Deus Ex Macchiato

One of the inspirations for this blog was Italian coffee. I mean that both literally – quite a lot of my posts are written with the aid of an espresso – and more theoretically; coffee in Italy is wonderful, cheap, and available very widely. I was curious how they managed it, and that lead to the very first post on this blog, over six years ago.

Today an article in the Guardian made me think about another incredibly efficient system in Italy, that of pizza. Again we have something that is cheap, readily available, and world-beatingly good*. Indeed, some of the finest pizza is also the cheapest. A meal and drink at the multi-award-winning Da Michele in Naples, for instance, will cost you less than ten euros. If you are anything like me, you will also think that this is the best pizza you have ever tasted.

The Guardian now says that there is a trend for gourmet pizza with exotic ingredients; figs, for instance, or truffle oil. That’s fine. People will always try to find a way to charge more for something that is less good. It worked pretty well for Starbucks, after all, so it might work for some of these ‘ultra-pizza’ chefs. But I strongly doubt that it will influence true Italian pizza, just as I doubt Starbucks will ever make much money in Italy. The original is just too good for a challenger to be that successful.

This robustness is a characteristic of good socio-economic systems. So too is the property that everyone profits, but no one makes too much. There isn’t much growth – a small town only needs one decent pizza joint – but there is solid demand for good quality. Tasty tomatoes and buffalo mozarella goes in, pizza comes out, and everyone – including the tomato grower and the cheese maker – is happy. Moreover, because everyone knows what good pizza is like, there is little demand for bad pizza. Thus there is a positive feedback loop which keeps average quality high, at least in much of Southern Italy.

Another good thing about the pizza system is that it is democractic. You can’t get a better pizza at Da Michele by paying more; you can’t jump the queue by slipping the Maitre d’ a hundred, not least because there isn’t a Maitre d’. The system serves a broad spectrum of interests, not a narrow one. Long may it continue.

*One of the most absurd claims I ever heard was that there was better pizza made in Brooklyn than in Naples. This is akin to claiming that the AMC pacer is a better looking car than the Ferrari F12 Berlinetta.

Posted in: Media and Popular Culture, Rules by David /
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…was huge. Really huge. The FT reports that JPM’s CIO

has built up positions totalling more than $100bn in asset-backed securities and structured products – the complex, risky bonds at the centre of the financial crisis in 2008.

These holdings are in addition to those in credit derivatives which led to the losses and have mired the bank in regulatory investigations and criticism…

The unit made a deliberate move out of safer assets such as US Treasuries in 2009 in an effort to increase returns and diversify investments. The CIO’s “non-vanilla” portfolio is now over $150bn in size.

Just when you thought it couldn’t get any worse. They own

more than £13bn (or 45 per cent) of the total amount of UK RMBS that has been placed with investors since the market re-opened in October 2009,” the BBA said.

Systemic, moi?

Posted in: Mortgages, Mother of all Bailouts by David /
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Izzy Kaminska has a nice article on Alphaville that reiterates some of the points I have been making about central clearing (see for instance here or here or here). She is writing about central clearing and collateral/liquidity.

Once again, we would like to draw on the analogy to a game of musical chairs.

The game depends on there not being enough chairs for all participants. While the music plays, the lack of chairs doesn’t matter much. Nobody actually needs a chair to sit on. But any anticipation that the music might stop, and the rush to allocate chairs begins to create panic.

But rather than have one central authority available to distribute chairs in a calm and collected manner between all parties, we’ve opted to introduce a system which depends on multiple authorities grabbing whatever chairs they can for some players but not for others — in effect creating a have and have-not system.

Meanwhile, as the grabbing of good quality assets intensifies thanks to this process, the supply of high quality collateral across the overall system diminishes with it.

What’s more, as the best collateral gets absorbed by the CCPs and/or capital and liquidity reserves, that leaves everyone else handling the dregs.

Posted in: Clearing and Collateral, Liquidity and liquidity risk by David /
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The St. Louis FED map of bank failures clearly suggests buying banks based in New England against shorting those in the rest of the US.

I’m joking of course, but it is interesting – and I am sure this map gave someone in the Boston FED a good day.

Posted in: Bank Run, Fun by David /
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… is a good idea. Sallie Krawcheck writes on the HBR blog:

Because the barriers to entry are low, there’s usually no good reason why returns in an institutional banking business should stay very high for an extended period. Competition should drive those returns down. As a result, sustained high returns on equity — especially higher returns than competitors are earning — can be a sign of impending trouble. They might mean a business is taking outsized risks, or misunderstanding the risks it is taking, or is skirting too close to the regulations. Not all high-return businesses crash, but variations on the comment “In hindsight, the returns were probably too good and too steady” are all too common in the financial sector.

Update. A related issue is that high and stable returns create a huge pressure to grow the business. Then there is a risk that you become too big relative to the size of the market. As Aleph says, citing the examples of AIG, Equitable and LTCM:

Anytime you get a large fraction of the market’s volume, you should stop, and re-evaluate. You’re probably doing something wrong.

Posted in: Authority and Leadership, Decision Making by David /
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I have finally managed to track down the transcript of Jamie’s embarrassing call. My favourite part relates to JPMorgan’s VAR:

We are also amending a disclosure in the first quarter press release about CIO’s VAR, Value-at-Risk. We’d shown average VAR at 67. It will now be 129. In the first quarter, we implemented a new VAR model, which we now deemed inadequate.

67 to 129. Not an immaterial change then. Ooops.

Update. Does this give JPM a Sarbannes-Oxley problem?

Another update. IFR reports

the Chief Investment Office, the unit responsible for the high-profile loss that JP Morgan disclosed last Thursday, had a separate VaR system.

It used a less stringent calculation that gave a lower risk assessment of its trades, according to people who previously worked at the bank.

The unit also reported directly to CEO Jamie Dimon, a factor which allowed it to maintain a separate risk monitoring set-up to other parts of the investment bank, these people said.

For me, the reporting line and oversight issues are even worse than the VAR model ones.

Posted in: VAR by David /
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Hedges, pace JP Morgan, are meant to reduce risk. There are, it seems to me, two important ways to hedge. Although real hedges overlap between these categories, the distinction is useful.

First, there are P/L volatility hedges. Here the idea is that risk is earnings volatility, and that you have some position which generates earnings volatility, which you want to remove. At its extreme, you may be happy with the long run risk of the position, but the ride is too bumpy in the short term. Hence you put on a hedge which is likely to move from day-to-day in an equal and opposite way to the position. Buying protection on the CDX against owning a diverse portfolio of corporate bonds would probably count as a P/L volatility hedge.

Second, there are tail hedges. Here something bad, while perhaps unlikely, could happen, and you want something that will pay off to offset your losses in that bad situation. Thus for instance you might buy an out-of-the-money put against owning an equity to hedge against sudden bad news.

Now here’s the interesting thing. Often, the type-two hedges are more effective at protecting the firm when it matters, but type-one hedges can look better. Management scrutinise the P/L every day, but (in many firms, it seems) they don’t have detailed knowledge of the positions. The type-one hedges look good as the P/L doesn’t move. Moreover, risk reports that concentrate on small moves would show them as low risk. Hedges like this often fail in stress conditions though – exactly where type-two hedges work.

Hedging the second way is organizationally difficult. It involves educating management why the P/L is volatile from day-to-day, and why the risk reports show substantial risk from small moves (albeit proportionally much less from large ones). It also involves being right about what tail event(s) are possible, and covering those; there is nothing worse than paying for a tail risk hedge then discovering that you have hedged the tail of the wrong risk factor.

If the risk is large enough to get external attention, then the problem is even worse. Trying to explain tail risk hedging to journalists or equity analysts after you have had an earnings miss is difficult, and management don’t want to run the risk of that embarrassing call.

The net result of all of this, I suspect, is that a lot of type-one hedges are put on that are utterly superfluous to the bank, while too few type-two ones are executed.

Posted in: Derivatives, Hedging and Convexity by David /
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At last…

Posted in: Photography by David /
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When Magellan emerged from the strait that bears his name into the Pacific ocean, he thought that he was only a few days sailing from Portugal and home. Good try, but no cigar. A similar navigational issue seems to be plaguing folks over last night’s $2B JPMorgan loss. Here are some things we can, and cannot conclude from this ‘egregious’ loss.

• Buying protection on a CDS index sometimes doesn’t hedge a long bond portfolio very well. (JP is supposed to have invested excess deposits in short dated corporate paper, then hedged the credit risk with index CDS; or perhaps bought tips then constructed a synthetic corporate linker portfolio by selling protection – can someone please get to the bottom of this?)
• Hedging is difficult, but if you have a position that a lot of people have noticed, and written about, then you call it a storm in a teacup, don’t lose a $2B on it. You look silly.
• Defining what a hedge is precisely enough to allow hedging but prohibit proprietary trading, as the Volcker rule must try to do, is very hard.
• This is not evidence that JPM (or anyone else) is under-capitalized. Sorry, but it isn’t; they absorbed the $2B with little more than mild embarrassment. (Of course, they may be under-capitalized, but you can’t conclude that from this story, however much you might want to.)
• When you have fair value items hedging accrual accounted items, then you get earnings volatility. Your risk measure looks kinda screwy, too, if you include the former but not the latter in it. (See the 10-Q here, pg 74.). The accounting rules probably have not served JPM particularly well here.
• Social media manager for Goldman Sachs is, today at least, not the toughest job in finance.

Update. FT alphaville makes a similar point about the difficulty of identifying a ‘good’ hedge here.

Posted in: Credit, Derivatives, Hedging and Convexity, Reputational Risk, Risk Management by David /
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In an important and interesting article on VoxEU, Singh and Stella discuss a new and to my mind convincing analysis of the money multiplier (or the lack thereof). It is well known that, despite a massive increase in central bank money, there has not been anything like the concommitant increase in credit that the multiplier would predict. Singh and Stella have two explanations:

The first relies on a correct interpretation of the liquidity needs and management of a modern financial system which comprises not only conventional banks but also financial institutions operating in their shadows. Such non-bank financial institutions do not have access to monetary base as they hold no reserves at the central bank. Instead they rely on their access to the repo market predicated on their ownership of what is perceived to be highly liquid collateral.

Due to this shift, the liquidity fulcrum of the pre-crisis US financial market was composed only partly of central bank liabilities—and it was a very small part. More importantly, the magnitude of the liquidity fulcrum was determined not by the monetary policy authorities but instead by market practice. The nature and volume of assets determined by the market to be acceptable collateral is the key.

I absolutely agree with this, which is why in the past I have suggested that the central bank consider not one but three policy tools; the rate at which it provides money (as usual), but also the amount and the collateral against which it will lend. Central banks should explicitly the implications of their definition of eligible collateral and, if necessary, change it. That is because collateral is in competition between being used at the central bank and being used in repo. As S&S explain:

The enormous increase in bank reserves reflects a substitution of monetary base largely for highly liquid government securities in private-sector portfolios. But as government securities serve as collateral in the private-credit market, the effective size of the market liquidity fulcrum is unchanged by such operations. Little wonder then that market liquidity conditions remain tight despite the increase in bank reserves. That is, although quantitative easing which merely swaps bank reserves for US Treasury bills increases the textbook monetary base and “should” lead to an increase in market credit, in our view this accomplishes virtually nothing in terms of easing liquidity pressures. It merely changes the composition of assets within a given sized liquidity fulcrum.

Central bank operations only create new liquidity if they take as collateral assets that are no longer accepted at full value as collateral in the market.

The part of the story that S&S are missing is the impact of capital. Banks don’t just need funds to lend, they also need capital to support the risk of lending. Add in that dynamic (and understand the impact of rehypothecation), and I think you have a much more convincing account of the money (de-) multiplier than the textbook one.

(HT FT Alphaville.)

Posted in: Economic Theory, Liquidity and liquidity risk by David /
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This is my initial reaction to the fundamental review of the trading book. I’ll set out what is in the FRTB in roman, then my reaction in italics. In many cases I’ll quote the Basel document for the former.

Preamble

First the good news. The Committee recognises that the Basel 2.5 revisions did not fully address the shortcomings of the market risk framework.

• The framework lacks coherence;
• The boundary issue (between the trading book and the banking book) has not been fully addressed;
• Problems remain unaddressed in the standardized market risk rules.

Basel 2.5 was, in my view, a sticking plaster, designed to ameliorate the immediate problem – and to dramatically increase the capital required for the trading book – but not to provide a coherent solution. The FRTB is an attempt at that solution.

The trading book/banking book boundary

The boundary is an issue in that some things were put in the trading book pre crisis which turned out to be illiquid. Trading book rules designed to capitalise short term market risk assigned too little capital to these positions. Therefore the committee wishes to strengthen the boundary criteria.

The Committee is consulting on two possible solutions to the boundary:

• A “Trading evidence”-based boundary where instruments will be admitted to the trading book provided that the bank has trading intent plus proven ability to execute that intent; or
• A “Valuation”-based boundary where the trading book will be defined by those items which are fair-value accounted.

To a certain extent, if the Committee addresses illiquidity as proposed below, then boundary arbitrage might either go away or, more likely, go the other way; the banking book might be cheaper than the trading book post FRTB. In any case, philosophically, the market risk rules should capitalise variation in fair value, so the second approach is clearly more coherent than the first (which would permit fair value variation to go uncapitalised in the banking book).

Stressed calibration

The Committee, understandably, wants:

• to ensure that regulatory capital is sufficient in periods of significant market stress; and
• to reduce the cyclicality of market risk capital charges.

Calibrating the capital framework to a period of stress helps to achieve both of these objectives.

I agree, but the devil is in the stress here. What we don’t want is banks all having book that would be very robust if the last crisis happened again, but which are all vulnerable to the next one. That’s the problem with uniform capital rules; they encourage herding.

Moving from value-at-risk to expected shortfall

ES will be used instead of VAR in models-based approaches.

While this aspect of the FRTB has received a lot of attention, it is not a massive change. Banks will be able to use their existing VAR infrastructure to calculate ES, and ES charges – while larger than VAR – should behave much like a stressed VAR.

A comprehensive incorporation of the risk of market illiquidity

This, in contrast, is a big change. It will, if implemented, force firms to take asset liquidity a lot more seriously.

• The framework will incorporate an assessment of market liquidity for regulatory capital purposes. Banks’ exposures would be assigned into five liquidity horizon categories, ranging from 10 days to one year.
• Capital will be based on the assigned liquidity horizon.
• There will also be capital add-ons for jumps in liquidity premia, which would apply only if certain criteria were met. These criteria would seek to identify the set of instruments that could become particularly illiquid, but where the market risk metric, even with extended liquidity horizons, would not sufficiently capture the risk to solvency from large fluctuations in liquidity premia.
• The Committee is consulting on two possible options for incorporating the
  “endogenous” aspect of market liquidity. (Endogenous liquidity is the component that relates to bank-specific portfolio characteristics, such as particularly large or concentrated exposures relative to the market.) The main approach under consideration by the Committee to incorporate this risk would be further extension of liquidity horizons; an alternative could be application of prudent valuation adjustments specifically targeted to account for endogenous liquidity.

