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, 30 Dec 2008

Shares pledges by Satyam promoters

The farce at Satyam Computers gets worse and worse with the company announcing that “The promoters informed Satyam that all their shares in the company were pledged with institutional lenders, and that some lenders may exercise or may have exercised their option to liquidate shares at their discretion to cover margin calls.”. This bizarre announcement highlights a deficiency in the disclosure requirements in India regarding transactions by directors and other insiders.

In the United Kingdom, earlier this month, David Ross resigned from the boards of all four public companies of which he was a director after admitting his “unintentional” failure to disclose that he had pledged his stake in one of the companies (Carphone Warehouse) as collateral for personal loans. The model code on insider trading in the UK listing rules states that “dealing” in shares includes “using as security, or otherwise granting a charge, lien or other encumbrance over the securities of the company;”. Thus pledge of shares is subject to the same disclosure requirements as other dealings in shares. Interestingly, at the time when Ross resigned from the boards, none of his personal loans were in default – the situation in the Satyam case appears to be much worse.

In the US, Regulation S-K Item 403(b) was amended in 2007 to provide that while disclosing their beneficial interest in the shares of the company, directors must also “indicate, by footnote or otherwise, the amount of shares that are pledged as security.”

In India, the Prohibition of Insider Trading Regulations do not to the best of my knowledge deal with pledge of shares. In the Substantial Acquisition of Shares and Takeover Regulations, a pledgee of shares is regarded as an acquirer of shares, but banks and financial institutions are exempt from this clause. In any case, even these regulations do not say that the pledger is regarded as a seller.

Posted at 11:43 on Tue, 30 Dec 2008     View/Post Comments (0)     permanent link

Mon, 29 Dec 2008

Teaching finance the hard way

I was recently asked for my views on whether and how we should change the way we teach finance after all that we have seen in 2007 and 2008. Some of my thoughts are as follows.

In short, I believe finance teaching particularly in MBA courses during the early and mid 2000s became too soft and easy to cater to the needs of an ever growing body of students who sought a career in finance without any real aptitude for the subject. We dumbed finance down for the mass market. The time has come to go back to teaching finance the hard way – and perhaps there will be fewer students in the classroom.

Posted at 14:39 on Mon, 29 Dec 2008     View/Post Comments (13)     permanent link

Sun, 21 Dec 2008

Credit losses and the Mandelbrot parable of the receding shore

During the last year and a half, expected credit losses have always been around twice the actual credit losses recognized by the banks. Long ago, banks had recorded only $100 billion of losses and people estimated that total losses would be $200 billion. Now that a trillion dollars of writedowns have taken place, estimates of total losses seem to be around two trillion dollars.

This reminded me of Benoit Mandelbrot’s parable of the receding shore (“Forecasts of Future Prices, Unbiased Markets, and Martingale Models”, The Journal of Business, 39(1), 242-255, January 1966):

Once upon a time, there was a country called the Land of Ten Thousand Lakes ... The widest was a sea 100 miles across, the width of the rth Biggest was 100/√r, so that the smallest had a width of only 1 mile. But each lake was always covered with a haze that made it impossible to see across and thus identify its width. ... The people of that land were expert at measuring distances, however; they also knew all about the computation of averages ... They knew, therefore, that as one of them stood on an unknown shore, he had before him a stretch of water of expected width equal to 2 miles. He could very well travel 1 mile to reach the center of “the” expected lake; but he could never go beyond this point! Suppose, indeed, that he succeeded in sailing forth to a new total distance just short of 100/√r miles. In the meantime, the other shore would have “moved on,” to a new mean distance from him equal precisely to 100/√r. It is clear therefore that those Lakes were ruled by Spirits who would never let them be crossed by a stranger. However far the traveler might sail, the Spirits would spread the lake ever farther, and the stranger would always remain right in the middle of water; his boldness should eventually be punished by death, but all travelers were eventually reprieved by a special grace.

I learnt more about fat tailed distributions and power laws from reading Mandelbrot than from reading anybody else (including Embrechts), and after four decades, the parable of the receding shore is still perhaps the best introduction to the subject. This parable also seems to be a good explanation of what is going on today. We are all now waiting to be “reprieved by a special grace.”

