Deus Ex Macchiato

I like naked capitalism: it often has interesting things. One of them recently was an article about liquidity buffers. I have to confess to laughing, though, when I first read it. The august head of the BIS was rechristened cuddly Jamie Caruana. Jaime wouldn’t like that. In fact, he doesn’t like much. As NC says:

Caruna, argued at a secret (not) central bankers’ conference in Sydney that banks also need to carry more in the way of liquid assets… [He] recommended that banks hold enough to allow them to survive a month without access to funding. Note that idea only seems radical now, since banks have spent decades perfecting the art of running lean. The rule of thumb in banking is to lend out $9 of every $10 in deposits. In the 1960s, only $5 of loans versus $10 in deposit was considered prudent.

Certainly if Jaime gets his way then it will make for icy times for banks. But perhaps that is what we want. It would certainly be politically popular: the bonus problem goes away if banks are less profitable. It would of course be stability enhancing too. But in the long term, will finance ministers really be willing to put up with a cost of credit as high as it would be under these proposals. Perhaps ultimately this will be battle ground of 21st century regulation: those on the side of stability vs. those on the side of growth.

Posted in: Uncategorized by David /
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That’s Norwalk, Connecticut.

In Risk, we find:

faced with accounting changes that would result in more financial instruments being reported at fair value through the income statement – meaning changes in value would appear as profits or losses – regulators have been quietly discussing radical new rules that would separate profits into buckets depending on the liquidity of the underlying assets.

The new reporting regime would then allow regulators to restrict how gains on less-liquid instruments are used. As a result, derivatives and structured product businesses could find a huge chunk of their profits fenced away.

This is a variant on an idea I suggested earlier, and a bad variant to boot. The good thing about separating realised from unrealised gains is that only the latter are a good form of capital. If you have rigourous valuation risk management, then the P/L on the illiquid books is just as good as the P/L on the liquid ones, since both have sufficient valuation adjustments to cope with the uncertainties involved. Supervisors would be better off doing the boring (but hard) job of ensuring that firm’s are valueing their books properly, and then treating all unrealised profits as potentially suspect, not just level 2 and level 3 ones.

Posted in: Accounting, Capital and Contingent Instruments, Regulation by David /
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In the midst of a good nag, Europe’s voters are the biggest obstacle to ambitions to become more dynamic and successful, the Economist stumbles on a truth:

… lots of Europeans do not want to live in the most dynamic and competitive economy in the world. They prefer to work fewer hours than Americans or Japanese (about 10% fewer, on average), to take long holidays, and to retire as soon as possible.

Honestly, reader, do you really blame them? Who aspires to spend more hours in the office? Who doesn’t like holidays?

If economists persist in tutting and sucking their teeth when people decide that economic growth is not the most important thing in the world ever, then they display a rather shallow understanding of people, as well as of economics.

Posted in: Economic Theory, Philosophy and Hedonics by David /
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Jonathan Hopkin has an excellent piece on the current climate change research debacle:

My argument is basically that the incriminating emails probably don’t significantly undermine the findings of Phil Jones and his team, and the whole story has been overblown – scientific research is always imperfect, and there are always issues about the reliability of data. And, sometimes, academics behave badly over email. Amazing but true.

He’s right, but then he understands how science is done, as this passage demonstrates:

The truth is that the world of scholarly research is a world which revolves around argument and disagreement: present a paper at a conference and, if it is at all interesting, hands will go up as other researchers seek to challenge and scrutinize your findings. The main reason for this is probably vanity – asking a tricky question and putting another scholar on the spot wins you respect and standing. But the fortunate side effect is that poor research has a good chance of being revealed as such.

In other words, science as she is practiced does not involve mining little nuggets of truth. It is a fermenting brew, with lots of people stirring the mixture, adding ingredients, trying to throw a batch out and start again. Only years later – in some cases decades later – does it settle down enough that we have some chance of seeing what we have really got.

Note too the use of `interesting’ in the above. Being wrong isn’t the main scientific sin. Being boring is. Fortunately many scientists have low standards (although perhaps not quite as low as economists), so they take an interest in quite a lot of ideas. But it is certainly career enhancing to produce something that a lot of people find interesting, even if it turns out to be wrong. Those wrong ideas are useful in part because opposing them often helps to create a less wrong idea.

I think it is extremely probable – but not certain – that current climate science is correct. We have a big problem, and we need to do more to fix it, even while acknowledging that we do not know quite how big it is. It would be a tragedy if a failure to understand how science happens were to be the reason we don’t do enough.

Posted in: Mathematics and Science by David /
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Time magazine has an interesting article about Roy Smith, a NYU professor and former Goldman partner. (Hat tip Felix Salmon.) Smith picks up a point that was originally (so far as I am aware) made by Willem Buiter in the FT, namely that a major enabler of financial crises is a large amount of money looking for a home.

There is now about $140 trillion in market capitalization in the word’s financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis.

This is absolutely true. Remember, we could not have had the crunch without buyers of AAA ABS risk. Who bought it? People looking for a safe home for their money that had a bit higher a return than AAA government bonds. Without all that money from the BRICs countries, baby boomer pensions and so on, we would not have had a crisis. We need to get better at finding genuinely safe ways of investing that amount of liquidity without introducing the risk of massive instability. Hot money naturally moves when there are problems. The right answer isn’t obvious.

I’ll make two observations, though.

The first is that the historical answer was to hide the instability. That’s what accrual accounting does. If money is in bank deposits, and is used to make loans, as in the classical banking model, then the same instabilities are there, but they are damped first by deposit protection and secondly by accrual accounting. The investors can’t see the problem with their investments (namely rising credit risk in the bank’s loan book) until it is almost too late. Therefore they don’t run, and so mostly we don’t have banking crises. It’s just that when we do, as in Japan, they are hugely costly and long lasting.

The second is that in the past there was significant inter-temporal subsidy. The classic defined benefit pension is a good example of this: an investor doesn’t get what they put in, but rather a benefit that is only loosely connected to it. If their contributions are invested well, everyone in the fund benefits; whereas if their contributions suffer a period of poor investment performance, everyone’s contribution rates are raised to cover the shortfall. As we have moved to more personalised investments, this form of cross subsidy is much less common.

My suspicion is that we need to find ways of damping down the flow of hot money without sacrificing too much growth. (Hence ‘the Bears problem’ – we want the velocity of investment funds to be high enough that credit can be obtained, but not so high as to endanger stability. It needs to be just right.) But what those dampers should be remains a difficult problem.

Posted in: Liquidity and liquidity risk, Pensions, Rules by David /
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Consider a bank which has:

• Non performing loan coverage of only 105%
• Total assets over 65% of its country of incorporation’s GDP
• With that country having unemployment over 15%
• The bank had falling EPS and efficiency ratios in 2009 despite the recovery of the markets

OK, the leverage (assets to shareholder’s equity) is not that silly at 15.5x, but total assets of over a trillion euros are scary big.

Question for the reader: is this bank too big to fail? If so, should it be broken up?

Posted in: Markets, Mother of all Bailouts by David /
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In general I am a staunch defender of credit derivatives: they make the credit markets much more efficient; they help to companies honest by letting traders short a credit; and the ability to hedge credit lets banks lend more. However, it has to be said that creditor’s rights can be a problem with credit derivatives. Specifically if I own a bond (or make a loan) and have credit protection on that exposure, I may have the right to vote in creditor’s proceedings, such as restructurings, but I may have a different incentive to vote, or no incentive at all, thanks to the credit protection. This situation is sometimes called an `empty creditor’.

A particular problem is that an investor can sometimes buy bonds for less than par, buy CDS on those bonds, then get paid par if there is a credit event. They are incentivised to vote the bonds in such a way as to maximise the likelihood of that credit event, not to ensure that the company survives (or even that the bonds have the highest ultimate payout).

Now an interesting riff on the problem of empty creditors has come up. Risk.net reports that:

Goldman Sachs stopped making markets in bonds and credit default swaps on US freight company YRC Trucking for around two weeks from December 16… The decision to stop quoting on YRC is understood to have been taken at a very senior level in Goldman, after freight union International Brotherhood of Teamsters (IBT) sent letters to congressmen, senators and state attorneys-general accusing the bank of encouraging investors to torpedo YRC’s restructuring – which would have threatened the jobs of around 30,000 IBT members.

Goldman quickly threw its weight behind efforts to help the company stay on its feet, sourcing additional bonds for investors that wanted to vote in favour of the restructuring, which subsequently went through successfully… the union obtained screenshots of a Bloomberg run sent by a Goldman trader on December 16, quoting prices on three YRC bonds and – on the same screen – CDSs in the trucking company. This was, they argued, proof the bank was encouraging empty creditors to build basis packages in YRC with the aim of killing the company.

Kudos to the teamsters: that was smart. Taking out an investment bank at the crucial time worked well, and Goldman was the obvious choice given their elevated reputational risk at the moment. There is a lesson here for subsequent distressed restructurings.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation, Reputational Risk by David /
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Bloomberg tells us:

European yacht makers Princess Yachts and Beneteau SA said sales are picking up as wealthy buyers resume purchases of their most-expensive models.

“Boats over 100 feet are selling very strongly as the very wealthy feel the crisis less and tend to buy bigger and more modern boats,” Simon Clare, head of marketing for Princess Yachts, said in an interview at the Dusseldorf boat fair.

I’m not surprised. There is a lot of anecdotal evidence that the top of the market – silly sports cars, houses priced in eight figures, even (to a lesser extent) fine art – is recovering. My advice? Buy first growth claret and flip it fairly fast. I’m not at all convinced that the plebs are sufficiently well off that this rally has legs, but if the worst comes to the worst, you can always drink that particular investment mistake.

Update. More evidence, again from Bloomberg:

A sculpture by Alberto Giacometti last night became the most expensive work of art sold at auction as wealthy collectors battled for rare works by 20th-century artists at the biggest auction held in London, Sotheby’s said.

The life-size bronze of a walking man, being sold by Germany-based Dresdner Bank AG, fetched 65 million pounds ($103.4 million) with fees.

Over a hundred million for a Giacometti? That is in crazy Klimt territory. It might just be time to buy stock in diamond producers…

Posted in: Art, Markets by David /
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Rajiv Sethi writes:

In a series of papers starting with Promises Promises in 1997, John Geanakoplos has been developing general equilibrium models of asset pricing in which collateral, leverage and default play a central role… The latest paper in the sequence is The Leverage Cycle, to be published later this year in the NBER Macroeconomics Annual. Among the many insights contained there is the following: the price of an asset at any point in time is determined not simply by the stream of revenues it is expected to yield, but also by the manner in which wealth is distributed across individuals with varying beliefs, and the extent to which these individuals have access to leverage. As a result, a relatively modest decline in expectations about future revenues can result in a crash in asset prices because of two amplifying mechanisms: changes in the degree of equilibrium leverage, and the bankruptcy of those who hold the most optimistic beliefs.

Sethi is right: this is important work. What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

Posted in: Economic Theory by David /
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Felix Salmon has a good post on the problems of classical free trade thinking when applied to food:

In a Ricardian world it makes sense for Ohio to overwhelmingly grow corn and soy, since growing corn and soy is what it does best. And because of economies of scale, it makes sense to grow just one type of each, on farms of mind-boggling size. Ohio can then trade all that corn and soy for the food it wants to eat, and everybody is better off.

Except in reality it doesn’t work like that. Monocultures are naturally prone to disastrous outbreaks of disease, which can wipe out an entire crop…

A system of globalized agriculture can break down, as we saw during the commodity boom of 2008. As the price of soy and rice and wheat soared, exporters started hoarding rather than selling, and importers couldn’t obtain necessary supplies at any price. As the World Bank’s Ngozi Okonjo-Iweala noted, Ukraine had 5 million tons of surplus wheat, but the international food markets were very thin, and it was extremely difficult to get that wheat exported. The system didn’t work like it was meant to: when put to a real-world test, it broke down.

The problems are severe enough, but they are not the only ones. Firstly transport costs are not constant, and indeed are likely to increase significantly in a carbon-constrained world. Second, even if it is cheap enough, some people (like me) don’t want to eat asparagus from Peru in the middle of the UK winter. Third, the varieties the megafarms grow are typically not the tastiest, and anyway have probably been dosed with nasty chemicals to improve their shelf life. A stick of easy to grow, long lasting asparagus from Peru is simply not fungible with native British asparagus varieties grown organically. Thus the theory of comparative advantage breaks down as we are not comparing like with like. Finally, locally produced food is less likely to disappear for political reasons or because changes in the FX rate makes importing them no longer attractive: if you want to be sure of your apple supplies, buy ones from the farm down the road.

All of this is leading, haltingly, to a new localism. It is very hard to be a complete localvore, but trying to increase the amount of locally grown food and drink you buy makes sense. It will be tastier, it’s good for your carbon budget, it keeps money in the local community, and it doesn’t hand power to global agribusiness.

Posted in: Economic Theory by David /
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A good lesson in finance is to sell what you can hedge. That is, a guiding principle in product design is to produce a structure that leaves your book looking good, either because it hedges risk you have already, or because you can find a liquid hedge instrument with no nasty basis risks or unquantifyable factors to spoil your risk reports.

On that criteria, participating mortgages look good. Here rather than loaning money against property collateral, the bank also has an equity stake in the house. If the house value goes up, the mortgage redemption amount does too. Crucially though if property values fall, then so does the mortgage amount, protecting both borrower and lender from the trap of negative equity. As FT alphaville points out in coverage of a speech by Andrew Haldane,

a traditional mortgage incentivises cash-machine like use, either through equity withdrawal or ‘trading up’ when assets are appreciating — hence accelerating the house price rise effect — it happens also to amplify the exact opposite behaviour when asset prices depreciate.

The good news first. This type of mortgage would have a direct hedge using property derivatives. Banks could sell their house price exposure on to investors in a very clean fashion. (A conventional mortgage has house price risk via the property prices fall-defaults rise-mortgage losses rise spiral, but there is no accurate hedge for the exposure.)

Moreover, as Haldane says, this type of mortgage would be good for the financial system by reducing the amplitude of the credit cycle. There would be fewer defaults, and this would be good for borrower and lending.

To see the idea in action, suppose I buy a house for £100,000, with an 80% mortgage. If house prices go up 20%, then my place is worth £120,000. Presumably under Haldane’s proposal, my mortgage amount goes up from £80,000: for instance under a 50% participating mortgage, the bank would get half of the increase in value, so if I sold, I would have to repay £90,000 (minus whatever principal I had paid off while the loan was in force). Therefore I walk away with £30,000: my original deposit, plus half of the property price appreciation.

