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 Dec 2009

Indian coupling with global risk aversion in 2009

I wrote a column in the Financial Express today about why Indian markets were swayed by global developments in 2009.

Indian markets in 2009 appeared to dance almost completely to the tune of global developments, reminding us of how strongly integrated we are with world financial markets.

Unlike China, the Indian economy does not depend so much on exports for its growth. Collapse of global trade in 2008 and early 2009 did impact sectors like textiles, diamonds and software services, but collapsing exports did not crush the whole economy because many other sectors thrived on domestic demand.

India’s tight coupling with global markets was not due to trade linkages, but to its dependence on foreign portfolio flows for risk capital. Over the last few years, more and more Indian investors have sold their shares in Indian companies largely to foreign investors (but also partly to Indian promoter groups seeking to increase their stakes).

Foreigners might have bought because they are more bullish about our country than we are, or because their global diversification makes them less concerned about India-specific risks. What is important is that Indian asset prices are now increasingly determined by foreign investors.

This dependence has three implications. First, when foreign portfolio flows reversed, as in late 2008 and early 2009, risk capital disappeared completely. A few companies with strong balance sheets were able to raise modest amounts of debt locally, but those with weaker balance sheets found that they could not raise money at all.

When the corporate sector talked about a liquidity crunch in early 2009, it was really bemoaning the lack of risk capital. Banking system liquidity was probably adequate by early 2009, but this liquidity was not risk capital that could meet the needs of cash-strapped businesses. It was the return of foreign risk capital in mid-2009 that saved the day for these companies.

The second implication of India’s dependence on foreign risk capital is that asset prices in India depend on global risk aversion as much or even more than on domestic sentiment. Capital inflows can ignite asset-price bubbles and outflows can prick the bubbles.

Many of us worried about asset-price bubbles in India in 2007, particularly in the stock markets and in real estate. This view can be debated, but if it is accepted, some of the air went out of these bubbles in 2008 and early 2009, and the bubbles might have been inflated again in the second half of 2009. They could deflate again if global risk appetite reverses in 2010.

The third implication of reliance on foreign risk capital is that equity portfolio flows have a strong effect on the exchange rate. Reserve accumulation by the central bank dampens currency appreciation but does not eliminate it completely. A regime of managed exchange rates creates difficulties for the conduct of monetary policy.

Despite all these problems, foreign risk capital (unlike debt capital inflows) brings huge benefits to the economy. Even in the extreme scenario where all inflows are sterilised in the form of reserves, capital inflows provide dramatic risk reduction for the economy as a whole.

This benefit was clearly visible in late 2008 and early 2009 when foreign investors sold shares at prices well below what they had paid only months earlier and converted the rupee proceeds into dollars at exchange rates much higher than the rate at which they had bought rupees when they came in.

Whenever foreign investors sell cheap after buying dear, they make a loss and India as a nation makes a profit. More importantly, we as a country make a profit precisely when the economy is not doing too well. This is a wonderful risk hedge that is worth all the costs that come with it.

Looking forward to 2010, it is quite likely that the ups and downs of global markets will be felt in India as well. Major downside risks remain in the global economy and the question is how well positioned we are to cope with their impact on India.

The Indian corporate sector has used the recovery of 2009 to repair balance sheets in a variety of ways. A lot of the rebuilding of balance sheets has been made possible by foreign risk capital.

Some companies have raised new equity in 2009 largely in the form of private placements and sales to strategic investors. Many companies that found themselves struggling to roll over short-term debt in 2008 have taken advantage of benign conditions in 2009 to refinance short-term debt with longer-term debt.

A few companies have also addressed the problem of busted convertibles. The recovery of 2009 enabled them to successfully exchange old convertibles that had uncomfortably high conversion prices for more viable instruments. The re-emergence of mergers and acquisitions activity also allowed some companies to carry out asset sales to rebuild their balance sheet strength.

As a result of all this, the Indian corporate sector is better positioned to face new challenges in 2010.

Posted at 12:48 on Tue, 29 Dec 2009     View/Post Comments (5)     permanent link

Wed, 23 Dec 2009

Letting large banks fail

I wrote a column in the Financial Express today about the reform legislation winding its way through the US Congress. I argue that the regulatory goal of making large banks failure proof will not be realized and that it is better to have a policy of letting even large banks fail.

Towards the end of 2008, US policymakers halted the panic phase of the global financial crisis with three simple words: “No more Lehmans.” In the short run, this statement could mean that there would be no more bankruptcies like Lehman – any large financial entity on the verge of failure would be simply bailed out. AIG was the first beneficiary of the new policy.

However, in the long run, the ‘No more Lehmans’ policy can only mean that there would be no more failures like Lehman. Either financial entities should be unimportant enough to be safely left to the bankruptcy courts when they fail, or they should be robust enough to make their failure extremely unlikely.

In this context, the US House of Representatives has passed a comprehensive 1,279-page Financial Reform Bill, but the Bill could change significantly before it is passed by the Senate and becomes law. How effective would this law be in eliminating Lehman-like failures?

First, the new US provisions (as well as the recent Basel proposals at the global level) impose higher capital requirements on financial institutions. While higher capital would reduce the chances of failure, it would not make failures so unlikely that governments can safely promise to bail out any large bank that slips through the cracks. Other elements of the new legislation are, therefore, designed to make it easier to let large institutions fail.

A second key part of the legislation extends the existing resolution mechanism for failed banks to systemically important non-banks and bank holding companies. Under the old law, Lehman could not have been resolved in this manner and while the banking part of Citigroup could have been resolved, the holding company itself (which owned many of the foreign subsidiaries) could not have been.

The new resolution mechanism makes it easier for the regulator to contemplate the failure of a large entity because the messy bankruptcy is replaced by a more orderly resolution process. There is also a provision for a bailout fund (Systemic Dissolution Fund) to facilitate the resolution process, but this fund is to be financed by contributions from the financial industry itself.

The problem with this proposal is that while it avoids bailing out shareholders of a large entity, it actually formalises the bail-out of their creditors through the systemic dissolution fund. It would, therefore, have the perverse effect of encouraging banks to become even larger to exploit this implicit guarantee from the government.

A third key element in the legislation is the reform of the OTC (over-the-counter) derivatives market. Lehman was not spectacularly large in terms of assets and liabilities. The systemic importance of Lehman (and even more so of AIG) came from OTC derivatives.

Lehman was a large dealer in OTC derivatives and AIG was a large counterparty for subprime-related credit default swaps. They were not too large to fail, but were described as too interconnected to fail. Reform of OTC derivatives is intended to prevent this kind of a situation from arising.

The straightforward solution to the OTC derivative problem is to move these derivatives to the exchanges where a central counterparty (the clearing house) collects margins from all participants and assumes responsibility for all trades. Lehman did have a portfolio of 66,000 contracts totalling $9 trillion of interest rate swaps cleared by LCH.Clearnet in London. LCH not only resolved the Lehman default without any loss, but also returned a large part of the margins that it had collected from Lehman.

To understand the difference with the OTC market, suppose that Lehman had sold $100 billion of a certain OTC swap to some parties and bought $90 billion of the same OTC swap from others. Its failure would force all its counterparties to terminate their $190 billion of Lehman deals and establish new contracts with other counterparties. When all these trades are done through an exchange, the clearing house would have to liquidate only the net position of $10 billion, and this is easier because of the margins that the clearing house has collected.

The US law tries to mandate clearing of standardised OTC derivatives, but the proposals are riddled with loopholes that threaten to make them ineffective. First, it does not mandate exchange trading; it only mandates clearing and that too if a clearing house accepts the concerned derivative for clearing. Second, many OTC derivatives lack price transparency and are therefore illiquid. Without a push towards transparency, many derivatives will simply be unacceptable for clearing. Third, minor changes in terms may make a derivative non-standardised and therefore not subject to clearing.

All in all, the 1,000-odd pages of complex provisions riddled with loopholes in this legislation will not make Lehmans sufficiently unlikely in future. I would suggest that ‘No more Lehmans’ is not the correct policy after all. True capitalism is about letting insolvent banks fail, however painful that might be.

Posted at 09:03 on Wed, 23 Dec 2009     View/Post Comments (2)     permanent link

Sun, 20 Dec 2009

How broken are the OTC markets?

The SEC has filed a complaint against the world’s largest inter dealer broker ICAP which dominates trading in US government securities and many other OTC markets. ICAP has settled the charges for $25 million and an undertaking to implement remedial action to be suggested by an independent consultant.

The charges are very serious:

It is depressing that charges of such seriousness are settled without an admission of guilt. The alleged actions shake the very foundations of market integrity and make one wonder whether OTC markets can be trusted at all.

Around the same time that I was reading this complaint, Rortybomb alerted me to a Bloomberg story of a few months ago about an investigation against Markit. The charges here are of a very different nature but they are disturbing in their own way. It is alleged that Markit agreed to provide price information to a clearinghouse only if the latter agreed to clear only trades that involved a dealer.

The question in my mind now is how badly broken are the OTC markets. Whenever, people describe the stock exchanges as casinos, my response is that even if many of the participants are only gambling, the stock exchange still performs the socially useful purpose of price discovery. OTC markets that do not provide transparent price discovery do not perform this function and are much closer to pure casinos. Those that distort the price discovery are worse than casinos.

Posted at 11:50 on Sun, 20 Dec 2009     View/Post Comments (2)     permanent link

Fri, 18 Dec 2009

Getting rid of cheques

The UK Payment Council this week announced a plan to abolish cheques in less than a decade. Actually, it is the clearing of cheques that would be closed on October 31, 2018, but that is as good as abolishing cheques themselves.

The report points out that “A number of countries including The Netherlands and Sweden have already largely or totally eliminated cheques. However volumes of paper credit payments in these countries remain significant. The cheque replacement programme in the UK would be going beyond these countries in aiming to modernise the payment system ...”

The usage of cheques in the UK peaked nearly two decades ago in 1990 and has been falling relentlessly since then. “Cheque use is in long-term, terminal decline.” The UK therefore proposes to shift remaining users of cheques to paperless channels (ATMs, mobile banking, internet banking and stored value cards) over the next decade and then get rid of cheques completely.

The report has a section on “cheque dependent consumers.” This group consists mainly of individuals with degenerative conditions and individuals living in care homes or with mobility problems. The main advantage of cheques is that they allow third parties to assist the user by filling up the cheque before the user signs the cheque. My own sense is that biometrics would be safer than reliance on a third party in such situations.

Interestingly, the report also discusses a few UK statutes which do not allow any alternative to paper payment – these include penalties for dog fouling, litter, releasing greenhouse gases and cigarette smoke.

Posted at 16:04 on Fri, 18 Dec 2009     View/Post Comments (1)     permanent link

Wed, 16 Dec 2009

Samuelson and finance theory

I found it surprising that most of the Samuelson obituaries do not refer to the impact that he had on finance theory. Along with Modigliani and Arrow, Samuelson was among the few mainstream economists who had an enduring impact on finance theory.

Indeed it appears odd that while modern finance theory is often regarded as the bastion of free market economics, it owes so much to Samuelson who was the dominant left wing economist of his era. By contrast, Samuelson’s great right wing rival, Milton Friedman, contributed very little to modern finance theory apart from his famous pronouncements on destabilizing speculation.

Samuelson more or less established the modern “martingale” concept of market efficiency (as opposed to the now largely discredited random walk model) in his landmark paper entitled “Proof that Properly Anticipated Prices Fluctuate Randomly.”

Samuelson also had a strong influence on option pricing through his doctoral student Robert Merton though Samuelson’s own work in this area is completely obsolete.

Above all, I think the mathematical approaches that Samuelson brought to economics were necessary prerequisites for modern financial economics to develop.

Posted at 12:36 on Wed, 16 Dec 2009     View/Post Comments (0)     permanent link

Tue, 08 Dec 2009

Principles based securities regulation

Cristie Ford has posted on SSRN an interesting paper on “Principles-Based Securities Regulation in the Wake of the Global Financial Crisis.” The paper argues that the Global Financial Crisis has not discredited principles based regulation.

According to Ford, what the crisis has done is to demonstrate that principles based regulation requires as much (and sometimes more) regulatory resources and trained staff as any other form of regulation. Principles based regulation “requires greater regulatory capacity in terms of numbers, resources, and expertise than has been allocated to it in some of the infamous examples of regulatory failure in the past two years – the failure of Northern Rock in the UK, and of the the SEC’s CSE Program”.

Principles based regulators also must have the ability to obtain transparent and reliable data directly, for otherwise, they effectively cede the field to the regulatees.

Ford also argues that regulators’ hiring decisions must be based not only on applicants’ relevant industry and legal expertise, but also with a view to whether applicants seem to have sufficient confidence and independence of mind.

Ford’s paper is an insightful analysis of the issues involved and is definitely worth reading.

Posted at 16:17 on Tue, 08 Dec 2009     View/Post Comments (0)     permanent link

Thu, 03 Dec 2009

Pirate stock exchanges and the origin of stock exchanges

Reuters has an interesting report on the stock exchange set up by Somali pirates to fund their activities. It is a fascinating story of how a stock exchange is operating in a near-barter economy. One of the shareholders got her “dividend” for contributing a grenade launcher which she received as alimony from her ex-husband.

The interesting thing is that this is exactly how finance began. Meir Kohn provides the following interesting description of the capital market before 1600 (page 13-14):

While landowners and governments could finance themselves with long-term debt, this option was generally not available to business: it lacked the security and the reliable cash flow required for a debt issue. On the other hand, business could promise substantial gains if things went well to compensate for the possibility of loss if things went badly. This potential for extraordinary returns did provide a basis for equity finance.

The fundamental problem of equity finance is to ensure equity-holders a fair return on their investment. Today, there exists a complex of institutional mechanisms to address this problem – accounting procedures and an accounting profession, legal protections, extensive reporting and analysis of financial information. Since none of these existed before 1600, equity finance had to rely on a simpler mechanism: wind up the business periodically, and divide up the proceeds among the shareholders. This procedure was possible, because business was largely commercial and did not require any substantial investment in fixed capital.

A few months ago, I wrote a post on ultra-simplified finance which revolved around equity markets. To see how powerful equity markets can be even when there is almost nothing else by way of a financial system, one has three choices:

  1. read Kenneth Arrow’s classic paper (“The role of securities in the optimal allocation of risk-bearing”);
  2. go back in time to the pre-industrial era;
  3. take a trip to Somalia.

Posted at 13:30 on Thu, 03 Dec 2009     View/Post Comments (1)     permanent link

Wed, 02 Dec 2009

Payment and Settlement Systems

I wrote a column in today’s Financial Express about payment and settlement systems in India in the context of the vision statement released by the Reserve bank of India

RBI recently released a vision statement for the payment systems in India for the next three years. The mission is “to ensure that all the payment and settlement systems operating in the country are safe, secure, sound, efficient, accessible and authorised.”

It is true that the payment system in India has made considerable progress in the last few years with the emergence of Real Time Gross Settlement (RTGS) system, National Electronic Fund Transfer (NEFT) system, implementation of core banking software in most large banks and rapid spread of the ATM network. With these developments, India is gradually moving away from antiquated paper-based payments to a modern payment system. The progress is slower than one would like, but it is progress all the same.

However, the global financial crisis in 2007 and 2008 has changed the way we look at the safety and soundness of payment systems, and the RBI vision statement does not reflect these new concerns and priorities at all. In fact, the document is characterised by a pre-crisis world view that makes it largely complacent about settlement system risks.

The first lesson from the crisis is that any payment or settlement system that settles in commercial bank money is simply unacceptable as a ‘safe, secure and sound’ system. During the crisis, credit default swap spreads on some of the largest banks in the developed world as well as in India rose to levels indicating serious concerns about their solvency.

This immediately brings up the horror scenario of every payment or settlement system: pay-ins take place into the settlement banks of these systems just before the settlement bank fails. In other words, the settlement bank fails after receiving the pay-in but before making the pay-outs.

Since the major securities and derivative settlement systems in India settle in commercial bank money, this horror scenario should be giving sleepless nights to the securities regulator and to the central bank. Unfortunately, the vision statement does not betray any such concern.