Posted at 15:14 on Sun, 21 Dec 2008     View/Post Comments (0)     permanent link

Sat, 20 Dec 2008

Madoff, Markopolos and the SEC

The Wall Street Journal has a bland story (subscription required) about the efforts made by a rival hedge fund manager named Markopolos to convince the SEC back in 2005 that Madoff was running a Ponzi scheme. Much more interesting are two documents that the WSJ has put up on its public pages (no subscription required) on this subject: Markopolos’ nineteen page submission to the SEC describing all the red flags about the Madoff operation and extracts from the SEC’s Case Opening Report and Case Closing Recommendation.

I found the Markopolos submission extremely persuasive and well argued. It appears to me to be a good example of forensic economics – the difference being that this is done not by academics (like the Nasdaq market making study) but by one of Madoff’s rivals.

Markopolos’ theoretical argument that Madoff’s alleged option trading strategy would deliver T-bill like returns is absolutely correct. This is what we teach in all derivative courses.

Markopolos also makes a valid argument about the open interest in the exchange traded options being too small to support Madoff’s alleged strategy given the large funds under management. He also points out that OTC option trades on this scale would breach counterparty limits and therefore explicitly requests the SEC to seek trade confirmation directly from the trading and operations teams at the counterparty.

What I found most interesting is Markopolos’s analysis of why Madoff did not set up a hedge fund himself but instead chose to be a white label agent for hedge fund of funds. Markopolos argues that it does not make sense for Madoff to give up the attractive 2/20 fees of a hedge fund unless he has something to hide. He also argues that the arrangement is best described as Madoff borrowing money at 16% interest. It is worthwhile understanding this part of the submission in detail, because the moment one accepts this analysis, it becomes clear that it can only be a Ponzi scheme.

Why then did the SEC miss all this? I could not get away from the feeling that the SEC bungled this investigation very badly. But I also suspect that regulators are much more geared towards dealing with complaints from whistleblowers or other complaints with a “smoking gun” proof rather than some forensic economics that most regulators probably do not understand. Perhaps also the fact that a complaint comes from a rival automatically devalues its credibility in the eyes of many regulators.

I believe that in financial regulation, both these attitudes are completely mistaken. Forensic economics is usually more valuable than “smoking guns” and complaints by rivals and other interested parties are the best leads that a regulator can get. Regulators should perhaps hire some PhDs in market microstructure and derivative pricing in their surveillance and enforcement departments. Under normal times, PhDs in these fields would probably not want to work in these departments of a regulator, but these are unusual times.

Posted at 19:33 on Sat, 20 Dec 2008     View/Post Comments (4)     permanent link

Wed, 17 Dec 2008

Satyam and Maytas

Sandeep Parekh has two posts and and T T Rammohan has a post on the corporate governance issues raised by the aborted acquisition (bailout?) by Satyam of Maytas – a company owned by Satyam’s promoters. Sandeep Parekh concludes: “I think this is a clear case of violation of fiduciary duties by the executive and independent directors of the company and I would go so far as to state that they have violated all three duties imposed upon them as fiduciaries – the duty of care, the duty of diligence and the duty of loyalty.”

Posted at 20:28 on Wed, 17 Dec 2008     View/Post Comments (4)     permanent link

Sun, 14 Dec 2008

Irish takeover panel snubs its own government

FT Alphaville pointed me to this fascinating ruling by the Irish Takeover Panel. The panel says that when the government is a shareholder of the target company, any concessions made by the acquirer to the government in the area of public policy (lower consumer prices) is tantamount to giving one shareholder (the government) more favourable terms than the other shareholders.

I am not a lawyer, but I think this is a complete game changer in takeover law. Any agreement with the promoters that gives them any kind of favourable terms even if it is not at all in their capacity as shareholders seems to be forbidden by this ruling. I blogged about this kind of issue nearly three years ago, but the Irish solution goes beyong anything that I imagined at that time.

Posted at 16:33 on Sun, 14 Dec 2008     View/Post Comments (4)     permanent link

Sovereign Limitations

I wrote a column in the Financial Express this week about the limitations of the government in dealing with financial crises:

The ongoing global crisis has seen the government assume an ever increasing burden to keep the financial system afloat. But governments are not omnipotent, and emerging market governments are even more constrained. Investment bankers who thought they were omniscient during the boom have turned out to be clueless. It is perfectly possible that governments that appear omnipotent today will begin to look powerless before we are finished with this crisis.

The first signal regarding this is coming from the credit default swap market where one can buy insurance against default by corporate or sovereign borrowers. As of end–November, this market quoted a premium of ½% per annum to insure against a default by the US government. This is comparable to the premium that one would pay to insure a building against fire. Of course, all insurance premia reflect not only the actuarial probability of loss, but also a compensation for risk and the CDS premium does so to an even greater extent than in normal insurance. Yet, a ½% CDS premium indicates a frighteningly high probability of a default by the world’s sole superpower.

