Deus Ex Macchiato

Part of a continuing series of facts that seem obvious, but are in fact news: the changing nature of equity market trading (more bots, more ETFs) has affected the dynamics of the market. (See here for a previous item.) Specifically, according to FT alphaville (who cite Barclays research) equity correlation has had a close relationship with the increased ETF volumes. Barclays say:

An important structural shift in the equity markets over the past few decades has been the advent of index funds as an alternative to actively managed mandates… Since the dominance of this kind of index-based component in the equity fund flows should logically lead to an increase in equity correlation, it is tempting to theorize that the secular shift in equity correlation documented above is driven by this effect.

Then do (a little) analysis and conclude

while equity correlation continues to be highly dependent on volatility, the rise in indexation has led to a permanent increase in its “base” level

File under ‘n’ for ‘not a surprise’ and ‘w’ for ‘why did you think you could count on a correlation to tell you very much about the comovement of the market anyway?’

Posted in: Model risk, Quantitative Trading by David /
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DeLisle Worrell, Governor of the Central Bank of Barbados, had these sensible words to say in a speech recently:

Traditional Economics remains trapped in a time warp defined by the concepts that Leon Walras borrowed from the physics he knew at the time of the development of the marginalist theory of market economics which underpins the classical, keynesian, neoclassical and new keynesian views of the world. At that time only the first law of thermodynamics – the conservation of energy – was known. The notion of equilibrium is a form of expression of the first law. Physics subsequently discovered the second law – that entropy (disorder or randomness) is always increasing. The implication of the second law is that if the system were ever to reach equilibrium it would be dead.

In other words, equilibrium models of social systems are models of dead systems. No real economy is anywhere close to equilibrium in the physical sense. (This is a point that we have made before: see for instance here or here.) Mr. Worrell then suggests that ‘viewing the economy as a complex adaptive system provides us with a new set of tools, techniques and theories for explaining economic phenomena.’ Now if the governor of the Central Bank of Barbados can talk sense like that, why can’t we have it from the central bankers of larger countries?

Posted in: Economic Theory by David /
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From the Committee, edited down for brevity:

The Committee retained most of the definition of capital proposals set out in the December 2009 consultative package. However, it concluded that certain deductions could have potentially adverse consequences and may not appropriately take into account evidence of realisable valuations during periods of extreme stress. Therefore, the following amendments to the December 2009 proposal have been agreed.

Definition of capital

The Committee will allow some prudent recognition of the minority interest supporting the risks of a subsidiary that is a bank. The excess capital above the minimum of a subsidiary that is a bank will be deducted in proportion to the minority interest share.

The December 2009 reform package required that unconsolidated investments in financial institutions be deducted when the holdings exceed certain thresholds. These thresholds continue to apply. The December paper also stated that gross long positions may be deducted net of short positions only if the short positions involve no counterparty risk. The Committee agreed to eliminate this counterparty credit restriction on hedging of financial institution investments and to include an underwriting exemption.

Instead of a full deduction, the following items may each receive limited recognition when calculating the common equity component of Tier 1, with recognition capped at 10% of the bank’s common equity component:

• Significant investments in the common shares of unconsolidated financial institutions. “Significant” means more than 10% of the issued share capital;

• Mortgage servicing rights (MSRs); and
• Deferred tax assets (DTAs) that arise from timing differences.

A bank must deduct the amount by which the aggregate of the three items above exceeds 15% of its common equity component of Tier 1.

Counterparty credit risk

The Committee is making the following modification to the treatment of counterparty credit risk, including the bond equivalent approach to calculating the credit valuation adjustment (CVA):

• Modify the bond equivalent approach to address hedging, risk capture, effective maturity and double counting;

• To address the excessive calibration of the CVA, eliminate the 5x multiplier that was proposed in December 2009;
• Keep the asset value correlation adjustment at 25% to reflect the inherent higher risk of exposures to other financial entities and to help address the interconnectedness issue, but raise the threshold from $25 billion to $100 billion; and
• Banks’ mark-to-market and collateral exposures to a central counterparty (CCP) should be subject to a modest risk weight, for example in the 1-3% range, so that banks remain cognisant that CCP exposures are not risk free.

Leverage Ratio
The Committee agreed on the following design and calibration for the leverage ratio, which would serve as the basis for testing during the parallel run period:

• For off-balance-sheet (OBS) items, use uniform credit conversion factors (CCFs), with a 10% CCF for unconditionally cancellable OBS commitments (subject to further review).

• For all derivatives (including credit derivatives), apply Basel II netting plus a simple measure of potential future exposure based on the standardised factors of the current exposure method.
• The leverage ratio will be calculated as an average over the quarter.

When it comes to the calibration, the Committee is proposing to test a minimum Tier 1 leverage ratio of 3% during the parallel run period.

The parallel run period commences 1 January 2013 and runs until 1 January 2017. During this period, the leverage ratio and its components will be tracked, including its behaviour relative to the risk based requirement. Bank level disclosure of the leverage ratio and its components will start 1 January 2015.

Procyclicality, systemically important financial institutions, and the net stable funding ratio have all been kicked into the long grass, with further proposals at the end of the year (i.e. past the G20 Basel 3 deadline of November).

The Liquidity coverage ratio stays, but with some recalibration:

• Retail and SME deposits: Lower the run-off rate floors to 5% (stable) and 10% (less stable), respectively (from 7.5% and 15%). These numbers are floors and jurisdictions are expected to develop additional buckets with higher run-off rates as necessary.

• Operational activities with financial institution counterparties: Introduce a 25% outflow bucket for custody and clearing and settlement activities, as well as selected cash management activities.
• Deposits from domestic sovereigns, central banks, and public sector entities (PSEs):
  • For unsecured funding, treat all (both domestic and foreign) sovereigns, central banks and PSEs as corporates (ie with a 75% roll-off rate), rather than as financial institutions with a 100% roll-off rate.

  • For secured funding backed by assets that would not be included in the stock of liquid assets, assume a 25% roll-off of funding.
• Undrawn commitments: Lower retail and SME credit lines from 10% to 5%. Treat sovereigns, central banks, and PSEs similar to non-financial corporates, with a 10% run-off for credit lines and a 100% run-off for liquidity lines.
• Inflows: Rather than leave it to bank discretion to determine the percentage of “planned” net inflows, establish a concrete harmonised treatment in the standard that reflects supervisory assumptions.
• Definition of liquid assets: All assets in the liquidity pool must be managed as part of that pool and are subject to operational requirements. The December 2009 proposal outlined that the assets must be available for the treasurer of the bank, unencumbered, and freely available to group entities. The Committee will finalise these operational requirements by the end of this year.

  As part of the narrow definition of liquid assets, allow the inclusion of domestic sovereign debt for non-0% risk weighted sovereigns, issued in foreign currency, to the extent that this currency matches the currency needs of the bank’s operations in that jurisdiction.

• Introduce a “Level 2” of liquid assets with a cap that allows up to 40% of the stock to be made up of these assets.
  • Include (with a 15% haircut) government and PSE assets qualifying for the 20% risk weighting under Basel II’s standardised approach for credit risk, as well as high quality non-financial corporate and covered bonds not issued by the bank itself (eg rated AA- and above), also with a 15% haircut.

  • Utilise both ratings and additional criteria as outlined in the December proposal (bid-ask spreads, price volatility, etc) to determine eligibility.
• Develop standards for review at the September 2010 BCBS meeting for jurisdictions which do not have sufficient Level 1 assets to meet the standard.

Posted in: Basel, Regulation by David /
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FT alphaville has an interesting post on the Spanish stress test results. They quote Deustche bank research as follows:

We regard the impairment assumptions (both on sovereign and the different credit buckets) as sufficiently severe and consistent. We are, however, less convinced by and have lower visibility on what is included in and how the regulator arrived at some of its forecasts on PPP [pre-provisioning profit], capital gains and other “impairment buffers”. This is particularly relevant as under a marginally tougher set of assumptions in this area, a larger number of institutions would have failed the test (nine instead of five, with another six below 6.5% Tier 1), although admittedly the incremental amount of capital is limited to EUR 3.5B.

The point is that the stress test results are rather sensitive to these PPP estimates. As Alphaville says:

Reducing the PPP forecasts by 20 per cent leaves nine banks below the magic 6 per cent Tier 1 capital ratio used in the tests

Now it’s easy to use this as evidence of stress test fudging, and I won’t bother to do that – the tests have been analysed enough elsewhere, and the markets have their own view. Instead I’ll make a broader point: wouldn’t it be nice in financial statements to get some sensitivity analysis of key variables? That is, instead of getting a static book of a financial statement, with all the numbers hard-wired, what I’d like would be a little model. The default conditions of the model would be the reported financials. But then you could vary a few of the key parameters – loan loss provisions by book, say, or funding cost – and see the impact on the financial statements. That would really give investors a much better idea of what the company’s risks were. For that reason, I suspect it will not happen in my lifetime.

Posted in: Accounting by David /
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… the worst knock-knock joke ever.

Knock knock.

Who’s there?

Sutton.

Sutton Hoo?

Posted in: Fun, Photography by David /
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Here’s something I would like to do – it is far too much work for me (or I suspect less than a team of 30) to actually do, but never mind that, let’s just run with it.

First, build a mini model of the banking system as a set of autonomous agents. You’ll need a variety of banks and brokers, securities markets and lending, central banks and monetary policy, treasury activities and trading, investment managers and hedge funds. The simulation does need not be hugely complex: a few different securities will probably do for instance, but prices should be set by real market activity, and there should be analogues of government bonds and corporate bonds. You will need the interbank markets, too, with credit risk being taken in a variety of ways. Financial institution bankruptcy can happen due to either liquidity or solvency crises, and if a financial firm goes bankrupt, its portfolio is sold to the market. Demand for credit is set by the economic cycle, and there are fundamentals bubbling along too with random defaults of entities issueing bonds and taking loans.

Next, set some rules for the banks and brokers. We can start with the current regulatory capital rules. Banks will have a capital structure with both a term structure of debt and equity, and they will have to capitally adequate at all times. The same goes for brokers, but they can have different reg cap rules in general to model the SEC vs. FED divide.

Now the game. There are two classes of players. The first class is the bankers: they define trading rules for an individual bank. They can’t dictate transactions; rather, they write rules which determine what transactions a bank will do, depending on market conditions. There can be as many bankers as there are banks, but balance sheet size and initial capital is allocated randomly to players at the start of the game subject to plausible distributions.

The game proceeds by the simulation being run through time; this is then repeated many times. The banker’s payoff is the average of the positive part of the bank’s profit averaged across all the simulations. So, like the real world, these guys score higher if their banks make a lot of money in a variety of conditions.

The second class of players is the regulator. This player rewrites the rules that the banks must obey. Their score is based on the number of bankruptcies and both the volatility and level of credit supply: basically they score highly if there are no bank failures and credit grows slowly but steadily.

With sufficient (= a lot of) computing power, you could have a number of people playing as regulators, each simultaneously facing all the bankers. You could even use genetic algorithms or any other adaptive strategy you like as the regulator. It would be fascinating to see what rules emerged as winners.

There is a lot more you could do, too. For instance, you could impose a change on fundamentals and see what happened. You could road test new rules and see how players game them. You could with a bit of work find out what market dynamics lead to most bankruptcies, or the biggest systemic crises. You could see what bank strategies are most profitable but lead to high tail risk. It might not be a popular as world of warcraft, but I bet if you got the user interface slick enough, quite a few financial services people would play, and all that expertise could be used to improve the capital rules. The key point is that even if you don’t believe the results of the simulation are realistic, having something that suggests financial system vulnerabilities on the basis of actual dynamics and attempted gaming of the system could be quite useful.

Posted in: Emergence, Rules by David /
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Here’s an interesting conjecture from the Futurist. First he points out that we have had a massive stimulus, yet this has not lead to inflation. Remember, $1T of liquidity and an essentially zero FED funds rate have not lead to any prospect of inflation. Now you all I am sure know the conventional explanations of this, but bear with the Futurist while he gives you a novel one.

A technology company exists under the reality that all inventory depreciates very quickly (at over 10% per quarter in many cases), and that price drops will shrink revenues unless unit sales rise enough to offset it (and assuming that enough unit inventory was even produced). This results in the constant pressure to create new and improved products every few months just to occupy prime price points, without which revenues would plunge within just a year. Yet, high-tech companies have built hugely profitable businesses around these peculiar challenges, and at least 8 such US companies have market capitalizations over $100 Billion. 6 of those 8 are headquartered in Silicon Valley.

Now, here is the point to ponder : We have never had a significant technology sector while also facing the fears (warranted or otherwise) of high inflation. When high inflation vanished in 1982, the technology sector was too tiny to be considered a significant contributor to macroeconomic statistics. In an environment of high inflation combined with a large technology industry, however, major consumer retail pricepoints, such as $99.99 or $199.99, become more affordable. The same also applies to enterprise-class customers. Thus, demand creeps upwards even as cost to produce the products goes down on the same Impact of Computing curve. This allows a technology company the ability to postpone price drops and expand margins, or to sell more volume at the same nominal dollar price. Hence, higher inflation causes the revenues and/or margins of technology companies to rise, which means their earnings-per-share certainly surges.

So what we are seeing is the gigantic amount of liquidity created by the Federal Reserve is instead cycling through technology companies and increasing their earnings. The products they sell, in turn, increase productivity and promptly push inflation back down. Every uptick in inflation merely guarantees its own pushback, and the 1.5% of GDP that mops up all the liquidity and creates this form of ‘good’ deflation can be termed as the ‘Techno-Sponge’. So how much liquidity can the Techno-Sponge absorb before saturation?

Now I have no idea whether this is even half way to true. But it is an interesting idea. Certainly tech spending, unlike magnums of Krug (so déclassé – I prefer Salon), can increase productivity. If that creates more wealth, then you can have growth without inflation, especially if the basket that defines inflation is tech heavy.

Posted in: Economic Theory, Inflation by David /
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Underground, overground, Baseling free
The people of the BIS thirty are we
Making good use of the things that we find
Things that the everyday banks leave behind

OK, OK, that was a cheap shot, but I did like the Wombles when I was a kid, and the Basel Committee is meeting today to work on Basel 3. (If you want to be pedantic, it’s 27 countries not 30, but the EU has a seat too, as does the secretariat, and that is close enough for government work.) So, in the spirit of good natured advice to the committee, which I fully expect to be utterly ignored, here’s what I think they should do today.

The definition of capital. Clearly, something needs to be done. Equally clearly, you cannot do it quickly, because asking the banking system to raise hundreds of billions of new equity in a hurry is a recipe for instability and dramatic falls in credit supply. So, yes, set a 4% core tier 1 ratio as the target, but do it over ten years, and amortise in the effect every year. Declare all tier 1 and upper tier 2 instruments as de facto core tier 1 for now, then let that bleed out over time. Require a total capital ratio of 10% also in ten years, again amortising from now to then. Allow contingent capital as part of tier 2. Remove the asymmetric treatment of deductions in subsidiaries, but make DTAs tier 2.

Liquidity. This for me is the most important part of the proposal to get right. Both the net stable funding ratio and the liquidity coverage ratio are good ideas, but the definitions are flawed. On the NSFR, a lot of work with the quantitative impact study results will be needed to figure out what financial institutions (and I don’t just mean banks – remember this is being implemented in the EU for all investment firms) can get to without severe stress in the liquidity markets. Consider an explicit capital charge for interest rate risk in the banking book, too. For the LCR, a liquidity stress test is a good idea, but it should probably be a pillar 2 issue with extensive pillar 3 disclosure.

Leverage. Define an on balance sheet leverage ratio, but base it on the statutory accounts assets vs. shareholder’s funds, (relying on accounting standards convergence to level the playing field). Give banks five years to meet the target, and make the ratio large so it acts as a last ditch backstop rather than an everyday constraint. Thirty or thirty five to one might do it.

Counterparty risk. The previous proposals were far too severe. One might suspect that they could have been politically motivated, that is designed not to cover risk, but rather to incentivise a move to CCPs. It really is back to the drawing board time here I would suggest.

Anticyclical measures. Do further study and work with the accounting standards setters to develop forward looking provisioning methods. Then, once you have a good definition of an expected loss provision, in the capital rules add an explicit countercyclical provision based on historical max EL vs. current EL.

Other things that should be done (but won’t be). Fix the low correlations for retail mortgages in the Basel 2 IRB formula. Change the requirement for securitisation retentions from 5% flat to be a function of the weighted average coupon of the underlying assets. Remove the ill-judged trading book VAR plus stressed VAR plus IRC charge, and instead implement max(VAR, stressed VAR) plus max(IRC, stressed IRC). This would be countercyclical and a reasonable holding position until the committee has time to get back to the trading book issues.

The Committee then needs to promise to do a full impact study of the new proposals and rewrite where necessary in 2011.

That was cathartic to write, in the way that fantasies sometimes are.

Update. The press release from the meeting is here: it says rather little, apart from setting out a new counter-cyclical buffer proposal. That’s here: I will have a look at it shortly.

Update. I can’t resist quoting this summary of Basel 3 from FT Alphaville:

In short: a complex rule cut to the crazy-quilt cloth of financial globalisation, to be implemented roughly once every geological epoch and with uncertain ultimate impact on the real economy.

