Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 22 Feb 2006

FSA Loses Minmet Insider Trading Case

The Independent pointed me to a very interesting decision by the Financial Services and Markets Tribunal overturning an insider trading decision of the Financial Services Authority in the United Kingdom.

The most damaging part of the tribunal’s decision is towards the end when it states:

We have kept in mind that the burden of proof lies on the Authority, and the standard of proof (the balance of probability) must take into account the gravity of the allegation made. But our decision in the applicants favour does not depend on the burden of proof. On consideration of the whole of the evidence we are satisfied that there was not a telephone conversation between Mr Nolan and Mr Baldwin on 29 July 2003, and are satisfied that WRT’s trading in Minmet and Tiger shares was innocently conducted.

Usually when courts and tribunals acquit somebody they are quite happy to take shelter under the assertion that the prosecution has not met the standard of proof. Here the tribunal goes beyond this to assert that the accused have proved that they are innocent. It is difficult to imagine a more comprehensive defeat for a regulator.

Interestingly, the tribunal avoids even a suggestion that the main prosecution witness was lying. Even while stating categorically that they preferred the evidence of the accused to that of the key prosecution witness, the tribunal states:

We found no reason to doubt the good faith of any of the witnesses, who we considered were all doing their best to assist us.

The experts that the FSA relied on are also treated kindly but the tribunal does find that the experts were “inappropriately constrained” by the remit that the FSA gave them. At the end of it all, only the FSA comes out as the loser in this decision.

Posted at 13:39 on Wed, 22 Feb 2006     View/Post Comments (0)     permanent link

Mon, 13 Feb 2006

Reliance Demerger as Backdoor Delisting

I wrote an article in today’s Financial Express about the Reliance demerger.

In January 2006, Reliance Industries Limited demerged four companies accounting for about a quarter of its market capitalization. The delay in listing these new companies means that about a quarter of the original company (representing a market value of over $7 billion) have been effectively delisted since January 18, 2006.

This has three consequences

  1. Millions of shareholders in these companies cannot trade these shares.
  2. The corporate governance provisions regarding independent directors and investor protection do not apply to these companies.
  3. These companies are under no obligation to provide the continuing material event disclosures to the exchange that a listed company is required to provide.

The result is that a company with a million shareholders is subject only to the disclosure and governance regime that applies to a mom and pop company with a dozen shareholders.

I argue that the exchanges and the regulator should not look at the listing of the demerged companies through the framework of initial public offerings that are obviously designed to make it difficult for a company to list. Rather they should use the framework of the delisting guidelines which are designed to make it difficult for a company to delist. The situation in a demerger or delisting is that the public has already put in its money and the regulator’s priority is to ensure that the company does not slip away from the clutches of the listing regulations.

Posted at 18:36 on Mon, 13 Feb 2006     View/Post Comments (1)     permanent link

Tue, 07 Feb 2006

Leverage in banks and derivatives

Commenting on my blog about an Economist column on CDOs, Ajay Shah wrote in his blog that the comparison between derivatives and banks is equally instructive when looking at leverage. He points out that leverage in banking is more than in derivatives and correctly argues that the (inverse of the) capital adequacy ratio is not the correct measure of leverage for a like-for-like comparison with derivatives leverage.

I completely agree with Ajay on this. I present below a few like-for-like comparisons of varying levels of sophistication all of which point to the same reality that banks embody high levels of risk:

Posted at 15:38 on Tue, 07 Feb 2006     View/Post Comments (1)     permanent link

Thu, 02 Feb 2006

Economist Buttonwood on CDOs

When I first read the Buttonwood column on Collateral Debt Obligations (“Of Scorpions and Starfighters”, Economist, January 31, 2006), I disagreed strongly with it but put it aside without much further thought. But then Anuradha suggested that I should blog about it; so here I go.

Buttonwood paints a picture of CDOs as being dark and mysterious things and so I began to wonder what is it about CDOs that creates unease in the minds of many. A CDO is a fairly straightforward and legitimate instrument. After all, a commercial bank is at bottom nothing but a CDO — though doubtless it is a rather crude and old fashioned way of creating a CDO.

I therefore went through the Buttonwood column replacing CDOs by banks and bank loans. A large part of the column goes through quite nicely. This is a sample of a few paragraphs:

If most of the borrowers stay solvent, the bank makes good money. If more than a handful default, then depositors and investors begin to take a hit ... The precise mixture of risks and payouts depends on how the bank is managed.

Moreover, the value of a bank loan portfolio depends not just on expected rates of default, but also on what might be recovered from defaulting companies’ assets. ... Bank loan portfolios are dynamic: they are in the hands of managers who can weed out the exposure to companies before they default, or trade credit risk with the aim of improving the portfolio.... Banks slice themselves into tranches of differing risk — deposits, (subordinated) debt and equity. Thus in theory investors can pick the collection of risks that suits them. They are helped by the existence of credit ratings, at least for the safer tranches (the riskiest equity tranches, which bear the first loss in the event of default, usually have no rating). But they must also consider the likely market price of the tranche they invest in, both for accounting reasons and in case they want to sell before maturity.

Bank loans are not that actively traded .... So it is often near impossible to establish a market price for them. Accountants have a horrible time when auditing books of illiquid bank loans, being forced to use numbers that they know are nearly meaningless.

One can go on with much of the rest of the column. For example, Buttonwood decries CDOs of CDOs, but in reality a CDO squared is not very different from a bank lending to another bank or investing in the subordinated debt of another bank. But let me not belabour the point.

Buttonwood also seems to think that cash settlement of credit derivatives is a bad thing that somehow disconnects them from reality. This is not true at all — the only difference between cash and physical settlement is one of transaction costs. Buttonwood is also worried about the notional vlaue of credit derivatives exceeding the total amount of debt that the company has issued. Again this is quite common in derivative markets. People are quite willing to take a little basis risk to operate in a more liquid market and therefore the largest derivative contracts usually attract a volume and open interest that is much larger than the direct risk exposure to the underlying of this contract. It is natural for people to use Delphi related CDSs or CDOs to hedge exposures to the entire auto component industry and also to cross hedge some General Motors or even auto industry risk. It is not at all surprising that the notional far exceeds the outstanding debt of Delphi

Let me end with a provocative question. Having invented banks first, humanity found it necessary to invent CDOs because they are far more efficient and transparent ways of bundling and trading credit risk. Had we invented CDOs first, would we have ever found it necessary to invent banks?

Posted at 21:54 on Thu, 02 Feb 2006     View/Post Comments (3)     permanent link