Let’s suppose that the committee is broadly comfortable with the overall level of capital assigned to the trading book after the Basel 2.5 changes. That’s an assumption, but a reasonable one I think, as B2.5 was a quick fix designed to get the level of capital roughly right. In this case, clearly highly liquid areas (FX, most cash equities, some rates) will benefit from these proposed changes, while less liquid ones (most junk credit, most ABS) will suffer.

Treatment of hedging and diversification

The Committee is proposing to more closely align the treatment of hedging and
diversification between the standard rules and internal models.

Notice that this cuts two ways: reducing the diversification (and perhaps hedging) benefits for banks with models permisssions, while increasing them for standard rules banks.

The Committee proposes

• Constraining diversification benefits in the internal models-based approach to address the Committee’s concerns that such models may significantly overestimate portfolio diversification benefits that do not materialise in times of stress.
• Supervisor imposed (stressed) correlations will be a floor to diversification benefit within the internal models regime; and
• Revisions to the standardised approach that will enhance its risk sensitivity.

The hard part here will be improving the standard rules. There is very little detail from the Committee on this aspect.

Relationship between internal models-based and standardised approaches

The Committee considers the current regulatory capital framework for the trading book to have become too reliant on banks’ internal models that reflect a private view of risk. In addition, the potential for very large differences between standardised and internal models-based capital requirements for a given portfolio is a major level playing field concern and can also leave supervisors without a credible option of removing model permission when model performance is poor. To strengthen the relationship between the models-based and standardised approaches the Committee is consulting on three proposals:

• First, establishing a closer link between the calibration of the two approaches;
• Second, requiring mandatory calculation of the standardised approach by all banks;
  and
• Third, considering the merits of introducing the standardised approach as a floor or surcharge to the models-based approach.

This follows a general theme of backstopping models-based capital requirements by cruder, deliberately less risks sensitive calculations (in case the latter are wrong). Again, though, the devil is in the details; how will the Committee make the calibration ‘closer’ and how will it ensure that the two approaches do not drift too far apart?

Revised models-based approach

The Committee proposes to

• strengthen requirements for defining the scope of portfolios that will be eligible for internal models treatment; and
• strengthen the internal model standards to ensure that the output of such models reflects the full extent of trading book risk that is relevant from a regulatory capital perspective.

A key tool here will be desk-level models permission, based on

• P/L attribution and
• Backtesting

In other words, a bank won’t have models permission or not (a binary thing), but rather will have permission for some desks but not others. Even the most sophisticated banks may struggle to meet the standards to use models on some exotics businesses, for instance. While this approach makes sense, it is vulnerable to supervisory arbitrage, i.e. it will be vital that individual national supervisors interpret these criteria equitably.

Revised standardised approach

Two suggestions are given:

• Partial risk factor approach: Instruments that exhibit similar risk characteristics would be grouped in buckets and Committee-specified risk weights would be applied to their market value.
• Fuller risk factor approach: map instruments to a set of prescribed regulatory risk factors to which shocks would be applied to calculate a capital charge for the individual risk factors. The bank would have to use a pricing model (likely its own) to determine the size of the risk positions for each instrument with respect to the applicable risk factors. Hedging would be recognised for more “systematic” risk factors at the risk factor level. The capital charge would be generated by subjecting the overall risk positions to a simplified regulatory aggregation algorithm.

The appropriate treatment of credit risk within the market risk framework

Currently the market risk framework capitalises jump-to-default (and ratings migration) risk via IRC models, while charging for credit spread risk in VAR.

The Committee is consulting on whether, under a future framework, there should

• continue to be a separate model for default and migration risk in the trading book,
• or a single model.

Clearly consistency between the treatment of the same risk in the banking and trading books is to be desired.

Areas outside the scope of these proposals

• Interest rate risk in the banking book. The Committee intends to consider the timing and scope of further work in this area later in 2012.
• Capital for CVA risk.

IRRBB is something the FSA believes should be capitalized, but where it faces strong opposition from other supervisors. The industry is unhappy with the CVA proposals in Basel 3, and in particular with their poor treatment of market risk hedges to the CVA, but the Committee is not proposing to address this in the FRTB.

Summary

Overall, I find these proposals fairly sensible, if lacking in detail in a number of key areas. The thinking on liquidity, in particular, is valuable and welcome. The trading book/banking book boundary, while a flaw in the current regime, is in practice not a major vulnerability, and so it is good that the Committee is not suggesting anything too radical here. Expected shortfall is clearly a more stable risk measure than VAR, so again moving to this approach represents a sensible incremental improvement. A lot remains to be done though, especially developing the standard rules proposals.

Posted in: Basel by David /
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Quoth Gensler:

Clearinghouses can only survive if they have reliable pricing feeds on a daily basis to mark to market their positions, and also have reliable, liquid markets in default scenarios… There is far less risk in a clearinghouse if you have both pre-trade transparency and post-trade transparency.

He’s right. The problem is, there isn’t enough trading in many products to provide the desired transparency. Gensler probably thinks that OTC derivatives are like futures – they’re not. Days can go by without a representative trade in some products (where by product I don’t mean ‘OTC call’ but ’7 year 120% strike OTC call’). Dealers are willing to bear that liquidity risk for a price; clearing houses aren’t supposed to and, if they do, great suckitude will result. Thus, of course, such products aren’t clearable. Does Gary realise this I wonder?

Posted in: Clearing and Collateral by David /
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…is out. First reaction is that it isn’t bad. A more detailed response will follow shortly.

Posted in: Basel by David /
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A recent post by the Streetwise Professor made me wonder: how risk sensitive do we want capital requirements to be? Or to try to be?

Let me explain.

In the 1980s and 90s, it was a tenet of both regulators and banks that capital requirements should be risk sensitive. More risk requires more capital. That’s a good thing, right?

Well, yes and no. There are (at least) four problems.

1. Capital rules are always behind, and sometimes far behind, industry progress in risk measurement. The goal cannot be attained.
2. Relative risk equality is important, by which I mean that the same risk taken in different ways should attract the same capital charge. The Basel capital rules (increasingly) don’t meet this basic goal. Let’s fix this before we try and figure out the harder task of charging appropriately for different risks.
3. Risk measures are procyclical. That’s an inherent property of a good risk measure. There is a strong argument against procyclical capital rules.
4. Risk models can turn out to be flawed, or mis-calibrated. Therefore there needs to be some kind of backstop to prevent the massive growth of products which look low risk according to a (as it will turn out) flawed methodology.

Given this, I am tempted to ask (but not – notice – answer) a difficult question.

Is the task of trying to create a risk-sensitive capital framework worth attempting, given that it is not achievable, and failure necessarily leads to arbitrage?

Your thoughts, as always, are welcome.

Posted in: Basel, Regulation by David /
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Go Stephen King. From the Daily Beast:

I’ve known rich people, and why not, since I’m one of them? The majority would rather douse their dicks with lighter fluid, strike a match, and dance around singing “Disco Inferno” than pay one more cent in taxes to Uncle Sugar…

Mitt Romney has said, in effect, “I’m rich and I don’t apologize for it.” Nobody wants you to, Mitt. What some of us want—those who aren’t blinded by a lot of bullshit persiflage thrown up to mask the idea that rich folks want to keep their damn money—is for you to acknowledge that you couldn’t have made it in America without America. That you were fortunate enough to be born in a country where upward mobility is possible (a subject upon which Barack Obama can speak with the authority of experience), but where the channels making such upward mobility possible are being increasingly clogged. That it’s not fair to ask the middle class to assume a disproportionate amount of the tax burden. Not fair? It’s un-fucking-American is what it is. I don’t want you to apologize for being rich; I want you to acknowledge that in America, we all should have to pay our fair share.

Posted in: Politics, Taxation by David /
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When I googled ‘Davies’, the second hit was a typical Sun headline, Hollyoaks party girl Stephanie Davies flashes her bum as she straddles male model. Sadly, it wasn’t that Davies I was looking for. Mind you, this particular story is as predictable as a minor TV soap star behaving badly in public. It is Howard Davies defending globalization.

Let’s summarize. Howard presided over FSA as the light touch regulatory regime was constructed, then (in an egregious example of the revolving door) became a non-executive Director of Morgan Stanley. More recently he was director of LSE when it took money from Libya, and subsequently resigned citing ‘errors of judgement’. So when Howard tells you something, a measure of skepticism is worth deploying.

Here he is in Slate:

In the financial arena, there are many signs of a revival of nationalistic approaches to regulation and currency policy…

Host regulators are increasingly nervous about banks that operate in their jurisdictions through branches of their corporate parent, without local capital or a local board of directors. So they are insisting on subsidiarization. From the banks’ perspective, that means that capital is trapped in subsidiaries, and cannot be optimally used across its network. So banks may prefer to pull out instead.

He then goes on to support the Basel line that a robust global resolution framework is the answer. He hopes that this tendency for local regulators to want capital (and funding) in their own country does not catch on.

He’s wrong. I hope that it does catch on, for two reasons.

First, local supervisors need to be able to supervise their banking system. Think of the poor Croatians, for instance, with over 90% foreign ownership. Latvia is in a similar position. It is even an issue in Mexico. It is clearly unacceptable for such countries’ central banks to be unable to control their banking systems. If they have to force the owners to set up separately capitalized (and funded) subsidiaries, then so be it.

Second, there are huge economies of scale in large banks. This assists institutions in becoming too big to fail. Local capital requirements and subsidiarisation go the other way, and make it harder for a global bank to get bigger. Surely that is a good thing.

Posted in: Regulation by David /
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Lisa Pollack has an interesting, if rather too fair minded post on Alphaville about the dubious claim that the Black-Scholes formula somehow caused the crisis.

Let’s be clear. Black-Scholes is about options pricing, and hedging in particular. It has nothing to do with securitization, and little with tranching. So the claim that Black-Scholes caused the crisis is BS.

There is a boarder claim that somehow mathematical finance in general – and risk models in particular – were to blame. Certainly many VAR models under-estimated risk before the crisis, while some models of tranches were response for assigning great ratings to assets that didn’t perform well. But no model went out on a wet Wednesday about bought fifty billion of sub-prime ABS. A trader did that. Blame them, and the incentive structure in their firm that encouraged them.

Posted in: ABS, Model risk by David /
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If you wander around Shoreditch, you see some strange things. Some of them are the result of the whole area being a kind of informal gallery space. Take this pair for instance:

They just appeared a few months ago, hung around for a while, then disappeared. The two signs were indeed about 100m apart and they pointed at each other. I do appreciate someone adding that touch of oddity to my day.

Posted in: Art by David /
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An interesting initiative this, from the US. The HuffPo explains:

Both Houses of Congress are currently considering a bill which, in my humble estimation, would be wildly popular with the public — if they knew about it, that is. This is a truly non-partisan issue, one that pits every taxpayer in the country against the 535 members of Congress themselves — regardless of their party affiliation. The idea is a simple one, as evidenced by the bill’s official title: the “No Budget, No Pay Act.”

That’s it in a nutshell. The title is so good, it barely needs explaining. If Congress doesn’t pass a completed budget on time — both the budget blueprint and the 12 appropriations bills necessary — then when the new federal fiscal year dawns on the first of October, they stop getting paid. Their paychecks halt until the budget is complete, and they are not allowed to (later on, under the cover of night) award themselves retroactive pay for this period.

What is interesting about this – apart from the idea itself, which rocks – is that it pits the interests of all politicans (or very nearly all, at least) against those of the people. As such, it is very hard to get measures like these enacted. When you have cartel parties, though, such measures are necessary.

Update. It turns out that this comes from a rather interesting group, No Labels. Check them out.

Posted in: Politics, Rules by David /
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According to Bloomberg, The largest U.S. banks, including JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS), told the Federal Reserve that a limit on their credit exposure is unnecessary and “fundamentally flawed.”

They are of course wrong. The FED’s single counterparty credit limit (10 percent of capital for credit risk between a company considered systemically important and any counterparty when each has more than $500 billion in total assets) is a sensible move to address interconnectedness. Why is it that few challenge the proposition that the derivatives market – where exposures are typically collateralised every day – is too interconnected, but when it comes to direct interbank credit, no one cares that one SIFI owes another billions?

Posted in: Credit, Regulation by David /
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Yes, it (often) does. Credit Suisse offers us an example. First, what we know, from CS themselves.

In 1Q12, we entered into the 2011 Partner Asset Facility transaction to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers:

1. first loss (USD 0.5 billion),
2. mezzanine (USD 0.8 billion) and
3. senior (USD 11 billion).

The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis.

Basically, then, three parties own the credit exposure on CS’s OTC derivatives portfolio: the bank themselves, their employees, and a senior hedge provider. Selling the mezz to the employees (in lieu of bonus) is really smart as it gets around all sorts of disclosure and alignment of incentives issues associated with a third party hedge.

What’s left is presumably AAA risk or pretty close. But – and here’s the rub – the hedge provider has written a CDS on it. That’s an OTC derivative. So that generates CVA. Moreover like any senior tranche, while losses on it might be unlikely, there can be serious MTM volatility. So I bet, to keep the CVA down, CS has got its counterparty to agree to daily cash collateral but the counterparty, worried about the liquidity implications of this, has got CS to agree to lend it the money. It’s just a round trip. CS’s loan book lends money to the counterparty, who post it straight back as collateral under the CDS. Look, no CVA on the hedge, and all of our capital requirements on the CVA are gone. Magic, isn’t it?

(HT Dealbreaker.)

Posted in: Clearing and Collateral, Derivatives, Hedging and Convexity, Regulation by David /
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Steve Randy Waldman observes the problem:

The behavior of politicians, in Europe as in the United States, suggests that the people to which they are accountable are not primarily the fraction of their labor force that is out of work. This is different from the 1970s, when elected officials did seem to behave as though they were accountable to unemployed people, and put central bankers under intense pressure to be accommodative. Something has changed.

Jonathan Hopkin has the answer:

[parties became] ‘catch-all’ parties, no longer focused on mobilizing a core electorate, but instead diluting their ideological identities to attract voters from outside their traditional hunting grounds. In order to do this, parties became more centralized around their leaderships, whilst the membership – which constrained the leaders’ strategic room for manoeuvre – were neglected. Increasingly parties become professionalized, with the role of grassroots activists replaced by paid experts in media and communications…

Where mass parties [of the past] acted as links between civil society and the state… [these new cartel parties] have been entirely absorbed by the state, and correspondingly detached from civil society.

In other, plain words, they don’t work for you even – especially – if you are a party member. They work for the apparatus; and that, of course, means mostly those with the money, the media, and the lobbyists.

Posted in: Politics by David /
3 Comments

A typically histrionic post on Naked Capitalism about interest rate risk in the banking book gave me pause for thought. (Don’t you wish there was a browser plugin that could turn down a website automatically; it would substitute ‘unexpected inconvenience’ for ‘hidden time bomb’ for instance… Also, NC, for reference, the duration of a bond does not increase ‘exponentially’ as the coupon rate falls.)