I think urgent steps should be taken to allow major settlement agencies like the clearing corporations of the stock exchanges, derivative exchanges, commodity exchanges, the Clearing Corporation of India and similar entities to make settlements in central bank money. Whether this takes the form of giving them a limited banking licence or of opening up the RBI’s payment system to systemically important non-bank entities is a matter of detail that need not bother us here.

The point is that we do not have a true delivery-versus-payment (DVP) system unless the payment happens irrevocably in central bank money. Before the crisis, it was possible to pretend that large banks are safe enough to allow settlement to happen in their books. After the crisis, the regulators would be irresponsible and delusional to accept this idea.

An even bigger problem exists in the settlement of foreign currency transactions where time zone differences preclude any true payment-versus-payment (PVP) settlement of these transactions. Herstatt Risk has really not been solved several decades after Herstatt Bank in Germany failed after receiving payments in its currency but before making payments in foreign currency.

The international community has come up with the idea of having a private bank (CLS Bank) handle the global settlement of foreign currency trades. This avoids banks having to take exposure on each other, but requires them to take exposure on CLS Bank and sometimes on a participant bank that provides access to CLS Bank.

The thinking was that a settlement and custody bank like CLS Bank cannot fail, but this is a delusion. During the 2008 global crisis, questions were raised about some US banks that were largely settlement and custody banks rather than lending banks. Moreover, even settlement and custody banks can suffer from acute operational risk as was demonstrated in a famous episode two decades ago in the US. As a member of the G20, India has an opportunity to argue for putting foreign exchange settlement on a sounder footing.

Many alternatives can be thought of. First is that the IMF could take on the responsibility of running foreign currency settlement not only because it holds all the currencies of the world, but also because it enjoys multilateral guarantees that would make settlement in IMF books a true PVP. The second possibility is that the world’s major reserve currencies (and currencies of invoicing) can be persuaded to run a 24/7 RTGS that eliminates the time zone problem.

The third solution, closer in line with the post-crisis philosophy of each country taking responsibility for risks within its territory, is for RBI to run a US dollar RTGS in Mumbai by taking advantage of its huge dollar reserves. In short, a lot needs to happen before we can say that “all the payment and settlement systems operating in the country are safe, secure and sound.”

Posted at 11:05 on Wed, 02 Dec 2009     View/Post Comments (2)     permanent link

Fri, 27 Nov 2009

Dubai World brings Islamic finance down to earth

Back in 2007 and 2008, people were fond of arguing that the crisis was due to highly complex financial instruments and that if finance became boring, it would be a good thing. People even argued that Islamic finance would be a good idea.

This week Dubai put an end to this talk by making it clear that Dubai World would default on debt issued by its subsidiary Nakheel Development Limited. The debt falls due in the middle of December, but Dubai wants creditors to agree on a standstill till May while a restructuring is worked out.

The interesting thing is that the instrument in question is an Islamic bond – a Sukuk. The prospectus (available in the FT Alphaville Long Room) proudly refers to the “pronouncement dated 11 December 2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic Bank PJSC confirming that, in their view, the proposed issue of the Certificates and the related structure and mechanism described in the Transaction Documents are in compliance with Sharia principles.” (page 34)

Of course, one can argue that there is really nothing Islamic about modern Islamic bonds other than an opportunity for some religious scholars to earn a living by issuing pronouncements on Sharia compliance. But that itself is a warning that trying to legislate simplicity in finance is often futile.

Modern corporate finance teaches us that money is made and lost on the asset side of the balance sheet. To adapt a favourite statement of the Austrian economists, losses occur when wrong investment decisions are made. The defaults on the liabilities side of the balance sheet only serve to announce and crystallize this loss. Last month, I blogged about how bank losses from loans in the current crisis exceed losses on securities. The default on the Sukuk reinforces this idea that mis-allocation of capital produces losses regardless of the composition of the liability structure.

Posted at 11:19 on Fri, 27 Nov 2009     View/Post Comments (3)     permanent link

Tue, 17 Nov 2009

Bayesians in Finance

At the EconLog blog, Bryan Caplan asks why academic economists are not Bayesians. Caplan was talking about a Bayesian approach to the validity of economic theories. Stephen Gordon responded with a post about why economists do not use enough of Bayesian econometrics. Both questions are valid and should cause some introspection.

The issue is probably even more important in finance where key parameters are estimated with such large confidence intervals that the prior does not get washed out by the sample. In fact, I think that one of the defining characteristics of finance as a discipline is that first moments (for example, mean returns) are estimated very poorly even with extremely large samples while second moments (variances) are somewhat better estimated.

For example, Aswath Damodaran has an interesting paper last month discussing the difficulties of estimating the Equity Risk Premium reliably. Damodaran states bluntly that:

At the risk of sounding harsh, the risk premiums in academic surveys indicate how far removed most academics are from the real world of valuation and corporate finance and how much of their own thinking is framed by the historical risk premiums they were exposed to back when they were graduate students.

What Damodaran is really saying is that despite being exposed to recent academic research using centuries of global stock market data, the posterior distributions of most academics are still strongly influenced by the prior distributions formed during their student days. In such a situation, there is merit in making the prior distribution quite explicit rather than leaving it implicit.

Classical statistics also involves priors; the tragedy is that in that framework, there are only two kinds of priors:

  1. Dogmatic priors which totally ignore what the data says, and arbitrarily set some parameters to zero or some other special value.
  2. Diffuse (or improper) priors which impose no priors beliefs at all and leave everything to the data.

Bayesians can however use the more interesting priors which reflect non trivial prior beliefs that can be overruled by the data.

At a different level, I think it is also essential to incorporate Bayesian learning into theoretical models. Rational expectations models are richer when they recognize that even with large samples, posterior distributions could have large error variances.

Posted at 14:02 on Tue, 17 Nov 2009     View/Post Comments (0)     permanent link

Tue, 10 Nov 2009

Lehman, Reserve Primary or TARP?

In the popular imagination, the crisis in the global financial markets in the last quarter of 2008 is identified with the collapse of Lehman on September 15, 2008. However, many perceptive analysts believe that it was not the collapse of Lehman itself, but the resulting collapse on September 17 of the Reserve Primary Fund (a large money market mutual fund) that was the real culprit. Finally, some revisionists like John Taylor have argued that the panic started not with the Lehman collapse but with the mishandling of the TARP legislation later in September.

William Sterling has a nice paper analyzing this issue relying on a broad index of financial conditions covering money markets, bond markets and equity markets. Taylor’s use of measures related to Libor was controversial because at the time, people joked that Libor was the rate at which banks did not lend to each other. I like the more comprehensive measure chosen by Sterling.

Based on this index, all three views receive some support, but on balance Sterling rightly concludes that the revisionist case is quite weak. The financial conditions index fell 9.85 points when Lehman collapsed, and fell a further 10.37 points when the Reserve Primary Fund failed. If we regard these two as a single event, the fall in the index over the three days was 20.76 points. But the biggest single day fall was 11.77 points on the day that Congress rejected the first TARP bill. (The index is constructed as a Z-score so that each point change in the index can be regarded as one standard deviation move. Clearly, all three days are extreme tail events).

The most intriguing thing in the paper is the 12.68 point rise in the index on the day before a bailout plan for the money market mutual funds was announced. This is the largest one day change in the index in its entire history. It appears to me that this is indicative of insider trading on a truly massive scale. If this interpretation is correct, this insider trading would make Galleon look like small change.

Posted at 13:48 on Tue, 10 Nov 2009     View/Post Comments (0)     permanent link

Mon, 09 Nov 2009

SEC Division of Risk, Strategy, and Financial Innovation

Back in September, the SEC created a new division of Risk, Strategy, and Financial Innovation and appointed a well respected law professor, Henry T C Hu, to head it. Hu has been very active in writing about regulation and financial innovation. For example, twenty years ago he wrote a hundred page paper about the regulatory challenges of regulating the swap market arguing that the Basel framework would be ineffective in dealing with anything beyond the most plain vanilla swaps. He concluded that “the BIS Accord’s reliance on legalistic solutions – rigid, classification-based rules administered and maintained by government regulators – is reflective of a simpler, more static financial era. The process of financial innovation is now far too institutionalized and complex to be so confined. ”

Hu’s appointment was widely welcomed at the time, but it was clear that the success of the new division would depend on the people that Hu is able to hire. On this score, the news last week was good. The division announced three new hires with diverse backgrounds all relevant to the tasks that the division has to perform. The best known was Richard Bookstaber, the author of the excellent book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation” in which he describes his experience running firm-wide risk management at Salomon Brothers and at other firms.

Clearly, the division will soon have the talent and experience to perform its mandate: “identifying new developments and trends in financial markets and systemic risk; ... [and] making recommendations as to how these new developments and trends affect the Commission’s regulatory activities.” The open question is whether the rest of the SEC can be reformed adequately to take advantage of this.

Posted at 20:32 on Mon, 09 Nov 2009     View/Post Comments (0)     permanent link

Wed, 28 Oct 2009

Indian overnight interbank market in October 2008

The Reserve Bank of India’s Report on Trend and Progress of Banking in India 2008-09 has a series of charts (Chart VII.3 on page 250) comparing the volatility of the overnight interbank interest rate in India with that of several other (mature and emerging) economies.

India and Russia stand out in the charts for the ridiculously high volatility in October 2008. The inability to keep the overnight rate close to the policy rate in these two countries is so glaring that one is forced to conclude that central banking was virtually suspended in India and Russia for a few weeks in that period.

It is not that the mature economies were doing a great job of liquidity management in those days. Only in August 2008, Willem Buiter had gone to the Jackson Hole symposium to tell the assembled central bankers that “The deviations between the official policy rate and the overnight interbank rate that we observe for the Fed, the ECB and the Bank of England are the result of bizarre operating procedures ...” (Page 531). If the mild volatility in the US and Europe appeared bizarre to Buiter, I wonder what he would say if confronted with the Indian data.

Posted at 16:28 on Wed, 28 Oct 2009     View/Post Comments (1)     permanent link

Wed, 21 Oct 2009

Galleon Insider Trading Charges

The US Justice Department and the US SEC filed insider trading complaints against the billionaire Raj Rajaratnam, his Galleon hedge fund and several other friends and associates a few days ago. All the interesting stuff (for example, the transcripts of telephone conversations) are in the criminal complaints filed by the Justice Department. If one reads only the SEC complaint, one would not realize that there are several smoking guns here.

The fact that the whole thing was made possible by the FBI’s use of informants and wiretaps appears to provide some support for a controversial paper by Peter Henning posted at SSRN last month. In this paper, titled “Should the SEC spin off the enforcement division?,” Henning argued that “To allow the SEC to regulate Wall Street properly, splitting off at least a portion of the enforcement function to an agency with expertise in prosecutions – the United States Department of Justice – is at least worthy of consideration as the government looks to increase regulation.”

One reason why the Department of Justice had all the advantages here is that insider trading is very simple to understand. There is no need for a PhD in finance to recognize insider trading if the prosecutors have access to all the communications that are taking place. But absent such access, insider trading is notoriously difficult to prove. So here, wiretapping expertise beats finance expertise hollow.

At another level, it was interesting to find that with all the insider information that they had from multiple sources, the defendants lost money trading AMD shares prior to its announcement of the spin off of the fabrication facilities and a capital infusion by Abu Dhabi. The complaint attributes it to a general decline in stock prices due to the global financial crisis. The defendants bought AMD stock beginning August 15, 2008, the Lehman collapse occurred in mid September, the AMD announcement happened on October 7, 2008 and the defendants sold stocks around October 20, 2008.

But the global financial crisis is not the whole story as seen from the graph below. Even if the defendants had hedged their AMD long position with a short position in the Nasdaq Composite index, they would not have made money. Yes, AMD does outperform Intel over the period, but not by a huge amount.

AMD versus Nasdaq price graph

It appears from the graph that around the time that the defendants were buying AMD on inside information, many others were also buying. They could also have been buying on inside information or on pure rumours. The graph reminds me of the old adage: “buy the rumour, sell the fact.” It is also possible that the Abu Dhabi deal was not as attractive as people initially thought and the prices reacted to this reassessment. In other words, if Galleon had the advantage of superior information, other traders might have had the advantage of superior analysis. The complaint contains the transcript of a telephone conversation where two defendants agree on a division of labour: one of them is to collect the information and the other is to analyze it. The second person probably was not up to the task.

Posted at 16:45 on Wed, 21 Oct 2009     View/Post Comments (1)     permanent link

Tue, 20 Oct 2009

SEC response to Madoff failure

I have a column in the Financial Express yesterday about the SEC response to its failure to detect the Madoff fraud and what this means for other securities regulators worldwide. Some of my related blog posts can be found here, here and here.

After its dismal failure to detect the Madoff fraud despite plenty of warnings, the US SEC conducted a review by its own Inspector General of what went wrong. This report published in August was uninteresting as it explained it all away as incompetence and inexperience of the staff concerned.

This explanation was not completely convincing given the detailed information that people like Markopolos provided to the SEC over several years. In any case, there is little point in a 450 page report that reaches a conclusion that could be arrived at simply by applying Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity.”

At the end of September, however, the Inspector General released two more reports (totalling 130 pages) indicating that incompetence might not be the whole story. A survey carried out by the Inspector General found that 24 percent of the SEC enforcement staff felt that cases were improperly influenced or directed by management and 13% stated that they had observed lack of impartiality in performance of official duties.

In this article, however, I will focus on the Inspector General’s recommendations (which the SEC has already accepted) for improving the enforcement and inspections processes at the SEC. These recommendations represent very significant changes in the mindset of how to run these divisions not only at the SEC but at other regulators worldwide.

The report recommends that 50% of the staff and management associated with examination activities should have qualifications like the Certified Fraud Examiner and Certified in Financial Forensics. This recommendation is a sanitised version of what Markopolos recommended when he testified to the US Congress in February about the SEC failure to uncover Madoff despite his detailed complaints.

Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current SEC staffers. He also claimed that SEC staffers with credentials like CPA and CFA are not allowed to have their designations printed on their business cards presumably because if the SEC allowed its few credentialled staff to do so, it would expose the overall lack of talent within the SEC.

The Inspector General recommends that all examiners should have access to relevant industry publications and third-party database subscriptions sufficient to develop examination leads and stay current with industry trends. It also talks about establishing a system for searching and screening news articles and information from relevant industry sources for potential securities law violations.

This recommendation responds at least partially to Markopolos’s testimony that most of the time all the SEC uses is Google and Wikipedia because both are free and the SEC regional offices do not have access to industry publications and academic journals.

The SEC estimates that it would cost $300,000-$400,000 annually to provide data access in one room in each office; providing access to each examiner will cost a lot more. It also estimates that it would cost $3-4 million to implement the system for searching news reports and other media, but this appears to be a one time cost rather than an annual cost.

The Inspector General wants examiners to have direct access to the databases of the exchanges, depositories, clearing corporations and various self-regulatory organisations rather than having to get data from these agencies as and when required. This is a huge change of mindset because it blurs the distinction between the self-regulatory organisations as first line regulators and the SEC as the apex regulator. It moves the SEC into the regulatory frontline.

In line with this change, the SEC proposes to train its examiners in the mechanics of securities settlement (both in the US and in major foreign markets), in the trading databases maintained by the various exchanges as well as in the methods to access the expertise of foreign regulators, exchanges, and clearing/settlement agencies.

Turning to investigation, the Inspector General wants all investigation teams to have at least one individual on the team with specific and sufficient knowledge of the subject matter (like Ponzi schemes or options trading) as well as access to at least one additional individual who also has such expertise or knowledge.

During the last quarter century, many regulators elsewhere in the world have looked upon the SEC as the gold standard in securities regulation enforcement and have consciously or unconsciously fashioned themselves on the SEC.

The lesson from Madoff is that the role model should not be the SEC of recent decades but the SEC of the 1930s and 1940s under chairmen like Douglas who believed that the management of the SEC was a higher form of business management. Or perhaps, the role model should be the modern New York Attorney General’s Office.

