Deus Ex Macchiato

FT alphaville has a post on derivatives netting, which is mostly reasonable, although it links to a piece by (self-proclaimed?) expert Das, which isn’t.

To begin with, it is important to understand what a properly executed master agreement does. I think of it as glue: it binds up all the contracts between two parties, so that instead of many little contracts, there is one big complicated contract. As a result of this glueing, the parties owe each other whatever the net value of the big contract is. Thus we get two forms of netting: payment netting on everyday cash movements, reducing the number of cashflows between parties; and close out netting, which means that if one of the parties is in contractual default, then only a single net amount is payable.

In jurisdictions where this works (which is most of them – Russia and China being the most prominent examples where it may fail), this means that there is a single claim against the estate of a failed bank (or a single payment to it if the defaulter is in the money on the big contract).

Now, the really delicate thing is how this close out amount is determined. Unsurprisingly, a standard methodology is not imposed as part of the standard master agreement as this agreement has to deal with both bank-to-client relationships, where there are often a small number of derivatives which are easy to value, and bank-to-bank relationships, which may be much more complex. Of course, the vast majority of close-outs are of bank-to-client relationships – and you don’t hear anything about these proceeding without disputes (which they do, all the time).

A big bankruptcy like that of Lehman Brothers generates litigation on pretty much everything. The amounts of money at stake are large enough that it is worth sueing. So people do, on whatever can reasonably be disputed – and often on something things that can’t. Derivatives are part of this, but they are not especially problematic. Indeed, as Kimberly Summe points out, Lehman’s derivatives have received a lot of unnecessary and unwarranted stigma. The unpalateable truth is that it was real estate lending and bonds that broke Lehman, combined with liquidity risk, not swaps.

So far, we have noted that derivatives are not unusual in creating court cases, and that most close outs are simple and effective. But there is an issue that remains: how can it be that reasonable people differ on what the close out amount on a derivatives portfolio is? The answer is that while bankruptcy law usually has a simple idea of what you can claim, determining that amount is not straightforward. Thus for instance in UK law, broadly, if I suffer a loss of £10 because of your bankrupcty, I have a claim of £10 against the estate of the bankrupt. The obvious example is that I have lent the tenner to the bankrupt. But with a derivatives portfolio, what have I lost? Clearly it depends on how much it costs me to close out the risk. I can’t – especially if I want to look good in front of the judge – just use my own valuation: I have to actually go into the market and close out the risk, then add up the cost of doing that. And what I do has to be ‘commercially reasonable’. Thus for instance getting separate bids on the equity, credit and commodity derivatives sub-portfolios might well be commercially reasonable, but doing separate trades on every derivative rather than offering a portfolio of mostly offsetting instruments to the market probably isn’t. (This is a point which Das gets wrong and which lies at the heart of the Nomura vs. Lehman case.)

The problem at the heart of close out, then, is figuring out what value a bank has been deprived of when one of their derivatives counterparties fails. This is often simple, but for a large multi-asset portfolio, it can be both complicated and sufficiently uncertain that it is worth going to court about. The real story isn’t that there is a problem with netting: it is that the valuation of big portfolios of financial instruments is difficult, especially when you have to do it in a crisis.

Posted in: Derivatives, Hedging and Convexity, Fair Value, Legal Risk and Trade Documentation by David /
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FT alphaville askes How much is this plain vanilla derivative in the window?, noting

Banks aren’t marking a [-n uncollateralized] swap to market anymore, but to the model which dictates their internal cost of funds.

Why do we care?

Because it means pricing even the most basic (uncollateralised) swaps is now very complex.

Well, yes and no. A few points:

• A vanilla derivative is a collateralized one under the standard CSA these days (cash collateral in the same currency, daily MTM, daily margin). Anything else is exotic, because it involves an exotic collateral option.
• Accounting standards require firms to take account of their own cost of funds in calculating fair value. So using your own cost of funds to discount uncollateralized flows from you to a counterparty is not just standard, it is necessary.
• It is true that, as the IFR article Alphaville references says, Unsecured trades now present a serious valuation headache. But, um, that’s because they are really hard things to value. ‘Mark to market’ is a chimera here: fair value is the answer, and that is an institution-specific thing because it depends on funding cost.

