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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Tue, 29 Jan 2008

Socgen scandal becomes murkier

My blog four days ago stated that there was perhaps more to the Socgen fraud than meets the eye, and the deluge of information since then confirms this first impression. It is pointless to even attempt to cite all the stories that have come out in the last few days and I will be very selective. Socgen’s own five page non explanation of what happened is of course mandatory reading, but the Aleablog, the Alphaville blog, the Financial Times and the Independent have been the best English sources – the truly best sources are obviously in French. Another quick observation is that the blogs have been better at covering this than the mainstream media.

The issues that emerge are the following:

Posted at 17:13 on Tue, 29 Jan 2008     View/Post Comments (1)     permanent link

Sun, 27 Jan 2008

Margin Changes in Exchange Traded Derivatives

Surjit Bhalla wrote a provocative piece in the Business Standard yesterday describing the system of automatic revision of margins in Indian stock exchanges as ugly and insane – the first adjective is quite appropriate, but the second is not. Bhalla is right in saying that the Indian system is different from what the rest of the world does, but it does not follow that the system is wrong, much less that it is insane.

Most exchanges around the world change margins infrequently and in a discretionary manner. Everywhere in the world, market turbulence does lead to a rise in margins. Last week itself when the Chicago Mercantile Exchange (CME) left margins unchanged on stock index futures, it raised margins on interest rate futures sharply in response to increased volatility. What the Indian system does is (a) to take the discretion out of the system completely and (b) to make the revisions more frequent.

The system adopted in India is similar to the internal models that banks and securities firms use to monitor and control the risk of their trading positions. Like any other sound margining system, it does have the potential to create a vicious cycle of falling prices, margin calls, unwinding of levered positions and further price falls. It is ugly but it can hardly be called insane.

It is also true that there is significant over-margining in the Indian system. Partly, this reflects a greater risk aversion on the part of Indian regulators and the broader political system. As Indian regulators and politicians become more comfortable with well functioning derivative markets, the risk aversion should decline. The over-margining is also due to the lower level of capitalization of securities firms in India which forces exchanges and brokers to rely almost entirely on margins to ensure solvency. As Indian brokerages consolidate and shore up their capital base, this problem should also get attenuated. Over a period of time, therefore, the margining system could become more relaxed – both in terms of lower quantum of margins and in terms of lower urgency in raising margins in response to volatility spikes.

What India does need urgently is an abandonment of informal and ad hoc margin tightening in times of crises. One keeps hearing anecdotes about members being asked to reduce positions or deposit more margins than is mandated by the regular margining system. A greater degree of transparency in this regard would also be welcome so that false rumours do not circulate about this.

Posted at 15:17 on Sun, 27 Jan 2008     View/Post Comments (1)     permanent link

Fri, 25 Jan 2008

How to lose $7.1 billion

The announcement by Societe Generale that a rogue trader had caused losses of $7.1 billion was cryptic and baffling. The press release says that the bank:

has uncovered a fraud, exceptional in its size and nature: one trader, responsible for plain vanilla futures hedging on European equity market indices, had taken massive fraudulent directional positions in 2007 and 2008 beyond his limited authority. Aided by his in-depth knowledge of the control procedures resulting from his former employment in the middle-office, he managed to conceal these positions through a scheme of elaborate fictitious transactions.

Assuming that the indices in question have fallen by about 20% in line with the broad European equity index, the notional value of the plain vanilla futures position must have been over $35 billion. That a trade of this size could be concealed by an isolated individual appears difficult to believe since most large banks have internalized the lessons from Leeson’s fraudulent trades at Barings more than a decade ago. I have a sense that there is more to this than meets the eye.

Posted at 08:11 on Fri, 25 Jan 2008     View/Post Comments (2)     permanent link

Fri, 18 Jan 2008

Compensation of bankers (and their regulators)

Raghuram Rajan wrote a provocative article (“Bankers’ pay is deeply flawed,” Financial Times, January 9, 2008) arguing that “Significant portions of [bankers’] compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.” Martin Wolf agreed enthusiastically with this idea and went further “Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse. ” (“Why regulators should intervene in bankers’ pay,” Financial Times, January 16, 2008).