Harsh, but not clearly unfair.

Posted in: Basel by David /
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The good news is that June’s sunshine has left me with some gorgeous flowers.

The bad news is that last month was the hottest June ever recorded worldwide and the fourth consecutive month that the combined global land and sea temperature records have been broken, according to the US government’s climate data centre. Our failure to act on Kyoto, and the subsequent disappointment of the Copenhagen climate summit is going to have serious consequences. The flowers might be nice now, but life in an overheated world won’t be in ten or twenty years time.

Posted in: Mathematics and Science, Photography by David /
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There has been some comment recently about a paper by Reginald Smith on the impact of high frequency trading (HFT) on market dynamics. I want to spend a little timing explaining what the paper says, roughly, and why it matters.

We can clearly demonstrate that HFT is having an increasingly large impact on the microstructure of equity trading dynamics… the Hurst exponent H of traded value in short time scales (15 minutes or less) is increasing over time from its previous Gaussian white noise values of 0.5. Second, this increase becomes most marked, especially in the NYSE stocks, following the implementation of Reg NMS by the SEC which led to the boom in HFT. Finally, H > 0.5 traded value activity is clearly linked with small share trades which are the trades dominated by HFT traffic. In addition, this small share trade activity has grown rapidly as a proportion of all trades.

So first, what is a Hurst exponent?

Roughly speaking, Hurst exponents measure autocorrelation or, even more loosely, predictability. If H is close to 0.5, the series is a random walk, or what we were told equity prices did in Finance 101. In particular, if H = 0.5, the idea of volatility makes sense, and we can quantify risk using volatility.

If H is bigger than 0.5, though, the series shows positive autocorrelation: roughly, it has very busy periods when volatility is high, and quieter low volatility periods. It switches regimes between these with no warning. Thus we might try to calibrate a simple risk model but if we are unlucky we will calibrate it to a low vol period and then when the high vol hits, our risk estimates are wrong.

So, what the paper seems to have proved (and I have not checked all the details) is that HFT has changed the nature of stock price returns from being a random walk (H = 0.5) to having significant positive autocorrelation. Increasingly we see quiet periods when not much happens followed by periods of intense volatility, and the change between these is unpredictable. Now notice the time period cited, 15 minutes or less. What is happening, then, is that HFT appears to be creating islands of high volatility amid an ocean of more stable prices. Something sets off a price change, which creates a flurry of HFT activity, exacerbating volatility; this then dies away over a period of minutes or hours.

Why does this matter to the ordinary investor? Simply that their trading might hit one of those flurries of activity, and they might well get a significantly worse price than average if it does. Moreover of course simple risk models such as VAR will be less and less accurate risk gauges the higher the autocorrelation. I suspect on the typical VAR one day holding period this does not matter much, but it might.

Finally, there is the issue that HFT might be increasing the risk of flash crashes. If autocorrelation is too high then the probability of very large deviations from the mean over short timescales increases dramatically. I have no idea if this research supports the idea that we have got to that point yet. But I do think that someone should find out.

Posted in: Financial Models, Markets, Quantitative Trading by David /
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From Steve Randy Waldman at Interfluidity:

I feel about the financial sector the same way I would feel about my morphine dealer after looking down to find piranha feeding between my ribs.

That’s a little unfair, but you take his point. However much you might despise bankers (and I like a good few of them) you cannot but admit that right now, we need banks. More specifically, we need banks to provide credit or we are all what a professional economist would call ’screwed’.

Posted in: Economic Theory, Fun by David /
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Rajiv Sethi makes an important and subtle point in a post on Naked Capitalism. He is discussing the behaviour finance literature, and in particular the idea that failure to correctly estimate the probability of bad outcomes leads to the design of unsafe securities that look safe:

…what troubles me about this paper (and much of the behavioral finance literature) is that the rational expectations hypothesis of identical, accurate forecasts is replaced by an equally implausible hypothesis of identical, inaccurate forecasts. The underlying assumption is that financial market participants operating under competitive conditions will reliably express cognitive biases identified in controlled laboratory environments. And the implication is that financial instability could be avoided if only we were less cognitively constrained, or constrained in different ways — endowed with a propensity to overestimate rather than discount the likelihood of unlikely events for example.

Now this is a little unfair in that the authors don’t make the explicit read across from ‘if people are wrong about the likelihood of crashes, then they produce overpriced securities which will fail catastrophically in a crisis’ to ‘overpriced securities which failed catastrophically in a crisis were produced, therefore people mis-estimated tail probabilities’. But certainly the authors invite such a reading, so Rajiv’s comment is reasonable. It is next part of his argument that really resonates though:

This narrowly psychological approach to financial fragility neglects two of the most analytically interesting aspects of market dynamics: belief heterogeneity and evolutionary selection. Even behavioral propensities that are psychologically rare in the general population can become widespread in financial markets if they result in the adoption of successful strategies. As a result, asset prices disproportionately reflect the beliefs of investors who have been most successful in the recent past. There is no reason why these beliefs should consistently conform to those in the general population.

I think that this is right, and it deserves to be better understood. I would even go further, because this argument neglects the explicitly reflexive nature of market participant’s thinking. (Call it social metacognition if you really want some high end jargon.) Traders can both absolutely understand that a behavioral propensity is rare and likely to lead to catastrophe and behave that way: they do this because they believe that other market participants will too, and behaving that way if others do will make money in the short term. Even if you think that it is crazy for (pick your favourite bubblicious asset) to trade that high, providing you also believe others will buy it, then it makes sense for you to buy it along with the crowd. Moreover, worse, you may well believe that they too think it is crazy: but all of you are in a self-sustaining system and the first one to get off looks the most foolish (for a while). Most people are capable of spotting a bubble if it lasts long enough: the hard part is timing your exit to account for the behaviour of all the other smart people trying to time their exit too.

Posted in: Emergence, Markets, Rules by David /
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An interesting article in Risk magazine by Mark Pengelly raises some questions about the range of collateral accepted by some CCPs:

One New York-based head of collateral at a major dealer says the types of collateral often accepted by CCPs can also create wrong-way risk: “If you look at the clearing house structures, the types of collateral that are taken really can have a wrong-way aspect to them. If an equities clearing house is accepting equities as collateral, they have to be pretty well diversified in order to ensure the collateral value isn’t shrinking as the equities are tanking.” As a member of a CCP, the bank has tried to work with clearing houses to get these standards tightened, they add.

The collateral policies of CCPs are not uniform. The rules of the Chicago-based Options Clearing Corporation, which clears futures and options traded on various US exchanges, allow for a variety of different assets to be posted. They include certain equities and corporate bonds, shares in money-market funds, US Treasury bonds, cash, letters of credit and the debt of government-backed mortgage lenders Fannie Mae and Freddie Mac. Frankfurt-based derivatives exchange Eurex says it accepts a “wide range of cash and securities as collateral”… But just as some dealers are nervous about CCPs accepting a wide range of collateral, others are eager that the range of eligible collateral be extended. New York-based International Derivatives Clearing Group, which clears OTC US dollar interest rate swaps, currently only accepts US Treasuries and agency securities. However, the clearing house is looking to extend its range of acceptable collateral to other fixed-income securities. “Clients would like the types of collateral we take to be as broad as possible…” says chief risk officer Michael Dundon.

I am sure that clients want as broad a range of collateral as possible: I’d like to be able to repo out my dry cleaning receipts too. But for a security to be good collateral it must be high quality, low volatility, have low correlation with the exposure (the reverse situation – where the collateral value declines when the counterparty owes more money is wrong way risk), and be subject to an appropriate haircut. CCPs are rushing to gain new business at the moment as it is clear that there will be only a small number of winners in each asset class, perhaps only one. Everyone wants to be the winner. There are two obvious ways to compete: lower initial margin, and accepting a wider range of collateral with lower haircuts. Both of these have the potential to increase systemic risk – you can imagine the implications of posting a corporate bond as collateral against a CDS on a highly correlated underlying, for instance, or equities as collateral against equity derivatives. Banks are subject to strict supervision to control this, with the Basel accords containing firm language about wrong way risk. But it seems that things may be a little laxer in the world of CCPs.

Posted in: Clearing and Collateral by David /
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Looking at last night’s equity index closes (most things down 0.5%), I get the feeling that this the pattern for the rest of the year. Mild disappointment. We are drifting lower on a slowing economy on both sides of the atlantic. My rationale for an extended period of boredom is a combination of government spending cuts and cheap money. It isn’t that carefully thought out: this is a gut call (and so likely wrong). But FTSE 4000 feels more achievable than 6000 right now.

Posted in: Markets by David /
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Just to remind ourselves how unnecessary the Osborne deficit fetishism is, here’s the long view of UK net public debt

Posted in: Economic Theory, Politics by David /
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As Reuters correspondents go, Chrystia Freeland is sensible, certainly more so than some of her fishy colleagues. She recently pointed out the importance of systemic weakness rather than people in the Crunch, a point I have been making since it began:

Blaming the crisis on human error is a lot easier than trying to work out the systemic problems it laid bare… But just because something is easy doesn’t make it accurate.

In particular she points out that Chuck Prince actually had a point in his much-derided “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” remark:

What’s really unsettling about Prince’s observation is not that he was wrong, but that he was right… Peter Weinberg [said] “It’s very, very hard to lean against the wind in a bubble. … If one of the heads of the large Wall Street firms stood up and said, ‘You know what, we’re going to cut down our leverage from 30 to one to 15 to one, and we’re not going to participate in a lot of the opportunities in the market’ — I’m not sure that chief executive would have kept his job.”

This is entirely on point. In the main, investment bankers did their job. OK, there were some clear errors of judgment, perhaps some fraud, perhaps some inadequacies of disclosure. But the big question, the question that must be addressed if we want a safer financial system, is ‘why did the system make it their job to do these things?’ Ms Freeland points out

Not only is betting against an asset bubble dangerous — buying into it can be smart.

She then references a 2003 Brunnermeier and Abreu Econometrica article which you can find here. This of course leads to the vexed and complicated question of macroprudential regulation, aka anti-cyclical regulation: how can we stop it being so attractive for firms to inflate bubbles. We are still taking baby steps in this area. But it is this, rather than throwing stones at individuals, that will make the next crisis less likely.

Posted in: Regulation, Rules by David /
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I do try, on occasion, to write boring titles, but with this one, honestly, I think I’ve set the bar fairly high. Bear with me.

The Kruger-Dunning effect is the phenomenon whereby the worse someone is at performing in a given domain, the worse they are at estimating how good they are. The great performers know they are great; the terrible ones think they are kinda OK verging on good. As Kruger and Dunning say

In essence, we argue that the skills that engender competence in a particular domain are often the very same skills necessary to evaluate competence in that domain-one’s own or anyone else’s.

Hence the bad performers don’t have the skills to know they are bad.

The K-D effect is well known and explains a lot (especially to those of us who sometimes have to spend time talking to people in authority whose understanding is, shall we say, imperfect). But it occurred to me the other day that cultural factors can mitigate or accentuate it. For instance in cultures where praise of effort rather than results is common, one might expect the K-D effect to be stronger, whereas in less supportive, more results-driven cultures, there is more evidence that the bad are indeed bad, and hence the effect might be less. Now I am not nearly stupid enough to suggest paradigmatic countries in each group, but the evidence here (see for instance the section ‘Cross Cultural comparison’ in this link) is interesting.

For financial companies of course, the moral is clear. If you don’t impose objective performance standards, not only will the good guys get upset and leave, the bad ones will actually start to think that they are good. They might even (if they are talented self-publicists) convince you that they are. The only defence against K-D is objective assessment. Or, to put it in slightly more populist terms, show me the money.

Posted in: Mathematics and Science by David /
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Central clearing and CCPs have been much in the news recently, thanks to their prominent role in US regulatory reform and Basel 3. Some commentators remain skeptical, and I commend both the Streetwise Professor (see for instance here or here) and Jon Gregory (see here) to your attention. Here I am not going to address the debate head on, but rather correct a few misconceptions.

1. Clearing houses reduce risk. Wrong. Clearing houses concentrate risk. Counterparty risk does not go away if you use a clearing house; rather it is all gathered up in one big systemically risky lump.

2. There will be one CCP. Certainly wrong. There will be a diverse architecture of CCPs clearing different products in different regions with some products not clearable anywhere.
3. Central clearing increases netting benefits. Right, provided that the same clearing house is used for everything. But as we point about, there won’t be. In fact, using central clearing might well decrease netting benefits compared with the current OTC market, especially where a clearable trade hedges a non-clearable one.
4. Central clearing is needed for transparency. Wrong. Trade repositaries can provide transparency without requiring central clearing.
5. CCPs have the technology and understanding to clear OTC derivatives. Partially right, but the devil is in the detail. Some CCPs have the technology and understanding to clear some OTC derivatives. Many derivatives will never be liquid enough nor have a visible enough price to be clearable.
6. Central clearing is more legally robust than the OTC market. Wrong. No clearing house anything like the number of legal opinions that their close out procedures work in bankruptcy that the OTC market does.
7. OTC default is the same as CCP default. Wrong. The terms of default vary from CCP to CCP, and do not in general match default under OTC agreements. Therefore a firm can be in default under an OTC and not to a CCP and vice versa.
8. CCPs will cooperate to reduce the impact of multiple clearing venues. Unknown, but just contemplate for a moment the systemic consequences of one CCP putting another into default and shudder.
9. Margin with a CCP is safe. Mostly wrong, especially given that for many (but not all) CCPs, it does not have the same degree of safety as a bank deposit.
10. CCPs will have access to the central bank window in time of trouble. Unclear. Some central banks oppose this.

Factor in CCP competition on margin requirements and the fact that a CCP’s default fund does not cover some risks the CCP might run (such as operational risks including legal risk), and I fear that if central clearing of OTC derivatives is badly implemented, it might leave us in a worse position systemically than we are in today.

Posted in: Clearing and Collateral by David /
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It is definitely make the banks better capitalised but not yet. From the FT today:

…the G20 has watered down the previous target of achieving the new capital standards by the end of 2012. That date is now downgraded to an “aim”.

But to keep individual countries with weak banks happy, the phase-in of the new global rules “will reflect different starting points and circumstances with initial variance around the new standards narrowing over time as countries converge”, the communiqué added.

The Basel consensus will probably hold, but only at the expense of a long transition period and weaker standards.

Posted in: Basel by David /
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Enjoy it while you can – with a budget like George’s, sunshine is about the only thing you will be able to enjoy soon.

Posted in: Photography, Politics by David /
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Anyone who has worked in the capital markets for a while will have become used to routine dishonesty about performance. It is both psychologically and sociologically difficult to admit that you lost money because you made the wrong call. Of course, the best traders are those that can admit their mistakes and learn from them, but these individuals are quite rare.

It is therefore with a degree of admiration that I turn to something I have been meaning to blog about for a while, Scottwood capital management’s May letter to investors. We have Dealbreaker to thank for this document becoming public. Here are the highlights:

May will be – by far – the worst monthly performance in Scottwood’s 8 ½-year history… we were, quite obviously and simply, positioned wrong. Specifically:

• We were too slow to recognize that we had entered a market (albeit practically overnight) where “all correlations went to 1.” Hence the comfort we derived from our historical non-correlation proved to be a false one…

• As our positions appreciated significantly in the first four months of this year, we viewed that as validating our investment theses. While this was no doubt true, in part, it also left us much more vulnerable to near-term profit-taking (unfortunately by others) which, given the size of the profits in these positions, led to larger price drops than we had anticipated would be likely given these positions’ changed fundamentals…

These mistakes — these specific mistakes — are common enough. But admitting to them is not.

Posted in: Markets by David /
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The latest Bank of England financial stability review contains the following interesting passage:

Finalisation of the Basel III package will take place this year. This should provide banks and other market participants with a clearer view on future regulatory requirements, thereby reducing uncertainty. But it is important that policymakers also provide clarity over the implementation timetable for the new requirements.

Although higher levels of capital will ultimately be needed, it would not be appropriate for banks to be increasing their capital buffers immediately if this were at the expense of a reduction in lending to the real economy. Work is under way internationally to gauge these transitional costs. The transition to new regulatory standards does not need to be rushed and should, in principle, be contingent on the economic environment.

Combine this entirely sensible thinking with the increasingly-discussed risk of a double dip recession, as in this quote from today’s Guardian –

Signs of deep rifts at the G8 and G20 summits in Toronto over how quickly governments should cut deficits added to financial market jitters today, with the Americans warning of the dangers of a double dip recession if all countries started to rein back spending at once.

What that leaves you with is the financial analogue of St. Augustin’s famous quote: make the banks better capitalised but not yet. The Basel committee meeting to finalise the third accord is certainly going to be interesting.

Update. Even Robert Preston has noticed the issue. As he says, the fear is that if we insist that banks lend less and less riskily relative to their capital at this particular juncture, they’ll respond by turning off the credit tap more-or-less completely – and we’ll be tipped back into recession.

Posted in: Basel by David /
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It’s funny how things change. Ten years ago if you had suggested that a sophisticated investment bank did not know how to value a plain vanilla interest rate swap, people would have laughed at you. But that isn’t too far from the case today.