Their point is that at some point rates in the US will likely rise, and that this will have an impact on bank earnings. That’s true. The direct impact however is both minor and well-disclosed. Here for instance is the relevant table from Citi’s 2011 annual report, showing the impact of 100 bp move in rates.

These disclosures are mandated in Basel 2, and clearly the numbers are not material for Citi.

Note too that this disclosure should include both behavioural effects on mortgages and their hedges, so that you will see some convexity for large rate shocks in the mortgage book (which a bank might well hedge with caps or swaptions, for instance). These behavioural effects include prepayment behaviour and fixes of mortgages with front end floating periods that flip (or can be converted) to fixed. To get a feel for the convexity, I would also like to see Citi disclose the impact of a 200 bps move.

What is also not there, and what may be an issue, is the impact of rates on the credit risk in mortgages. Rising rates cause extension in mortages and that in turn means that the borrower is on risk for longer. In a poor credit environment with a foreclosures still going at a good rate, being on risk for longer is a bad thing. The estimated increase in provisions under the different rate scenarios would therefore be another useful additional disclosure. Still, ‘rate risk = hidden time bomb’ feels seriously overblown to me.

Posted in: Mortgages, Risk Management by David /
3 Comments

In a recent speech, Bill Dudley describes why he believes the pre-crisis OTC derivatives market needed reform. Let’e examine his case.

[During the crisis] collateral calls generated by sharp movements in the mark-to-market value of the OTC derivative trades drained liquidity buffers and provoked the fire sales of assets. These fire sales increased volatility and provoked still greater margin calls.

Yes, but nothing proposed since would ameliorate this. The trades concerned would not have been clearable (no one is proposing clearing CDS on ABS), and indeed the introduction of clearing is making margin-driven liquidity risk worse not better.

the bilateral nature of the OTC derivatives market – between the two parties to the contract – be it dealer and customer or dealer and dealer – created its own set of difficulties. When counterparties became concerned about the health of a particular dealer, they often moved their trades – via novation – to other dealers. They did this to protect themselves should the dealer subsequently fail. But this process was difficult to carry out quickly and in size. The cumbersome nature of the process disturbed market liquidity and function. It also tended to drain off the liquidity from the troubled dealers because these dealers often used the counterparty cash collateral to fund their own operations. When customers moved their business, the collateral balances departed with them and this worsened the funding crunch on the troubled dealers.

This is fair, but notice that to fix this, we don’t need central counterparties; we just need a more efficient way to do novation. Dudley may also be suggesting here that the use of collateral-as-funding is a problem too, in other words he wants to see rehypothecation reduced. Again, this does not require CCPs. Finally of course clearing introduces a new version of this risk, where clearing members try to leave CCPs when they lose confidence in them. The absurdly low ‘cover 2′ capital requirement for CCPs makes this more likely. No, what you need to address this concern is compulsory initial margin on trades held at a trusted third party.

when a large counterparty, Lehman Brothers, filed for bankruptcy, it could no longer meet its obligations. The claims of Lehman’s customers, including those open OTC derivatives positions in which Lehman owed them money, were frozen. The lack of adequate segregation of the customers’ assets from the Lehman estate and the inability to move the outstanding obligations to other dealers – which we refer to as the lack of portability – created large problems for Lehman’s counterparties. Often Lehman’s clients were in the position that one side of a trade executed with Lehman was frozen, but the offsetting side remained open and exposed to volatile financial markets. This asymmetry contributed to the sharp increase in market volatility, the dramatic reduction in market liquidity, and the impairment in market function following the Lehman failure.

OK, so this is a motivation for clearing. But you could do a lot to help this problem by (a) building continuity of derivatives into the resolution regime for large financials (as, typically, is happening), (b) fixing the unenforced mess that are the segregation rules (cf. MF global) and (c) slowly – and carefully – moving away from collateral rehypothecation.

When I searched for Dudley’s speech by document name – r120323b.pdf – one of the hits on the first page was a recipe for pork tongue. If the whole process of OTC derivatives market reform reminds you of messing around with unpleasant meat products (and the famous quote often attributed to Bismarck about sausages), you wouldn’t be alone.

Posted in: Clearing and Collateral by David /
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NPR reports:

More U.S. homes are entering the foreclosure process, setting the stage for a surge in properties repossessed by lenders this year.

The number of homes that received first-time foreclosure notices rose 7 percent in March from the previous month, foreclosure listing firm RealtyTrac Inc. said Thursday.

The US housing market is not out of the woods yet, with the usual suspects (CA, UT, NV, AZ, FL, MI and IL) doing particularly badly. On average, 1 in every 662
housing units received a foreclosure filing in March 2012 but it was more like 1 in 300 in the worse affected states.

Posted in: Mortgages, Photography by David /
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From that most reputable of news sources, the Daily Mash:

The chances of shale gas exploration releasing a monstrous denizen of the underworld are less than one in three, experts have claimed.

As the army continues to fight two hundred chittering, horned creatures released during a test extraction in Blackpool, energy companies insist they can keep demonic activity at levels that would be classed as ‘normal’ for a seaside town.

Roy Hobbs, an engineer with Shell, said: “By my calculations the Shadow Lord Cthulhu currently rests nine leagues deeper than the shale gas so I’m sure it’ll be fine.

Posted in: Fun by David /
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(Crossposted from FT Alphaville.)

“The question is,” said Alice, “whether you can make words mean so many different things.”

In a recent Alphaville post, I made the claim that if the monolines had been required to mark the credit risk that they had taken to market, they would not have played such a prominent role in the financial crisis. Here I want to provide some support for that claim.

There will be several threads to this narrative. We begin with credit spreads.

What’s in a credit spread?

A credit spread is the compensation the taker of credit risk receives for risk. It is well-known that this includes more than just compensation for default risk. Citi research, for instance, produced this illustration recently, showing the default and non-default components of generic BBB credit spreads over time:

They use the term ‘risk premium’ for the non-default component: in reality this component is a mix of compensation for liquidity risk, funding risk, and other factors.

Notice how this non-default component varies over time. What this means is that a holder of credit risk who is marking to market suffers some P&L volatility that is unrelated to default risk (as well as some that is).

The consequences of marking credit to market

If you have to mark a credit risk position to market, then:

• You have to fund losses caused by credit spread volatility;
• You have to support the risk of credit spread volatility with some equity; and
• The risk of the position includes the risk of movements in the non-default component in the credit spread.

A non-mark-to-market holder of the same risk does not have these issues. Depending on their precise accounting standard they may have earnings volatility resulting from changes in perceptions of default, but they won’t have volatility resulting from non-default factors, and thus they don’t need as much equity to support the same position. The need for less equity means that a non-MTM credit risk taker will require a lower return than one who has to mark-to-market.

The history of historic cost

Long ago, the existence of multiple ways of accounting for financial instruments made sense. There were liquid (or at least semi-liquid) securities, and these were marked; there were totally illiquid loans, and these were accounted for based on historic cost (with a reserve being taken if the loan was judged to be impaired). Banks had a buy-and-hold strategy in the loan book, so recognising P&L on an historic cost basis made sense, while marking to market was natural for the flow-based trading book. Insurance companies had approaches* that were similar to historic cost: essentially they recognised premiums as they were paid, and reserved for claims that had been incurred but not yet presented.

Over the 1990s, these boundaries became blurred. Credit default swaps and securitisation liquidified banking book credit risk, and some institutions adopted originate-to-distribute strategies, while others were able to take credit risk in unfunded form by writing credit protection.

This meant that an arbitrage became available whereby the same risk could be taken by both mark-to-market players (by buying a trading book security) and non-MTM players (by writing credit protection which did not have to be marked or making a loan).

So how exactly did you take unfunded credit risk without having to mark it?

Several methods were developed to allow insurance companies to take unfunded credit risk without having to mark it to market.

• In the transformer approach, the insurance company would write a contract of insurance to a SPV which then wrote a CDS. Provided that neither the insurer nor the CDS buyer consolidated the SPV, this provided a compound contract that at one end looked like and was accounted for as insurance, and at the other end looked like and was accounted for as a credit default swap.
• In the wrap approach, the insurance company provided a financial guarantee contract on a bond. If the guarantor was AAA-rated (which the large monolines were pre-crisis), this essentially split the bond into a funding component provided by the buyer of the wrapped bond and a risk component, provided by the insurer.

Insurance companies took credit risk in other ways, too, of course, including some mark-to-market ones; we will come back to this shortly.

Why was taking credit risk in unfunded non-MTM form attractive to some insurers?

The insurance business model is, roughly: take risk by writing insurance, receive premiums, invest the premiums, and pay claims when presented. It works well when the value of invested premiums is larger than that of the presented claims. Given this model, some insurers found credit risk attractive: due to the non-default components of the credit spread, it seemed as if they could get paid more to take credit risk than defaults would cost them, and the structuring technology described above allowed them to do this without having to worry about intermediate earnings volatility caused by having to mark to market. The only question in this business model was ‘do you expect ultimate default losses to bigger or smaller than the value of invested premiums?’

Insurance risk models vary significantly from firm to firm, but what they share is a desire to estimate the capital required to support the risk of unexpectedly large claims. In other words, they assumed that the key risk was the risk of bigger-than-expected claims; something that is perfectly reasonable given the insurance accounting model.

Credit risk taking, then, was potentially attractive to insurers for three reasons:

• It could be made to look like a business model they were familiar with (take premiums, invest them, pay claims);
• It could be accounted for as insurance; and
• The capital required to support some forms of credit risk taking, such as writing protection on asset backed securities, was rather small according to their models.

Was insurance accounting a gateway drug?

It is certainly not that case that most credit risk taken by insurers pre-crisis was non-MTM. AIG, for instance, used fair value accounting on most of the contracts it wrote. However I believe that the availability of the non-MTM model in the early 2000s acted as a kind of ‘gateway drug’, getting some insurers into credit risk taking. Without it, the capital required to support credit risk taking would have been higher, and thus the business would have seemed less attractive. Moreover, the earnings volatility potentially created by having to mark to market** would have at least have given pause for thought at a much earlier stage.

To be fair to insurance accounting standards setters, it is hard to see what they could have done differently. Financial guarantee accounting makes some kind of sense where the guarantor is writing a wrap on an entire municipal bond, and there are no reasonable proxies available. The transformer structure, where a transaction is accounted for as insurance at one end and marked to market as CDS at the other, is less defensible. Arguably, though, the transformer SPV is a major part of the issue, and the rules governing when such things are consolidated have been tightened up (as have the details of financial guarantee accounting). One does wonder, though, what the relevant supervisors had in mind given their evident comfort with the types of practice described here.

Conservation of P&L volatility

Many laws in physics say that in any interaction, some property such as momentum or charge is conserved: the total amount of it in the system remains the same. In a certain sense, moving credit risk from an MTM to a non-MTM player violates conservation of risk. A non-MTM party sees less risk in the deal than an MTM party as the volatility of the non-default-related component of the spread has disappeared. Early 2000s structures such as the one we have described facilitated this, and thus allowed the non-default component of the spread to be monetized.

The introduction of CVA made this situation somewhat better. Non-MTM parties do not get the full benefit of their accounting if they have to post collateral based on the mark of the position – at very least they have to fund the collateral, and that is a drain on their liquidity. So many of monoline trades were done without collateral agreements. This in turn meant that once CVA charges were imposed, some of the volatility of the non-default component of the credit spread reappeared as CVA volatility. This risk hadn’t disappeared after all. Perhaps that is the real lesson: if your trade seems to make risk disappear, there’s something wrong with it.

*Obviously a one sentence account glosses over many complexities and jurisdictional differences.

**Of course, being able to use a model to mark means that much of this volatility can be avoided, at least while the asset credit protection has been written on is not obviously impaired.

Posted in: Accounting, Credit, Insurance and Actuarial Practice by David /
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My earlier post on the duty a company has to maximize profits to shareholders attracted quite a lot of comments (well, quite a lot for DEM anyway). Andy helpfully pointed me towards Dodge v. Ford Motor Company, and that in turn lead me to Lynn Stout’s paper on the case.

What we seem to have, in US law (and Delaware law in particular, given most large corporates in the US are incorporated in Delaware) is the following:

• There is no obligation for a US corporation to make money for shareholders provided that it says what it is going to do. Non-profits are often structured as corporations for instance.
• However, there is an obligation to treat all shareholders equitably. (This was one of the main issues in Dodge v. Ford.)
• Moreover absent a statement that a company isn’t there to make money for shareholders, there is a presumption that it is.
• However the business judgement presumption (that absent compelling evidence to the contrary, Directors are presumed to be acting in the interests of the corporation) is very strong in Delaware law, so shareholders often find it difficult to find a colorable claim on management for conduct that didn’t end up being in their best interests.

In other words, a Delaware corporation can act in the interests of a wider group than just shareholders, and it is unlikely that they can be sued for it. Exactly where the boundary of business judgement lies here, though, would have to be settled on a case-by-case basis.

Posted in: Legal Risk and Trade Documentation by David /
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They also, in a hat tip to Lisa Pollack, say that kicking lolcats is wrong. Probably.

The new CPSS IOSCO report on Principles for financial market infrastructures is here and, like prior documents from CPSS IOSCO, it is lamentably short on detailed objectively testable requirements. Take this, for instance:

Principle 4: Credit risk

An FMI should maintain sufficient financial resources to cover its credit exposure to each participant fully with a high degree of confidence. In addition, a CCP that is involved in activities with a more-complex risk profile or that is systemically important in multiple jurisdictions should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates.

A high degree of confidence but which one? 99.9% one year like Basel 2? Or 99% ten day like the failed market risk standard pre Basel 2.5? Or something even more lenient? (The margin requirement in principle 6 sets 99% as a minimum but it doesn’t mention a holding period, so presumably 99% five day would pass.)

Systemic CCPs have to meet a ‘cover 2′ standard. To see how lax that is, consider a crisis. Because large banks are highly correlated, and especially because post Dodd-Frank it is (reasonably enough) hard to rescue banks, the failure of two large clearing members of a systemic CCP is entirely conceivable. Then what? The CCP has to be resolved. Clearly that is a bad thing to be happening, especially in a crisis.

No, what one wants instead is that systemic CCPs have enough financial resources to (a) withstand a plausible worst case default and then (b) still have enough capital to keep the market’s confidence. ‘Cover 2′ plus capital for counterparty credit risk to a 99.9% one year standard would do the job; ‘cover 2′ alone doesn’t.

CPSS IOSCO has come up with something that in crucial areas is loose and unconstraining. The global financial system deserves better.

Update. By the way, what happens if a CCP that meets ‘cover 2′ suffers 1 default and thus no longer meets it? Does it have to shut down or be resolved? If not, how long does it have to get back to ‘cover 2′? How will you stop clearing members leaving (and so forcing the CCP to sell assets to repay initial margin) after such an event?

Posted in: Clearing and Collateral by David /
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Bloomberg tells us:

Two years after President Barack Obama vowed to eliminate the danger of financial institutions becoming “too big to fail,” the nation’s largest banks are bigger than they were before the credit crisis.