Posted in: Derivatives, Hedging and Convexity, Fair Value by David /
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An article by Raihan Zamil on vox.eu makes – albeit a little unclearly – a point I have emphasised for a long time: valuation matters more than capital. (See also for instance here and here.)

Why?

Well, let’s take a typical bank. Say it has 100 of assets, supported by 90 of liabilities and 10 of equity.

Adding 2 or 3 to the equity is really controversial: asking for a Basel ratio of 12% is a hard sell. (15% is crazy, by the way. Just saying.) So going from 100/90/10 to 100/88/12 is difficult for supervisors.

But what if the assets aren’t really worth 100? If they are only ‘really’ worth 95, then what we really have is 95/90/5, and the ‘true’ Basel ratio is only 5.2%. Then increasing the equity by 2 points would still leave the bank a significant distance from being well capitalised.

Moreover, a 5% difference in asset valuation across something as big and complicated as a bank can easily happen. Ensuring that provisions in the banking book and marks in the trading book are accurate is really, really hard (even if you are not trying to pull the wool over the shareholder’s eyes).

What does this mean for bank supervision? It means that before worrying about capital, supervisors have to put a lot – and I mean a lot – of effort into checking valuation methodologies, both in theory and in practice. To be fair this happens to some extent in most juristictions already, but given how critical it is, and how hard it is to do correctly*, it would be far better to be over- than under-resourced here.

Now, once you are sure that the valuations are reasonable, you can then look at how leveraged the bank is and how quickly it might lose its capital. But you can’t look at that absent confidence in valuations as you basically know nothing about an institition if you don’t know that its valuations have been diligently determined.

* The above might be seen to imply that there is a ‘correct’ value which can be discovered with sufficient diligence for all assets and liabilities. I don’t believe that is true. In many ways the process – the process of testing valuations and reporting uncertainties, of checking methodologies – is more important than the precise answers.

Posted in: Accounting, Capital and Contingent Instruments, Fair Value, Regulation by David /
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Doug, in a truly excellent comment on my previous post, says this:

The reason speculative markets tend to price assets and risks correctly is because over time bad speculators make losing trades and have shrinking capital bases, and good speculators grow their capital base.

With the nonlinear assets (credit protection, vol, skew, correlation, carry trades, many quantitative mean reversion strategies, a lot of the volatile energy products) this mechanism breaks down. At any given time some players who are making losing trades with ex-ante negative expectation will have very large capital bases, because they’ve been consistently collecting the small payout and haven’t hit a large asymmetrical loss.

In other words, if you have only unleveraged longs and shorts in the market, and no derivatives assets, price discovery works. But as soon as you have convexity, so for instance people can write puts and pick up premium, then the mechanism starts to break down. Doug goes on:

This is especially true in a world where managers market to raise capital and people base their investment decisions off of short(ish) term track records. In a world where people only managed their own money and grew or shrunk their capital base from the returns on the initial investment, many of these asymmetrical payoff strategies wouldn’t have time to grow that large before collapsing. However the nature of hedge funds creates a world where capital grows super-linearly with returns (growing from the returns on the initial capital, as well as the influx/outflux of funds that a good/bad track record brings).

Thank you Doug; that is a most insightful comment.

Posted in: Derivatives, Hedging and Convexity, Fair Value by David /
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FT alphaville has an interesting article on Citi reclassifying $12.7B of assets in the Special Asset Pool from held to maturity to trading. Alphaville quotes the FT proper:

[This] “enables it to take advantage of a recovery in the market for distressed assets and boost capital buffers as Basel III rules are phased in between 2013 and 2019,”… Which is actually a nice way of saying the bank will be able to avoid higher capital charges on the assets.

Well yes. But it is worth knowing why this works.

The key is writedowns. Capital charges were designed for assets that are marked at par. Thus for instance if I have an ABS worth 100, and I have capital of 20%, then I can withstand a price fall to 80 before eroding my capital cushion. But most of the assets in Citi’s pool would not be marked at 100 – more like 40. They are fallen angels. For ABS like this, substantial price increases – 20 points or more – are entirely possible, while price falls are floored at zero. If capital is based on the face value of the asset, then it is penally large for fallen angel assets. (Note that these were transferred into HTM at marks a lot less than par during the crisis and have been held at those marks ever since – that’s what held to maturity means.)

