? Above all, how can any entity provide protection against default by the government itself?

These same questions arose and were adequately answered years ago when the major ratings agencies downgraded Japan at a time when it was the largest creditor nation on earth running a large current account surplus. I therefore find it strange that the same questions are arising again now when the creditworthiness of the US is being doubted.

This time, the rating agencies dare not express doubts about the creditworthiness of the US since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonize the government that holds the regulatory sword of Damocles over them. The doubts are instead being expressed by impersonal markets in the form of CDS spreads.

So, let us once again remind ourselves that governments can and do default on debt denominated in their own currency. Creditworthiness is not only about ability to pay, but also about willingness to pay. It is reasonable to assume that governments have the ability to pay by printing currency though occasionally a government (Zimbabwe for example) has run out of ink and paper to print notes. The principal problem is about willingness to pay.

The Russian default of 1998 on its ruble debt is a good place to begin understanding the issue. I like to imagine the Russian government being forced to choose between paying its soldiers and paying its creditors. Obviously, it chooses to pay its soldiers – if it makes the wrong choice, it does not survive to tell the tale. Unlike creditors, soldiers cannot be paid in worthless paper. They have to be paid in something that can buy food and other essentials.

The government must therefore print notes on a scale that produces the maximum seigniorage revenues to the government. There is a very simple formula which states that in real terms seigniorage revenues are equal to the stock of real money times the rate of growth of nominal money. If it prints money on so large a scale as to create hyper inflation, then the stock of real money declines (and ultimately collapses to zero) and the government cannot earn any seigniorage revenues regardless of how fast it grows the nominal money supply by printing money.

A point is therefore reached where a government concerned about seigniorage revenues decides to default rather than print more notes. Stating the issue in terms of soldiers versus creditors dramatizes the issue, but we can as well think of it in terms of voters versus creditors and the analysis would be the same.

When one looks at the matter in historical perspective, the idea of government debt being risk free is a twentieth century illusion that is of as little relevance in the twenty first century as it was in the nineteenth century.

Let me now turn to the second question. Is it reasonable to assume that anybody can actually insure against default by the US government? I think the answer is yes provided one takes care not to take out insurance on the Titanic from somebody who is on board the Titanic itself. If one is paranoid, one might want the CDS contract to be governed by say English law rather than New York law and to pay out in say Euros rather than dollars. One might also like the counterparty to be outside the US or at least to have substantial assets outside the US. If these elementary precautions are taken, the CDS can indeed do the intended job as well for defaults by the US government as for defaults by any other reference entity.

Posted at 5:16 pm IST on Sun, 30 Nov 2008         permanent link

Categories: sovereign risk

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Wrong investors and market dislocation

I have been reading the transcripts of the US House of Representatives Oversight Committee hearing on hedge funds and the financial crisis.

Having enjoyed Andrew Lo’s excellent book on hedge funds, I read his testimony with particular care. I was particularly fascinated by the following statement that he made:

Dislocation comes not from losing money, but from the wrong investors losing money. (lines 725-726, p 34)

I mentioned earlier that dislocation happens not when losses occur, but when losses by individuals that are not prepared for those losses occur. The hedge funds that invest in the worst risk tranches, they are prepared for losses; but when money market funds, pension funds, mutual funds invest in AAA securities that then lose substantial value, that is really the cause for dislocation. (lines 1067-1073, p 49)

That diagnosis ties in well with a report at FT Alphaville about why Lehman’s demise was so devastating to the markets. During the run up to the Bear Stearns collapse, investors stopped rolling over its commercial paper and the amount of this paper outstanding fell by over 80% as far as I can make out from Figure 1 in the report. After the Bear bailout, investors assumed that a large investment bank would not be allowed to fail. As Lehman lurched towards bankruptcy, its commercial paper issuance not only did not fall but actually increased nearly five times.

This means that at the point of its failure, Lehman was being increasingly funded by what Lo called “wrong investors”. The tipping point in the post Lehman crisis was the closure of a prominent money market mutual fund due to losses on its investments in Lehman commercial paper. This in turn led to the collapse of the entire prime commercial paper market necessitating a bailout of that market and an ever widening range of other bailouts.

This is a very potent example of the moral hazard caused by government bailouts. Absent implicit government support, a weakening institution sees a withdrawal by risk averse investors and its funding comes increasingly from those who in Lo’s words are “prepared for losses”. The moral hazard caused by previous bailouts breaks this adjustment and makes subsequent failures a lot more painful than they would otherwise be.

This analysis also suggests that a “silent run” on a financial institution could actually be a good thing under certain circumstances if it is Lo’s “wrong investors” who are doing the running.

Posted at 2:04 pm IST on Fri, 28 Nov 2008         permanent link

Categories: crisis, risk management

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Show me the balance sheet

I wrote a column in the Financial Express suggesting that quarterly financial disclosures should be improved. In particular, the balance sheet should be disclosed quarterly:

In the current regulatory regime, Indian investors get to see the balance sheet of their companies only once a year, while they get to see the profit and loss information once a quarter. In the context of the current crisis, we need to change this urgently because the investor today wants to see the balance sheet as much or even more than the profit and loss data.

For example, if an Indian real estate company or non bank finance company were today to give its investors the choice between receiving a quarterly balance sheet or a quarterly profit and loss account, many investors would choose to get the balance sheet. Investors are currently more concerned about declining liquidity and solvency than they are about declining profitability. Indeed, the maturity and currency composition of the debt and the debt covenants are very critical pieces of information in assessing the survival prospects of these companies.

Another problem is that many companies have adopted the ugly practice of taking foreign exchange losses to the balance sheet in defiance of the accounting standards by taking refuge in some anachronistic arguments of doubtful legality. This means that the balance sheet is essential even to understand the true profitability of companies.

In the 1990s, when Sebi mandated quarterly disclosures of abridged profit and loss data, it was a huge step forward. It moved the Indian market to higher levels of informational efficiency and greatly improved price discovery. It would also be fair to say that quarterly disclosures have done more to reduce insider trading in India than the insider trading regulations themselves.

The time has now come to build on this and take it forward to its logical conclusion. In the 1990s, the only feasible mode of disclosure was a newspaper advertisement, and cost considerations severely constrained the amount of disclosure that could be mandated. The regulators therefore chose a minimal set of line items (all from the profit and loss account) for the quarterly disclosure.

Today online disclosure through the website of the stock exchange has become the primary means of information dissemination. The stock exchange data is then republished by several commercial and media web sites as well as by many online trading platforms. The online medium is not subject to the severe cost constraints that restricted the amount of information that could be published through newspaper advertisements. It is now feasible to mandate comprehensive quarterly disclosure of information.

In the US, Form 10K for annual disclosure and Form 10Q for quarterly disclosure are almost identical in terms of the basic financial data (income statement, balance sheet, cash flows, notes and other disclosures). India should also move to the same system where the quarterly disclosure contains all the information required for annual disclosures under Schedule VI of the Companies Act as well as the listing agreement.

Under normal conditions, this disclosure regime would be phased in gradually after extensive consultations and debate. But these are not ordinary times. The ongoing crisis puts a premium on the availability of information. I believe therefore that Sebi should take extraordinary measures to implement this on an emergency basis.

I propose that the top 500 companies (say the BSE 500) should be required to disclose the complete financial statements (balance sheet, profit and loss account and cash flow statement along with notes and schedules) through the stock exchange website beginning with the October-December 2008 quarter in January 2009. There is nothing to be done in the January-March quarter because it is coterminous with the year end. Therefore the remaining companies should be asked to disclose the extra information from the April-June 2009 quarter.

This disclosure requirement should not pose any problems for the companies. No sensible accountant prepares a profit and loss account without preparing the balance sheet and so my proposal would only require the companies to disclose what they have already prepared internally.

The stock exchanges may need software changes to upload all this extra information to their website. But if only 500 companies are subject to this regime in January 2009, it is quite feasible to upload the information manually in the worst case. The exchanges should undertake the extra effort involved in doing this while making software changes to allow them to handle everything automatically from July 2009.

On a related note, I also think RBI should require banks and financial institutions to disclose vastly more information regarding non performing assets and valuation of financial assets. Accelerated adoption of accounting standard AS 30 for financial instruments should also be considered. Current practices allow banks and finance companies to hide losses by improperly parking assets in the held to maturity category. This should be stopped. At the very least, voluntary early adoption of AS 30 should be encouraged. The market can be counted upon to penalise those companies that choose not to do so.

Posted at 11:39 am IST on Thu, 27 Nov 2008         permanent link

Categories: accounting, corporate governance, crisis, regulation

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Liquidity or solvency?

I wrote a column in the Financial Express about the potential solvency problems in the Indian financial sector today.

During the last month, Indian policymakers have responded with a series of measures including cuts in interest rates and in cash reserve ratios to improve liquidity in the financial sector. These measures were certainly necessary, and I believe we would and should get more such measures.

However, lurking behind the current liquidity problems is a deeper problem of solvency that needs to be addressed quickly and decisively. It appears to me that India is now where the US was a year ago – the measures that we saw in India in October 2008 were broadly similar to what the US and Europe undertook in August and September 2007. In terms of the deflation of the real estate bubble also, India seems roughly where the US was a year ago.

One difference is that the US had early warning signals in the form of house price futures and ABX indices that provided valuable information on asset prices and credit quality. These measures combined with stringent mark to market accounting enabled analysts to make reasonable guesses about which financial institutions would be hit severely and which were likely to remain solvent. In India, we do not have these markets and the health of financial intermediaries has become the subject matter of rumours and gossip rather than reasoned analysis.

The only market signal of solvency that is available in India is the stock price. The majority of the 17 listed private sector banks for which information is available in the CMIE database are today quoting at a price to book ratio of 1.0 or below which is a crude signal of potential solvency issues. Of the same set of 17 banks, only two traded at a price to book of 1.0 or below at the beginning of last year.

At this point of time, accounting data is not quite reliable because the carrying values of assets do not reflect their fair value. This is a serious problem for banks and non-bank finance companies that have exposures to real estate and to other stressed borrowers. It is also difficult to assess the exposure of banks to troubled non-bank finance companies and weak banks. But the problem is much wider and extends also to debt mutual funds that have exposures to real estate, banks and non-bank finance companies.

Mutual fund net asset values have become unreliable for two reasons. First in respect of short-term financial instruments, mutual funds have the ability to carry the assets at amortised cost rather than market value. Second, some of the really distressed paper does not trade at all and this makes the valuation judgmental. SEBI has allowed greater freedom to mutual funds to mark down the valuation of debt paper by using higher discount rates rather than the rating based spreads that were mandated in the past. This is a good step, but its usefulness depends on the voluntary decisions by funds to mark down the net asset values of their funds.

Solvency problems should be addressed at the earliest possible stage because the longer the corrective action is delayed, the greater the eventual costs of solving the problem. It is necessary to move swiftly to triage financial intermediaries into three categories: those that are financially sound, those that need to be recapitalised or restructured and those that should be shut down. This requires price discovery for stressed assets. Indian policy makers should therefore move swiftly to put in place structures similar to what the Americans and Europeans have done in the last couple of months to restore the health of the financial sector.

A strong financial sector is essential to confront the challenges of a slowing world economy. Unlike during the Asian crisis, this time, emerging economies face a shrinking world market for their exports. The threat of a “beggar thy neighbour” policy of competitive currency depreciation is very real.

The Korean won today trades lower than it did as it was emerging out of the Asian crisis in 1999. The news coming out of China is also quite bad, and the Chinese seem determined to boost their economy through all possible measures. At some stage, these measures will probably include a depreciation of their currency. To make matters worse, many East European currencies are also in danger of going into free fall, and some of them could be formidable competitors in the IT and BPO industries despite a language handicap.

All of this could make the economic slowdown even worse than it would be otherwise. A slowing economy increases non-performing assets and induces financial sector weakness that in turn impacts credit availability and weakens the economy further. The way to stop this vicious spiral is through aggressive recapitalisation and restructuring of the financial sector. We have a window of a few months to do this before India enters election mode.

Posted at 6:00 am IST on Wed, 12 Nov 2008         permanent link

Categories: crisis

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Land as an asset

The doyen of Indian housing finance, Deepak Parekh is today quoted as saying that land is no longer an asset (“There is no need for irrational pessimism”, Business Standard, November 7, 2008). Parekh says “Land prices have collapsed, land is no longer an asset – people don’t want land as a security. Today, there is surplus land, low demand ... the value of land is probably half of what it was ...”

This explains why real estate companies reportedly have to pay 35% interest after providing collateral (land) notionally equal to three times the value of the loan.

Another interesting statement in this context is in a speech by Fed Governor Kevin Warsh (hat tip Calculated Risk) “We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world.”

Posted at 2:58 pm IST on Fri, 7 Nov 2008         permanent link

Categories: miscellaneous

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Credit Default Swaps on Indian Entities

The Depository Trust and Clearing Corporation has published what is perhaps the first comprehensive official numbers on the global credit default swap market including the top 1000 reference names. The top 1000 names accounts for over 95% of the market by gross notional value and a little less than 90% by net notional value. Entry into this list is a measure of how important an entity is in global fixed income markets, but this is not a list that entities are eager to get into (many of the top names on this list are shaky sovereigns and shakier financials!).