Five banks — JPMorgan Chase & Co. (JPM), Bank of America Corp., Citigroup Inc., Wells Fargo & Co., and Goldman Sachs Group Inc. — held $8.5 trillion in assets at the end of 2011, equal to 56 percent of the U.S. economy, according to the Federal Reserve.

Five years earlier, before the financial crisis, the largest banks’ assets amounted to 43 percent of U.S. output.

Posted in: Mother of all Bailouts by David /
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OK, the Robert Biggert Collection of Architectural Vignettes on Commercial Stationery might not be for everyone, but check it out, it’s awesome.

Posted in: Art by David /
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Charles Goodhart and Wolf Wagner have an interesting but flawed idea which harks back to a recent post of mine:

…[The] lack of diversity [among financial institutions] is very costly for society. Similar institutions are to encounter problems at the same time. This makes systemic crises – such as the crisis of 2007-2009 – more likely…

… [The] tendency for the financial system to become excessively homogenous provides a rationale for regulation that encourages diversity. But what form should such regulation take?

We believe that imposing direct restrictions on the activities of financial institutions is not a promising avenue. As argued above, diversity arises through many and very different channels. Such regulation would thus be very complex and burdensome. An additional issue is that diversity cannot be easily quantified. For example, it would be an onerous task for regulators to measure similarities in bank funding structures – not to speak of similarities created by counterparty risks.

We instead advocate an approach where financial institutions will be subjected to capital requirements that condition on how correlated their overall activities are with the rest of the financial system. This may be in the form of a surcharge on existing capital requirements or, preferably, a redefinition of current risk weights that keep average capital requirements unchanged.

The problem with this is that it makes it impossible to manage your capital. You don’t know what your charge will be because you don’t know what other institutions are doing. Moreover, measuring correlation is very hard: Goodhart and Wagner suggest using equity return correlations or relative correlations, but equity is call on asset value struck at the face value of debt, so equity/equity correlations relate non-linearly to asset value correlations. The latter though are not observable.

What you want is some approach that incentises strategic diversification. Strategic change takes a while though; you can’t suddenly turn Goldman Sachs into HSBC or vice versa even if you wanted to. Even if Goldman wanted an emerging market retail banking franchise, for instance, it would take them years to acquire it and figure out how to run it.

Goodhard and Wagner have the right aim but the wrong way of getting there. Their proposal doesn’t allow for the difficulty of changing your correlation with the rest of the system, nor for the importance of a clear target level of capital that does not vary with unhedgable factors. This idea deserves some more thought.

Posted in: Emergence, Regulation by David /
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In my alphaville parrot post, I claimed that clients find CVA confusing, and further that going with the cheapest all-in quote for a given trade is not necessarily optimal, because (a) CVA depends on the existing portfolio and (b) some banks have more or less expensive CVA calculation approaches.

Here’s an example.

Let’s describe the position in terms of some risk measure like DV01, and assume all trades are in the same IRS. Suppose that the client starts with the following position at two dealers:

• Dealer A, -10
• Dealer B, 0

The client has a new trade of 10.

• Dealer A has an expensive CVA calculation and quotes 1. (His net risk position if the new trade is done with him is zero, so this is cheeky.)
• Dealer B has a cheap CVA calculation and quotes 5 based on a net risk after the trade of 10.

We will look at two approaches.

1. Cheapest quote approach

The client trades with A given that A’s CVA quote is smallest (i.e. their price is best).

The risk positions are now:

• Dealer A, -10 + 10 = 0.
• Dealer B, 0.

The total risk for the client is 0 and the total CVA paid is 1.

Now the client has a new trade of 10.

• Dealer A quotes a CVA of 10
• Dealer B quotes a CVA of 5

Based on cheapest quote, the client goes to B.

The risk positions are now:

• Dealer A, 0.
• Dealer B, 10.

The client’s total risk is 10 with B, and the total CVA paid over all trades is 6.

The client now has a trade of -20.

• Dealer A quotes 20
• Dealer B quotes 10

The client trades with B.

The risk positions are now:

• Dealer A, 0.
• Dealer B, -10.

The client’s total risk is -10 with B, and the total CVA paid is 16.

2. Best CVA given the risk approach

Recognising the expensive CVA that A is quoting, the client trades with B.

The risk positions are now:

• Dealer A, -10.
• Dealer B, 10.

The client’s risk position is -10 to A, 10 to B, and the total CVA paid is 5.

As before, the client has new trade of 10.

• Dealer A quotes 1
• Dealer B quotes 5

Based on the best CVA, the client goes to B.

The risk positions are now:

• Dealer A, -10.
• Dealer B, 20.

The client’s risk position is -10 to A, 20 to B, and the total CVA paid is 10.

As before, the client now has a trade of -20.

• Dealer A quotes 10
• Dealer B quotes 0

Based on best CVA, the client trades with B.

The risk positions are now:

• Dealer A, -10.
• Dealer B, 0.

The client’s total risk is -10 with A, and the total CVA paid is 10.

Conclusions

What we see from this is that going with the cheapest quote one trade at a time does not necessarily lead to the best position in the long run. Dealer A’s cheap quote at the start suckered the client into trading with them, despite their expensive CVA calculation. The client would have been 60% better off going with dealer B for all its trades, despite B being more expensive on the first trade.

Posted in: Clearing and Collateral by David /
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The fourth and fifth Alphaville posts are here and here. Normal service will be resumed here next week, but meanwhile thanks to the Alphaville team for a fun week of guest blogging, and to Alphaville readers for their great comments.

Posted in: Clearing and Collateral, Publications by David /
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I cordially dislike that phrase, but a lot of people call it that so I got in line. Ah well, mildly histrionic terminology notwithstanding the third Alphaville post is up.

Posted in: Clearing and Collateral, Publications by David /
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The second in the series of FT alphaville posts on CVA is here.

Posted in: Clearing and Collateral, Publications by David /
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All this week I am very pleased to announce that I will be a guest blogger at FT Alphaville, with a series of posts on CVA. The first one is here.

Posted in: Clearing and Collateral, Publications by David /
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Posted in: Photography by David /
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This is really a placeholder for something I want to get back later: the question of what corporations are for. It’s inspired by an article by Ken Jacobson on the Salon website:

“It is literally – literally – malfeasance for a corporation not to do everything it legally can to maximize its profits. That’s a corporation’s duty to its shareholders.”

Since this sentiment is so familiar, it may come as a surprise that it is factually incorrect: In reality, there is nothing in any U.S. statute, federal or state, that requires corporations to maximize their profits. More surprising still is that, in this instance, the untruth was not uttered as propaganda by a corporate lobbyist but presented as a fact of life by one of the leading lights of the Democratic Party’s progressive wing, Sen. Al Franken. Considering its source, Franken’s statement says less about the nature of a U.S. business corporation’s legal obligations – about which it simply misses the boat – than it does about the point to which laissez-faire ideology has wormed its way into the American mind.

The notion that the law imposes a duty to “maximize shareholder value” – a phrase capturing the notion that profits are mandatory and it is the shareholders who are entitled to them – is so readily accepted these days because it jibes perfectly with assumptions about economic life that constantly come down to us from business and political leaders, from academia, and from the preponderance of the media. It is unlikely to occur to anyone under the age of 40 to question this idea – or the idea that the highest, or even sole, purpose of a corporation is to make a profit – because they have rarely if ever been exposed to an alternative view. Those in middle age or beyond may have trouble remembering a time when the corporation’s focus on shareholders’ interests to the exclusion of all other constituencies –customers, employees, suppliers, creditors, the communities in which it operates, and the nation – did not seem second nature.

This narrow conception of corporate purpose has become predominant only in recent decades, however, and it flies in the face of a longer tradition in modern America that regards the responsibilities of a corporation as extending far beyond its shareholders.

What I want to know, specifically, is whether the claim ‘there is nothing in any U.S. statute, federal or state, that requires corporations to maximize their profits’ is true. It’s just that, shockingly, there are some seemingly factual statements on the internet which aren’t actually true. And I would be really interested to know if it is true.

Posted in: Economic Theory by David /
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One year Eurostoxx off 20%, Brent still over $120/barrel, a (maybe minor) Spanish funding crisis, and (my favourite head shaking story of the week, this) the CIA used American modern art – including Jackson Pollock, Robert Motherwell, Willem de Kooning and Mark Rothko – as a weapon in the Cold War. It’s enough to turn anyone bearish on the state of the world. Perhaps things will look better after Easter. Meanwhile, though, take care if you go for a walk in the woods. He might be more scared of you than you are of him, but he has big claws.

Posted in: Photography by David /
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Doug had a very interesting comment to my post about evolutionary diversity and banking. I’ll set up the problem, then quote some of his comment and try to give my spin on his questions.

Essentially we are concerned with an unknown fitness landscape where we are trying to find the peaks (best adapted organisms or most profitable financial institutions) based on changes in makeup (genetics or business model). The landscape might have one peak, or two, or twenty seven. The peaks might be similar height, or they might be wildly different; the local maxima may or may not be close to the global maxima or they might not. Moreover, you only have knowledge of local conditions. The question is how you optimize your position in this landscape.

This is related to the topic of metaheuristics… A typical scenario would be a doing a non-linear regression and finding the model parameters that maximizes fit on a dataset. In the scenario there’s no analytical solution (e.g. in linear regression) so the only thing you can do is successively try points [to see how high you are] until you exhaust your resource/computational/time limits. Then you hope that you’ve converged somewhere close to the global maximum or at least a really good local maximum.

The central issue in metaheuristics is the “exploitation vs exploration” tradeoff. I.e. do you spend your resources looking at points in the neighborhood of your current maximum (climbing the hill you’re on)? Or do you allocate more resources to checking points far away from anything you’ve tested so far (looking for new hills).

One of the most reliable approaches is simulated annealing. You start off tilting the algorithm very far towards the exploration side, casting a wide net. Then as time goes on you favor exploitation more and more, tightening on the best candidates.

Simulated annealing is good for many of these kinds of problems; there are also lots of other approaches/modifications. A couple of things to note though; there is no ‘best’ algorithm (ones that are good on some landscapes tend to fail really badly on others, while those that do OK on everything are always highly suboptimal compared with the best approach for that terrain); moreover, this class of problems for arbitrary fitness landscapes is known to be really hard.

In what follows, I’ve taken the liberty of replacing the terms ‘exploration’ and ‘exploitation’ for ‘wide ranging exploration’ and ‘local exploration’ as I don’t think ‘exploitation’ really captures the flavour of what we mean. Back to Doug:

I believe the boom/bust cycle of capitalism operates very much like simulated annealing. Boom periods when capital and risk is loose tend to heavily favor wide ranging exploration (i.e. innovation). It’s easy to start radically new businesses. Bust periods tend to favor local exploration (i.e. incremental improvements to existing business models). Businesses are consolidated and shut down. Out of those new firms and business strategies from the boom periods the ones that proved successful go on to survive and are integrated into the economic landscape (Google), whereas those that weren’t able to establish enough of a foothold during the boom period get swept away (Pets.com).

All of this is tangentially related, but it brings up an interesting question. Most of the rest of the economy (technology is particular) seems to be widely explorative during boom times. Banking in contrast seems to be locally explorative even during boom times, i.e. banking business models seem to converge to each other. Busts seem to fragment banking models and promote wider exploration.

So why is banking so different that the relationship seems to get turned on its head?

The cost of a local vs. global move is part of it. Local moves are expensive for non-financials, almost as expensive as (although not as risky as) global moves. That makes large moves attractive in times when the credit to finance them is cheap. When credit is expensive and/or rationed, incremental optimization is the only thing a non-financial can afford to do.

It’s different for many financials however. The cost of climbing the hill – hiring CDO of ABS traders – is relatively small compared to the rewards. Moreover there is more transparency about what the other guys are doing. Low barriers to entry and good information flow make local maximisation attractive. To use the simulated annealing analogy, banking is too cold; there isn’t enough energy around to create lots of diversity.

And is this a bad thing for the broader economy, and if so why?

I think that it is, partly because the fitness landscape can change fast and leave a poorly adapted population of banks. Also, there are economies of scale for financial institutions and high barriers to entry for deposit takers and insurers (if not hedge funds), so there are simply not enough material size financial institutions. It is as if all your computation budget in simulated annealing is being spent exploring the neighbourhood of two or three spots in the fitness space.

A large part of the answer, it seems to me, is to make it easier to set up a small bank and much harder to become (or remain) a very large one.

Posted in: Emergence, Mathematics and Science, Rules by David /
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An old speech of Paul Tucker’s, made me think. (Danger, Will Robinson.)

To begin, two unconnected facts.

First, fair value gains are unlike most (not quite all, but run with me) other accounting gains, in that there isn’t necessarily a matching loss. If I issue 100 shares, and you buy 50 for $1, then I sell a further ten for $1.50, you can mark your 50 up to $1.50 without anyone having lost anything. Thus unlike a growth in credit (where there is an obligation to repay and hence a liability matching the asset), fair value gains are asymmetric.

Second, the monetary base is asymmetric; the central bank can create (or destroy) it out of nothing. When the central bank opens the window to repo in assets, it usually creates new money.

Thus in a certain sense, fair value gains are like the monetary base in that they are money with no matching liability. Both are forms of money that banks can use without worrying about liquidity risk. Indeed, fair value gains are in a sense even better than M0 in that audited FV gains count as retained earnings and hence as part of a bank’s capital. They can thus be used to lever broad money (that is, deposits), something central bank liquidity doesn’t do.

This of course means that asset price growth has inherent leverage: buy a share for $1, mark at $1.50, take $0.50 as P/L, count that as capital, use it and borrowed money to buy some more shares.

This leads me to suspect that you can’t really think about money and the Ms without thinking about capital too. Broad money creation – as we said before
here – doesn’t just depend on credit demand, it also requires both funding and capital.

Update. More on the modern view of money multipliers (and that whole Krugman vs. the Minskians thing) can be found here, here and here.

Posted in: Accounting, Economic Theory by David /
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I’m late with this, but I should be honest, so here goes.

The 2011 macro conviction trades were:

1. Eurozone fears are overdone. Many market participants are in my view overestimating the likelihood of Eurozone breakup, especially in the short to medium term. Long the Spain/Germany spread.

Result. It made money on an accrual basis, but the P/L volatility on a mark to market basis was ugly. Score 1/2.

2. The developed equity markets are overbought. They are likely to continue that way for some time, so I like selling 3 or 4 year slightly out of the money calls on the Eurostoxx and SPX.

Result. The Eurostoxx trade, the SPX one (so far) didn’t. Score 1/2.

3. Japan might finally get its act together. OK, perhaps not that likely, but a medium sized punt on the Nikkei feels like reasonable value. Expect yen appreciation, though, so you might want to currency-protect that.

Result. Underwater, but not by too much. Score 1/2 mainly for calling the currency right.

4. Liquidity becomes better priced. Basel will force banks to consider security liquidity more carefully, and thus liquidity premiums will increase. Hang on to assets with great liquidity characterisistics for now, and look to bleed them out via two way total return swap structures or similar as the banks get more desperate.

Result. Hard to assess but certainly not wrong. Score 1.