In the trading book however these assets will have a capital requirement that is based on their mark. So yes, by moving them to trading, you take an immediate P/L hit, but you can subsequently benefit from the upside, and you have capital based on their market value.

Posted in: Accounting, Fair Value, Regulation by David /
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Deutsche Bank (HT FT Alphaville) have analysed the fraction of bad assets in the Cajas under various definitions of ‘bad’:

In the Alphaville article this leads to a discussion of the varying amounts of capital the Cajas might need under different scenarios: €15B, €24B, €30B, even €69B. For me though what is striking is the spread of these numbers. Obviously if you give the Cajas €50B and they turn out only to need €15B, you look like a doofus, while giving them €15B for now and hoping that they don’t need more risks having a rolling banking crisis that plays out over three to five years (see ‘Ireland’).

Note that the use of historic cost accounting means that the Caja are solvent under all the possible scenarios until the loans are actually written down, and we know from the example of Japan that that process can be delayed for many years. In other words, part of the reason we don’t know how much capital we need is that we don’t have a precise definition of solvency. The accounting model these banks have means that, at the moment at least, there are literally tens of billions of euros of uncertainty about their solvency. So much for the much vaunted Spanish model.

Update. The Daily Telegraph, commenting on RBS, highlights the same issue:

According to RBS’s latest accounts, which were calculated using IFRS, the bank has tangible shareholder assets of £58bn and core tier one capital of 10.7pc.

Tim Bush … has calculated that under pre-2005 UK GAAP … RBS would have a tangible shareholder assets of £33bn and a core tier one capital of just 6pc.

IFRS … allows banks to disguise the build-up of risks within banks because distressed loans are not reported until they default.

Now I am not sure that this in itself is sufficient reason to move to fair value for the whole of a bank’s balance sheet – that too can be subjective for illiquid assets – but I certainly think that an objective standard with less uncertainty about whether a bank is or is not solvent would be a good idea.

Posted in: Accounting, Capital and Contingent Instruments, Fair Value by David /
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A reader whose knowledge of Spain and Spanish banking is much greater than mine commented regarding the previous post:

[There is ] a clash of cultures – specifically those of international capital and Spanish regional banking.

The conflict comes into play in the way that equity-for-debt real estate would be dealt with. In the Spanish context of a pre-20th century love of property, the strategy is a no-brainer. The homes they take in lieu of loans have a really low cost of carry (possibly competitive with physical gold) and they are concrete apartments that don’t deteriorate much. And they will sell, eventually. The 30% provision mandated by the BdE should suffice in most cases and would do the trick were Spain still an isolated exotic kind of place.

The capital market people won’t see it that way at all. Aside from the matter of bank accounting standards, they are confusing properties with bad loans. This won’t change.

(I will happily put a link in to your blog, Spanish expert, if you wish.)

I don’t disagree with any of this. The Caja might represent a perfectly reasonable business model. (I have my doubts, but I know far less about the issue than the writer quoted.) But they do not represent a good business model for a modern European bank. Even without factoring in the low ROE of this business model, you can’t fund it without deposits as anything else has too much liquidity risk. But then deposits vs. mortgages is a strategy that has been prone to boom-and-bust cycles over the years. Equity holders ought to hate this kind of play because the earnings are so volatile even under accrual. Perhaps that’s the equity holder’s problem – they have unrealistic expectations of both bank ROE and bank equity risk – but even if the model has a low risk of ultimate insolvency, I still don’t get the joke.

Posted in: Accounting, Fair Value, Mortgages by David /
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The Economist discusses the changing reputation of the Spanish regulatory system. Spain has a system of dynamic provisioning which required their banks to put money aside for expected losses before they started to be incurred. In many ways this is the poster child for new style banking book reserving. But did it serve Spanish banks well? The Economists suggests not:

Spain’s provisioning system may have smoothed the impact of the crisis but did not prevent the system from needing to be recapitalised. Countries that have had “mark-to-market” crises were forced to beef up capital more swiftly, which looks like a good thing now that sovereign-debt worries have people concerned about the potential impact of bank bail-outs on the state.

