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

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Fri, 25 Apr 2008

Away on vacation

I am away on vacation for about seven weeks. I will not be posting on my blog till mid-June

Posted at 19:12 on Fri, 25 Apr 2008     View/Post Comments (1)     permanent link


Tue, 22 Apr 2008

UBS thought subprime was safer than Japanese Government Bonds

The Shareholder Report on UBS Write-Downs is very informative and interesting, but what I found most striking was the fact that UBS started buying US asset backed securities in 2002 because it thought that Japanese Government Bonds were too risky. This switch took place in the Relative Value Trading (RVT) portfolio used by central treasury to manage the liquidity buffer for the entire UBS Group. This portfolio was run by Foreign Exchange / Cash Collateral Trading (FX/CCT) within the investment banking business of UBS. The report states:

UBS created the ABS Trading Portfolio in late 2002 / early 2003 after Credit Risk Control (“CRC”) downgraded its country rating for Japan. This meant that FX/CCT had to reduce its then substantial holding of Japanese Government Bonds (“JGB”). Because FX/CCT retained the same level of funding liabilities and an unchanged revenue budget, it proposed to build up a portfolio of US ABS. In order for the assets to be a suitable replacement for the holdings of JGB that were to be liquidated, any replacement securities had to be:

There were also a number of other advantages of ABS perceived at the time, including small spreads, USD denomination and no interest rate dependencies (floating rate instruments only in the portfolio). Because they had a higher yield (e.g. than government bonds), including ABS in the RVT Portfolio meant that there was no negative carry trade in the RVT Portfolio.

This reminds me of the famous statement by Mirabeau during the French Revolution: “I would rather have a mortgage on a garden than a mortgage on a kingdom”. The fate of UBS’ subprime assets has been only marginally better than that of Mirabeau’s assignats.

Posted at 16:14 on Tue, 22 Apr 2008     View/Post Comments (0)     permanent link


Thu, 17 Apr 2008

Doubts on LIBOR

Yesterday’s Wall Street Journal has a story about bankers questioning the reliability of Libor. Last month, the BIS Quarterly Review discussed the issue at length with lots of data and some amount of econometrics:

Gyntelberg and Wooldridge find that: “The US dollar market stands out for being the one market where Libor rose by substantially less than similar fixings during the stress period. The average spread between Sibor and Libor widened from about zero in the normal period to 2 basis points in the stress period, and the spread between H.15 and Libor widened from -1 to 7 basis points.” Of these, Libor is the only one that is used as a reference rate for swaps and other derivatives while H.15 (named after the table number in which the Federal Reserve publishes the data) is the only one which is based on actual transactions.

Since H.15 was 7 basis points above Libor, it does confirm that banks were actually paying more than what the Libor panel was quoting during the Libor fixing. Though 7 basis points is not a trivial difference when trillions of dollars of debt is referenced to this rate, it is much less than the 30 basis points being mentioned in the WSJ article. Moreover, there is a different way of looking at whether Libor is too high or too low and that is by comparing it to the Overnight Index Swap based on overnight rates. Under the expectations hypothesis, the OIS and Libor must be equal. Michaud and Upper find that during the crisis, Libor exceeded the OIS by 50 to 90 basis points. From this perspective, the problem is that Libor was too high, not that it was too low.

Gyntelberg and Wooldridge re-estimated Libor using a bootstrap technique instead of the trimmed mean used by the BBA and found that the bootstrapped estimate is not significantly different from Libor. “Moreover, the 95% confidence interval around the bootstrapped mean loosely corresponds to the interquartile range in the Libor panel ... In other words, the bootstrap technique indicates that 19 days out of 20, the design of the Libor fixing produces an estimate that is close to the true interbank rate. This is the case even during the stress period.”

They also argue that “many of the banks on the US dollar Libor panel are also on the euro Libor panel, and there are no signs that signalling distorted the latter fixing.” I do not find this argument convincing because Chapter 2 of the same issue of the BIS Quarterly Review provides a chart on page 21 which highlights how lopsided the US dollar interbank market has become. The data suggest that US banks have raised more dollar deposits from non banks than they have lent to non banks while the position is the reverse for European banks. The result is that European banks have probably borrowed about half a trillion dollars from US banks in the short term inter bank market. In times of heightened concerns about counter party risk, positions of this size become difficult to roll over and poses huge systemic risk. The incentives for strategic quoting are much higher in the dollar market than in the euro market.

All this has a bearing on the common assumption made in recent years in the credit derivative market (both in the theoretical literature and in the practicing world) that the correct risk free rate is the swap rate (essentially Libor) and that the TED spread is essentially a liquidity premium and not a credit spread. Since the crisis of 2007 and 2008 is simultaneously about liquidity and about counterparty risk in the inter bank market, all the turmoil fails to throw light on this hugely important issue.