I agree with the basic idea that incentives are critically important but would like to go down a different fork. Why not link the pay of bank supervisors to the fate of the banks that they supervisors? If 50% of the pay of those who supervised Northern Rock were in escrow in an uninsured deposit in Northern Rock itself, I suspect that the stress tests that the supervisors carried out would have been a little tougher. I recall reading that long ago when private clearing houses performed some kind of deposit insurance and lender of last resort functions, they did sometimes hire supervisors on somewhat similar terms. The advantage is that this proposal requires regulators to change only their own HR practices and not of everybody else in the world.

In a similar vein, investors could put pressure on the rating agencies to invest a large percentage of their rating fees in the securities that they rate (with the percentage being higher for high ratings). If this had been in force, I very much doubt whether there would have been so many AAA ratings in the sub prime CDO space.

Posted at 08:13 on Fri, 18 Jan 2008     View/Post Comments (0)     permanent link

Thu, 17 Jan 2008

Will Stoneridge save the banks and the rating agencies?

The decision of the US Supreme Court in the Stoneridge case is doubtless a victory for business, but I doubt whether it will be enough to save the banks and the rating agencies when it comes to the inevitable sub prime related litigation. The court refused to allow investors to sue “entities who, acting both as customers and suppliers, agreed to arrangements that allowed the investors’ company to mislead its auditor and issue a misleading financial statement affecting the stock price.”

I am not a lawyer, but I think the penultimate paragraph of the opinion seems clear enough: “Unconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere. ... In these circumstances the investors cannot be said to have relied upon any of respondents’ deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability to petitioner under the implied right of action. ”

While agreeing that that the anti fraud provisions of securities law are not “limited to preserving the integrity of the securities markets,” the court asserts that these provisions do “not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.”

I do not see how any of this will help the originators and underwriters of sub prime securities or the agencies that rated them if their actions turn out to be fraudulent. It will take a lot of investigative effort to determine whether there was fraudulent behaviour (and even more effort to establish the fraud if any in a court of law), but private players have every incentive to expend this effort.

Posted at 12:21 on Thu, 17 Jan 2008     View/Post Comments (0)     permanent link

Wed, 16 Jan 2008

SEBI loses case on misleading recommendations

Last week, the Securities and Exchange Board of India (SEBI) lost a high profile case regarding misleading investment recommendations: the Securities Appelate Tribunal (SAT) set aside the SEBI order against Mathew Easow.

SEBI’s order in September 2006 stated that “While Mathew Easow has been advising the market to buy a stock, he himself has taken contrary positions. This indicates an obvious attempt to mislead the investors through investment recommendations, in a striking posture of ambivalence coupled with interest. ”

On appeal, SAT was scathing in its criticism:

We cannot uphold any of these findings which are based on a complete misreading of the recommendations made through the e-mails. ... We are amazed that the adjudicating officer could not understand this basic concept. Unfortunately, the adjudicating officer did not apply his mind to the merits of the recommendations made by Mathew. He did not even make an attempt to understand what the recommendations meant.


In view of the aforesaid discussion, we allow the appeal, reverse the findings recorded by the adjudicating officer and set aside the impugned order. The damage caused to the reputation of Mathew cannot be undone. However, he will have his costs which are assessed at Rs.1 lac.

There is an enormous conflict of interest inherent in a person making investment recommendations while also trading in the same securities. Disclosures and disclaimers coupled with investor education are meant to address this conflict of interest. The facts that SEBI has brought on record do not appear to be sufficient to elevate this inherent conflict of interest to the level of a “a fraudulent or an unfair trade practice”. We do not know whether a more thorough investigation and a deeper analysis would have led to a different set of facts and a different set of conclusions. However, based only on the facts that are available in the SEBI order and the SAT judgement, I find it difficult to disagree with the SAT.