Of course it is not fair to point the finger at dynamic provisions for this: failure to get the bad news out is a feature of accrual accounting generally, and Spain’s system is better at this than most accrual approaches. But it is fair to point out that a larger proportion of the Spanish bank’s balance sheets are accrual than in many other countries, so in some sense Spain is a test case for modern accrual methods. For me, the issue boils down to confidence. If investors can get comfortable that the provisions are adequate, then confidence is restored, and accrual does not cause systemic risk. But if they can’t, then properly applied fair value may be better. What would the cajas look like on that basis?

Posted in: Accounting, Fair Value by David /
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This blog has consistently emphasised (OK, consistently bored the pants off its readers by emphasising) the importance of valuation ranges for financial instruments. For many such things, the idea of a single correct fair value is a mirage. Instead, it is more helpful to think of a range of values which might be correct.

Steadily both accounting standards and regulation has been coming around to our way of thinking (something for which we certainly claim no credit). There is a particularly clear example in the latest FSA discussion paper:

In April 2008, the Bank of England’s Financial Stability Report analysed the range of values produced by six Large Complex Financial Institutions (LCFIs) at the end of 2007 for super-senior tranches of Collateralised Debt Obligations (CDOs).

These tranches were the most senior slice of CDO structures and would therefore be expected to have a AAA credit rating at inception. The chart below shows the maximum capital requirement for such a position relative to the valuation range. In all cases, the maximum capital requirement is smaller than the variation in valuations (highest valuation minus lowest valuation reported) of the tranches produced across the six firms.

Now, it is important to understand what is claimed here. These ranges are not for the same security. One cannot infer that Bank A had a partcular mezz supersenior at 90 and Bank B had the same tranche valued at 45. All that one can infer is that Bank A had one mezz supersenior security valued 55 points over Bank B’s value for an entirely different mezz supersenior tranche. Thus much of the range reflects differences in CDO composition. Quality matters in a crisis.

The capital requirement is also misleading in that if the piece is written down from par, that loss reduces capital, so the effective capital taken is the capital requirement plus the writedown. (There is amusingly pious language elsewhere from FSA about trying to ensure that capital requirements are never more than 100% of notional – something they have thus far failed to do in various places in the capital rules.)

FSA legerdemain (which for me weakens their argument considerably) aside, there is a real point here. There are some securities whose fair value cannot always be determined accurately. It is likely that different banks will have different valuations for securities like this. Moreover, in some extreme cases, the range of values can be a significant fraction of the effective capital requirement. That’s fine, but it needs to be understood by readers of financial statements.

Posted in: Fair Value by David /
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From Ben Bernanke’s speech, The Supervisory Capital Assessment Program–One Year Later:

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

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

Later in the speech, Ben makes another interesting point:

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

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

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

Posted in: Accounting, Fair Value, Mother of all Bailouts by David /
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I like Steve Randy Waldman so I don’t want to cricitise him too much, but I think he makes an error in the following:

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

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

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

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

Posted in: Capital and Contingent Instruments, Fair Value, Mother of all Bailouts by David /
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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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Willem Buiter, reneging on his earlier negativity on the IASB, quotes from a statement made on April 2, 2009 by the Trustees of the International Accounting Standards Committee Foundation:

Sir David Tweedie, Chairman of the IASB, reported to the Trustees that at their joint meeting last week the IASB and FASB agreed to undertake an accelerated project to replace their existing financial instruments standards (IAS 39 Financial Instruments, in the case of the IASB) with a common standard that would address issues arising from the financial crisis in a comprehensive manner. Though the IASB is consulting on FASB amendments related to impairments and fair value measurement, the Trustees supported the IASB’s desire to prioritise the comprehensive project rather than making further piecemeal adjustments.

This is good. They are not being rushed into anything, and they are not following the FASB in giving in to the banks. However it does make it vital that the IASB gets sufficient informed comment on fair value during its consultative process. I would encourage anyone who cares about these issues to visit the IASB page here, download the consultative document, and comment on it.

Posted in: Accounting, Fair Value by David /
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The Geithner plan, understandably, has generated many column inches since it was unveiled on Monday. There is little consensus among the commentariat, but the markets have taken it well. What should we take from Timmy’s last (or at best next to last) stand?