Another point of comparison is that ½% was roughly the CDS premium for insuring against default by India and several other major emerging markets in mid 2007. In other words, the US is perceived to be as risky today as India was in mid 2007. Before the crisis began, the CDS premium for the US was less than 0.1%. A five fold increase in the CDS premium clearly indicates that the risk perception has increased dramatically as the US government has taken more and more risk on to its own balance sheet.

We see a similar phenomenon in other countries as well. The cost of insuring against a default by the UK is as high as 1%. On the other hand, a country like Germany which still retains a conservative fiscal balance sheet enjoys significantly lower spreads than the US, UK or Japan.

In 2002, Japan encountered the same problem as it went on a fiscal binge to try and support its ailing economy. The rating agency Moodys downgraded the world’s second largest economy which was then the biggest creditor nation on earth to a single A rating placing it below Botswana which was then receiving foreign aid from Japan.

This time around, the ratings agencies have confined themselves to acting against small countries like Iceland which used to have a AA+ rating not too long ago, but has had its sovereign rating cut to BBB- (just one notch above junk). This has happened mainly because Iceland has assumed most of the liabilities of its banking system. The rating agencies are hesitant to take harsh action against major countries like the US or the UK 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 antagonise the government that holds the regulatory sword of Damocles over them. The doubts about sovereign creditworthiness are instead being expressed by impersonal markets in the form of CDS premia.

In emerging markets like India, the worries about creditworthiness are even greater for a variety of reasons including foreign currency external debt and weaker institutional structures. Since the Indian government itself does not have foreign currency bonds outstanding, the CDS market relies on sovereign proxies like the State Bank of India. Using this sovereign proxy, the CDS premium for insuring against default by India has widened from about ½% in mid 2007 to about 4% by end November 2008. At its peak during the panic of October 2008, this premium was over 7½%.

We must also keep in mind the fact that India entered the crisis with a weak fiscal situation. Falling oil prices may reduce some of the off balance sheet obligations of the government, but a slowing economy will also reduce tax revenues. The fiscal position will thus remain precarious if not worsen further. What this means is that the Indian government must perforce be highly selective in terms of the bailouts that it provides. It has to distinguish between systemically important financial intermediaries, other financial entities and the general corporate sector. If the state expends its scarce fiscal resources supporting everybody that seeks help, then it might find itself too weak if and when the more systemically important entities need assistance.

During a downturn, many corporate entities will need to go through a debt restructuring if they have a liquidity or solvency problem. This debt restructuring may involve maturity extension, debt reduction or debt-equity swaps where creditors take significant losses, but shareholders suffer even more. If this causes losses to the the banks, their shareholders would also take a hit in the process. It is only after all this is exhausted that government support needs to be considered.

Posted at 11:00 on Sun, 14 Dec 2008     View/Post Comments (1)     permanent link

Mon, 08 Dec 2008

Good Moves by SEBI

The Securities and Exchange Board of India made several good moves at its board meeting last week (their press release is here). The huge move towards transparency has been widely welcomed in the mainstream media and in the blogosphere.

I will therefore focus on the change that they have made to prohibit early exit from closed end mutual funds. This change appears to be directed towards Fixed Maturity Plans (debt funds) which were designed to eliminate interest rate risk for investors by investing in paper with the same maturity as the tenor of the scheme. The intention was to lock in the rate of return at inception and avoid any price risk at maturity. There could be a small reinvestment risk because of reinvestment of intermediate coupons, but this was negligible given the short maturity of most of these schemes.

This investor expectation about a predictable return has been rudely shaken because of large redemptions by big corporate investors during the liquidity crisis of October 2008. The mutual funds had to sell some investments at a loss and more importantly the residual portfolio quality also suffered because the best and most liquid investments were sold. The RBI’s scheme to lend to mutual funds does not solve this problem because the valuation of some assets is suspect and the liquidity window actually helps redeeming investors exit at an unrealistically high valuation.

SEBI’s move to simply prohibit premature exit restores the closed end debt scheme to its original function and design. With this in place, the RBI scheme for lending to mutual funds can be scrapped and can hopefully be replaced by a scheme to lend against units of mutual funds. This would provide liquidity to corporate investors who now face an unanticipated liquidity need. Evidently, liquidity is a privilege for which they should expect to pay a fair market price.