However, the kind of place I want to live in now costs £120,000. My thirty grand will get me a 75% LTV loan on a new place worth this much. I have deleveraged my property exposure, but not as much as I would have done with a conventional mortgage.

If property prices had fallen 20%, though, my loan amount would fall to around £70,000, and I would not have lost my whole deposit. I would still have positive equity, and hence an incentive to perform on the mortgage.

[Obviously we can imagine more complex participation structures, for instance where the mortgage holder is effectively long a put spread on some of the notional and short a call spread.]

The bad news is of course that the borrower makes less from rising house prices in this structure. They have less leverage. Hence I suspect the structure would not prove that popular even if banks were to offer it. It’s an intriguing (and very Islamic) idea though.

Posted in: Mortgages by David /
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From Naked Capitalism reader Matthew G:

How many quants does it take to screw in a lightbulb?

Using ten racks of co-located blade servers, one quant can detect a janitorial inefficiency, step in between janitor and light fixture, and screw in 49,500 bulbs in less than a millisecond, keeping five hundred lightbulbs of profit.

Two quants competing with each other can screw in 99,998 bulbs in a millisecond, with each quant retaining a profit of one lightbulb.

When ten quant firms try to screw in a light bulb, the bulb explodes, the light fixture gets ripped from the ceiling, the building falls down, the entire electrical grid of the city of Greenwich shuts down, innocent civilians all over the world have their retirement accounts electrocuted, and the Federal Reserve has to give the counterparties of each quant firm five hundred million light bulbs to maintain the stability of the system.

Update. FT alphaville saves me from having an entirely frivolous post by referrring to this article at Trader’s Magazine. They say:

Bryan Harkins, an executive with the Direct Edge ECN, noted the market is “saturated” with high-frequency shops. He doesn’t expect overall industry volume to increase substantially in the next few years.

Volume, in the past three years, has doubled due to a large extent to the activities of high-frequency traders. Average daily volume is about 10 billion shares today. That compares to 5 billion shares in early 2007.

“Someone leaves a high-frequency trading shop to start a new one,” Harkins said. “You do a meeting [with them] and they say ‘We’re going to do 100 million shares a day.’ You get all excited with the next big account and then six months later they’re struggling to stay in business.” About half of Direct Edge’s volume comes from high-frequency trading firms, Harkins said.

[NYSE Euronext's Paul] Adcock noted the changes in volume at NYSE Arca’s top five high-frequency accounts mirror those of the VIX “almost perfectly.” And because most high-frequency strategies are similar, he adds, only the “biggest and fastest will make those strategies work.”

(Emphasis mine.) The comments above refer to the good times, too. Imagine what would happen if one of those big guys liquidates, or if we have a very high volatility episode with extreme decorrelations, as might happen for instance if there is a sovereign crisis. It won’t be pretty but we cannot say that we have not been warned.

Posted in: Financial Models, Fun, Markets, Quantitative Trading by David /
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Matthew Lynn writes for Bloomberg:

President Barack Obama has taken a sledgehammer to the model that Wall Street investment banks have created over the last three decades.

And yet, as is always the case in business, one man’s misfortune is another man’s opportunity.

If Europe plays this right, it could establish its banks and financial centers as the industry’s leaders. The dominance of Wall Street may be coming to an end.

In effect, “Wall Strasse” can overtake Wall Street: European financial centers can lure refugees from the tightly regulated New York markets, and the big European banks can start offering customers the all-in-one service that their U.S. rivals won’t be able to anymore.

Aside from the curious Wall Strasse coinage (’Mauerstrasse’ would be more accurate, although the real insider would probably write ‘Theodor-Heuss-Allee’), Lynn is entirely right. This is a big opportunity for European universal banks. Paribas, Deutsche, Credit Suisse and Barclays are probably best placed to seize that opportunity, although some of them may have capital issues which will make it harder for them to take US market share.

It may well not play out like this of course, especially if Obama’s proposals are watered down significantly. But the combination of being a national champion in a leading European state and having a reasonable investment bank looks pretty attractive right now.

Posted in: Markets, Organisational Structure by David /
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At Jack on tap we find:

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle… Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does.

(Hat tip FT alphaville.)

This all seems reasonable (and comes with the usual I-am-not-a-lawyer-indeed-I-don’t-even-know-how-to-cook-one disclaimer). And undoubtedly there are many instances of devious, scheming bankers selling products they knew (or strongly suspected) were toxic to naive investors, including naive professional investors. The industry short hand in some quarters used to be `Belgian pension fund’, meaning any sleepy, ill-informed party who had the authority to enter into transactions they could not price and might well not have understood the risks of. If some people had something they really couldn’t sell to the cognoscenti, they found a Belgian pension fund.

CDOs of ABS, however, are a slightly different story, at least in some cases. These were products that neither buyer nor seller understood. In many cases both parties used the same flawed model to analyse the product; both parties failed to dig deeply into the underlying collateral; both parties did not think through the consequences of the forms of credit enhancement present*. It suits the current mood to blame the industry – or just Goldman Sachs if you prefer – for knowingly blowing investors up. But the truth is rather more complex. I doubt that this will ever come out. The `we didn’t understand it either’ defence might work against a claim of fraud or misrepresentation, but it does rather open the door to a case of failure of due diligence…

* A good example is the use of excess spread accounts. These work as credit enhancement providing defaults happen late enough in the life of the structure. If they happen early, however, as in most of the 2006 and 2007 vintage CDOs of ABS, they are useless.

Posted in: ABS, Reputational Risk, Securitisation and Tranching by David /
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Evidently not. From the FT:

Greek stocks and bond markets surged on Monday as investors flooded the government with demand for its first bond offering of the year… The coupon interest payment on the deal, expected to be worth €5bn, is likely to be 6.12 per cent – or 3.8 percentage points higher than equivalent German bonds. This is a record spread and underlines the premium Greece must pay over Germany, the benchmark market in the eurozone, for its financial troubles.

For Greece that is one challenge negotiated, at least. Fixed income investors are still hungry for yield, and Eurozone government risk at 380 over bunds is evidently attractive. High(er) yield issuers everywhere take note – if you are even somewhat generous, you can currently get long-dated deals done at yields that are in absolute terms delightfully low.

Posted in: Markets, Sovereign Default by David /
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Governments borrow by issueing bonds of various maturities. They liquify the banking system by lending banks money, often for very short maturities. If the yield curve points up, as it often does, then banks can make money simply by borrowing for one week from the central bank and investing the proceeds in longer term bonds. Providing this is done in the banking book, it attracts no capital charge.

Usually banks don’t do this as the returns offered by lending the money out to corporates or individuals are attractive given the risks: the safety of government bonds is not needed. But in the current environment, with elevated credit risk and concerns over capitalisation, some banks are engaging in this rather attractive carry trade.

Is that OK? Well, no. It is a direct subsidy from taxpayers to the banks. It is also damaging for the economy as it reduces the amount of bank credit available.

There are a few obvious fixes.

• There should be a capital charge for interest rate risk in the banking book.
• Access to the central bank window should be conditional on new lending. That is, banks should only be able to borrow from the central bank if they pledge a certain amount of recently originated loans, commerical or retail, as additional collateral.
• Tax interest on government bonds held by banks more punitively. (This is however problematic if we want to force banks to hold some govvies to improve their liquidity risk.)
• Manage the shape of the yield curve to make the trade more attractrive, e.g. through quantitative easing.

Posted in: Liquidity and liquidity risk, Regulation by David /
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One thing that is interesting about the Obama proposal for banking reform is the fact that some things – owning private equity groups, sponsoring hedge funds – are going to be banned for banks. Not fully supported by equity: banned. Obama is effectively saying that no amount of capital, not even 100% of notional, is sufficient to remove the risk of these activities. I am supportive of the desire to ensure that Never Again Will the American Taxpayer be Held Hostage by a Bank that is ‘Too Big to Fail, but an outright ban seems a crude instrument. It might work, if Obama can get this through Congress, but now I think about it, it feels neither proportional nor optimal.

Update. From the FT:

The best that can be said for Barack Obama’s latest plan for financial regulation – banning deposit-taking banks from proprietary trading and capping financial groups’ market share of funding – is that it shows he now sees only radical policies can crisis-proof the financial system. But the claim that these ones will increase stability is misguided, if not misleading.

Being cut off from trading securities for their own book will not stop banks from putting insured deposits at risk. Their inventiveness in finding ways to lose money knows no bounds, and the most time-honoured money-loser of all – making bad loans – remains available.

I would not go quite as far as the FT: the Obama proposals will probably increase stability. But they will indeed not remove all risk from the financial system, and indeed we want some risk, because there is a trade off between financial system risk and the maximum achievable economic growth. Being forced to eat their own lunch – to keep credit risk they originated – does at least provide a good incentive structure for banks, even if this is the traditional way for financial institutions to lose money.

It remains that case that well designed capital rules remain the cornerstone of financial stability. They provide damping, limiting leverage, and leveling the playing field between diverse types of risk. Simply banning banks from carrying out certain activities, especially activities which will be carried out in unregulated institutions, is no substitute for trying to write good capital rules.

Posted in: Regulation by David /
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I rather doubt it, but these are worrying times for those that have not yet decanted from the Wharf to Mayfair. As Bloomberg says: President Barack Obama will offer proposals to limit financial institutions’ size and trading activities as a way to reduce risk-taking, an administration official said… The proposals could affect trading at some of the nation’s largest banks, including New York-based Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co., said Frederic Dickson, chief market strategist at D.A. Davidson & Co. in Lake Oswego, Oregon. Banks conduct proprietary trading for their own benefit, not for that of their clients. This is probably more effective than a new Glass-Steagall: universal banks with minimal prop operations would pose a lot less risk than broker/dealers with them, and the idea that a Goldman sans lending is not too big to fail is not credible. I fear the curbs will not be effective, but certainly I applaud the desire to prevent too big to fail firms from costing the tax payer too much. *Any suggestions that this title is just there to provide spurious justification for the picture will be ignored. Update. John Hempton points out that the definition of prop trading is not entirely clear. I agree: drawing the line is difficult, and likely to be arbitrageable. That does not mean that some attempt to limit bank’s prop risk is not sensible however.

Posted in: Regulation by David /
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There is an interesting letter in the current LRB from Wilhelm Schneider:

… In many cases it is true that the ‘future’ (of chemical processes, say) can be precisely predicted on the basis of the laws of nature, and engineers take advantage of those fortunate circumstances. But there are also counter-examples: it is notoriously difficult, for example, to predict the exact time an earthquake will occur.

Should predicting the occurrence of financial crises in any case be the aim of an economic theory? Those of us who work in engineering have adopted a more modest, though still challenging, approach. In aerodynamics, for instance, we investigate how to get turbulent air flows under control, instead of trying to predict ‘catastrophic’ events.

That is a useful distinction I think. Predicting a crisis seems to be a difficult problem. Building the system in such a way that crises are less likely seems to be simpler. Now often it turns out that seemingly hard problems are simple and vice versa (AI cracked `diagnosing heart disease’ very quickly; building a robot that could walk turned out to be a much harder problem) — but still, tackling the simpler problem seems sensible.

Posted in: Economic Theory, Mathematics and Science by David /
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There has been much incendiary and ill-informed comment on the ’shadow banking system’ and Wall Street as ‘a giant Ponzi scheme’. As always in the aftermath of a crisis, hyperbole is not in short supply. Still, there is one sense in which a limited version of this claim might be true: the business of making CDOs of ABS could have been a form of Ponzi scheme. Here’s how.

Note that there are three types of tranche in a CDO: senior, mezz, and junior. One main reason for making a CDO in the pre Crunch period was to create AAA-rated senior securities. Lots of people wanted to buy these, so distributing them was not a problem. (Of course, these securities turned out to much more dangerous than many people thought, but that is not the point: in 2003-07 selling AAA ABS tranches was not a problem.)

The junior was typically retained by the originator; if it wasn’t, there were plenty of (mostly hedge fund) buyers. So that was not a problem either.

In order to have a real transfer, and to convince their risk managers that they really had sold the CDO, the makers of CDOs of ABS had to sell the mezz too. This was a lot more problematic. The ratings were not AAA; the yields were not that attractive (often high tens or low hundreds of bps for risk in the low investment grade or high junk area); and buyers knew that there was risk in these tranches.

So what might some banks have done? One answer could have been to set up (or find) friendly asset managers to buy the mezz. Remember, in managed CDOs the asset manager has considerable discretion about which collateral to buy. If you could find a supposedly independent third party who you could somehow persuade to buy your mezz – perhaps because you had provided them with support somehow – then you could claim that you had sold the whole CDO, and you would be allowed to make another one.

This would be a kind of Ponzi scheme if the originator was covertly financing the mezz purchaser, or otherwise providing sufficient support that the mezz purchase was not a free market transaction. It would mean that CDO tranches prices were not the result of willing buyers interacting with willing sellers, but rather connected buyers taking subsidies for being seen to buy known rubbish. These prices in turn would then support the AAA pricing: after all if the As were seen to be trading at 80 over, it made 15bps for the AAAs seem reasonable.

What do we learn from this hypothetical? Simply that if you want to understand what happened in the CDO of ABS market in the run up to the Crunch, the question ‘who bought the mezz and why?’ is particularly relevant.

Posted in: ABS, Securitisation and Tranching by David /
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Chris Atherton has an interesting explanation for Why experts are morons (which I have edited mildly to suit my purposes):

Below is a recipe for modest success … and for becoming a legitimate ‘expert’. (Quantities and ingredients may vary according to your needs and experience.)

• You need to be bright-ish. Not supernova bright, just bright enough. (If you’re too bright in school, you’ll get bored; see next point.)
• You need to be well-behaved. (If you don’t behave, you’ll be labelled disruptive and that will do exactly what you think it will to your chances of academic success. Yes, even if you are bored because lessons are too easy.)
• It helps to crave everyone’s approval. (If you don’t care what your teachers or parents think, why would you try hard on subjects that don’t really interest you?)
• Questioning authority probably isn’t in your nature. (Or if it is, it’s a very specific kind of critical thinking, like “hey, maybe nukes aren’t that great an idea, mmkay?”)
• You are comfortable letting other people set goals for you (“You think I should go to university? Great!”)
• You acquire a certain nerd-like pleasure (flow, if you like) from gnawing on very specific questions.
• Your school years have conditioned you to understand that most people are mean, and best avoided.
• Metaphorically or actually, you have let a thousand cups of tea go cold while you geek out on your chosen subject.