For regulators who are far behind even the current SEC in terms of talent and resources, the SEC experience should be a wake-up call to put their houses in order.

Posted at 12:32 on Tue, 20 Oct 2009     View/Post Comments (1)     permanent link

Tue, 13 Oct 2009

Mumbai elections: Do machines need a holiday?

India’s national stock markets are closed today because of elections in Mumbai where the main exchanges are headquartered. It is true that Mumbai accounts for more than half of the trading in the pan India stock markets, but still the question does arise – do machines need a holiday on election day?

It is surely possible for the stock exchange servers to keep running so that the rest of India can trade. Alternatively, the lower trading volumes on a day on which Mumbai is closed provides a wonderful opportunity to test the exchanges’ business continuity plan by running the trading engine off the back up servers outside of Mumbai.

For a variety of legal reasons, it is desirable for the disaster recovery site of the exchanges to be located in a state different from the one where the main site is located. This would provide a safeguard against any one city or state imposing exorbitant taxes and other levies on what is really a national market.

It is interesting to note that when it comes to the payment system, the nearly universal global practice is to close the system only on days which are holidays for the entire country or region. In the Eurozone for example, the Target system closes only on days which are holidays in every participating country. The Indian RTGS also closes only on national holidays though the number of holidays is larger than that of Target.

Stock markets (and more importantly, their regulators) globally have been much more willing to close the markets. The worst manifestation of this was after 9/11 when the US stock market remained closed even after the US Treasury market re-opened though the loss of lives in the Treasury market was more severe (I had a post on this subject way back in 2005).

Posted at 12:42 on Tue, 13 Oct 2009     View/Post Comments (2)     permanent link

Thu, 08 Oct 2009

SEC formalizes bail out of fat fingers

Exchanges world wide have often bailed out fat fingered traders who punch in wrong buy or sell orders. I have blogged about this here, and also about a rare contrary example here and here. Such bail outs create a moral hazard problem because traders have insufficient incentives to install internal controls and processes to prevent erroneous orders.

Instead of stopping this practice, the SEC has now stepped in to formalize the moral hazard and has also set exceptionally low thresholds for such bail outs:

In general, the new rules allow an exchange to consider breaking a trade only if the price exceeds the consolidated last sale price by more than a specified percentage amount: 10% for stocks priced under $25; 5% for stocks priced between $25 and $50; and 3% for stocks priced over $50.

I believe this move by the SEC reflects regulatory capture: those who are harmed by trade cancellation are typically day traders and other small traders who have little voice in the regulatory system, while those benefited by the bail out tend to be large trading firms. (The very term day trading is always used pejoratively – when a large firm does it, the terminology changes to high frequency trading which suddenly sounds a lot more respectable).

Three years ago, I wrote: “Clearly exchanges can not be trusted with the discretion that is vested in them. The rule should be very simple. Traders should bear the responsibility (and the losses) of their erroneous trades.” I wonder now whether the regulators can be trusted with the discretion that is vested in them.

Posted at 09:37 on Thu, 08 Oct 2009     View/Post Comments (5)     permanent link

Sun, 04 Oct 2009

Bank Losses: Securities versus loans

I have been arguing for some time now (for example, here) that the financial crisis in the US is looking more and more like an old fashioned banking crisis rather than a problem in the securities markets. The IMF Global Financial Stability Report released earlier this week provides strong evidence for this.

Table 1.2 in Chapter 1 shows that out of the trillion dollar losses projected for US banks, 64% would come from loans and only 36% from securities. The losses on loans are estimated as 8.1% of the total loans held by the banks while the losses on securities are 8.2% of the securities holding. These practically identical loss rates demolish the idea that we would not have had a crisis if the US had boring banks which just took deposits and made loans.

For the world as a whole, the loss rate on securities (5.9%) is significantly higher than loans (4.7%). Despite that, 67% of the $2.8 trillion losses come from loans and only 33% from securities.

Posted at 13:56 on Sun, 04 Oct 2009     View/Post Comments (0)     permanent link

Tue, 22 Sep 2009

More on negative swap spreads

The universal feedback that I got on my last post on this subject was that it was very difficult to understand. So let me try again.

At the outset, let me state that in my view the negative swap spread is a result of market dislocation; I do not even for a moment believe that it is really a rational market outcome. Yet, some people are making the argument that the negative spread is rational and can be explained in terms of default risk. I am therefore, trying to analyze (and hopefully) disprove this claim; mere hand waving is not enough.

Specifically, the claim being made is that the fixed leg of the swap is less risky than the 30 year bond because there is no principal payment at the end. So I begin by making the extreme assumption that the 30 year bond can default, but all the promised payments in the swap will be paid/received without default even if the government and one or more Libor rated banks default.

My initial thinking was that:

  1. Libor is the floating rate at which a Libor rated bank can borrow
  2. The swap rate must be the fixed rate at which such a bank can borrow
  3. The 30 year bond yield is the fixed rate at which the US can borrow
  4. The T-bill yield must be the floating rate at which the US can borrow

If all this is true, then by assuming that the T-bill yield is always less than Libor, it would appear to follow that the bond yield must be less than the swap rate.

Unfortunately, this simple minded analysis is inadequate because it assumes that interest rate risk and default risk can be nicely separated from each other and do not interact. The interest rate risk is reflected in the spread between Libor and the swap rate (a rising yield curve) and also in the spread between T-bills and the long bond (again, a rising yield curve). The default risk is reflected in the spread between T-bills and Libor and also the spread between the long bond yield and the swap rate. The world would be so simple if these two risks were orthogonal to each other and did not come together in crazy ways.

To understand this interaction, suppose that on the date of default somebody makes good the default loss to us by paying us the difference the par value of the bond and its recovery value. The default loss is therefore eliminated. Does this mean that there is no loss at all due to default? No, we are now left with the par value of the bond in our hands, but that is not the same thing as receiving the remaining coupons and redemption value of the bond. If we try to invest the par value of the bond, we may not be able to earn the old coupon rate if interest rates have fallen.

A default in a low interest rate scenario is in some ways similar to a bond being called. In fact, a default with 100% recovery is completely identical to a call. Conversely, a default in a high interest rate environment has some similarities to a put; and the similarity becomes an equality if recovery is 100%. Therefore, in addition to the default risk, we need to consider the value of the implicit call or put that takes place when the bond defaults.

The situation that I envisaged in my previous post was that if the US government defaults only in a low interest rate environment, its yield must include a premium not only for default losses but also a premium for its implicit callability. The swap rate will be the yield on a non callable bond, because the swap continues even if one or more Libor rated banks default. I am assuming that the risk of the swap counterparty defaulting is taken care of by sufficient collateral. If the yield sweetener required for the implicit callability of the US Treasury outweighs the extra default premium (the TED spread) embedded in Libor, it is possible for the Treasury yield to exceed the swap rate. I emphasize that I do not consider this likely, but it is a theoretical possibility.

To demonstrate this theoretical possibility, I now present an admittedly unrealistic numerical example where this happens. I assume a default risk on US Treasury of about 15 basis points annually while Libor contains 30 basis points of default risk embedded in it. From a pure credit risk point of view, the Libor rated bank is riskier than the US, but in my extremely artificial model, the 30 year swap rate is only 4.06% while the 30 year US Treasury yield is 4.27% (roughly similar to early September numbers). This happens because in this toy model, Treasury default is perfectly correlated with interest rates and amounts to callability of the bond. In this model, the yield on a hypothetical default free 30 year non callable bond is only 3.76% while the yield on a default free 30 year bond callable after 10 years is 4.08%. This means that the hypothetical default free callable yields more than the defaultable non callable swap. The defaultable Treasury has to yield more than the default free 30 year callable to compensate for default risk.

The precise model that yields the above numbers is as follows. The US Treasury defaults with 10% probability exactly at the end of 10 years with a recovery of 55%. This corresponds to an expected default loss of 4.5% or 15 basis points annualized over the 30 year life of the bond (in present value terms, the annualized default loss is obviously slightly different). The default free term structure over the first 10 years is roughly similar to the actual US Treasury yield curve in early September. The only two numbers we need are the 10 year zero yield (3.59%) and the 10 year par bond yield (3.45%).

At the end of 10 years, there are two possibilities:

  1. The US government defaults and the risk free rate remains constant at 0% (zero) over the next 20 years. The probability of this is 10%.
  2. The US government does not default and the risk free rate remains constant at 4.75% over the next 20 years. The probability of this is 90%.

Note for the finance experts: all probabilities above are risk neutral probabilities.

In this model default is perfectly correlated with interest rates and a defaultable bond with 100% recovery would be the same as a default free callable bond. This allows us to decompose the 51 basis point spread (4.27% – 3.76%) of the US bond over a default free non callable into two components: a callability component of 32 basis points (4.08% – 3.76%) and a default loss component of 19 basis points (4.27% – 4.08%). The swap is non callable and its entire spread over the default free non callable bond of 30 basis points (4.06% – 3.76%) is due to default risk. This default loss spread is 11 basis points more than that embedded in US Treasury indicating that it has higher default risk. This 11 basis points can be interpreted as the average implied TED spread over the entire period.

While this example is theoretically possible it is clearly unrealistic. The purpose of my previous post was to prove that under realistic assumptions, it is not possible for the US Treasury yield to exceed the swap rate even if we assume that the swap payments will continue without default even after Treasury has defaulted. But that argument is necessarily abstract and complex.

Posted at 20:59 on Tue, 22 Sep 2009     View/Post Comments (0)     permanent link

Wed, 16 Sep 2009

Negative swap spread

The fact that the 30 year US dollar swap rate is lower than the interest rate on the 30 year US treasury bond was till recently something that only fixed income specialists worried about. Sure, the Across the Curve blog has been putting NEGATIVE in capital letters in each of his daily blog posts on the swap spread for several months now, but the mainstream financial media did not bother much about it. Last week, however,the Financial Times carried a detailed story ("Negative 30-year rate swap spread linger," September 9, 2009) on the subject.

Under the current view that financial markets have normalized, the negative swap spread is an embarrassment because it suggests that even a year after Lehman, simple arbitrage trades are not happening because of a paucity of the balance sheets required to put on the trades. Alternative explanations are being sought for the phenomenon, and the report states that “questions are being asked in the market about the assumption governing whether a 30-year swap is riskier than a 30-year bond.”

In this post (necessarily long and highly technical), I shall try to examine this question. I shall initially assume that the interest rate swaps have no counterparty risk because of high degree of collaterilization. This is very different from asserting that the swap rate is a risk free rate.

I shall assume that the Libor rate on the floating leg of the interest rate swap is a rate that includes a default risk component. I shall also assume that the default risk inherent in Libor is greater than that of US Treasury. More precisely, I shall assume that the TED spread (the excess of Libor over the T-Bill yield at the same maturity) is expected to remain positive. I shall also assume that the positive TED spread reflects the greater credit risk of Libor as compared to the T-Bill. Before the crisis, it was fashionable in the CDS market to assume that Libor and swap rates were risk free rates and the TED spread was due to liquidity and tax effects. I believe that this claim is untenable today.

Since banks are afloat today with huge government support, I think it is reasonable to assume that the government is more credit worthy than the banks. But I do not assume that the US government is risk free either. It too can default, but the probability of this default is lower than that of the banks.

Libor is the borrowing rate of a bank with what is often called a “refreshed Libor rating.” On every day that Libor is polled, only a sample of “sound” banks is considered. Therefore, the default risk inherent in three-month Libor is that of a bank defaulting in the next three months given that it meets the Libor creditworthiness standard today. Libor exceeds a hypothetical three month risk free rate by a compensation for this possibility of default.

Assuming that the interest rate swap itself has no default risk, the fixed rate payer should be willing to pay a fixed rate that exceeds the risk free rate because what he receives on the floating leg is higher than the risk free rate. He should also be willing to pay more than he would on a swap in which the floating leg was the US T-bill yield instead of Libor because I am assuming that the TED spread (T-bill yield minus Libor) is expected to be positive. The T-Bill yield itself exceeds a hypothetical risk free rate because of the the possibility of default by the US government.

Unfortunately, even from all these assumptions, it does not follow that the 30 year UST yield should be less than the 30 year swap rate without some further assumptions that we will come to at the end. The problem is that the interest rate swap is not terminated by the default by one or more of the Libor rated banks or by the default of the US government. Several banks may fail and Libor may still be computed the next day based on the few banks that remain. The floating rate payer on the swap would have to make floating leg payments at this Libor rate, and the fixed rate payer would have to make fixed leg payments at the fixed rate.

The holder of the 30 year bond however will not continue to receive coupons if the US government has defaulted. To eliminate the default risk of the US Treasury, we must consider a hypothetical asset swap on the 30 year bond. Consider an asset swap in which (a) the owner of a newly minted bond sells it to an asset swap buyer at par, (b) the buyer agrees to make fixed rate payments at the coupon rate of the bond, and (c) the seller agrees to make a floating rate payment at Libor +/- a spread.

Assuming that the asset swap is risk free, the asset swap seller now has a risk free stream of payments equal to the coupon of the 30 year UST bond. If it were true that the floating leg payment would be equal to the T-bill yield, then we can immediately conclude that the 30 year bond must yield less than the fixed rate of the 30 year interest rate swap. If not an arbitrageur would enter into an asset swap as a seller and simultaneously enter into an interest rate swap as a fixed rate payer. It would be left with two sources of profit from these two swaps:

  1. the fixed rate it receives on the asset swap would exceed the fixed rate that it pays on the interest rate swap because the 30 year bond yields more than the swap rate
  2. the floating rate it pays on the asset swap (T-bill yield) would be less than what it pays in the interest rate swap (Libor) because the TED spread is expected to be positive.

If US Treasury were risk free, it is evident that the floating leg would be equal to the T-Bill yield. We just add a notional exchange of principal at the end (which simply cancels out). The fixed leg must be worth par because it is economically the same as the newly minted 30 year Treasury (par) bond. Therefore the floating leg payment including the notional payment must also be worth par, but this “floating rate bond” can be worth par only if the floating rate is the risk free rate which is the T-Bill yield.

This equivalence breaks down when US Treasury can default. To understand this consider a modified asset swap which terminates without any termination payments if and when US government defaults. In this case, it is easy to see that the modified asset swap floating leg must equal the T-Bill yield. The case where the US government does not default has already been analyzed above, so consider what happens if there is a default.

In this case, we add a notional exchange between the swap buyer and the swap seller not of the principal value of the bond but of the recovery value of the defaulted bond. With this notional payment included, the fixed leg again is the same as the US treasury bond. It must therefore be worth par because the Treasury bond is a par bond. The floating leg must therefore also be worth par which means that it (including the notional payment at default of the recovery value) must be a par floater. But the T-Bill yield is precisely the yield on a par floater of the US government.

With this understanding in place, let us now return to the only possible explanation for the swap rate being less than the UST rate in a perfect market – the asset swap floating leg must exceed Libor (or the asset swap spread must be positive). In this case, in a perfect market the fixed leg (which is the UST bond yield) must also exceed the swap rate – the asset swap seller receives a larger fixed leg than in an interest rate swap but also pays a higher floating rate.

So the position is that for the current interest rates to be consistent with a perfect market, the asset swap spread should be positive while we know that the modified asset swap spread (the one that terminates on default by the US government) is the negative of the TED spread and is therefore expected to be negative. The difference between the asset swap and the modified asset swap is that after default by the US government, the modified swap terminates while the ordinary asset swap subsists.

Everything now depends on what Libor is likely to be after the default by the US government. If Libor is expected to be high, the asset swap seller would have to make large floating rate payments in return for the fixed rate payment from the asset swap buyer. The subsisting swap would therefore be a liability to the asset swap seller and he would therefore insist on paying a lower (more negative) spread in the asset swap than in the modified asset swap where this liability would not exist. This would imply that the asset swap floating leg would be even lower than the T-Bill yield and therefore much lower than Libor. The 30 year UST yield must therefore be less than the swap rate.