I could spot four Indian entities in this list (ICICI, Reliance Industries, State Bank of India and Corus) in the middle of the list (ICICI is actually in the top 500). The top Indian names also serve as sovereign proxies and therefore the numbers must be interpreted with some care.

Posted at 10:57 am IST on Wed, 5 Nov 2008         permanent link

Categories: crisis, derivatives

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Policy Choices for India

Most of my posts in recent days have focused on the risks that I see for the Indian economy and the financial system rather than on the policy responses. Jahangir Aziz, Ila Patnaik and Ajay Shah (APS) address the question of policy responses in a paper that I mentioned in an earlier post. They recommend among other things that the policy makers should undertake the following measures:

• Increase rupee liquidity substantially with the CRR being cut to 5% and the SLR to 20% with a further de facto reduction in SLR by allowing oil bonds to be counted as SLR.
• Provide substantial dollar liquidity to the market in the form of currency swaps.
• Let go of the currency and allow it to fall.

I agree with the broad thrust of most of these recommendations. Unlike APS, I do not worry that these proposals would amount to over reaction, rather I fear that they would not be enough. I look at what Korea has done and believe that India’s responses can be only mildly milder than theirs. Neither India nor Korea needs to go to the IMF for dollar funds, but the good news really stops there.

Our reserves are sufficient to finance the current account deficit for a couple of years and to take care of the dollar needs of the banking system and a few systemically important entities. As in the case of Korea, the reserves are not enough for anything more ambitious, and we will have to take harsh decisions beyond that. Meeting the dollar needs of the entire corporate sector as APS appear to suggest would risk depleting the reserves to alarming levels. Defending the currency as the RBI has been doing is of course plainly unsustainable.

My main complaint with the APS paper is its title which makes it appear as if we are faced with only a liquidity crunch. No, I think we are faced with a much bigger threat to our economy than during the Asian crisis of 1997. As I have written in earlier posts, in terms of the evolution of the current crisis, we are only where the US was in September 2007. The big shocks are yet to come.

We have not yet had our Bear Stearns moment, but that moment will surely come. We have not yet had a collapse of the real estate market. The big real estate companies have been borrowing at 35-40% interest rates in the hope that the festive season (Diwali) will bring much needed home sales. This has clearly not happened, and November will perhaps see the first distress sales of property. Non performing assets in the financial system will probably start climb rapidly from then on. At least some banks, mutual funds and systemically important non bank finance companies will need some kind of bail out.

For the corporate sector, the real distress is still in the future as the large capacity expansion of recent years encounters a slowing economy. We are also yet to see the flood of cheap imports from countries like Korea that have let their currencies fall sharply. I fear that some East European currencies could collapse to the point where they become competitive with Indian IT and BPO companies unless the rupee itself goes into free fall. It is likely that aggregate Indian corporate earnings will decline significantly. A wave of corporate defaults will of course put further strains on the financial system.

As in the US and Europe, our government too cannot stop the carnage. The government can only try to mitigate its worst ill effects. Moreover the Indian government will have to be even more selective than other governments because it enters the battle with a rather weak fiscal position. If it tries to save everybody, then it will be in need of succour itself. Moreover, the government will face intense pressure for fiscal measures to boost the economy if necessary by monetizing the deficit.

Posted at 3:47 pm IST on Mon, 27 Oct 2008         permanent link

Categories: crisis

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Will Asia go on a fiscal binge?

In my last post, I argued that Asian currencies are likely to witness a round of competitive devaluations. The purpose of this post is to consider whether this could be accompanied by a fiscal binge as well.

But first some elaboration of my two fold argument for Asian devaluations. The first part of the argument is that reserves are large but not infinite – reserves may be drained rather quickly if the country tries to defend the currency. The Koreans found this out quickly. (My definition of Asia does not include Russia, but the Russians may also be in the same boat right now. Their half trillion dollar reserves are the third largest in the world, but they have already lost a tenth of it and clearly, this rate of reserve loss can not last forever).

Faced with this reality many countries will let the currency find its level and let the rest of the world deal with its consequences. Korea is today telling the rest of Asia what US Treasury Secretary, Jim Connally told his European counterparts back in the 1970s: “The dollar may be our currency, but it is your problem.” The added twist is that Korea is also telling its own corporate sector that the won is their problem, not that of the government. Many Asian companies will hear the same message. Any emerging market company with lots of foreign currency debt will lilkely find itself staring into the abyss.

The second part of the argument was that faced with a global recession that threatens to be a global deflation, currency depreciation becomes a desparate attempt to maintain exports. Commentators on my earlier post asked whether this can succeed. Of course, beggar thy neighbour cannot succeed if everybody tries it as the world found in the great depression, but that does not prevent everybody from trying it.

There will therefore be two kinds of currencies – those that are taken down by the markets and those that are taken down by their own governments. Some currencies will be somewhere in between – the markets will begin the job and the governments will finish it.

Now back to the fiscal implications. During the 1997 crisis, the discipline of currency markets was a strong factor in favour of fiscal restraint. This time around, that restraint will be lacking. In fact, the governments will be tempted to use fiscal boosts to lift the economy out of recession. Two statements from the just concluded Seventh Asia-Europe Meeting were interesting in this regard:

• Indian Prime Minister Manmohan Singh stated quite bluntly: “As a counter cyclical device, increased infrastructure investments in developing countries, if backed by increased resources flows from multilateral financial institutions such as the IBRD and Regional Development Banks, can act as a powerful stabilizer.” India has still not let go of its currency and so the call for support from the world bank makes sense. But the day the government decides that the rupee is somebody else’s problem, this support will be less important. Elsewhere in his speech, Dr Singh also quoted Keynes with approval.
• The statement of the Seventh Asia-Europe Meeting on the International Financial Situation contains this line: “Leaders called on all countries to pursue responsible and sound monetary, fiscal and financial regulatory policies, enhance transparency, inclusiveness, strengthen oversight, and improve crisis management mechanisms so as to maintain their own economic development and the stability of the financial markets.” This was remarkable for not talking about price stability or orderly exchange rates. One could argue that financial markets include currency markets, but in today’s context, the terms refers more to credit markets.

The fiscal binge (particularly when financed by the printing press) is just the currency debasement strategy applied internally rather than externally. It is a very powerful weapon against “debt deflation”, but the remedy can sometimes be worse than the disease.

Can the fisc substitute for the lost foreign demand? The fisc is ill suited to buying the stuff that Asia is used to selling to the now retrenching American consumer. The fisc is best suited to building roads to nowhere providing some support to the steel and cement industries which are now gasping for breath.

Posted at 9:41 am IST on Mon, 27 Oct 2008         permanent link

Categories: crisis, international finance

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The coming wave of competitive devaluations in Asia

We are today seeing a significantly altered re-run of the 1997 crisis in large parts of Asia. Once again, there is a “sudden stop” and reversal of capital flows. The big difference is the the large reserves that Asian countries accumulated during the crisis.

Korea was the first to realize a few weeks ago that unless they threw the reserves away in a futile defence of the currency, the reserves were large enough to cover the sovereign debts as well as the debts of the banking system. A crashing currency could bankrupt reckless companies, but the country would be safe. They have therefore let the currency collapse and have been free to use the reserves to lend to their over extended banks. In 1997, Asians did not have this option. They thought that the only way to prevent a run on the country was to defend the currency and signal to the rest of the world that they were sound.

I believe that the Korean currency depreciation of recent weeks is going to be the new pattern in Asia. Under normal conditions, most Asian governments are suborned by their corporate sectors, but under conditions like this, these same governments would let reckless companies stew in their own brew. An added incentive this time is that with a slowing global economy, the Asians are going to be fighting for a share of a shrinking export pie. We will therefore see more of the beggar thy neighbour game that the Europeans and Americans played during the great depression. This time around, the western world does not seem inclined to play this game leaving the field wide open to the Asians.

We in India know how ten years ago the Koreans used their depreciated currency to capture the white goods market in India. Now that the won is again at 1400 (closer to 1450 as I write) to the dollar, I see an even bigger onslaught by the Koreans because the best run conglomerates are in far better shape than they were in 1998. It will not just be white goods but every industry where there is global excess capacity (which probably means just about everything).

The won will also put pressure on Japan to embark on large scale intervention (possibly half a trillion dollars over the next year or so) to keep the yen down. The Japanese are possibly more concerned about the euro-yen cross today and their intervention could indirectly help the Europeans. But the Chinese would feel the heat of a declining won and yen.

For a couple of months now, the smart money has been shorting the renminbi (what a change a few months makes!). As Chinese exports slow down, a depreciation of the renminbi would be just what the doctor ordered. Since probably as much as half a trillion dollars of hot money flowed into China in the last couple of years, the Chinese government would just have to sit back and watch this money flow out and pull the renminbi down as it leaves. I would not be surprised if a year from today, Japan once again has the world’s largest foreign currency reserves.

Competitive devaluation by Korea, Japan and China would leave India with no choice but to let the rupee fall to levels which would be frightening (if not bankruptcy threatening) to those who have been stupid enough to borrow in dollars. Beggar thy neighbour is a very ugly game when countries start playing it in right earnest.

Posted at 11:35 am IST on Fri, 24 Oct 2008         permanent link

Categories: crisis, international finance

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More on India being in September 2007

I received several comments on my post yesterday in which I argued that India is now where the US was in September 2007. Several focused on the large correction that has taken place in the equity markets and argued that in this sense, much of the pain is over. I disagree. India had a most outlandish bubble in the equity market and a partial correction of this is not what I mean by pain. At this point, only momentum investors in Indian equities are suffering; longer term buy and hold investors are in the money.

Two reference dates that allow stock markets across the world to be compared are the highs that most markets reached in early 2000 at the height of the dot com bubble and the low points that many markets reached after the 9/11 event in 2001.

• The Sensex close of yesterday was over 70% above the dot com peak. In comparison, the Dow in September 2007 was 18.5% above its dot com peak while its close yesterday was 27% below that peak.
• The Sensex close of yesterday was almost four times the post 9/11 low. In comparison, the Dow in September 2007 was about 69% above its 2001 low while its close yesterday was pretty close to this low (a mere 3.4% above it).

Let us for the moment put aside the possibility of the Sensex returning to its post 9/11 low – that would be a drop of almost 75% from yesterday’s levels. But what about the Sensex returning to its dot com highs (a 40% fall from yesterday’s level)? Is that possible? Well if aggregate corporate earnings were to fall as they well might in a recession and if the PE multiples were to shrink in line with slower global growth opportunities, this is by no means beyond the realm of possiblity.

India and China are essentially leveraged bets on the global economy. When the global economy goes into recession, stock markets in these two countries will fall much more than global markets just as they rose much more than global markets on the way up.

Other commentators argue that India will not see much pain because we did not have the wild excesses of the US. The UK has had very little of the teaser rate mortgages and other such toxic stuff that we talk about in the US context, but the picture that the Governor of the Bank of England painted in his speech earlier this week was quite dismal. And did we not have excesses in India? Did we not reach a point last year where many companies found that it was cheaper to hire a senior manager in the US than in India, that it was cheaper to rent office space almost anywhere in the world than in India?

Posted at 3:43 pm IST on Thu, 23 Oct 2008         permanent link

Categories: crisis

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Comments have been enabled again

I am happy to inform my readers that I have finally enabled comments once again on my main blog site. I had to disable comments temporarily last month after somebody starting spamming me at the rate of one spam comment every minute. It took me 45 minutes to realize what was happening and disable comments. It took much longer to manually take out the offending comments. Had he done it at a time when I was not watching, he might have had a comment spam on every one of my blog posts!. I used to think that my CAPTCHA’s will stop spam, but they stop only automated spam. They do not stop somebody who starts spamming manually.

It took me a lot longer to write some code in my blogging software to allow comments to be moderated. I have now done this and tested it out. It seems to work. Please email me if there are any problems.

It is my intention to use moderation only to filter out spam. I do not mince words on my blog and I do not expect you to mince words in the comments. Comments are also moderated on my Wordpress mirror.

Posted at 5:40 pm IST on Wed, 22 Oct 2008         permanent link

Categories: miscellaneous

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India is now in September 2007

In terms of the financial crisis in India, I believe we are where the US and Europe were in August/September 2007. This is how the comparative chronology stacks up.

US and Europe: August/September 2007	India: October 2008
August 9/10, 2007. Liquidity strains in the money market becomes acute. ECB injects liquidity of € 95 billion. Fed injects $ 38 billion.	October 10, 2008. Liquidity strains in the money market become acute. RBI injects liquidity of Rs 600 billion by cutting the cash reserve ratio (CRR).
September 18, 2007. Fed cuts Fed funds target by 50 basis points (0.5%). It also cuts discount rate by 100 basis points (1%) including a cut a month earlier.	October 20, 2008. RBI cuts repo rate by 100 basis points (1%).
Q3 2007. Real estate prices (Case Shiller index) after peaking in the second quarter of 2006 has been declining for five quarters but has fallen by only 5% from the peak.	October 2008. Real estate prices in India probably peaked in late 2006 or early 2007 and has also been declining unofficially for several quarters, but the sticker price has not yet fallen significantly.
Q3 2007. The ABX index of AAA rated sub prime securities indicates losses of only 5-10% of par value. Actual defaults and even downgrades of AAA securities are yet to come: the infamous downgrade of nearly 2,000 AAA securities over a mere two days came only in April 2008.	October 2008. Lenders still believe that the best real estate lending will hold up reasonably well and think that losses will be confined to the really low quality loans.