First, it might actually work either by accident – because we are through the worst anyway and it doesn’t hurt – or by design. It is certainly positive in the short term for the shareholders of American banks. And it betokens a reluctance to nationalise which, while negative for the taxpayer, is the kind of thing markets like.

Second, it is clearly an ineffective use of money. The government is providing nearly all the cash. If the same amount had been spent on recapitalising the banks, then there would be more leverage and hence more assets controlled for a dollar saved. Taxpayers should be outraged by this.

Third, it indicates that Geithner believes that an interestingly modern form of systemic risk is important: the risk that quasi-forced sales by one institution causes losses at others via mark to market. This plan achieves a de facto recapitalisation (albeit wastefully) via the ability for all banks to mark their assets to the purchase price in the plan. This means of course that the plan managers will be strongly encouraged to pay more than the market price for the assets: something they can afford to do given the government subsidy built into the structure.

In summary, then, the plan is far from optimal, but it will probably help a bit. The concern is that it won’t be enough. If that happens, then Timmy will need a new job.

Update. Felix Salmon picks up an interesting quote from Sheila Bair. This makes it clear that the intent of the plan is to crush the non-default component of the credit spread:

They [the prices assets are bought into the plan] will still be, they will be market prices. We’re just trying to tease out the liquidity premium. What’s weighing on market prices right now is that people can’t get financing to buy assets, they can’t get financing to buy assets not many people want to buy, you don’t want to buy. And then you have to hold on to them forever because there’s nobody to sell them to. So, that’s — by providing that liquidity that’s lacking now, we’re hoping to get the prices up to what would really be a true market level.

They are doing this by removing all the risk – funding risk, liquidity risk, and credit spread volatility risk. It’s an awfully expensive way to recapitalise the banks.

Posted in: Fair Value, Mother of all Bailouts by David /
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No, not the closing down sale at one of Britain’s many bankrupt retailers, although it could be. Rather it is the fall in property prices from the peak in one of the exurbs of Fort Myers, Florida. The NYT story is here. But mull on that number for a second. 80%. Then consider putting -0.8 in the HPI vector, and think what that will do for the price of even prime RMBS.

Posted in: ABS, Fair Value, Mortgages by David /
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This week’s no shit Sherlock award goes to… Treasury Overpaid For TARP Investments. What is more interesting, though, is utterly spurious precision being treated as fact. Yes, I am sure Treasury overpaid, but saying things like Treasury paid $254 billion for assets worth approximately $176 billion implies that with a bit of due diligence, we could find the ‘right’ value. And we really can’t.

Posted in: Fair Value, Mother of all Bailouts by David /
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A great data point from S&P via the New York Times:

The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency.

The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.

Or as a friend of mine put it, `if you wanna throw the dart at the board and give me an HPI vector, I can tell you what the bond is worth. But who the hell knows what’s the right HPI?’ Given that future house price inflation cannot be known today, he has a point.

Posted in: Fair Value, Mortgages by David /
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From the FED, Information on Principal Accounts of Maiden Lane LLC as at Wednesday, Oct 22, 2008

Net portfolio holdings of Maiden Lane LLC: $26,802M

Outstanding principal amount of loan extended by the Federal Reserve Bank of New York: $28,820M

So the FED is a couple of billion underwater. On October 16th, the assets were valued at $29,492M.

Posted in: Broker/dealers, Fair Value by David /
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Why, sometimes I’ve believed as many as six impossible things before breakfast said Alice. This quotation came to mind in the discussion of the 30y dollar swap spread in the FT recently:

“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

Oh dear me. A mathematical impossibility is 2 and 2 adding to 5, or the sudden discovery of a third square root of 4. A physical impossibility is something that we think is impossible according to our current understanding of science: accelerating from rest to go faster than the speed of light, say.

Negative swap spreads are neither of those. They simply represent an arbitrage. An arbitrage is when you can make free money without taking risk. Ignoring for a moment the risk de nos jours – counterparty risk – swap spreads allow one to lock in a positive P/L if one can fund at Libor flat. Free lunches do not often exist in finance, but they do happen in particular when there are no arbitrageurs left standing. No arbitrage relies not on the theoretical possibility of a free lunch, but on enough people actually wanting to dine for nothing that prices move to stop the feast. At the moment there is such a shortage of risk capital that one can indeed find free food. So `impossible’ things are happening not just before breakfast but all through the day. Bon appetit.