For the 30 year US yield to be higher than the swap rate in a perfect market therefore the asset swap must be beneficial to the asset swap seller after the default by the US government. This can happen only if interest rates are very low after default. I do not find this very plausible. I would expect sovereigns to default on local currency debt after inflation has been tried and found to be wanting. With double digit inflation, one would imagine Libor also to be in double digits and the asset swap would be a huge liability to the asset swap seller who would be receiving something like 4.5% fixed. Considering this liability, the asset swap spread should be less than the T-bill yield which in turn is less than Libor.

Thus it appears to me that a 30 year swap rate less than the 30 year UST yield is consistent with perfect markets only if we are willing to make either of the two assumptions:

  1. The TED spread is expected to be negative implying that banks are safer than the US government; or
  2. A potential default by the US government would happen in an environment of very low rates where Libor would be very low.

I find both these assumptions implausible and would believe that the phenomenon that we are seeing in 30 year swaps is due to the limits to arbitrage arising from inadequate capital and leverage.

One final question that might trouble the reader is the assumption that there is no counterparty risk in the swaps even when the sovereign itself has defaulted. Actually, if we simply assume that all the swaps terminate on default by the US government, the above arguments still go through. The fixed rate payer in the interest rate swap makes money before the default. If at this point, he is allowed to pack up his bags and go home, that is fine in this model.

This has been a difficult piece of analysis for me and I would welcome comments, suggestions and corrections.

Posted at 16:30 on Wed, 16 Sep 2009     View/Post Comments (5)     permanent link

Tue, 15 Sep 2009

Lehman Anniversary

I have a column in the Financial Express today on the anniversary of the Lehman failure.

As we examine what we have learnt in the year since the collapse of Lehman Brothers, the most important lesson for Indian policymakers is that for macro risk management purposes, India must now be regarded as having an open capital account.

From a micro-economic perspective, India has a plethora of exchange controls that often force businesses to go through several contortions to perform what would be very simple tasks in a completely open capital account. But from a macro perspective, these regulations only serve to impose some transaction costs and frictions in the process. Exchange controls have ceased to be a barrier – they are only a nuisance.

Large capital inflows and outflows do take place through three important channels which are not subject to meaningful cap – inward portfolio flows, outward foreign direct investment and external commercial borrowing. In addition, foreign branches of Indian banks and foreign affiliates of Indian companies have relatively unrestricted access to global markets. Through all these channels, Indian entities can build up large currency, liquidity and maturity mismatches in foreign currency.

Each one of these global linkages was well known to perceptive observers for a long time, but it took the Lehman collapse to demonstrate the strength of these linkages taken together. Policy makers were taken by surprise at the ferocity with which the storm in global financial markets hit Indian markets.

We must now wake up to the reality that as in the case of East Asia in 1997, the power of the corporate lobby has ensured that capital controls have disappeared in substance while remaining deeply entrenched in form. I believe that in India today, there are only three effective capital controls that have macro consequences.

First, Indian resident individuals cannot easily borrow from abroad. This ensured that Indian households did not have home loans in Swiss francs and Japanese yen unlike several countries in Eastern Europe. In India, the corporate sector has had the monopoly of speculating on the currency carry trade. From a socio-political perspective, this mitigated the impact of the crisis, though it is doubtful whether the macro-economic consequences were important.

Second, Indian companies cannot borrow in rupees from foreigners as easily as they can borrow in foreign currency. This contributed to large corporate currency mismatches which were a huge source of vulnerability during the Lehman crisis.

Third, it is difficult for foreigners to borrow rupees and therefore speculation against the rupee is more effectively carried out by Indians than by foreigners. Currency speculation by foreigners typically takes the form of portfolio inflows and outflows. This has potential macro prudential consequences, but it was not a material factor in the Lehman episode.

This, therefore, is the first lesson from Lehman – Indian regulators should now think of India as having an open capital account while framing macro risk management policies.

The second lesson is that, as Mervyn King put it, global financial institutions are global in their life, but national in their death. Each nation has to take steps to ensure that failure of foreign institutions does not disrupt its domestic markets.

The collapse or near collapse of several large US securities firms did not pose any threat to the solvency of Indian equity markets because of the margin requirements that we impose on FIIs. Under the doctrine that each country buries its own dead, foreign creditors of a bankrupt FII can lay claim to this collateral lying in India only if there is something left over after the claims of Indian stock exchanges and other Indian entities have been satisfied.

In this context, the existence of a large over the counter (OTC) derivative market in India where foreign banks trade without posting margins is a huge systemic risk. Lehman was a bit player in the interest rate swap and other OTC markets in India. As such, its collapse did not create a major disturbance. However, the failure of a large foreign bank which is very active in the OTC market would be very serious indeed.

It is absolutely imperative to move the OTC markets to centralised clearing to eliminate this source of systemic risk.

The final lesson from Lehman is that the idea that emerging markets are somehow very different from mature markets has been rudely shaken. The most mature economies of the world have had an “emerging market style” financial crisis. In the past, the US did not think that it had anything to learn from crises in emerging markets, and was therefore completely unprepared for what happened after Lehman. In retrospect, the US belief in its own exceptionalism was a colossal mistake.

India must also abandon any belief we might have in our exceptionalism and learn from the experiences of other countries so that we do not have to learn the same lessons at first hand.

Posted at 07:30 on Tue, 15 Sep 2009     View/Post Comments (4)     permanent link

Sun, 06 Sep 2009

Madoff and Renaissance Technologies

A short while back, I blogged about the OIG report on the SEC investigation of Madoff. One of the interesting nuggets in this report is about how the leading hedge fund, Renaissance Technologies, analysed and dealt with their Madoff exposure way back in 2003. It struck me as a good example of prudent risk management.

The first internal RenTec email about its Madoff exposure contains a brief description of the red flags, but what interests me is the risk analysis:

Committee members,
We at Meritage are concerned about our [Madoff] investment. ...

... you have the risk of some nasty allegations, the freezing of accounts, etc. To put things in perspective, if [Madoff] went to zero it would take out 80% of this year’s profits.

Sure it’s the best risk-adjusted fund in the portfolio, but on an absolute return basis it’s not that compelling (12.16% average return over [the] last three years). If one assumes that there’s more risk than the standard deviation would indicate, the investment loses it[]s luster in a hurry. It’s high season on money managers, and Madoff’s head would look pretty good above Elliot Spitzer’s mantle. I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk-reward on this bet is not in our favor.

In one short email, you have several lessons in risk analysis:

What is interesting is that this email led to a flurry of emails analysing the red flags in Madoff at great length, collecting data from published sources and from conversations with market participants. At the end of it all, there was disagreement about the course of action between those who wanted to exit the position completely and those who drew comfort from the fact that Madoff had survived an SEC investigation. Finally, they decided to reduce the exposure by 50% (perhaps as a hedge fund they had the risk appetite to lose 40% of profits in a worst case scenario, when the investment looked attractive otherwise).

What is also interesting is that these smart hedge fund managers thought that the one regulator who was likely to catch Madoff was the New York Attorney General, Spitzer. Markopolos also thought that the New York Attorney General was the best financial regulator in the country (see my blog post here).

Of course, the RenTec people come across as having a self confidence bordering on hubris. At one point, they analysed Madoff’s stock trading and determined that “the prices were just too good from any mode of execution that we were aware of that was legitimate. ... And we would have loved to figure out how he did it so we could do it ourselves. And so that was very suspicious.” They finally decided that Madoff could not be doing what they were not able to do themselves: “Well, I knew it wasn’t possible because of what we do.”

I can quite imagine the RenTec people thinking that there was no way Madoff with his AS400 could do what RenTec could not do with the 60th largest supercomputer in the world.

Yet, there is no reason we should not learn from a bunch of arrogant people.

As an aside, I thought that the internal RenTec emails were the best leads that the SEC got. These were not complaints and were not even intended to be read by SEC – they just got picked up during an SEC examination of RenTec. There was clearly no motive, no hidden agenda. The SEC was peering into the unedited thinking of some of the smartest hedge fund managers in the world.

As another aside, the very fact that these internal emails got picked up as a lead for investigation of another entity conflicts with the idea that the SEC is so badly incompetent. My Hanlon’s Razor is taking some dents.

Posted at 17:42 on Sun, 06 Sep 2009     View/Post Comments (1)     permanent link

The SEC Madoff Investigation Report

Ever since the Markopolos documents became public, we have known that the SEC bungled its investigation of Madoff very badly (see my blog posts here and here). So when the SEC asked its Office of Investigations to investigate the SEC’s failure, there was only one question to answer – was it incompetence or was it something worse? We now have a 450 page report (with only minor portions redacted) describing how the SEC dealt with various complaints against the SEC.

In my first blog post last year, I wrote that:

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.

By and large, the investigation report tells the same story. But I think the report pushes the incompetence story a bit too much to the point where it almost reads like a whitewash job. I counted the term “inexperienced” or “lack of experience” being used 25 times in the report and that count excludes several other similar phrases. When an investigator is a good attorney, the report complains that the person had no trading experience; when the person had trading experience, it complains about his lack of investigative experience.

I am a firm believer in Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity,” but the report’s furious attempt to document incompetence makes one wonder whether it is trying to cover up something worse than incompetence.

At several points in the last few years, the SEC staff appear to have been tantalizingly close to uncovering the fraud. They knew that Madoff was lying to them repeatedly, but their seniors seemed to be unwilling to let them go where the facts seemed to point them. On all occasions, the staff seem to have been intimidated by Madoff’s standing in the industry and within the SEC itself. Repeatedly, the senior staff in the SEC seemed to turn any complaint about Madoff into one on front running even when the complaint was not about front running or explicitly stated that front running was unlikely. Of course, front running was the one crime that Madoff was not guilty of!

The report gives a completely clean chit to the SEC where it really matters:

The OIG did not find that the failure of the SEC to uncover Madoff’s Ponzi scheme was related to the misconduct of a particular individual or individuals, and found no inappropriate influence from senior-level officials. We also did not find that any improper professional, social or financial relationship on the part of any former or current SEC employee impacted the examinations or investigations.

Rather, there were systematic breakdowns in the manner in which the SEC conducted its examinations and investigations ...

While Sandeep Parekh states that he is “impressed that such a self critical report was put up on the main page of the SEC’s website,” the SEC OIG report appears to me to be a report of self exoneration.

My adherence to Hanlon’s Razor remains unchanged, but this adherence is in spite of the OIG report and not because of it.

Posted at 16:22 on Sun, 06 Sep 2009     View/Post Comments (0)     permanent link

Thu, 03 Sep 2009

Corporate OTC derivatives

Last month the Association of Corporate Treasurers put out a document explaining why companies must be exempted from all the reforms being proposed for OTC derivatives. This “international body for finance professionals working in treasury, risk and corporate finance” does not want the corporate use of OTC derivatives to be subject to central counterparties, collateralization, and exchange trading.

The main argument that they give is that while the OTC derivatives reform proposals are motivated by systemic risk concerns, the corporate use of OTC derivatives is not a systemic risk:

The risk to the system as a whole from failure of a commercial customer of a bank is unlikely to be material. ...

Importantly, non-financial companies generally deal in large but not systemically significant amounts. ...

It is unlikely that a non-financial services sector company using derivatives for hedging will itself represent a systemic risk to the financial services sector.

I am amazed that the Association of Corporate Treasurers could make such claims when the fact is that the last couple of years have seen a corporate derivatives disaster on a scale that has been systemically important enough to require government bail outs.

Korea is a good example of a country where derivative losses on KIKO (Knock In Knock Out) foreign exchange options in the small and medium enterprises were so large that the government had to step in to provide liquidity support and credit guarantees on a large scale to the sector. In Brazil and Mexico, the central bank conducted foreign exchange interventions that were designed to bail out the companies that had suffered huge losses in foreign exchange derivatives.

The June issue of Finance and Development published by the IMF provides quick summaries of what happened in Asia (China, India, Indonesia, Japan, Korea, Malaysia, and Sri Lanka) and Latin America (Brazil and Mexico). These reports indicate that “An estimated 50,000 firms in the emerging market world have been affected.”

Though the losses were large ($28 billion in Brazil alone) and systemically important, they came at a time when the financial sector was losing money in trillions, and inevitably less attention was paid to those who were content to lose money by the billion.

The Association of Corporate Treasurers is particularly horrified that a company doing a derivative deal should put up collateral:

In attempting to remove the credit risk between company and bank which is not systemically significant, a serious liquidity risk for the firm would introduced instead. ...

... if a company has to put up cash collateral it turns its hedge transaction into an immediate cashflow which will not match the timing of the counterbalancing commercial cashflow being hedged – perhaps by many years. This introduces a serious cashflow problem, potentially nullifying much of the benefit of the hedge.

What I have observed is that the discipline induced by mark to market is extremely valuable in risk management. Among the rules of thumb that I like to apply to corporate risk management are the requirements that: (a) the derivative position must be acceptable if held to maturity even if the intention is to unwind the position within a short period, and (b) the mark to market losses must be acceptable even if the position is intended to be held to maturity. These two symmetric rules rule out a whole lot of speculative positions.

Finally, when the Association of Corporate Treasurers talks of liquidity risk, it must be remembered that the relevant liquidity risk is a tail risk. The day to day volatility of mark to market cash flows does not produce a significant risk to the company – this is a liquidity nuisance and not a liquidity risk. The real risk is when the mark to market losses are large enough to threaten financial distress.

Under such conditions, the uncollateralized OTC derivatives impose equally severe liquidity risk because (a) the OTC derivatives may provide for margins to be deposited in these extreme cases, and (b) other lenders (including trade creditors) start refusing to roll over their debt. Cases like Ashanti Goldfields highlight the liquidity risk of OTC derivatives to the company.

Posted at 14:11 on Thu, 03 Sep 2009     View/Post Comments (0)     permanent link

Tue, 01 Sep 2009

In praise of noise

Lord Turner, the head of the UK FSA has gone on record in support of the Tobin Tax as part of the regulatory response to the global financial crisis. I think this idea is completely mistaken.

Short term “noise” traders played no role in the crisis. On the contrary, one could argue that the lack of noise traders in key asset classes like real estate and some pegged currencies contributed to the crisis. The “great moderation” was characterized by low volatility which lulled everybody into complacency. The excess volatility that noise traders are usually accused of generating would actually have been a good thing during the great moderation. The crisis was caused not by volatility but by tail risk and attempts to reduce volatility usually increase tail risk.

Rather than a Tobin tax, perhaps we should consider a Tobin subsidy in asset classes like real estate where there are too few noise traders. For example, anybody who sells a house within a month of buying it could get a refund of stamp duties and other taxes paid when the house was bought. In other words, the optimal rate for financial stability purposes of the Tobin tax is inversely related to the volatility of the asset class and is probably negative for many of the asset classes that were affected by the global financial crisis.

If we want to use fiscal policy to promote financial stability, I think an MM tax (more precisely, the complete or partial withdrawal of the MM subsidy) on leverage would be a much better idea. The MM (Modigliani-Miller) analysis shows that a key reason for leverage is the tax advantage arising from the tax deductibility of the interest paid on debt. If we impose an MM tax, then debt would be used mainly for its governance advantages (Jensen-Meckling). A huge deleveraging of the financial sector would become regulatorily feasible and that would be a good thing.

Posted at 15:34 on Tue, 01 Sep 2009     View/Post Comments (0)     permanent link

Fri, 28 Aug 2009

Credit card frauds

One of the world’s foremost experts on computer security, Bruce Schneier, writes on his blog about the recent theft of 130 million credit card numbers:

Yes, it’s a lot, but that’s the sort of quantities credit card numbers come in. They come by the millions, in large database files. Even if you only want ten, you have to steal millions. I’m sure every one of us has a credit card in our wallet whose number has been stolen. It’ll probably never be used for fraudulent purposes, but it’s in some stolen database somewhere.

Years ago, when giving advice on how to avoid identity theft, I would tell people to shred their trash. Today, that advice is completely obsolete. No one steals credit card numbers one by one out of the trash when they can be stolen by the millions from merchant databases.