If we assume that the peak to trough decline in real estate prices in India will be comparable to what we have seen in the US, then it is clear that most of the pain still lies ahead.

Posted at 11:11 am IST on Wed, 22 Oct 2008         permanent link

Categories: crisis

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India and its two giant hedge funds

I like to think of what has been happening to India on the external front in recent months in terms of the two giant hedge funds that we as a country have been running. The first hedge fund is the product of our (Foreign Institutional Investors) FII regime and the Reserve Bank of India’s policy of reserve accumulation. Up to 1997, FIIs bought stocks in India and the RBI stashed away the dollar inflows in its foreign exchange reserves in the form of US Treasuries and other assets. As a nation therefore we were short Indian stocks and long US Treasuries.

During the past year or so this has been an immensely profitable trade for India. Think of an FII that brought a billion dollars into India when the exchange rate was say Rs 40/$ and the stock market index (Sensex) was say 20,000. The billion dollars fetched Rs 40 billion and these rupees in turn fetched 2 millions “units” of the Sensex. Today, the FIIs are stampeding out of the exits when the Sensex is say 10,000 and the exchange rate is say Rs 50/$ (let us choose nice round numbers). The 2 million Sensex “units” can now be sold for Rs 20 billion and these rupees fetch $400 million. The RBI sells $400 million of US Treasuries and pays off the FIIs. The remaining $600 million of US Treasuries are now ours to keep as they will never have to be paid back. India as a nation makes a cool profit of $600 million through our “FII hedge fund”. And that is not counting the profits that we made on the US Treasuries as the global turmoil pushed their yields down to ridiculously low levels. This is a fabulous return and any hedge fund anywhere in the world would give an arm and a leg for this kind of performance.

But India has been running another giant hedge fund which is doing very badly indeed. Unlike the open door policy that we had towards FII investments in Indian equity, we kept our corporate bond markets largely closed to foreigners. In a policy regime which can only be described as incredibly perverse, we did however allow the Indian corporate sector to borrow practically unlimited amounts in foreign currency in global markets. We did have a cap on External Commercial Borrowings (ECBs), but in practice, this cap was simply raised whenever it was approached. This coupled with the inefficiency of the domestic financial system (because of incomplete deregulation) drove the Indian corporate sector to borrow large amounts overseas. Consumed by some amount of hubris, Indian companies splurged billions of dollars on buying marquee companies around the world even when the domestic stock market told them in clear terms that they were overpaying.

This is the second giant hedge fund (the “ECB hedge fund”) that we as a nation have been running – long cyclically sensitive assets in India and around the world, short US dollars. A large part of the dollar borrowings were also in relatively short term funding which has to be renewed at today’s punitive interest rates. The credit spread on Indian paper has risen by around 500 basis points (5 percentage points), the dollar has risen, cyclical assets have been hammered down due to global recessionary fears – the “ECB hedge fund” has been living through a nightmare. Aziz, Patnaik and Shah estimate that the Indian corporate sector will require at least $50 billion of dollar liquidity in the coming year. This is one reason why there is so much shortage of liquidity in India today: with dollar borrowing next to impossible, dollar borrowings are being repaid our of rupee borrowings.

So all in all, the “ECB hedge fund” has performed disastrously and could conceivably end up losing more money for us as a nation than the “FII hedge fund” makes for us.

In the fullness of time, when we come around to reviewing our capital account policy frameworks, we will hopefully keep this in mind.

Posted at 11:21 am IST on Tue, 21 Oct 2008         permanent link

Categories: international finance

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Mutual funds cannot borrow their way out of redemption trouble

Indian mutual funds have been facing redemption pressure for some time now and the policy response to this was to allow them to borrow more easily. The Reserve Bank of India early this week created a special repo facility of Rs 200 billion to enable banks to meet the liquidity needs of banks. This facility has thankfully not been very popular so far and I hope that it does not become popular because it is a prescription for disaster.

A mutual fund is very different from a bank. When a bank borrows to repay depositors, there is a capital cushion that can take losses on the assets side. When this capital is gone, the bank also needs to be recapitalized and cannot solve its problems by borrowing from the central bank. A mutual fund does not have any capital separate from the unit holders. This means that the only prudent way for a mutual fund to repay unit holders is by selling assets. If it borrows, then it is exposing remaining unit holders to leveraged losses.

Imagine a mutual fund with assets of Rs 1,000 (worth par) and 100 units of Rs 10 outstanding. The net asset value (NAV) of the fund is Rs 10.00 at this point. Suppose now that some of the assets deteriorate in quality and the true value of the assets is only 88% of par value. If the instruments were liquid and well traded, the mutual fund would mark its holdings down to market value, and the NAV would drop to 880/100 = Rs 8.80 per unit. But because the instrument is illiquid and not well traded, the mutual fund would avoid doing this by pretending that the assets are all good. The NAV would on paper remain as 10.00 instead of 8.80. If the mutual fund borrows 200 to meet a redemption request at the old NAV then only 80 units are remaining to absorb the loss on the assets. The true NAV at this point is only (880-200)/80 = 680/80 = Rs 8.50. Every unit holder who remains in the fund has lost Rs 0.30 in order to allow the redeeming unit holder to exit without a loss.

What this means is that every intelligent unit holder now has the incentive to redeem and exit at 10.00 rather than wait and be left with only 8.50. It is far better to force the fund to sell assets at distress prices if necessary. Suppose in the above example, the market prices are distressed and the assets which are truly worth 88% of par can be sold only at 80% of par. In this case, the NAV of the fund drops to 8.00 by being marked to market. Suppose 20 units want to redeem and the fund sells assets with a face value of Rs 200 at 80% to pay out the NAV of 8.00 x 20 or 160. Suppose the remaining unit holders sit out the distress and hold on to their units till the assets rise to their fundamental value of 88% of par, the assets of the fund at this point would be Rs 800 of face value which are worth 88% x 800 = 704. The NAV of the remaining 80 units would then be 704/80 = 8.80. Thus the remaining unit holders have a gain of 0.30 per unit at the expense of the redeeming unit holders. This is as it should be. Those who demand liquidity during troubled times should pay for it and the patient capital that sits out the storm should be rewarded. What this would also do is to reduce the incentive to redeem. Only those with pressing liquidity needs would redeeem.

The questions therefore is whether Indian mutual funds are facing only a liquidity pressure or whether they are also facing the problem of hidden non performing assets. I think the latter is clearly the case today. The liquid funds and fixed maturity plans that are facing redemption pressure today have broadly four clases of assets in the portfolio:

• Bank Certificates of Deposit: Under the current global scenario where exposure to banks is effectively sovereign exposure, it is reasonable to assume that these assets are not impaired.
• Securitized paper mainly pertaining to auto loans. The underlying loans are witnessing high delinquencies and it is fair to assume that this paper is impaired significantly beyond their carrying values.
• Securities of Real Estate Companies. It is fair to assume that this paper is impaired significantly beyond their carrying values.
• Securities of Non Bank Financial Companies: These companies in turn have large exposure to real estate, home loans, auto loans and other retail assets. It is fair to assume that this paper is impaired significantly beyond their carrying values.

In the current scenario, therefore, the NAVs of many debt oriented mutual funds today are not very credible. The only way to establish true NAVs is if the underlying paper is sold. Giving the mutual funds a credit line delays this day of reckoning. The danger is that the sophisticated corporates who are redeeming today get a good deal and the unsophisticated retail investors still holding on to their units will be left with all the rotten assets.

All of this is not to deny that a policy response is needed to the liquidity problem of mutual funds. If lending them money is not the answer, then what is the solution? There are two models available.

• The US solution of providing a sovereign guarantee to liquid mutual funds is one alternative. Part of the costs of this guarantee can be recovered by simultaneously withdrawing the tax break that the debt mutual funds get today.
• The solution adopted by Korea during the 1999 crisis in their mutual funds (ITCs) after the bankruptcy of Daewoo. This involved purchase of bonds from the ITCs by government entities (this was a purchase and not a loan), recapitalization of the ITCs and partial redemption freezes.

At the very least what is required today is a partial redemption freeze to ensure that nobody is able to redeem units of mutual funds at above the true NAV of the fund. Anybody who wants to redeem should be paid 70% or 80% of the published NAV under the assumption that the true NAV would not be below this. The balance should be paid only after the true NAV is credibly determined through asset sales. If this is done, then the Rs 200 billion line of credit would make sense to avoid distress sale of assets.

Posted at 5:18 pm IST on Fri, 17 Oct 2008         permanent link

Categories: crisis, mutual funds, regulation

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Bubble in our backyard

I wrote a piece in the Financial Express on Saturday about India’s home grown financial bubble.

While Indians have been worrying about the spillover from the global financial crisis, a homegrown crisis has been brewing gradually. Like in the US, this crisis has its origins in a bursting real estate bubble and its effects are likely to be similar.

It is a mistake to assume that the US financial crisis was caused by the kind of securitisation and financial innovation that has been repressed in India. The deadliest financial innovation at the heart of the global financial crisis is a millennia-old innovation called the mortgage loan. We have had plenty of that in India.

During the last few years, India experienced a bubble in both residential and commercial real estate fuelled by easy availability of credit. Indians have been buying expensive houses almost completely financed by banks. The cumulative loan to value ratio including “furniture loans” and other forms of financing has been close to (and has sometimes exceeded) 100%. Unlike in the past, many of these transactions have been largely free of black money and therefore there is no hidden cushion in the loan to value ratio. Moreover, our young upwardly mobile professionals have been taking on large mortgage payments (EMIs) assuming that these would be affordable on the basis of projected salaries one or two years down the line. With declining salary growth, the affordability of these mortgages is now questionable.

Commercial real estate has been equally if not more frothy. Much of recent corporate lending by the banks has been to sectors like infrastructure, SEZs and retailing that have been essentially real estate plays. The real estate bubble has also helped banks to reduce non performing assets as companies have been eager to settle old problem dues in order to monetise their real estate.

The real estate bubble in India is clearly bursting. Anecdotal evidence points to declines of 20% or more in key markets. But this understates the severity of the problem. Real estate prices are sticky and they fall only gradually. Hidden discounts are more common than public price cuts. Evidence from the stock prices of real estate companies indicates that the value of their land bank has fallen by over 50%. Even if this is exaggerated, it is clear that a 30-40% nationwide fall in real estate prices from peak to trough is very likely.

Under this assumption, a large fraction of recent home buyers would have negative equity in their homes. They would also face increasingly unaffordable mortgage payments as the job market deteriorates. As in the US, we too have witnessed a significant easing of credit standards in retail lending in the last few years. We have anecdotal evidence that the retail unsecured lending portfolio of some large finance companies (including some foreign owned ones) received exit valuations of as little as 30% of face value early this year, and are probably worth even less currently. If credit standards in mortgages were similar, the home loan portfolio of the banking system could see severe losses as home prices fall.

I do hear people argue that while property loans in the US are without recourse, this is not the case in India. Actually, only in a few states of the US is it true that mortgages are without recourse to the borrower by law. However, elsewhere in the US and in other countries, where legally the lender has recourse to the other assets of the borrower, this makes very little difference in practice. The part of the loan that is in excess of the sale value of the house is an unsecured personal loan whose recovery in default is quite low and often lower than the costs of litigation.

Globally, therefore prudent lenders regard mortgages as being without recourse in practice. The lenders’ best bet is to modify the mortgage terms to persuade the borrower to stay on in the house and keep paying the reduced EMIs. This is because a house is typically worth more to the existing owner than to a potential buyer.

The picture in Indian commercial real estate is even worse because of the greater possibility of negative cash flows and acute liquidity stresses. There is of course a lag between dropping footfalls in malls to rising vacancy rates and then to negative cash flows, but the trends are clearly in evidence. It does appear that the situation in Indian commercial real estate is worse than that in the US.

Indian banks, mutual funds and other intermediaries have large exposures to residential and commercial real estate and there is a significant risk of their facing liquidity and solvency stresses similar to those faced by global banks. A “quiet run” is already beginning on some of these institutions. The question is whether Indian policy makers would respond to these stresses with the same speed and flexibility that the Americans and Europeans have exhibited.

Posted at 3:46 pm IST on Wed, 15 Oct 2008         permanent link

Categories: bubbles, crisis

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Securitization has little to do with crisis

I have been arguing for sometime now that the global financial crisis has little to do with securitization and CDOs and everything to do with real estate lending. The data in the IMF Global Financial Stability Review released this week confirms this view. Of the estimated losses (Table 1.1) of $1.4 trillion, as much as 30% are in unsecuritized loans. The corresponding percentage was only 24% in March 2008 and as little as 17% in October 2007. During the last year, the percentage of losses attributable to unsecuritized loans has almost doubled.

What we see is that because of the mark to market approach, securitized assets show losses earlier while the held to maturity approach allows losses on loans to be concealed and deferred. In this sense, the securitized paper was the canary in the mine that alerted us to problems quite early. Policy makers are completely mistaken in believing that absent securitization, we would not have had any problem. All that would have happened is that banks would have been in a state of denial longer.