Things were fine until the crunch. But during 2008 and 2009, two phenomena arose which changed thinking about what a swap is worth for good.

The first had been around for a while, but had often been ignored. It is the cross currency basis swap. Here we swap say 3m dollar libor for 3m yen libor.

Now, these swaps _should_ price flat according to naive swaps pricing theory. That is, market participants should be willing, at least ignoring bid/offer spreads, to enter into that swap without a spread. After all, the definition of the forward FX is given by the respective interest rates, so the forwards should price to par. The trouble is, cross ccy basis swaps don’t trade flat. This has been a worry in yen vs. dollars for a while, but not too troubling in other ccys. In the crunch, though, the cross ccy basis sawp spread went to 100 bps at longer maturities in some other currencies.

This was the first sign that the standard no arbitrage argument was not working.

The second is tenor swaps. A tenor swap swaps one tenor of Libor for another, 3m USD Libor for 6m USD Libor say. Standard theory says that you can derive 3m Libor 3m forward from 3m spot Libor and 6m Libor by saying that there is no free lunch – you should not be able to make money by borrowing for 3 m and then another 3 vs. lending for 6 or ther other way around. Thus tenor swaps should price flat.

But sadly 3m vs. 6m tenor swaps trade, and they do not price flat either. Ooops.

So clearly the derivation of 3m Libor 3ms forward from a naive no arb argument is wrong. And that is how we have been deriving the Libor curve for 25 years. Big oops.

What is wrong?

One way to understand it is to realise that there is a difference between investing a Libor for 3m and then for another 3 and investing for 6: at that is in the first trade, you can pick who you want to leave the money with for the second 3m period. So in a world where banks are risky, 3m then 3m is safer than investing for 6m thanks to the embedded credit option.

Another problem is collateral. These days, again thanks to credit risk, most interdealer swaps trades are collateralised at least to some extent. And that collateral does not earn Libor, it earns OIS. Thus once think about replicating a swap’s cashflows including collateral, you are naturally drawn to the OIS curve for discounting.

Finally, there is funding. The assumption that a major swaps market participant funded at Libor flat was not too bad in 2005 — it was clearly tosh in 2008.

So where does that leave us? Well, with a list of desiderata for a swaps pricing model that only a few houses can meet:

• It should recover the quoted prices of quoted instruments in multiple ccys including plain vanilla IRS, cross ccy IRS, basis swaps and tenor swaps to within bid offer spread.
• It should correctly price swaps with and with collateral.
• It should be arbitrage free.
• It should correctly include the firm’s cost of cash and collateralised borrowing.

And that is harder than it looked in 1990. The state of the art is to build one discounting curve based on OIS (assuming your deals are mostly collateralised) and different prediction curves for the different tenors (1m, 3m, 6m etc.). Transformation from one tenor to another involves a quanto adjustment just as if it were another currency.

Update. I should say too that then there is CVA (the adjustment for the counterparty’s credit) and DVA (the adjustment for your own credit). But that is a story for another day.

Posted in: Derivatives, Hedging and Convexity by David /
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An interesting data point here. This is the spread history of European 3-5y AAA CMBS spreads and RMBS in various countries. Clearly the AAAs, well, aren’t, but confidence is returning to some extent. The RMBS have always been better, and in somewhere like the Netherlands, where default rates have historically been rather low (partly because recourse is so extensive there), the AAAs will doubtless come in further. I doubt we will see new issues in France at more than 200 over, but clearly conditions are approaching levels where new RMBS might make sense for some issuers.

Posted in: Securitisation and Tranching by David /
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A couple of thoughts about sovereign CDS. I’ll kick off with an article from Derivatives Week. They say (from behind a firewall):

Increased hedging by banks has been an influential factor behind moves in sovereign credit default swap spreads, according to the Bank of England. In its quarterly bulletin, the central bank said that according to its contacts in the industry, specific counterparty valuation adjustment desks of banks with large uncollateralized foreign exchange and interest rate swap positions with supranational or sovereign counterparties have been hedging positions in the sovereign CDS markets.

(The Bulletin is here.)

This is a classic example of unintended consequences. One element of Basel 3 is a capital charge for the variation of counterparty valuation adjustment – basically the adjustment derivatives traders take to reflect the credit quality of their counterparties. The CVA is largest on uncollateralised swaps: collateral reduces it massively. And which is the most significant class of counterparties who refuse to post collateral? Sovereigns and supranationals. Therefore making banks hedge their CVA better has the effect of forcing them to buy more sovereign CDS, which in turn may increase government borrowing costs. Spread widening isn’t necessarily caused by the evil CDS market speculating on sovereign default; instead it may well be regulatory action that is the cause.

What to do about it? That brings me to my second, more speculative riff. Whatever the cause of sovereign CDS spread widening, if governments don’t like it, the answer is clear. Write CDS on yourself. The principle is actually well established in the corporate area. An ISDA claim is pari passu with senior debt, therefore in the event of default a self-written CDS gets recovery. (OK, it is a little more complicated than that given the auction process, but it’s broadly right.) Therefore if you think, say, recovery = 33%, a self written CDS is equivalent to a CDS written by a risk free counterparty on a third of the notional. Governments need simply go into the sovereign CDS market and write protection on themselves in crushing size. That would bring spreads in fast, and raise them some premium income in the process. Simples.

Posted in: CDS and Negative Basis by David /
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Bloomberg reports:

HSBC Holdings Plc’s $3.4 billion issue of undated 8 percent notes marks the first sale of debt securities designed to qualify as capital under current and proposed bank regulations.

The bonds count as so-called Tier 1 capital under current rules by permitting HSBC to defer coupons in some circumstances and benefit the bank because it pays interest from pretax earnings, according to the deal’s prospectus. To meet new terms proposed by regulators, HSBC can convert the notes into preference shares that pay dividends from after-tax earnings…

The Basel Committee on Banking Supervision proposed in December phasing out so-called innovative hybrid securities such HSBC’s because they failed to absorb losses during the financial crisis. When the rules change, set for the end of 2012, innovative securities issued after the proposal date won’t qualify as Tier 1 capital.

Close, but no cigar. It is not clear when the grandfathering date will be: it certainly might be earlier than the end of 2012. So this is a ballsy play from HSBC. They are essentially gambling that these notes will count as capital: and they have a par call in Dec 2015 in case they don’t.

Investor demand for this issue was immense: initial guidance was 300 million, so the deal was upsized over ten times. This shows that the lack of recent bank issuance – caused by uncertainty over what will count as capital in Basel 3 – has left investors panting for good quality names. We will surely see other banks issuing similar deals in the coming months. Once it is clear what will count as capital, everyone will be coming to market: the smart players will get ahead of that wave.

Posted in: Basel, Capital and Contingent Instruments by David /
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We will be back shortly.

Posted in: Photography by David /
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Larry Elliott has a thought provoking article in today’s Guardian. He quotes Roubini, who says

… that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”

But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.

Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.

Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.

What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen … until there is system failure.

This is an interesting thesis. I don’t wholly buy it, but the idea that precisely by doing enough to fix the immediate problem, but not enough to address its causes, we have left ourselves exposed to a Japanese style slow, shallow but long lasting recession is interesting. Certainly by missing the chance to nationalise the worst affected parties, such as RBS, we also lost the opportunity to restructure banking broadly. It might well turn out that that ideologically-motivated decision was a bad one. That won’t be clear for some years, and it may well be that the summer 2010 panic is minor. But if it isn’t, we will be criticising 2008’s crisis management for some time.

Posted in: Mother of all Bailouts by David /
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FT Lex (behind an increasingly annoying firewall) says:

…a bank should not have to hold as much capital against US government debt as for complex structured loans. Basel … rules therefore attribute different capital ratings according to risk. At the top of the pile, government bonds rated AA and above are assigned a zero risk weighting.

They then suggest that this is a problem, and that banks should not be able to use infinite regulatory capital leverage on e.g. buying Spanish government bonds.

I agree, and I think that the lowest risk weight should be 3 or 4% rather than 0%. (That is, after all 25 or 33x leverage.) But note that the FT’s point is not true in the capital rules used by most large and many medium sized banks, the IRB: it only applies to the standardized approach. In the IRB, the minimum PD is 0.03% rather than 0%. That is not enough, as we suggested earlier, but it is a good start. The proposed Basel III balance sheet leverage constraint might help here too, if it is well-designed (which the current proposals aren’t). In fact, it occurs to me that you can kill two birds with one stone: there would be no need for the leverage requirements if you removed 0% risk weights in the standardised approach and set the minimum PD high enough (0.07%? 0.1%??) in the IRB.

Update. I got one of the details wrong above. If the risk weight is 4%, then the capital charges is 4% of 8% of notional, or 0.32%. That’s 1 / 0.32% or 312x leverage. Ouch. Maybe a 10% minimum risk weight is more like it.

Posted in: Basel, Credit by David /
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Ricardo Caballero has an interesting idea:

the fundamental problem in the current global macroeconomic and financial equilibrium is one of asset shortages. In particular, there is a shortage of safe “AAA” assets. The world seems to need more US Treasury-like instruments than are available.

This shortage of safe assets existed before the crisis, but it is even worse today. The demand for these assets has expanded as a result of the fear triggered by the crisis – as it did for emerging markets after the 1997-1998 crisis. But this time the private sector industry created to supply these safe assets – the securitisation and complex-assets production industry – is severely damaged.

Broadly I think that he is right. The demand for safe assets was one of the key enablers of the credit crunch. There was a wall of money looking for AAAs. Now of course that source of AAAs is gone, but the demand hasn’t. This means low rates for real AAAs, and that is not good for the real economy (as opposed to bank’s earnings). No, Ricardo has a point: it is time to expand the range of true AAAs, perhaps via government guarantees on private sector assets. Only this time (pace Fannie and Freddie), the government needs to charge the right amount for its credit enhancement.

Posted in: Credit, Markets by David /
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Even for me, I will admit that is a cryptic title. It gets worse. It’s about accounting.

Let me explain. The principal US accounting standard about fair value was Federal Accounting Standard 157, or FAS 157 to its (few but loyal) friends. As part of its update, 157 has acquired a new number, and it is now FASB ASC Topic 820, Fair Value Measurement and Disclosure. The FASB text is here.

Why should you care, dear reader? Well, there are two things in 820 that struck me as apposite; one good, one bad.

(At this point if you don’t know about the three levels of FAS 157 you might either like to read about them or skip to the next post.)

The good one first.

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Now the bad part. They have made this a lot less useful than it would otherwise be by extending (or at least clarifying the extent of) level 2.

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied might be in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Update. I looked for the corresponding point in IFRS 9 and didn’t find it, because it is in IFRS 7. Duh. Anyway. It’s no clearer there.

Posted in: Accounting by David /
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A long time ago, I asked if it was possible that Lance Armstrong might be on drugs. A few people thought that he wasn’t. Now, the evidence seems somewhat firmer. All I will say is that I would never trust anyone who could subtitle a book My Journey Back To Life. Surely he should have his medals removed on grounds of schmaltz alone?

Posted in: Sport by David /
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Last year, several banks structured some CDO-squared, or Re-remic deals. These were typically repacks of old RMBS which had eroded in quality: the point of the repack was to produce a new AAA tranche by introducing more credit enhancement.

Bloomberg now reports that this did not work so well. What was AAA last year is now junk.

So what? Well, it seems that some people who appear not to understand structured finance are upset. Felix Salmon says

S&P knew, when it was rating these re-remics, exactly where it had gone wrong in the first round of structured-credit ratings, yet somehow was unable or unwilling to fix the problems in that group.

A rating can be right last year, and wrong today. This is especially true in structured finance, where deals are typically highly robust for a certain level of stress, but then fail catastrophically beyond it. While a corporate bond might degrade slowly; 100, 99, 98, 97, 96; a structured finance deal is more like 100, 100, 100, 100, 40. If the probability of getting the 40 is low enough, the deal can (and often both was and is) be rated AAA. All this shows is the foolishness of trying to encapsulate the whole CDR/CPR risk space in a single letter grade.

Posted in: Ratings, Securitisation and Tranching by David /
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Usually I abhor exclamation marks, but this one seems appropriate. Little noticed by most of the financial press, the first private label US RMBS deal since the crisis closed a little while ago. Dow Jones reports:

The first residential mortgage bond to come to market after the housing bubble burst was sold on Friday to strong investor interest.

Bidding for the $222.4 million triple-A-rated deal from Redwood Trust was so strong that investors were willing to accept a lower yield–3.75% instead of the original 4%.

The deal is composed of particularly attractive mortgages–jumbo loans made to high-net-worth borrowers with good credit histories who put more than 20% as down payment. CitiMortgage, a unit of Citigroup, originally made the loans.

80% LTV jumbos to high FICO borrowers does sound like reasonable risk. The AAAs, though, were attached at 6.5%, which gives a relatively thin layer of credit protection – yet the deal was apparently eight times oversubscribed. If you want to google, the issuer is I think technically Redwood’s Sequoia Mortgage Trust, and the deal is dubbed “SEMT 2010-H1″. The big picture take away though is clear: the RMBS market is back.

Update. WAL 3 years, WAY on the portfolio 4.8%, average loan size $932K, 74% IOs (!), WA Original LTV 57%, WA FICO 768, 46% California. I’d like to know the loan age to get a sense as to how good that LTV really is. If they are recent, then it looks like a safe deal. If they are two years old, not so much.

Posted in: Mortgages, Securitisation and Tranching by David /
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I should admit from the outside that I have, very rarely, worn a cravat. It was however ironic. Or some such similar excuse.

With that out of the way, let’s turn to Morgan Stanley and their dead presidents. The problem for MS is that there are some suggestions that it misled investors. These are similar to the Abacus accusations against Goldman although, so far as I know, there are no formal charges thus far, although there is apparently an investigation.

Let’s put this into context. To do that, consider the following. A trader at BBB (Big Bad Bank) decides that her life would be easier, and she could make more money, if she could put some long dated equity put options. In fact, most equity derivatives traders would love to do this as running a equity derivatives book which is long vega in the wings is safer than running it short. The problem is because lots of people want this position, it is hard to acquire, and usually expensive. But the BBB trader has an idea. She contacts a large, credit worthy corporation who she thinks might sell her the puts. And, lo, they do.

Now what we have here is a trade entirely structured to meet the firm’s risk management objectives. No consideration has been given to whether the trade is suitable for the customer: they are simply a convenient supplier of what is needed. In the current climate you might conclude that something must be wrong.

What if I tell you that the corporation is Berkshire Hathaway and that Warren Buffett personally agreed the trade?

There are two sides to every transaction. Someone wants to buy and someone wants to sell. Now, contrary to popular belief, this is not a symmetric situation. Both can win: both can lose: or one can win and one can lose. (This is because one party might be hedging and the other might not be: if a call goes up, an unhedged long might make money, if the short hedges, then they can make money too depending on the level of delivered volatility vs. the price of the option. But that is a story for another day.) But even if it were symmetric, provided that they both know what they are doing, and information asymmetries have been overcome, why should we not let caveat emptor have a role?

It may well be that Morgan Stanley structured a trade because they wanted to go short. I don’t see a problem with that. No one was forced to buy CDO tranches. Just because you lost money doesn’t mean that you were necessarily cheated. It just means that you are not as smart as Warren Buffett. But then who is?

Update. Some of the MS deals have reinvestment risk (sometimes known as extension risk). That is, rather than the CDO amortising as the underlying bonds do, the funds are reinvested in new collateral. Bloomberg quotes an Ambac executive regarding this risk:

“I can’t imagine anybody would take that bet knowingly… You’re overriding the natural process of risk-mitigation.”

Resisting manfully the temptation to make sarcastic remarks about anyone listening to Ambac talk about risk, I will say that lots of people did take that bet knowingly. Investors wanted term deals. They clamoured for them. Managing the uncertain flow of cash from an amortising mortgage deal was too much trouble, and they preferred something that looked more like a corporate bond.

The idea that there is a ‘natural process of risk-mitigation’ is absurd. There’s nothing natural about risk-mitigation. It is something you choose to do because you don’t like a risk. Of course, that assumes that you thought about the risk and made a decision. Perhaps if more investors in deals with extension risk had done that, we would be in better shape.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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A little while ago I speculated on a possible Ponzi scheme (in fact if not in intention) in pre Crunch CDOs of ABS. The basic idea is that there was a false market in subprime RMBS tranches if there were no real bids, or few real bids, for mezz tranches other than other CDOs.

Bloomberg now leaps into the debate with an article How Wing Chau Helped Neo Default in Merrill CDOs Under SEC View. The key part:

“People on the outside thought the market was going gangbusters because of all the deals getting done,” said Gene Phillips, director of PF2 Securities Evaluations, a New York- based company that helps banks and funds evaluate CDOs. “People on the inside knew this [i.e. the CDO-squared and managed CDO business] was a last-gasp attempt to clear out the warehouses”…

Interactions across the industry among bankers, asset managers, ratings firms and lawyers contributed to what Lang Gibson, head of CDO research at Merrill until early 2008, called a “Ponzi scheme” of CDOs buying other CDOs.

Posted in: ABS, Securitisation and Tranching by David /
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What I’d like to see in the current political mess is a grand coalition of the progressive parties forming around a Queen’s speech with one commitment – parliamentary reform, including a referendum on proportional representation (and ideally a fully elected second chamber). What I fear we will get is a Tory-LibDem pact without electoral reform. And that would be a tragedy.