… okay, that much will get you through university and into a postgraduate programme. At this point, it will be particular helpful if you can screen out information about the world around you, because this will just distract and confuse you about the relevance of what you are doing. (Having a crisis of meaning is one of the fundamental stages of doing a Ph.D.)

Much the same argument applies to the associate stage at an investment bank, too, only the hours are worse.

So, where do we get to given that this treadmill is operating?

Chris says that the

side-effect of being an ‘expert’ is that if you’re not naturally inclined to cause trouble, question the system, or think critically about more than subject-matter problems then sometimes you end up saying really dumb stuff

This is essentially because you have rather less connection with `real life’ than most people, and share rather little context with them. Looking at the testimony of the bank chiefs to the Financial Crisis Commission Testimony, their actions on pay, the bonus tax, and so on, one is struck by how out of touch they are. But perhaps most experts, be they bankers or academics, are similarly disconnected. It’s a scary thought.

Update. The Epicurean Dealmaker has (what I hope he will not object to me characterising as) a similar if more eloquent take on the unusual nature of the men who run investment banks here.

Posted in: Organisational Culture by David /
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From Laurie Goodman at Amherst Securities via the Big Picture:

Freddie will likely lose around $178 billion of its $1.86 trillion credit guarantee book, and Fannie will likely lose $270 billion of its $2.81 trillion book. Combine the credit guarantee books of the two firms, and you reach a $4.67 trillion book, with estimated losses at just under 10%, or $448 billion.

My, that is a big number. And of course it suggests that the right capital haircut for residential mortgages is not 4% as per Basel, but rather 8-10%.

Posted in: Basel, Federal Agency, Mortgages by David /
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… and you get spam comments (mine were primarily from Russia), then you might want to add an .htaccess file. The skinny is here.

Posted in: Software and Virtual Worlds by David /
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This came up in FT alphaville a little while ago, and I should get back to it. It is a somewhat complicated story, so let’s take it slowly.

Firstly, the new Basel proposals:

No adjustment should be applied to remove from the Common Equity component of Tier 1 unrealised gains or losses recognised on the balance sheet.

In other words, Basel says that in future, the regulation should go like the accounting. So how does the accounting go?

Going forward, the IASB suggest that there will be two measurement-categories for financial instruments

• fair value; or
• amortised cost.

And in particular available for sale accounting – which is pretty commonplace at the moment – will disappear.

Thus firms have to elect either fair value or accrual for an asset, and if they select fair value, gains and losses will immediately feed through into regulatory capital. We have commented on the vicious circle this introduces earlier – small losses erode capital which increases leverage which forces asset sales turning unrealised losses into realised ones.

Banks will not want that. So what will happen? JPMorgan (via FT alphaville) suggest:

By avoiding adjustments for unrealised gains or losses, the regulators are putting more pressure on the accounting model. In other words, if the accounting treatment assigning a valuation measure (i.e. amortised cost or fair value) is essentially automatically determining the regulatory treatment, this may lead banks to be more motivated to exploit perceived advantages of using accounting categorisations that are most favourable for regulatory purposes. This may encourage banks to maximise the amount of financial instruments which are classified in the amortised cost category, so there are no mark-to-market gains or losses on balance sheet and regulatory capital is more stable.

That seems entirely likely. Thus the combination of a seeming rationalisation – making the regulation follow the accounting – and doing away with AFS means that we will get less transparency on the value of bank assets and less volatile, i.e. accurate regulatory capital estimates. Bravo.

Posted in: Accounting, Basel by David /
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From the Guardian:

Top universities accuse Gordon Brown of jeopardising 800 years of higher education, warning that they could quickly be “brought to their knees” by the government’s spending cuts of up to £2.5bn, thereby damaging Britain’s ability to recover from recession.

Quite right, and exactly as we said before Christmas when these plans first came to light. It really does hurt for a labour government to be doing this.

Posted in: Politics, Universities by David /
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After an ‘interesting’ 2008 and 2009 in the markets, will 2010 be any quieter? Perhaps not. The Economist is calling a bubble in a number of markets: For all the panic last year, asset values never quite reached the lows that marked other bear-market bottoms, and now the rally has made several markets look pricey again. In the American housing market, where the crisis started, homes are priced at around fair value on the basis of rental yields, but they are overvalued by almost 30% in Britain and by 50% in Australia, Hong Kong and Spain. Stock markets are still shy of their record peaks in most countries. The American market is around 25% below the level it reached in 2007. But it is still nearly 50% overvalued on the best long-term measure, which adjusts profits to allow for the economic cycle, and is on a par with two of the four great valuation peaks in the 20th century, in 1901 and 1966.

Naked Capitalism agrees that the equity markets are overvalued, citing the lack of participation of real money investors in the current rally:

…the stock market rally is due almost entirely to hedgies, pension funds, banks and other institutional investors, and not every day investors.

They also suggest that the current levels are due to central government support, something that seems to me to be self evident, and reference remarks by Bill Gross and Nouriel Roubini about the Ponzi nature of the current stimulus. Gross is explicit about the withdrawal of government liquidity in his latest newsletter:

… if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets.

I don’t think we are due for an equity market crash in the G4 quite yet. But I do think that the current levels are unsustainable given corporate profits, and that a setback is likely if central bank liquidity is withdrawn quickly. The markets are also highly vulnerable to bad news: something like a Chinese crash could easily cause a global market tumble. If you have been long equity, taking some money off the table might be good advice.

Posted in: Markets by David /
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I recently had an email suggesting that I might like to republish Deus Ex on another website. The deal on offer involved no money, but more readers. Moreover, given the other content on the website concerned, those new readers would be less erudite than you, and I would be making money for the website owner. Why on earth would I want to do this?

A rejection was clearly unexpected to the proposer. He evidently expected me to acquiesce with a few grateful words. Undoubtedly some bloggers take the view that any publicity is good publicity — and that’s fine. But I think a number of more nuanced models of web content can coexist.

Paid for content makes sense in some situations: as an author, I certainly support it, and I find Google’s attempts to scan everything they can lay their hands on rather troubling.

Free content but with restricted rights – as in the particular creative commons license I use – is also a useful model. And of course much free content is in practice restricted by how hard it is to find. If someone in the know does not tell you that it is there, you are unlikely to ever come across it.

If you want the maximum number of readers, and you don’t care about their quality, or the amount of spam, idiotic, or otherwise dubious comments you get, then completely free content with copious redistribution is the way to go. But that does not suit every blog, let alone every form of online content. Like most evangelists, the content wants to be free mob have an overly simplistic view of the web. Some of us are perfectly happy in our little corners far from the crowds.

Posted in: Media and Popular Culture by David /
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Where do you want to be when a crisis strikes? The answer is clearly `not head office’. It was noticeable that the bankers who did well after the ‘98 Russian crisis were often those who had senior positions in Asia or Latin America, and who were perceived to have acted like good corporate citizens (i.e. cut like Jack the Ripper when told to). The same thing happened after the 2001 Nasdaq crisis, and now FT alphaville reports that it is happening again:

Citigroup has just become the third big US bank (at least) in under four months to decide to pull its Japan chief out of the country… Douglas Peterson, Citi’s top executive in Japan, will shortly move to New York to become chief operating officer of Citi’s North American commercial and retail banking operations.

Being a big fish in a smallish office is often a bum deal as you are out of the HQ power loop. But it can certainly prove to be a blessing when more or less everyone back home is implicated in massive losses.

Posted in: Intellectual Capital, Organisational Structure by David /
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Snow is so much easier to bear in places that are used to it. Unlike, um, London.

Posted in: Fun, Photography by David /
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“The defining characteristics of having E are qualitative impairments of social communication and interaction, along with restricted and repetitive activities and interests. Individual symptoms occur in the general population and appear not to associate highly, without a sharp line separating pathological severity from common traits… A high percentage of individuals with E show unusual abilities.”

Would you say that E = “a PhD is economics” was one reasonable assumption? In fact of course E is “autism spectrum disorder”: the text I have used is from wikipedia. But hopefully the point is made – economists, like many academics, often display behaviours that hint at Asperger’s syndrome. There is nothing wrong with that of course.

However, as Jonathan Hopkin points out, it does mean that using assumptions about how economists behave to derive broader conclusions about how the wider populace behaves is fraught with danger. In particular many behavioural economics experiments are done on economics students – because they are easy for the experimenters to get their hands on. (I wonder if economics departments have ethics committees the way psychology departments do?)

A particular issue is that economists by definition are more attuned to money than most people. They think about it all the time. Thus they do things that most of us wouldn’t think of, like driving from more than half an hour each way to save a trivial amount on their groceries*.

Policy derived from the behaviour of this biased sub-population may well be bad policy if their behaviour is assumed to apply to us all. Or as Hopkins says

… the assumptions behind this behaviour also end up underpinning predictive and normative models of social dynamics, which can inform policy decisions. These policy decisions constrain behaviour, undermining the social ties that people value.

*Once you factor in the price of petrol, this is of course economically illiterate.

Posted in: Economic Theory by David /
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I used to quite like Felix Salmon’s writing but lately his writing has become worse and his arguments less cogent. A recent piece There’s no tradeoff between dynamism and safety is a good example.

We start off with something eminently sensible, from the mouth of someone else:

Raghuram Rajan tells the WSJ’s Mark Whitehouse that when it comes to capitalism, there’s a natural tradeoff between security, on the one hand, and dynamism, on the other.

In other words, at any given time you can have higher growth with a larger chance of a bust, or lower growth with more stability.

Salmon misunderstands the claim, and opposes his idea of it thus:

The dynamism of capitalism is largely a function of safety nets, dispersed risk, and limited downside. The limited-liability joint-stock company run by professional managers is a both a driver of dynamism and an exercise in maximizing the safety of as many principals as possible.

No, the dynamism is largely a function of efficient capital allocation. The fundamental problem of financial stability is how to permit this without cooking in crunch producing instabilities. Highly leveraged banks permit faster growth, for instance, at the risk of a banking crisis. Similarly joint stock companies encourage risk taking but they too bake leverage into the system. (In fact there is a good argument that Islamic finance, with its insistence on equity type risk taking in any financing, is fundamentally more stable than Western style joint stock companies.)

Salmon next adds a complete non sequitur.

A large reason for the excesses of the financial-services industry over the past decade is the insane level of bankers’ pay.

This may or may not be true, but in any event there is no argument to support the claim. ‘A large reason’ is also rather clumsy: a case of my reason is bigger than yours perhaps? Moreover the claim that reducing bankers pay would in and of itself, without any other measures, enhance financial stability seems more vindictive than theoretically well founded.

There are no quick fixes for financial stability. You need to understand how the system works, and (re-) write the rules of it to make the dynamics you want more likely and the ones you don’t less likely. It would be wonderful if you could do that and still keep the level of growth of the economy high, but I very much doubt that you can.

Posted in: Economic Theory, Rules by David /
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The first commercial transatlantic air services date from around 1940, so this service has been around for about seventy years. Based on a recent experience, I think that the peak for air travel was in the late 1990s and we are now on the downswing.

Ten years ago Concorde was still flying, Virgin Atlantic was trying very hard to impress with their new Upper Class, and BA had not yet turned into a travesty of its former self. Airports too were less soul destroying: the war on fluids only began with Richard Reed, and security was not then nearly as time consuming or invasive as it is today.

The time that air travel takes today is also another good indicator that we are past the peak. The timeline for my journey was roughly

• 7.30am, leave my flat in East London
• 9am, arrive Heathrow the recommended 3 hours before departure
• Spend more than an hour queueing for checking in, queueing for security and queueing for extra security at the gate
• 12pm, scheduled departure
• 1pm, actual departure, due to delays in boarding thanks to extra security
• 8pm, land in Boston
• 8.30pm, clear US immigration and collect bag. Queue for taxi
• 9pm, arrive at destination

14 hours to travel 3,300 miles equates to 235 miles an hour. That is roughly the same speed as the latest generation of TGVs. And at least you can work on a train. If transatlantic air travel in 2010 cannot go faster than a high speed train, then it is clearly in decline. The situation is unlikely to improve, especially given the amount of carbon airliners spew out. We are past peak air.

Posted in: Transport Policy by David /
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Posted in: Photography by David /
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Consider three recent news items. We begin with France:

Sarkozy unveils €35bn ‘big loan’ boost for French universities and museums

Then two from the UK. First

Peter Mandelson cuts higher education funding by £500M and proposes shorter, cheaper ‘degrees’.

(The original letter can be found here.) And –

Call for universities to charge well-off students £30,000 a year.

The French, of course, get it: Mandelson doesn’t. Now is exactly the right time to be investing in higher education and skills. Unfortunately we currently have a University system which does not suit the country’s needs well: there are too many people doing media studies and not enough engineers; too much concentration on short term applied research and not enough high quality truly academic research; and the poor subsidise the education of the rich.

Here’s what Mandelson should have done.

• Let Universities charge undergraduates the real cost of their degrees.
• Introduce a comprehensive system of scholarships, allowing the less well off who want to go to University, and who have the qualifications, to do so without being loaded with debt.
• Target both undergraduate and research funding mostly, but not exclusively, at those areas the country needs including science, engineering, and mathematics. If people want to do MBAs, that’s fine, but they can pay for that themselves via a student loan.
• Police standards of undergraduate and graduate teaching much more tightly. Single digit contact hours a week are a disgrace, as is the degree-by-cheque that is the masters’ programme in some institutions.
• Ensure that a small amount of research funding is not peer reviewed. That may sound odd, but in times of budgetary constraint, peer review often ensures that it is the most mediocre research that is funded – the stuff that everyone can agree will work. If you know it will work, it is likely that it will not to be very original or innovative. So some mechanism is needed to ensure that real blue skies research is kept alive.

We could have a University system that works a lot better, does not privilege the rich over the poor, and provides world class teaching and research. It would generate more wealth and educate people better. All Peter needs to do is to have the courage to ask for it.

Posted in: Universities by David /
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There were some treats from the BBC this Christmas: one of my favourites was a delightful production of Willy Russell’s Educating Rita on Radio 4, with Bill Nighy and Laura Dos Santos. Much of the dialogue is great, but one section particularly resonated with me. Rita is talking about her husband:

He thinks we’ve got choice because we can go into a pub that sells eight different kinds of lager. He thinks we’ve got choice already: choice between Everton an’ Liverpool, choosin’ which washin’ powder, choosin’ between one lousy school an’ the next, between lousy jobs or the dole, choosin’ between Stork an’ butter.