Another interesting thing that we have seen in recent days is that the global stock markets can take something like a trillion dollars of losses in a single day without stock exchanges collapsing. When banks take less than a trillion dollars of losses over more than a year, it looks like the end of the world. This tells us something about the inherent fragility of a bank dominated financial system and the need to move towards a world dominated by liquid financial markets. We also see that under conditions of extreme stress, liquidity collapses in inter bank markets, but not in stock markets and other non bank markets. Yet another reason to reduce the dependence on banks in the long run.

Posted at 1:57 pm IST on Sat, 11 Oct 2008         permanent link

Categories: bond markets, crisis, derivatives

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SEC Audit Report on Bear Stearns

At the beginning of this week, the SEC released two reports of its Inspector General on the Bear Stearns failure and more generally the SEC’s supervision of the broker dealers. I am quite disappointed about this report which I approached with high expectations. This was a report requested by the US congress and the Inspector General had retained the services of one of the world’s leading authorities on market microstructure as an outside expert. The redactions in this report are not very large and I do not believe that the unredacted report would contain anything more useful.

The critical question in the SEC’s supervision of the broker dealers relates to the capital and liquidity regulations. On this the audit report states:

Bear Stearns was compliant with the CSE program’s capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements;

One expects an audit report to go beyond such an inane statement.

I read the audit report once again in the light of the management response by the SEC’s Division of Trading and Markets. I found myself agreeing more with the management response than with the audit report.

I remember being quite critical of the UK FSA’s internal audit report on Northern Rock, but today I must confess that the FSA report was definitely superior to this SEC report. We are reconciled to regulators being reactive rather than proactive, but if a regulator cannot do even a proper post mortem, then it is a matter of serious concern.

Posted at 1:41 pm IST on Sat, 4 Oct 2008         permanent link

Categories: crisis, investigation, regulation

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More on financial crunch potential in India

I received several comments (some by email and some on the Wordpress blog) in response to my post about the possibility of a home grown financial crunch in India. Let me respond to some of them.

• Several comments asserted that there is a lot of black money in Indian real estate and this protects the lenders. It is difficult to make a categorical statement about black money which is by definition not publicly disclosed. My impression is that the prevalence of black money in real estate has been declining over time. The young upwardly mobile professionals have been demanding and getting white money transactions that can be almost completely financed by banks. I believe that much of the banking system’s real estate exposure involves transactions with negligible black money or structures which achieved high LTVs even after accounting for the black money.
• One comment asserted that the decline in property prices in India is confined to big cities and that the rest of the market is unaffected. This was true in the United States several months ago and is still partly true today – California and Florida account for a lot of the problems. Gradually, in India too, the problems could spread nationwide as they did in the US.
• Another comment highlighted the fact that while property loans in the US are without recourse, this is not the case in India. Actually, only in a few states of the US is it true that mortgages are without recourse by law. However, elsewhere in the US and in other countries, mortgages are in practice without recourse because of the difficulty of collecting. As we all know, when an unsecured retail loan defaults, recovery is quite low. Normally, what happens is that the banks modify the mortgage terms to persuade the borrower to keep paying the loan. But if the borrower defaults, the bank is left with whatever it can get for the collateral.

Posted at 10:21 pm IST on Tue, 30 Sep 2008         permanent link

Categories: crisis

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Can a US style financial crunch happen in India?

When people ask me what impact the global turmoil would have on India, my response is that the relevant question to ask is whether a similar crunch could happen in India. The first point to emphasize is that the US turmoil has nothing to do with CDOs and securitization and everything to do with the bursting of a real estate bubble (see for example this, this, this and this).

Real estate prices are sticky (particularly downward) and therefore the bursting of the bubble is a very slow process – it is more like a leaking balloon than a bursting balloon. On the other hand, a liquid financial asset whose value is linked to real estate prices will decline sharply reflecting not merely the current fall in real estate prices but also the entire anticipated fall in real estate prices. This is why the first signal of problems in the US real estate came in the derivative markets (the ABX Index contracts). From there, the problems spread to the mortgage securities and CDO tranches that were most sensitive to real estate prices. To blame CDOs for this crisis is really no different from blaming the messengers for the bad news that they bring. I am fond of saying that the deadliest financial innovation that brought about the global turmoil is a millenia-old innovation called the mortgage loan. We have had plenty of that in India.

In India, the only liquid financial market related to real estate is the stock market. If we want to throw light on the boom and bust in real estate prices, it is to the stock market that we must turn. The stocks comprising the BSE Realty Index lost over 65% of their value between December 2007 and September 2008 while the broader market lost only 35-40% of value. Since the market value based debt-equity ratio of the realty companies was quite small (of the order of 10%), and the realty companies were valued in the stock market on the basis of the estimated value of their land bank, it is clear that the implied drop in nation-wide land prices is very steep. The implied drop is much higher than the 20% drop in selected pockets that is often mentioned anecdotally.

Just as the ABX Index prices (and housing futures prices at CME) have been the beacon of light in the US market in assessing the true state of US real estate, the realty stock prices are the beacon of light in understanding the true state of Indian real estate. The broad picture that we see is of an ultimate drop in real estate prices that is comparable to what is expected in the US. Since Indian mortgage loans are not marked to market (unlike the US mortgage securities) the impact of the problems in Indian real estate are hidden from the public view and are likely to manifest themselves in financial sector balance sheets only over a period of time.

Another way of looking at the Indian situation comes from reading Ellis’ paper “The housing meltdown: Why did it happen in the United States?”, BIS Working Paper 259. Many of the factors mentioned by Ellis are equally applicable to India:

• The supply elasticity of real estate construction has been very high in the current boom (compared to the past) and this supply overhang has the potential to deepen the correction that is required.
• There has been a significant easing of credit standards in retail lending in the last few years. We have anecdotal evidence that the retail unsecured lending portfolio of some large finance companies (including some foreign owned ones) received exit valuations of as little as 30% of face value early this year, and are probably worth even less currently.
• The cumulative loan to value ratio (CLTV) has been around 100% in many cases because of furniture loans and other similar loans that were added on to the basic housing loan.
• The tax system in India encourages mortgages in the same way as in the US.
• By affordability measures, Indian housing would be more expensive than in the US particularly but not only in cities like Mumbai.

All this implies that the housing price correction and associated mortgage defaults could be a serious problem in India. The key imponderable is the trajectory of monetary policy as well as GDP growth in India.

What is worse is that unlike in the United States, commercial real estate (CRE) is probably as badly (or even more badly) affected than residential real estate. There is of course a lag between dropping footfalls in malls to rising vacancy rates and falling CRE prices, but the trends are clearly in evidence.

Problems in commercial real estate are a serious problem for the banking system because a great deal of the improvement in non performing assets in recent years has been due to rising real estate prices. Many corporate defaulters queued up for settling the defaulted loans because the real estate value exceeded the value of the debt.

Moreover, the entire infrastructure sector which has received a lot of bank credit in recent years is largely a real estate play. If commercial real estate collapses, the viability of many of these projects would be seriously in doubt.

In a modern economy, lending of 80% of the value of real estate is a prescription for disaster when real estate prices come down. Real estate finance globally is in serious need for reform as I argued in a blog post several months ago. Real estate leverage ratios need to be brought down to more realistic “corporate finance” levels. (It is possible to achieve 80% or higher debt levels in repo markets and margin trading, but that requires the discipline of daily mark to market which is impossible in illiquid assets like real estate.)

Posted at 8:36 pm IST on Thu, 25 Sep 2008         permanent link

Categories: crisis

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More on market for buyers only

Ankit Sharma sent me detailed short selling restrictions from various countries around the world. I have summarized the picture as follows:

• Short selling (naked or covered) prohibited in all stocks: Australia
• Naked short selling prohibited in all stocks: Switzerland
• Short selling (naked or covered) prohibited in key financial stocks: UK, US, Canada, Ireland
• Naked shorting prohibited in key financial stocks: Belgium, France, Germany, Luxembourg, Netherlands

Needless to say, this is a crude summary which glosses over exemptions and a lot of fine print.

Posted at 8:04 pm IST on Tue, 23 Sep 2008         permanent link

Categories: crisis, short selling

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Towards a market only for buyers

The current state of progress towards a market where only buying is permitted is as follows:

• Pakistan: There is a floor price on the main index. “This Floor-Price-Level means that, KSE index cannot decrease below the closing level of [27th of August, 2008]: For KSE-100 index, the Floor-Price-Level is 9144.93 points. This action is taken because of the decline in KSE index to very low levels.”
• Russia: The stock market itself was closed for a couple of days.
• United Kingdom: Shorting of all financial stocks is banned: “The FSA stands ready to extend this approach to other sectors if it judges it to be necessary.”
• United States: Probably headed in the same direction. Updated: They are already there

Posted at 1:30 pm IST on Fri, 19 Sep 2008         permanent link

Categories: crisis, regulation, short selling

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New blog feeds

I have been receiving several complaints about problems with my blog feeds particularly in Bloglines. People have also complained about the accessibility of my blog itself in terms of the uptime of the server on which it is hosted. I have done two things to make things better.

1. I have started an atom feed in addition to the RSS feed. So if you have a problem reading my blog in Bloglines, you could unsubcribe from the old RSS feed and subscribe to the new atom feed: ../index.atomfeed
2. I have also begun mirroring my blog at Wordpress. The blog address is http://jrvarma.wordpress.com/ and the RSS feed is http://jrvarma.wordpress.com/feed/. My reason for choosing Wordpress rather than Blogspot is that Wordpress allowed me to import all my old blog posts while Blogspot does not allow me to do so. As of now, I first post on my regular blog and then cross-post on Wordpress as soon as possible.

Posted at 5:47 pm IST on Mon, 15 Sep 2008         permanent link

Categories: miscellaneous

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Visible benefits of margining FIIs

Foreign Institutional Investors (FIIs) resisted being margined in the Indian stock market, but the benefits of margining are now quite visible. Today, the Wall Street Journal reports that “Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.” Lehman may yet be rescued, but the report serves to remind all of us that a bankruptcy of a US firm leaves non US creditors totally in the lurch as explained by the London Banker in the Finance and Markets Monitor at RGE Monitor.

The basic premise is that each jurisdiction buries its own dead and keeps whatever treasure or garbage it finds with the corpse. Local creditors get to recover their claims out of the locally available assets. ...

The key to having a happy insolvency, if such a thing exists, lies in ensuring that when a globalised bank goes bust, all the best assets are inside your borders and subject to seizure by your liquidators on behalf of your creditors. Everyone else outside your borders is on their own.

The margining system ensures that there are enough assets within Indian borders to satisfy the needs of Indian counterparties. In this context, the unmargined OTC inter bank market leaves Indian counterparties at risk when foreign entities go bankrupt. That is an additional reason why the RBI should abandon its bias in favour of OTC markets and move more and more markets to an exchange traded and novated platform.

Posted at 12:02 pm IST on Sun, 14 Sep 2008         permanent link

Categories: exchanges, international finance, regulation

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Governments can keep secrets if they want

Writing about the takeover of Fannie and Freddie in his Infectious Greed blog, Paul Kedrosky says: “Apparently the government is better at keeping secrets than anyone else in the capital markets. I’m not sure if that’s reassuring, or frightening.”

Kedrosky has a point. If the stories in the New York Times (“As Crisis Grew, a Few Options Shrank to One”, September 8, 2008) and the Wall Street Journal (“Mounting Woes Left Officials With Little Room to Maneuver”, September 8, 2008) are right, the decision to take a drastic action was taken more than a week before the announcement. The New York Times says that Treasury Secretary Paulson briefed President Bush over secure video on August 26, while the Wall Street Journal reports that the decision on conservatorship was taken on August 30/31 (the Labor day weekend). Yet, the markets did not get even a whiff about it until the government informed Fannie and Freddie about the decision on Friday, September 5 and asked them to get their boards to accept the terms of the rescue. From that point onwards, the media knew the broad contours of the rescue package and the announcement on Sunday morning was largely a formality.

In India also, we observe that the government is able to keep secrets if it wants to. Budget proposals are a wonderful example. Sometimes, the budget speech reserves its sting for the tail and then one an observe that until the closing minutes of the speech, the market has no clue about what is to come. And then within seconds, the market tanks as the finance minister reads out the nasty proposal.

The private sector by contrast finds it very difficult to keep secrets. It is very difficult anywhere in the world to even begin a merger discussion without the news leaking to the media.

Evidently, the incentive structures that the government can bring to bear are far more severe than anything that the private sector can muster. To answer Kedrosky’s question, I personally find it more frightening than reassuring – it suggests that governments simply cannot be trusted because their secrecy processes allow them to get away with blatant lying if they choose.

Posted at 2:51 pm IST on Tue, 9 Sep 2008         permanent link

Categories: miscellaneous

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More on currency futures

I received some offline comments on my earlier blog post on currency futures in India and would therefore like to elaborate on my views.