Posted in: Politics by David /
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I attended a meeting last week at which a doctrinaire free markets economist was praising the benefits of a market in markets. The theory was that lots of different markets in the same asset would somehow give better liquidity, cheaper trading and hence better price transparency. What tosh.

No, what we see instead is that a diversity of markets produces poor liquidity, gappy markets, and just occasionally, near disaster. That seems to have happened on the 6th of May, when a market fall erased a trillion dollars in value in what Bloomberg dubs a ‘flash crash’. The WSJ account is here. It seems that a ‘fat finger’ trade, i.e. a mistaken transaction where perhaps a trader executed billions rather than the intended millions set off the wave. What happened then, it seems, is that waves of automated trading intensified the problem. Some of the smaller dark pools – alternative markets – were overwhelmed by the orders placed and became disorderly.

As Rajiv Sethi says, this is a recipe for disaster: computer-driven trading executed in milliseconds, poor liquidity, and no automatic trading stops make for instability.

The Bloomberg article above then says

One SEC memo, according to people who saw it, discusses a theory raised yesterday by NYSE Euronext spokesman Ray Pellecchia, who said sudden price moves in multiple stocks reached so-called liquidity replenishment points. That prompted the exchange to slow trading in those shares as it tried to ensure an orderly market. Such incidences allow other exchanges to ignore NYSE price quotes.

Trades sent to electronic networks then fueled the drop, said Larry Leibowitz, chief operating officer of NYSE Euronext. While the first half of the Dow Jones Industrial Average’s 998.5-point plunge probably reflected normal trading, the decline snowballed as orders went to venues lacking liquidity to match them, he said in an interview yesterday…

NYSE competitors such as Nasdaq OMX Group Inc. don’t use liquidity replenishment points. The SEC and CFTC in their joint statement raised concerns that the plunge may have been caused by exchanges not adhering to uniform practices.

“We are scrutinizing the extent to which disparate trading conventions and rules across markets may have contributed to the spike in volatility,” the regulators said.

No wonder. It is time to end this market in markets, and to throw some sand in the cogs of the algos. If every trade executed in the same, say, five second interval got the same price, instability would be greatly reduced, yet ordinary investors would not notice the effect. And if every trade were executed on the NYSE, or at least using the same market conventions, then officials could actually stop everything when things get out of hand.

Update. Here’s the letter from Senators Ted Kaufman and Mark Warner asking the SEC and CFTC to investigate the events of the 6th. The joint SEC/CFTC ‘we are looking at it’ letter is here.

A very readable and plausible account from a sell side analyst is here. I’m going to quote it at length as it deserves the widest possible dissemination:

I’ve got 28 pages in front of me of P&G prints [individual trades in Procter and Gamble] that occurred between $39 and $50 per share and between 2:46 p.m. and 2:51 p.m. At 36 prints per page, that means P&G traded over one thousand times at those “crazy” and “surely erroneous” levels. I’m sorry, but that isn’t an error, THAT IS WHAT WE LIKE TO CALL TRADING. So what happened here? Three things:

1. Sellers probably had orders in algorithms – percentage-of-volume strategies most likely, maybe VWAP – and could not cancel, could not “get an out.” These sellers could be really “quanty” types, or high freqs, or they could be vanilla buy side accounts. It really doesn’t matter. The issue here is that the trader did not anticipate such a sharp price move and did not put a limit on the order. The fact that the technology may have failed does not mean the trader deserves a do-over, it means that the trader and the broker who provided the algorithm need to decide whether any losses should be split.
2. Sell stop orders were triggered which forced market sell orders into an already well offered market.
3. While the market was well offered, it was not well bid. Liquidity disappeared. For example, in P&G, 200 shares traded at $44.10 at 2:51:04 in the afternoon and one second later, at 2:51:05, three hundred shares traded at $47.08. That’s a three dollar jump in one second. Bids disappeared, spreads blew out, and no one was trading except a handful of orphaned algo orders, stop sell orders, and maybe a few opportunists who had loaded up the order book with low ball bids (“just in case”). High frequency accounts and electronic market makers were, by all accounts, nowhere to be found.

It boils down to this: this episode exposed structural flaws in how a trade is implemented (think orphaned algo orders) and it exposed the danger of leaving market making up to a network of entities with no mandate to ensure the smooth and orderly functioning of the market (think of the electronic market makers and high freqs who can pull bids instantaneously as opposed to a specialist on the floor who has a clearly defined mandate to provide liquidity).

Posted in: Markets, Regulation, Software and Virtual Worlds by David /
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From Ben Bernanke’s speech, The Supervisory Capital Assessment Program–One Year Later:

Importantly, the concerns about banking institutions arose not only because market participants expected steep losses on banking assets, but also because the range of uncertainty surrounding estimated loss rates, and thus future earnings, was exceptionally wide. The stress assessment was designed both to ensure that banks would have enough capital in the face of potentially large losses and to reduce the uncertainty about potential losses and earnings prospects.

The premise here is I think entirely accurate: it was not just current losses that were spooking investors during the Crunch, it was uncertainty over how large future losses would turn out to be. I’m not sure the FED’s stress assessment did that much – the capital and liquidity injections were much more important – but still, the phrasing is interesting. (Remember that the stress tests were not that stressful.)

Later in the speech, Ben makes another interesting point:

Importantly, to conduct effective stress tests, banks need to have systems that can quickly and accurately assess their risks under alternative scenarios. During the SCAP, we found considerable differences last year across firms in their ability to do that. It is essential that every complex firm be able to evaluate its firmwide exposures in a timely way. One of the benefits of the stress testing methodology is that it provides a check on the quality of firms’ information systems.

As I discussed, one reason for the success of the stress tests was the public disclosure of the results. We are evaluating the lessons of the experience for our disclosure policies.

Clearly there is the potential for disclosures here to be really insightful for investors. We have seen how useless VAR disclosures were for predicting losses during the Crunch: perhaps stress tests results, especially if standardised across the industry and thus directly comparable, will be more useful. It certainly can’t hurt (well, it can’t hurt unless an actual loss appears in a situation which is close to one of the ones tested, and it is much bigger than that test would have indicated). Stress tests are here to say, and financial institutions will need to get used to them; to resource themselves so that they can run them easily; and to prepare for the consequences of disclosing the results of them.

Posted in: Accounting, Fair Value, Mother of all Bailouts by David /
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In the past I have made the argument that there is a trade off between financial stability and growth. You can have low growth and financial stability; you can have high growth and instability; if you get it really wrong, you can have low growth and instability. But what you can’t have is high growth and stability. The new Basel reforms in bank capital will have an impact on the growth rates of the economies in which they are applied.

There have been various hints at the quantification of this recently, including a ’secret’ estimate prepared by PWC for the British Banks. But now Nout Wellink, chairman of the Basel Committee, has revealed according to the FT that

Economists at the Dutch central bank had calculated that the proposed reforms would knock a cumulative 0.5 to 1 percentage points off global growth

Wellink apparently thinks that ‘that price is not too high’. I wonder if finance minsters of the G20 will agree with him. After all 1% is little enough if you are China with 12% growth: but it is a lot for the Eurozone with GDP growth less than 1% already…

Posted in: Regulation by David /
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One of the things that depressed me most about the UK Labour government of Tony Blair (and God knows there are enough items on that list) was their failure to live up to the ‘education, education, education’ motto, especially with regard to higher education. Gordo, of course, has not changed this approach, and things will be substantially worse for Universities whoever wins the election. I have been meaning for a while to cast this critique in the light of an excellent presentation A Life Beyond the Golden Arches from Simon Shurville.

Shurville identifies some key trends in education:

• The rise of academic capitalism, where the purpose of research becomes the production and exploitation of intellectual property;
• A massive growth in student numbers, leading to commodification of learning.
• This, when combined with a new culture of supposed accountability (which of course means being able to prove not that you did something good, but rather that you did not do something bad), in turns leads to what Shurville refers to as the McDonaldisation of higher education. Essentially principles first elaborated in high volume service industries are now being applied to higher education.
• A lack of resources and the danger of truly innovative research and teaching – that it might fail – intensified these trends.

The presentation suggests that flexibility delivery and IT can help. I’m not so sure. I think we have made several key errors in higher education policy, and it is only by reversing them that we will succeed.

First, funding. University research and teaching in the UK needs more money. Simple.

Second, access. Too many students are going to University, partly because the status of non-University forms of Higher and Further Education are low. This too will require a considerable amount of money as well as deliberately engineered cultural change to fix. The natural consequence of this is that there should be fewer departments claiming to be research active. Ten or twenty great departments in a subject in the UK are a lot better than fifty mediocre ones. And yes, some of those mediocre ones today are in Russell Group Universities. A few of them even, whisper it not, are in Oxbridge. It is time to admit this truth and deal with it.

Third, University academics should be accountable not narrowly on student satisfaction or the (now officially recognised) inanity of the research assessment exercise. The new Research Excellence Framework is no answer, especially given its enthusiastic embrace of academic capitalism. Rather we need a long term research assessment framework that facilitates academic freedom yet forces academics to actually do their jobs. That means single digit contact hours per week, with most ‘teaching’ done by graduate teaching assistants, should not be acceptable. Passionate and talented academics in my experience want to teach, and many great institutions (including the leading North American ones) force their professors to spend time with students.

Academic capitalism is all very well, but it should not be the only reason we fund universities. This is true not least because it is often the most obscure and theoretical of studies that generate new industries, so if you stick to what seems to be economically significant, your industries will in fact underperform thanks to lack of really radical new ideas. We need to walk away from the trends of recent years, and rediscover what universities are actually good at, and who they are actually good for.

Posted in: Politics by David /
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There is a noticeable piece of terminological gymnastics that commentators engage in when discussing regulatory measures. If they are in favour of something, they call it risk sensitive. If they are against, they call it procyclical. Now, not all risk sensitive measures are procyclical and vice versa, but the connection between them is strong, and the tension is unavoidable.

This is particularly so as there is a paucity of satisfactory solutions to modifying current regulatory arrangement to make them less procyclical. The ‘Spanish’ dynamic provisioning scheme is one suggestion, but this only addresses expected loss provisions not capital, and it is anyway fraught with difficulties, many accounting-related. (Some firm’s accounting is focussed only on provisions for loans which are already uncollectable, in some sense; others provision for expected future losses which have not yet occurred: many mix the two. The Spanish proposal essentially allows for a flow from the EL provision into the incurred provision in bad times, and forces higher EL provisions in good ones, but it only works if you have both types of buffer.) Clearly if one could identify the place in the cycle then one could set an anticyclical capital buffer, for
instance requiring a 10% Basel ratio at the top of the cycle vs. a 6% one at the bottom. But the difficulty is knowing where one is. It seems (and this is anecdotal – I will try to find a reference) that the ratio of credit growth to GDP growth is a reasonable way of identifying the upswing in the economic cycle, but that it is less helpful for spotting a crisis. One could perhaps devise a methodology involving various stress indicators such as the price of credit (i.e. bond and CDS indices), the price of liquidity (i.e. the spread between interbank and government rates), market volatility indicators (such as the VIX) and country risk. But the model risk is considerable.

Subjective judgements are also problematic. Imagine the impact on confidence if the financial stability board officially announces that we are in a crisis and so bank capital ratios have been cut by 2%. A clearer signal to stop lending in the interbank and repo markets is difficult to imagine.

Another problem with risk sensitivity is that, like any measure which discriminates, well, it discriminates. Specifically it makes credit more expensive for borrowers which are perceived as riskier. If you want to ensure that access to credit is broad, and that the price of credit does not vary too much over time, then that is problematic. Certainly some governments do want to achieve this end, claiming that it is a societal good. In that case, having ever more risk sensitive capital requirements gets them further from their goal, not closer.

Of course, the argument in the other direction is forceful. If capital requirements are not risk sensitive, then some trade or other will be incentivised: in the case we suggest, it will be better to lend to low credit quality companies and worse to lend to AAA corporates. If one has a bias at all, that one makes sense, as high quality companies have access to the bond markets, whereas low quality ones often do not. However the subprime crisis demonstrates the dangers of making credit too cheap for bad borrowers, so more generosity is not necessarily better.

Posted in: Regulation, Rules by David /
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Nicola Gennaioli, Andrei Shleifer, and Robert Vishny have a new paper on Financial Innovation and Financial Fragility which makes some interesting points.

Their basic claim, to distil an extended argument into too small a space, is that financial innovation often causes instability because the risks of the innovative instruments are misjudged. In particular, securities are often created which are judged as safe, but which have significant tail risk. When the markets visit this tail, a crisis results as investors sell the innovative security: there is a flight to simplicity.

There is much to commend in this model. It seems to capture some salient facts of not just this but previous crises (CDOs in 2008, CMOs in the early 90s, junk bonds in the 80s). However, one area where I do not wholly agree with their account is in why investors buy these innovative securities. The paper says:

We assume that both investors and financial intermediaries do not attend to certain improbable risks when trading the new securities.

That may be true for some investors, but I think that the dynamic is more subtle. Firstly these innovations are a phenomenon of plenty: they happen when there is a lot of money looking for a home. In such conditions, government rates tend to be depressed, and credit spreads collapse. Innovation rightly searches for yield, as there is enormous investor demand for it. One way to create a low probability of default security with a yield above government rates is to take a completely safe security and then take a bit of unlikely-to-happen risk. In options terminology, you sell an out of the money put. Or in ordinary parlance, you insure an unlikely event. The extra premium received juices up the yield of your safe investment.

Now, of course, the problem with this is that if that unlikely event does come to pass, you are creamed. But if everyone is doing it, and everyone thinks the premiums are attractive given the risk, the tempation to join in is considerable. You might very well understand exactly what you are doing (at least in terms of what might happen), and yet still decide to participate. Of course, typically here there is a general misestimate of the probability of these unlikely events, but that isn’t the point. The risk is not ignored: it is simply judged acceptable, given the rewards. Investor greed, in other words, rather than stupidity, drives innovation.

Krugman moreover points out one reason why estimating the probability of these tail events is difficult:

The low-probability event that revealed the falsity of these perceptions [that the innovative security was worth buying] wasn’t exogenous. What has happened instead was that the very growth of the financial sector led to an upward trend in asset prices that masked the real risks — the way the housing bubble masked the true risks of subprime lending is a key example, but not unique.

In other words, by buying these securities, an investor stimulates the creation of more of them, typically with lower standards, less yield and higher risk, and thus increases the probability of a bad crash.

Posted in: Rules by David /
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Deus Ex has tried, and mostly succeeded, to post daily since the start of the financial crisis. Now, though, the posting rate has slowed, and that will probably not change, at least for a while. The reasons are multiple: there is a new stridency about much financial blogging, which I do not want to emulate, and which is clearly a risk; there is a new hostility, too, with both readers and writers willing to blame before seeking to understand. I heard a new definition yesterday of a financial derivative: it is of course that instrument which takes the blame in any problematic situation, regardless of its role.

Clearly regulatory changes are needed. We have argued that all along. But much of what is being proposed at the moment is disproportionate, ill-designed, and badly targeted. Some of it will even make matters worse. (A good example is central clearing: if you can only clear 75% of trades – and that is likely to be the case for some years, regardless of regulatory pressure – then for most counterparties, central clearing will actually increase credit risk, as some of the clearable trades will be offsets for the non-clearable ones.)

The Goldman vs. SEC case also worries me greatly. This is not because I don’t think Goldman did anything wrong: I have no idea if they did anything wrong. But the disconnect between what the case is about and what it is portrayed as being about is deeply unhelpful. The complaint accuses them of failure to disclose relevant information. This has been reported as designing a security which they knew would fail. One can easily be guilty of the former without having contemplated the latter. So, while the headline ‘Goldman accuses of fraud’ might be helpful for certain political agendas, it is actually somewhat distant from the truth.

In an effort to retain a degree of equilibrium, therefore, and to try not to fall into the trap of writing knee jerk posts, Deus Ex is going to slow down. Expect slightly longer posts, rather less frequently.

Posted in: Legal Risk and Trade Documentation, Mother of all Bailouts, Regulation by David /
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In all the comment about SEC vs. Goldman, the transaction structure has not been very clear. So what happened?

Conceptually it’s not too complicated. First suppose we have an ordinary CDO: an SPV buys some bonds and issues some tranched securities. Easy.

Now suppose that a hedge fund wishes to bet that the bonds will decline in value. It can’t short them as you would an equity as there is no borrow market. So instead it buys CDS protection on them, paying the SPV a premium in exchange for protection on the bonds.

Perhaps in order to have some role in the structure, perhaps to reassure investors in the higher tranches, or perhaps for other reasons, the hedge fund then buys some or all of the equity tranche. This tranche will perform reasonably if the deal goes well and in some cases when it goes badly. (That part is counterintuitive until you remember that in many circumstances the equity gets the excess carry after the other tranches have been paid even when it has suffered complete principal loss. A 20% coupon for ten years is good even if you don’t get any principal back at the end.)

The effect of the hedge fund’s short is to upsize the deal: it now has risk from the securities it bought, plus the risk supplied by the hedge fund’s short. It can issue more tranched notes than it would have done earlier, thanks to the synthetic short.

