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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Sun, 30 Nov 2008

Sovereign defaults

According to data from Markit regarding the five year credit default swap (CDS) market on November 27, 2008, the cost of insuring against default by the US government was 0.5% per annum and the cost of insuring against a UK government default was almost 1%. The CDS market is now attaching a slightly higher probability to a default by the US than by Japan. Germany is seen as significantly less risky than any of these countries.

For comparison, 0.5% is the kind of premium that one might normally pay to insure a decent building against fire. But one must keep in mind that the CDS premium measures the risk neutral probability of default which could be several times the real world probability while for fire insurance, the risk neutral and real world probabilities are much closer to each other.

The sharp rise in the US CDS premium from the single digit levels prevailing before the crisis has left some people wondering whether all this makes any sense at all. Can a government default on debt in its own currency when it can print unlimited amounts of that currency? Above all, how can any entity provide protection against default by the government itself?

These same questions arose and were adequately answered years ago when the major ratings agencies downgraded Japan at a time when it was the largest creditor nation on earth running a large current account surplus. I therefore find it strange that the same questions are arising again now when the creditworthiness of the US is being doubted.

This time, the rating agencies dare not express doubts about the creditworthiness of the US since these agencies are themselves in the dock for the silly ratings that they gave to mortgage securities. It is obviously not a good idea for the rating agencies to antagonize the government that holds the regulatory sword of Damocles over them. The doubts are instead being expressed by impersonal markets in the form of CDS spreads.

So, let us once again remind ourselves that governments can and do default on debt denominated in their own currency. Creditworthiness is not only about ability to pay, but also about willingness to pay. It is reasonable to assume that governments have the ability to pay by printing currency though occasionally a government (Zimbabwe for example) has run out of ink and paper to print notes. The principal problem is about willingness to pay.

The Russian default of 1998 on its ruble debt is a good place to begin understanding the issue. I like to imagine the Russian government being forced to choose between paying its soldiers and paying its creditors. Obviously, it chooses to pay its soldiers – if it makes the wrong choice, it does not survive to tell the tale. Unlike creditors, soldiers cannot be paid in worthless paper. They have to be paid in something that can buy food and other essentials.

The government must therefore print notes on a scale that produces the maximum seigniorage revenues to the government. There is a very simple formula which states that in real terms seigniorage revenues are equal to the stock of real money times the rate of growth of nominal money. If it prints money on so large a scale as to create hyper inflation, then the stock of real money declines (and ultimately collapses to zero) and the government cannot earn any seigniorage revenues regardless of how fast it grows the nominal money supply by printing money.

A point is therefore reached where a government concerned about seigniorage revenues decides to default rather than print more notes. Stating the issue in terms of soldiers versus creditors dramatizes the issue, but we can as well think of it in terms of voters versus creditors and the analysis would be the same.

When one looks at the matter in historical perspective, the idea of government debt being risk free is a twentieth century illusion that is of as little relevance in the twenty first century as it was in the nineteenth century.

Let me now turn to the second question. Is it reasonable to assume that anybody can actually insure against default by the US government? I think the answer is yes provided one takes care not to take out insurance on the Titanic from somebody who is on board the Titanic itself. If one is paranoid, one might want the CDS contract to be governed by say English law rather than New York law and to pay out in say Euros rather than dollars. One might also like the counterparty to be outside the US or at least to have substantial assets outside the US. If these elementary precautions are taken, the CDS can indeed do the intended job as well for defaults by the US government as for defaults by any other reference entity.

Posted at 17:16 on Sun, 30 Nov 2008     View/Post Comments (3)     permanent link


Fri, 28 Nov 2008

Wrong investors and market dislocation

I have been reading the transcripts of the US House of Representatives Oversight Committee hearing on hedge funds and the financial crisis.

Having enjoyed Andrew Lo’s excellent book on hedge funds, I read his testimony with particular care. I was particularly fascinated by the following statement that he made:

Dislocation comes not from losing money, but from the wrong investors losing money. (lines 725-726, p 34)

I mentioned earlier that dislocation happens not when losses occur, but when losses by individuals that are not prepared for those losses occur. The hedge funds that invest in the worst risk tranches, they are prepared for losses; but when money market funds, pension funds, mutual funds invest in AAA securities that then lose substantial value, that is really the cause for dislocation. (lines 1067-1073, p 49)

That diagnosis ties in well with a report at FT Alphaville about why Lehman’s demise was so devastating to the markets. During the run up to the Bear Stearns collapse, investors stopped rolling over its commercial paper and the amount of this paper outstanding fell by over 80% as far as I can make out from Figure 1 in the report. After the Bear bailout, investors assumed that a large investment bank would not be allowed to fail. As Lehman lurched towards bankruptcy, its commercial paper issuance not only did not fall but actually increased nearly five times.

This means that at the point of its failure, Lehman was being increasingly funded by what Lo called “wrong investors”. The tipping point in the post Lehman crisis was the closure of a prominent money market mutual fund due to losses on its investments in Lehman commercial paper. This in turn led to the collapse of the entire prime commercial paper market necessitating a bailout of that market and an ever widening range of other bailouts.