I had read in the past about online thieves selling credit card data for a few cents per thousand cards, but I did not realize that things were so bad.

What is also interesting is that you do not need to use credit cards in online transactions, or in some fraud prone South East Asian country for your card number to land up in a stolen database. The number gets stolen from large retail chains in the best of countries.

Of course, Schneier is talking only about credit card numbers, so with the increasing use of two factor authentication, it may take something more to actually use the card, but that something more is often surprising little.

Posted at 11:54 on Fri, 28 Aug 2009     View/Post Comments (1)     permanent link

Thu, 27 Aug 2009

Basel Committee captured

The extent to which the Basel Committee on Banking Supervision has been captured by the banking industry that it regulates is clear from Guiding principles for the replacement of IAS 39 that it released today:

The new two-category approach for financial instruments should not result in an expansion of fair value accounting, in particular through profit and loss for institutions involved in credit intermediation. For example, lending instruments, including loans, should not end up in the fair value category.

There should be a strong overlay reflecting the entity’s underlying business model as adopted by the Board of Directors and senior management, consistent with the entity’s documented risk management strategy and its practices, while considering the characteristics of the instruments.

The new standard should ... permit reclassifications from the fair value to the amortised cost category; this should be allowed in rare circumstances following the occurrence of events having clearly led to a change in the business model

The IASB should carefully consider financial stability when adopting the timing of the implementation of the final standard.

The new standard should provide for valuation adjustments to avoid misstatement of both initial and subsequent profit or loss recognition when there is significant valuation uncertainty.

The new standard should utilise approaches that draw from relevant information in banks’ internal risk management and capital adequacy systems when possible (eg approaches that build upon or are otherwise consistent with loss estimation processes related to bank internal credit grades may be useful).

Is Basel saying for example that all through this crisis they have been quite happy with the robustness of “the underlying business model as adopted by the Board of Directors and senior management” of the banks as well their “documented risk management strategy and ... practices”?

Posted at 20:58 on Thu, 27 Aug 2009     View/Post Comments (0)     permanent link

Wed, 26 Aug 2009

Change of address fraud

Floyd Norris points to a FINRA press release about a eight year long fraud at a Citigroup brokerage office in California.

The $850,000 fraud was carried out by a sales assistant, which as Norris points out, is about as low as you can be in a brokerage office. The critical element in the fraud as detailed in the press release was to change the address of the customer (using falsified documents) so that account statements showing the unauthorized withdrawals do not reach the customer. Of course, she was also smart enough to chose customers who were unlikely to monitor their accounts regularly and notice the absence of periodic account statements.

There is one thing here that I do not understand. The best practice in the financial industry while recording a change of address is to send a confirmation of the change to the old address. I am fond of saying that responding to a change of address request with a confirmation letter to the new address is a matter of courtesy, and nothing will happen if this confirmation does not go out. But sending a confirmation to the old address is an elementary fraud precaution and under no circumstances should this fail to happen. It is the last opportunity to the customer to stop the fraud.

So did Citigroup not have a process for ensuring this standard fraud control process? Or is sending a confirmation to the old address not as well understood and practiced in the industry as it should be?

Posted at 15:28 on Wed, 26 Aug 2009     View/Post Comments (0)     permanent link

Sat, 22 Aug 2009

Winding up Lehman Europe

While much has been made about the difficulty of winding up large and complex financial institutions, it appears that it is the simplest of structures that are the hardest to wind up. Giving some of one’s things to another for temporary safe keeping on “trust” is probably older than lending money (debt markets) or selling equity interests in assets (stock markets) – it is probably older than money itself. Yet it is the simple trust structure that is proving so difficult with Lehman Brothers International Europe (LBIE) in London.

The UK High Court has ruled that the normal scheme of arrangements in bankruptcy do not apply to trust property:

51. On analysis Part 26 is concerned with the general estate of a company. It cannot override ordinary trust principles. In the case of creditors, whether actual, prospective or contingent, it deals with persons who have claims which they can bring against the pool of assets which comprises the general estate of the company. A creditor’s claim ranks pari passu with other creditors’ claims against that general estate. It is perfectly comprehensible, therefore, that Part 26 should provide that if those creditors wish to rearrange or compromise their rights against the company, they should be able to do so, by the requisite majorities, because, at the end of the day, they all look to the company’s assets for satisfaction of their pecuniary rights.

52. By contrast with that is the person who has placed his assets with a trustee. There the position is totally different: the essential feature of so doing is that the owner knows that he can have his property, which remains his throughout, dealt with by the trustee in accordance with the terms of the trust. The property is not vulnerable to interference merely because the trustee becomes insolvent: the trust remains. The fact that the trustee is a corporate trustee is likewise immaterial to the integrity of the trust; no less immaterial is that the trustee happens to be a company liable to be wound up under the Insolvency Act 1986 (or the equivalent provision in Northern Ireland), these being the types of company to which the court’s jurisdiction under Part 26 applies where a compromise or arrangement is proposed between a company and its creditors or any class of them: see section 895(2)(b).

53. The fact that the proposed scheme is confined to persons who have a pecuniary claim, however prospective or contingent that claim may be (for example a claim for damages or compensation for the delay in returning that person’s property), does not assist the administrators. While the existence of that claim may provide the basis for a scheme of arrangement directed to that and other pecuniary claims against LBIE, it does not justify interference with the underlying property rights of the property owner. Aside from the fact that the property owner’s remedy (as beneficiary under the trust) for breach of trust is principally directed to securing performance of the trust, rather than to the recovery of compensation or damages, the existence of the pecuniary claims does not affect, and is certainly not the origin of, the owner’s property rights. To suggest otherwise and to ground the intention of the scheme to interfere with the owner’s property rights merely because that owner also has a pecuniary claim against LBIE in view of the possibility that LBIE has acted (or may yet act) in breach of trust is to invert the position. Indeed, the scheme, if it is allowed to proceed, risks turning the position of the beneficial owner on its head: this is because under a trust it is for the trustee to justify and account for his dealings with the trust estate whereas under the scheme the onus will be on the owner to come forward, as a dissentient, to explain and justify why that owner’s property rights should not be dealt with and varied under the scheme.

What I found most amusing was the idea that when a hedge fund gives collateral to a prime broker with unlimited right to rehypothecate, “the owner knows that he can have his property, which remains his throughout.” But then I am not a lawyer.

The court of course thinks that the absence of a scheme of arrangement does not matter. The court has enough powers to sort things out. By that argument, one does not need a scheme of arrangement for creditors either – the courts can sort that out too.

77. Establishing what client assets of any given client LBIE holds or controls, what competing claims there may be to those assets by other clients or by LBIE (or others) and how LBIE and the administrators are to discharge their duties in respect of those assets with a view to their due distribution to those entitled to them are all matters where the court has, in the exercise of its trust jurisdiction, well-developed processes to assist the accountable trustee or other fiduciary. For example, the court is well used to authorising a trustee to make distribution of a fund where there can be no certainty that all of the claimants to it have been identified and the trustee desires the protection of a court order in the event that a further claimant should subsequently appear or matters subsequently come to light which question the basis on which the distribution is made. In one sense, dealing with the matter by recourse to the court’s assistance in this way can be simpler (and less costly) than the often complex processes involved in the promotion of a scheme under Part 26.

78. At the risk of appearing glib, I do not consider that a structured approach of this broad kind is beyond practical achievement in the exceptionally difficult circumstances of LBIE’s administration.

In short, it appears that the legal system in the foremost financial centre in the world does not have a practical way of dealing with the simplest and oldest financial contract – property held under trust.

Posted at 14:48 on Sat, 22 Aug 2009     View/Post Comments (0)     permanent link


I wrote a column in the Financial Express today about the role of securitization.

The global financial crisis began two years counting from the first liquidity crisis in Europe and the US on August 9, 2007. Over these two years, we have found that many of the conclusions that we came to in the early days of the crisis were simply wrong.

In 2007, we thought that the problem was about subprime mortgages, that it was about securitisation and that it was about CDOs (collateralised debt obligations). Now we know that these initial hasty judgments were mistaken. Defaults are rising in prime mortgages, huge losses are showing up in unsecuritised loans, and several banks have needed a bailout.

In 2007, when the first problems emerged in CDOs, people thought that these relatively recent innovations were the cause of the problem. Pretty soon, we realised that a CDO is simply a bank that is small enough to fail and conversely that a bank is only a CDO that is too big to fail.

Both banks and CDOs are pools of assets financed by liabilities with various levels of seniority and subordination. As the assets suffer losses, the equity and junior debt get wiped out first, and ultimately (absent a bailout) even the senior tranches would be affected. In retrospect, both banks and CDOs had too thin layers of equity.

Over the last two years, our understanding of securitisation has also changed significantly. As global banks released their results for the last quarter, it became clear that bank losses are now coming not from securitised assets but from unsecuritised loans or whole loans.

The Congressional Oversight Panel (COP) set up by the US Congress to “review the current state of financial markets and the regulatory system” published its latest report a few days ago. The report focuses entirely on whole loans and paints a very scary picture. Losses on troubled whole loans in the US banking system are estimated to be between $627 billion and $766 billion.

The COP report also states that “recent reports and statistics published by the FDIC indicate that overall loan quality at American banks is the worst in at least a quarter century, and the quality of loans is deteriorating at the fastest pace ever. The percentage of loans at least 90 days overdue, or on which the bank has ceased accruing interest or has written off, is also at its highest level since 1984, when the FDIC first began collecting such statistics.”

It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.

Potential losses on loans could be hidden and ignored for several quarters until they actually began to default. Losses on securities had to be recognised the moment the market started thinking that they may default sometime in the future. Securitised assets were thus the canary in the mine that warned us of problems lying ahead.

Until recently, it could be argued that securitised loans were of lower quality than whole loans and that at least to this extent securitisation had made things worse. But this statement is true only for residential mortgages and not for commercial mortgages, where the position is the reverse. Securitised commercial mortgages (CMBS) are of higher quality than whole loans.

The COP report states: “While CMBS problems are undoubtedly a concern, the Panel finds even more noteworthy the rising problems with whole commercial real estate loans held on bank balance sheets. These bank loans tend to offer a riskier profile as compared to CMBS, suggesting high term default rates while the economy remains weak.”

Two years into the crisis, therefore, we find that the initial knee-jerk reaction against securitisation was a big mistake.

Securitisation doubtless redistributed losses throughout the world so that losses from the US real estate emerged in unexpected places – German public sector banks, for example. But securitisation was not responsible for most of the losses themselves.

We must also remember the US home owner gets a bargain that is available to few home owners elsewhere in the world – a 30-year fixed rate home loan that can be repaid (and refinanced) at any time without a prepayment penalty. This is possible mainly through securitisation and deep derivative markets that allow lenders to manage the interest rate risks.

In India by contrast, the home owner gets a much worse deal: most home loans are of shorter maturity (20 years or less) and are usually either floating rate or only partially fixed rate. The few ‘pure fixed rate’ loans involve stiff prepayment penalties when they are refinanced. It would be sad if we keep things that way because of an irrational fear of securitisation.

Posted at 10:16 on Sat, 22 Aug 2009     View/Post Comments (9)     permanent link

Fri, 21 Aug 2009

Estimating the Zimbabwe hyperinflation

Hanke and Kwok have written a paper in the Cato Journal estimating the hyperinflation in Zimbabwe in November last year. They conclude that the monthly (not annualized) inflation rate of 80 billion percent was the second highest in world history (next only to Hungary in July 1946).

I was at first skeptical about the methodology that they use. Since Zimbabwe stopped publishing inflation data during the period, Hanke and Kwok rely on the share prices of the South African insurance and investment company, Old Mutual, in the stock markets in Harare and London. This involves making two assumptions:

I thought that both assumptions are highly suspect for reasons that I explain below.

We do know that, absent capital controls, the relative share price of the same company in different countries tracks the exchange rate very closely. This was true as early as the eighteenth century (Larry Neal, “Integration of International Capital Markets: Quantitative Evidence from the Eighteenth to Twentieth Centuries”, Journal of Economic History, 1985) and it is even more so today. Even the well known paper of Froot and Dabora (“How are stock prices affected by the location of trade,” Journal of Financial Economics, 1999) found problems with the pricing of twin stocks but not the prices of the same twin in multiple markets.

At the same time, exchange controls can play havoc with this assumption. For example, Indian ADR prices trade at large premia to the underlying Indian shares. The difference between Shanghai and Hong Kong share prices of mainland China companies reflects the same phenomenon. These examples suggest that relative prices could be off by nearly a factor of two in the presence of stringent capital controls.

In the kind of lawlessness that prevailed in Zimbabwe, the margin of error is I think higher. I would not be too surprised to find a deviation of prices by as much as a factor of ten.

The second assumption about PPP is even more suspect. Under normal conditions, PPP does not hold up too well except over the very long run. Lothian and Taylor needed 200 years of data to demonstrate that PPP does hold at all (“Exchange rate behavior: The recent float from the experience of the last two centuries,” Journal of Political Economy, 1996).

One would hope that to the extent that PPP is held back by sticky prices, the extreme flexibility of prices during hyperinflation would make PPP hold better. I think there is merit in this argument.

However, in situations like Zimbabwe, the US dollar would probably be valued more as a store of value than as a medium of exchange. The exchange rate is then driven by asset market considerations rather than goods market considerations. Extreme financial repression in which the real rate of interest on Zimbabwe dollar could be hugely negative (approaching -100%) would make the US dollar extremely attractive. People would then buy the US dollar not on the basis of what it is worth now, but on the basis of what it will be worth in future. At the same time, it is impossible for a foreigner to go long on the Zimbabwe dollar without assuming Zimbabwe sovereign credit risk and legal risk.

Under these conditions, I would not be surprised if the exchange rate undervalued the local currency by a factor of ten or more. Taken together with the earlier factor of ten for the stock price, this implies that Hanke and Kwok could be off by a factor of 100.

Surprisingly, this would make very little qualitative difference to the results of Hanke and Kwok. The monthly percentage rate of inflation in Zimbabwe that they estimate is roughly 80 billion. Revising it down by a factor of hundred would bring it down to 800 million. That is still higher than the third highest rate on record (Yugoslavia, January 1994) of 300 million. No plausible margin of error in the opposite direction will bring Zimbabwe within even shouting distance of the highest recorded hyperinflation (Hungary, July 1946) which was 4 followed by 16 zeroes.

Put differently, to push Zimbabwe down to third place, the Hanke and Kwok estimate would have to be off by a factor of 250. Much as I dislike the smug confidence that Hanke and Kwok seem to have in arbitrage relationships in a society where there is security of neither life nor property, I find it difficult to argue that the arbitrage relationships may be off by a factor of 250.

Posted at 15:11 on Fri, 21 Aug 2009     View/Post Comments (0)     permanent link

Thu, 20 Aug 2009

Comments recovered from black hole

I realized a couple of days ago that many of the comments on my blog in June and July had disappeared into a black hole. I am still trying to figure out what the problem was with my blogging software (this did not affect the comments on the Wordpress mirror).

In the meantime, I have now recovered most of these comments and added them to the blog. I have also written some code to retrieve orphaned comments and bring them up for moderation so that hopefully this does not happen again.

As I have stated in the past, it is my intention to use moderation only to filter out spam and not to filter out comments that I do not like. So if you find your legitimate (non spam) comments not appearing on the blog within a few days, please do point it out to me by email.

Posted at 13:32 on Thu, 20 Aug 2009     View/Post Comments (0)     permanent link

Mon, 17 Aug 2009

Economics of counterfeit notes

There has been much alarmed discussion in the press about the counterfeit Indian rupee notes allegedly being smuggled into the country from across the border. As I see it, the barriers to counterfeiting currency notes are economic and not technological.

Introducing more and more complex features into the notes does not make counterfeiting impossible. What it does is to increase the scale economies in printing by requiring larger and larger initial investment and therefore larger and larger scale of production to make the printing of counterfeits economical. Scale economies are not a problem for the government itself because it anyway prints notes on a very large scale.