If the fund had written protection on a tranche rather than the underlying securities, then that simply increases the size of the relevant tranche. The tranche investors, of course, do not necessarily know that the short is in place. And therein may lay the problem…

Update. Alea has a different description from me, not least because they have different facts. They say (and I do not know that they are wrong) that Abacus is a pure synthetic deal, not a hybrid. If that is true, we can ignore the equity as no one had that.

What Alea describes is:

• Paulson buys protection on the 45% to 100% tranche from GS;
• GS is short, and buys that protection back from the SPV;
• The SPV is now short on the 45% to 100% tranche;
• The SPV buys a financial guarantee from ACA on the senior attached at 50%. ABN buys the wrapped bond.
• GS buys the 45% to 50% tranche from the SPV.

This much makes sense. Paulson is short the 45%-100%, the SPV is flat, ACA is long the 50%-100%, and GS is long the 45% to 50% tranche. It probably did not want that, but my guess would be that it kept it to make the deal work.

The trouble is, this does not account for the mezz. IKB and ACA bought the mezz tranches from 10% to 45%. Where did that risk come from? Someone had to write a default swap on that in a purely synthetic deal. If GS wrote it, then they were short the 10% to 45% tranche and their $90M loss (which fits well with their only position being long the 45% to 50% tranche) does not make sense. Alea seems to imply that GS wrote this swap then sold it on to Paulson, which would fit with their P/L. It also means that Paulson was short all the way from 10% up to 100%. This is consistent with the claim that Paulson made more than $1B on the trade: at 45% to 100%, it is difficult to see how Paulson could have made that much, as the total notional would only been $1.1B, and the supersenior recovery is likely more than 10 cents on the dollar.

Posted in: Securitisation and Tranching by David /
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Not proven, thanks to realistic doubt. Level 3 is your friend.

Posted in: Accounting by David /
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Via Felix Salmon, I picked up a post by the Streetwise Professor on the CME liquidation of Lehman’s positions. Remember that Lehman’s portfolio on the exchange comprised liquid contracts which the exchange might have you believe can easily be valued. Nevertheless, the liquidation of these positions cost Lehman’s estate $1.2B more than its marked value. This reflects the point made in the previous post about closeout always being lower than going concern value.

The Streetwise Prof calls the problem replacement risk:

when somebody defaults, its counterparties have to find new firms to take the place of the defaulter. In stressed market conditions associated with the failure of a major dealer or trader (e.g., LTCM), it is likely that these replacement trades will occur at prices that deviate substantially from the prices prevailing before the default; those stepping in for the defaulter are only willing to trade at far more favorable prices than the pre-default prices.

Well, that’s exactly what happened here. Goldman, DRW, etc., replaced Lehman as the counterparty on these trades, and were only willing to do so at prices that differed substantially from the pre-auction prices. In the event, Lehman’s collateral was sufficient to cover the replacement cost (this can happen in the OTC market too), but it is not outside the realm of possibility that the collateral of a big defaulter would not be sufficient, and that other clearing members would be called on to make up the difference.

This should be a cautionary tale for those hot to force a substantial extension of the use of clearing. Many of the products that are not cleared now, but which would be cleared under mandates, would be less liquid, more difficult to value, and pose risks more difficult to evaluate than currently cleared products like those that Lehman held at CME (and similarly, at LCH.Clearnet’s SwapClear). As a result, any replacement cost problem would likely be more severe than that experienced at CME in 2008, and the risk that collateral would be insufficient would be greater.

Just how much capital, exactly, would the clearing house need to cover replacement risk for all these new contracts it will have to clear?

Posted in: Clearing and Collateral, Derivatives, Hedging and Convexity, Markets by David /
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I like Steve Randy Waldman so I don’t want to cricitise him too much, but I think he makes an error in the following:

On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September 15, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B.

What’s wrong? I suspect at least the following:

• First, the costs of bankruptcy are considerable. The Enron liquidation, for instance, involved fees of more than $600M, and Lehman is a lot more complicated than Enron. Therefore we can chalk up at least a couple of billion to bankruptcy costs, and probably more.
• In bankruptcy you are a known, forced seller (and terminator of derivatives contracts). The Lehman bankruptcy happened in a crisis – indeed in some ways it caused it. This meant that Lehman’s assets were liquidated under the worst possible conditions. The fact that they were sold for less than their holding value is unsurprising. A 20% discount to sell an illiquid asset in hurry would not be surprising – and Lehman had at least $300B of illiquid assets. So perhaps $60B here.
• More to the point, while Lehman sailed fairly close to the wind on its valuations, what it did not do – what few firms do – was be honest about the uncertainty in those valuations. If you read the detail of the valuation section of the Valukas report, you will find that a lot of the time, the correct value of assets is simply impossible to determine. What Lehman did was not perhaps conservative, but it was not illegally aggressive according to Valukas. Given Lehman’s assets, a 5% uncertainty in valuation is not surprising. That’s another $15B.

The real point is leverage. If you have (in round numbers) $30B of capital supporting $600B of assets, then $30B of uncertainty in valuation wipes you out. If you were half as leveraged, you could tolerate twice as much uncertainty. No financial will ever be liquidated for anything close to its accounting value, particularly in a crisis. But if firms are less leveraged, then they are more likely to have higher recoveries. Given Lehman’s leverage, going from a going concern value of +$30B to a bankruptcy value of -$50B is not at all surprising.

Posted in: Capital and Contingent Instruments, Fair Value, Mother of all Bailouts by David /
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As was always very highly likely, Greek default has been averted. You might add ‘for now’, and certainly the omens are not entirely good. However in looking at the PIIGS one must understand the context: the Euro project, as we have previously commented, is not primarily an economic one. It is political. This means that things will be done which are perhaps not rational economically. If you bet against Greece, you are not betting on the Greeks failing to sort out their problems. You are betting against the rest of the Eurozone, and Germany in particular, not supporting them. Despite Germany becoming more selfish recently, this seems unlikely: a lot more unlikely than the markets are estimating, anyway. I still like selling first to default protection on the PIIGS: if Citigroup and JPMorgan are too big to fail, how much more so are Greece, Portugal, Ireland, Spain and Italy? The Eurozone may seem disorganised, slow to react, and sclerotic. It might have labour markets which frighten economists, pensions deficits going to the sky, and low growth. But it is one of the richest areas in the world, and it will remain such. It can afford to rescue its members, and my guess is that if push comes to shove, that is what will happen.

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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I’ll be away for a few days, which is a shame in some ways, as the flowers are just starting to look good.

Posted in: Photography by David /
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I think it is appropriate at Easter to celebrate two substantial achievements of the past quarter century.

First, one of Tony Blair’s. I am not a fan of Blair, and his score on the warmonger/peace maker axis is decidedly unimpressive, but he did do a lot to make peace in Northern Ireland possible. For that, at least, we should praise him. Andrew Rawnsley’s new book offers plenty of reasons to condemn Blair, but it also makes the case for his commitment and substantial contribution towards the Northern Ireland peace process. The two sides – Martin McGuinness and Gerry Adams; David Trimble then Ian Paisley — stepped up to the table Blair prepared and ultimately cut a deal. It is perhaps difficult now to understand how big an achievement this was for everyone involved. We are still too close to it. But history will be kind to those who helped to resolve the conflict.

Second, the fall of the iron curtain. Timothy Garton Ash yesterday praised Helmut Kohl for his role in the reunification of Germany, but there are many other people who deserve to be remembered too including the people of Solidarity; Václav Havel and the velvet revolutionaries; Gorbachev, Yeltsin and the proponents of Glasnost. There are far too many to list, and far more courage was shown than we commonly remember. So perhaps, just for a moment, we might honour the memory of these peacemakers. Between them they changed the face of Europe and eliminated two long standing conflicts. They have shown that progress is possible, that armed struggle is not the only answer. Surely this is a message that we can all applaud.

Posted in: Politics by David /
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Andrew Lo and Mark Mueller have a new paper which has a very nice explanation of an idea that I have long held, namely the importance of distinguishing between those situations where you know the form of the distribution and it suffices to estimate its parameters, and those situations where the parameters change over time.

I gave the example of a dice with sides between n and n+5. If you know n is fixed, then it does not take many observations to know what n is. Once you have seen a 10 and a 15, for instance, you know n = 10. But if n itself varies, then you are in a much more difficult situation. Seeing a 10 and a 15 does not prove that n = 10 since it might have been 8 for the first observation and 11 for the second. Even if n only varies slowly, you need a lot more data to make good statistical estimates.

Lo and Mueller propose a more detailed hierarchy of model uncertainty as follows. I will use my dice rather than their examples as illustrations.

• Level 1: complete certainty. The dice has 5 on every one of its sides.
• Level 2: risk with (Knightian) uncertainty. Standard six sided dice. The probability of each outcome is fully known.
• Level 3: fully reducible uncertainty. Six sided dice with each of the numbers between n and n+5 on one of the sides. n is unknown but it is fixed and therefore can be precisely deduced with enough observations.
• Level 4: partially reducible uncertainty. Six sided dice with each of the numbers between n and n+5 on one of the sides. n is unknown and with some fairly low probability may go up or down by one each throw. Here we know something about the path of n from observing the dice rolls, but we can never be certain what it is at any point in time. The distribution of outcomes can therefore never be completely known.
• Level 5: irreducible uncertainty. Completely random numbers on the sides of the dice which change on every throw. We know nothing.

Like Lo, I think that in finance we often pretend to be in level 2 when in fact we are in level 3 or 4.

Posted in: Economic Theory, Mathematics and Science by David /
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From the BBC:

Scientists have shown that they can change people’s moral judgements by disrupting a specific area of the brain with magnetic pulses.

They identified a region of the brain just above and behind the right ear which appears to control morality. And, by using magnetic pulses to block cell activity, they impaired volunteers’ notion of right and wrong.

Experience has taught me that relying on summaries of scientific papers posted on news sites is fraught with danger. Nevertheless, if the paper does say what the BBC says that it says, this is fascinating. (Note that unlike the other post today, the BBC story was prior to 1st April.)

Posted in: Mathematics and Science by David /
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Bloomberg points out something that we should be quite troubled by:

In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

Guidelines on liquidity risk management, which were published March 17 by the Federal Reserve, the Treasury Department and the Federal Deposit Insurance Corp., also avoided spelling out how much banks need to hold, and in what form, to make sure they don’t collapse if short-term lending dries up…

“They’re assessing the processes and monitoring of liquidity but not addressing the quantities of liquidity that banks need to hold.”

The issue here is regulatory creep. When times are good, banks will reduce their liquidity buffers, and this will seem reason to regulators. They will hold back egregious reductions, but they might be unable to stop a slow trend where banks become less liquid.

The Basel committee had proposed something a lot tougher here: a 100% net stable funding ratio, meaning that all of a bank’s anticipated funding needs over a one year horizon would have to be met by deposits and long term financing. That, of course, would dramatically reduce the profitability of many banks since they make a lot of their money from punting the yield curve – funding short and lending long. The view of the experts polled by Bloomberg is that the Basel proposal will be watered down substantially.

This is shameful. Liquidity risk is a major vector, perhaps the most important vector, of bank failure. Without fixed liquidity rules, banks and non-bank financials will fail more easily: rules like this would have meant that Bear Stears and Lehman could not have got into trouble the way they did. Add in a firm, low leverage ratio, like 15%, and we would have gone a long way towards making the financial system more robust. The failure to address liquidity risk with a fixed net stable funding requirement is a massive missed opportunity and we should decry it.

Posted in: Basel, Liquidity and liquidity risk by David /
4 Comments

An excellent perspective on financial reform from Steve Randy Waldman:

I won’t hold a grudge against some mid-level banker who put together crap CDOs because everyone was doing it, and who knew housing would collapse*, and it was very lucrative…

[There are] organized practices which, innocuous act by innocuous act, do in fact serve to extract wealth from many and distribute it to a well-organized, well-placed few. And if you work in the industry and that makes you uncomfortable, it should make you uncomfortable, even if your accuser is a hypocrite and morally reprehensible himself. We can and should make better rules and fix perverse incentives in the financial system. But we won’t be able to design a game so perfect that self-interested amoral agents plus an invisible hand ensure decent outcomes. We need industry participants to take responsibility for the organizations and practices in which they participate, and to take an active, serious role in policing those practices. That will require a cultural shift, an understanding that actions that are legal and profitable can be illegitimate and disreputable, and should be avoided even if competitors will profit from your scruples.

*I rather think that very few people ‘knew’ housing would collapse, and not many more thought that it might, but that is by the bye.

Posted in: Rules by David /
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The Sunday Times (via FT alphaville) suggests:

Advisers to the government are working on a secret plan that could allow the state to start cutting its shareholdings in British banks just weeks after the general election.

The plot would see the Treasury create “convertible gilts” — government bonds that could be exchanged for shares in the banks once certain price targets are met.

It’s not a bad idea, and certainly it will allow the government to monetise the volatility of the stocks even if the CBs do not end up being converted. A long dated structure with a fairly far out of the money strike price would work well.

Another idea, reminiscent of how Caja Madrid got out of their position in Telefonica, is for HMT to sell physically settled calls and use some of the proceeds to buy OTM cash settled puts. The puts would floor losses for taxpayers, while the calls would provide an exit above current stock price levels. Ideally you do a strip, say 5% of the stake every quarter, so you get out of the stake slowly and thus without crushing the stock price. The first (three month) option could be set slightly out of the money, with later maturities having higher strikes.

Posted in: Bonds and CBs, Derivatives, Hedging and Convexity by David /
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In an interesting FED paper, How Did a Domestic Housing Slump Turn into a Global Financial Crisis? Steven Kamin and Laurie Pounder DeMarco discuss how the subprime issues created a global financial crisis. They agree with the perspective I took in my two articles in Quantitative Finance (here and here) that direct exposure to subprime did not cause the crisis. There were simply not enough subprime mortgages and they were not widely enough held to cause the intensity of problems that we saw. Rather there were other channels of contagion which combined with direct exposure (and counterparty risk) to cause the crisis. Kamin and DeMarco’s list is similar to mine:

• No one knew who held what, and whether it was fairly marked. Without general confidence that institutions had correctly marked their losses, and that they had disclosed all material exposures, confidence was lost.
• Amid heightened demands for liquidity, financial institutions that depended heavily on short-term funding were subject to runs. This follows from the loss of confidence.
• In particular, following Paribas’ refusal to redeem shares in several of its SIVs and conduits, the ABCP market dried up, forcing assets back on balance sheet (thanks to backup liquidity lines) and intensifying the funding crisis.
• Historically contagion was caused by direct interbank exposure. In this crisis in contrast, it was caused by mark to market. Selling, sometimes forced (by funding difficulties and/or inability to meet margin calls), lowered asset prices, which caused mark to market losses to all holders. In an illiquid market selling a relatively small position caused big falls which affected all holders who were properly marking their position.
• Investors realised that whether or not a bank had direct subprime exposure, it likely had business practices sufficiently similar to troubled market participants that it was vulnerable. Nearly everyone was too leveraged, had too much funding liquidity risk, too much exposure to complex mark to model instruments, and lax supervisors. This ‘wake up call’ caused a widespread loss of confidence in financial institutions of all kinds.
• At the same as losing confidence in their counterparties, market participants increased their risk aversion. Ratings were (rightly) distrusted; structured assets of all types were viewed with suspicion; risk capital became very scarce. This again caused asset selling which reinforced the price falls/losses/capital reduction/loss of confidence spiral/forced deleverage spiral.

If we want to reduce the likelihood and severity of future crises, we need to address these vectors of contagion. This requires:

• Enhanced disclosures from financial institutions, better valuation methodologies, and much better supervision of valuation. Lehman’s ambitious valuations as disclosed in the Valukas report is evidence enough of the need to do this.
• Better liquidity risk management, and tighter supervision of liquidity.
• Intense supervision of funding liquidity risk in vehicles which are not supported by insured deposits.
• Breaking the link between mark to market and capital.
• Increased diversity in the financial system.
• The introduction of anti-cyclical capital measure which reduce the impact of crises on regulated institutions.

Posted in: Accounting, Mother of all Bailouts, Rules by David /
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Yesterday the Guardian suggested that one of the ways to improve the spectacle of Grand Prix would be to draw lots for grid places, and award points for overtaking rather than finishing. That would make for an interesting race. It’s another of their suggestions, though, that intrigued me: banning communication with the pits.

I have no idea if this would significantly improve Grand Prix, but certainly the idea of a sportsperson being in constant communication with their team does not seem, well, very sporting. In cycling banning communication would help immensely: I would love to see a Tour de France where the riders were on their own once they started. Changing wheels or making other critical repairs is reasonable, but nothing else: no going back to the team car for a chat, refreshments only available from official points, not from the team, and certainly no race radio for the riders.

This year the key stages seem to be the 9th (the Colombiere and Madeleine climbs) and the 16th (the Tourmalet and the d’Aubisque), although the 17th (the Tourmalet again – twice in two days is cruel) and 19th (individual time trial) stages could be fun too. The 3rd stage includes some Belgian cobbles, which will be a trial if it rains.