This is a very potent example of the moral hazard caused by government bailouts. Absent implicit government support, a weakening institution sees a withdrawal by risk averse investors and its funding comes increasingly from those who in Lo’s words are “prepared for losses”. The moral hazard caused by previous bailouts breaks this adjustment and makes subsequent failures a lot more painful than they would otherwise be.

This analysis also suggests that a “silent run” on a financial institution could actually be a good thing under certain circumstances if it is Lo’s “wrong investors” who are doing the running.

Posted at 08:34 on Fri, 28 Nov 2008     View/Post Comments (1)     permanent link


Thu, 27 Nov 2008

Show me the balance sheet

I wrote a column in the Financial Express suggesting that quarterly financial disclosures should be improved. In particular, the balance sheet should be disclosed quarterly:

In the current regulatory regime, Indian investors get to see the balance sheet of their companies only once a year, while they get to see the profit and loss information once a quarter. In the context of the current crisis, we need to change this urgently because the investor today wants to see the balance sheet as much or even more than the profit and loss data.

For example, if an Indian real estate company or non bank finance company were today to give its investors the choice between receiving a quarterly balance sheet or a quarterly profit and loss account, many investors would choose to get the balance sheet. Investors are currently more concerned about declining liquidity and solvency than they are about declining profitability. Indeed, the maturity and currency composition of the debt and the debt covenants are very critical pieces of information in assessing the survival prospects of these companies.

Another problem is that many companies have adopted the ugly practice of taking foreign exchange losses to the balance sheet in defiance of the accounting standards by taking refuge in some anachronistic arguments of doubtful legality. This means that the balance sheet is essential even to understand the true profitability of companies.

In the 1990s, when Sebi mandated quarterly disclosures of abridged profit and loss data, it was a huge step forward. It moved the Indian market to higher levels of informational efficiency and greatly improved price discovery. It would also be fair to say that quarterly disclosures have done more to reduce insider trading in India than the insider trading regulations themselves.

The time has now come to build on this and take it forward to its logical conclusion. In the 1990s, the only feasible mode of disclosure was a newspaper advertisement, and cost considerations severely constrained the amount of disclosure that could be mandated. The regulators therefore chose a minimal set of line items (all from the profit and loss account) for the quarterly disclosure.

Today online disclosure through the website of the stock exchange has become the primary means of information dissemination. The stock exchange data is then republished by several commercial and media web sites as well as by many online trading platforms. The online medium is not subject to the severe cost constraints that restricted the amount of information that could be published through newspaper advertisements. It is now feasible to mandate comprehensive quarterly disclosure of information.

In the US, Form 10K for annual disclosure and Form 10Q for quarterly disclosure are almost identical in terms of the basic financial data (income statement, balance sheet, cash flows, notes and other disclosures). India should also move to the same system where the quarterly disclosure contains all the information required for annual disclosures under Schedule VI of the Companies Act as well as the listing agreement.

Under normal conditions, this disclosure regime would be phased in gradually after extensive consultations and debate. But these are not ordinary times. The ongoing crisis puts a premium on the availability of information. I believe therefore that Sebi should take extraordinary measures to implement this on an emergency basis.

I propose that the top 500 companies (say the BSE 500) should be required to disclose the complete financial statements (balance sheet, profit and loss account and cash flow statement along with notes and schedules) through the stock exchange website beginning with the October-December 2008 quarter in January 2009. There is nothing to be done in the January-March quarter because it is coterminous with the year end. Therefore the remaining companies should be asked to disclose the extra information from the April-June 2009 quarter.

This disclosure requirement should not pose any problems for the companies. No sensible accountant prepares a profit and loss account without preparing the balance sheet and so my proposal would only require the companies to disclose what they have already prepared internally.

The stock exchanges may need software changes to upload all this extra information to their website. But if only 500 companies are subject to this regime in January 2009, it is quite feasible to upload the information manually in the worst case. The exchanges should undertake the extra effort involved in doing this while making software changes to allow them to handle everything automatically from July 2009.

On a related note, I also think RBI should require banks and financial institutions to disclose vastly more information regarding non performing assets and valuation of financial assets. Accelerated adoption of accounting standard AS 30 for financial instruments should also be considered. Current practices allow banks and finance companies to hide losses by improperly parking assets in the held to maturity category. This should be stopped. At the very least, voluntary early adoption of AS 30 should be encouraged. The market can be counted upon to penalise those companies that choose not to do so.

Posted at 06:09 on Thu, 27 Nov 2008     View/Post Comments (5)     permanent link


Wed, 12 Nov 2008

Liquidity or solvency?

I wrote a column in the Financial Express about the potential solvency problems in the Indian financial sector today.

During the last month, Indian policymakers have responded with a series of measures including cuts in interest rates and in cash reserve ratios to improve liquidity in the financial sector. These measures were certainly necessary, and I believe we would and should get more such measures.