Posted in: Fair Value, Financial Models by David /
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Long, long ago, when I was responsible for the valuation of a lot of financial instruments at an investment bank, I used to set a lot of store in valuation adjustments. The basic idea is that the precise fair value of many instruments is uncertain. You value them at your best guess, and you take a valuation adjustment to cover the potential uncertainty. They are a kind of accounting error bar, if you like.

There are two main reasons to do things this way rather than simply to mark conservatively. The first is that value affects risk: if you mark as accurately as possible, your risk measures are as accurate as possible. [This is particularly an issue for derivatives since d (delta) / d (vol) is non-zero: marking to a 'conservative' implied vol gives you the wrong deltas.] The second is that the size of the valuation adjustments are an important signal to management about the size of the valuation uncertainty in the book. That in turn gives important information on illiquidity, marketability etc.

Borio in a fascinating BIS paper The financial turmoil of 2007- argues that firms should disclose these uncertainties, and that this disclosure would be a useful disclosure to the users of financial statements. I agree completely. The only problem is that many people currently think that some firms would be insolvent based on plausible error bars. But they don’t know precisely who those firms are.

Posted in: Accounting, Fair Value by David /
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Yesterday, a most propitious day for stocks, the IASB chose to announce that they will permit a new wave of opacity to sweep over company accounts.

Notice that it is retrospective. This is a very negative development if we ever want to get out of this mess. The taxpayer deserves to at least know what we are bailing out and what condition the banks we now own are in.

Posted in: Accounting, Fair Value, Mother of all Bailouts by David /
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There is a lot of talk at the moment about fundamental value. This mostly focusses on how good it would be if the market prices of assets rose back towards ‘fundamental value’, and what the government could do to assist that process.

There’s only one problem. You can never know what the number is.

Consider a loan. Either it defaults, in which case you get some interest followed by recovery; or it doesn’t, in which case you get scheduled P&I. In both cases the fundamental value is the PV of the cashflows. But you don’t know whether it will default or not, so you can’t combine the fundamental value on default with that for no default to get a single number.

In credit risk modelling we solve this problem by positing a probability of default, and then deriving that PD from spreads. But that’s an argument that depends on the credit spread being fair compensation for default risk.

And of course ontologically it makes no sense to talk about a ‘probability’ of default. Either default happens or it doesn’t and we only get one chance at finding out. Given that we can’t take the same obligator, duplicate them a hundred times, and look at their performance on each occasion, we can never know that our ‘probability’ is correct. Thus there is literally no such thing as a ‘fundamental value’ in any scientific sense because we could never know whether we had such a thing.

Posted in: Accounting, Fair Value by David /
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I had a conversation about this last night and thought it was worth writing some of it down and extending it a little. So…

Let’s begin with the market. For our purposes there are some known current market variables which we assume are correct. This could be a stock price, interest rates, a dividend yield — and perhaps one or more implied volatilities.

Secondly we have a model. The model is often, but not always, standard, i.e. shared between most market participants. Let’s start with standard models. Here the model is first calibrated to the known market variables.

At this point we are ready to use the model. There is a safe form of use and a less safe one. In the safe one we use the model as an interpolator. For instance we know the coupons of the current 2, 3, 5, 7 and 10 year par swaps (plus the interest rate futures prices and deposits) and we want to find the fair value coupon for a 4.3 year swap. Or we know the prices of 1000, 1050 and 1100 strike index options and we want to price a 1040 strike OTC of the same maturity.

The less safe use is when we use the model as an extrapolator. We want a 12 year swap rate, for instance, or the price of a 1200 strike option. That’s not too bad provided we don’t go too far beyond the available market data, but it is definitely a leap.

(Both of these, by the way, count as FAS 157 level 2.)

Note that there are two ways that we realise P/L in derivatives. Either we trade them or we hedge them. If we are in the flow business then trading is important. We need to use the same model as everyone else simply because we are in the oranges business and we need to kInow what everyone else thinks an orange is worth. We take a spread just like traders of other assets, buying for a dollar and selling for a dollar ten, or whatever. The book might well be hedged while we are waiting to trade, but basically we are in the moving business. Swaps books, index options, short term single stock, FX, interest rate and commodity options, and much plain vanilla options trading falls into this camp.