I see this market evolving in three phases:

1. In phase one, the market is largely retail. Retail traders simply did not have access to the forward market and assuming that they would like to use currency derivatives, the futures market is the only option for them. Some of the retail participation would be purely speculative, but there would be substantial hedging demand as well. The fact is that you can have an exposure to exchange rates even if all your economic transactions are with domestic participants and are denominated in Indian rupees. For example, a small pepper farmer who sells produce in the local market in Indian rupees is exposed to currency risk to the extent to which domestic pepper prices are linked to global prices denominated in dollars or other foreign currency. I believe that retail demand alone would be sufficient to take the market to the point where it has sufficient liquidity and depth for amounts of $50,000 to $200,000.
2. This would bring the market to phase two where the liquidity and depth is enough to attract small and medium enterprises (SMEs). SMEs do not trade in the interbank market – they do forward contracts with their regular bank and face quite significant transaction costs. It is easy for the futures market to be competitive for this segment in terms of liquidity and depth. The futures market have the advantage of not tying up credit limits, but have the disadvantage of daily mark to market cash flows. Assuming that the broking business in India is more price competitive than the banking business, I expect brokers to find ways of meeting SME hedging demand at a lower all-in-cost than the banks do. Large SME participation would provide the market with good liquidity at a depth of around a million dollars.
3. At this stage, the market is ready for phase three, where the market starts competing with the inter bank market for the smaller lots traded there. It is at this point (probably a year or more from today) that the restrictions on the futures market in terms of FII participation and client level position limits will start to bite. Assuming that these restrictions are lifted by then, the futures market could provide stiff competition to the inter bank market if the exchanges provide strong support for direct market access (DMA) and algorthmic trading and persuade agencies like Reuters and Bloomberg to give enough visibility to futures market quotes.

Posted at 1:23 pm IST on Mon, 8 Sep 2008         permanent link

Categories: derivatives, exchanges, international finance

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Indian Currency Futures

Ajay Shah’s blog post yesterday provides a lot of interesting data about liquidity and trading in India’s nascent currency futures market. The contract is doing quite well for a newly introduced product, but clearly it is miniscule compared to the OTC market. What are the prospects of this market really becoming mainstream?

How does an illiquid market grow and take liquidity away from an established market? One important factor based on lessons from the well known battle for bund futures (see for example Cantillon and Yin) is the ability of the market to attract a different group of traders into the new market. New markets get their initial momentum from new entrants and not from switchers from old markets. This group of new entrants who value the liquidity of the old market less than the other characteristics that the new market offers start trading and gradually build up liquidity in the new market to the point where it can start attracting switchers.

For currency futures in India, there are several such groups available:

• Those who do not have the underlying exposure that the RBI requires for trading in the OTC market but are allowed to trade in the cash settled futures.
• Those who trade in lots smaller than the million dollar (or half-million dollar) lot required in the OTC market.
• Those who prefer the anonymity of the futures market as opposed to the bilateral trade that takes place in the OTC market.
• Those who prefer depositing margins or collateral in the futures exchange to tying up credit lines in the OTC market.

The restrictions in the currency futures market (position limit and absence of FIIs) do not bite at this stage because they do not by and large affect this group of new entrants.

The real battle for market share would begin when the market builds up reasonable depth and liquidity to attract participants from the inter-bank market (as opposed to the customer market from which the initial traders would come).

Globally, we know that the currency futures have a role in price discovery that is disproportinate to its share in trading (Rosenberg and Traub) though improved transparency in the OTC market has reduced this role quite sharply between 1996 and 2006. In India, the price discovery role of currency futures is potentially greater because of regulatory restrictions on the OTC market. An additional complication is that since covered interest parity does not yet hold in India, there is information content in the forward/futures market distinct from what is there in the spot market. Globally, one assumes that the information in futures and spot markets is the same.

Posted at 5:49 pm IST on Thu, 4 Sep 2008         permanent link

Categories: exchanges, international finance

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Indian and Asian Money Markets

The September 2008 issue of the BIS Quarterly Review has an interesting article on Asian money markets by Loretan and Woolridge.

Their Graph 1 shows that as a percentage of GDP, the Indian Treasury Bill market is quite tiny. The Treasury and Central Bank Bill markets in countries like Malaysia, Phillipines, China and Taiwan are much larger as a percentage of GDP. India’s large fiscal deficit ensures that the government securities market as a percentage of GDP is reasonably large and I had not thought of this as a problem area. But Loretan and Woolridge data does suggest that there may be an issue with the maturity composition of the debt. A lot of the Asian T-Bill and CB-Bill market came out of sterilization operations and to my mind this makes sense. If a lot of the reserves are invested in short maturity assets, it makes sense to fund them with short matutirity liabilities as well. The question is why did India use Market Stabilization Bonds instead of Market Stabilization T-Bills.

The second thing that stands out in the paper is the volatility of the interbank interest rate. Indian rates are so volatile that in Graph 3 of the paper, Loretan and Woolridge plot India and Indonesia on a separate graph titled “Higher Volatility Markets”. Even between these two, it is the Indian interest rate that swings more wildly – even in a graph of the two most volatile rates, the Indian rate goes out of the graph. I can understand this happening when the central bank was targetting money supply rather than interest rates – even a monopolist cannot simultaneously control the quantity of money and its price. But this kind of volatility ought not to be present today.

Table 1 about turnover in derivatives market is distressing in terms of what India is missing out on, but at least here most of emerging Asia gives us company.

Posted at 3:53 pm IST on Mon, 1 Sep 2008         permanent link

Categories: bond markets, crisis, international finance

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Catastrophe bonds to recapitalize banking system

Anil Kashyap, Raghuram Rajan and Jeremy Stein presented a fascinating paper at the Jackson Hole Symposium. This is my third post related to this symposium and yes, finally, the papers are available at the Kansas Fed website. The Buiter paper that I blogged about a few days ago after reading it on the WSJ website is also now available at the Kansas Fed website.

Kashyap, Rajan and Stein propose an instrument similar to a catastrophe bond which would automatically recapitalize the banking system when system wide losses cross a certain threshold. The starting premise of their paper is that the high level of leverage in banks is a rational response to governance problem of banks. If one accepts this premise, then their proposal for contingent capital makes a lot of sense. It gives banks capital to the banks when it is needed in the crisis, but does not give it to them in the boom when they might squander it.

It is a very clever idea, but I tend to be sceptical of the notion that there is something special about banks that exempt them from the Modigliani Miller arguments about capital structure. Rather I think Friedman was right in his statement in a different context that banks are not regulated because they are different, but banks are different because they are regulated. After all, many non bank financial firms run quite well with lower levels of leverage than banks, and the free banking era was also characterized by relatively low levels of leverage.

Kashyap, Rajan and Stein design their instrument very elegantly to deal with moral hazard problems at the level of the individual banks. My fear is that it will attract moral hazard on the part of the regulators. In fact, I think that their bond is best seen as non voting equity in a deposit insurance corporation. The governance implications of this are a nightmare.

Posted at 6:45 pm IST on Wed, 27 Aug 2008         permanent link

Categories: banks, crisis, leverage, regulation

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Buiter on the central banks

Willem Buiter’s paper at the Jackson Hole Symposium castigating the major central banks of the world (and the Federal Reserve in particular) is worth reading in full (144 pages) even if one disagrees with what he has to say. I am surprised that as of today, I still cannot find the symposium papers at the web site of the Kansas Fed which organized the symposium, but the paper is available in the public section of the website of the Wall Street Journal.

Some people have been mis-characterizing the paper as dogmatically opposing central bank interventions on moral hazard grounds. That is not the impression that I got by reading the paper. The paper does accept that the central bank has to intervene in times of crises, but Buiter does oppose the particular forms that this intervention has taken.

Below are some interesting quotes from the paper:

• A case can even be made for taking the setting of the official policy rate out of the central bank completely ... the central bank is the only agency that can manage liquidity. It will also have to implement the official policy rate decision ... But it does not have to make the official policy rate decision. The knowledge, skills and personal qualities for setting the official policy rate would seem to be sufficiently different from those required for effective liquidity management, that assigning both tasks to the same body or housing them in the same institution is not at all self-evident. ... In the UK, the Governor of the Bank of England could be a member, or even the chair of the MPC, but need not be either. (p 36)
• The deviations between the official policy rate and the overnight interbank rate that we observe for the Fed, the ECB and the Bank of England are the result of bizarre operating procedures – the vain pursuit by the central bank of the pipe dream of setting the price (the official policy rate) while imposing certain restrictions on the quantity (the reserves of the banking system and/or the amount of overnight liquidity provided) ... Ideally, there would be a 24/7 fixed rate tender at the official policy rate during a maintenance period, and a 24/7 unlimited deposit facility at the official policy rate. (p 37-8)
• Libor now is the rate at which banks won’t engage in unsecured lending to each other. (p 25)
• ... those engaged in applied statistics should not leave their ears and eyes at home. Specifically, it pays to get up from the keyboard and monitor occasionally to open the window and look out to see whether a structural break might be in the works that is not foreshadowed in any of the sample data at the statistician’s disposal. (p 64-5)
• The UK ... a Net International Investment Position of around minus 27 percent of GDP in 2007 ... a primary deficit of almost five percent of GDP. ... both external assets and external liabilities are close to 500 percent of GDP. The characterisation of the UK as a hedge fund is only a mild exaggeration. (p 68)
• The decision to discontinue publication of the M3 series also smacks of intellectual hubris; effectively, the Fed is saying: we don’t find these data useful. Therefore you shall not have them free of charge any longer. (p 80)
• If we add together the statements by the world’s central bank heads (from the industrial countries, from the commodity-importing emerging markets and from the commodity exporting emerging markets) on the origins of their countries’ inflation during the past couple of years, we must conclude that interplanetary trade is now a fact: the world is importing inflation from somewhere else. (p 82)
• On August 17, 2007, there were no US financial institutions for whom the difference between able to borrow at the discount rate at 5.75 percent rather than at 6.25 percent represented the difference between survival and insolvency; neither would it make a material difference to banks considering retrenchment in their lending activity to the real economy or to other financial institutions. This reduction in the discount window penalty margin was of interest only to institutions already willing and able to borrow there (because they had the kind of collateral normally expected at the discount window). It was an infra-marginal subsidy to such banks – a straight transfer to their shareholders from the US tax payers. (p 97)
• Both the 1998 LTCM and the January 21/22, 2008 episodes suggest that the Fed has been co-opted by Wall Street - that the Fed has effectively internalised the objectives, concerns, world view and fears of the financial community. This socialisation into a partial and often highly distorted perception of reality is unhealthy and dangerous. It can be called cognitive regulatory capture (or cognitive state capture), because it is not achieved by special interests buying, blackmailing or bribing their way towards control of the legislature, the executive, the legislature or some important regulator or agency, like the Fed, but instead through those in charge of the relevant state entity internalising, as if by osmosis, the objectives, interests and perception of reality of the vested interest they are meant to regulate and supervise in the public interest. (p 101-2)

Posted at 4:00 pm IST on Mon, 25 Aug 2008         permanent link

Categories: monetary policy

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Bernanke and his tag clouds

Paul Kedrosky’s Infectious Greed blog compares Bernanke’s speech at the Jackson Hole symposium this year with his speech at the same event last year. Using Wordle, Kedrosky produces nice tag clouds for the two speeches that highlight how sharply Bernnake’s concerns have moved from mortgage markets to the entire financial system.

I liked the Wordle tag clouds so much that I created one for my own blog which appears at the end of this post. The tag cloud confirms my description of the blog as being about financial markets.

Coming back to Bernanke’s speech, I found a few interesting things.

First, there was the sentence “The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions.” This seems to vindicate those who have been arguing for quite some time now that the Bear Stearns rescue was a bail out of J P Morgan Chase. JPM had the largest derivative book by far of all the commercial banks and was a large counterparty of Bear Stearns.

Second, was the passage that has been widely quoted in the blogosphere: “A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.”

I wonder whether a new statutory framework is really necessary to achieve this. The monoline bond insurance companies have been able to negotiate cash settlement of the guarantees (which they had issued when they were AAA rated) at haircuts that reflect their current reduced credit worthiness. I would imagine that if Bear Stearns had not been bailed out, similar haircuts could have been negotiated with its counter parties as well. The Bear Stearns rescue was essentially a $29 billion loan under a second loss credit note collateralized by Bear Stearns assets. I do not see why the Fed could not have lent directly to Bear under a similar structure and adjusted the second loss trigger point to achieve any desired haircuts for the counter parties. I suspect that the alleged lack of legal frameworks is an excuse for lack of spine.

The Wordle tag cloud for my blog is shown below:

Posted at 2:12 pm IST on Sat, 23 Aug 2008         permanent link

Categories: crisis

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Faster rights issues in India

The Securities and Exchange Board of India (SEBI) has announced “changes in timeline [that] would enable a right issue to be completed within about 43 days as against about 109 days currently available for a rights issue.” It is indeed very creditable that SEBI has chose to attack the problem decisively rather than tinker at the edges.

Just to provide perspective, the ill fated rights issue of HBOS in the UK took almost three months (from late April to late July) to complete and during this period a 45% discount to the market price turned into a premium. After this experience, the UK is also attempting to bring this period down.

Posted at 11:36 am IST on Fri, 15 Aug 2008         permanent link

Categories: equity markets, regulation

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Insider Trading by Underwriters

Robert Preston at BBC News reports about the extraordinary insider trading that took place after the HBOS rights issue flopped miserably and the underwriters were left holding the bulk of the issue:

On Friday, Dresdner and Morgan Stanley both knew that existing shareholders had shunned the rights issue, since they were organising the share sale. But the market was only given the information this morning.