Posted at 13:10 on Thu, 17 Apr 2008     View/Post Comments (0)     permanent link


Tue, 15 Apr 2008

Thoughts on Global Financial Turmoil

What follows are the comments that I posted on Ajay Shah’s interesting blog post on understanding the global financial disturbance of 2007 and 2008.

Q1: Why was there a surge in demand for a yield pickup?

Ajay Shah is absolutely right in saying that monetary policy was loose, but then the question is why did it feed into asset prices rather than goods prices. It is the answer to this question that takes us to finance as opposed to economics. I often say that we must approach the study of finance with Ito’s Lemma in one hand and a copy of Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises in the other.

Q2: Why did dodgy practices on home loan origination and securitisation flourish?

This is question 1 in a different form: greater tolerance for operational risk instead of market risk.

Q3: Why did liquidity collapse in key markets thus doing damage to Finance?

I would argue that liquidity collapses when prices are not allowed to fall. Why are the ABX contracts liquid? Because they have been allowed to undershoot. The ultimate providers of liquidity in any market are the value investors and they do not enter until prices have undershot.

On what Ajay Shah regards as the “well understood” questions, my answers are slightly different from his:

Why did a modest rate of default in a relatively small part of finance lead to such a crisis?

My answer: The real problem is not sub prime (which is only the canary in the mine), but falling real estate prices. Real estate is a huge part of finance. See also my earlier blog entry on real estate finance.

Did the Fed do right in rescuing Bear Stearns?

In my opinion, No.

First, as Kindleberger used to say, "A lender of last resort should exist, but his presence should be doubted." Even after LTCM, there could be doubts. After Bear Stearns, there can be none. This is a great tragedy.

Second, I can understand LOLR (lender of last resort), I can even understand outright nationalization (Northern Rock). I cannot understand buying a second loss credit linked note on $30 billion of hard to value securities.

See also my earlier blog entry on the rise of Mahathirism in the US and UK.

Why has the impact on the real economy of these events been relatively modest?

My answer: Canary in the mine again. I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.

It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.

Posted at 12:42 on Tue, 15 Apr 2008     View/Post Comments (2)     permanent link


Mon, 14 Apr 2008

Mahathirism thriving in US and UK

Mahathir was Prime Minister of Malaysia during the Asian Crisis a decade ago and shocked the world with controversial responses that stretched the limits about how responsible governments are supposed to behave. Looking around the world today, it is clear that Mahathirism is alive and kicking in the heart of the developed world. The actions of the US in the Bear Stearns bail out and of the UK in pursuing the enemies of HBOS smack of the same intolerance of market forces and preference for crony capitalism that characterized Mahathir.

The legal problems with the Bear Stearns deal have been analysed very ably by Prof. Davidoff in a series of articles in his Deal Professor column in the New York Times Dealbook (one, two, three, four, five, six, seven, eight, and nine.) Davidoff argues that the deal violates NYSE listing regulations (but the worst that NYSE can do is to delist Bear Stearns and this is going to happen anyway after the merger) and probably violates Delaware corporate law too. The circumstantial evidence certainly points to a deal that was imposed by the government with scant concern for the requirements of good corporate governance. Davidoff is also right in raising questions about the Bear Stearns directors selling their shares in the market rather than tendering it to the acquirer under the deal that they have approved. It is also evident that the creditors of Bear Stearns (and to a lesser extent, its shareholders) have been bailed out.

The story about HBOS in the UK is Mahathirism of a different kind. Since HBOS is known to have considerable exposure to the mortgage market, it has attracted considerable short interest. After rumours spread about liquidity problems at HBOS, the Bank of England took the extra-ordinary step of denying problems at this bank. The Bank of England does not usually talk about individual institutions. For example, during the Northern Rock hearings, the Chairman of the Treasury Committee of the Parliament had the following exchange with the Governor and another Director of the Bank of England:

Q129 Chairman: ... Are there any others in potential trouble? You do not need to name them!

Mr King: I think you know perfectly well that central bank governors cannot go ---

Q130 Chairman: Governor, I was not even talking to you; I was talking to Paul Tucker.

Mr Tucker: Central bank directors take the same approach.

Yet, the Bank of England went out of its way to deny the HBOS rumours. Moreover, though the BOE statement has been reported very widely in the press, I cannot find the text of the statement at the web site of the Bank of England despite searching its web site and also running down its list of press releases. So much about transparency.

The Financial Services Authority went further with a probe into the short selling episode. Its statement is quite bland, but press reports clearly indicate that the FSA is taking the probe very seriously. The FT Alphaville blog describes an imaginary conversation between the FSA and speculator showing how silly this whole idea of probing the short sales really is:

FSA: Why did you short this bank?