Scale economies need not deter the counterfeiter; it only requires the counterfeiter also to operate on a large scale. The problem for the counterfeiter is that the distribution of counterfeit notes is characterized by large diseconomies of scale.

It is pretty easy to distribute a few hundred counterfeit notes with very little chance of detection. Distribution of a million counterfeit notes however requires a distribution network that is very difficult to set up and operate without being detected.

This combination of scale economies in production and scale diseconomies in distribution imply that there is often no viable scale of operation for a private counterfeiter. The total expected cost of manufacturing and distributing the counterfeit note approaches the face value of the note itself.

Counterfeiting by a foreign government is only slightly different. To the extent that they can use the equipment used in their own note printing operations, counterfeiting may be economically viable for them at lower print runs. More importantly, if their goals are not purely economic, the profitability of the operation is not an issue.

However, the problem of the distribution channel is still an issue. The experience of German counterfeiting of UK currency notes during the second world war suggests that the technical quality of the counterfeiting is not the real problem. How to get the notes into enemy territory in large scale is the critical issue. The German experience suggests that using the espionage network to put the notes into circulation only compromises the espionage network itself.

Often, the goal of putting counterfeit notes into circulation in enemy territory is not to make a profit but to disrupt the enemy’s economy by making people distrust their own currency. The strategy of the Indian government and the RBI to deal with the problem of counterfeit notes quietly and without spreading panic is therefore a very sensible one.

For a profit motivated rogue government, the most attractive currency to counterfeit is the US dollar. An estimated 70% of US dollar notes circulate outside the US; many users of the currency are not very familiar with it; the design of these notes is relatively stable; and finally, dollar resources are very valuable in international trade.

Anecdotal evidence suggests a greater percentage of counterfeit US dollar notes (at least outside the US) than in most other currencies. Yet the percentage of counterfeit notes is still quite manageable. I think therefore that the fears that are being expressed in the Indian press about counterfeit rupee notes are excessive.

Posted at 21:15 on Mon, 17 Aug 2009     View/Post Comments (7)     permanent link

Thu, 13 Aug 2009

Madoff and his AS/400

The brain behind Madoff’s huge fraud has been revealed – it was the well known IBM AS/400 minicomputer. Well, that is a bit of an exaggeration, but only slightly so. The SEC complaint against a key Madoff lieutenant, Frank DiPascali, turns out to be a long litany of the accomplishments of his AS/400.

Printing millions of pages of trade confirmations (one for each stock and for each account for every fictitious trade) was one of the major uses of the AS/400. DiPascali also used a random number generator program to break up the massive trades into orders of various sizes and prices and to randomly distribute the trades across different times. Apart from the AS/400, Madoff also had a fake computer trading platform set up in the office, just in case somebody wanted to witness real time trading.

For all its prowess, the AS/400 could not generate trade blotters and order tickets. Perhaps, doing this with credible execution times, counterparties and executing brokers would have needed more powerful machines (and tick level price feeds not to mention top quality programmers) of the kind employed by the hedge funds that do high frequency trading today.

I get the sense that while Madoff was an early adopter of technology, he did not keep pace with it in the later years. As investors started demanding faster trade confirmations, the amount of time that DiPascali could look back to construct the profitable phony trades became shorter and shorter. I suspect that even if the market crash of 2008 had not blown up the Ponzi scheme, it would have become harder and harder to keep the ruse going with the aging technology that Madoff and DiPascali had available to them.

Posted at 14:11 on Thu, 13 Aug 2009     View/Post Comments (0)     permanent link

Sun, 09 Aug 2009

High frequency trading and rebates

High frequency trading is very much in the news these days with controversies about flash trades, rebates and so on. In this context, this paper by Foucault, Kadan, and Kandel is very interesting (hat tip Aleablog). It develops a model which explains why it may be optimal for exchanges to pay market makers for trading (in the form of rebates) while charging market takers for trading.

The paper discusses the determinants of what they call the make-take spread – the difference between the (possibly negative) fees charged to market makers and the (positive) fees charged to other traders. I found it more convenient to think in terms of the take-make spread (or the negative of the make-take spread) which can be interpreted as the subsidy to market makers.

The paper shows that a reduction in the tick size increases the optimal subsidy to market makers. They argue therefore that decimalization might have been an important factor in the emergence of rebates to market makers.

The subsidy for market makers is greater when there is a small number of market-makers relative to the number of market-takers. Quote driven markets tend to be dominated by a small number of market-makers and the rebates offered by these exchanges is in line with the predictions of the paper. The fact that order driven markets do not subsidize limit orders relative to market orders is also consistent with their model because these markets are characterized by large number of participants using limit orders.

While these are useful contribution, the paper still left me uneasy at the end. Why are quote driven markets unable to attract a large number of market makers when order driven markets have no difficulty attracting millions of limit order users? Is there something fundamentally wrong with quote driven markets that make them inherently anti-competitive leading to a cosy oligopoly of market makers?

Posted at 19:09 on Sun, 09 Aug 2009     View/Post Comments (0)     permanent link

Fri, 07 Aug 2009

Importance of better risk models

I have been writing for some time now about better risk models (my SSRN paper is here and my blog post on that paper is here). Phorgy Phynance has a fascinating graph about the difference between the normal distribution and a fat tailed (stable) distribution in computing the 1% daily VaR for the S & P 500 going back 80 years (hat tip Felix Salmon).

His second graph shows that using stable distributions would not by itself have provided any better warning during the boom years of 2005-2007. But the early warning that it provides from early 2007 onward is truly impressive. During 2007-2009, the stable distribution VaR gives about 6-9 months advance warning about where the normal distribution VaR will be. In the world of financial markets, that is more than enough warning even if you were holding a bunch of illiquid stocks.

This also means (via the Merton model) that one would have had several months advance warning of corporate credit market stresses. That good models are better than bad models might look like an obvious statement, but too many people that I talk to seem to have convinced themselves (or let Taleb convince them) that all models are useless in times of crises.

But the performance of even the stable distribution during 2005-2007 highlights the need for using data going back several business cycles. This is also a point that I emphasize in my paper.

Posted at 12:13 on Fri, 07 Aug 2009     View/Post Comments (13)     permanent link

Wed, 29 Jul 2009

Open source research in finance

Eighteen months ago, Bill Ackman of the Pershing Square hedge fund released his “Open Source Model” providing detailed data on 30,499 tranches of 534 CDOs to which the big US bond insurers (MBIA and Ambac) had exposure. On the basis of this model, he claimed that MBIA and Ambac were insolvent. At the time, many regarded it as a publicity stunt; after all Ackman was heavily short these insurers and was merely talking his book.

While many read Ackman’s letter, few bothered to download the actual data. This was partly because the data was really huge (110 megabytes) and the letter warned that each recalculation of the model took about half an hour on a typical workstation. Moreover, the yousendit link where the data was uploaded expired within a few days. In any case, after the near-collapse of the bond insurers, people lost interest in the model.

However, last month Benmelech and Dlugosz published a paper on what they called “The Credit Rating Crisis” which relies partly on this data to document the failures of the rating agencies. Among other things, Benmelech and Dlugosz show that CDOs rated by only one rating agency were more likely to be downgraded than those rated by two or more agencies. They also confirm what was well known anecdotally about one particular rating agency being worse than the others.

This suggests that open source research can work in finance. One way to get transparency about the balance sheet of financial institutions might be for the regulators to create large detailed databases which anybody can analyse. I think several gigabytes of data would do the job, but even if the data grows to a terabyte or more, it would be well worth the effort.

Updated: Changed “collapse of the bond insurers” to “near-collapse of the bond insurers”

Posted at 12:09 on Wed, 29 Jul 2009     View/Post Comments (5)     permanent link

Sun, 26 Jul 2009

More on Debt Management Office and the Reserve Bank of India

Sankt Ingen responds to my previous piece on this subject and asks what is it that the Debt Management Office can do that the RBI cannot do. Sankt Ingen thinks that I am arguing for fancy derivatives and similar stuff conjured up by bright young MBAs. No, what I would like to see is very low brow stuff.

In an institution like the RBI that does something as high brow as monetary policy and financial stability, the low brow job of peddling government bonds will never be treated with respect and seriousness. While the DMO whose sole job is to peddle those bonds will I hope do that with the same professionalism that an FMCG company brings to peddling toothpaste.

Yes, I mean that in all seriousness. The job of distributing government bonds to every nook and corner of the country is as much a matter of logistics, distribution and marketing as the selling of detergents and toothpastes. In India (and in many other countries), the system for distributing toothpastes is far superior to the system of distributing government bonds (and many other financial products).

Government bonds are a critical element of the asset allocation strategies of individuals, companies and institutions. It is a scandal that their effective distribution is restricted to a handful of elite institutions.

This lack of diversity of participants is a key factor in the underdevelopment of the government securities market in India. In equities, when domestic retail investors are selling, maybe domestic institutions are buying, and when both of them are selling, maybe foreign institutions are buying. One wishes that foreign retail could also participate and bring even greater variety to the market, but we do have reasonable diversity of players. We did not have this diversity in the late 1980s or early 1990s in Indian equities and the markets then lacked the resilience that they have now. At the slightest shock, the exchanges simply shut down the market to deal with the imbalance.

When I look at government securities market today, it is just banks (and LIC at the long end). All banks face the same liquidity shocks and markets can therefore easily become highly one sided. At a deeper level, banks are the wrong kind of buyers for long term government bonds because of the asset liability mismatch. The real reason why governments borrow from banks is the same as the reason why robbers steal from banks – that is where the money is easily available.

The government securities market today is not a market filled with investors, hedgers and speculators with diverse liquidity needs and different investment horizons. We have a crazy scheme of small savings that completely fragments the market by segregating retail investors in separate instruments altogether. Even the retail trading of government securities themselves is segregated from the inter bank market.

The biggest problem is that the RBI does not see investors in government securities as its customers at all – the banks are its wards and retail investors are just a nuisance to be segregated in a tiny and separate corner of the market. I wrote a paper on this five years ago.

I believe that with the right market design, India can and should aspire for a government securities market that is deeper and more liquid than that of the typical emerging market. I think in terms of the size of the economy, the outstanding stock of rupee government debt, the existence of a critical mass of financial intermediaries of reasonable sophistication and the abundance of finance talent in the country. Yet, the vibrancy that one sees in the equity market or the commodity derivatives market is lacking in the government bond market.

I hope that we will get a DMO with a low brow mandate of making government securities as easy to buy as toothpastes and detergents. I hope that such a low brow DMO will over a period of several years give us a deep and vibrant government securities market. This may be a misplaced hope, but hope is the last thing that I would like to lose. Anybody who hoped in the 1980s to see a well functioning equity market would have been dismissed as a day dreamer, but over two decades, this has indeed come about. Maybe we can repeat that miracle once again in the market for government securities.

Posted at 20:53 on Sun, 26 Jul 2009     View/Post Comments (0)     permanent link

Thu, 23 Jul 2009

Debt Management Office and the Reserve Bank of India

I wrote a column in the Financial Express today about the reported views of the Reserve Bank of India on the establishment of a Debt Management Office in India.

I deliberately avoided mentioning monetary policy anywhere in the whole column, but focused on the implications for the government securities market and for borrowing costs.

The reported suggestion by RBI to postpone the establishment of a debt management office (DMO) is not a good idea. An independent DMO would help create a vibrant and dynamic government debt market, and would reduce the government’s borrowing cost in the long run.

It is worth remembering that the development of a vibrant government debt market is one of the few financial innovations that have changed the course of world history. Beginning with sixteenth century Holland, whose war for independence from the Spanish Empire was immensely aided by its superior debt market, it has been true that governments that have been able to borrow from willing lenders have prevailed over those that have had to rely on forced loans.

India is today at a stage in its economic and financial development where it needs to shift from relying on captive buyers of government securities (the modern day equivalent of forced loans) to creating a deep market of willing buyers for its debt. I see the DMO as an essential and valuable step in this direction.

When a private sector company issues securities, it goes to great lengths to assess investor appetite for different kinds of securities and tries to tailor its securities accordingly. It works with its investment bankers to improve the liquidity of its securities because it knows that higher liquidity ultimately reduces the cost of its borrowing.

Until the late twentieth century, governments around the world were insufficiently sensitive to these factors and often behaved in a distinctly investor unfriendly way. All that has changed with the creation of professionally managed debt management offices in country after country both in the developed world and in emerging markets.

These DMOs look at debt issuance exactly the way a corporate treasurer looks at corporate debt issuance. They have a mandate to borrow at the lowest possible cost, and they know that they can do this only by making their securities attractive to investors. DMOs around the world have worked on making the systems for issuing, trading and settling government securities much more investor friendly.

Partly as a result of this, government debt markets globally have evolved in depth, liquidity and sophistication. For too long, India has relied on the easy route of placing government securities with captive banks and insurance companies. The unfortunate side effect of doing this is that the development of government securities markets in India has been stunted.

Thanks to our fiscal profligacy, India has a large outstanding stock of government securities as a percentage of GDP. This large stock of debt provides a foundation for a very liquid and deep market. Unfortunately, this potential has not been realised.

Other than a few on “the run securities”, most government securities are hardly traded. Even the market for liquid “the run securities” securities lacks diversity of players. Government securities is largely an inter bank market. As a result, when there is a liquidity shock to the banking system, the government securities market becomes a one sided market. It lacks resilience – the ability of the market to quickly return to normalcy after a large shock.

A professionally managed DMO should change all this. In the long run, the establishment of a DMO with a clear mandate and accountability would help reduce borrowing costs for the government in many ways. Unlike the RBI or the Ministry of Finance, the DMO has only one function and a very well defined objective. This makes it easy to measure the performance of the DMO.

When one reads the audit reports evaluating the DMOs of some leading countries in the world, one is impressed by the clarity of discussion on factors like the maturity composition of debt that impact the borrowing cost of the government. In India by contrast, there is today no real accountability for the interest cost of the government, which is currently the single biggest item of government expenditure.

Apart from lower borrowing costs for the government, there are many other benefits from a liquid and well developed market for government bonds. The yield curve for “risk free” government securities is the benchmark for all other interest rates in the economy.

The lack of a reliable and robust yield curve in the Indian government securities market impedes the valuation and trading of other debt securities as well. In other words, a sophisticated government securities market is the first step to the creation of a vibrant corporate debt market.

I believe therefore that India should not waste any time in setting up a professionally managed DMO. What about the argument that this is the wrong time to do so because of the large borrowing programme this year? The savings pool in India is deep enough for the government to borrow enough to cover its fiscal deficit in the free market. No, we do not need “forced loans” – at least not yet.

Posted at 11:08 on Thu, 23 Jul 2009     View/Post Comments (4)     permanent link

Tue, 21 Jul 2009

Simplified Finance: Part III

In my last two posts on this subject, I talked about how a simplified financial sector would look like. Part I presented an ultra simplified financial sector with a payment system, a stock exchange, “narrow” insurance companies and practically nothing else. I argued that this system with no banks, no debt and no central banks would do a reasonably good job of supporting economic growth provided high levels of corporate governance could be enforced. Since that was unlikely to happen, Part II introduced long term corporate debt but still avoided banks. The difficulty here was that debt would not be available to smaller enterprises.

What happens when we introduce banks or bank like entities? To understand this we must recognize that corporate debt is already a derivative contract – because of limited liability, debt is economically the same as a put option on the assets of the company. If the value of the assets is less than the amount of debt, the company default and the assets belong to the creditors. This is economically equivalent to the shareholders selling the assets to the creditors at a price equal to the amount of debt. This is nothing but a put option. So the model of Part II had derivatives already though they were not described as such.

In part II, the toxicity of these derivatives was reduced by two means – first by allowing only long term debt and second by requiring this debt to be bought directly by individuals and not by financial intermediaries. The effect of this restriction would be to reduce the quantum of the debt and thereby reduce the amount of derivatives floating around in the economy. The low leverage also avoids the need for corporate hedging.

Once we introduce banks, we would also have to bring in short term debt since the assets and liabilities of the banks would be short term. The presence of banks as well as short term debt would encourage companies to take on higher levels of leverage to benefit from the interest tax shield. This makes corporate risk management essential.