The SEBI press release also says that these Fixed Maturity Plans should not invest in paper with maturity beyond the tenor of the scheme. This too is necessary to ensure that these plan work as advertised. However, the language used refers to all closed ended schemes and would therefore appear to preclude a closed end equity fund since by definition an equity share is perpetual in nature. Hopefully, this will be fixed in the actual regulations.

I also think that SEBI needs to put in place a regulatory provision for suspending redemptions even from open end funds in extreme cases where it is impossible to determine the net asset value (NAV) of the fund reliably. The ongoing financial crisis continues to worsen. Earlier people like me worried mainly about defaults by real estate companies and NBFCs. Now the fear extends to the corporate sector as well with at least three of India’s largest business groups being perceived to be at risk of severe financial distress.

We still hope this distress will stop short of default, but a situation could arise where uncertainties about the financial situation of systemically important borrowers could lead to a situation where the NAV of mutual funds cannot be reliably determined.

As far as I am aware, there is no explicit requirement in the mutual fund regulations prohibiting redemption of units above net asset value or prohibiting redemption if the NAV cannot be reliably ascertained. (I think this is because the regulations were designed largely to protect the investors from the fund and not to protect the investors from each other.) I do not know whether a prohibition against such unfair redemptions (fraudulent preference?) can be inferred from general trust law. In any case, for complete clarity, it would be useful to write these into the regulations.

There is enough international experience in dealing with the impact of systemic defaults on mutual fund redemptions. I think Korea handled the DTC crisis after the Daewoo bankruptcy in an admirable way and there are lessons from there both for SEBI and for RBI. There are useful lessons from the Lehman bankruptcy in the US as well. Regulators should study these lessons and stand ready to apply them if such unfortunate situations arise in India.

Posted at 12:30 on Mon, 08 Dec 2008     View/Post Comments (2)     permanent link

Thu, 04 Dec 2008

Who creates CDOs today?

While many think that CDOs and other complex instruments contributed to the crisis, the US government has been very enthusiastic in its use of these structures. In fact, if the behaviour of the US government is any indication, CDOs seem to be part of the solution. Let me give a couple of examples.

One of the best is the bail out of Citigroup. If one looks at the term sheet for this transaction, it is clearly a CDO structure:

Now why is such a complex structure required when most of the parties involved are arms of the government itself and every reasonable person would agree that all pieces are clearly at significant risk? Clearly, the government is now abusing CDOs for the same reasons that Wall Street abused it – to fool oneself or to fool others.

As a second example, consider the terms of the restructuring of the loans to the AIG announced by the New York Fed yesterday. There is an LLC set up to buy CDOs and this has a complex structure.

My last example has nothing to do with CDOs and is not a recently designed instrument, but the consequences of some needless complexity in the design is showing up only now. Long ago the US Treasury introduced inflation indexed bonds (TIPS) whose coupons and redemptions are indexed to the consumer price index. This is close to a real risk free bond and is a useful asset class for many investors. It is also useful in creating a market implied estimate of expected inflation (simply subtract the TIPS yield from the nominal yield of an ordinary government bond).

The US Treasury however fouled up this simple and elegant instrument by adding a totally unnecessary complexity when it stated that the redemption will not drop below par even if inflation over the term of the bond turns out to be negative. This adds a European put option exercisable at par at maturity to the instrument. Under normal conditions, this option is far out of the money and can be ignored. If one wanted to be more accurate, one could assume a volatility for the inflation rate, value this put and compute the option adjusted spread (OAS) for the TIPS.

The problem is that these are not normal times. Some people believe that the risk neutral distribution of the CPI at maturity is bimodal with one peak at 80% of current levels and another at 140% of current levels. Black Scholes valuation is hardly appropriate and nobody knows what the true value is. What we do know is that the yields on two TIPS with the same residual maturity have vastly different yields (a spread of 200 basis points) depending on when they were issued and therefore how much of inflation adjustment is already impounded in the principal. Mankiw blog has an excellent discussion on this issue. Econbrowser also discusses this and I have drawn on ndk’s comments in that post for the bimodal distribution mentioned above.

There is an old joke which asks what is the difference between the godfather and the investment banker. The answer is supposed to be that the godfather makes you an offer that you cannot refuse while the investment banker makes you an offer that you cannot understand. The US government is now very clearly in the business of making offers to the rich and well connected that the tax payer cannot understand.

Posted at 18:18 on Thu, 04 Dec 2008     View/Post Comments (0)     permanent link