5. Sovereign CDS basis to increase on the best quality countries. The trend in the previous point will make govies more attractive while CVA hedging will increase the demand for CDS. This will cause the CDS/bond basis to increase. Consider the negative basis trade on govies.

Result. That worked. Score 1.

3 1/2 out of 5. Not too bad. I’ll let you know where to leave the 2 and 20.

Posted in: Hedge Funds, Markets by David /
2 Comments

Some good things are coming the week after Easter, so be sure to tune in to DEM on Monday week. They are under construction at the moment, but things are progressing well… Due to this building work, though, next week might be a little quiet.

Posted in: Photography by David /
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Hans asked a good question in comments to a prior post:

when you start off with 40 medium size banks, eventually a few will have a better business model than the others. And then the business model gets copied (due to shareholders seeing the return at the more successful banks and wanting the same) which leads to a convergence to 40 banks with (more or less) the same business model. Basically what we saw in the run-up to the financial crisis. After which the take-overs can begin due to economy of scale.

In other words: I agree that ‘evolution’ thrives on diversity, but how do you prevent convergence to one (or 2/3) business models?

I have to say that that one has me stumped for now. The fitness landscape changes fast for banks, so rapid change (what an evolution biologist would call Saltation) is the norm. If we let evolutionary pressure bear on a diverse set of creatures in a fitness landscape with a single peak – a single business model – the ones that don’t climb the peak aren’t very successful. So do we have to imagine legislators coming in like comets every 50 years and imposing diversity again? That’s pretty depressing.

The problem is the premise: a single-peaked fitness landscape. Diversity is encouraged when there are lots of local maxima in the fitness landscape. We need, in other words, to make sure that lots of banking different models are acceptably profitable. There are two ways to do this of course: lifting up the little guys (aka the wildlife sanctuary approach) or crushing the big guys (aka a cull). To your elephant guns, gentlemen.

Posted in: Emergence, Mathematics and Science, Rules by David /
10 Comments

From MNI:

Bank of England Deputy Governor Paul Tucker Saturday said the practice of rehypothecation by primary brokers had fallen “under the radar” and suggested it may merit greater regulation by financial authorities.

By using clients money and assets, rehypothecation by primary brokerages means “in economic substance, they are banks,” Tucker said at a Federal Reserve conference in Washington.

“This is a really significant issue that lies absolutely under the radar. We have to think through what rehypothecation means, and what we should do about it,” Tucker said.

I might rather tartly remark that just because something has gone under the radar of the great and the good doesn’t mean that it has escaped everyone, but that is beside the point. It is true that rehypothecation enables broker/dealers to liquify collateral, and that this can introduce systemic risk. It is also true however that this process is built into the current financial system, and that you cannot ban it without substantially changing liquidity dynamics. A vital first step before imposing any change is measurement: the authorities need to understand liquidity dynamics rather better before they attempt to influence them.

Posted in: Clearing and Collateral by David /
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No, not an advertisement for the new chocolate Philadelphia, but rather a comment on the ratio of the default to non-default component of credit spreads. The following is from Citi investment research, via FT alphaville:

Now, note that tihs isn’t quite as straightforward as it looks: we are comparing current default rates with compensation for future risk, so it isn’t entirely clear that credit spreads are rich – if defaults in the future are much higher, then they might not be. Still, it does look as if now might be a good time to take (a diversified pool of) corporate credit risk.

Posted in: Credit, Markets by David /
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In the first three parts, we saw that the new Basel rules for the trading book should have the following elements:

1. Capital to support losses in a credit crisis, where spreads go out, volatility rises, equity prices fall, and rates either go up or down; plus
2. Capital to support losses due to idiosyncractic risk; plus
3. Capital to convince the markets that the bank is still solvent after these two classes of loss.
4. We also need a global model benchmarking regime to provide confidence that the process is not being gamed.

Thus total capital = 2 x (stress capital + idiosyncractic capital). The 2 x being there to account for item 3.

We saw that idiosyncractic risk is by definition uncorrelated, so idiosyncractic capital is the square root of the sum over all risk factors of F x daily stressed volatility of risk factor x number of days to hedge the bank’s position in the risk factor in a stressed market. F is a prudence factor needed to obtain the right degree of confidence: for instance, F = 2.33 would give you 99% confidence under a normality assumptions; it would be better to calibrate F using a fat tailed model, which would probably give you 6 or 8 or something like that.

Posted in: Basel, Regulation by David /
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This is another in my continuing series on the upcoming Basel fundamental review of the trading book.

Today I want to talk about models, and consistency. Now while I have a lot of sympathy with A foolish consistency is the hobgoblin of little minds, it has to be admitted that perceived lack of consistency between different banks’ capital models has caused a lot of comment which has damaged the reputation of the regulatory process. I say ‘perceived’ because few people really understand the materiality of the differences between different banks’ models. That has not stopped commentators from Jamie Dimon to Andy Haldane suggesting that there is too much room for banks to reduce capital by changing their models, and too little supervisory consistency, though, and I can see their point.

All the same, there’s no getting away from models. Only a model can hope to measure risk accurately. Standard rules – like capital = 8% of notional – are just bad models.

So what should we do?

The answer is that the fundamental review of the trading book should introduce a benchmark portfolio regime. All systemically important banks should be required to calculate capital using their own models on a number of standard portfolios every quarter. These portfolios would be updated regularly. Bank results would be compared, and those that were low would have higher capital multipliers imposed. Anyone who was too far out would not be permitted to use their model for that asset class at all. The process could be run by the financial stability institute in Basel, and results should be public. That would certainly enhance confidence in the financial system.

(The cynical among you might note it would also generate wonderful opportunities for folks like, ahem, me, to help banks ‘improve’ their models before the process started. That might be true. But just because something would be a consulting goldmine doesn’t make it bad. Does it?)

Posted in: Basel, Regulation by David /
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For some reason there are a lot of spam comments around right now; the filter is catching them, but the sheer number means that I don’t have time to check the spam queue for real comments before deleting it, so if by chance yours was incorrectly classified, my apologies.

Posted in: Photography by David /
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From the final paragraph of a wonderful essay by Harvey Rosenblum, Dallas Fed executive vice president and director of research:

The road to prosperity requires recapitalizing the fnancial system as quickly as possible. The safer the individual banks, the safer the fnancial system. Te ultimate destination—an economy relatively free from financial crises—won’t be reached until we have the fortitude to break up the giant banks.

Go read it.

Posted in: Moral Hazard, Mother of all Bailouts by David /
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Yesterday we saw that a major plank of the new Basel trading book regime should be capital against a large systemic shock aka a credit crisis. Today we will look at another element of capital requirements: that for idiosyncratic risk.

Now, if we are truely capturing idiosyncractic risk with no systemic component – which is a reasonable assumption as we got the systemic stuff yesterday – we can make a zero correlation assumption. The total capital requirement is then just the root-mean-square of the capital requirements for each individual risk.

What’s the capital requirement for each individual risk? Well that depends on two things: the volatility of returns in the risk factor, and the holding period, i.e. how long we are on risk for. The first is easy to estimate – just use a long run historical average volatilty. (Again, this is not imprudent as we captured high volatility periods in our systemic risk capital in the prior step).

The second is harder as it depends on how long it would take us to hedge the risk. For FX, that is probably minutes. For an illiquid ABS, it may be months. So the shock we apply should depend on the time to hedge, and that in turn should depend on (a) the size of the position relative to normal market size and (b) the liquidity of the risk factor in stressed conditions. In short, large positions relative to stressed market liquidity should attract a lot more capital than smaller, easily hedged ones.

Posted in: Basel, Regulation by David /
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The long-promised feast, the Basel fundamental review of the capital rules for the trading book, will be upon us soon. (Probably.) So what should be in it?

First note that the current Basel trading book rules are an awful mess. VAR plus stressed VAR plus IRC plus CRM plus securitisation carve out plus counterparty credit risk (default and CVA charges). If it reminds you of Vicky Pollard, you wouldn’t be the first.

So, what should the fundamental reviewers do? After all, they do have the mandate to clear up this mess. I want to say a reasonable amount about this, so I am going to split this discussion over several posts. Today though I want say a little something about simplicity.

Clearly the current capital rules lack simplicity. They feel as if they were assembled piecemeal, with every new risk that some supervisor became concerned about generating a new charge. There is no attempt at coherence, lots of double counting of the same risk, and little focus on what makes banks fail.

First, a design principle. It is this: banks should hold enough capital such that they can withstand a very substantial shock and continue to fund themselves.

What kinds of very substantial shocks do we see in the financial system? Simple. Credit shocks. Credit spreads go out, equity prices fall, volatilities go up. Depending on the shock, interest rates either rise (an inflationary crisis, such as 1973) or fall (as in the 2008 crisis). FX moves some, and you can’t really predict which way. A modest number of scenarios can cover all of the relevant possibilities.

The most important element of trading book capital rules, then, is that they should properly capitalize the risk of a credit shock. Few other risks in the trading book are likely to bring a big sophisticated bank down, but this one can. So keep the rules simple, and ensure that they treat the important risk prudently.

Posted in: Basel, Regulation by David /
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Steve Randy Waldman has a typically intelligent post about partial equilibria and choice. Amongst other things, he quotes Nick Rowe on how rational actors react to change:

[P]eople can solve partial equilibrium problems a lot more easily than they can solve general equilibrium problems. When a shock hits, each individual can solve for how his own reaction function should shift in response to that shock. But he can’t easily solve for the new Nash equilibrium point, because that requires him to figure out how every individual’s reaction function has shifted, solve for the new intersection point of all those reaction functions, assume everyone else will do the same, and expect everyone else will move to the new Nash equilibrium too. That’s hard.

I think the insight is right, but framing it in terms of equilibria is unhelpful. Here’s why.

A ball lying in a dip is in equilibrium. It won’t move. Add some energy – give it a kick – and it might find another equilibrium. But this game is stop go: kick, wait for the ball to stop, observe, kick again. The economy isn’t like that at all. It’s more like tetherball. There is never time to find an equilibrium before the ball gets another wack. What is interesting is not where the final equilibrium might be, but the dynamics of the ball. Part of that dynamics is driven by forces which tend to equilibrium – gravity in this case – but there are also the repeated strokes from the players which keep the ball from ever finding equilibrium. (Note too, incidentally, that there are multiple equilibria corresponding to the ball lying at different points around the circumference of the pole, and predicting which one it will end up at even if the players stop hitting the ball is very hard.)

Non equilibrium problems are hard: much harder than equilibrium ones typically. But recognising that much of macro is a dynamical systems problem where the frequency of forcing is faster than the relaxation time is important. If it ain’t anywhere close to equilibrium, modelling it as if it was might well not help.

That said, though, the Rowe quote is interesting as it points out that we can relatively easily estimate our own first response to a change – our own first swing of the bat when the ball has changed direction if you will – but we can’t easily predict others’ reactions and hence understand the dynamics of the complete system. As the Streetwise Professor wisely said recently (a propos clearing, and kindly referencing an earlier paper of mine):

For decades the Corps [of Engineers] has intended to impose order on a complex system of rivers. The results have been less than happy. The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises

Posted in: Economic Theory by David /
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I know that ‘the Soros campaign to eliminate golf’ is fictional, but goodness me, what a good idea. Let’s start with South Africa, a country with a serious drinking water shortage, but which nevertheless has 18 golf courses – all requiring precious water – on the Garden route alone. Just because something is a paranoid fantasy doesn’t mean that it is not great policy, and this is exactly the case with the campaign to ban golf.

(Andrew Muir says that the average South Africa golf course requires 350,000 liters of water a year, enough for 1,200 people. He says that there are over 700 courses in the country in total, implying that without golf, 800,000 more people would have safe drinking water. According to the WHO, 5 million mostly rural South Africans did not have access to safe drinking water in 2010, so banning golf would fix 16% of the problem.)

Posted in: Sport by David /
3 Comments

Greece CDS auction initial market midpoint 21.75, S&P mildly up at a four year high of 1,406. Stay out of the wild wood, kids, if you don’t want to get spooked.

Posted in: Photography by David /
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Greg Ip has an interesting post on the Economist website. He explains that there are three puzzles in the US currently; stubbornly high inflation, slow GDP growth, and unemployment falling faster than GDP would suggest it should. There is an unpleasant explanation for all three:

both the level and growth rate of American potential output is much lower than we think. This would resolve all these puzzles: GDP growth of 2.5% is above, not at, trend, the output gap is closing, and it was probably smaller than we thought to begin with. That would explain why unemployment is falling so quickly, and why core inflation hasn’t fallen further. The excess supply of workers and products that ought to be holding back prices and wages is not as ample as we thought.

Now here’s a conjecture, albeit a highly speculative one that I am not sure I believe myself. What if the secret sauce is financial leverage? That is, could credit supply (and cost) be depressing US GDP growth? Or, to put it another way, how would you test this hypothesis (without being credibly accused on being pro- or anti-bank)?

Posted in: Economic Theory by David /
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From The Money Illusion, via Brad DeLong:

In late 2008 the markets were telling us that the Fed was making a tragic mistake by allowing NGDP expectations to plunge. But the economics profession didn’t listen, as they view stock investors as being irrational. Economists were obsessed with the notion that the real problem was banking distress, and that fixing banking would fix the problem. No, the real problem wasn’t banking, the real problem was nominal.

That goes a little far for me – it’s pretty hard to have rising aggregate demand if the credit supply is falling due to a broken banking system (and in particular a broken transmission mechanism) – but there is more than a grain of truth to this.

Posted in: Economic Theory, Inflation by David /
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Charlie Stross has an interesting insight. He has been trying to buy a used car, and has discovered…

…there are no bargains any more. Nor are there any horribly overpriced vehicles, either (unless you want to go to the authorized dealer, in which case you’ll pay over the odds but also get some hand holding). Nor are there any secrets about what can go wrong: there are model-specific online bug lists, online vehicle status reports that can tell you if it’s been chopped or stolen or is liable for outstanding finance, and getting an estimate of its book value isn’t a high hurdle to leap either. The process of evaluating a second hand car has become more transparent, but by the same token, so has the process of selling one: so nobody offers a car for much below the standard asking price.

Personally, I blame the internet. The web disintermediates supply chains, and the used car market is of course a supply chain, just like any other.

This feels entirely right to me. In something less liquid that I know about – large format camera lenses – something similar has happened. There is still price volatility, and a few quasi-bargains, but prices are a lot less volatile than they used to be, and many more people know the going rate for a 300m f5.6 symmar. This is a reasonably unusual lens, but still you can easily discover what they have sold for in the recent past, what shape the seller thought they were in, and so on. As a result the bid/offer spread has come in dramatically, and it is very hard to make money trading lenses unless you are willing to go to house clearance sales or otherwise expend effort sourcing inventory most folks cannot find.