More troubling is the risk management of the banks themselves. A bank is nothing but a CDO as I argued more than three years ago (see also this entry) – it is a portfolio of debt securities. The probability distribution of a credit portfolio is extremely skewed and fat tailed even if the values of the real assets are normally distributed. (Vasicek derived this so called normal inverse distribution way back in 1997). If the real assets themselves have fat tailed distributions and display non linear dependence patterns, the distribution of the credit portfolio is even more toxic. To manage the toxicity of this distribution, the bank has to use various risk management tools.

An economy with free floating exchange rates and interest rates must provide its banks (and leverage companies) with interest rate and currency derivatives. This presents us with a trilemma – (1) the economy can operate with fixed exchange rates and administered (repressed) interest rates or (2) it can run without banks and leveraged companies or (3) it can create derivative markets. In terms of financial innovation we cannot roll the clock back to the 1970s without also restoring the world economic order of the early 1970s

In all this, I have not talked about credit to individuals at all because it is possible to visualize a fairly advanced economy in which there is no consumer credit at all. It is possible to argue that the economic benefits of retail credit is quite small. Most of retail credit is for housing and as I argued in Part I, there is little economic reason for people to own the houses that they live. From the days when the suffrage was limited to those owning immovable property, home ownership has been a political question rather than an economic one. Most of the other consumer credit (credit cards and credit for consumer durables) is taken by those who are less than fully rational.

While economists talk about consumption smoothing, very little of consumer credit actually performs this function. The only important consumer credit in my opinion is the educational loan which allows investment in human capital. This is potentially as important as credit to businesses (which allows investment in physical capital), but as I argued in Part I, there are other equity like solutions to this problem as well.

A financial system without a mortgage market at all would not have encountered the crisis of 2007 and 2008 which have been rooted in the mortgage markets. But it would not have been immune to crises. Financial history teaches us that exposure to commercial real estate and to over-leveraged companies can create banking crises without any help from mortgages or from any other financial innovation.

In short, creation of banks and other pools of credit is the most toxic financial innovation ever but there might be good reasons for living with the consequences of this toxicity.

Posted at 21:34 on Tue, 21 Jul 2009     View/Post Comments (0)     permanent link

Fri, 17 Jul 2009

Loose fiscal plus tight monetary policy

I have a column in the Financial Express today on the dangers of combining loose fiscal policy with tight monetary policy.

The movement of equity and bond markets after the announcement of the budget is threatening to look like a re-run of early 2008 when falling stock markets and rising interest rates delivered a double whammy to the economy. Monetary policy needs to respond to this threat and avoid a similar double whammy now.

To recall what happened in early 2008, the stock market dropped by nearly 40% from mid-January to mid-July, while the 10-year government bond yield rose by over 180 basis points. The corporate sector found that both equity and debt were either unavailable or too expensive. With a lag, this funding squeeze had a highly negative impact on investment and on the broader economy.

The rise in interest rates at that time was due to the tight money policy followed by the RBI in response to double digit inflation caused by rising prices of food and oil. What nobody knew then, but is evident now is that the inflation of early 2008 was a transient phenomenon that was being killed by the global economic downturn. In retrospect, the tightening of interest rates was unnecessary.

The situation now has some similarities. The failure of the monsoon so far is causing fears of food price inflation. These fears would weigh on RBI and could induce it to keep monetary policy too tight. At the same time, the spending and borrowing programmes announced in the budget has caused long-term interest rates to rise. Interest rates would rise even further if RBI does not accommodate the borrowing through monetary easing.

Loose fiscal policy combined with a monetary policy fixated on inflation can cause interest rates to explode. In the US, in the early 1980s this was what happened when President Reagan embarked on a spending spree while the Federal Reserve under Paul Volcker declared war on inflation. The yield on long term US government bonds crossed 15% and shorter maturity yields rose even higher. This combined with the rising dollar (itself a result of the high interest rates) brought about a nasty recession in the US.

A recession induced by high interest rates is the last thing that India needs today when the economy is being kept afloat by a large fiscal stimulus. If we take away the support provided to the core sectors from government spending on infrastructure and the support provided to consumer durables by the sixth pay commission, the economy is in pretty bad shape. In this context, the fiscal stimulus is unavoidable and the only question is whether the central bank will accommodate the fiscal deficit through its monetary policy.

A lot of the discussion on the fiscal deficit in recent days has focused on the ‘crowding out’ of private borrowing by government borrowing. In today’s environment I worry more about private borrowing being crowded out by high interest rates, and fortunately monetary policy is a tool that can prevent this.

Many countries are running large deficits. The fiscal deficits of the US and the UK are much higher than ours as a percentage of GDP. The big difference is that in those countries, extremely loose monetary policy has worked in tandem with the fiscal policy. At extremely low interest rates, higher levels of government debt are sustainable simply because the cost of servicing the debt is low.

In India on the other hand, we have turned to fiscal policy long before exhausting the limits of monetary policy. This means that the government is undertaking huge borrowing at relatively high interest rates. The resulting high interest bill will only make the fiscal position worse in coming years.

In the event of a failed monsoon, tight monetary policy can control food price inflation by ensuring people run out of money before they run out of food. It is, however, much less painful for the broader economy to take advantage of our comfortable foreign exchange reserves and tackle food price inflation through aggressive imports.

Turning to the stock market, a modest decline in stock prices is not worrying. There is little point in propping up asset price bubbles when the economic fundamentals are as weak as they are today. What I find more worrying is the possible closing of the primary equity market that had begun to open up for Indian companies in May and June in the form of private placements.

There are signs that this window is closing again due to rising global risk aversion as well as changing risk perceptions about India. If this were to happen, then the corporate sector would be starved of risk capital as it tries to restructure and deleverage while grappling with the challenging economic environment. It is important to keep the primary market open for sound companies that are willing to raise equity at realistic valuations.

Posted at 10:55 on Fri, 17 Jul 2009     View/Post Comments (2)     permanent link

Wed, 15 Jul 2009

Lehman Risk, Segregation, Net Margins and Cash Margins

Lehman’s bankruptcy was a nightmare for those who had deposited margins with Lehman (particularly Lehman Brothers International Europe in London) for their derivative trades. Many of them ended up as unsecured creditors of Lehman and will have to wait for years to get back a few cents in the dollar. Margins deposited with Lehman US were protected by segregation rules which cannot be overridden by contract, but apparently many hedge funds chose to use LBIE in London to get higher leverage and signed away many of their rights.

Lehman risk is a significant risk for derivative exchanges because even when the risk containment processes of the exchanges work perfectly, the ultimate customer ends up with little or no protection at all. This is an important issue, but even after fruitful discussions with some UK lawyers on this matter, my understanding of the legal issues has been rather poor.

Now however we have access to a 158 page report submitted by derivative dealers to the New York Fed that is based on work by 13 lawyers from six countries on all the legal complexities involved in providing protection to ultimate customers. The report focuses on Central Counter Parties (CCPs) clearing CDS contracts but the principles are of broader application.

The key takeaways from the report are:

Finally, the report states upfront that “This Report does not address the risk of fraud, and assumes that the relevant CM has complied with its segregation and other obligations in respect of customer margin.”

Indian derivative exchanges use gross margins and enforce some degree of segregation of client assets, but I think that a lot can and needs to be done to improve customer protection against Lehman risk. I particularly like the idea of replacing cash margins with security interest in low risk securities.

Posted at 14:33 on Wed, 15 Jul 2009     View/Post Comments (0)     permanent link

Tue, 14 Jul 2009

Simplified Finance: Part II

In my earlier post (see Part I) on this subject, I talked about an ultra-simplified financial system that “has a payment system, a spot foreign exchange market, “pure” life insurance companies, an equity market and practically nothing else ... no banks, no central banks, no debt markets and no derivative markets.”

I did emphasize that my speculation was completely ahistorical. I did not perhaps make it clear that I also assumed fairly well developed legal systems and governance structures without which equity markets are a complete non starter. In early stages of economic and financial development, it is difficult to create equity markets that work. I have no quarrels with the claim (for example at the Lin roundtable) that stock exchanges are pre-mature at that stage of development.

Coming back to the minimalist design, the next thing that one would want to add would be a debt market. First a government bond market and second a corporate bond market.

I mentioned in my first post that the government bond market is as above all a concession to the practical reality of governmental profligacy. Many people that I talk to think of government bond markets as mechanisms that increase the asset allocation opportunities for investors and allow them to choose less risky portfolios if they like. I think that a lot of this is money illusion. Government bonds are in fact very risky because of the ever present threat of inflation and hyper inflation. The tail risk of bonds is greater than the tail risk of equities.

The introduction of government bonds does not by itself require the introduction of any other markets including interest rate derivatives. These derivatives are needed when you have leveraged financial institutions and in the minimalist design so far there are no such institutions.

Adding a corporate bond market is more complicated because it creates leveraged entities. It is difficult for leveraged entities to exist without derivative markets particularly commodity and currency derivatives. We could avoid this by having only long term corporate bond markets. The absence of financial institutions and short term debt markets would automatically limit the leverage of firms and then it may be possible to get by without derivative markets.

More troublesome is that adding corporate bonds without adding banks and other financial intermediaries would create a strong bias against small firms. It is easier for small firms to access equity markets than it is for them to access corporate bond markets. To level the playing field, it may be necessary to add bank like intermediaries that would lend to smaller enterprises. But once we add leveraged financial intermediaries, it is impossible to have a simplified financial system anymore as I shall discuss in the next part of this series.

Posted at 18:22 on Tue, 14 Jul 2009     View/Post Comments (2)     permanent link

Thu, 09 Jul 2009

UK proposal for consumer guidance in financial services

The UK has put out its proposals for financial regulation reforms, but many people expect the current government to lose the elections next year and believe that the new government will push regulations in a totally different direction.

The Governor of the Bank of England has been on a confrontational path with the government and some believe that he is already more concerned about his relationships with the next government than with the current one. He has been arguing for more powers to go with the Bank’s mandate for financial stability complaining that

So it is not entirely clear how the Bank will be able to discharge its new statutory responsibility if we can do no more than issue sermons or organise burials.

I thought therefore that the following passage in the government’s proposal was telling the governor to get on with his sermons and stop complaining.:

One of the existing key responsibilities of the Bank of England, which will continue to be a significant feature of its new role, is to analyse and warn of emerging risks to financial stability in the UK, principally by means of its Financial Stability Report, published twice-yearly. It is important that the Bank retains this independent voice, to warn publicly of risks facing banks and financial markets in the UK.”

What I found more interesting than all this petty politics is the set of suggestions on consumer education and protection:

One distressing element in the cost benefit analysis is the claim that arming the FSA with greater powers to curb short selling would bring benefits of up to £9 billion over the next ten years in present value terms. I think the upper bound here should be zero and the lower bound a large negative number.

Posted at 17:01 on Thu, 09 Jul 2009     View/Post Comments (0)     permanent link

Wed, 08 Jul 2009

Governance of banks

I read two interesting pieces today about bank governance. First was John Kay’s column (“Our banks are beyond the control of mere mortals”) in the Financial Times in which he says that the top management of UK banks were people of exceptional ability:

... most of the people who sat on the boards of failed banks were individuals whose services other companies would have been delighted to attract ... Our banks were not run by idiots. They were run by able men who were out of their depth. If their aspirations were beyond their capacity it is because they were probably beyond anyone’s capacity.

The statement of Kay that I agreed with most was:

If you employ an alchemist who fails to turn base metal into gold, the alchemist is certainly a fool and a fraud but the greater fool is the patron.

Needless to say my understanding is that the true patron in this case was not the shareholder but the government.

Today, I also read a paper (“Subprime Crisis and Board (In-)Competence: Private vs. Public Banks in Germany ”) by Hau and Thum (hat tip FinanceProfessor). This paper tries to understand why during the current crisis, the losses at the large public sector banks in Germany were far worse than those of private sector banks. While the big three private banks (Deutsche, Commerzbank and Dresdner) have suffered quite badly, the losses (as a percentage of assets) of the large public sector banks (like Bayern LB, West LB and KfW) are truly dismal.

Hau and Thum do a painstaking job of going through the biographical data of each and every board member of each of the 29 banks in Germany with assets above € 40 billion and rating each of these 593 board members on 14 different indicators measuring three dimensions of competence – educational qualification, management experience and finance related experience. They first show that the board members of public sector banks fared badly on all these three dimensions. Next, their regression results show that performance of banks is strongly related to the finance experience of the board members. They conclude that the poor performance of the German public sector banks is due to their poor governance.

My only problem with this conclusion is that their first regression equation using just a dummy variable for state ownership has much higher explanatory power (R-square) than their later regressions using board competence measures. Unfortunately, they do not report any regressions containing both board competence and the ownership dummy. Therefore, we do not know whether board competence has any incremental explanatory power over and above that as a proxy for state ownership. The only light that they throw on this is a regression where they show that state ownership has only a small impact on executive compensation. They use this result to argue that state ownership is not the causal variable. But state ownership can affect performance in other ways – for example, by encouraging greater risk taking because of the implicit government support.

Posted at 17:29 on Wed, 08 Jul 2009     View/Post Comments (1)     permanent link

Tue, 07 Jul 2009

How far can finance be simplified? Part I

In the wake of the global financial crisis, there has been a lot of discussion about how finance became too complex and how it needs to be simplified. This led me to speculate on how far finance can indeed be simplified. This is a question that I would like to address in several parts as I use this blog to clarify my own thoughts. Caveat: my entire speculation is completely ahistorical – it is a clean slate design which ignores the existing institutional structure completely.

In this post, I describe an ultra-minimalist financial sector that has a payment system, a spot foreign exchange market, “pure” life insurance companies, an equity market and practically nothing else. In this ultra-minimalist model, there are no banks, no central banks, no debt markets and no derivative markets. The payment system would essentially be a retail version of a real time gross settlement system which in principle needs neither banks nor a central bank. It is essentially a piece of technological infrastructure and nothing more – a central depository for cash. Money could be fiat money or commodity money or anything else.

By pure life insurance, I mean first of all that the companies offer term insurance which unlike endowment insurance is not bundled with investment products. Secondly, level premiums would be replaced by rising (actuarially fair) premiums so that there is very little investment component in the insurance product. Finally, insurance would ideally be redesigned so that the life insurers take micro mortality risk (the cross sectional variation in mortality rates at a point in time) but not macro mortality risk (changes in life expectancy over time).

If we can make these changes, insurance companies become easy to run and easy to regulate. They simply become applications of the law of large numbers and involve vastly reduced risk taking over long horizons. Incidentally, I believe that macro-mortality risk is practically unhedgeable and uninsurable. Insurers can credibly claim to provide protection against this risk only by having recourse to a bail out by the state. Perhaps, it is ultimately beyond even the resources of the state to credibly insure against macro-mortality risk.

In the absence of debt, there are hardly any prudential regulations except possibly for the insurance companies. Financial regulation consists primarily of conduct of business regulators and consumer protection regulators.

How can a financial system operate without debt? Well, the Modigliani-Miller theorem says that lack of debt is not a serious problem for the corporate sector except that the tax advantage of debt is lost. One could assume that the government simply enacts a lower rate of corporate tax so that the elimination of tax deductible interest is revenue neutral to the state.

If there is no leverage of any kind, the need for derivative markets is vastly reduced. Corporate use of derivatives is principally to economize on equity capital. Since equity is the ultimate hedge of every conceivable (and inconceivable) kind of risk, if you have enough of equity, you can choose not to hedge anything at all and still you will not go broke. One could use a version of the Modigliani-Miller argument to show that corporate hedging is irrelevant unless it introduces deadweight losses like bankruptcy costs.

This is not the whole story because apart from corporate hedging we must also worry about optimal allocation of risk among individuals. I believe however that in the spirit of Arrow’s 1964 paper (“The role of securities in the optimal allocation of risk-bearing”), the equity markets span sufficient states of the world to permit a reasonable allocation of risk bearing among individuals. The practical consequences of not having a derivative market may not be much in a world without debt.