In other words, the choice between alternatives selected to suit others’ needs, the needs of choice providers, is often no choice at all. Rita wants one good school, not a choice of bad ones; she wants the opportunity to be some decent fraction of what she can be, rather than a cog in cheap machine.

This dialogue, then, is not only acerbically accurate, it is also prescient. Educating Rita premiered in 1980. As we struggle with the legacies of the bizarre Blairite belief in choice — waste and dysfunction we can ill afford in education, transport, healthcare and the rest — perhaps we can hope that some Russell’s insights might penetrate into public policy, even if it is thirty years too late.

Posted in: Politics by David /
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An interesting observation from Financial Crookery about the Lloyds Cocos:

the 15% ECNs were indicated at 122/123 on minimal volumes, compared to 110/112 for the previous 13% series. Absent the EU-mandated 2 year coupon pass for the 13% security for “burden sharing”, the 13% notes would have been trading around 132/133, so credit markets value the trigger risk at around 10 points higher than the additional 2% coupon. Is this enough? How should the ECNs be valued?

In exchange for protection from regulatory cashflow interference and the coupon hike, investors add a “wander to loss” risk to the pre-existing “jump to default” risk. These two volatile processes are correlated, and can be modelled to value the ECN. It is essentially a 15% bond which knocks-out if either (i) Lloyd’s book value falls around 45% during the 10 years, returning the value of the (correlated but more volatile) stock price at that time or (ii) Lloyds jumps to default in the normal credit way.

I am conscious of the jaundiced reader’s likely view of model-based pricing. Nevertheless my own valuation of the ECN using this framework was in the 115-120 range(1). The cost of the “wander to loss” risk is higher than credit markets are estimating. The current ECN quote is not particularly cheap on this reckoning, particularly as the ECN would usually trade at some discount to theoretical value. In short, I think the stampede to exchange may have been misguided.

The model used could be questioned – in particular using a 2 factor random walk with correlation strikes me as a rather simplistic way of modelling the joint equity/book process, especially for a credit like Lloyds with a lot of different kinds of subordinated debt – but it is still a pretty reasonable start.

The only question remaining is why the market values the Co-Co’s so generously. The answer may be surprisingly straightforward: a hunger for yield, maintenance of current income and resolute belief in the sovereign put.

I suspect the high coupon is also attractive to those playing tax games. High interest income certainly used to be necessary in some tax ’structuring’ (aka defrauding the ordinary tax payer).

Furthermore, some capital structure arbitrage players, assuming there are any left, would be hedging the note with purchased protection on Lloyds sub debt. That would be a classic short credit gamma long carry position. And we know how well those sometimes work out…

Posted in: Capital Structure Arbitrage, Credit by David /
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Posting will probably be somewhere between light and non-existent from here to year end, so here are few predictions to mull on. They are in the tradition of Saxo Bank’s 10 Outrageous Predictions for 2010, although some of them are a little less far into the tail. I don’t expect any of them to come true, but if one could get exposure to them very cheaply, it might be a lottery ticket worth buying. A few we have already commented upon either here or elsewhere, so no claims are made for originality – see what you think.

1. A major European bank, hitherto seen as one of the winners of the Credit Crunch, will announce surprisingly large losses.
2. The Yen will finally get the creaming it so richly deserves, given the state of the Japanese economy. USDJPY to 110, EURJPY to 150.
3. Very few bankers of any import will leave the UK once they discover how boring and well-regulated Switzerland is.
4. The ECB will cut liquidity too fast, then have to reverse and pour funds into the financial system.
5. 1 week dollar Libor does not breach 0.5% all year.
6. The US winter lasts into April, and natural gas prices surge.
7. Equity market volatility will collapse, with the VIX trading below 15. This will make guaranteed equity products cheap, but few will buy them.
8. There will be heavy equity market falls in China, causing at least a mini emerging market crisis, and possibly something bigger.
9. Greece will be fine, and its five year CDS spread will tighten below 160 b.p.s. before the year is out.
10. Basel III won’t be nearly as bad as feared for the banks, and share prices of large banks will recover fast in 2010.

Posted in: Markets by David /
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This is a lovely idea from Naked Capitalism. First the build up, originally in the Independent:

Goldman Sachs has threatened the UK Treasury with plans to move up to 20 per cent of its London-based staff to Spain in a standoff over tax and bonuses.

Now the punchline:

The Bank of England has indicated that it would regard the departure of banksters as a cost it is willing to bear in the interest of having a financial system that operated more prudently than the one we have now. But having Goldman shift staff to Spain and yet be part of the financial grid and therefore still able to suck off the Fed and the Bank of England when it gets itself in trouble is abuse, pure and simple.

The Treasury may blink at the prospective loss of revenues, but if the government in the UK is reasonably unified on this matter and had any guts, it could bring Goldman to heel.

I was in Japan in 1985 when the head of Merrill [Lynch] in Japan, which had one of the longest-standing foreign securities operations in the island nation, told me of a recent conversation with a senior official at the Ministry of Finance. Japan had pretty much no written securities laws (Japan is not a contractual society); everything was subject to bureaucratic “guidance”. Merrill wanted to do something that it regarded as permissible under the rather scanty regulations in existence; the MOF official made it clear he took a dim view of it.

The Merrill chief said, “What can you do if we go ahead anyway?” The MOF official said, “How would you like to be audited every day?”

A MOF audit was a particularly exquisite form of torture. At the start of the business day, a team would arrive, all wearing white gloves. The leader would blow a whistle, and announce, “Let the audit commence!” The auditors would run and slap seals on all the file cabinets (so they could not be opened) and impound the computers.

Now you can’t do that to a TBTF institution these days, …

Why not?

… but there are plenty of other ways the UK could punish Goldman. This is a starter list, and readers are encouraged to come up with their own ideas:

1. A departure tax on all UK staff relocated to a time zone within two hours of GMT. It should be VERY painful, the only question being whether to levy it on Goldman or the employees.

2. Harassment. This is crude but would be very effective. Given what a total surveillance society the UK has become, the officialdom probably has a pretty good handle on who in the UK works for Goldman, and if it put some effort behind it, could identify the non-UK based Goldman employees who visit England regularly, and in particular, the staffers who would be relocated to Spain. I am sure it could be made very difficult and time consuming for them to enter the UK (being whisked to a holding tank for 4-8 hours on a regular basis would put quite a dent in a busy investment banker’s schedule).

Does it not warm the cockles of your heart at this time of year to think of every Goldman employee, every time they went through a UK airport, having a comprehensive search and all their documents examined. Every email going into and out of the UK from Goldman being held up for examination by tax authorities and related parties. Every packet, even, on the internet heading for Goldman being sequestered. Who could not celebrate such a wonderfully Kafkaesque solution to the problem of relocation? And it would at last give the surveillance state some use, other than the destruction of ancient British liberties. Happy Christmas.

Posted in: Taxation by David /
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The market’s reaction to the latest Basel committee document was swift and severe: bank share prices fell significantly. However, a close reading of the proposals suggests that those falls might be overdone. Here’s the good news/bad news skinny: (where I’ve used ‘good’ to mean ‘good for the banks’ – the skeptical might well take that to mean ‘bad for financial stability’)

Bad news: the predominant form of capital will eventually be common equity and retained earnings. Funkier capital instruments, such as innovative tier 1 instruments (a form of callable step up bond) will be phased out.

Good news: not yet. Moreover, existing instruments will likely be grandfatherered. Furthermore, the calibration of the new capital levels is going to be based on an impact study, making it likely that banks that are average or better will be fine. There is no firm indication, in this document at least, that most banks will have to raise more capital.

Bad news: unrealised gains on available for sale instruments may not be acceptable capital.

Good news: that was only important in a few places, such as Japan, anyway.

Bad news: goodwill and deferred tax assets are a deduction from capital.

Good news: the market thought that they were anyway.

Bad news: significantly higher capital requirements for counterparty credit risk.

Good news: this provides a great lever for firms to use to persuade their counterparties to sign tighter margin/collateral agreements. Renegotiation of credit support annexes could remove much of the extra capital required.

Bad news: an overall constraint on balance sheet leverage.

Good news: again, set using an impact study, and hence likely only to impact outlier institutions.

All in all, this is much better than the industries’ worst fears. Whether you think that is good news or bad news depends on your perspective.

Posted in: Basel, Capital and Contingent Instruments, Credit, Regulation by David /
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Financial risk is the risk of loss. That implies that you know the current value of your portfolio. After all, saying that you might lose $10M from market moves is not that helpful if the portfolio is already worth $20M less than you think it is. Valuation, then, is absolutely fundamental to financial risk management. It is also very difficult to get right: checking the valuation of every instrument in even a moderate sized portfolio is difficult, especially if there are OTC derivatives or illiquid securities in it. So I suppose it is no real surprise that firms continue to the numbers wrong. But getting the process wrong – failing to a complete methodology for checking the valuation of the portfolio – that is fairly shocking.

It happens, though. From the Guardian:

The London branch of Toronto-Dominion Bank has been fined £7m by the Financial Services Authority for repeatedly breaching the rules governing the pricing of financial products…

The FSA found that the bank – one of the largest in Canada – had repeatedly failed to follow established procedures in ensuring that a proprietary trader’s books were independently verified, and did not have adequate controls in place that could have detected the pricing issues.

Posted in: Fair Value, Risk Management by David /
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…now get more capital.

That seems to be the message anyway. The press release is here, with links to two consultative papers. Full analysis follows next week, but on first glance there does not seem to be anything particularly unexpected in the document: leverage ratios, countercyclical capital requirements, high standards of liquidity risk management, and high quality capital are all there.

Posted in: Basel, Regulation by David /
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MBIA, once one of the most important monoline insurers, is sueing Credit Suisse for pervasive and material misrepresentation of the risk that they insured on RMBS. From Bloomberg via FT alphaville:

A Credit Suisse Group AG unit was accused in a lawsuit by MBIA Insurance Corp. of making fraudulent misrepresentations about mortgage-backed securities… [in a] transaction that was sponsored, marketed and serviced by the Credit Suisse units…

“CS Securities fraudulently induced MBIA to participate in the transaction,” MBIA said in the complaint. MBIA said the bank claimed it had “used certain strict underwriting guidelines to select the loans sold into the transaction when in fact it did not.”

So far, so ordinary. Insurers takes risk, insurer takes hit, insurer claims it did not know what it was doing because the client did not tell them everything, insurer sues is a sadly common story. But this one gets better:

Since the transaction closed, the securitized loans have defaulted “at a remarkable rate,” MBIA said.

“Through Oct. 31, 2009, loans representing more than 51 percent of the original loan balance, or approximately $464 million, have defaulted and been charged-off, requiring MBIA to make over $296 million in claim payments,” MBIA said.

MBIA said that a review of the defects of the loans included in the transaction show they were “systematically originated with virtually no regard for the borrowers’ ability or willingness to repay their obligations.”

One might wonder why MBIA did not notice this before they agreed to take the risk. So (as FT alphaville puts it) in order for MBIA to succeed, it will have to convince a court that its much-vaunted underwriting and due diligence weren’t actually all that great. Mind you, given that MBIA have gone from being AAA-rated to BB-, that might not be too much of a surprise to some people.

Posted in: ABS, Legal Risk and Trade Documentation, Monoline, Mortgages by David /
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This table, from Yahoo via the Big Picture, might well at least do the first part. These are just stock holdings, not total wealth. One should probably assume that the people who run Goldman have some level of financial sophistication and understand the importance of diversification, so their whole wealth is unlikely to be in Goldman stock. Therefore Lloyd Blankfein is presumably worth a good deal more than $274 million. Perhaps it shouldn’t, but the fact that the CEO of Goldman can be worth that much makes me angry.

I ask again, why is investment banking so profitable? Is it not the fact that it is one of the major – perhaps the major – cause of our current problems? Without excess profitability, the incentive to take too much risk declines, the bonus debate becomes unimportant and clever people are not sucked into socially useless activity. Understanding and fixing the sources of investment bank profitability is the key to making the financial system more stable.

Let me end with a nice insight from Martin Taylor, ex CEO of Barclays, in today’s FT. He points out that megabonuses are quite new, with the real boom period in compensation being 2004-2007.

Observers of financial services saw unbelievable prosperity and apparently immense value added. Yet two years later the whole industry was bankrupt. A simple reason underlies this: any industry that pays out in cash colossal accounting profits that are largely imaginary will go bust quickly. Not only has the industry … been spending money that is no longer there, it has been giving away money that it only imagined it had in the first place.

Taylor suggests that the sources of these imagined profits include ‘unrealised mark-to-market profits on the trading book’ and ‘the net present value of streams of income stretching into the future’. In other words, fair value gains which were not certain. No distinction was made between genuine earnings, and these conjectured profits. Taylor then points out

Paying out 50 per cent of revenues to staff had become the rule, even when the “revenues” did not actually consist of money.

Perhaps accounting matters quite a lot after all.

Posted in: Accounting, Compensation by David /
2 Comments

Parachutists sometimes count “A thousand and one, a thousand and two, …” since it takes roughly a second for each increment: it provides, apparently, a reasonably accurate measure of how fast the ground is rushing up towards you. So, this is post number a thousand and one, and thus by the peculiar analogising that you have been kind enough to put up with, a second. And in this second kilopost I should like to thank my readers for their attention, comments and interest over the last three years. Festive greetings to you all – well, all of you apart from the spammers. Normal service will reserve shortly. Meanwhile if, like me, you miss the sun at this time of the year, here is a poor but perhaps aesthetically pleasing substitute.

Posted in: Photography by David /
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This is post one thousand on Deus Ex Macchiato. Moreover, it is the traditional time of the year for reviews and previews. So let’s take a longer perspective, at least for today.

The loose – at times so loose as to be completely invisible – thread holding the blog together was how the rules of a system influence the behaviours it can display. Many of our examples have been from finance, but we have included various areas of science, transport, politics, and much else besides too. Since the rules of the game for finance are defined chiefly by regulation – including the dubious doings of the Basel committee – and accounting, these two topics have featured prominently.

When this modest enterprise started, in March 2006, the start of the Crunch was a year away, and only the savviest commentators were raising concerns about subprime mortgages. AIG and Lehman Brothers were still good credits, and Merrill Lynch was proudly independent. Yet even then, some significant issues with the financial system were evident.

Posting was a first fairly spasmodic on Deus Ex. We were still finding our feet. But the major themes started to emerge fairly fast. Some early posts on highlighted issues that are now well known but were rather less fashionable before the Crunch, including

• The importance of liquidity risk;
• The dangers of financial modelling based on the normal distribution – and thus ignoring both fat tails and history.