In the hedging business in contrast we trade things that we do not expect to have flow in. Most exotic option businesses are an example here, as are many long dated OTC options. There is no active market here so instead we have to hedge the product to maturity. Thus here the model hedge ratios are just as important as the model prices. Valuation should reflect the P/L we can capture by hedging using the model greeks over the life of the trade. Thus standard models are more questionable in the hedging business than in the moving business since it is not just their prices — which are correct by construction — but also their greeks that matter.

Things start to get really hairy when we move away from standard models. Now we are almost certainly dealing with products where there is no active market (some kinds of FX exotics are a counterexample) and we do not even know that the model prices are correct. There is genuine disagreement across the market as to what some of these things are worth. Different models also produce radically different hedge ratios. How can we judge the correctness of such a model? The answer is evident from the previous paragraph: it is correct if the valuation predicted can genuinely be captured by hedging using the model hedge ratios. [Note that this does not necessarily give a unique 'correct' model.]

In summary then: for flow businesses we need interpolators between known prices and, to a lesser extent, extrapolators. For storage businesses we need models which produce good hedge ratios.

Posted in: Fair Value, Financial Models, Model risk by David /
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I have been meaning for a while to blog about a post on VOX about wine pricing. To paraphrase heavily, Parker determines the en primeur price, but the price at maturity depends on how good the wine really is. Given that Parker isn’t a really great judge of how a wine will mature, and weather charts are better than him, there is an arb. The most obvious example I remember is the 86s, which were clearly overpriced in their youth, and now have faded to over-oaked oblivion while the 85s are still going strong.

Posted in: Fair Value, Wine by David /
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In what is either a strong buy signal for the market or a strong sell signal on the stock, MBIA has announcing that it was not changing its projection of losses on its mortgage-related exposures. The FT story is here. Yes, they had some bizarre FAS 159 gains (CNN is here and my take on the rules is here): yes, they resumed a share buy-back programme. But ignoring all that, if their actuarial loss estimates for RMBS have not changed, either that is a very useful datapoint on where realised default losses actually will be, or their actuaries are fools and it is time to short the stock again. It will be interesting to see which.

Update. John Dizard has pointed out the possible value in the monolines as a vulture play on the eventual losses on RMBS. I can see the idea, but I’d like to know more about the implied residual value of the monolines given the current equity price. Are they really cheap yet?

Posted in: Fair Value, Insurance and Actuarial Practice, Monoline, Mortgages by David /
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Loath though I am to quote from a Murdoch publication – just look at the sad decline of the WSJ to see what being owned by him does to a paper – I do want to comment on something by Anatole Kaletsky yesterday. Fortunately it is an utterly wrong-headed piece which misunderstands fair value accounting. First the good bit:

the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to gauge – this liquidity and maturity transformation is, in fact, the main social function that a banking system provides.

Agreed. But here’s the thing. Banks can only do that if people have the confidence to give them their money to lend to someone else. That depends, for the retail investor, on deposit insurance; and for the wholesale depositor, on credit quality. Both of those in turn rely on the bank being well capitalised: regulators demand it to reduce moral hazard, and market counterparties need it as part of their risk assessment.

Now how can we tell if a bank is well capitalised if it is allowed to pretend nothing is wrong until it actually suffers losses? That is what accrual is all about – the fiction that all is well while the ship steers at full speed towards the iceberg. At least fair value shows you what is ahead.

Posted in: Accounting, Fair Value by David /
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CFO.com has an excellent post on Fair Value accounting. One quote in particular amused me:

James Tisch, who was effectively the sole voice of dissent on the first panel, complained bitterly that fair value accounting required reams of nearly incomprehensible disclosure information and often forced his company to make poor economic choices.

Tisch … said that if insurance companies had to run mark-to-market accounting through their income statements, “[they] would essentially be out of business”

And that, as we have seen with the financial guarantee insurers, is clearly right. But perhaps if the insurers were forced to use fair value, they might deploy less leverage and pay a little more attention to what the market is telling them.