Posted in: Sport by David /
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Oliver Burkeman in the Guardian quotes Alasdair MacIntyre:

One key reason why the presidents of large corporations do not control the United States is that they do not control their own corporations… When implied organisational skill and power are deployed and the desired effect follows, all that we have witnessed is the same kind of sequence as when a clergyman is fortunate enough to pray for rain just before the unpredicted end of a drought.

Broadly, I think that that is right. Even worse, when it isn’t right, the corporation is often a considerable risk because the CEO has the power to change the firm for the worse. Consider the two Greenbergs, Ace at Bear Stearns and Hank at AIG for example. They were both strong leaders, much more in control of their companies than is typical. And they were both in the hot seat when the seeds of disaster were sown. You only want a strong leader if you are really, really sure that that leader is never going to do anything silly. Typically a leader is only good for a while, and then does something damaging. At least if they are weak, that damage is likely to be easier to repair.

Posted in: Organisational Culture by David /
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Rather like Lost, the Monoline Death Watch has been going on so long that one can neither remember all the twists and turns, nor rouse much enthusiasm for the final denouement. Still, the news from Bloomberg that Wisconsin Insurance Commissioner Sean Dilweg

is taking over a portion of Ambac’s policies to protect municipal bondholders who count on the company’s guarantees. He halted payments on the $35 billion of mortgage bond policies and other contracts

The press release is here: comment from Rolfe Winkler (who seems to be a rather less hysterical and better informed Reuters blogger than Felix Salmon) is here.

Basically Dilweg is segregating the muni insurance business written by Ambac Assurance Corp from the bad stuff, primarily CDS on ABS. The CDS counterparties will get 25 cents on the dollar or so, plus a share in any eventual upside from there. This is an event of default for credit derivatives referencing Ambac.

Update. There is a provocative post on the legal implications of the segregated account approach Ambac has taken by Stephen Lubben at Credit Slips here. I’m not up to speed with the details here, but it certainly seems that the possibility of being forcibly novated into a position with less access to liquidity and much less capital might be troubling to a counterparty…

Posted in: CDS and Negative Basis, Monoline by David /
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The ten year USD swap spread went negative. As I believe the kids are not saying, big woot. Some commentators went so far as to suggest that this is because swap spreads represent AA credit, and the USD government is not even that these days. What tosh. Sorry, but really, it is.

First note that most swaps are done on a collateralised basis. The amount of credit risk in a ten year interest rate swap in dollars with daily collateral is minimal.

Second note that while treasury yields represent government borrowing, swaps don’t necessarily represent borrowing at all. You certainly don’t simply borrow at the swap rate: you might pay 10 year fixed, but you received floating at the same time. So the sense in which a swap spread is compensation for credit risk is really unclear.

No, what a negative swap spread is caused by is simply lots of people wanting to receive fixed and a massive supply of treasuries to finance the US deficit. More receivers than payers means lower swap rates: more selling than buying of USTs means higher T rates. Either of those cause the swap spread to compress. If the effect is intense, then the swap spread goes negative. That’s it.

Posted in: Derivatives, Hedging and Convexity, Markets by David /
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FT Alphaville picks up a warning from Credit Suisse Research on one of the more obscure aspects of Basel III (2.5?), credit valuation adjustments.

There are several things going on here. First the idea is that you should mark credit on bilateral contracts so that if we do a swap, I discount net cashflows from you to me at your credit spread, and vice versa (absent collateral and assuming that netting works). The regulators then say, OK if you are doing that, then you will have losses on in-the-money uncollateralised OTCs as your counterparty’s spread widens. Those losses were substantial in the Crunch: apparently 2/3rds of total losses due to counterparty risk arose this way, rather than through default. Therefore, the argument goes, there should be capital against unexpected losses here to a suitable degree of confidence.

The problem that CS identify is that the capital amounts required under the calculation the BCBS propose could be large. For some banks, really quite large. At the moment we are still in the comment stage of the Basel proposals, so there is no need to panic. But if CS are right about the numbers, it might be time for the industry to get pen and ink out. The deadline for comments is the 16th April.

Posted in: Basel, Credit, Derivatives, Hedging and Convexity by David /
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After a disaster it is easy to say that the people involved behaved badly. Your car crashed, so the manufacture ‘must’ have been at fault: your wine was bad, so the cork ‘must’ have been too cheap. But often bad things happen when you are trying to give the customer what they want. CDO structuring is a good example. In the mid 2000s, clients wanted spread. They were desperate for spread. And so any sensible client-focussed structuring desk gave them tranches with relatively high spread. That meant putting in high spread collateral. The collateral was high spread for a reason: it was risky. But that was not what clients wanted to hear: they just wanted a few more basis points. If you tried to give them bonds which were too safe, they wouldn’t buy them, as the spread was too low.

These days, then, we get stories like Banks Bundled Bad Debt, Bet Against It and Won in the NYT or the suggestion that banks

just needed one or two well place bombs, hidden among the rest of their very good deals

This seems to me to be very unlikely to be true. Firstly it implies that the banks knew what was going to happen — and their portfolios indicate that broadly they didn’t. Secondly no rational sales person blows up their clients: it makes finding new clients rather more difficult. Perhaps for once we could consider the actions of the people who bought these high spread tranches as well as those that sold them?

Posted in: Securitisation and Tranching by David /
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Is it really old fashioned of me to be depressed at having found two grocer’s apostrophes in the abstract of a Harvard paper? Now admittedly it is only an undergraduate paper, but really, whatever our view of CDOs, we definitely should not tolerate CDO’s.

Posted in: Media and Popular Culture, Securitisation and Tranching by David /
2 Comments

I have an embarrassing confession. I have never understood the concept of fractional reserve banking. Or, at least, while I could follow the argument easily enough, when I tried to write the corresponding accounting entries, I couldn’t. This was filed under `things I will figure out at some point’ until recently, when I read a post at the Big Picture pointing out that the M1 money multiplier is now less than one. Clearly there is something fishy about the whole ‘new reserves create even more new money’ story.

What’s going on? The first point to notice that the money does not have ‘central bank money’ and ‘bank money’ printed on it (or attached to balances for that matter). So any story that relies on distinguishing between them must not be the whole truth. The second is to note that the reserve fraction is zero in some countries for some deposits: demand deposits require zero reserves in the US for example. Hence theoretically infinite leverage is possible, and any account that claims that the reserve ratio limits the supply of credit is false. Third, note that reserves are not the constraint on credit: capital is. So that must enter into the story too.

With that in mind, let’s try to see how credit creates money – in the sense of increasing the measure of broad money. Suppose you start with a house worth £100. Your assets are £100, your liabilities are zero, and so your net worth is £100. Now suppose you get a mortgage on that house for £80. That gives you £80 in addition to the house, deposited in an account at your bank. Your liabilities are now the £80 mortgage, and your net worth has not changed. The money supply has increased.

Now think of the bank’s accounting. It has added an asset to its balance sheet – the mortgage – and a corresponding liability – a deposit of the money it has lent you. If you move that deposit, by spending it say, then it must replace that deposit with other funding. It also allocates some of its capital to support the capital requirement on the mortgage.

What stops the bank creating new broad money like this forever is regulation. Once capital requirements rise to be nearly as large as the bank’s actual capital, it has to stop (or get more capital).

Central bank intervention comes into the process when there are not enough deposits or interbank money around to support the credit that the banks want to make and are well enough capitalised to make. Then the central bank creates new money via open market operations (essentially repoing old securities for new money). This fills the gap between assets the banks want to create (new loans) and liabilities that they cannot attract (scarce funding).

Reserve requirements are essentially a funding liquidity risk reduction tool. By imposing reserve requirements on some types of deposit, banks are forced to stay somewhat liquid. If there is any way of funding the bank which does not have a reserve requirement (such as issueing CP) then reserve requirements cannot completely constrain credit creation.

What new central bank money does not always do, then, is create credit. If a bank’s reserves grow, then that increases the asset side of its balance sheet. The corresponding liability in modern open market operations is a liability to the central bank. If those increased reserves allow it to take more of a certain type of deposit, then those deposits come from somewhere. It may be that the bank creates credit after obtaining central bank money and the liability matching the new loan is in the form of deposit account which requires a reserve, but that is by no means guaranteed.

In this version of the story then the money multiplier is the ratio of newly created broad money – mostly credit – to central bank money. It is greater than one if the banks are well enough capitalised to create lots of loans, and can find people they want to lend to at spreads they like. But if they can’t – as now – pumping in more central bank money won’t necessarily increase broad money that much. Instead banks will hoard the money until they have solved their capital problems and there are more attractive risks around.

Fractional reserve banking, then, is a useful theory if all bank liabilities require reserves and if capital is not a limit on credit creation. This could have been true once. But it certainly isn’t today. Shouldn’t we be teaching economics students a rather more accurate version of the story?

(Linkage: There is a different [German school kids?] account of the story from Naked Capitalism here: the comments to that article reference this post, which some may find helpful. This link is useful too as the accounting behind the story is discussed.)

Posted in: Economic Theory by David /
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Felix Salmon appears to have spotted something which casts a whole new light on the pro exchange slant of the Dodd bill:

Dodd’s wife, Jackie Clegg, is a director of the CME, which paid her $153,219 in 2009; she also owns shares in the company worth about $235,000.

If this is true the industry should scream conflict of interest rather loudly.

Posted in: CDS and Negative Basis, Regulation by David /
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From a short but frank Reuters interview:

There is a war that is about to happen over not just who regulates Wall Street but what the rules are.”

“To put it in the crudest possible way, these firms have to be smaller and less profitable,” Lewis told Reuters. “If they were regulated properly and the rules of their game were sane, it would be less profitable to be a trader at a big Wall Street firm … It is really a war over money.”

Certainly I agree that the big guns will soon be brought out. How the conflict will be resolved, though: that is the interesting question.

Posted in: Regulation by David /
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As a palate cleanser between stodgy doses of regulation and financial disaster tourism, I’d like to reference an interesting criticism I read recently of the advertiser led business model — Google’s business model.

The article is EMC vs. Google: There Should be No Competition by Rob Enderle on IT business edge. For me the key point is this one:

It isn’t really clear who Google’s customer actually is. Advertisers pay the bills …, but most of the products are focused on providing services to others… Harry Potter doesn’t fly in and create an enterprise offering. Someone is paying the bill to create it and that someone is going to want value. When you decouple revenue from the product, it becomes very difficult, and you can see this with Google, to stay focused on quality and customer satisfaction.

In one sense Google is a hugely successful company. It makes adverising-led free (or cheap) products work. But this is at a significant cost for the user in privacy and security. You get what you pay for. In the retail space, Google’s focus on selling advertising and providing an insecure but free service might make sense for some. But in the enterprise space, the argument is much less clear. Corporate IT might be moving to the cloud, but I doubt the Google model will have that much success there. At the end of the day, companies understand that if you are not the customer, the product is not designed for you, and it probably won’t meet your needs.

Posted in: Organisational Culture, Software and Virtual Worlds by David /
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Many people knew that banks created bonds explicitly for use at the central bank window, and never showed these bonds to the market. It is interesting that the broker/dealers were in on the trick too. Or, at least, one of them was. From page 1393 (I know, I know – but I probably sleep more than Yves Smith) of the Valukas report on Lehman:

Lehman did indeed create securitizations for the PDCF [the FED's primary dealer credit facility] with a view toward treating the new facility as a “warehouse” for its illiquid leveraged loans. In March 2008, Lehman packaged 66  corporate loans to create the “Freedom CLO.” The transaction consisted of two tranches: a $2.26 billion senior note, priced at par, rated single A, and designed to be PDCF eligible, and an unrated $570 million equity tranche. The loans that  Freedom  “repackaged” included high‐yield leveraged loans, which Lehman had difficulty moving off its books…

A 20% haircut on a concentrated illiquid high yield portfolio in exchange for government funding? Not bad at all. And certainly actually selling that senior note at par would have been difficult when Lehman created it in March 2008.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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I very much hope not, but this ill-advised clause is in the draft Dodd Financial Reform bill:

It shall be unlawful for any person, other than an eligible contract participant, to enter into a swap unless the swap is entered into on or subject to the rules of a board of trade designated as a contract market…

Update. Bloomberg’s view is that this may well be not a problem. The quote Cornelius Hurley, an academic, who says that there are ‘loopholes galore’ so this ‘not going to have Wall Street upset’. I worry that this might be overly optimistic and that the give-and-take of the lawmaking process may leave us with a decidedly sub-optimal situation in the US.

Posted in: Regulation by David /
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With the (justified) fuss over Repo 105, some of the earlier material in the excellent report by Anton Valukas of Jenner & Block on the Lehman failure seems to escaped much comment. Here, then, I would like to comment on the rather depressing perspective the report casts on risk management. My sources are in volume 1 of the report, and I’ll cite the starting page number of the relevant section as I go.

First the risk management failings as identified by the report:

• One of Lehman’s major  risk  controls was  stress  testing.  As Lehman’s exposure to  real  estate  and  private  equity grew, the firm did not modify its stress testing to address its evolving business strategy, so the largest risks were not stress tested, or were tested inadequately (pg. 66). 
• Lehman had a series of “risk appetite limits” that it considered the “center of its approach to risk.” Yet Lehman was repeated over both the whole firm limit and its concentration limits. It repeatedly raised the limits yet still violated the increased limits (pg. 71).
• Management’s presentations to the board about risk were limited, optimistic, and in places misleading (pg. 92, 116, 139). In particular board risk information did not include all transactions which, had they been included, would have shown the firm to be substantially in excess of its risk limit (pg. 141).
• Lehman did not even have an ALCO until July 2007, and came to realise the need to manage their daily liquidity properly only very late in the Crunch (pg. 125).
• Materials presented to the board also overstated Lehman’s liquidity position and did not mention the firm’s internal view of the problematic nature of its funding (pg. 148).
• The firm’s Risk and Finance committee was not kept informed of the results of the worst stress tests, nor were they aware of substantial changes to the risk appetite calculation (pg. 155).

As corporate governance failures relating to risk go, those are substantial.

Now the good news for Lehman execs:

The Examiner Does Not Find Colorable Claims That Lehman’s Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman’s Risk Management Policies and Procedures …

The Examiner Does Not Find Colorable Claims That Lehman’s Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning the Level of Risk Lehman Had Assumed.

This is not because they didn’t do anything wrong, but simply because the standard of proof under Delaware law is so high. Thus for instance (pg. 184)

During 2007, there were a number of instances in which management did not provide information to the Board. For example, management did not disclose its decision to exceed or disregard the various concentration limits applicable to the leveraged loan business and to the commercial real estate businesses, including especially the single transaction limit, contrary to representations to the Board that management took steps to “avoid [] over‐concentration in any one area.”

Yet because the board did not explicitly direct management to provide it with this information, management are fine. As Valukas says, Establishing a violation of the duty of candor with respect to risk management is particularly difficult.

The Directors too are off the hook: the examiner did not find Colorable Claims that they breached their Fiduciary Duty by failing to monitor risk either.

The firm left the impression that their risk controls were firm, when in fact they were advisory, and that advice was rejected. Thus for instance (emphasis mine):

Lehman’s management decided to treat the firm’s risk appetite limit as a soft limit rather than as a meaningful constraint on management’s assumption of risk.

This, it seems, is fine, at least under Delaware law. Management can behave like this and the Board can oversee it, and no one can sue when it goes wrong. That surely is one of the lessons of Lehman. If we want better risk management, then we need changes in the US regulatory framework so that when something like this happens again — as it will — someone senior goes down for it. The FSA in the UK already has such a regime, through its approved persons regime. (This was introduced after Barings, when the directors managed to successfully argue that no one was responsible for the failures of control that let Leeson bring the bank down.) The Americans need something like it – or they might as well abandon any pretence that risk management acts as significant protection for their firms.

Update. It belatedly occurs to me that Sarbanes Oxley might do the job. Does anyone know? If it does, why doesn’t Valukas think there is actionable case?

Posted in: Legal Risk and Trade Documentation, Risk Management by David /
2 Comments

Senator Ted Kaufman writes: I start by asking a simple question: Given that deregulation caused the crisis, why don’t we go back to the statutory and regulatory frameworks of the past that were proven successes in ensuring financial stability? It is a reasonable question. There are three components to the answer: First, the finanical system is different. We have securitisation, the big arbitrage tool for Basel 1; we have more internationalised banking and a different profile of lending; and we have different policies from central banks. That in turn is because the economy is different. It has different needs. Large corporates in particular demand a wider range of services. Moreover we are unwilling to accept a large fraction of society being denied credit as they were in the past. We are less tolerant of boom and bust: we want both high growth and stability. There is a real danger of looking back with rose tinted spectacles (if not without our heads). The regulatory system was not perfect in the days before OTC derivatives when Glass Steagall still ruled. (See here for a short list of financial crises in the last forty years.) As Dave said in the comments to a previous post, we need to design a regulatory system for the future, not for the past.

Posted in: Economic Theory, Photography, Regulation by David /
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Two contradictory signals. First from the FT:

Regulators have ordered UK banks to run a new round of tougher stress tests that assume the economy will endure a double-dip recession that would force unemployment up to 13.3 per cent.