However, lurking behind the current liquidity problems is a deeper problem of solvency that needs to be addressed quickly and decisively. It appears to me that India is now where the US was a year ago – the measures that we saw in India in October 2008 were broadly similar to what the US and Europe undertook in August and September 2007. In terms of the deflation of the real estate bubble also, India seems roughly where the US was a year ago.

One difference is that the US had early warning signals in the form of house price futures and ABX indices that provided valuable information on asset prices and credit quality. These measures combined with stringent mark to market accounting enabled analysts to make reasonable guesses about which financial institutions would be hit severely and which were likely to remain solvent. In India, we do not have these markets and the health of financial intermediaries has become the subject matter of rumours and gossip rather than reasoned analysis.

The only market signal of solvency that is available in India is the stock price. The majority of the 17 listed private sector banks for which information is available in the CMIE database are today quoting at a price to book ratio of 1.0 or below which is a crude signal of potential solvency issues. Of the same set of 17 banks, only two traded at a price to book of 1.0 or below at the beginning of last year.

At this point of time, accounting data is not quite reliable because the carrying values of assets do not reflect their fair value. This is a serious problem for banks and non-bank finance companies that have exposures to real estate and to other stressed borrowers. It is also difficult to assess the exposure of banks to troubled non-bank finance companies and weak banks. But the problem is much wider and extends also to debt mutual funds that have exposures to real estate, banks and non-bank finance companies.

Mutual fund net asset values have become unreliable for two reasons. First in respect of short-term financial instruments, mutual funds have the ability to carry the assets at amortised cost rather than market value. Second, some of the really distressed paper does not trade at all and this makes the valuation judgmental. SEBI has allowed greater freedom to mutual funds to mark down the valuation of debt paper by using higher discount rates rather than the rating based spreads that were mandated in the past. This is a good step, but its usefulness depends on the voluntary decisions by funds to mark down the net asset values of their funds.

Solvency problems should be addressed at the earliest possible stage because the longer the corrective action is delayed, the greater the eventual costs of solving the problem. It is necessary to move swiftly to triage financial intermediaries into three categories: those that are financially sound, those that need to be recapitalised or restructured and those that should be shut down. This requires price discovery for stressed assets. Indian policy makers should therefore move swiftly to put in place structures similar to what the Americans and Europeans have done in the last couple of months to restore the health of the financial sector.

A strong financial sector is essential to confront the challenges of a slowing world economy. Unlike during the Asian crisis, this time, emerging economies face a shrinking world market for their exports. The threat of a “beggar thy neighbour” policy of competitive currency depreciation is very real.

The Korean won today trades lower than it did as it was emerging out of the Asian crisis in 1999. The news coming out of China is also quite bad, and the Chinese seem determined to boost their economy through all possible measures. At some stage, these measures will probably include a depreciation of their currency. To make matters worse, many East European currencies are also in danger of going into free fall, and some of them could be formidable competitors in the IT and BPO industries despite a language handicap.

All of this could make the economic slowdown even worse than it would be otherwise. A slowing economy increases non-performing assets and induces financial sector weakness that in turn impacts credit availability and weakens the economy further. The way to stop this vicious spiral is through aggressive recapitalisation and restructuring of the financial sector. We have a window of a few months to do this before India enters election mode.

Posted at 00:30 on Wed, 12 Nov 2008     View/Post Comments (5)     permanent link


Fri, 07 Nov 2008

Land as an asset

The doyen of Indian housing finance, Deepak Parekh is today quoted as saying that land is no longer an asset (“There is no need for irrational pessimism”, Business Standard, November 7, 2008). Parekh says “Land prices have collapsed, land is no longer an asset – people don’t want land as a security. Today, there is surplus land, low demand ... the value of land is probably half of what it was ...”

This explains why real estate companies reportedly have to pay 35% interest after providing collateral (land) notionally equal to three times the value of the loan.

Another interesting statement in this context is in a speech by Fed Governor Kevin Warsh (hat tip Calculated Risk) “We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world.”

Posted at 09:28 on Fri, 07 Nov 2008     View/Post Comments (6)     permanent link


Wed, 05 Nov 2008

Credit Default Swaps on Indian Entities

The Depository Trust and Clearing Corporation has published what is perhaps the first comprehensive official numbers on the global credit default swap market including the top 1000 reference names. The top 1000 names accounts for over 95% of the market by gross notional value and a little less than 90% by net notional value. Entry into this list is a measure of how important an entity is in global fixed income markets, but this is not a list that entities are eager to get into (many of the top names on this list are shaky sovereigns and shakier financials!).

I could spot four Indian entities in this list (ICICI, Reliance Industries, State Bank of India and Corus) in the middle of the list (ICICI is actually in the top 500). The top Indian names also serve as sovereign proxies and therefore the numbers must be interpreted with some care.

Posted at 05:27 on Wed, 05 Nov 2008     View/Post Comments (8)     permanent link