Then the crunch happened, and things started to get more interesting.

We were pretty soon on the trail of the monolines, and we have dealt with securitisation and ABS from well before the crunch, taking the view that products are not good or bad, but that they can be used in bad ways, especially by those who have not understood what they are dealing with. Caveat emptor still seems to me to be a reasonable principle for those dealing in the capital markets.

On the other side, we got Lehman wrong, judging that it would not be allowed to fail. Ah well: at least some of our market calls were right.

Away from finance, one theme has been cost benefit analysis. Evidence based policy making is vitally important for conserving scarce resources, especially given the current state of the economy. How you define `cost’ and `benefit’, though, can make a big difference to the answer you get. There’s model risk in a lot of places.

The financial system today is radically different from the one we started with. There are a few good points – including public desire for reform, and open, widespread discussion of fairer taxation systems – but the overall picture is pretty bleak. Some of the surviving too big to fail firms have got bigger. Reform has thus far been piecemeal, mostly ineffectual, and frequently watered-down. The political will to do more seems to be disappearing, especially in the US. It has been a hell of a ride, and a lot has been learned, but not it seems by the people in charge. Either that or courage really is a rare quality in a politician. But you don’t need me to tell you that.

Posted in: Photography by David /
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The tax payer can thank the Gods that we have the right result. According to the FT:

Andrew Caldwell, a partner at BDO Stoy Hayward, the accountancy group, who was appointed by the Treasury last year to determine whether investors should qualify for a pay-out, said there was no value in Northern Rock’s shares.

Posted in: Mother of all Bailouts by David /
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Paul Kedrosky provides me with a good opportunity to do something my publisher has patently failed to do with any diligence – promote my book. He points out that:

There has been an explosion in books published about the ongoing financial crisis. From just two books published per month back in June of 2008 we have spiked all the way to 20 financial crisis books per month, even touching 26 books per month briefly.

But all of that is set to end. According to current publishing industry schedules, we will see a sharp increase in financial crisis books in December, but then declines through the first five months of 2010, taking as all the way down to only six books per month about the financial crisis. Six! Who can survive with only six?

And it gets worse. Unless something changes and a few more writers sign contracts … we could be under five financial crisis books a month by June of 2010. It is a horrifying thought.

So, ladies and gentlemen, hedge yourself. Buy a copy of mine: you can always read it backwards if you need something new. Meanwhile I shall contemplate rewriting it under the Macau constraint…

Posted in: Publications by David /
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A few weeks ago, I discussed the idea that we could reduce both moral hazard and the profitability of banking by charging banks for the cost of the option the bank has to be rescued by the state. In related work, Elijah Brewer and Julapa Jagatiani at the Philadelpha FED have attempted to estimate how much banks are willing to pay to become too big to fail (and thus ensure that they have that option). The paper is here: hat tip (as so often) FT alphaville.

Posted in: Mother of all Bailouts, Regulation by David /
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In Sunday’s Observer, Will Hutton makes some poignant observations:

The City of London is now too big and too risky for a country our size. It is not just that bailing it out has cost £850bn, as the National Audit Office reported, and that the recession it imposed has led to the biggest ever increase in peacetime public borrowing. For years it has crowded out exporters and manufacturers. Money has flowed into the City forcing the pound up to crazy levels, and making it hard for exporters to compete, while at the same time generating credit flows that have made property, construction and financial services the routes to quick profits. Under City influence the alpha and omega of business life has become keeping up the share price. Innovation and investment can go hang.

It should be no surprise that half the growth between 1997 and 2007 came from finance, construction and property. Over the same period, manufacturing shrank from 20% to 12% of our national output…

Britain has to do three strategic things that are interlinked. It has to shrink the City of London, stimulate the non-City of London parts of the economy to plug the gap, and manage down this year’s expected £175bn-£180bn public deficit quickly enough to maintain financial confidence but not so fast it damages the recovery.

I have argued this line before: see for instance here, here or here. But now this idea seems to be gaining wider circulation. Even Peter Mandelson appears to understand that a sound economy usually involves more than passing around money and building. It may be that there is more rejoicing in heaven over one sinner who repents than over ninety-nine righteous people who don’t need to repent, but I fear this particular conversion may be too little, too late. In its last months, Labour and its followers are rediscovering their heritage: perhaps if they had remembered it a little earlier, the UK would be in a better state, and they would have a better chance of retaining power.

Posted in: Economic Theory, Politics by David /
7 Comments

Why do both Felix Salmon and Paul Krugman think that it is OK to say thank bank regulation is boring? Aren’t these people actually paid to take an interest in it? If supposed experts can’t rouse any interest in the most fundamental topic in finance right now, what hope is there?

Update. The Epicurean Dealmaker, in contrast, does a pretty decent job of highlighting many of the important issues at least in the US. Add in some changes to capital requirements too, for instance as we discussed here, and you would have a really rather sound manifesto.

If non-professional commentators like this can have a decent working knowledge of regulation, I don’t think it is too much to ask Krugman and Salmon to knuckle down and read the Basel Accords. And the revisions to them. It’s only a few thousand pages, and it is much more interesting that Krugman’s usual reading matter.

Posted in: Regulation by David /
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The vexed topic of bonuses is provoking lots of people: see for instance here for a news story about windfall taxes, or here for Alistair Darling’s latest.

A lot of ink has been split and a lot of pixels lit on this topic. So just two thoughts from me.

First, if banks did not make so much money, bonuses would not be an issue. Banking is after all one of the few genuinely socialist industries: the workers really do share in the benefits of production. So if there were fewer benefits, there would be rather less money to pay them, and all would be if not well, then at least less controversial. Perhaps we should be asking how it is that a few institutions are able to make so much so reliably. Perhaps it is because the large banks together constitute a functional monopoly in many areas of finance?

Second, I find it hard to begrudge a share of the profits to the most talented risk takers. Someone who can run a large trading book and make solid realised profits (not just mark to market ones) is valuable, at least as the financial system is currently set up. But what is bizarre, at least to me, is the trickledown effect. In some firms the back office people get six figure bonuses: the secretaries, five figures. It isn’t just the people who make the money who get large bonuses, it is more or less everyone who has worked for an investment bank for more than a couple of years. And remember a £30K bonus might be laughably low to a trader, but it is still more UK median earnings. There are a lot of people in financial services who get this level of bonus, so actually quite a bit of the total bonus pot is soaked up by people who do perfectly ordinary jobs in a bank rather than another type of company. If you are from the left, should you celebrate that sharing of rewards or decry the bonus culture? If you are from the right, how do you feel about the lack of any credible lever for shareholders to stop this money – money that would otherwise go to them – being paid out?

Posted in: Compensation by David /
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From Naked Capitalism:

in a sudden and uncharacteristic burst of courage, Connecticut Senator Chris Dodd has proposed a federal subsidy for vampire hunting. “Nothing brings a community together like a vampire hunt,” commented Senator Dodd. “Moreover, a vampire hunt requires serious tools. You don’t want to break into that crypt with a cheap stake that might snap or a hammer with a fragile plastic handle. Before you go after that inhumanly powerful undead creature with glowing red eyes, you are going to head down to the Home Depot or your neighborhood hardware store and load up on heavy-duty, top-of-the-line equipment.”

Treasury Secretary Tim Geithner, though, has doubts about Dodd’s proposal. “One problem is that it can be difficult to determine which blood-sucking supernatural parasites are in fact vampires and which are duly authorized and well-regulated components of the financial system, such as investment banks.

A cheap shot perhaps but it made me laugh.

Posted in: Fun, Mother of all Bailouts by David /
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The two first introduce Limited Purpose Banking, or LPB. They then write, in How to take moral hazard out of banking:

Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate – small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors’ principal. The first line of all other funds’ prospectuses would state: “This fund is risky and can break the buck.”

(The full FT article is here.)

Um, no. First, mutual funds don’t have a 100% capital requirement: they have a 0% one. All their funding is debt. This makes them highly risk averse: at the first sign of trouble, they sell, exacerbating liquidity problems in the short term note and CP markets. Using short term notes to fund longer term risk taking is a recipe for disaster. Instead we do at least know that historically using insured retail deposits to fund loans is relatively sound, provided that capital requirements are high enough. Splitting originating loans from taking the risk on them doesn’t work as there is no alignment of interests: splitting deposit taking from risk taking doesn’t work either due thanks to mismatch in the term of funding.

Turning now to Felix Salmon, we find:

if investors think that huge losses are coming around the corner, or that a bank is incapable of making sustainable profits over the long term, then no amount of capital today is likely to reassure them that a bank is safe.

This is not true. Some amount of capital will certainly reassure them: an amount equal to the plausible worst case losses, plus a bit, say. OK, that might be quite a bit more than 2% core tier 1 ratio permitted under Basel, but that’s fine.

stock-market investors don’t necessarily reward well-capitalized banks and punish those with only thin layers of equity — in fact the opposite is true much of the time.

Duh, as Homer would say. High leverage = high returns in the good times = high equity price. Of course the equity markets reward high leverage most of the time: most of the time, high leverage is fine. It’s just that when it isn’t, the costs are enormous. No, I wish I had a better recipe than the universal bank under high capital requirements, but I don’t, and I don’t think anyone else has either. Unless of course you know different.

Posted in: Commercial Paper, Liquidity and liquidity risk, Regulation by David /
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Like most things which create careers and make money, science isn’t what it claims to be.

It claims to be objective; validated by experiment; unbiased. Of course it isn’t because that takes far too much time. Usually the cranks are exactly that. So it would be an awful waste to test their claims or otherwise take them seriously. Similarly the promotions are in the hot topics, the topics that are getting published in the big journals. Stick with those, stick with the orthodoxy, and you have a career. This is entirely rational: paradigm changing science comes along infrequently, and it is a very good working assumption that any given anomalous result is a screw up rather than a harbinger of a dramatic new theory. Moreover, scientists are people: they have rivalries, jealousies, and such like too.

Scientists, then, for entirely practical and understandable reasons, don’t do science very objectively. And mostly that does not matter. A really good idea will win out eventually, albeit possibly after its creator has died. Some middling good ideas never make it, but the loss is not huge given the increase in efficiency that seeming-crank-avoidance brings. It’s OK, really, most of the time.

(Much of the landscape here has been surveyed by sociologists of science, such as Pierre Bourdieu. Donald MacKenzie has a nice take in the LRB here.)

Unfortunately, as Daniel Henninger points out in the WSJ, when politics enters the picture, things become rather less OK. I don’t agree with much of the Henninger article. However, his basic point – that the failure of scientists at the East Anglia Climate Research Unit to act the way scientists are supposed to act has caused great damage to the image of science – is sound. And it is a great pity.

First, it is worth saying that most people’s emails, if widely published, would cause some embarrassment. It is no surprise that things are no different for scientists.

Second, as we have seen in several cases recently, politics asks too much from science. Or at least politicians do. The real answer to many, perhaps most scientific questions is we don’t know. Experts give advice based on best guesses. This is particularly the case with climate models: like models in many other areas, they are approximations. We think that they work. There is good evidence that the work in some domains. But we are using them well beyond the area that we are really comfortable with. That means that there is model risk. So yes, climate change might not be as bad as our best guess – and it might be worse. It might happen sooner or later than we think. The balance of risk versus cost strongly suggests doing something now, and something pretty drastic. But we can no more know for sure that this is the right thing to do than we can know for sure that the sun won’t explode tomorrow.

What we need desperately is more evidence based politics. This requires three things:

• Carefully gathering evidence, and using the best available theory to analyse it;
• Forming policy on the basis of that analysis;
• Ongoing review, including changing your mind if the evidence and/or the theory changes.

Politicians find that last part particularly hard as it can involve loss of face. But what would you rather have, someone trying to do the right thing, while acknowledging that they might be wrong about what that thing is, or someone who has blind faith in their decisions whatever the evidence?

Posted in: Cost Benefit Analysis, Mathematics and Science, Model risk, Political Metrics, Politics, Reputational Risk by David /
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Susanna Rustin in The Guardian is being annoying today:

Museums have invested hugely in access programmes over the last decade, and many have figures to prove it. Manchester Art Gallery saw pet visits increase from 32,000 to 77,000 over the last four years. Even grown-up and not obviously pet-friendly collections, such as the Wallace and Dulwich Picture Gallery in London, now have pet days. While pet owners are hugely appreciative of what galleries have to offer, and above all of the fact that they are free, most can remember a visit to an art gallery where they ended up feeling awkward and in the way.

You are probably spluttering at this point. Dogs and Delacroix? Cats and Corot? No one needs to bring a pet python to see Piero della Franchesca, right? Well yes, you are right. But neither does anyone need to bring a two year old. Yet the Guardian is actually talking about parents rather than pet owners – I just substituted a few words. Susanna spends rather a lot of the article talking about the awkwardness that occasionally puts off poor parents when attempting to use the National Gallery as a creche. What it is conspicuously silent on how screaming, running and tantrums spoil the sublimity of Stubbs for the rest of us. You can’t bring a wolfhound to see the Watteau, so why can you bring a toddler to the Titian? Or do the non-child-equipped have no rights in this matter at all?

Posted in: Art by David /
6 Comments

Dealbreaker says:

Robert Litterman is head of quantitative resources at Goldman Sachs Asset Management… And as he sees it, … quantitative hedge funds have to do a better job of making money for their clients. And in Litterman’s considered opinion, they need to find new ways of making money. New and non-quantitative, apparently.

We’re putting together data that’s not machine-readable.

I see. Any other pearls of wisdom?

You have to adapt your process. What we’re going to have to do to be successful is to be more dynamic and more opportunistic.

Totally worth the price of admission to the Quant Invest 2009 conference (flight to Paris not included). Thank you, Bob.

Now that is quite amusing, but perhaps a little unfair. What is clear is that you can make money for extended periods of time by being long liquidity premiums and short volatility. Many hedge fund ’strategies’ are just versions of this strategy: get exposure to illiquid assets, leverage up, and hope there is not a flight to quality before you have got paid your 2 and 20. If you can guarantee your leverage through good times and bad (or are not leveraged at all and can lock investors in for long enough), this strategy is often successful even through a crisis. But if you have to sell into the storm, things will go rather less well.

One thing that might be interesting, then, is somehow measure alpha relative to probability of having to deleverage. That is, we ought to level the playing field between funds that generate high alpha at the expense of running the risk of having to sell into a crisis and those funds which generate less excess return, but which never have to deleverage.