That information was - in theory at least - highly price sensitive. You’d think therefore that both Dresdner and Morgan Stanley would be banned from dealing in HBOS on their own account till the market had been told the extent of the rights take-up.

But apparently no such prohibition applied.

...

Well after the rights closed at 11am on Friday, they were both allowed to take a short position in HBOS, to cover themselves against a future fall in the HBOS share price.

So they duly shorted HBOS in massive size. I understand Morgan Stanley took a 2.4 per cent short position in the mortgage bank - which is huge.

If this story is true, it means that the UK Financial Services Authority (FSA) has given up all pretence of being a referee rather than a market player itself. The FSA’s stand against what it called abusive short selling now sounds truly hollow.

Posted at 1:17 pm IST on Tue, 22 Jul 2008         permanent link

Categories: equity markets, insider trading, regulation, short selling

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US too turns against the shorts

The headline on FT Alphaville says “America suspends capitalism” while the Wall Street Journal’s Deal Journal suggests that the regulators would simply have put a bounty on a short seller’s head if only they knew that it could be done. They are both referring to the emergency order of the US SEC against naked short selling in 19 financial stocks including Lehman Brothers, Fannie Mae and Freddie Mac. These orders were issued under Section 12(k)(2) of the Securities Exchange Act which provides that the SEC “in an emergency, may by order summarily take such action ... as the Commission determines is necessary in the public interest and for the protection of investors ... to maintain or restore fair and orderly securities markets.”

I can well see that a ban shorting Fannie Mae and Freddie Mac might help the central banks of China, Russia and other countries which together hold close to a trillion dollars of these Agency bonds, but I fail to see how it protects the US investors whom the SEC was set up to protect.

It was only last month that I commended US regulators for not being as harsh on short sellers as the UK had been. My praise was clearly premature. In addition to the ban on naked shorting, the SEC was also talking loudly about “enforcement investigations into alleged intentional manipulation of securities prices through rumor-mongering and abusive short selling.”

Incidentally, Aleablog tells us that there is an ETF that allows one to short the US Financials Index without being naked short at all. That post also tells us June was the best month for short sellers since the dot com bust seven years ago.

Posted at 6:39 pm IST on Wed, 16 Jul 2008         permanent link

Categories: short selling

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Y V Reddy on Indian Financial Stability

Reserve Bank of India Governor, Dr. Y V Reddy in a speech at the Meeting of the Task Force on Financial Markets Regulation in the United Kingdom earlier this month talked about how “India has by-and-large been spared of global financial contagion due to the sub-prime turmoil”:

The credit derivatives market is in an embryonic stage; the originate-to-distribute model in India is not comparable to the ones prevailing in advanced markets; there are restrictions on investments by resident in such products issued abroad; and regulatory guidelines on securitisation do not permit immediate profit recognition. Financial stability in India has been achieved through perseverance of prudential policies which prevent institutions from excessive risk taking, and financial markets from becoming extremely volatile and turbulent. As a result, while there are orderly conditions in financial markets, the financial institutions, especially banks, reflect strength and resilience.

First of all, I would have liked the word “yet” to be added while talking about India being spared the turmoil because it is too early to say whether India will emerge unscathed out of all this. It has been my view that the global turmoil is first and foremost about the bursting of an asset price bubble in real estate and secondly about excessive leverage. The specifics of the financial products involved – credit derivatives, financial guarantees, securitization, CDOs and SIVs – are relatively less important. India has not yet had an equally severe correction in property prices though correction in the share prices of real estate companies suggests that such a correction is in progress. I also think that there is a high degree of leverage in Indian real estate and a fair degree of sub prime lending too. One part of the sub prime lending (unsecured personal loans) has already witnessed severe losses mainly for finance companies. A 20% nation wide fall in real estate prices in India is not inconceivable, and if that were to happen, the consequences would be ugly for the financial sector.

Second, the idea that institutions in India are prevented from excessive risk taking is quite incorrect. Indian banks can make bad loans as easily as banks elsewhere in the world, and there is little evidence that the culture of credit appraisal is particularly strong in large parts of the banking system. Low levels of non performing assets in an (until recently) booming economy prove nothing.

Third, the assertion that financial markets in India do not become extremely volatile is plainly wrong. I would recall January 16, 1998 in the fixed income markets, August 20, 1998 in the currency markets and January 21, 2008 in our equity markets as evidence of what can happen in a single day in three different financial markets. Low volatility during benign periods is irrelevant; what matters is the volatility when things go wrong.

The speech refers to several counter cyclical policies of the RBI:

• encouraging banks to create an Investment Fluctuation Reserve
• permitting them to transfer bonds to the Held to Maturity category
• increasing the risk weight for real estate loans, consumer credit and capital market exposures.

The first and the third are valid points and highly creditable. The second is quite dubious as it only allowed banks to avoid mark to market losses.

Posted at 6:22 pm IST on Fri, 11 Jul 2008         permanent link

Categories: crisis, regulation

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Crude oil spot and futures markets

There appears to be a lot of confusion about the relationship between spot and futures markets for crude oil after Paul Krugman set the ball rolling with his remark: “Well, a futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price.” Krugman led up to this with an even more provocative example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any direct involvement in the production of oil, make a bet: Joe says oil is going to $150, Harriet says it won’t. What direct effect does this have on the spot price of oil – the actual price people pay to have a barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved in buying or selling the stuff make? And if there are 10 million Joe Shmoes, it still doesn’t make any difference.

Such provocation was bound to elicit an extreme response and Peak Oil Bebunked did just that with the oppposite claim:

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by ... adding a premium to, or subtracting a discount from, certain benchmark or marker crudes. ... Originally, the benchmark prices were spot prices, but over time ... many key oil exporters shifted away from the spot market, and began to use futures prices as the benchmark.

... Krugman and Birger are profoundly confused about the way the international oil markets actually function. Futures aren’t a paper bet on the direction of prices determined by some independent process. Futures themselves *determine* the price of most physical oil traded today. The futures price (+ or - the differential) literally *is* the price of oil.

Peak Oil Bebunked left many commentators on his blog thoroughly confused. One commentator for example wrote:

I always wondered about this. I figured the futures prices had to adjust to the spot price (which was driven by actual oil) as the contract expired. If they didn’t, a arbitrage opportunity would exist that would correct the imbalance.

But given this explanation, I guess not. I guess the “spot” prices adjusts to the futures price.

The downside to this approach is that supply/demand fundamentals don’t necessarily determine the price.

Crude oil markets are pretty complex and Peak Oil Bebunked’s description of this market is actually quite correct, but there is a sense in which Krugman’s textbook model is not totally wrong either. It is worthwhile understanding this market in some detail. For concreteness, I will focus on the Brent Crude market.

The term Brent crude today refers to crude coming out of any of four oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk – collectively referred to as BFOE.

The most important market for physical Brent crude is the cash BFOE market which is essentially a forward market. It is based on 21 days advance declaration (though 15 day and other periods are also in vogue). In July, a buyer and seller may conclude a transaction for delivery in August without fixing even the approximate date within the month. The buyer can choose the date later but has to give 21 days advance declaration to the seller. It is the price of this contract that most participants would regard as the price of physical Brent crude oil. Price discovery does happen in this market though it is heavily influenced by the futures price. Moreover, though this is a market for physical crude, it is a forward rather than a true spot market.

Let us then move to the closest that we get to a spot transaction – the dated Brent crude market. The terms are usually FOB – the buyer brings the vessel and the seller provides the berth at the terminal and loads the cargo. Dated Brent is a market for a specific cargo (typically 600,000 barrels) to be loaded at the terminal close to Brent during say July 23-25. The middle day (July 24) is the scheduled day of loading, but the buyer can usually bring the vessel to the terminal at any time within the three day period known as the laydays. Dated Brent contracts are actively traded between oil industry participants. Also, when a buyer gives an advance declaration in the cash BFOE contract, it effectively becomes a dated Brent contract.

Since the laydays span three days and the loading period itself could be close to two days, there is considerable deviation in the precise day of loading of the cargo even in the dated Brent market. Similarly, if the buyer of an August cash BFOE contract gives declaration for a date late in August, it is possible that loading takes place only on say the 2nd of September. Contracts often allow for further exceptions even beyond this if there is a curtailment of production in the oilfield or for other reasons beyond the control of the buyer or seller. These complications are natural in any genuine spot market for a non financial asset.

The dated Brent market probably has very little impact on price discovery for Brent crude. This is because these transactions are concluded on a differential to the (forward) cash BFOE price. The dated Brent for July 23-35 might for example be traded at August cash BFOE plus 10 cents.

Finally, we come to what is by far the most important price of Brent crude – the Brent crude futures at ICE. The ICE Brent Futures is a deliverable contract based on EFP delivery with an option to cash settle. Cash settlement is based on the cash BFOE market as explained in the contract specifications:

[T]he ICE Futures Brent Index ... is the weighted average of the prices of all confirmed 21 day BFOE deals throughout the previous trading day for the appropriate delivery months. These prices are published by the independent price reporting services used by the oil industry. The ICE Futures Brent Index is calculated as an average of the following elements:

1. First month trades in the 21 day BFOE market.
2. Second month trades in the 21 day BFOE market plus or minus a straight average of the spread trades between the first and second months.
3. A straight average of all the assessments published in media reports.

Essentially, therefore, the underlying for the Brent futures is the cash (21 day) BFOE market. The standard textbook model of cash-futures arbitrage implies that the futures price cannot deviate too much from this underlying “spot” price. Even if we regard cash BFOE as a forward rather than spot contract, it is linked to its underlying which is dated Brent. The moment the buyer of cash BFOE gives declaration, he effectively turns his contract into dated Brent crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At this level, Krugman’s argument that a futures contract is a bet about the future price is not without merit.

But things are much more complex than this because long term contracts for crude in regions far away from the North Sea are based on Brent futures price plus/minus a differential. ICE claims that the Brent contract “is used to price over 65% of the world's traded crude oil.” On the other hand, BFOE is only a miniscule part of the total crude oil production in the world. This is the point that Peak Oil Bebunked is making. Brent futures are far more important and influential than any of the markets for physical crude. Most price discovery actually happens in the futures market and the physical markets trade on this basis. In an important sense, the crude futures price is the price of crude.

Crude is a particularly nasty example, but similar phenomena exist even in financial assets. Much of the price discovery in stock markets happens in the index futures market. Individual stocks are priced taking the broader market index as given. If the index has fallen 5% on a day and a specific stock has not traded so far, a person contemplating placing a bid for this stock would implicitly price it off the index futures price taking into account the beta of the stock and any stock specific information. Yet the index futures contract is settled using the cash index value and is therefore itself tied down to the cash market through cash-futures arbitrage. This is not inconsistent with the fact that the major element of price discovery happens in the index futures market.

Posted at 3:32 pm IST on Fri, 4 Jul 2008         permanent link

Categories: commodities, derivatives

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Non-use of ratings in SEC regulations

I am not fully satisfied with the 222 page proposal that the US SEC has put forward for eliminating the use of credit ratings in various regulations. It is certainly commendable that the SEC has done a comprehensive job of identifying all regulations that refer to ratings and then systematically eliminated every one of them. Moreover, in many cases, the SEC has also identified meaningful alternatives to the use of ratings. My disappointment is in relation to the two or three truly critical uses of rating in the SEC regulations.

The first is in capital requirements for broker dealers where the existing regulations specify different levels of haircuts for their proprietary positions in debt securities with different levels of credit rating. A good solution to this problem could have provided the template for eliminating the use of ratings in Basle 2 as well. Instead what the SEC proposes is:

We are proposing the substitution of two new subjective standards for the NRSRO ratings currently relied upon under the Net Capital Rule. For the purposes of determining the haircut on commercial paper, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the three highest rating categories by at least two NRSROs -- with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately. For the purposes of determining haircuts on nonconvertible debt securities as well as on preferred stock, we propose to replace the current NRSRO ratings-based criterion -- being rated in one of the four highest rating categories by at least two NRSROs with a requirement that the instrument be subject to no greater than moderate credit risk and have sufficient liquidity such that it can be sold at or near its carrying value within a reasonably short period of time.

We further believe that broker-dealers have the financial sophistication and the resources necessary to make the basic determinations of whether or not a security meets the requirements in the proposed amendments and to distinguish between securities subject to minimal credit risk and those subject to moderate credit risk. The broker-dealer would have to be able to explain how the securities it used for net capital purposes meet the standards set forth in the proposed amendments.

Notwithstanding our belief that broker-dealers have the financial sophistication and the resources to make these determinations, we believe it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers to refer to NRSRO ratings for the purposes of determining haircuts under the Net Capital Rule.

The last paragraph above means that while technically the SEC gets ratings out of its rule book, for all practical purposes nothing really changes. Broker dealers would use ratings exactly as before with the full blessings of the SEC.

The SEC has a similar non solution in the second place where ratings play a critical role. Money market funds are allowed to value their holdings at amortized cost rather than fair value on the ground that regulations restrict their investments to short term debt securities in the two highest short-term rating categories. The proposal is to rely on a determination of “minimal credit risk” by the board of directors of the fund. In the context of the large losses that many money mutual funds have taken during the sub prime crisis, I would have thought that the logical thing to do would have been to mandate fair value accounting for money market funds and treat them like any other mutual fund.

