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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Fri, 29 Feb 2008

Vulture funds restructuring sub prime home loans

Bloomberg has an interesting story (hat tip Aleablog) about how vulture funds are buying up delinquent mortgages and then reducing the interest rate to allow the borrower to resume payments.

A market solution like this appears to be a better strategy than the loan waivers that we are seeing in India and the government sponsored home loan restructuring that is being proposed in the United States.

Posted at 18:47 on Fri, 29 Feb 2008     View/Post Comments (0)     permanent link

Thu, 21 Feb 2008

FICO scores and subprime defaults

Thomas Brown has an interesting article at which indicates that US mortgage defaults might not be driven by low FICO scores at all. Brown compares the various mortgage pools underlying the widely tracked ABX index and shows that in many cases, the worst performing pools have higher FICO scores than the best performing pools. In some cases, the average FICO scores of the worst pools are around 640 so that they do not even count as subprime according to the standard definition. Until last year, subprime was generally defined as FICO scores below 620, but after the subprime turmoil began, some lenders have raised the cutoff to as high as 680.

In some sense, this is not surprising. FICO scores are not about creditworthiness as measured by income, assets or cash flows. They are simply about past credit histories. If a household with an impeccable credit history is given a housing loan that is well beyond what it can afford in terms of its income levels, the FICO score would be excellent, but the default risk would be high.

Brown’s data shows a clear pattern where pools originated by some lenders like Wells Fargo have the lowest default rates while those originated by other lenders like WMC have the highest default rates. Geography matters too – the worst pools have high exposure to some of the most frothy housing markets of 2006.

Brown interprets his data to mean that mortgage losses are not likely to be as high as feared because many subprime mortgages will not default. While I grant this, an equally valid conclusion from the data is that many non subprime mortgages will default because the trajectory of housing prices matters more than FICO scores.

All this has implications for India where many hopes are being pinned on the creation of credit registries and similar agencies that would make FICO-like scores possible in India as well. In a country where recovery is even harder than in the United States, excessive reliance on credit histories might not be such a good idea at all. The smartest crooks will build excellent credit histories with a series of small loans until they can take out a large loan. Long ago in the United States, the term Brazilian straddle was used to describe a huge market position which the trader intended to run away from if it proved unprofitable (the other leg of the straddle was supposed to be a one way air ticket to Brazil). What the equivalent straddle should be called in India is left to the imagination of the reader. I would confine myself to the observation that credit histories provide little protection against such straddles.

Posted at 17:01 on Thu, 21 Feb 2008     View/Post Comments (3)     permanent link

Sun, 17 Feb 2008

XBRL - Is India missing the bus?

Nearly two months after the Securities and Exchange Board of India (SEBI) launched its XBRL enabled electronic filing platform, no XBRL tools are available on this platform, while the corresponding platform in the US continues to innovate in providing increasingly better and more powerful interactive tools to view and analyze the data. On Friday, the US SEC unveiled its new XBRL tool, Financial Explorer, which prompted me to do a quick comparison.

I looked up Infosys Technologies in the Indian filing system and got static tabular data with which one cannot do anything meaningful except by downloading it. Unfortunately, the site does not appear to allow the data to be downloaded in XBRL or any other usable format. I then went to the SEC’s Interactive Financial Viewer and could download the raw XBRL filing as well export the data into Excel. I could also compare the filing of Infosys with that of Satyam in parallel columns. The power of XBRL allows similar elements in the two filings to be lined up correctly in this tabulation while also providing data in each that is not present in the other. The site also allows the user to chart the data choosing the rows and columns of data that is to be charted.

I then went to the Financial Explorer page and saw how various interactive charts could be produced from the XBRL data. These charts rely on the semantic information embedded in XBRL. For example, since XBRL encapsulates knowledge of what are the elements of shareholder equity, it can generate a chart explaining the changes in shareholder equity in terms of the changes in its constituent elements.

Above all, the SEC is providing the source code for most of its application at its XBRL viewers page and is encouraging software developers to take this and build other tools based on this. In a couple of years from today, I expect that financial data will be shared, analyzed and presented using XBRL tools. I have previously argued that one day financial statements will also be prepared using XBRL tools.

SEBI certainly needs to do far more than it has done so far to bring the power of these exciting tools to Indian investors.

Posted at 14:51 on Sun, 17 Feb 2008     View/Post Comments (2)     permanent link

Tue, 12 Feb 2008

Unbundling derivatives clearing from trading

The US Department of Justice has put out a very well argued and cogent paper arguing that unbundling derivatives clearing from trading would lead to greater competition in derivative trading with attendant benefits in terms of greater innovation and lower costs for the users of derivatives.

The DOJ’s theoretical reasoning is quite sound:

If exchanges did not control clearing, an appropriately regulated clearinghouse could treat contracts with identical terms from different exchanges as interchangeable, i.e., fungible. The incentives of such a clearinghouse would be to maximize its own profits, and it thus likely would treat identical contracts as fungible. In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sustained head-to-head competition. A trader could open a position on one exchange and close it on another. In such a world, a trader could execute against the best price wherever offered without fear of being unable to exit the position because there is insufficient trading interest (or of being forced to exit at a poor price) on the new entrant trading venue when a trader chooses to exit.

In addition, if exchanges did not control clearing, an appropriately regulated clearinghouse could reduce member margin obligations by recognizing offsetting positions in correlated financial futures contracts traded on different exchanges. The ability to offset correlated positions in a futures clearinghouse can significantly reduce the capital required to trade.

This theoretical reasoning is backed up by some excellent discussion about the attempted entry of Eurex into US Treasury futures as well as of other competitive battles in the derivative industry.

But the most important confirmation came from the stock market: the share price of the CME Group that runs the largest derivative exchange in the US dropped by 18% after these comments were released and rose again after subsequent news reports suggested that the proposed changes were unlikely to happen anytime soon.

Posted at 17:00 on Tue, 12 Feb 2008     View/Post Comments (2)     permanent link