What is interesting to me, though, is that this has not happened to the bond market to anything like the same degree. The problem is that people keep bond for sale and purchase information confidential. Sure, there is Trace, but not only isn’t it complete, more importantly you don’t get market colour, only prices. If you read the LF forum, you’ll find out that that 300mm Symmar is a well regarded lens optically, but it is heavy and big (especially as it comes in a Copal 3 shutter), so it’s usually pretty cheap. Knowing that the Denbury Resources 8.25% of 2020 last traded at 111.125 is useful, but it isn’t such high quality information. Now of course putting gossip, the internet and trade reporting together could be a recipe for disaster, but it is interesting to wonder why it is that second hand car (or lens) buyers find it easier to become well informed than corporate bond buyers do…

Posted in: Bonds and CBs, Markets, Photography by David /
11 Comments

Jonathan Hopkin has an excellent post discussing neoliberalism and why it isn’t a dead idea yet. The final paragraph is especially insightful:

The problem is that academic political economists know a lot more about the historical record than the average voter does, and there is no point in assuming that voters are going to come to the same judgement – they don’t have time to read Quiggin, Crouch and Krugman (alright, a few read Krugman). Voters never understood Keynesianism, so why would they understand neoliberalism? To achieve change, we need a mythical story about social democracy that sounds as good as the mythical free market – a vehicle for aspiration of a better life. If nobody has ever explained to voters how a better life doesn’t always come through a market, than we can’t expect neoliberalism to die the death it deserves.

Posted in: Markets, Politics by David /
4 Comments

A new paper of mine, The possible impact of OTC derivatives central
clearing on counterparty credit risk is available here. As usual, any comments would be much appreciated.

Posted in: Clearing and Collateral, Publications by David /
1 Comment

Back in May last year, I wrote:

Greek CDS typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?

People are now waking up to this. FT alphaville for instance says today:

…Old R trades won’t have bucketed auctions even when the credit event in question is a restructuring.

So the question becomes whether anyone wrote CDS contracts with anything other than Old R trades on Greece. If there are MR or MMR trades there would have to be an auction with buckets.

Now, FT Alphaville didn’t think anyone had MR or MMR trades on Greece. Or, if they did, we thought it would be a booking error that would be cleared up.

But then, we saw this in a note from JP Morgan on February 24th (emphasis ours):

A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause “Old Restructuring” (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small.

Now, that’s weird.

That was the first we’d ever heard of Greece CDS trades with MR or MMR. And we’re still thinking that someone at some point made a mistake.

Not necessarily. Restructuring is just a convention. You can negotiate whatever you want. Maybe someone needs restructuring to get capital relief*. Maybe they are doing a basket and they want the same restructuring choice on all the names in the basket. Maybe they just ticked the wrong box. But once you have agreed to, say, MMR, changing it to Old R is going to cost something. Pretty soon we’ll see if it was worth paying or not…

Now it is nearly the weekend, and I don’t plan on spending it thinking about CDS, so let me leave you with one of the more interesting google hits on ‘Old R’. Can anyone tell me what a single Oerlikon is and how it might help me in a bond auction?

*That, BTW, is why US corporates trade on XR – the FED does require restructuring as a credit event to give capital relief, while European regulators do. For extra amusement, read the letter from the insurers to ISDA over Xerox. It is in appendix one of this document, the choice sentence being ‘The current definition of Restructuring is clearly not workable if it is susceptible to the misinterpretation, as it apparently is in the minds of certain market participants, that there has been a Credit Event with respect to Xerox.’

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Sovereign Default by David /
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Thank you to a good gentlemen for this. Click it, it’s amusing.

Posted in: Fun by David /
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I had coffee with someone today who – very politely – asked an interesting question. She said I had changed my position on some things over the years and wondered how that had come about. I said something about the credit crunch having shown the flaws in a lot of positions, my own included, then mentioned the desirability of risk sensitive capital rules as something that in particular I was embarrassed at my previous whole hearted support for.

That was true so far as it went, but thinking about it as I walked back, the full story is a little more complex. I think many people who worked in investment banks in the 90s drank the kool aid (to use an American cliche) to some degree. We didn’t see the credit crunch coming; we believed that more liquidity was always better; and that the more efficient markets were, the better they would allocate capital. What consenting investment banks and their clients did in private, we believed, was their own business provided that it was legal. In short, we lost sight of systemic risk and we have a very simplistic idea of the connection between finance and the real economy.

I still don’t believe that most of the folks who worked in investment banks in the 1990s were particularly evil, nor particularly culpable for the crunch. One can point at a few key figures – Greenspan, Mozilo, Fuld and so on – but that’s just an entertaining sideshow. The real story is about the failure of institutional arrangements. The nature of US mortgages and the US mortgage distribution system; lax regulation of broker/dealers and monolines (and to a lesser extent banks); an abject failure by most of the industry and its supervisors to understand how dangerous liquidity risk is; abandonment of caveat emptor by everyone from RMBS buyers to mortgage borrowers: these were some of the more important causes of the crisis. That’s why the rules of the game are so important. Bad people can’t do too much damage in a system with good rules. But even good people end up contributing to something very bad if controls are lax and incentives are wrong.

Posted in: Rules by David /
1 Comment

I have been mean about Felix Salmon in the past, but this piece is really good.

The basic problem is this. If I have bought protection on 100 notional of a bond then I expect to be able to deliver whatever 100 notional of the bond turns into after the restructuring event, even if there is collective action and an exchange into new bonds. So if my 100 turns into 20 notional of new bonds which actually trade at 21 post exchange, I should be settled on the value of those 20 notional.

Felix points out that sovereign CDS documentation doesn’t track notionals, so I have to deliver 100 notional of new bonds, even if it was not a 1 for 1 swap. (Benton!)

Surely this is relatively easy to fix. All we need to say is that if 100 of old bonds turn into 20 notional of new bonds, an apple and two chocolate eclairs, I can deliver 20 new bonds, a pumpkin and two chocolate eclairs into the auction and get 100, or alternatively get cash settled on the current market value of 20 new bonds, a pumpkin and, yes, two chocolate eclairs. (For the avoidance of doubt, the chocolate eclairs are clearly the most valuable part of the package.)

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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In a previous post, I introduced the notion of a central margin custodian: a body which administers and settles both initial and variation margin for OTC derivatives. You might ask what CCPs do above and beyond this – the answer is that they act as a guarantor of derivatives receivables. As a technical matter the CCP is actually a party (the clue is in the ‘P’) to cleared trades, but it need not be. You would get the same functionality if the CCP acted as an insurer, where the thing insured is the cleared derivatives receivable.

Thus we have CCP = CMC + derivatives receivable insurer

Of course, insurers need financial resources, and that is what the CCP’s default fund (and the wafer-thin slice of equity they have) are for. They are, to be precise, amounts of money that are available to meet credit losses above IM. Given that the CMC covers losses up to IM, the decomposition is precise.

Now thinking about things this way has the key advantage that we can see the relationship between IM and DF more clearly. From the CMC’s perspective, it doesn’t care how high (or low) IM is: it is just an amount of money to be collected. (Well it might have a preference for it to be higher so that it has more funds under management, but that is hopefully a secondary effect.) For the insurer, though, it matters a lot. The tranche of loss it has insured is attached at IM, so the lower IM is, the more risk it has. It will need more financial resources – more DF – to support that risk. In fact one thing that would make me feel more comfortable about CCPs would be knowing that the insurance premium charged was commercial: would Berkshire Hathaway, say, write credit insurance on the cleared derivatives receivable if the premium available was the default fund contributed charged by LCH, and IM was determined by LCH’s model? How about ICE or CME? And if Berkshire wouldn’t trade at that level, what does that tell you about the safety of the leading CCPs?

Or, to put it another way, suppose that the credit insurance part of a CCP was a standalone business, with the CCP’s capital and DF behind it. How would it be rated?

Posted in: Clearing and Collateral by David /
8 Comments

In the mists of time, pretty much when dragons walked the earth, CDS referenced specific bonds.

What that meant was that if there was a credit event on that bond then you got to deliver that bond or were cash settled* on the value of that bond after the credit event. This meant that if you owned that bond and the CDS on it, you were hedged against the consequence of credit events (although obviously not against things that turned out not to be credit events**).

This was really good in that there was little basis risk between the CDS and the bond. But it was really bad in that it made CDS fairly illiquid. In this setting, a 1 year CDS on say the UK 4¾% Treasury Stock 2015 is not the same as one on the 4% Treasury Gilt 2016 despite the fact that both bonds are senior obligations of the UK government and both cross default. It would be really hard to imagine a credit event on the 4¾s of 2015 that wasn’t also a credit event on the 4s of 2016 – and vice versa – yet these two CDS are not in any way fungible. That reduces liquidity dramatically, and it means that dealers have to hedge each CDS with its underlying bond (or another CDS referencing the same bond). Well, either that or take basis risk anyway.

The market decided that it preferred some deliverability risk to illiquidity, so instead of trading CDS that referenced specific bonds, it began to trade CDS that referenced a specific obligator. You bought CDS on the UK (or more specifically on senior unsecured UK government obligations) rather than on a given bond. That single step dramatically increased liquidity, but it brought deliverability risk in cash settled CDS: you now no longer knew that the price the CDS settled at would reflect the value of the bond that you owned, as the settlement process was determined with respect to a basket of instruments.

Now all of this was long before the auction process was developed, and it was the key decision that meant that CDS were not as good a hedge as they used to be. The market chose to trade a product that hedged individual bonds less well in exchange for having a more liquid instrument. Now I am not going to take a position on whether that was a good choice or not, but I will say this. If you want a CDS that references a particular bond, and whose settlement amount is determined by the price of that bond after the credit event – or which allows you for sure to deliver a given bond – then buy one. Yes, it will cost you more than a standard CDS that is more liquid. It won’t have a readily observable price (although one might assume it would mostly trade in line with more liquid standard CDS). It will be hard to trade. But if you want a Ferrari, why are you buying a Ford?

*Of course, you want to be rather careful how a cash settlement amount on an illiquid bond is determined.

**Cf. restructuring. That is a different story, which also must be understood in any analysis of what CDS do and don’t do.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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There once was a very old horse
Who after some years in the force
Was lent to Ms Brooks
Who had cops on the books
A fact unrelated of course

(Yes it is terrible. Rebekah Brooks deserves no better.)

Posted in: Fun, Poetry by David /
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Here’s a good idea (which will never be implemented). From Bloomberg:

The lack of transparency is a problem. Interested parties can’t provide relevant input at the early stages of the process. Banks and their lobbyists get an advantage because they are able to secure far more frequent private meetings with Fed officials than less well-heeled organizations that tend to support reforms. And opacity weakens final regulations, which won’t have the credibility and endurance that come from being hashed out in the public arena.

Other U.S. agencies, such as the Securities and Exchange Commission and the Commodity Futures Trading Commission, have taken a different approach. In most cases, before they propose a rule, they hold open meetings at which commissioners, and sometimes other interested parties, pose questions to the staff members charged with the actual regulation writing. They post webcasts of the events prominently enough that a layperson can find them on the agency’s site.

The Fed would do well to follow their example.

I would go further, given that the CFTC and SEC rule making process can also be fairly opaque and pre-emptory. What should happen is that the agency first sets out its supervisory objective. It then invites proposals for rules that meet that objective. It considers feedback, takes the best ideas from the proposals, and produces a draft rule. Then there is an open meeting and impact analysis, then final rule making. Of course, that rather assumes that the supervisors know what objective they are trying to meet when they propose new rules…

Update. This story, again from Bloomberg, is encouraging. Someone (who isn’t SIFMA) is making detailed, intelligent comment as part of the rule-making process. That doesn’t mean that the process doesn’t need reform – it does – but it is nice to see a well-organized group of outsiders taking up the gauntlet. Go Occupy the SEC, go. I might not agree with all of your positions, but I think that your careful involvement in the process is wonderful.

Posted in: Regulation by David /
3 Comments

This is a new (so far as I know) idea that I had over the weekend. The essential motivation is that OTC derivatives central clearing does some good things, such as impose a margin discipline, but some bad ones too, such as splitting OTC derivatives portfolios into cleared and uncleared pieces (and indeed into pieces cleared in the US, the EU, etc.) This splitting can increase credit risk, and indeed thanks to all this splitting, counterparty credit risk could well be higher under central clearing than it was before clearing was mandated.

How can we keep some of the good things – including both initial and variation margin – without introducing central counterparties?

One potential answer is to introduce a central margin custodian, or CMC.

It would work like this. For some class of OTC derivatives counterparties (e.g. everyone but small end users) regulations would require:

• Both parties have to charge each other daily variation margin (‘VM’) with zero threshold;
• Both parties have to post initial margin (‘IM’);
• IM and VM must be cleared through a central settlements body, the CMC; and
• The CMC holds IM for both parties.

Thus in a bilateral trade between A and B, both A and B post IM which is held by the CMC, and the CMC manages VM flows from A to B or vice versa.

If B defaults, A has a claim on B’s IM at the CMC, but A is still exposed to B for the residual close out amount over IM if any, and vice versa. Moreover, failure to post at the CMC is an event of default on the whole portfolio of derivatives between A and B.

The CMC does not take credit risk (apart from intraday risk on VM movement). It just manages margin.

There are a number of advantages to this set-up. First there is no need for the CMC to have a lot of financial resources, as it is not guaranteeing trades. It is only at risk on very short term margin movements so in particular there is no need for a default fund, and the failure of a CMC is much less likely than that of a CCP. Moreover, since the CMC is involved in all OTC trades between two parties, there is no breaking of the bilateral netting set into clearable and unclearable parts. Furthermore there is no dilution of the incentive for parties to assess each other’s credit. Parties can charge higher IM if they wish (and the other party agrees) and this will clear through the CMP, but they can’t charge lower levels than the CMC-prescribed minimum (which CPSS IOSCO could regulate).

Of course there are disadvantages: there is still the rehypothecation problem [that margin cannot be reused] as funds are tied up at the CMC. The CMC has operational risk which needs some capital to support it. Moreover CMC IM calculations will probably be somewhat procyclical (CCPs have this problem too of course). Finally there is no benefit from netting clearable trades into a single exposure to the CCP.

I’m not sure that CMCs could even prosper given the entrenched advantages of CCPs (thanks to Dodd Frank and EMIR) – but still I think the idea is interesting, representing as it does a kind of half way house between the bilateral market and clearing.

Posted in: Clearing and Collateral by David /
12 Comments

Back in March 2009 I wrote:

The Guardian had another set of articles on Barclays’ tax structuring group yesterday. The point is not whether the practices of this group are legal. Some may be; some are borderline; some may not be. The point is the continuing reputational damage being done to the Bank …

And now, behold, that damage continues. From the BBC:

Barclays Bank has been ordered by the Treasury to pay half-a-billion pounds in tax which it had tried to avoid…

Announcing the crackdown, Exchequer Secretary to the Treasury, David Gauke, said the bank should never have devised the schemes in the first place…

Mr Gauke told BBC Radio 4′s Today programme that the experience of Barclays showed that the system of compulsory disclosure for legal tax avoidance schemes was working.

“They have got caught, they disclosed this information, the HMRC has acted very quickly, there will be no benefit to the bank, they are clearly taking a substantial reputational hit and we have demonstrated that banks are simply not going to be able to get away with it,” he said.