The third critical use of rating and rating agencies is in the field of disclosure. Rating agencies are exempted from the prohibition of selective disclosure under Regulation FD. The SEC proposes to maintain this exemption. I think this exemption is inconsistent with the stand of the ratings agencies that their ratings are “editorials”. Similarly, the SEC permits but does not require issuers to disclose credit ratings in their offer documents. The SEC’s proposal leaves this substantially unchanged. My problem here is that if ratings are editorials, then they should be permitted to be disclosed in offer documents only in the same way and to the same extent that other editorials, research reports or expert opinions are permitted to be disclosed.

Posted at 5:09 pm IST on Wed, 2 Jul 2008         permanent link

Categories: credit rating, regulation

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Where is London's alleged light touch?

At least when it comes to short selling in today’s troubled markets, the UK Financial Services Authority’s vaunted light touch has given way to a heavy handed approach that makes the US regulators appear light touch. The US regulators have been content to be silent spectators while outspoken short sellers attack key financial institutions. Ackman has brought the bond insurer MBIA to its knees and Einhort has put enormous pressure on Lehman without any rebuke from any regulator.

By contrast, the FSA in the UK has ham handedly pursued those who shorted the leading UK banks particularly HBOS. In April, I blogged about the FSA initiating a probe into short selling in HBOS shares. Since then, HBOS shares have fallen by almost 50% as a stream of bad news has come out of the bank. In late April, HBOS launched a rights issue at what was then a deeply discounted price of 275p. On a couple of occasions recently, the share price has dropped below the rights issue price threatening the success of this capital raising effort. The FSA stepped in earlier this month with fresh regulations against short selling in companies which are conducting rights issues. The new regulations require public disclosures of any short position exceeding 0.25% of the issued capital of a company that is conducting a rights issue. The FSA stated:

The FSA views short selling as a legitimate technique which assists liquidity and is not in itself abusive. But it is also the case that the rights issue process provides greater scope for what might amount to market abuse, particularly in current conditions. ...

In addition to the new disclosure regime, we are also giving consideration to whether it might be necessary to take further measures in this area. We are currently examining a number of options including the following: restricting the lending of stock of securities in rights issues for the purposes of enabling short selling; and restricting short sellers from covering their positions by acquiring the rights to the newly issued shares.

Much of this is silly. It is precisely when a company is raising billions of pounds of new capital from the public that investors need the genuine price discovery that is promoted by short selling. As it is, the FSA is dangerously close to complicity in a scheme to sell overpriced shares to the public on the basis of an artificially elevated share price. The FSA has been saved from this only by the ineffectiveness of its measures in propping up the share price on a sustained basis. After a short spike, the price has again been testing the 275 level.

Meanwhile, press reports state that the FSA is ending the probe that it launched in April – apparently, it is unable to put together a case against anybody in that case. If true, this vindicates all those who thought that the investigation itself was misguided.

I think what we are seeing is a clear regulatory conflict of interest. In its role as the supervisor of HBOS, the FSA seems to be putting the health of HBOS above the health of the capital market which it regulates.

Posted at 2:56 pm IST on Tue, 24 Jun 2008         permanent link

Categories: crisis, regulation

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Offmarket transactions on the exchange for tax reasons

We have been discussing order matching and market microstructure in class during the last two weeks and this morning, students brought up the report in the Economic Times today about whether Ranbaxy promoters could use bulk trades on the exchange to sell their holdings to the Japanese acquirers. The reason for doing this is that India does not levy capital gains tax on transactions done on the exchange – the Securities Transactions Tax (STT) levied on exchange transactions is supposed to be in lieu of capital gains tax.

The price that the Ranbaxy promoters have negotiated with the acquirer is at a premium of about 27% to the current market price and SEBI regulations allow block trades negotiated outside the exchange to be put through the exchange only within a price band of 1% of the market price. It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.

Obviously, a transaction of this kind would be done on the least liquid exchange on which Ranbaxy is quoted and it would be done at a time when the sell side of the order book is as thin as possible. There are two problems with this however.

The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens. There is nothing to be lost and everything to be gained by doing so. The acquirer has to make a tender offer at 127, but this is only for 20% of the issued shares and selling one’s entire holding at 125 is better than tendering into that open offer and taking one’s chances. If enough people put limit orders at 125 or so, then the cost of eating through the entire order book can quickly become prohibitive. This possibility is very real because people who have the ability to borrow stock can place these limit orders even if they do not own the stock. Immediately after the bulk deal, the price will drop back to normal levels and the short seller can buy back from the market and close out the position.

The second problem is the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003 (endearingly known as FUTP). I am not a lawyer, but I think FUTP raises some very interesting issues that have not I believe been tested in this context. The question is whether executing a bulk trade in this manner would amount to market manipulation. Regulation 4(2) of the FUTP states that:

Dealing in securities shall be deemed to be a fraudulent or an unfair trade practice if it involves fraud and may include all or any of the following, namely:-

• (d) paying, offering or agreeing to pay or offer, directly or indirectly, to any person any money or money’s worth for inducing such person for dealing in any security with the object of inflating, depressing, maintaining or causing fluctuation in the price of such security;
• (e) any act or omission amounting to manipulation of the price of a security;

I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative. I know we do not have OTC equity derivative markets in India, but imagine what the situation would be if there were large OTC barrier options at 125 that got trigerred by this trade. Would they not think that there was market manipulation?

In class today, we also considered the possibility of pushing the price only upto say 125.75 with a market order that just burns through the sell side of the order book and then using a block trade negotiated outside the exchange at 127 (within 1% of the market price). This would perhaps be even more manipulative and might not have any significant advantages over executing the entire transaction through the order book.

I think the most important lesson in all this is that the idea of treating the Securities Transactions Tax as a substitute for the capital gains tax is a huge mistake. It is not only inequitable in allowing very large untaxed incomes, but it also distorts markets and creates perverse incentives for many market participants.

Posted at 2:12 pm IST on Wed, 18 Jun 2008         permanent link

Categories: corporate governance, equity markets, regulation, taxation

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Takeover disclosures and cash settled derivatives

The New York District Court ruled earlier this week that the hedge fund TCI should have disclosed its cash settled derivatives (total return swaps) on CSX stock under the takeover rules of the US SEC (Rule 13d-3). Hitherto, it was believed that cash settled derivatives do not convey a “beneficial ownership of any equity security” as required by the statute. Rule 13d-3 defines the beneficial owner essentially as one who has or shares voting power and/or investment power over the security.

The New York District Court took a different line. Based largely on the expert report of Prof. Marty Subrahmanyam, the Court came to the conclusion that the only practical way for the swap counterparty to hedge its position was to buy the underlying stock. It also found that this was what they actually did:

But the evidence is overwhelming that these counterparties in fact hedged the short positions created by the TRSs with TCI by purchasing shares of CSX common stock. ... they did so on virtually a share-for-share basis and in each case on the day or the day following the commencement of each swap.

This is precisely what TCI contemplated and, indeed, intended. None of these counterparties is in the business, so far as running its swap desk is concerned, of taking on the stupendous risks entailed in holding unhedged short (or long) positions in significant percentages of the shares of listed companies. As a practical matter, the Court finds that their positions could not be hedged through the use of other derivatives. Thus, it was inevitable that they would hedge the TCI swaps by purchasing CSX shares.

The Court interpreted this as investment power. Moreover, it determined that TCI chose counterparties who were more likely to vote the shares in accordance with its wishes. The Court relied on the SEC position that “ability to control or influence the voting . . . of the securities” constitutes voting power.

The Court also referred to provisions in UK law based on economic interest rather than legal ownership and stated that “Yet there is no reason to believe that the sky has fallen, or is likely to fall, in London” as a result of such provisions.

Having come close to saying that cash settled derivatives meet the definition of beneficial ownership under Rule 13d-3(a), however, the Court refused to rule on this point at all, but proceeded to decide the case under Rule 13d-3(b) which deals with “contract, arrangement, or device ... as part of a plan or scheme to evade the reporting requirements”. The Court also allowed TCI to vote the stock after making the requisite disclosures.

The Deal Professor is of the view that everything now depends on how the the Second Circuit Court of Appeals deals with this case on appeal.

All this discussion is of great relevance in India because of the large cash settled single stock futures market in India. Indian law talks about acquisition of shares and voting rights. Shares “includes any security which would entitle the holder to receive shares with voting rights”, but this clearly does not cover cash settled derivatives. Another issue that comes to mind in the context of the US ruling is the issue of participatory notes as well as that of the non voting ADRs and GDRs issued by Indian companies.

Posted at 6:12 pm IST on Sat, 14 Jun 2008         permanent link

Categories: corporate governance, derivatives, regulation

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Reforming the rating agencies

In my last blog on my vacation reading, I was rather contemptuous of the efforts of the New York Attorney General and of IOSCO to reform the rating agencies, but Joshua Rosner goes much further. He says that the Attorney General’s proposal will actually reward the rating agencies, and I think he is right.

Rosner also has some very sensible suggestions for genuine reforms at the end of his post. I agree with all of them and also think that they are genuinely workable:

• Requiring that any regulated institution that was required to invest only in highly rated securities should generally hold only securities listed on a major exchange. They would be allowed to hold non-exchange traded securities only if they were able to demonstrate to examiners their own independent analysis in support of rating agency assessments.
• Reducing the structured finance liability exemptions for rating agencies
• When a rating agency finds that their model needs to be updated or corrected the rating agency should be required to, on a timely basis, re-rate all existing securities that were rated using the prior model.
• [For structured products], the rating agencies should be required to automate an objective method of utilizing the originally modeled assumptions and re-rating the security monthly using the original assumptions, originally assumed loss curve and tied to the monthly servicer remittance reports.
• A qualified team that is fire-walled from revenue line pressures and reports directly to a committee of independent Board members should create ratings models.

Posted at 1:55 pm IST on Tue, 10 Jun 2008         permanent link

Categories: credit rating, regulation

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My vacation reading

I am back from my vacation. I did not read email and newspapers while on vacation, but I did read some blogs and web sites selectively. I also used the opportunity to catch up on some reading material that I had not been able to finish before I began my vacation. As could be expected, my vacation reading was dominated by the global financial turmoil. Some of the more interesting stuff that I read:

• Socgen put out the final report (Part 1, 2 and 3) of its internal investigations. This report is more sensible than Socgen’s earlier “non explanations” as I called them in my blog.
• The Financial Services Authority (FSA) in the UK put out a heavily redacted version of its internal review on the supervision of Northern Rock. This is certainly more informative than the executive summary that I dismissed as uninteresting in March. I still disagree with much of what they are saying.
• Davidoff’s Deal Professor column in the New York Times Dealbook calls for a complete rethink of the SEC’s takeover regulations in the US. He is absolutely right and a similar rethink is required in many other jurisdictions including India.
• The gloom surrounding the sub prime crisis calls for some humour and I enjoyed Macroman’s modern nursery rhyme on the house that Jack built.
• David Murphy’s draft paper on the credit crunch was enlightening. I especially liked his description of SIVs as the “The New Way of Doing Old Style Banking”.
• FT Alphaville reported at length on the computer bug in Moodys rating of CPDOs and their attempt to cover this up.
• In this light, the agreement arrived at by the New York Attorney General with the rating agencies on rating securities based on residential mortgages appeared to many observers too little too late.
• However, the New York Attorney General did make almost irrelevant IOSCO’s consultation report on “The role of credit rating agencies in structured finance markets” and the subsequent changes in the code of conduct. IOSCO also published a report on the subprime crisis.
• The OECD’s Financial Markets Trends published a revised estimate of the size of the subprime crisis.
• Reinhart and Rogoff’s study of eight centuries of financial crises is most useful. The 12-page bibliography itself will keep many of us busy for a while.
• Andrew Kuritzkes and Til Schuermann wrote a fascinating paper on “What we know, don’t know and can’t know about bank risk” using quarterly earnings data for 20 years for 300+ U.S. bank holding companies that had total assets of at least $1bn. I suspect that earnings volatility understates default risk, but the relative contribution of different kinds of risk is still highly valuable.
• Many blogs referred to an interesting story in the Wall Street Journal that provided a rare behind the scenes view of how the US FDIC handled the closure of First Integrity Bank. Many of us had marvelled at the FDIC’s ability to do bank closures quickly and smoothly, and the WSJ story unravelled this mystery to some extent.
• Andrew Clavell at Financial Crookery provided an interesting analysis of Warren Buffet’s huge derivative trades that I blogged about in March. He points out quite unsurprisingly that the position is basically a vega play as the delta is extremely low. The interesting twist is the sensitivity to the dividend yield (known as phi or lambda). Clavell suggests a a fixed for floating dividend swap to offset the negative dividend growth rate locked into the option price. The very fact that somebody can suggest such a swap to Buffet tells us something interesting about how Buffet is perceived in the markets today. Incidentally, the market attaches a higher default probability to Berkshire Hathaway than to Brazil. In May 2008, Brazil priced a 10-year bond at 15 basis points tighter than a deal of the same maturity launched by Berkshire Hathaway Finance at nearly the same time.