*OK, some of you might not remember Blockbuster. It was a classic, in the sense of classically, heroically awful.

Posted in: Financial Models, Hedge Funds, Quantitative Trading by David /
2 Comments

Every so often, a commentator either states `Bank A is insolvent’ or suggests that it might be. Wikipedia’s article on Citigroup, for instance, states (at least as I write this)

During the most recent tax-payer funded rescue, by November 2008, Citigroup was insolvent

What exactly might this mean, and how can we judge if claims like this are true? This is quite an important question, after all, so there should be no room for loose language.

Unfortunately, there are two senses in which `solvent’ is used. The first is

Being able to meet obligations as they become due

I.e. liquid, and the other is

Having a positive market value

I.e. value of assets great than the value of liabilities.

Thanks in the main to the actions of central banks, very few banks recently have suffered from the threat of illiquidity. The massive opening of the window since Lehman has ensured that banks can borrow as much as they need to meet claims, and thus the risk of the first type of insolvency has been averted. Therefore as a practical matter if this is what you mean by insolvency, no significant institution has been insolvent since Lehman.

The second notion, balance sheet insolvency, is more subtle. This is because in order to judge if the value of a firm’s assets is greater than the value of their liabilities, we need first to value both the assets and the liabilities. That is hard for two reasons:

1. We need a valuation principles for each class of asset and liability; and

2. We then need to apply those principles to obtain values.

The first, then, implies that everyone agrees how to value assets and liabilities; and the second, that carrying out that process is more or less mechanical.

Neither of these things is true. The extent to which fair value should be used is controversial, for instance, for much of a bank’s balance sheet. The recent fight over IFRS 9 is evidence enough of that. Then even if we can agree how much of the balance sheet to apply fair value to, determining those fair values is difficult, as is determining the appropriate level of loan loss provisions. That is why accountants are paid the big bucks*.

In other words, determining the truth of a statement like `RBS is solvent’ or `Citigroup is insolvent’ involves an enormous amount of work, and reasonable men can reasonably differ on the right answer. Without a substantial additional statement about how the bank concerned’s assets are to be valued in practice, such a statement is essentially meaningless.

The clearest definition of solvency – being able to meet claims and having a positive value under audited accounts – is met by pretty much all banks all of the time. So if a commentator says that a bank is insolvent despite being able to meet claims and despite having audited accounts showing it is solvent in the balance sheet sense, you might want to ask them what exactly they mean by that statement, and in particular what valuation principles they adhere too.

* This is what passes for a joke among accountants. Least said, soonest mended.

Posted in: Accounting, Liquidity and liquidity risk by David /
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‘Be careful what you wish for’ might be a good motto for some participants in the CDS markets, given the recent auction results. To recap a rather complex story, in what was known as the small bang, the industry has recently moved to settling CDS contracts after a credit event using one or more auctions. Bloomberg takes up the story like this:

Thomson provided the first test of the procedures for settling contracts triggered by a restructuring in Europe when it said in August it was deferring payments on $72.5M of 6.05% private notes due this year.

(The ISDA press release on the Thomson restructuring event is here.)

The system for restructurings uses multiple auctions that set different payouts based on swap expiration dates. Dealers couldn’t settle the Thomson contracts with simpler failure-to-pay procedures that produce one recovery value because they were unable to prove the electronics company defaulted…

To determine the size of the payouts on contracts covering $2B in debt, bonds and loans were split by maturity date ranges into three so-called buckets and sold at auction.

Contracts that expired on June 20, 2012 — the first bucket’s latest date — sold for 96.25% of the face amount, meaning swap holders received 3.75% of the amount covered. Swaps expiring a day later paid 34.875% because the debt in that bucket went for 65.125%.

Holders of June 20 swaps covering 10 million euros in debt got 375,000 euros, while those with June 21 contracts received almost 3.5M euros. Swaps that terminated after Oct. 24, 2014, paid the most, 36.75%.

The Reuters story on the auctions is here. This emphasises the obvious: if you had sold cash settled protection in the two and a half year bucket, and you were in the auction, then you would probably be very happy. On the other hand, note that protection buyers did not have to be in the auction, and many weren’t. As Reuters notes, as of November 13th, 1,543 contracts remained, amounting to a gross notional exposure of $7.29B and a net $942M, according to the latest data from the DTCC.

The disparity was a result of too few securities in the first bucket to settle swaps, according to Matthew Leeming, a London-based strategist at Barclays. “An imbalance of supply and demand for the deliverables can affect the recovery rate,” he said in a note.

Because they were part of industry indexes, swaps referencing the company “dwarfed the amount of Thomson debt,” said Teo Lasarte, an analyst at Bank of America-Merrill Lynch in London.

The more swaps there are, the more investors with stakes in the contracts need bonds to settle them. About 81 million euros worth of debt was auctioned from the first bucket, compared with 221 million euros and 148 million euros from the second and third, according to data released by auction administrators Markit Group Ltd. and Creditex Group Inc.

This problem of more CDS than outstanding debt is well known – being able to sell more CDS than there was debt was the reason that Amherst could profit from JPM, for instance. Good trade reporting from central counterparties should eventually make this situation a lot less likely since market participants can at least now see how much is out there. But in the meanwhile situations like this do not cover the CDS market in honour, especially if many market participants spurn the auction process. Another bang may be needed before we get this right.

Posted in: CDS and Negative Basis, Legal Risk and Trade Documentation by David /
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The markets are all over the place today. That spells opportunity. For me the glaringly good one is Greek sovereign CDS: as Ibex Salad pointed out in a comment on my previous post on spread widening, from a fundamental perspective, this looks like money for old rope. Yes, spreads could widen further, so don’t buy a product with a spread trigger, but otherwise selling protection on Greece for over 200 running looks like a no brainer.

Here’s the spread history, courtesy of FT alphaville:

If you have even stronger nerves, consider a short in gold (ideally priced in Euros or Yen…)

Posted in: CDS and Negative Basis, Markets, Sovereign Default by David /
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Reuters reports:

Half of the losses suffered by banks could still be hidden in their balance sheets, more so in Europe than in the United States, the International Monetary Fund’s chief, Dominique Strauss-Kahn, was quoted as saying on Tuesday.

That is what is possible with accrual accounting, as practiced in Europe. Viva fair value.

Posted in: Accounting, Mother of all Bailouts by David /
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The BBC has come up with a very nice programme proposition: success in contemporary art as an exploit for reality TV. (Those of you who have access to BBC iplayer can see the show here; a review is here.) School of Saatchi has twelve artist contestants struggling for favour with the unseen collector, Mr. Charles himself. What’s lovely about this show is how it has subverted the conventions of reality TV to fit the contemporary art world. There is no voting, for instance: instead of a viewer poll, all the decisions are made off camera by Saatchi. The tasks the artists are set are entertaining, but there is no pretense that success or failure at them matters in the slightest. The man with money has all the power: everyone else, none. How modern.

Posted in: Art by David /
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In two pictures, both appropriately enough from the Big Picture.

First the good news: the S&P Case-Schiller national house price indices are up again:

The bad news, from First American Core Logic, is that despite recent price rises roughly a quarter of home owners are still underwater on their mortgages:

In both cases click for a larger picture.

Posted in: Mortgages by David /
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FT alphaville picks up some research from Paribas on sovereign CDS spreads. The claim is that spread widening in the peripheral EU countries are being driven by ECB policy: The ECB signalled on Friday that it would soon start retracting some of the liquidity provisions it put in place last year, in a bid to stop some of its lower-rated members from using them for financing investments in their own local government bonds — something that had helped keep European sovereign spreads tight. Certainly ECB action could cause a weakening in demand for certain government bonds as the ability to finance them cheaply and earn carry disappears. Spreads are definitely widening, as the illustration shows. (This story would be a little more compelling if we could see the historical spreads for Greece, Poland, Slovakia etc., but it is safe to assume that these have blown out too.) Is this all ECB driven?

I suspect not. In particular there is a popular credit derivatives product which packages up a leveraged sovereign CDS in a note. Essentially the buyer of the note gets an enhanced return in exchange for selling CDS on a multiple of their notional at risk. The catch with these products is that they do not just trigger on an ordinary credit event: in order to protect the selling bank, they also trigger on spread widening. Thus for instance on popular version of the product in 2008 year paid Libor plus 1% or so in exchange for seven times leveraged exposure on Spain, with a trigger if the Spanish sovereign CDS spread hit 100 – a level it is perilously close to today. These notes are reasonably subtle products in that they can seem to the naive like simple speculations on sovereign default – and no one expects Spain to default. But the spread trigger means that they are in fact rather sophisticated forms of credit spread option. The note issuers hedge by selling sovereign CDS on the other side. All else being equal, this should act as a brake on spread widening, as note buyers take advantage of better spreads to sell more CDS.

But who are the buyers of sovereign CDS on the other side of this and other trades? There is much less pressure to do negative basis trades on government bonds as there is little regulatory capital advantage. So what puzzles me about the spread action is who is paying these high prices to buy sovereign protection, especially on the better quality names. That is the real answer to the spread widening puzzle.

Posted in: CDS and Negative Basis, Derivatives, Hedging and Convexity, Sovereign Default by David /
6 Comments

Here is an interesting idea. The FDIC are suggesting that if a

large systemically important institution is put into receivership by the FDIC and there are not enough assets to cover the cost of unwinding it to the government, all secured claims would be automatically converted into unsecured loans with a haircut of up to 20%.

The original Reuters story is here, and comment from Across the Curve, based on Barclays research, is here.

This idea appears to be gaining traction. FT Alphaville reports on an amendment which passed yesterday in the House. Proposed by representatives Miller (D) and Moore (D), this would implement the FDIC proposal. In particular, as Across the Curve points out, it would have significant implications for the repo market, since even a fully secured repo would take a 20% hit in the event of FDIC intervention.

Is this good or bad for financial stability? It is frankly rather difficult to say.

On the one hand, it would encourage creditors to review the credit quality of counterparties rather better. But it would equally encourage a rush for the exit as an institution became troubled, and exascerbate funding liquidity risk. Remember it was counterparties declining to roll repos that caused the demise of both Bear Stearns and Lehman. So this rule change, if enacted, would make it more likely that secured funding is withdrawn as confidence is lost. That is pretty likely anyway, however, so it could be argued that the downside is not great. It might well encourage the development of a market in CDS on repo receiveables though…

Posted in: CDS and Negative Basis, Credit, Liquidity and liquidity risk, Regulation by David /
2 Comments

CRE prices are off roughly 40% in both the US and the UK.

Delinquency rates are rising, and office rents, even in prestige areas, are falling rapidly.

Deutsche Bank has turned into a casino operator (yes, yes, I know some of you think that this is not news).

John Carney has a nice summary of how we got to this point on Clusterstock, and many think that the future is bleak.

San Francisco Federal Reserve president Janet Yellen — not noted as a panic spreader — said that the prospects for the CRE industry are “worrisome.”

The phrase blood bath has even been used.

Very recently, however, there have been tentative signs of a mild upturn in both the US and the UK.

But, shameless blogger that I am, I am just using this background as an excuse to post a large format double exposure that I think is cute. Sorry. Normal service will be resumed at some point.

Posted in: Mortgages, Photography by David /
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It is an interesting sign of the times when the BBC feels that it is OK to show a banker being shot by an anti capitalist in a prime time show. Now this is fiction, of course, but I can’t help but think that this story line would not have been considered two years ago. The public mood has changed: banker beware.

Update. Joe Biden says bankers are less popular than rattlesnakes. Hardly controversial, I fear.

Posted in: Reputational Risk by David /
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There has been a lot of discussion recently about the SIGTARP report on the AIG bailout. See for instance here for Krugman, here for Naked Capitalism, and here for the Big Picture. At first I shared this outrage: Geithner undoubtedly underplayed his hand, and showed his usual snivelling obeiscance to the banks. But does it, in this instance, matter much?

What did he really do? He loaned AIG money, at a penal rate, so that they could meet margin calls on CDS. Derivatives receivables are technically pari passu with senior debt (and in practice better than that, due to a wide definition of default in the CSA), so he did nothing worse than lend money to AIG’s counterparties. He did not recapitalise them covertly: these payments were debt, not equity. And many of the counterparties, Goldman included, could have borrowed directly from the FED at that point. By allowing AIG to make the payments, he injected liquidity, and prevented a potentially systemic failure of the CDS market. Moreover, AIG (and thus the taxpayer) is on the hook for the performance of the CDS it had written anyway, and in due course we will see how that goes: the collateral payments were merely based on the current mark to market. If conditions improve (as they have done), AIG and thus the taxpayer will get the money back, with interest.

In conclusion, then, there are many, many things that we can criticise about Timmy’s actions (and inactions) during the crisis. But the AIG margin payments are not on the top ten Timmy screwup list.

Posted in: CDS and Negative Basis, Mother of all Bailouts by David /
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See the sun! Ignore the muddy puddle. That’s the regulators’ way, according to a great post at Interfluidity:

In good times, regulators have every incentive to take banks at their optimistic word on asset valuations, and therefore on bank capitalization. It is almost impossible for bank regulators to be “tough” in good times, for the same reason it is almost impossible for mutual fund managers to be bearish through a bubble. A “conservative” bank examiner who lowballs valuation estimates will inevitably face angry pushback from the regulated bank… Valuations can remain irrational much longer than a regulator can remain employed…

When a “systemic” banking crisis occurs, regulators’ incentives are suddenly aligned with bankers: to deny and underplay, to offer forbearance, to allow the troubled banks to try “earn” their way out of the crisis. Regulators, in fact, can go a step further. Bankers can only “gamble for redemption”, but regulators can rig the tables to ensure that banks are likely to win. And they do.

The whole post is definitely worth reading. The key point though – that banking crises make regulators look silly, and thus they have an incentive to underplay the seriousness of the issue and to covertly help the banks earn themselves back into the black – is very well made. Now would be a really good time to be highly suspicious of asset valuations, loan loss provisions, and other counterparty performance evaluations.

Posted in: Mother of all Bailouts, Photography, Regulation by David /
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Capital is protection against loss: the more capital you have, the more losses you can withstand without being insolvent. So far so obvious.

One popular way of thinking about this is to think of the value of a firm’s assets as varying: the firm is insolvent if the value of their assets falls beneath the value of their debt (or liabilities or whatever). Clearly the more capital a firm has, the less likely this is, as the further the assets must fall before disaster strikes. But with any leverage at all – any non zero amount of debt – insolvency is possible.