Posted in: Accounting, Fair Value, Insurance and Actuarial Practice by David /
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A couple of weeks ago I pointed out that while the US institutions have taken their write down medicine, raised new capital, and are busy getting on with trying to figure out what to do next, the Europeans have been much less assiduous in recognising their losses. Now Citigroup, via FT alphaville, comes up with a concrete example: Barclays. The corrected version of the Citi piece is said by the FT to include the following:

Barclays has reclassified some assets, most notably leveraged finance and CDOs, and accounts for them as if they were loans held to maturity. This means that these assets are not marked to market but impairment provisions are raised when the bank believes that there is a risk to the credit outlook. While this is an unusual treatment for leveraged finance, as the financing was originally intended to be sold down, the assets are at least primarily loans. The treatment is even more unusual for CDO exposures.

That four billion really does not look enough now, does it?

Update. It is not just CDOs. From the FT:

The debate has [also] focused on Barclays’ policy of accounting for leveraged loans by looking at the borrower’s financial performance rather than the price at which those loans are trading in the market.

This has puts it at odds with some US and European rivals, which value their leveraged loans on a mark-to-market basis. Most leveraged loans are trading at 80-90 per cent of their face value, with some changing hands for as little as 70 per cent.

Posted in: Accounting, Fair Value, Writedown by David /
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Tom Selling from The Accounting Onion was kind enough to point out his blog to me. Reading a post on FAS 157, it suddenly occurred to me that the implementation the audit firms have permitted of 157 on liabilities, based on the FASB staff position, isn’t consistent with the conceptual framework of 157.

The standard says:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Suppose I run David’s Broker/dealer, DBD. DBD bonds are liquid and so have an observable credit spread. If DBD credit spreads go out, DBD bond holders using fair value suffer losses which are reported in their P&L. But if DBD wants to buy back those bonds in an orderly transaction between market participants, DBD bond holders are very likely to force it to pay par plus accrued (at least if DBD is a going concern). Moreover it’s illegal for DBD to buy its own bonds back in the secondary market in most jurisdictions so the value of the liabilities for DBD is not symmetrical with the value to the holders: it cannot take advantage of its elevated credit spread even if it has the money to buy back the bonds. Hence the staff position doesn’t reflect economic reality, and what most people feel in their gut – that 157 gains on liabilities due to credit spread widening are bunk – really is true.

I’ll end with a quote from the amusingly petulant comment the Basel Committee issued on IAS 39:

it would be wholly unsatisfactory if an entity which was insolvent in the sense of its assets being worth less than the par value of its liabilities nonetheless appeared to be solvent because the fair value of its liabilities was recognised on its balance sheet, with the fair value below nominal value…we recommend that the exposure draft’s guidance on the fair value option be revised …[to] exclude the mark to market of own credit risk from the fair value option by limiting the mark solely to valuation changes due to general market movements

Posted in: Accounting, Fair Value by David /
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I have two conjectures for today. The first is that Ambrose Evans-Pritchard needs to drink better Rioja. He presents a bearish blog in the Telegraph, backed by a second class Reserva. I would suggest at least a 904 GR for such musings, and ideally the Murrieta.

Secondly and rather more importantly, it can be suggested that the loss trajectory for European banks will be rather different from their American cousins. Suppose we believe Evans-Pritchard’s loss figures: $123bn for Eurozone banks compared to $144bn for the US, and ignore for a moment the rather important distinction between bank and non-bank risk holders. (The US has far more of the latter.) My guess would be that most of the US risk is fair value accounted. So the Americans have taken or are in the process of taking their losses. Most of the European risk is probably accural, so losses will depend on the bank’s projected loan loss reserves rather than current fair value. At very least that will spread them out over many years – remember RMBS is often 30 year paper. Moreover if actual experienced defaults are better than the current fair values predict then the losses will be lower.

One could argue that this cancer will eat away at the European banking system for many years, long after the Americans have taken their medicine and moved on. Or one could argue that right now it allows European banks to keep lending and hence to both protect Europe’s economy from the worst of the losses and make themselves some money to pay for the losses. But certainly the bearish case for Europe is less convincing than that for the U.S.

Posted in: Accounting, Economic Theory, Fair Value, Markets, Wine by David /
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