Posted at 8:46 pm IST on Sun, 8 Jun 2008         permanent link

Categories: miscellaneous

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Away on vacation

I am away on vacation for about seven weeks. I will not be posting on my blog till mid-June

Posted at 7:12 pm IST on Fri, 25 Apr 2008         permanent link

Categories: miscellaneous

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UBS thought subprime was safer than Japanese Government Bonds

The Shareholder Report on UBS Write-Downs is very informative and interesting, but what I found most striking was the fact that UBS started buying US asset backed securities in 2002 because it thought that Japanese Government Bonds were too risky. This switch took place in the Relative Value Trading (RVT) portfolio used by central treasury to manage the liquidity buffer for the entire UBS Group. This portfolio was run by Foreign Exchange / Cash Collateral Trading (FX/CCT) within the investment banking business of UBS. The report states:

UBS created the ABS Trading Portfolio in late 2002 / early 2003 after Credit Risk Control (“CRC”) downgraded its country rating for Japan. This meant that FX/CCT had to reduce its then substantial holding of Japanese Government Bonds (“JGB”). Because FX/CCT retained the same level of funding liabilities and an unchanged revenue budget, it proposed to build up a portfolio of US ABS. In order for the assets to be a suitable replacement for the holdings of JGB that were to be liquidated, any replacement securities had to be:

• REPO-able;
• Highly rated - i.e. AA or AAA;
• Capable of being pledged to (one or more of) the primary Central Banks as collateral for UBS’s own borrowings; and
• Capable of being sold in the short term.

There were also a number of other advantages of ABS perceived at the time, including small spreads, USD denomination and no interest rate dependencies (floating rate instruments only in the portfolio). Because they had a higher yield (e.g. than government bonds), including ABS in the RVT Portfolio meant that there was no negative carry trade in the RVT Portfolio.

This reminds me of the famous statement by Mirabeau during the French Revolution: “I would rather have a mortgage on a garden than a mortgage on a kingdom”. The fate of UBS’ subprime assets has been only marginally better than that of Mirabeau’s assignats.

Posted at 9:44 pm IST on Tue, 22 Apr 2008         permanent link

Categories: bond markets, risk management, sovereign risk

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Doubts on LIBOR

Yesterday’s Wall Street Journal has a story about bankers questioning the reliability of Libor. Last month, the BIS Quarterly Review discussed the issue at length with lots of data and some amount of econometrics:

• Interbank rate fixings during the recent turmoil by Jacob Gyntelberg and Philip Wooldridge, and
• What drives interbank rates? Evidence from the Libor panel by Francois-Louis Michaud and Christian Upper)

Gyntelberg and Wooldridge find that: “The US dollar market stands out for being the one market where Libor rose by substantially less than similar fixings during the stress period. The average spread between Sibor and Libor widened from about zero in the normal period to 2 basis points in the stress period, and the spread between H.15 and Libor widened from -1 to 7 basis points.” Of these, Libor is the only one that is used as a reference rate for swaps and other derivatives while H.15 (named after the table number in which the Federal Reserve publishes the data) is the only one which is based on actual transactions.

Since H.15 was 7 basis points above Libor, it does confirm that banks were actually paying more than what the Libor panel was quoting during the Libor fixing. Though 7 basis points is not a trivial difference when trillions of dollars of debt is referenced to this rate, it is much less than the 30 basis points being mentioned in the WSJ article. Moreover, there is a different way of looking at whether Libor is too high or too low and that is by comparing it to the Overnight Index Swap based on overnight rates. Under the expectations hypothesis, the OIS and Libor must be equal. Michaud and Upper find that during the crisis, Libor exceeded the OIS by 50 to 90 basis points. From this perspective, the problem is that Libor was too high, not that it was too low.

Gyntelberg and Wooldridge re-estimated Libor using a bootstrap technique instead of the trimmed mean used by the BBA and found that the bootstrapped estimate is not significantly different from Libor. “Moreover, the 95% confidence interval around the bootstrapped mean loosely corresponds to the interquartile range in the Libor panel ... In other words, the bootstrap technique indicates that 19 days out of 20, the design of the Libor fixing produces an estimate that is close to the true interbank rate. This is the case even during the stress period.”

They also argue that “many of the banks on the US dollar Libor panel are also on the euro Libor panel, and there are no signs that signalling distorted the latter fixing.” I do not find this argument convincing because Chapter 2 of the same issue of the BIS Quarterly Review provides a chart on page 21 which highlights how lopsided the US dollar interbank market has become. The data suggest that US banks have raised more dollar deposits from non banks than they have lent to non banks while the position is the reverse for European banks. The result is that European banks have probably borrowed about half a trillion dollars from US banks in the short term inter bank market. In times of heightened concerns about counter party risk, positions of this size become difficult to roll over and poses huge systemic risk. The incentives for strategic quoting are much higher in the dollar market than in the euro market.

All this has a bearing on the common assumption made in recent years in the credit derivative market (both in the theoretical literature and in the practicing world) that the correct risk free rate is the swap rate (essentially Libor) and that the TED spread is essentially a liquidity premium and not a credit spread. Since the crisis of 2007 and 2008 is simultaneously about liquidity and about counterparty risk in the inter bank market, all the turmoil fails to throw light on this hugely important issue.

Posted at 1:10 pm IST on Thu, 17 Apr 2008         permanent link

Categories: benchmarks, derivatives

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Thoughts on Global Financial Turmoil

What follows are the comments that I posted on Ajay Shah’s interesting blog post on understanding the global financial disturbance of 2007 and 2008.

Q1: Why was there a surge in demand for a yield pickup?

Ajay Shah is absolutely right in saying that monetary policy was loose, but then the question is why did it feed into asset prices rather than goods prices. It is the answer to this question that takes us to finance as opposed to economics. I often say that we must approach the study of finance with Ito’s Lemma in one hand and a copy of Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises in the other.

Q2: Why did dodgy practices on home loan origination and securitisation flourish?

This is question 1 in a different form: greater tolerance for operational risk instead of market risk.

Q3: Why did liquidity collapse in key markets thus doing damage to Finance?

I would argue that liquidity collapses when prices are not allowed to fall. Why are the ABX contracts liquid? Because they have been allowed to undershoot. The ultimate providers of liquidity in any market are the value investors and they do not enter until prices have undershot.

On what Ajay Shah regards as the “well understood” questions, my answers are slightly different from his:

Why did a modest rate of default in a relatively small part of finance lead to such a crisis?

My answer: The real problem is not sub prime (which is only the canary in the mine), but falling real estate prices. Real estate is a huge part of finance. See also my earlier blog entry on real estate finance.

Did the Fed do right in rescuing Bear Stearns?

In my opinion, No.

First, as Kindleberger used to say, "A lender of last resort should exist, but his presence should be doubted." Even after LTCM, there could be doubts. After Bear Stearns, there can be none. This is a great tragedy.

Second, I can understand LOLR (lender of last resort), I can even understand outright nationalization (Northern Rock). I cannot understand buying a second loss credit linked note on $30 billion of hard to value securities.

See also my earlier blog entry on the rise of Mahathirism in the US and UK.

Why has the impact on the real economy of these events been relatively modest?

My answer: Canary in the mine again. I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

Posted at 12:42 pm IST on Tue, 15 Apr 2008         permanent link

Categories: crisis

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Mahathirism thriving in US and UK

Mahathir was Prime Minister of Malaysia during the Asian Crisis a decade ago and shocked the world with controversial responses that stretched the limits about how responsible governments are supposed to behave. Looking around the world today, it is clear that Mahathirism is alive and kicking in the heart of the developed world. The actions of the US in the Bear Stearns bail out and of the UK in pursuing the enemies of HBOS smack of the same intolerance of market forces and preference for crony capitalism that characterized Mahathir.

The legal problems with the Bear Stearns deal have been analysed very ably by Prof. Davidoff in a series of articles in his Deal Professor column in the New York Times Dealbook (one, two, three, four, five, six, seven, eight, and nine.) Davidoff argues that the deal violates NYSE listing regulations (but the worst that NYSE can do is to delist Bear Stearns and this is going to happen anyway after the merger) and probably violates Delaware corporate law too. The circumstantial evidence certainly points to a deal that was imposed by the government with scant concern for the requirements of good corporate governance. Davidoff is also right in raising questions about the Bear Stearns directors selling their shares in the market rather than tendering it to the acquirer under the deal that they have approved. It is also evident that the creditors of Bear Stearns (and to a lesser extent, its shareholders) have been bailed out.

The story about HBOS in the UK is Mahathirism of a different kind. Since HBOS is known to have considerable exposure to the mortgage market, it has attracted considerable short interest. After rumours spread about liquidity problems at HBOS, the Bank of England took the extra-ordinary step of denying problems at this bank. The Bank of England does not usually talk about individual institutions. For example, during the Northern Rock hearings, the Chairman of the Treasury Committee of the Parliament had the following exchange with the Governor and another Director of the Bank of England:

Q129 Chairman: ... Are there any others in potential trouble? You do not need to name them!

Mr King: I think you know perfectly well that central bank governors cannot go ---

Q130 Chairman: Governor, I was not even talking to you; I was talking to Paul Tucker.

Mr Tucker: Central bank directors take the same approach.

Yet, the Bank of England went out of its way to deny the HBOS rumours. Moreover, though the BOE statement has been reported very widely in the press, I cannot find the text of the statement at the web site of the Bank of England despite searching its web site and also running down its list of press releases. So much about transparency.

The Financial Services Authority went further with a probe into the short selling episode. Its statement is quite bland, but press reports clearly indicate that the FSA is taking the probe very seriously. The FT Alphaville blog describes an imaginary conversation between the FSA and speculator showing how silly this whole idea of probing the short sales really is:

FSA: Why did you short this bank?

Speculator: Because I thought it might have liquidity problems.

FSA: Why did you then tell the salesman at X broker that you thought this bank had liquidity problems.

Speculator: Because I thought it might have liquidity problems.

FSA: But it doesn’t have liquidity problems.

Speculator: Really?

Posted at 6:52 pm IST on Mon, 14 Apr 2008         permanent link

Categories: international finance

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Modernizing real estate finance

I believe that real estate finance today is where corporate finance was a hundred years ago, and the current global financial turmoil is the beginning of its transformation into something similar to modern corporate finance. About a century ago, corporate finance adopted its modern form where equity is owned by large diversified pools of capital with low levels of leverage. Real estate as an asset class is of the same size as the equity market, but it is still dominated by small undiversified owners with large amounts of leverage.

Most houses are owned by individuals who finance them with mortgage debt. A high quality mortgage might have a loan to value ratio of 80% while very few modern businesses are run with 80% debt to total capitalization. In lower quality mortgages, the loan to value ratio could be in excess of 90%. This is a prescription for financial fragility. While modern economies can easily absorb the stock market dropping by 50% in a year, their financial systems are devastated by even a 20% drop in real estate prices.

This is also a problem from the investor view point. Since real estate is as large an asset class as equities, an institutional investment portfolio should ideally have a large holding of real estate, but this cannot be achieved because ownership interests in real estate are not available in sufficient quantity (see for example, Hoesli, Lekander and Witkiewicz, “Real Estate in the Institutional Portfolio: A Comparison of Suggested and Actual Weights”, Journal of Alternative Investments, Winter 2003.) Almost all real estate is user owned and therefore the only exposure that you can buy to real estate in the financial markets is mortgage debt (residential or commercial).

Corporate finance was also like this centuries ago. Bond markets existed long before stock markets, and for the first couple of centuries of their existence, stock exchanges like the London Stock Exchange traded bonds more than stocks. Apart from their own money and that of their friends, businessmen had to rely largely on debt to finance their businesses. But all this changed in the late nineteenth century as Mitchell has described in his fascinating book The Speculation Economy: How Finance Triumphed Over Industry, BK Currents, 2007. The joint stock corporation meant that anybody anywhere in the world could own a piece of any business.

The equivalent transformation in real estate has yet to happen. For most individuals today, their home is the most undiversified investment that they have (even more undiversified than their human capital), and it is a heavily levered investment. If an individual were to buy shares worth several times his annual income on margin, we would doubt his sanity. But when he does the same thing in real estate, governments encourage the imprudence by giving generous tax breaks.

This fragile financial structure where everybody buys real estate on margin with a downpayment of only 10% or 20% is a prescription for huge systemic risk. By contrast, in the equity market, pension funds and mutual funds have negligible levels of leverage; very few individuals buy stock on margin; and corporate investments in stocks (strategic investments) are also financed with relatively low levels of debt.

The fragility of real estate finance is less of a problem so long as people irrationally keep paying mortgages even when they have negative equity in their homes. Standard valuation models of mortgage securities (whether it is prepayment modelling or default modelling) assume that the home owner is irrational and will neither exercise the prepayment option (call option) optimally nor exercise the default option (put option) optimally. As financial systems get more sophisticated, these assumptions are bound to be falsified. As this happens and jingle-mail becomes more prevalent, the business of selling near money put options on real estate (which is what mortgages are all about) is bound to be less and less viable.

In the period of transition, large portions of the financial system will doubtless lose much of their capital. This is what one is seeing in the global financial turmoil. It is a necessary part of the process of creative destruction through which hopefully real estate finance will be transformed just as corporate finance was transformed a century ago.

Posted at 6:13 pm IST on Fri, 11 Apr 2008         permanent link

Categories: crisis

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