Speculator: Because I thought it might have liquidity problems.

FSA: Why did you then tell the salesman at X broker that you thought this bank had liquidity problems.

Speculator: Because I thought it might have liquidity problems.

FSA: But it doesn’t have liquidity problems.

Speculator: Really?

Posted at 18:52 on Mon, 14 Apr 2008     View/Post Comments (0)     permanent link


Fri, 11 Apr 2008

Modernizing real estate finance

I believe that real estate finance today is where corporate finance was a hundred years ago, and the current global financial turmoil is the beginning of its transformation into something similar to modern corporate finance. About a century ago, corporate finance adopted its modern form where equity is owned by large diversified pools of capital with low levels of leverage. Real estate as an asset class is of the same size as the equity market, but it is still dominated by small undiversified owners with large amounts of leverage.

Most houses are owned by individuals who finance them with mortgage debt. A high quality mortgage might have a loan to value ratio of 80% while very few modern businesses are run with 80% debt to total capitalization. In lower quality mortgages, the loan to value ratio could be in excess of 90%. This is a prescription for financial fragility. While modern economies can easily absorb the stock market dropping by 50% in a year, their financial systems are devastated by even a 20% drop in real estate prices.

This is also a problem from the investor view point. Since real estate is as large an asset class as equities, an institutional investment portfolio should ideally have a large holding of real estate, but this cannot be achieved because ownership interests in real estate are not available in sufficient quantity (see for example, Hoesli, Lekander and Witkiewicz, “Real Estate in the Institutional Portfolio: A Comparison of Suggested and Actual Weights”, Journal of Alternative Investments, Winter 2003.) Almost all real estate is user owned and therefore the only exposure that you can buy to real estate in the financial markets is mortgage debt (residential or commercial).

Corporate finance was also like this centuries ago. Bond markets existed long before stock markets, and for the first couple of centuries of their existence, stock exchanges like the London Stock Exchange traded bonds more than stocks. Apart from their own money and that of their friends, businessmen had to rely largely on debt to finance their businesses. But all this changed in the late nineteenth century as Mitchell has described in his fascinating book The Speculation Economy: How Finance Triumphed Over Industry, BK Currents, 2007. The joint stock corporation meant that anybody anywhere in the world could own a piece of any business.

The equivalent transformation in real estate has yet to happen. For most individuals today, their home is the most undiversified investment that they have (even more undiversified than their human capital), and it is a heavily levered investment. If an individual were to buy shares worth several times his annual income on margin, we would doubt his sanity. But when he does the same thing in real estate, governments encourage the imprudence by giving generous tax breaks.

This fragile financial structure where everybody buys real estate on margin with a downpayment of only 10% or 20% is a prescription for huge systemic risk. By contrast, in the equity market, pension funds and mutual funds have negligible levels of leverage; very few individuals buy stock on margin; and corporate investments in stocks (strategic investments) are also financed with relatively low levels of debt.

The fragility of real estate finance is less of a problem so long as people irrationally keep paying mortgages even when they have negative equity in their homes. Standard valuation models of mortgage securities (whether it is prepayment modelling or default modelling) assume that the home owner is irrational and will neither exercise the prepayment option (call option) optimally nor exercise the default option (put option) optimally. As financial systems get more sophisticated, these assumptions are bound to be falsified. As this happens and jingle-mail becomes more prevalent, the business of selling near money put options on real estate (which is what mortgages are all about) is bound to be less and less viable.

In the period of transition, large portions of the financial system will doubtless lose much of their capital. This is what one is seeing in the global financial turmoil. It is a necessary part of the process of creative destruction through which hopefully real estate finance will be transformed just as corporate finance was transformed a century ago.

Posted at 18:13 on Fri, 11 Apr 2008     View/Post Comments (2)     permanent link


Thu, 03 Apr 2008

Google stock screener

Google Finance has launched a stock screener that allows the user to screen stocks based on several criteria including a number of balance sheet and profitability variables, several valuation metrics as well as variables related to stock price performance. This tool makes possible a variety of analyses that could earlier be done only by those with an expensive Bloomberg or Reuters terminal. However, the universe is limited to about four thousand stocks which is much less than you would get if you subscribe to one of the commercial services.

For example, one can list the stocks with a market capitalization of more than a billion dollars that have a negative beta. There are fifteen of them, but several are bond funds or ETFs.

It is also interesting to just list the tops stocks by market capitalization and observe that three of the top five stocks are from China and Brazil.

I wish they would also allow screening by industry and geography. The query string in the URL clearly shows that sector and exchange are potential search fields, but these do not appear to be enabled as of now.

Posted at 21:48 on Thu, 03 Apr 2008     View/Post Comments (1)     permanent link