The banks will be required to prove that their tier core one capital ratio – a key measure of banking safety – would stay above 4 per cent even if the economy contracted an additional 2.3 per cent for a total fall of 8.1 per cent from the boom, the Financial Services Authority said in its annual Financial Risk Outlook.

(The full document is here.)

Next from the FSA themselves:

the FSA said that it would not tighten quantitative standards before economic recovery is assured given that all firms were experiencing a market-wide stress. The FSA committed to giving a further update in the first quarter of 2010.

The FSA believes that it would be premature to increase liquidity requirements across the industry at the current time. This position will be reviewed later on in the year with a further announcement in Q4, 2010.

At first blush, this is odd. Stronger stress tests but no liquidity requirement (yet). But perhaps it is not so strange: the FSA is concerned about the possibility of a doble dip recession, and knows that banks have enough to worry about without meeting the liquidity requirements too. They have to balance making the banking system sounder with discouraging lending and hence making that double dip more likely. The news, then, is broadly positive: the stress tests probably won’t have much of a capital impact on most people, and the delay in the liquidity requirements will be very welcome for many banks.

Posted in: Economic Theory, Liquidity and liquidity risk, Regulation by David /
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As I expected, given the primarily political rather than economic character of the Euro project, Greek has been propped up.

This is both rational on a standalone basis, and as a signal to the markets. If Greece had defaulted, the pressure would have been huge on the rest of the the PIIGS. Sell one year first to default protection on Portugal, Ireland, Italy and Spain before the spreads come in too much.

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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What do regulators need to be successful? That the regulated are successful. Therefore it is no surprise that a regulator should defend their turf. Gary Gensler however goes further: here is his slick bait and switch in aid of the exchanges.

We’ll start with a classic example of ‘wouldn’t it be nice’:

A comprehensive regulatory framework governing over-the-counter derivatives should apply to all dealers and all derivatives, no matter where traded or marketed. It should include interest rate swaps, currency swaps, foreign exchange swaps, commodity swaps, equity swaps, credit default swaps and any new product that might be developed in the future…

First, we must explicitly regulate derivatives dealers. They should be required to have sufficient capital and to post collateral on transactions to protect the public from bearing the costs if dealers fail. Dealers should be required to meet robust standards to protect market integrity and lower risk and should be subject to stringent record-keeping requirements.

The only minor difficulty is that there is already such a framework. It is called the Basel capital accord. It might be inconvenient for Gensler, but we don’t need a new regulatory framework. What we need is for the Americans to apply the framework the rest of the world already uses, and they themselves use for the largest banks, to everybody else. Even if they don’t do that it hardly matters: the vast majority of derivatives are traded by dealers who are subject to Basel capital adequacy rules and to robust conduct of business requirements.

(Now of course Basel is not perfect, as I have argued elsewhere. But to pretend that there isn’t a regulatory framework when there patently is is at best sharp practice and at worst rank dishonesty.)

Second, to promote public transparency, standard over-the-counter derivatives should be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties to a derivatives transaction.

How on earth will putting OTCs on exchanges improve transparency? The swaps market is already highly transparent and highly liquid. Moving that would not change anything, except the profitability of exchanges. Some credit derivatives are illiquid: how would putting them on exchange make them more liquid? One needs only look at the stale, unrepresentative prices that exchanges distribute on their existing illiquid contracts to see that simply having a contract on the exchange is no guarantee of liquidity nor of accurate prices.

Trade reporting is important for credit derivatives, and a central counterparty or other counterparty risk reduction technology are also needed. But none of this needs an exchange. In fact the only people who need OTCs to put on exchange are the exchanges themselves and, it seems, their regulator.

Posted in: Clearing and Collateral, Regulation by David /
10 Comments

… is nearly three hundred billion euros of liquidity leaving the eurozone financial system. A great catch from Zero Hedge here:

Earlier today, the European Central Bank announced that it had drained a whopping €295 billion in an unscheduled, one-time liquidity-absorbring, fine-tuning operation.

The central bank weaning off has clearly begun, at least in EUR.

Update. FT alphaville points out that this is not that unusual, given that Tuesday wass the last day of the ECB’s latest reserve maintenance period: the ECB regularly drains cash from the euro zone banking system at the end of the period. All the same, this is a big number…

Posted in: Liquidity and liquidity risk by David /
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Rabobank can’t issue Cocos as, being a complicated cooperative, their equity is not traded, so there is nothing sensible for the Coco to convert into. So they have decided to issue an innovative (Tier 1?) instrument where, if their capital is eroded sufficiently, the investor’s principal is written down. From FT alphaville:

Instead of converting into equity when a certain Tier 1 level is triggered (à la Lloyds’ CoCos), the securities are simply written down by 75 per cent of their face value, with the remaining 25 per cent paid to investors. Otherwise they act like normal bonds… Rabobank currently has €29.3bn of equity capital. To hit the trigger, capital would have to fall by €12.9bn

I wonder where they will price.

Posted in: Capital and Contingent Instruments by David /
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This is a dissection of one of the most ill-informed NYT editorials it has ever been my displeasure to read. The column tackles OTC derivatives with a blend of ignorance, paranoia, and prejudice that is deeply disturbing in a paper that aspires to a high standard of journalism.

Let’s pick a few doozies.

These particular — and particularly complicated — instruments are traded privately among banks, their clients and other investors with virtually no regulation or oversight.

No, no, no. Bank derivatives trading is regulated: there are capital requirements, conduct of business requirements, and so on. There have been for many years. What wasn’t well regulated was certain US derivatives activities of broker/dealers. Given that there aren’t any broker/dealers left – they all became banks – this is not a problem.

A big part of the problem is that derivatives are traded as private one-on-one contracts. That means big profits for banks since clients can’t compare offerings.

No. Many OTCs, including swaps, CDS on hundreds of names, and OTC FX options, are liquidly quoted, and prices are more reliable on many of them than on most exchange contracts.

That is why it is so essential to move derivative trades onto fully transparent exchanges.

How would that help? An illiquid market on an exchange is more confusing than an OTC one. At least with the OTC market, you can see that there are no prices. With the exchange, you get stale prices reported as facts, confusing the unwary. Liquid markets don’t need to be moved to exchanges, and illiquid ones are not much improved by the move.

Effective trade reporting is a separate matter: this is being achieved via mechanisms such as the DTCC reporting of credit derivatives. It does not require an exchange.

It is worth noting here that the exchange have been extremely effective at using the crisis as a tool to get more business. If they can persuade legislators that all the world’s financial problem can be solved by putting OTC derivatives on exchange, then their shareholders will be very happy. But they are simply a lobby group: we don’t have to uncritically believe all their PR.

Derivatives investors who stand to make huge profits if a company or country defaults, for example, might try to provoke default — a situation that regulators should be able to prevent.

The problem isn’t going to be solved by banning CDS. What we need is proper contract design which ensure that the voting rights of creditors go with the risk. This is a matter of derivatives documentation – and it should be relatively easily solvable.

No one could argue that derivatives markets are perfect, nor that the regulatory framework for them could not be better. But pedalling lies, half truths, and remedies that won’t work or aren’t necessary is not the answer. Can we please have some informed debate about derivatives reform?

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Regulation by David /
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One habit that characterises the thoughtful trader or economic theorist is doubt. We see this time and again. Here for instance is Krugman, talking about the controversy of Malaysian capital controls in the late 90s:

In a more cosmic sense, though, the Malaysia story does illustrate just how totally wrong what passes for financial wisdom often turns out to be.

On the same day, we find the Big Picture asking this question:

more importantly, what might you be VERY wrong about?

Beunza and Stark, meanwhile, looking at fairly simple arb trading, say:

Through ethnographic observations in the derivatives trading room of a major investment bank, we found that traders use models… to look out for possible errors in their financial estimates.

Posting will likely be light next week as I am away, so let me leave you with some encouragement to be reflexive: what financial estimate might you have been horribly wrong about? It is a good question.

Posted in: Economic Theory, Information Fusion by David /
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There is a famous cartoon of a man sitting in his pyjamas at a laptop and calling out to his wife – who is in bed – ‘I can’t come to bed right now honey, there’s someone on the internet who is wrong’. I feel like that when reading Felix Salmon these days. He’s wrong, but pointing this out has limited effect. Still, this column of his is so mistaken that I can’t help deprive myself of a few minutes sleep to highlight some of its more obvious idiocies. I’ve reordered the points to make them quicker to shoot down, and reclaim a minute or so of slumber.

There’s a lot of blame to go around when it comes to this crisis, of course. But let’s see who deserves huge chunks of it:

• Traders at investment banks, who levered up and started making so much money that they ended up ousting the investment bankers who had historically run them.
• Arbitrageurs who made enormous sums of money by making leveraged bets that something with a 95% chance of happening was, indeed, going to happen.
• Senior US politicians who urged the deregulation of the derivatives industry over the objections of, among others, Brooksley Born.

No. Traders had nothing to do with it. It was mortgages, remember, that caused the crisis. Mortgages, not derivatives. So you should blame the people who made the loans – primarily mortgage banks – and the people who bought the risk, often insurance companies. But blaming derivatives or hedge funds for the subprime crisis is like blaming llamas for the Chilean earthquake: they might have been around, but they weren’t responsible.

• Senior management at investment banks, who urged their traders to take on ever more risk and leverage.
• Senior executives at big commercial banks who had no idea what risks they were running.
• Senior executives at big commercial banks who urged their fixed-income departments to take on ever-increasing amounts of risk.
• Board members at big commercial banks who failed to implement any kind of succession strategy should their CEO suddenly have to leave.

Oh come on. Either they knew about the risk and wanted more of it, or they didn’t know. In most banks of any size the risk decisions are taken far below the level of senior management – it is really no surprise if they don’t know the details of the bank’s risk position, just as it is no surprise if Warren Buffett has no idea how train signalling works. Moreover senior management work for the shareholders and hence rationally should use all the leverage that is safe. The blame rather lies in regulation that permitted that degree of leverage. But then Felix has proudly advertised his ignorance of regulation. And succession planning? You what?

• Senior US politicians who were responsible for dismantling Glass-Steagal.
• Bankers-turned-politicians-turned-banker s who institutionalized the revolving door between Wall Street and Washington, making it clear that if you did the banking industry’s bidding during your tenure in DC, you’d be rewarded on the other side with a highly remunerative job.
• Grandees who bullied lesser mortals into doing what they wanted just because everybody assumed they knew what they were talking about and because they were paid eight-figure salaries to just sit around and be grand.

Now we are in the realm of things it is reasonable to loathe, but had nothing to do with the Crisis. Many countries which did not suffer much had nothing like Glass-Steagal, from which we conclude that Glass-Steagal is a red herring. Similarly, find me a financial institution, and likely some of the senior people in it will be forceful characters. They might well make a lot of money. That does not make them responsible for the crunch, however dislikeable they are.

• Senior US politicians who ran US fiscal policy for the benefit of Wall Street, while asking for nothing but cheap debt in return.
• People so blind to their own weaknesses that even after the crisis happened, they refused to admit any responsibility for it at all.

Well, maybe. But you only score one out of ten, Felix. It’s easy to demonise people; to say that Rubin (or Greenspan or Mozilo or whoever) was responsible. And certainly there are people who do bear some of the blame. Nothing will improve, though, if we fine them, jail them, cover them in opprobium or indeed publically tar and feather them. Rather we need to fix the systemic weaknesses that led to the crisis. If incentive structures are wrong, there will always be people to exploit them. Who does it is almost irrelevant. Whereas if we rebuild the rules of the system properly – the accounting rules, regulation, and so on – then it is much harder for the actions of any group to lead us into another crisis. Hysterical blame slinging won’t fix the system however much it bolsters the righteous anger of some of Felix’s readers.

Posted in: Photography, Regulation by David /
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From the Guardian’s live coverage of the England vs. Egypt match:

Two Oxford Dons are sitting in a bar…
“Would you decline a little tequila, Oswald?”
“Certainly Jeffrey. Tequila, tequila, tequilam, tequilae”

Posted in: Fun by David /
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My apologies for the down time today: it was caused by issues at my host.

FT Alphaville has an update of the famous ARM reset chart from SNL financial

What this says to me is that it is unlikely that USD rates will go up much until mid 2012 – the damage to the housing market would be too severe. If you believe this, then the easy trade would be to sell two year at the money caps. Two more sophisticated versions would be to sell two year caps on one year libor with monthly observations, or to buy a tight range accrual note on one year libor. (The most popular indices for ARM resets are one year Libor and one year CMT.)

Posted in: Markets by David /
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Wolfgang Münchau suggests in the FT

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point.

This is nonsense from start to finish. Buying a bond is a pure speculative gamble too. There is nothing holy about being long, nor diabolical about being short. Shorts make the market more efficient, as all hardened speculators, and a good many other people – but clearly not Münchau – know.

FT alphaville has a longer defence from the excellent Sam Jones here. Frankly Münchau isn’t worth it.

Posted in: CDS and Negative Basis by David /
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Phil Hogan’s review of The Age of Absurdity in Sunday’s Observer made me realise that I had not explained myself very well a few days ago when I was talking about the baby boomer generation and pensions. Let me try again. First, Hogan:

Modern life … has deepening our cravings and at the same time heightening our delusions of importance as individuals. Not only are we rabid in our unsustainable demands for gourmet living, eternal youth, fame and a hundred varieties of sex, but we have been encouraged – by a post-1970s “rights” culture that has created a zero-tolerance sensitivity to any perceived inequality, slight or grievance – into believing that to want something is to deserve it.

What has this got to do with pensions? Well, three things.

1. The sense of entitlement has made it politically impossible not to make bigger and bigger promises. In some sense this is a good thing: looking after the elderly is a sign of civilisation.
2. However, because of the competing sense of entitlement of the current generation, these promises have not been funded. That has created an intergenerational tension that – at currently mortality and economic growth rates at least – is not resolvable. At least one generation is going to end up very unhappy, and possibly more than one.
3. At the same time, increasing selfishness has made the situation worse, in that structures have been designed which offer a bad balance between pensions risk and pension return.

That last point should be elaborated.

Suppose you have the choice of two pension schemes: one of which gives the return distribution in solid blue; the other the one in dotted green. The dotted green distribution has a higher average pension, but more volatility, and hence a higher probability of underfunding. It’s riskier. Most people, given the importance of their pensions as a fraction of their assets, would opt for the pension in blue.

Now though suppose that there is a backstop at the level indicated by the dotted line. Then the situation changes: we might well decide to take the extra risk, given that catastrophic underfunding is protected against.

Collective pension schemes provide two forms of diversification. Firstly they have asset diversification – by investing for many people together, they can access asset classes which require high minimum investments, such as some alternative investments. Secondly they have temporal diversification – we only need enough money to pay claims as they become due, not cohort by cohort, so periods of markets falls are offset to some degree by later or earlier rises. Mean reversion in asset prices works in the pensioner’s favour. Moreover regulation usually means that some form of backstop is provided for collective schemes either from the sponsoring company, or the state, or both.

Thus collective pensions can take greater risk than individual ones. If you are investing just for yourself, you rationally should take less risk and hence expect a lower return than if you participate in a collective scheme. This is downside of selfishness: if you don’t want your funds to be available to help other people, then your expected return is lower. No matter what your political persuasion, you should want the red flag flying over your pension fund.

Posted in: Economic Theory, Pensions, Politics by David /
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What’s the common thread between the Russian default of 1998 and the Greek travails of 2010? Tax avoidance of course. As Bloomberg says, tax dodging is common is Greece:

Prime Minister George Papandreou’s drive to tackle the European Union’s biggest budget deficit and pacify investors who have dumped Greek assets may hinge on convincing more people … to abandon this tax-dodging tradition. Papandreou says that Greek workers and companies have skirted tax worth 31 billion euros, more than 10 percent of gross domestic product.

This was the root cause of the Russian problems, too. As Chiodo and Owyang say

… [A] weakness in the Russian economy was low tax collection, which caused the public sector deficit to remain high.

In fact the Russian situation was worse in that the tax collecting authorities collaborated with tax avoidance in some cases:

The majority of tax revenues came from taxes that were shared between the regional and federal governments, which fostered competition among the different levels of government over the distribution. … this kind of tax sharing can result in conflicting incentives for regional governments [who collected most of the taxes] and lead them to help firms conceal part of their taxable profit from the federal government in order to reduce the firms’ total tax payments. In return, the firm would then make transfers to the accommodating regional government.

The lesson is clear. The sun will set on those states that can’t persuade their citizens, especially their high-earning citizens, to pay tax. As Ruth Sutherland said in an excellent article in the Guardian recently

Paying tax has terrible PR. But it is actually a good thing to pay the right amount of tax… The contempt for taxpaying of the past few decades has gone hand in hand with greater inequality, strained public services and an unthinking faith in the market, ideas that are now discredited. As we head towards an election, it’s time for a new way of thinking.

Quite right, especially as the alternative may well be default.

Update. We can start here with Lord Ashcroft. It is outrageous that the biggest donor of a UK political party is in the words of Chris Huhne, `a tax dodger from Belize’. He, like anyone with a prominent role in national life, should be taxed in the UK on his full global income.