The culture has clearly changed from the Blair/Brown years where, sadly, tax avoidance was all too acceptable. If the banks have any sense, they will be doing very significant due diligence before enacting any substantial tax ‘optimization’ transactions in future.

Posted in: Reputational Risk, Taxation by David /
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Back to finance tomorrow I promise but meanwhile… I love the fact that someone is thinking of using Kickstarter to fund a new translation of Antigone. OK, she might not have a novel take on the Tycho von Wilamowitz-Moellendorff problem (you knew I had to hit up the big T W-M, right?), but using a four year old technology to raise money to work on a 2,500 year old book is a lovely juxtaposition.

Posted in: Media and Popular Culture, Software and Virtual Worlds by David /
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… or so they say.

Posted in: Photography by David /
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Try playing So, what would your plan for Greece be?; it’s fun and insightful.

I got 52 the first time around, 5 the second. Interestingly reading the comments, those, 53, and 10 seem to be the most popular answers, with the full Argentina leading. My favourite comment though was the suggestion that the game should be called Dungeons and Draghi…

Posted in: Fun, Sovereign Default by David /
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When the RMMG (as it then was) issued the CVA capital rules in Basel 3, I said that they would lead to a number of capital arbitrage deals. Street talk was that the Swiss were first off the blocks; now we learn from Euroweek (HT FT Alphaville) of a deal by RBS:

Royal Bank of Scotland is in the market with a highly innovative capital relief trade, dubbed Score 2011-1, securitising a $2bn book of credit counterparty risk.

There are some challenges to getting both default risk and CVA charge capital relief in a securitization structure, but they aren’t insurmountable. I predict 2012 will see a goodly number more such deals.

Posted in: Basel, Credit, Derivatives, Hedging and Convexity by David /
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Standard procedure, this, for European banks these days. Bloomberg reports:

Commerzbank AG (CBK) will ask investors to swap hybrid capital instruments trading below face value for new shares, adding to steps by Germany’s second-largest lender to boost its financial strength.

The measures, announced as Commerzbank unveiled earnings that beat analyst estimates, could boost the German company’s core Tier 1 capital by more than 1 billion euros ($1.33 billion), it said… The principal amount of the capital instruments included in the offer totals about 3.16 billion euros, Commerzbank said.

In other words, you buy the hybrids (which are trading well below par) back at market or close to it, and issue new equity. This is Basel 3 capital enhancing as the hybrids are not good capital in the new regime, and you (probably) get a pop from the sub par buyback.

Update. As FT alphaville says, one of the things that is interesting about CBK’s progress is its progress on RWA mitigation. They quote Nomura research from Chintan Joshi and Omar Keenan and as follows [MSB = Mittelstandbank, a corporate banking unit, ABF = Asset-based finance]:

In MSB there was a lot of progress made on RWAs. The effects of adding collateral into systems was EUR 5bn alone and CBK staff are getting better at this. There is a team of 200 people working on this, and previously CBK in moving from Basel 1 to Basel 2 was also a laggard in taking advantage of capital efficiencies. Second, there were better ratings in MSB. Third, the bank adjusts the model parameters once a year. Germany experienced a low recovery rate historically because the average equity in German companies used to be 17%. However, this is now 28% on average and implies higher recovery rates. This reduces LGD and risk RWAs…

200 people just to optimize their regulatory capital calculation in one part of the bank? Wow.

The other part of the story of course is synthetic securitization to optimize capital, and unsurprisingly CBK are doing that too…

Posted in: Capital and Contingent Instruments by David /
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My main concern about last week’s idea from Interfluidity of government inflation linked savings accounts was the impact it would have on bank funding. Essentially I was worried that fewer deposits at banks meant more repo/CP funding. Now I notice that this is a design rather than a feature:

Frankly, it’s better if more bank funding were “hot” and regulators were frequently on the hook to choose between support or resolution of banks. It’d require regulators to much more actively involve themselves in the asset-side of bank balance sheets. I think it was Minsky who pointed out that, back in the day, monetary policy consisted primarily of discounting against bank loans as collateral, and that fact meant that central banks had a much richer and deeper understanding of the bank activities than in today’s regime, where direct lending to banks is frowned upon. The current regime lets regulators usually feel pure (since they’re not lending to banks directly), and let banks pretend they are private businesses without direct state support, but good feelings among regulators and bankers don’t necessarily serve the public.

(From a comment to the original post.)

Now this is really interesting. Essentially the debate comes down the feasibility of anyone – a supervisor, a senior debt buyer, a (non-insured) depositor – having a good enough understanding of a bank such that they can exert meaningful discipline. If they can then they should, and maybe Basel’s famous pillor 2, market discipline, can do some good. The problem is that I am not sure that this is possible, at least with current disclosures. Could anyone really, given FSA’s resources say, understand a bank like HSBC or RBS or Barclays well enough to make a meaningful credit decision on them? I rather doubt it but I would love to be proven wrong.

Posted in: Accounting, Liquidity and liquidity risk by David /
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Sunday in the woods:

(The negative was a little over-exposed, but the scanner still found quite a bit of detail. I quite like the effect.)

Posted in: Photography by David /
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From Steve Randy Waldman at Interfluidity, a typically intriguing and thoughtful post:

The Federal government should offer inflation-protected savings accounts to individual citizens, but with a strict size limit of, say, $200,000. These accounts would work like bank savings accounts, and might even be administered by banks. But deposits would be advanced directly to the government (reducing borrowing by the Treasury), and the government would be responsible for repayment. The accounts would promise a tax-free real interest rate of 0% on balances up to the limit. Each month, accounts would be credited with interest based on the most recent increase in the Consumer Price Index (adjusted for any revisions to estimates for previous months).

For me, there are two things really right with this idea. First, it creates a new class of safe asset for folks would cannot easily buy inflation-linked bonds. Second, it funds the government in a way that (like the issuance of linkers) creates an incentive not to let inflation run rampant. [This means, as SRW points out, that you would want to keep the total notional constrained - he suggests 25% of GDP.]

There is one thing that worries me slightly though, and that is the drain that this would cause on bank deposits. Right now deposit insurance means that the banking system receives retail funding without retail investors taking risk. This is good: it funds credit to the rest of the economy, while not exposing ordinary depositors to a risk they would find hard to assess. But starter savings accounts would compete directly with bank deposits: their presence would undoubtedly cause substantial falls in insured deposits at a time when we are trying to encourage banks to fund themselves via deposits (rather than via CP, or repo, or other risky sources). If the net effect of starter savings accounts is for the government to raise expensive money which it then has to lend to the banking system cheaply (because the discount window rate is less than inflation), then they might be a bit of an own goal…

Still, this is a good idea and it definitely deserves further study.

Posted in: Inflation by David /
1 Comment

From the FT:

US regulators are poised to increase 20-fold the amount of derivatives a company can sell before it is subject to strict new rules for the biggest traders, softening a significant plank of financial market reform…

The CFTC which has proposed the definition along with the Securities and Exchange Commission, is set to approve $2bn as the maximum gross notional value of swaps a company may sell in a year before it is designated a dealer, three people familiar with the matter said. This is 20 times higher than the $100m threshold included when the rule was proposed.

So that is a bit better. Still, $2B of IRS is not a lot. Conversely, it is quite a lot of CDS…

Posted in: Clearing and Collateral by David /
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A minor spat in the finance blogosphere – no one died. This is hardly news I know. But for me this fight is unnecessary; both parties have some of the truth. John Cochrane first – his tagline is

As long as some firms are considered too big to fail, those firms will take outsized risks.

That seems pretty reasonable. His account of the mechanism at work around the Lehman failure has a measure of truth about it too:

After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad…

Buttressing this story, let us ask how—by what mechanism — did Federal Reserve and Treasury equity injections and debt guarantees in October eventually stop the panic? An increasingly common interpretation is that, by stepping in, the government signaled its determination and legal ability to keep the large banks from failing. That too makes sense in a way that most other stories do not. But again, it means that the central financial problem revolves around the expectation that banks will be bailed out.

I might quibble with that ‘central’, but certainly too-big-to-fail is a problem, and certainly it needs to be resolved.

Next, Economics of Contempt, who lays into Cochrane. They choose instead to emphasise the liquidity aspects of Lehman’s failure:

…the end result is that LBIE’s [Lehman's main London entity's] failure caused hundreds of billions in liquidity to suddenly vanish from the markets. It also caused other hedge funds to pull their money out of their prime brokerage accounts at Morgan Stanley and Goldman (the two biggest prime brokers), since they were now scared that they wouldn’t be able to access their funds if either of the prime brokers failed…

And there was absolutely nothing minor about the run on the money markets. One of the biggest money market mutual funds, the Reserve Primary Fund, “broke the buck” because of losses on Lehman commercial paper. This caused a massive run on money market mutual funds, with redemptions totaling over $100bn.

This is perfectly fair, and indeed the liquidity aspects of the crisis are rather less well understood than the solvency ones, so EoC is right to discuss them. Having another angle does not justify calling Cochrane’s piece ‘mind-boggling nonsense’ though.

Now, I do think that Cochrane goes astray in his account of the TARP, but I don’t think he is being duplictious, and he does show some sympathy for the complexity of the policy choices the authorities faced after Lehman. He’s good on the fragility of some of the structures such as ABCP conduits used to fund mortgages, and on the ‘huge initiative of mostly pointless regulation that would move derivatives and cds onto exchanges, regulate hedge funds, force loan originators to hold back some credit risk, and so forth’.

Give both of them a read, Cochrane and EoC. They both have worthwhile things to say. There’s plenty of crisis to go around, with no need for a fight.

Posted in: Liquidity and liquidity risk, Mortgages, Mother of all Bailouts, Regulation by David /
4 Comments

The last post, BTW, was no. 1,500. Thank you wordpress for your sterling service over one and a half thousand posts.

Now to substantive if not entirely serious matters. You see, I was musing given all the furore over Moody’s placing us on negative outlook, shouldn’t we really teach them not to mess with sovereigns? We have those men in Hereford who work for the government, so surely some gentle persuasion can be applied…

Seriously though, does anyone really feel comfortable with the power the agencies still have, despite their manifest failings? As Claire Hill puts it, the history of rating agency reform has not been inspiring. Perhaps it is time to have another go.

Posted in: Fun, Sovereign Default by David /
3 Comments

The Libor probe is heating up. Bloomberg reports:

Global regulators have exposed flaws in banks’ internal controls that may have allowed traders to manipulate interest rates around the world, two people with knowledge of the probe said.

Investigators also have received e-mail evidence of potential collusion between firms setting the London interbank offered rate, said the people, who declined to be identified because they weren’t authorized to speak publicly.

Now I have no special knowledge of this situation, and I have no idea whether banks did indeed manipulate Libor. But I do think that the design of Libor is inherently flawed. When they are asked to submit the quotes that are averaged to produce Libor banks are asked

“At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size just prior to 11 am?”

Note the hypothetical: ‘could you… were you to…’. In other words, Libor isn’t necessarily the average of rates at which banks did borrow, but rather of rates at which they estimated they could probably borrow. That’s a big difference, and it makes it much harder for a bank to be sure that the numbers it submits to the Libor panel are right. [The issue is that banks don't borrow for longer tenors unsecured very much at all, so something like ten month Libor - or even one year Libor - may well be the average of guesses rather than of actual market rates.]

Obviously here there is a tension between having a lot of rates some of which are less well defined and having a rate that is really market price based. Personally though I would have thought that building a multi-hundred-trillion dollar industry on prices that may be the average of guesses might create some issues, such as the risk of manipulation…

Posted in: Derivatives, Hedging and Convexity, Legal Risk and Trade Documentation, Rules by David /
4 Comments

No, dear reader, not my Valentine’s day, but rather macroeconomic models. Volker Wieland and Maik Wolters has a nice post on VoxEU where they look at the performance of a goodly number of the leading macroeconomic models. This picture in particular struck me:

In other words, of the models studied, none – zero, nada, niente – predicted anything like the recession we got, and all the models predicted a materially stronger and swifter recovery than we got. Honestly given this performance shouldn’t there be rather more wailing and knashing of teeth from the economics profession than (with a few honourable exceptions) we have seen?

Posted in: Economic Theory, Model risk by David /
6 Comments

From a very nice article by Corinna Athanasopoulos from Sapient Global Markets (HT Bill Hodgson), a summary of the current state of OTC derivatives central clearing:

Posted in: Clearing and Collateral by David /
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This was amusing…

@justinwolfers: You’re my long-run target; my nominal anchor.

@SFFedReserve: I’m going to extraordinary measures to increase your stimulus

@AtlantaFed: I long for you as the economy longs for its long-run maximum potential

@PhiladelphiaFed: Her deviations are never standard, her probabilities never mean.

@PhiladelphiaFed: My initial projections never forecast someone like you would be in my next quarter.

@alanbeattie: I’d like to borrow you overnight and then hold you to maturity

@planetmoney: But, soft! What light through yonder discount window breaks? It is the East, and Ben is the sun.

@sffedreserve: My love is elastic, my commitment too big to fail

@ABWashBureau: You’re a systemic risk… to my heart.

@mckonomy: The sight of you fills me with irrational exuberance…

@CurtNickisch: My love for you is not nominal. It’s real.

@MarkThoma: The non-traditional stimulus was way better than I thought it would be.

Posted in: Fun by David /
1 Comment

One of the easy mistakes you can make scanning film (you know, film, one of the few things that Kodak makes money on) is that you can flip the horizontal when scanning. It’s really interesting how this effects pictures. Some things are more or less the same flipped, or at least both ways round make sense. This picture, which I used on the blog last month, is an example. Here’s the original:

And the flip:

You could make a case for both of those images I think.

Others fair less well though. I don’t mind this too much (although I don’t love it):

It’s flip, though, I hate.

It seems unbalanced to me. I can’t quite understand why it seems to work so much less well, but it does. Symmetry gets broken in photography too…

Posted in: Photography by David /
2 Comments

What is the next item in the list: 300; 600; 1,200; 1,600; ?

The series is, of course, how much client money was estimated to be missing from MF Global as time went on…

Posted in: Clearing and Collateral by David /
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From a speech by Jaime Caruana of the BIS:

The Committee on Payment and Settlement Systems and the International Organization of Securities Commissions have developed standards for addressing risks related to systemically important financial infrastructures, including CCPs, and will release finalised standards in the coming months…

We don’t know yet whether we are moving towards a system characterised by a small number of clearing houses based in major financial centres that will clear a wide range of instruments, or a system where there is a larger number of interlinked national and regional platforms. This is something that will evolve in line with the needs of dealers and end users, provided the minimum standards set by global regulators are satisfied.

With respect to Jaime, I think we do know. Regulators from Washington through Brussels and Tokyo to Syndey are demanding the use of local clearing houses. Getting from there to ‘a small number of clearing houses based in major financial centres that will clear a wide range of instruments’ is going to be a challenge…

Posted in: Clearing and Collateral by David /
2 Comments

From a recent speech by Benoît Cœuré, ECB Board member:

In normal times, private liquidity dominates official liquidity. But private liquidity is highly pro-cyclical and highly endogenous to the conditions that prevail in the global financial system. The inherent endogeneity of private liquidity means that it can easily evaporate in times of financial stress. The pro-cyclicality is documented via the strong interaction of private liquidity and the global risk appetite of financial institutions. Indeed, the global risk appetite is one of the main determinants of the multiplier that links levels of overall liquidity to levels of official liquidity.