Suppose that a bank is a entity that the state must rescue (or at least protect some of the depositors of). Further suppose that the state demands fair compensation for this protection from bank shareholders. If liquidity risk is not an issue (which in reality it is, but bear with me), then the state should charge an appropriate amount given the risk of insolvency.

How might we work that amount out? This is essentially a problem in the theory of capital structure: we have to figure out what the appropriate model of asset value is, and hence how likely it is for the asset value to fall beneath the liability value. The simplest model that would allow that to happen is Merton’s: there are a number of more sophisticated alternatives.

The basic idea, though, is quite simple and interesting, even if the details are complex. Banks pay a premium each year to the deposit protection agency (FDIC, central bank, whatever) based on their actual risk including how volatile their assets are and how much capital they have. These numbers will be large, too, especially for firms whose capital ratios are not substantial. Institutions would be able to choose higher leverage structures, but only at a very considerable immediate cost to their shareholders. Safer banks would pay less.

Of course, the devil here would be in the details. We would want to ensure that the state got an appropriate return for the expected costs of rescues, plus sufficient compensation for bearing the risk that those costs would be larger than expected. The estimates of those costs would be rather sensitive to the assumed asset dynamics. But there has been a lot of work in this area that could be applied, and advantages in terms of reduced moral hazard would be considerable.

Posted in: Capital and Contingent Instruments, Regulation by David /
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‘To frag’ is video game speak for to kill within the game. To efrag, in contrast, is to cravenly bend to the interests of German, French and Italian banks, or so it seems. From risk.net:

In a move that leaves the reform of financial instruments accounting under a Brussels-shaped cloud, the key European Commission advisory panel on Wednesday afternoon delayed endorsement of the first phase of the project, relating to the classification and measurement of assets…

The panel – the European Financial Reporting Advisory Group (EFRAG) – has promised to revisit endorsement in January, but opinions are split on whether that will happen

The issue is, of course, that IFRS 9 will, despite considerable watering down, still create more earnings volatility than the large European banks are used to. They lobbied the Commission and EFRAG, and bought some time. The FT puts it like this:

A decision by the German financial industry to back postponement of the standard until next year was decisive in the Brussels decision, people familiar with the situation said.

This is disgraceful. The IASB has gone to considerable efforts to consult widely and yet move quickly. IFRS 9 is not perfect, but it is a considerable improvement in IAS 39, which in turn is better than what came before it. Even the chairman of PwC is in favour of it. For an unelected group in the pocket of a narrow industry lobby to have a decisive vote in delaying a change like this across the whole EU is deeply unhelpful for both the financial system and European companies.

Posted in: Accounting by David /
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From Bloomberg, via Naked Capitalism:

Goldman Sachs Group Inc. paid off at face value some junior-ranking slices of two collateralized debt obligations at the potential expense of more-senior classes that now are likely to default, according to Fitch Ratings.

This seems very bad – usually the note holders are prepaid strictly in order, either senior first (sequential pay); or each class equally (parallel pay). Apparently Goldman (acting as trustee? as manager?) decided to use a documentation loophole to redeem the junior notes before the senior. Bloomberg, quoting a Fitch report, said that Goldman ‘used its “sole discretion” to ignore standard payment priority and use cash in reserve accounts for the Abacus 2006-13 and Abacus 2006-17 CDOs to retire lower-ranked notes’. These junior notes, of course, would likely be toast without this intervention. This type of intervention is unprecedented so far as I am aware.

One would have thought that it will generate two things: lawsuits; and tighter documentation on the waterfall for new CDOs. To the extent that there are any new CDOs sold, of course.

Posted in: Legal Risk and Trade Documentation, Securitisation and Tranching by David /
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One more thought about contingent convertibles. Clearly as designed having one of these convert is a really bad sign: they are designed to convert only in event of severe stress. Indeed the Lloyds structure was tweaked to go from converting at a Basel ratio of 6% to 5%, in order to make conversion less likely. This of course makes the instrument more attractive to investors. But I think from a stability perspective, it is a bad thing. What we want instead is a structure that converts gently and much more often. That way, conversion is not confidence sapping.

How about this. Ten year structure. Each month, a percentage max(0%, 12 x (12% – Basel ratio)) converts. The monthly observations fits with regulatory capital reporting. It means that even mild losses cause a topping up of capital to occur. Of course you can tweak the thresholds and multipliers, but the basic idea of an instrument that converts early and often is I think much better than one that converts only in an emergency – and by so doing, screams this is an emergency.

Posted in: Capital and Contingent Instruments, Regulation by David /
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More goodies from from Piergiorgio Alessandri and Andrew G Haldane: Hedge funds started this crisis in the doghouse. Yet they are the dog that has not barked. Their industrial structure may explain why. Unlike banking, the hedge fund sector does not comprise a small number of large players, but rather a large number of relatively small players. The largest hedge funds typically have assets under management of less than $40bn, the largest banks assets in excess of $3 trillion. Unlike banking, concentration in the hedge fund sector is low and has been falling. The top 5 hedge funds comprise around 8% of total assets, down from 30% a decade ago. Unlike banking, the business models of hedge funds are typically specialised rather than diversified… It may be coincidence that the structure of the hedge fund sector emerged in the absence of state regulation and state support. It may be coincidence that the majority of hedge funds operate as partnerships with unlimited liability. It may be coincidence that, despite their moniker of “highly-leveraged institutions”, most hedge funds today operate with leverage less than a tenth that of the largest global banks. Or perhaps it might be that the structure of this sector delivered greater systemic robustness than could be achieved through prudential regulation. If so, that is an important lesson for other parts of the financial system. The point is excellent. While there have been hedge fund losses during the crunch, the hedgies have not endangered financial stability to anything like the extent that regulated financial institutions have. This could well be because they are diversified in their risk taking, relatively small, and typically not highly leveraged. It is clear that 10,000 small, diverse, low leverage firms form a much more stable financial system than 10 huge, similar, highly leveraged ones.

Posted in: Hedge Funds, Regulation by David /
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It has come to my attention that I may be in violation of HR 666, the Finance Bloggers being rude about Goldman Sachs Act, due to an absence of sufficiently snide posts about the vampire squid. In mitigation, then, here’s something from Cassandra Does Tokyo which amused me:

Goldman Sachs is 100% categorically against abortion. We would never countenance aborting bonuses, at any part of the term but especially in late-term accrual, particularly when they’ve been earned in pursuit of such noble objectives as God’s Work.

Now I am pretty sure that this is not a real Lloyd Blankfein quote, but what do I know?

Posted in: Fun by David /
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The FT’s headline is Investment banking drives Barclays, and it’s accurate as far as it goes. Barclays uses retail bank deposits and credit rating to fund Lehman businesses would however be even more accurate. This is very much the model I discussed in I hate banking, just like the banks do. And it is profitable: £4.5B for the first nine months of 2009. But the financial stability consequences of this model should be troubling someone in FSA/Treasury/Bank of England, surely…

Update. Tangentially, Andrew Sorkin has an interesting post on the Barclays purchase of Lehman assets in the NYT here. It all sounds rather histrionic:

Barclays, it turns out, cut itself a remarkably good deal. A recent court filing — this one free of redactions — even accuses Barclays of making off with $5 billion without anyone noticing, an amount that Lehman’s creditors seem to think should be treated as the largest theft in banking history.

In simplest terms, the creditors to Lehman’s estate — including large pension funds and hedge funds — claim that Barclays bought the American firm for $5 billion less than it was worth.

This would be astonishing if it were true — which probably means that it is not strictly true, or at least that the story is a lot more complicated that Sorkin has it. Still, if Barclays cuts themselves a particularly advantageous deal at the expense of Lehman creditors, it would hardly be a surprise.

Posted in: Liquidity and liquidity risk, Markets by David /
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My apologies for the chart overload of late: this is the last one for a while, I promise. But it is a good one. Taken from the Turner Review (discussed previously here), it shows the very long term trend in capital adequacy for UK banks calculated by various authorities. The hint from FSA is clear: capital used to be higher, and it might well have to be higher again…

Update. An excellent commentary, from Piergiorgio Alessandri and Andrew G Haldane, illustrates the point very well:

[The ratio of] UK banks’ balance to GDP … is flat for almost a century, at around 50%… But from the early 1970s, this pattern changed dramatically. By the start of this century, bank balance sheets were more than five times annual UK GDP. In the space of a generation, the insurable interests of the state had risen tenfold.

By itself, this expansion of balance sheets need not imply that the state was bearing greater implicit risk. For example, banks could have self-insured by holding larger buffers of capital and liquidity. In practice, the opposite happened…

Since the start of the 20th century, capital ratios have fallen by a factor of around five in the US and UK. Liquidity ratios have fallen by roughly the same amount in half that time. Taken together, these balance sheet trends indicate a pronounced rise in banking system risk and hence in potential demand for state insurance. They have also affected the returns required by bank shareholders…

Between 1920 and 1970, the return on UK banks’ equity averaged below 10% per annum, with low volatility of around 2% per year. This was roughly in line with risks and returns in the non-financial economy… The 1970s signalled a sea-change. Since then returns on UK banks’ equity have averaged over 20%. Immediately prior to the crisis, returns were close to 30%. The natural bedfellow to higher return is higher risk. And so it was, with the volatility of UK banks’ returns having trebled over the past forty years.

This regime shift upwards in the risk and return profile of UK banks can be explained by the fall in their capital ratios. Higher leverage boosts required returns on equity because it simultaneously makes the banking system’s balance sheet more fragile.

Posted in: Basel, Capital and Contingent Instruments by David /
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Gordon comes out with a bombshell – or at least supports an idea that, despite its obvious and considerable merits, has not been mainstream. If there is one thing you could do to transform your legacy, improve the economy and enhance financial stability, it is to get agreement on a Tobin tax. Go Gordon go.

Posted in: Regulation, Taxation by David /
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Consider this chart:

To me, this does not suggest credit spreads searching for direction. The direction is clear: spreads have been trending down for the last six months. Could the wall of leveraged money hitting asset markets send them lower still? Sure. Will rising defaults hurt at some point? Sure. And don’t be misled by the scale: 80 is by no means the lowest possible level for the iTraxx. But below 50 would be stretch, so there is clearly more room on the spread expansion than contraction side right now. Plot it on a log scale if you want to make a bullish case…

Posted in: Credit, Markets by David /
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I often enjoy the lists in Canadian literary magazine McSweeney’s. Here from Mike Richardson-Bryan is a fine example, Airlines of Last Resort. It may have been slightly modified in transcription…

1. Icarus Air
2. Obstructed Airways
3. Air Maintenance-Is-Optional
4. Vengeful God Airlines
5. British Airways

Posted in: Fun by David /
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Chart of the day, on a Friday morning. This is as of the end of October, so we may be higher by the end of the day.

Source: thechartstore.com via Calculated Risk.

Posted in: Mother of all Bailouts, Regulation by David /
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In typically breathless style, Zero Hedge picks up a recent survey by reported Finextra.com of quantitative analysts:

A staggering two thirds of quantitative analysts think their supervisors do not understand the work they do

Now these numbers are likely to be distorted, firstly because the survey was done by a training provider, and secondly because there is a natural tendency for people to think that their boss knows nothing. Nevertheless, the fundamental proposition that the people who manage investment banks do not understand the details of quant trading is likely to be mostly true. It can hardly be a surprise that people who have been away from mathematics for thirty years, and trading desks for ten, are not in touch with the state of the art. What is more impressive is when the managers admit this. I once spoke to a very senior investment banker at a leading bank with regulators present: he frankly admitted that he had no idea how it all worked, but that he had people who worked for him did. He then explained the controls around the business: they were comprehensive and effective. Sometimes honesty and fear of the unknown produce a positive effect.

Posted in: Organisational Culture, Risk Management by David /
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If you have followed the story of the London 2012 Olympics at all, you will know that costs have risen enormously, a democratic mandate and scrutiny has been conspicuous by its absence, and the legacy of all of this public expense remains highly uncertain. To counter the cynicism of those of us who are actually paying for Tony and Tessa’s overweaning ambition, the authorities have been spending more of our money on publicity. Some of it has been spent on some of the most bizarre PR pictures I have ever seen. Fittingly, these people really do not look happy. It gets better. As the BJP blog points out, conspiracy theorists are all over this one. For instance one member on the David Icke board says: These bizarre pictures are, for me, covert symbolism from the filth behind the scenes of the puppet nature of those they have do their waork, in this case innocent celebrities and politicians. They have been told to pose lifelessly in the photos, not knowing that the overlords are ridiculing them and the public. The supremacists who rule us regard us as beasts of burden, and by publishing photos of those involved in the 2012 games posing as mannequins, they are both ridiculing us, and hiding in plain sight their opinion of us. And you know, I almost wish the 2012 Olympics were part of some grand, covert plan. Because then at least they would be good for something…

Posted in: Politics, Sport by David /
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All consultants have some subjects they spend a little too long on. Things they think should be better known or more popular than they are; things they thing are cute; things that amuse them. For me, contingent capital is one of those topics. The idea that you can keep capital levels low, and ROE high, when things are going well, but have access to more capital in a crisis is just too good not to be widely known.

Now it seems that contingent capital is coming of age. In particular, Lloyds is reported by the FT to be about to issue £7.5bn of a contingent capital instrument called a contingent convertible, or Coco.

Cocos behave like bonds until the bank finds itself in a crisis situation, at which point they convert into equity… A definition of a stress scenario that would trigger the instruments’ conversion would be Lloyds’ core tier one ratio falling below about 6 per cent

That 6% might change before the deal is done, but the basic idea is clear. You have a tier 1 bond with an attractive coupon most of the time – a coupon that escapes the European Commission rules on forced deferral by the way – and you only end up with equity if Lloyds’ Tier 1 ratio gets in a really bad state. Further discussion of the concept can be found here.

Update. Not entirely unexpectedly, the 6% has become 5%. That puts the contingent conversion option further out of the money, and should make the Cocos cheaper for Lloyds. The EU is however playing hardball, at least according to this LSE regulatory update. It seems that: the European Commission intends to require a commitment that members of the Group will not make a discretionary payment of coupons or dividends on hybrid capital securities pretty much regardless of the nature of the hybrid.