Posted in: Photography, Taxation by David /
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We begin with something interesting, if wrong. Did Woodstock hippies lead to US financial collapse? (HT the Economist’s View). The sense in which there might be something to this rhetorical (at least in the author’s mind) question is that changes in morality which started in the 60s in some sense contributed to the current crisis. But so too did flows of money which intensified with the rise of the baby boomer generation, combined with other social and political changes.

Consider the big picture:

• Morality first. There is no doubt that the attitude to debt has changed. North Americans, in particular, used to view repaying debt as more of a moral obligation than they do now. Thus we get more opportunistic (negative equity related) defaults than we used to. This was not a major driver of the credit crunch, but it did have an effect.
• Baby boomer pensions were a major cause. Those dang hippies were just too successful: they made all this money which needed a home. Government bond yields were derisory, so some of this cash was sucked into AAA rated ABS. The same goes for the riches of the newly industrialising BRICS. This wave of hot money, more than hippy morality, was a key crunch driver.
• Transactional, as opposed to relationship capitalism led to the originate-to-distribute model and so to making loans without worrying about whether they would perform. That is not a 1960s invention: it dates back at least to the 19th century, and arguably much further.
• Finally, wealth growth. If GDP keeps growing, and you can tax it at more or less a constant rate, you don’t have to fund current promises as the future will pay. This mañana attitude to government and pension finance allowed higher levels of consumption during the good times. But now times are not good, we need (in Interfluidity’s apposite phrase) ‘redistribution for which there is no overt legal framework or political consensus’.

The make love not war generation didn’t help, then, but it was not permissiveness that was primarily to blame: it was systemic weaknesses in Anglo Saxon capitalism that interacted with a wave of hot money to create the Crunch and its damaging aftermath.

Posted in: Economic Theory, Mother of all Bailouts, Pensions, Politics by David /
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The Guardian yesterday had a tacky little article, Why bankers aren’t Cristiano Ronaldo. The eponymous question could of course be answered simply by pointing out that most bankers are a good deal more honest than Ronaldo, a good deal less ostentatious, and rather better drivers.

Let’s review the vitriol.

When pushed, those who attempt to justify exorbitant pay in the corporate world often use comparisons between great sports players and their own “star” performers… But the comparison is disingenuous, if not duplicitous. When we watch Ronaldo score a spectacular goal, we know the only way we can do the same is in our dreams.

Now I don’t claim that everyone in an investment bank who gets a bonus is in any way special. But the big numbers do tend to go to people who have made a lot of money. And making a lot of money is not easy, given how much competition there is. Most people could only structure a convertible, or price a CDO, or build the book for an IPO in their dreams too. In fact you might argue that being a really talented banker is even more unusual than being a footballer (even one as bad a sportsman as Ronaldo) in that we can easily imagine what it might be like to be able to kick a ball well, whereas most people can’t even imagine what it is like to be an MD at Goldman.

The way to reduce distasteful bonuses isn’t to bad mouth hard working bankers, however little contribution to society they make. It is to stop banks making so much money. That is boring. It does not involve creating an artificial pariah class – rather it involves lots of detailed regulation and market structure reform. But it would do a lot more good in the long run than victimising some people who happen to have been talented (and lucky) enough to actually succeed at banking.

Posted in: Compensation by David /
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FT Alphaville reports

Most CDOs have overcollateralisation tests that are triggered if the CDO’s collateralisation levels fall below its minimum requirements, as defined in the deal. For certain CDOs, if that happens it’s counted as an event of default — triggering a potential reshuffling of payments for investors.

Whoever thought that this was a good idea? Using OC as a early am test makes sense: it gives senior investors more protection by giving them time to am out before the cashflow falls enough to endanger the coupons on their notes. But making it an event of default seems entirely unnecessary as it is not clear that any of the notes actually are in default: there could be enough value in the collateral to guarantee their eventual repayment. Now, of course, we are seeing some structures hitting these triggers:

Euromax IV is a €200m CDO backed by mezzanine residential and commercial mortgage-backed securities (RMBS and CMBS)… [It is] one of the first Fitch-rated European CDOs to breach an event of default based on its overcollateralisation trigger, according to a statement published by the ratings agency late Tuesday.

Fitch says:

A total 14% of Fitch-rated European SF CDOs (11 transactions) have an EOD OC ratio trigger. In Fitch’s view, as the performance of underlying SF assets continues to deteriorate, more than half of the 11 transactions are likely to breach their EOD OC ratio triggers over the next year.

The key point is that in some of these transactions, the EOD may lead to early liquidation of collateral rather than just interest diversion: or at least the potential for senior note holders to vote for such a thing. That would almost certainly get them off risk faster, but the consequences for junior note holders would be nasty. Caveat lector.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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A recent paper by Cecchetti et al. The Future of Public Debt has been widely noticed: see for instance here for Ritholtz or here for the Econgrapher. The paper is certainly thought provoking. In particular, it points out that the time bomb of ageing populations is not confined to Japan:

The current expansionary fiscal policy has coincided with rising, and largely unfunded, age-related spending. Driven by the countries’ demographic profiles, the ratio of old-age population to working-age population is projected to rise sharply. Interestingly, this rise is concentrated in countries such as Japan, Spain, Italy and Greece, which are already laden with relatively high debts. Added to population ageing is the problem posed by rising health care costs.

An ageing population who have been promised a lot combined with slower growth and hence less tax income gives a problem. A big problem in some countries, as these promises are simply unaffordable:

What can we conclude? The authors are clear:

fiscal problems facing industrial economies are bigger than suggested by official debt figures that show the implications of the financial crisis on fiscal balances. As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population

Clearly first world governments are not going to let interest service payments get to 10% of GDP without a struggle. That means some of (perhaps all of) reduced pensions and health care, lower public spending, and increased taxation. Reducing the real value of liabilities makes sense too, so expect somewhat higher inflation eventually – but not for a while. Intergenerational wealth transfer is going to become a key political issue in the developed economies, too. There are interesting times ahead…

Posted in: Credit, Economic Theory, Insurance and Actuarial Practice by David /
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I always thought that of the monoline insurer’s two businesses, writing wraps on muni bonds was safe, while writing wraps on structured finance instruments was dodgy. It seems I was wrong about the first part. From Bloomberg:

Ambac Financial Group Inc., the second biggest bond insurer, faces as much as $1.2 billion in claims if a judge in Nevada allows Las Vegas Monorail Co., which runs a train connecting the city’s casinos, to reorganize in Chapter 11 bankruptcy… The City Council of Pennsylvania’s state capital shelved a plan to sell taxpayer-owned assets to meet payments on $288 million of debt used for an incinerator funded in part with bonds insured by a unit of Bermuda-based Assured Guaranty Ltd. Harrisburg is weighing a possible bankruptcy filing.

With state tax collections last year through September showing the biggest drop since at least 1963, as measured by the Nelson A. Rockefeller Institute of Government in Albany, New York, local governments are seeking concessions from creditors of public projects, including bond insurers.

Ooops.

Update. A correspondent of Felix Salmon’s points out that the total claims-paying resources at National Public Finance Guarantee, the muni arm of MBIA, are $5.5B. That’s about 1.1% of its insured bonds. Hmmm, seems a bit light to me…

Posted in: Credit, Monoline by David /
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One of the things I love about the LRB is how it goes from high to low so effortlessly. Here are two sections from adjacent paragraphs in the same article in the current issue. First, the Frankfurt school:

… here’s something about the whole economic system that is false, because what capitalism brings about is the idea that things can’t be understood just in terms of what they are in themselves, but in terms of what they can be exchanged with

Next, — well, — let’s see what disturbs the author’s reverie on Walter Benjamin:

… in front of me was not a sluggish condom but an altogether more rapacious looking tool: a ten-inch-long dildo.

That kind of thing never happens in the FT.

Posted in: Fun by David /
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I love these reds… Sometimes in winter all it takes is a flash of colour in the sun to lift one’s mood.

Posted in: Photography by David /
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There has been considerable interest recently from the BIS in dynamic provisioning. The basic idea is that we should take provisions to reflect what expected losses will be over the life of the loan. Superficially this makes sense: if we know we are close to the peak of the economic cycle, then losses will be higher in the future, and so we should take more provisions. If we are in a downswing, then things will get better, and we need less. Thus dynamic provisioning can be countercyclical.

Note in particular that dynamic provisioning is in addition to specific provisions. This is important because dynamic approaches by their nature are ‘whole economy’ measures: to the extent that a bank’s portfolio is not average, it may need more provisions.

The idea of dynamic provisioning has been around for a while, as this 2002 Bank of England document demonstrates. But recent events have revived interest in it. In particular, as FT Alphaville points out, dynamic provisioning is seen as having been successful in the one place it has been tried, Spain, but it has some significant issues.

• Firstly, it does not fit with the current accounting model for provisions, and the standard setters are not accommodating. As Financial Director reports, the standard setters are also determined that financial regulators shouldn’t dump their problems onto financial reporting.
• Estimating where we are in the cycle can be difficult. In particular, while it is easy to know that we are in a crisis and so to release whatever reserves are available, it is hard to agree that we are in an upswing, and hence more reserves should be built.
• Interestingly the Spanish model is not an expected loss model, but rather uses current specific provisions to indicate the point in the cycle. If those specific provisions are correct, and the future is not a lot worse than the past, then the dynamic provision will be adequate. But if the current crisis is a lot worse, then as the FT points out, the provisions may have to go up. They quote JP Morgan research: ‘for the Spanish banks the scale of the generic provision has been seen to be too small, and may be revised upwards in the future.’ Certainly total provisions for the Spanish banking system at the end of 2007 of only 1.33% of total consolidated assets seem rather small.
• Lastly, the flipside of countercyclical provisioning is a lack of transparency about earnings volatility, and hence difficulty in estimating the true risk of a bank. Risk reports:
  

  the true scale of the problems in Spanish loan portfolios has been masked by the dynamic provisioning system, which requires the banks to make reserves based on past loss experience: “When times are going well, they will report lower profits than they’re really making and when times are worse they will report more profits than they’re really making. So the results seem relatively insensitive to the cycle, but only as long as the economy doesn’t perform significantly worse than you’ve seen in the past

  (Emphasis mine.)

There is no doubt that properly applied dynamic provisioning enhances financial stability. But that is because, in Grant Thornton’s words, it creates a disguised form of capital. I would much rather see procyclicality via capital without yet another layer of earnings manipulation.

Posted in: Accounting, Credit by David /
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Zero hedge picks up on some interesting information at the end of an Economist article:

JPMorgan Chase holds $3 billion of “model-uncertainty reserves”

That number feels reasonable in the context of a bank with nearly a hundred billion of capital. But I’d love to know how they got it past their auditors…

Posted in: Accounting, Model risk by David /
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John Kemp thinks that Greece should default and reschedule. I wonder.

The idea has immediate appeal from the point of view of punishing imprudent lenders. But, attractive though that is, would it be the best thing for the Greek people? It rather depends on whether the incremental cost of raising money post default is larger than the savings available through defaulting. There is no reason so far as I am aware that Greece could not default and still stay in the Eurozone. But obviously if they were to go for the nuclear option, then the spreads of Italy and Portugal would go out hugely – probably Spain too. And a lot of rather unsavoury people would make a lot of money.

I doubt very much whether this will happen, even if it is rational. But I have been wrong about Greece before…

Posted in: Sovereign Default by David /
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A draft of a new note of mine can be found here. Here is the abstract:

This note studies the optimal volatility for Black Scholes hedging in practice. The notion of hedging at a volatility which minimises the variance of the daily P/L of the hedged portfolio is introduced, and this measure is christened prophetic volatility. The relationship between realised volatility, implied volatility and prophetic volatility is studied for S\&P 500 index options during the period 1999-2009.

The main result is that prophetic volatility is close to realised for the whole of the data set; for quiet market conditions (such as pertained from mid 2003 to mid 2005); and for the market turbulence induced by the Credit Crunch. Implied volatility differs from prophetic for the whole period, indicating that it is at best an imperfect estimate of the right hedge volatility.

We review situations when prophetic volatility differs significantly from realised, highlighting the practical importance of gamma weighted realised volatility. Finally, the spread required to at least break even from selling calls is analysed for both prophetic and implied volatility.

Comments are welcome.

Posted in: Markets, Quantitative Trading by David /
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I have been meaning for a while to get to a speech given by Andrew Haldane recently: Haldane is one of the most thoughtful central bankers I have come across, and he usually has something interesting to say. The Debt Hangover is no exception.

Let’s start with Haldane’s explanation of the recent rally:

First, the rate at which the future cashflows on risky assets are discounted has fallen due to lower short and long-term global real interest rates.

Second … the premium that investors require to compensate for this risk – the risk premium – has fallen, boosting expected future cashflows on risky assets.

Third, improved liquidity in financial markets has lowered decisively uncertainty about future market prices. This has lowered … the liquidity premium.

The specific case of investment grade bond spreads is illuminating:

None of these trends can go on forever, of course, making it likely that the rate of increase in the prices of risky assets seen in the last year cannot be sustained. The FT gives further background here. They quote research from LBS suggesting that the equity risk premium, which averaged 4.4 per cent a year between 1900 and 2009, will be just 3 to 3.5 per cent in the future.

One reason Haldane is negative about asset prices is the debt hangover. Simply put, he argues that servicing the enormous amount of debt built up before the Crunch is going to hold back the recovery. We – consumers, corporates and governments – cannot deleverage fast enough. And we have a lot of borrowing to service:

Taking together the debt position of the financial sector, households, companies and sovereigns paints a sobering picture. Total debt ratios relative to GDP rose significantly in all ten countries studied [in a recent survey] by McKinsey’s, from an average of around 200% in 1990 to over 330% by 2008. Over the same period, UK debt ratios more than doubled, from just over 200% to around 450% of GDP.

Another reason, highlighted in the FT article, and promulgated in the the latest Barclays Equity/Gilt study, is that equity and bond returns since the 1920s have been largely driven by demographic trends, and the Baby Boomer generation are starting to move from net investors to net drawers down of capital:

Barclays’ models suggest this dearth of savings, combined with rising government deficits, will push Treasury and gilt yields from 4 per cent to 10 per cent, leading to negative real returns over the coming decade.

So, many smart people are pretty bleak about investment opportunities in the next little while. (Which, you might think, is a huge buy signal.) Still, the `negative real returns’ prediction is interesting. Certainly ten year government bonds at less that 4.1% (e.g. UK, Germany and US) are not hugely attractive, while the thin inflation premium (and high market expectations of forward inflation) make linkers unappealing. Seldom has the investment universe offered such a seeminglu unexciting menu. Perhaps it is a good time to keep your powder dry and see what the next few months bring – or to concentrate on sectoral themes like long biotech or short defence that are likely to be relatively unaffected by this bad macro picture.

Update. A similar account from Martin Wolf in the FT can be found here. He also quotes the McKinsey study (albeit only the executive summary)

Historic deleveraging episodes have been painful, on average lasting six to seven years and reducing the ratio of debt to GDP by 25 per cent

The only thing standing between us and disaster is, as Wolf knows, government spending. He says that massive fiscal tightening today would be a grave error, and I completely agree. But even without that, the prospects for investors who are not used to falling asset prices are poor. Sell out the money caps (short rates aren’t going up for a while); consider shorting linkers vs. nominals to profit when realised inflation is low; and if long dated implieds go up and further, sell long dated out of the money equity index calls. It’s ugly, but it might just work.

Posted in: Markets by David /
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Nice graffiti, shame about the delinquencies.

Posted in: Mortgages, Photography by David /
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There has been predictable outrage at Citi’s invention of a type of liquidity derivative. I have not looked at the specific Citi instrument, but I think that there is a place for liquidity derivatives.

First, notice that this risk is not new. Pensions funds — like many buy and hold investors — have been profiting from taking liquidity risk for a long time, for instance. It would make sense for them to sell certain liquidity derivatives.

A good example of a useful instrument is the total return swaption. Here in exchange for a fee, a party agrees that they will enter into a total return swap on a given bond at a fixed spread. Basically they are receiving a fee in exchange for agreeing to fund the bond if necessary. If the swap is cash collateralised and there is not significant default correlation between the bond and the counterparty, then this is a pure liquidity derivative. For unleveraged real money investors like pension funds, selling such total return swaptions could make sense. Leveraged investors who want to buy out of the money protection on their funding costs would be natural buyers. This market could help to make the financial system more secure by providing a certain type of liquidity risk hedge.

Posted in: Liquidity and liquidity risk by David /
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A nice list from the Big Picture of a few crises from 1970-2000 (which I have edited slightly):

• The Nifty Fifty stock market boom and subsequent correction of the early to mid 1970s
• Franklin National Bank Failure on 1974
• Penn Square Failure of the early 1980s
• Gold bubble in 1980
• The Savings & Loans crisis of the 1980s
• The Stock Market Crash of 1987
• The bond carry trade of 1994 and subsequent FED tightening
• Mexican Debt crises of 1982 and 1994
• The East Asian Financial Crisis on 1997
• LTCM of 1998
• The Tech Bubble on 2000-2001

The Argentinian default of 2001-2

Add in Brazil in 1998, Argentina in 2001-2, and the Credit Crunch and its aftermath in 2008-2009, and Greece in 2010, and you might think that the benign markets of 2003-2006 are the exception rather than the rule.

Posted in: Mother of all Bailouts by David /
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