It is really heartening to see the ECB thinking this way. Of course one cannot be sure what will come of it, but at least they are looking in the right places.

Posted in: Liquidity and liquidity risk by David /
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Macro and other market musings has an important and interesting posting on safe assets. The proposition is

If, however, the central bank slips and NGDP falls below its expected path, then some of the privately produced safe assets disappear, creating a shortage of safe assets. The government steps in and creates safe assets that, if produced sufficiently, would restore NGDP back to its expected path. In other words, if monetary policy does not do its job then fiscal policy could substitute for it, but in a way not normally imagined. It would do so not by increasing aggregate demand via higher government spending, but by making up for the shortage of safe assets that facilitate transactions.

I think that’s broadly speaking right. There are two main forms of demand for safe assets:

• Buy-and-hold investors who want to take no risk, such as some pension fund investments; and
• Investors who want the asset to facilitate transactions, mostly repo either bilaterally, trilaterally, or with the central bank.

The relative attractiveness of safe assets can therefore rise in three ways: more safe savings looking for a home; a higher volume of securitized financing needs; or ‘some of the privately produced safe assets disappear’. All of these deserve policy action.

There are profound consequences from this model. It highlights the importance of repo as determining the marginal cost of liquidity to the financial system, and hence the importance of targeting GC repo, rather than e.g. FED funds, as the rate to be managed. It also suggests that what is GC is of vital interest: a fact that was already obvious when we observe how the ECB’s recent actions has brought in Italian bond repo rates. By defining the basket of assets acceptable at the central bank window, a lot of pressure can be exerted for an asset to be considered if not safe, then at least ‘safe enough to repo’. This tool is extremely helpful, as the ECB has discovered.

Posted in: Economic Theory by David /
4 Comments

Sometimes a really clear summary of a bad position clarifies thinking. Here’s one, from Idiosyncracies:

The rationale for a clearinghouse is to create liabilities that are the joint obligation of all the members of the clearinghouse. In other words, the purpose of a clearinghouse is to place the responsibility for managing systemic risk where it belongs in a free market system — in the hands of the banks that are in a position to create and control systemic risk.

Certainly OTC derivatives clearing does that. But if imposing clearing was done with that rationale then boy is it a terrible idea. Let’s see. I decide to trade with you, and create a liability whose lifetime may be 30 years. But I don’t bear the consequences of that decision; rather, the whole system does. If things go smoothly, then I book my upfront profit and all is well. If instead things go badly, then I book my upfront profit and the system takes the loss (beyond IM and DF anyway). Wow, that creates a really great incentive for me to choose good counterparties doesn’t it? Indeed a better recipe for increasing counterparty risk in the system as a whole is difficult to imagine.

Posted in: Clearing and Collateral by David /
4 Comments

This guy is slick. Goodness me yes. Check this out:

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced.

It is, of course, the Epicurean Dealmaker, and I think he is quite right on the essentials. There will always be a tail of financial risk that society must absorb, and the policy debate should be about how much there should be of it and what compensation society extracts from the financial system for taking it, not how to remove it (because that is impossible).

[As an aside, one could imagine trying to price it. For instance, suppose that banks have to be 100% deposit funded, and all deposits must be insured but there is limited insurance. Banks have to bid for the available insurance. That would at least establish a market clearing price for deposit insurance.]

TED puts the general argument nicely though:

But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects.

Now, you may hate the following. I certainly do. But what if putting financial intermediaries less on the hook is better for society? What if it creates growth that more than pays for its extra costs? I’m not saying that is true – I don’t know – but the possibility must be acknowledged. Thinking about the problem as tail risk allocation at least saves us from knee-jerk responses which are unlikely to lie on the efficient frontier.

Posted in: Mother of all Bailouts by David /
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My talk at the LSE which was postponed due to the strike in November will now (if the Gods are willing) happen on Wednesday.

Title: Post crisis Bank Regulation and the Rôle of Capital
Time and date: 6-8pm, Wednesday 8th February
Location: Room NAB 1.04, New Academic Building, London School of Economics (entrance from the West side of Lincoln’s Inn Fields)

The slides are here.

Posted in: Bank Run, Capital and Contingent Instruments, Regulation by David /
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A site with a rather tacky name suggests:

One of the most common reasons I hear for not letting a model be more transparent is that, if they did that, then people would game the model. I’d like to argue that that’s exactly what they should do, and it’s not a valid argument against transparency.

Take as an example the Value-added model for teachers. I don’t think there’s any excuse for this model to be opaque: it is widely used (all of New York City public middle and high schools for example), the scores are important to teachers, especially when they are up for tenure, and the community responds to the corresponding scores for the schools by taking their kids out or putting their kids into those schools. There’s lots at stake.

Why would you not want this to be transparent? Don’t we usually like to know how to evaluate our performance on the job? I’d like to know it if being 4 minutes late to work was a big deal, or if I need to stay late on Tuesdays in order to be perceived as working hard. In other words, given that it’s high stakes it’s only fair to let people know how they are being measured and, thus, how to “improve” with respect to that measurement.

Instead of calling it “gaming the model”, we should see it as improving our scores, which, if it’s a good model, should mean being better teachers (or whatever you’re testing).

This is an interesting point. I certainly agree that is you are going to measure people on x then telling them what x is is only fair. But I would never promise that x was my only criteria for measuring a real world job, as I don’t believe we can write the specification for many activities well enough to always know that maximizing the x-score is equivalent to doing the job well.

(PFI contracts are of course a great example of this; one of the reasons that PFI is a terrible idea is that you can’t write a contract that defines what it means to run a railway well for ten years that stands up to the harsh light of events.)

Thus I would argue that the problem in the situation outlined above isn’t lack of transparency, it is using a fixed formula to evaluate something complicated and contingent. Sure, by all means say ‘these scores are important’, but leave some room for judgement and user feedback too. Humility about how much you can measure is important too.

There is also a good reason for keeping some models secret, and that is the use of proxies. Say I want to measure something but I can’t access the real data. I know that the proxy I use isn’t completely accurate – it does not have complete predictive power – but it is better than nothing. Here for instance is the FED in testimony to Congress on a feature of credit scoring models:

Results obtained with the model estimated especially for this study suggest that the credit characteristics included in credit history scoring models do not serve as substitutes, or proxies, for race, ethnicity, or sex. The analysis does suggest, however, that certain credit characteristics serve, in part, as limited proxies for age. A result of this limited proxying is that the credit scores for older individuals are slightly lower, and those of younger individuals somewhat higher, than would be the case had these credit characteristics not partially proxied for age. Analysis shows that mitigating this effect by dropping these credit characteristics from the model would come at a cost, as these credit characteristics have strong predictive power over and above their role as age proxies.

Credit scoring models are trying to get at ability and willingness to pay, but they have to use proxies, such as disposable income and prior history, to do that. Some of those proxies inadvertently measure things that you don’t want them to too, like age, but excluding them would decrease model performance.

Here, it is better that the proxies are not precisely known so that they are harder to game. The last thing you want in a credit scoring model is folks knowing how best to lie to you, especially if some of the data is hard to check. It is much better to ask for more than you need, as in psychometrics, and use the extra data as a consistency check (or just throw it away) than to tell people how your model works. Its predictive power may well decline markedly if people know how it works.

Of course, you need a regulatory framework around this so that models which try to measure, for instance, race, are banned, but that does not require model transparency. Sometimes it really is better to keep the model as a black box.

Posted in: Model risk, PFI, Rules by David /
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Picture credit: a sensible comment on Boris Johnson’s cycle policy from Andy.

Jonathan Hopkin gives us news of an unexpected but very welcome campaign from the Times to make London cycling safer. (The Guardian has been behind this for some time.)

I joined the London cycling campaign in 1993, and over that period more people have taken up cycling in the city and it has got somewhat safer. We are at a critical moment now, though. We have a nominally cycle friendly major who isn’t nearly as cycle friendly as he seems and a positively cycle hostile transport authority. We have hire bikes and cycle highways, not that either of these are an unequivocal good for the cyclist. Small measures, danger, and poor infrastructure aren’t going to help London get from current levels of cycling use (2% of journeys) to where we could and should be (the 20-30% typical of continental Europe).

The safety issue has to be addressed first. The most significant cause of cycling fatalities in London is lorries, specifically cyclists going past them on the left. My modest proposal therefore is to ban all private vehicles over 4 tonnes in London between 7am and 11pm.

Given that Transport for London cannot be trusted to design junctions which are not cyclist deathtraps, the mayor needs a cycling commissioner who has the power to over-rule TfL, and this person should actually be a cyclist.

The penalties for driving without due care and attention – a pretty standard charge against those few motorists who are prosecuted with anything at all when they hit a cyclist – are far too low. If I hit a cyclist with a baseball bat, I would be charged with at least common assault and could well go to jail for six months. If I cause the same injury with a car, I might well get away with a few points off my licence. This suggests to me that there is a strong case for dramatically increasing the penalties for motoring offenses.

Finally, cars blocking cycle paths are a major issue. The fines for this should be comparable to those for parking on a red route; that alone would persuade the boroughs to police it properly (if they were allowed to keep a share of the fine, anyway).

Posted in: Transport Policy by David /
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I have no idea. But I would have thought an FTT, like Sarkozy’s new one, would make HFT markedly less attractive, at least. Has anyone seen any analysis of this?

Posted in: Markets, Taxation by David /
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The Streetwise Professor pretty much nails one of the big winners in the (regulatory mandated) move to OTC derivatives central clearing:

big custodial banks will be even more tightly connected with all major participants in the derivatives trade because of their comparative advantage in providing collateral transformation, and the strong economies of scope between providing this service and providing other custodial services.

In other words, the folks who already know where the collateral is, like BNY Mellon and JP Morgan (the dominant two players in tri-party repo) will be big winners in the move to clearing because there will be a massive increase in the demand for collateral, and they can take a turn in connecting the people who have it with the people who need it. So clearing might increase rather than decrease interconnectedness. Just saying.

Posted in: Clearing and Collateral by David /
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Yesterday we saw that one good way of visualizing bond returns is to look separate at the survival probability and the distributions of returns given default (also known as the LGD distribution).

(A minor technical point – in the prior post I used normal LGD distributions, whereas in fact something like a beta distribution might be more suitable.)

We noted too that once we look at the distribution, subtler differences between bonds than just probability of default are obvious. Another example of this is how much uncertainty in recovery there is. Consider this example:

These two bonds have the same PD, the same average recovery and hence the same expected loss. But one has more uncertainty in recovery than the other, and hence can reasonably be called riskier.

Now, a plain vanilla tranched security supported by a diverse pool of collateral assets might well have quite a benign return distribution. Losses come from the bottom up, and if the loss distribution of the collateral is fat tailed, and our tranche is not the bottom of the stack, then we might well find something roughly like this (although of course the precise form is subject to considerable debate):

In other words, even if you do get a loss, it will likely not be large. The problem though is that this assumption is rather sensitive both to the collateral loss distribution, and to the structure of the securitization. Something like this is entirely possible too:

Now, remember first that it is really hard to know what the real loss distribution is – there is a lot of model risk – and second, its shape really effects the expected loss. For instance, for the first tranched ABS above, the expected loss (EL) is only 0.25%, whereas the EL for the second bond is 0.65%. Assessing the real world return distribution of these securities is difficult.

This brings us nicely to informationally insensitive assets. What people want is something with PD = 0 (and so EL = 0). There isn’t any such thing. What is available are assets with small PDs, and unknown loss distributions. Sovereign recoveries are typically low and uncertain: 30 to 40 isn’t a bad guess for an average. AAA ABS, on the other hand, can be structured to have whatever loss distribution the issuer wants. What we learn from this is that it is a serious error looking just at PD or EL in assessing credit quality; you need to get several different views of what the whole return distribution might be like. Moreover, a crisis in the securitized funding markets is caused not just by a reassessment of PDs, but also by a realization that the loss distribution is likely to be more like the third graph above than the second.

Posted in: Bonds and CBs, Credit, Model risk by David /
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I have been musing for a while on how best to give insight into the returns of fairly safe instruments, like an asset swapped government or investment grade corporate bond. Here’s what I have come up with.

The first thing you need is to understand what the probability of default is. Now, in a precise sense this number is meaningless in that ‘probability’ implies that we have some (ideally large) population of things that we are sampling, and they are IID. This isn’t true with a typical bond – either it defaults or it doesn’t, and no two bond issuers have exactly the same return distribution. Still, let’s pretend that probability of default makes sense. For high quality bonds, survival probabilities (i.e. 1 – PD) are close to one, so showing full return distribution won’t tell us much; instead then let’s zoom in to the 90% to 100% area. Our first visual aid then is survival probability, graphed between 90% and 100%.

The second thing we want to know is how much we get back if default happens: the recovery. Again, we can’t know this, nor does it really make sense to talk about a distribution of recoveries. We have Knightian uncertainty rather than risk. However, if we make the (false) assumption that recoveries for similar types of issuer are similar, then one could (mis-) represent unknown recovery as a distribution of possible returns, which we can also separately picture.

A typical high grade corporate bond with PD = 1% and average recovery 45% would then look like this:

(By keeping the ‘doesn’t default’ part separate from the ‘does default’ we can at least see what is going on in the latter.)

Now consider a higher quality corporate bond, with PD = 0.5% but still with average recovery 45% and the same uncertainty in recovery. Comparing the two bonds, we would have

Here we can clearly see that the second bond is safer: it is less likely to default, and the average recovery is the same. Thus for the first bond, the expected loss (EL) is 0.55% (1% PD with 45% average recovery), while for the second it is 0.275% (0.5% PD, same recovery).

Now let’s turn to a typical high grade ABS. Here credit enhancement typically means that the PD is low, but if the credit enhancement doesn’t work, then the losses can be quite large. Recoveries, in other words, are often lower when ABS don’t pay in full*. Thus we might have the following comparison:

This shows that the ABS has the same PD as the corporate bond but if it defaults, you are likely to get less back. Intuitively, it is riskier, and indeed its EL is 0.72%, higher than the 0.55% for the corporate bond.

Now let’s look at an ABS with the same EL as the corporate bond, but with ABS-style low recoveries. It’s PD is 0.764% or in pictures:

Which of these bonds is riskier? The corporate bond is more likely to default, but if it defaults, the expected recovery is higher. The two bonds have the same EL. Riskiness isn’t easy to call; it really depends on your tolerance for large losses vs. your desire for 100% capital return. Depending on your rating system, you could justify rating either bond a notch over the other – and all that that demonstrates is how hard it is to compare things with multidimensional properties on a single linear scale.

In the next post we will use this tool to discuss ABS structuring and the recurrent topic of informationally insensitive assets.

*This is not necessarily true, but it is common especially in structures where reserve accounts are used. We will say more about this tomorrow.

Posted in: Bonds and CBs, Credit by David /
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