Posted in: Capital and Contingent Instruments by David /
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As a postscript to my earlier post Never mind the quality, feel the funding, it is worth referencing an article by Nouriel Roubini in today’s FT. He calls the current situation the mother of all carry trades, since firms are borrowing in dollars to invest in risky assets, and implies that they have negative funding costs due to dollar depreciation. This isn’t strictly true as many of the assets are dollar denominated – unlike the yen carry trade from the 90s, there is not necessarily FX risk. But he is certainly right in suggesting that this bubble cannot stay inflated forever. Once solid US growth resumes, the FED will have to raise rates, and at that point the trade will become less attractive. Personally I don’t think that will happen until well into 2010, and if that is correct, we could have quite a large bubble by then…

Update. Further comment from FT alphaville is here. They comment on an interesting point – the increasing correlation of asset returns vs. the dollar. This quote from Olivier Jakob at Petromatrix explains the issue:

Equity analysts are saying that their markets are driven by the oil markets, oil analysts are saying that their markets are driven by the equity markets; everybody agrees on the Dollar correlation…

The level of speculative length in the oil commodities is extreme and these positions will require a further weakening of the Dollar Index to be sustained.

If oil is just another risky asset in this regard, then risk is accumulating in the system at a troubling rate. There is a way of getting cheap insurance though: buy cheap dollar calls vs. selling expensive oil calls.

Posted in: FX, Mother of all Bailouts by David /
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A nice article from FT alphaville reporting a publication by Moody’s:

In the current market conditions, it is common for notes issued by a structured finance issuer to be acquired by the related originator and used as collateral under a central bank repo.

As the sole noteholder, an originator may direct the trustee and issuer to waive breaches of transaction documents or consent to the modification of transaction documents.

Given that originators are typically parties to various transaction documents, they may pass noteholder resolutions that are favourable for them in some other capacity and potentially prejudicial [detrimental] to the credit quality of the notes.

But it is OK, because so long as the notes remain rated BBB-, they still count as collateral at the ECB window. So that’s OK then. After all, ratings will always be a completely reliable and timely indicator of credit quality, right?

Posted in: Liquidity and liquidity risk, Ratings by David /
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The inspiration here comes from an article with a great title by Jim Jubak: Why Big Banks Hate Banking (via the big picture). I would make the argument slightly differently…

• Retail banking can be reasonably profitable, but the ROE can suck, especially in a downturn. You can’t do much about that as the capital is set by the regulators.

• There is a lot of competition, and you need to be rather efficient to do it well.
• But, if you are big, you have lots of cheap funding and (almost certainly, thanks to all that capital the regulators made you keep), a good credit rating.
• Therefore do banking for the funding and the rating, then leverage those to do business with a higher ROE – trading (both proprietary and flow), derivatives structuring, and principal investment.

That has been the universal bank model as practised by banks from Citi through UBS and Deutsche to Westpac for many years. It views the actual banking as a necessary evil, with other activities generating most of the return. The question policy makers face is the extent to which they want to let deposits be used for these other activities. Broadly it seems that many informed commentators think that the right answer is not so much, but US regulators in particular do not seem to have the balls to act on that view.

Posted in: Regulation, Rules by David /
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I have blogged before about most of the proposals in this document from the commission, including the incremental risk charge in the trading book and the revised treatment of resecuritisation (CDO squared) positions, but I have not said much about stressed VAR. So without further ado:

Each institution must meet, on a daily basis, a capital requirement of:

1. The higher of (1) its previous day’s value-at-risk number; and (2) an average of the daily value-at-risk measures on each of the preceding sixty business days, multiplied by the multiplication factor;
   plus

2. The higher of (1) its latest available stressed-value-at-risk number; and (2) an average of the stressed value-at-risk numbers over the preceding sixty business days, multiplied the multiplication factor (m);
   plus

3. The sum of its weighted positions (regardless of whether they are long or short) resulting from the application of point 16a of Annex I (the treatment of securitisation positions);
   plus

4. The higher of the institution’s most recent and the institution’s 12 weeks average measure of incremental default and migration risk according to point 5a (the IRC charges).

(Note those pluses.)

The description of stressed VAR is fairly vague:

Each institution must calculate a ‘stressed value-at-risk’ based on the 10-day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. This stressed value-at-risk should be calculated at least weekly.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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Interest on debt is usually an allowable expense for tax purposes. Dividends on equity are not. As John Plender points out in the FT, this amounts to a big incentive to use leverage where you can, rather than safer equity funding. Fixing this would be helpful:

Policymakers should think about the tax treatment of debt. It beggars belief, after such a monumental debt binge, that this fundamental spur to leverage scarcely features on the policy agenda.

Posted in: Capital and Contingent Instruments, Taxation by David /
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Continuing a long line of dry posts about regulatory capital, a summary of some of the most recently proposed changes to the CRD:

• … credit institutions should… build up through-the-cycle expected loss provisions for credit risks during good times … and use these provisions during a downturn to cover (some) of the incurred losses. Through-the-cycle expected loss provisioning is essentially a countercyclical measure for timely capturing expected losses due to inherent credit risks that have not yet materialised as ‘incurred’ losses. The through the cycle provisioning should be applied to items on the balance sheet (such as loans) and possibly to off-balance sheet items (such as guarantees). It is different from countercyclical regulatory capital approaches that basically provide a capital buffer for unexpected losses.

• … the Commission is considering imposing additional and specific capital requirements for loans for residential property that are denominated in a currency other than that of the income of the borrower.
  Those additional requirements would apply above a specified loan to value ratio: up to a low and conservative loan to value ratio…

• There is also some measure of harmonisation of various areas of national discretion within the rules.

The illustration is a roadmap of CRD changes: subsequent posts will address some of the other areas.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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The standard argument that credit derivatives are not insurance runs in brief:

• They require no insurable interest;

• They require no proof of loss; and in particular
• The payout is independent of the counterparty

All of this is standard, and goes back to an opinion of Robin Potts. Now, with ill-advised US action to regulate some credit derivatives activity as if it were insurance deferred, there is a new and more comprehensive account of the issues from M. Todd Henderson.

Henderson does a reasonable job, although the case seems a little over-argued to me. In particular, credit derivatives product companies (CDPCs) are much like insurers in financial substance – as was the Financial Products Group of AIG. So arguing from the perspective of the need to regulate insurers not applying to companies engaging in CDS may involve ground that is not firm. Where Henderson is good, though, is pointing out where risk shifting and pooling contracts in other spheres do not constitute insurance. For instance, if I set up a company to sell naked puts to commodities producers, and invest the premium, then I am acting as a pooling and risk shifting enterprise, but not an insurance company. The paper is worth a read if you have an interest in these matters even if it does seem to me a little propagandist.

Update. It is worth pointing out that the ‘insurance’ vs. ‘not insurance’ question is about more than regulation. It also affects accounting – insurers have their own accounting framework which is rather like accrual – and taxation. Given that much of the need to regulate CDS relates to counterparty credit risk, it seems that a much more cost effective fix to the vulnerabilities revealed by AIG is simply to do what we are doing anyway – set up a central clearing and market data reporting entity. Add in a reclassification of financial insurance as a derivative, enforce fair value requirements, and prudent capital requirements, and you would have a reasonably robust regulatory framework without the need to get insurance regulators involved.

Posted in: Credit, Insurance and Actuarial Practice, Legal Risk and Trade Documentation, Regulation by David /
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Are pigs or lingerie better than parmesan? Better collateral that is…

Posted in: Credit by David /
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A few interesting observations from FSA’s discussion paper on A regulatory response to the global banking crisis:

• Pure narrow banking, whereby deposit takers buy gilts with deposits, and lending is separated from deposit taking, is not possible at the moment. There are not enough gilts out (c. £800B) there to soak up all the deposits (c. £950B), especially as lots of gilts (c. £300B) are owned by pension funds or insurance companies. Isn’t that amusing?

• Here’s a plot of bank size vs. Tier 1 ratio.

  

  Capital gets (relatively) smaller as banks get bigger. That is the opposite to what you want. As FSA say, there is a strong case for applying some form of capital (and perhaps liquidity)
  surcharge to systemically important banks.

• National regulation is back. FSA seeks greater emphasis on the standalone sustainability of national subsidiaries, with an overt global understanding that home country authorities will not consider themselves responsible for the rescue of entire groups.
• Despite steps in this direction already, there will be further reforms to the trading book capital regime [which] should significantly increase capital requirements and differentiate more strongly between basic market-making functions which support customer service, and riskier trading activities, with a bias to conservatism in relation to the latter.
• The resolution plan, aka living will, is definitely under discussion for large and/or complex firms.
• Here is a strong statement: There is a strong international consensus that the global framework for prudential regulation must be radically reformed to create a more robust and resilient financial system. I am not sure that it is true, but it is a hell of a way for a regulator to start the chapter in a discussion paper. Bravo.

  There is more going on in Basel than one might think here. Here’s a summary of the work under progress:

  

Posted in: Mother of all Bailouts, Regulation by David /
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From the FT: [Credit] spreads have collapsed for both risky and investment grade credit. Emerging market spreads have shrunk too. Meanwhile, publicly traded real estate markets (the EPRA index) have soared some 70 per cent… No doubt many brokers would like to attribute this to fundamentals… Yet, if you talk at length to traders – or senior bankers – it seems that few truly believe that fundamentals alone explain this pattern. Instead, the real trigger is the amount of money that central bankers have poured into the system that is frantically seeking a home, because most banks simply do not want to use that cash to make loans. Central bankers face a huge problem then. Without massive liquidity injections, the banking system cannot function at the moment. But with it, they are creating new bubbles. We will have to be very lucky for this to end well.

Posted in: Liquidity and liquidity risk, Markets by David /
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Let’s (grit our teeth and) read the text of the new UK rules on liquidity. What follows is from the FSA’s PS09_16:

12.2.1 R (1) A firm must at all times maintain liquidity resources which are adequate, both as to amount and quality, to ensure that there is no significant risk that its liabilities cannot be met as they fall due.

(2) For the purpose of (1):

(a) a firm may not include liquidity resources that can be made available by other members of its group;

(b) an incoming EEA firm or a third country BIPRU firm may not, in relation to its UK branch, include liquidity resources other than those which satisfy…

[They are]:

• under the day-to-day control of the UK branch’s senior management; and

• held in an account with one or more custodians in the sole name of the UK branch; and
• unencumbered; and
• (for the purpose of the overall liquidity adequacy rule only,) attributed to the balance sheet of the UK branch.

Now this is very interesting. It is the nastiest part of the new rules by far as it means that the UK branches of foreign banks cannot rely on the parent for their liquidity: they have to have adequate levels of cash or near-cash assets locally. It is interesting that this is even legal under EU law: the relevant section of 2006/48/EC is The host Member State’s competent authorities should be responsible for the supervision of the liquidity of the branches and monetary policies. This allows FSA to be tough, and it has been tougher than any other major regulator thus far. It will be interesting to see if others follow suit. But in the mean time, we can at least salute their courage.

Posted in: Liquidity and liquidity risk, Regulation by David /
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According to Bloomberg:

Bank of England Governor Mervyn King stepped up his call for governments to tackle the dangers posed by banks that are “too important to fail,” saying new capital rules won’t shield taxpayers from funding any future bailouts.

So far, so reasonable. From here it gets interesting though:

He added it is “hard to see why” proposals such as those of former Federal Reserve Chairman Paul Volcker to separate proprietary trading from retail banking are “impractical.”

One’s immediate reaction is that any steps to break up the too big to fail banks would be a good thing. But I am not sure that King’s proposals are practical. In theory one could split insured deposit taking from investment banking, with the latter enjoying no government guarantee, but in practice few governments could resist saving a large, systemically important investment bank. Look at what happened when they let Lehman – not the largest investment bank by a long way – go down.

So yes, break up the behemoths. But a new Glass Steagall is not the way to do it. Rather, let’s see lots of smaller fragments cloven from too big to fail banks. That would produce a more stable financial system than the fiction that we can avoid guaranteeing the dominant securities market or derivatives market players.

Posted in: Mother of all Bailouts, Regulation by David /
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Jonathan Weil has an suitably skeptical take on Goldman’s latest media posturing in Bloomberg here. This article is of course just another in a string of negative stories. Goldman’s previously impeccable media profile has clearly taken a turn for the worse. Matt Taibbi might have kicked off matters in Rolling Stone, but many others have followed since. The interesting question is why now? After all, Goldie has never been universally loved – no bank, investment or otherwise, has been. But since Goldman came out of the crunch far ahead of the pack, it has attracted a lot more criticism. Is this just a belated realisation from the media that it is OK to criticise banks, especially profitable ones, or is there an element of tall poppy syndrome?

Posted in: Reputational Risk by David /
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The usual asset liability orthodoxy is that assets should be funded in the currency they are denominated in, so if you make a Hong Kong dollar loan, you fund it using a HKD liability.

There is no comparable orthodoxy for capital. This is usually held in the firm’s home currency only. It occurred to me today that that is odd for at least two reasons.

First, capital is funding. If you make a $100M loan and take an 8% capital requirement, that $8M is funding too. You only need $92M of deposits or debt to fund the rest.

Second, if that $8M happens to be held in yen, because the bank concerned is Japanese, it is 726M JPY at 90.75. But if dollar/yen moves to 100, that 726M JPY is only $7.26M and the capital is no longer adequate simply due to an FX movement. Which is not helpful.

Surely then, at least roughly, it would make sense to keep capital in the currency of the asset it was supporting. In some cases – notably VAR where diversification makes it hard to say what is supporting what – this is not easy. But in many cases it is. Is there a good reason firms do not do this?

Posted in: Capital and Contingent Instruments, Regulation, VAR by David /
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Bloomberg has an interesting (if hard to parse) story on the consequences of the bout of CB issuance earlier in the year: CEOs Showing Remorse on Shares Stifle Convertibles. The basic gig is that vols were high in the first couple of quarters, so corporates monetised that by blowing out CBs. The equity markets went up, so these CBs are now in the money, and the companies are upset at the resulting dilution. CB investors have done well thanks to the share rally and tightening credit spreads. It can’t last of course, and those who have waited now face a much better issuance market. Sure, vols are lower, but 25% upside from there is unlikely, and spreads are unlikely to go much tighter in the near term. Blow out a 3 year deal non call 1, and thank the Gods you were patient.

Posted in: Bonds and CBs, Markets by David /
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Leaf peepers that is. But you can see their point: Maine in the Fall is very pretty.

Posted in: Fun, Photography by David /
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The Quantitative Impact Study from the BCBS is here. Broad brush conclusions:

• Trading book capital roughly doubles, overall capital up c. 11%

• Three components are of very roughly the same size: the incremental capital charge; stressed VAR; and the new specific risk charges.
• The stressed VAR is on average 2.6x the unstressed VAR.

More analysis will follow once I have had a chance to digest the details.

Posted in: Basel, Capital and Contingent Instruments, Regulation by David /
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