Posted at 19:17 on Wed, 16 Jan 2008     View/Post Comments (0)     permanent link

Mon, 14 Jan 2008

Moody's archaeology is quite unconvincing

Last week, Moody’s published a report on the global credit crisis (Archaeology of the Crisis) that I found totally unconvincing. To begin with, the word “archaeology” in relation to such a recent event is perplexing, but that is a minor issue.

My most serious disagreement is with the section in the report on “Reduced risk traceability in the financial innovation process”. Moody’s argue:

Rating agencies were supposed to bridge some of the information asymmetries, but this proved to be some-what unrealistic when the incentive structure of (sub-prime) loan originators, subprime loan borrowers, and market intermediaries also shifted in favour of less information.

... The problem in the case of extreme complexity of inter-connecting financial systems is that it is hard to see how the level of information could reach levels adequate to enable reasonable risk management standards.

Risk traceability has declined, probably forever. It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies.

This leads to two conclusions. First, more capital buffers will be needed or required by counterparties and regulators. Second, not just more but more intelligible information is needed ...

Moody’ is trying to argue that rating agencies failed because the task that they were asked to do was impossible. The first problem with this argument is that they should have thought about this before they accepted the rating assignment and collected their fees. The second problem is that the solution of greater capital buffers (higher attachment points for various rated tranches) was available to the rating agencies all along, but they chose not to go this route.

The third problem with Moody’ argument is that it is becoming increasingly clear that the credit crisis that we are seeing today has nothing to do with financial innovation but is more like the familiar credit and banking crises of the past. For example, it is quite similar to the Japanese banking crisis of the 1990s which also had its origins in a property market collapse.

In August of 2007, it was possible to argue that the credit crisis was somehow related to the difficulty of valuing complex financial instruments like CDOs. One might have thought that credit correlations (which are difficult to estimate) might have been underestimated but there was no problem with the core credit assessment. However, the fall in prices of sub prime linked instruments has been so steep and persistent that it is now clear that the issue is not about correlations but about the value of the underlying credit. A good deal of this underlying value depends on macroeconomic variables like housing prices and GDP growth where there is little if any information asymmetry.

Today, the rating agencies can really take one of only two positions. Either they can admit that they made a grave error in estimating credit risk in a whole large class of credits without any significant attenuating circumstances. Or they can argue that the markets have got it all wrong and the credit quality of sub prime and alt-A housing loans is not as bad as the market thinks. With every passing week of new data coming in from the US, the second position looks increasingly untenable.

In 2001, when the rating agencies were severely criticized for their failures in relation to Enron, I argued that the most that one could accuse them of was some degree of complacence. I wrote: “Any criticism about the rating agencies must keep in mind that the agencies gave Enron a rating that reflected a high level of risk.” Moreover, there were significant information asymmetries between the rating agencies and Enron. The asymmetries in sub prime lending were much lower and the rating agencies had the law of large numbers on their side. I think therefore that a mea culpa would be more appropriate than the kind of archaeological sophistry that Moody’s has dished out to us.

Posted at 16:23 on Mon, 14 Jan 2008     View/Post Comments (0)     permanent link

Tue, 08 Jan 2008

Change in my phone numbers

My telephone numbers will change around January 15, 2008. The first digit will change from 2 to 6. The office number will become 6632 4867 and the residence number will become 6632 5318.

Posted at 13:39 on Tue, 08 Jan 2008     View/Post Comments (0)     permanent link

Sun, 06 Jan 2008

Short selling moves closer to reality

RBI’s new year gift on December 31, 2007 approving short selling by FIIs moved short selling one step closer to reality in India. The financial press reports that February 1, 2008 would be the launch date for short selling and securities lending, but there is no confirmation about this on the web site of SEBI.

Posted at 19:15 on Sun, 06 Jan 2008     View/Post Comments (1)     permanent link