General insurance is essentially a substitute for derivatives and it too can be eliminated in this minimalist design. If corporations do not have debt and if individuals hold diversified portfolios of non human assets, then they can self-insure all forms of property risk. Insurance is required only for non diversifiable human capital which is why pure life insurance cannot be eliminated.

The Capital Asset Pricing Model would not hold because there is no risk free asset. I do not see this as a problem because we would still have the zero beta model of Black (1972) which is not significantly more difficult to use. (As an aside, if we focus on real returns instead of nominal returns, there is no risk free asset anyway. Inflation indexed bonds issued by the government are subject to significant default risk since the printing press is not sufficient to pay off these bonds.)

Passively managed mutual funds (exchange traded index funds for example) are nice to have because they allow individuals to achieve diversified portfolios very easily. But if the stock exchange allows shares to be traded in small lots, even small investors may be able to hold 25-40 stocks directly and obtain most of the gains of diversification. Exchanges could also allow basket trades in indices to achieve the same thing.

In the ultra-minimalist design there is no trade finance other than whatever trade credit one corporation chooses to extend to another out of its own resources. There are no letters of credit (which are actually highly complex credit derivatives!).

The absence of a debt market means that there are no mortgages. One possibility is that most houses are owned by corporations that rent it out to individuals. We do not need to own the homes that we live in any more than we need to own the offices that we work in. (See my post on this a year go.)Individuals would be able to obtain exposure to real estate by buying shares of these companies. (Another – less preferred – option is that people would live in rented houses in early stages of the life cycle and buy houses only later in life.)

One difficulty with the minimalist design is the lack of educational loans. Education would have to be financed through equity claims to an even bigger extent than it is today. Even today, the successful university that attracts lots of endowments essentially has an equity claim (an out of the money call option?) on the human capital of each of its alumni and the returns on this equity claim are used to subsidize (finance) a lot of the education.

I see two big problems with this ultra-minimalist design. First is that Jensen-Meckling pointed out in 1976 that the disciplining power of debt is useful in reducing the agency problems between the managers and the shareholders. We would therefore need very robust corporate governance frameworks (including a healthy market for corporate control) in a world without any debt. This would be a problem more for mature businesses that generate a lot of free cash flow.

Second is that under the assumption that governments are and will always be profligate, we need a government bond market. Theoretically also government debt can achieve some intergenerational transfers that would otherwise be difficult to accomplish, but I think this is less important than the practical reality of governmental profligacy.

In subsequent blog posts, I hope to extend the ultra-minimalist financial sector to allow for a corporate and government debt market increasing complexity one step at a time.

On the whole however, even the ultra-minimalist financial sector would be able to support a vibrant and modern economy. Clearly, it is the equity market that does the heavy lifting in this minimalist design by taking charge of both resource allocation and risk allocation.

Posted at 18:14 on Tue, 07 Jul 2009     View/Post Comments (1)     permanent link

Sun, 05 Jul 2009

Incentives of regulators and supervisors

During the current global financial crisis, a lot has been written about the flawed incentives of those who run the banks. At the same time Kane has been writing a series of papers on the flawed incentives of regulators and supervisors.

Kane is of course well known in the finance literature for his seminal work starting three decades ago on regulatory competition, the action-reaction dynamic of financial innovation and regulation, and the evils of directed credit (“Good Intentions and Unintended Evil: The Case Against Selective Credit Allocation,” Journal of Money Credit and Banking, 1977, “Technological and Regulatory Forces in the Developing Fusion of Financial Services Competition” Journal of Finance, 1984 and “ Interaction of Financial and Regulatory Innovation” American Economic Review, 1988).

Kane’s work on the current crisis draws on the same ideas to develop a model of what he calls “subsidy induced crisis.” Some interesting passages from his papers on the current crisis:

[T]he principal source of financial instability is not to be found in the aberrant behavior of a few greedy individuals or in a sudden weakening of important institutions of a particular country at a particular time. Systemic financial fragility traces instead to a web of contradictory political and bureaucratic incentives that undermines the effectiveness of financial regulation and supervision in every country in the world. Weaknesses in supervisory incentives encourage modern safety-net managers not only to tempt financial institutions and their customers to overleverage themselves in creative ways, but also to close their own eyes to the unbudgeted costs of the loss exposures that excess leverage passes onto financial safety nets until it is too late for anyone to control the damage that results.

[T]echnological change and regulatory competition simultaneously encouraged incentive-conflicted supervisors to outsource much of their due discipline to credit-rating firms and encouraged banks to securitize their loans in ways that pushed credit risks on poorly underwritten loans into corners of the universe where supervisors and credit-ratings firms would not see them.

What the press describes as a “banking crisis” may be more accurately described as the surfacing of tensions caused by the continuing efforts of loss-making banks to force the rest of society to accept responsibility for their unpaid bills for making bad loans.

[T]he current crisis exemplifies not just the limits of market discipline, but the power of government-induced incentive distortions – and the limits of official supervision as commonly practiced.

Most importantly, references to ratings should be removed from all SEC and bank regulations, including Basel II. Government rules that rely on CRO ratings reduce investor incentives to conduct sufficient due diligence before making investments. At the same time, such rules reduce the accountability of government regulators and supervisors for neglecting their duty of oversight. By outsourcing due diligence to credit rating organizations, regulators shift the blame for the safety-net consequences of ratings mistakes away from themselves.

In government enterprises, decision-making horizons could be lengthened if employment contracts included a fund of deferred compensation that heads of supervisory agencies would have to forfeit if a crisis occurred within three or four years of leaving their office (Kane, 2002). Calomiris and Kahn (1996) show that such a system worked well in the 19th century Suffolk banking system, where claims to deferred bonuses were paid only after losses had been deducted. The public embarrassment of having to forfeit compensation would incentivize top supervisors to use market signals more efficiently and help them to resist political pressure to bail out zombie firms.

Giving more power to regulators without first improving their incentives will not fix anything important. One cannot improve the quality and effectiveness of government regulation and supervision merely by rewriting a few rules and mission statements. Even in countries whose markets are unsophisticated, good incentives and reliable information can produce effective regulation. That bad incentives generate misinformation and painful losses is the cumulative lesson that this and other crises impart.

[Credit rating organizations] claim only to be expressing an “opinion.” ... Whenever someone (say, a lawyer) collects a large fee for communicating his or her opinion to another party, the distinction between opinion and advice seems to break down.

Financial deregulation is often blamed for causing crises ... However, deregulation does not necessarily provide greater opportunities to shift private risk exposures onto the safety net. ... In principle, relaxing controls on interest rates, charter powers and portfolio structure promised to improve banks’ ability to foster economic growth and economic justice. But coupling deregulation with inadequate supervision of leverage and asset quality is a recipe for disaster ...

Authorities’ positive response to this competitive pressure has been labeled financial deregulation, but our ethical perspective makes it clear that the response is better described as desupervision.

Some of this resonates well with other perspectives that I have blogged about in the past. For example, my post about the panel discussion between Niall Ferguson, Nouriel Roubini, Jim Chanos and others as also the post on the paper by Bebchuk and Spamann on bankers’ pay and incentives.

Posted at 11:48 on Sun, 05 Jul 2009     View/Post Comments (0)     permanent link

Thu, 02 Jul 2009

Indian government clings to obsolete categories of financial intermediaries

As I read the Economic Survey presented by the Indian government today, I was struck by how the government is still clinging to obsolete categories of financial intermediaries. In Chapter 5 (paragraph 5.61), the government classifies financial institutions into (a) term lending institutions, (b) refinance institutions and (c) investment institutions.

This looks fine except that investment institutions refers to public sector insurance companies and not to mutual funds, venture capital funds or other true investment institutions. What is worse is that the private sector insurance companies are not included in this list but are discussed in a separate section on insurance companies.

The table on the next page (after para 5.64) is even more hilarious. The data on term lending institutions in this table includes SIDBI which is classified as a refinance institution in para 5.61. The table also includes a separate row for specialized institutions which includes a couple of venture capital companies but not all the SEBI regulated venture capital funds.

The entire classification is completely useless. During the mid 1990s, the entire category of financial institutions became increasingly anachronistic. However, more than a decade later, the government clings to this obsolete category.

Other countries have similar problems though perhaps not as ridiculous as this. In the US before the crisis, Countrywide was classified as a thrift but has now become part of a bank (Bank of America). Goldman Sachs was a Consolidated Supervised Entity (CSE) and has now become a bank holding company.

Even if we cannot bring sanity into our balkanized regulatory frameworks, can we not use sensible classifications when collecting and presenting statistical data?

Posted at 21:19 on Thu, 02 Jul 2009     View/Post Comments (0)     permanent link

Thu, 25 Jun 2009

US fondness for ratings continues

Last week, I blogged about the US being an outlier in terms of its excessive use of ratings in its regulations. This fondness for credit ratings (particularly the highest rating) continues. Yesterday, the US SEC announced proposals for reforms of money market mutual funds. Reforms are clearly needed here – among the most scary consequences of the Lehman bankruptcy last September were the problems at the Reserve Primary Fund which saw its Net Asset Value drop below par.

SEC is eliminating the ability of the money market funds to hold 5% of their assets in “Second Tier” securities that have the second highest credit rating instead of the highest rating. This was of course one of the recommendations of the industry body (ICI) in its report of March this year. But even that report admitted that investment in second tier securities had nothing to do with the post Lehman crisis. Lehman had a Prime-1/A-1/F-1 short term credit rating (making it a first tier security) right up to its bankruptcy.

To my mind, this reform is indicative of regulatory capture. This is the kind of tiny change that has propaganda value for the fund management industry (“money market funds are safer than ever before”) while changing nothing substantive. If the SEC genuinely wanted to use ratings to make funds safer, it could have said that the issuer must also have a AAA/AA long term rating – Lehman was rated A long before its bankruptcy.

Actually, having something like 5% in second tier securities is not entirely a bad thing in that it reduces the skewness of the distribution. A portfolio of top rated securities can only experience downgrades and this produces a skewness towards the left. A small proportion of securities that can experience upgrades could make the distribution more symmetric.

The weighted average credit rating of a portfolio is more important than the minimum rating as a measure of credit risk. The current SEC rule does not distinguish between gradations within the highest rating category. A money market fund with a small amount of second tier securities and a lot of A1+/F1+ securities in its portfolio can have a higher weighted average credit rating than a fund which has no second tier securities at all. In the run up to its bankruptcy, Lehman had an A1/F1 rating and not an A1+/F1+ rating.

Finally, the best reform (something that a regulator captured by the industry would never dream of doing) is simply to prohibit stable (amortized) value completely. All funds should be required to operate a proper net asset value (based on market prices) that would fluctuate up and down so that investors do not get a false sense of security.

Posted at 16:40 on Thu, 25 Jun 2009     View/Post Comments (5)     permanent link

Mon, 22 Jun 2009

Rethinking SEBI Pricing Guidelines

I participated in a panel discussion on SEBI pricing guidelines on CNBC last week. Transcripts are here and video is here. Some excerpts from my comments:

I think this two-week, six-months averaging and all that is a bureaucrat’s paradigm. It completely ignores market reality. ... when the environment has changed you need to be able to price based on what the current reality is. You cannot price on a two-week average when current market realities are totally different. ... I think the entire pricing guidelines are based upon bureaucratic delusions and they must go at least for liquid stocks.

I repeated my earlier arguments (see here and here) that regulators must trust market prices at least for liquid stocks.

Posted at 16:24 on Mon, 22 Jun 2009     View/Post Comments (1)     permanent link

Fri, 19 Jun 2009

Obama's Financial Reforms and Rajan Committee

I wrote an article in today’s Financial Express comparing Obama’s proposals for financial regulatory reform in the United States with the Rajan Committee proposals in India. Obama’s speech is available here and the full report is available here. The Rajan Committee report is available here.

On Wednesday, US President Obama unveiled an 89 page blueprint for reforming financial regulation in the US in response to the financial crisis. The proposals have several striking similarities with the recommendations of the Raghuram Rajan Committee in India a few months ago.

Obama outlined the need for overhauling the regulatory structure very succinctly. He said that where there were regulatory gaps, regulators lacked the authority to take action and where there were overlaps, regulators lacked accountability for their inaction. The US and India face this problem of regulatory gaps and overlaps far more acutely than many other countries (like the UK, Singapore or Germany) which have a more streamlined regulatory architecture.

While recognising this problem, both the Obama and Rajan proposals make only incremental changes to the existing architecture and eschew more ambitious proposals to scrap the system altogether and start all over again. The reality is that even these proposals might test the limits of what is politically feasible.

Obama called for the creation of a Financial Services Oversight Council (FSOC) which is very similar to Rajan’s Financial Sector Oversight Agencies (FSOA) in terms of its composition and structure. Both bodies consist of the heads of all regulatory agencies and have a permanent secretariat. One difference is that the FSOC is chaired by the Treasury Secretary.

The much bigger difference is that Rajan’s FSOA was also to be the macro-prudential regulator for systemically important financial conglomerates and organisations. Under Obama’s proposals, the macro-prudential regulator for such conglomerates (unimaginatively called Tier 1 Financial Holding Companies) is the Federal Reserve Board. Arguments can be made in favour of both models. In the Indian case, the critical concrete question would be whether the RBI should be the macro-prudential regulator for the LIC or whether this role should be performed by all sectoral regulators meeting together.

Obama calls for the creation of a Consumer Financial Protection Agency (CFPA) whose role is very similar to that of the Office of the Financial Ombudsman (OFO) proposed by the Rajan Committee. The key difference is that the CFPA is vested with vast statutory powers while the OFO was conceived of as having much of the characteristics of a self-regulatory organisation. I believe that while there is merit in starting out with less formal statutory powers, the OFO should also move in the direction of the CFPA whose bite is as formidable as its bark.

On the markets, the corner piece of the Rajan report was the merger of the commodities derivatives regulator (FMC) into the securities regulator (SEBI). In the US too there were high expectations about merging the CFTC into the SEC, but Obama has stopped short of this.

Given the perception of the SEC today as a failed regulator (Bear Stearns, Lehman and Madoff), it is perfectly understandable that the President is reluctant to reward it with greater powers. The one regulator whose failures were even more egregious than that of the SEC – the OTS which regulated AIG – is proposed to be disbanded. Another infamous regulator – the OFHEO which regulated Fannie and Freddie – has already been replaced by the FHFA. In this context, the SEC should count itself lucky that it has been left largely intact.

In the long run, however, a merger of the CFTC into the SEC is inevitable and if Mary Shapiro’s attempts to reform the SEC succeed, we might not have to wait for the next crisis for this to happen. In India, the arguments for folding the FMC into Sebi are very strong and there is no need to wait at all.

Obama’s proposal (like the Rajan report) calls for moving most Over The Counter (OTC) derivatives towards centralised clearing and bringing them under the purview of the market regulators. This is absolutely necessary. Obama’s blueprint also states that key settlement and clearing agencies should have access to central bank accounts and facilities to reduce their dependence on banks. This is an extremely important issue in India as well where the dependence of securities clearing agencies like NSCCL and CCIL on commercial banks has become an unacceptable source of systemic risk.

Obama’s reforms recognise the importance of preserving vibrant financial markets. Obama rightly states that the role of the government is not to stifle the market, but to strengthen its ability to unleash creativity and innovation. The goal is to restore markets in which we reward hard work and responsibility and innovation, not recklessness and greed. He also says that the purpose of regulation is to allow markets to promote innovation while discouraging abuse, and to allow markets to function freely and fairly, without the risk of financial collapse.

These are important principles to keep in mind. The current global crisis has discredited the existing regulatory regime for financial markets; they have not discredited financial markets themselves.

Posted at 21:42 on Fri, 19 Jun 2009     View/Post Comments (0)     permanent link

Thu, 18 Jun 2009

Stocktaking on the use of credit ratings

Earlier this week, the Basel Committee (along with IOSCO and IAIS – the Joint Forum) published a report entitled “Stocktaking on the use of credit ratings” which documents the use of credit rating in banking, securities and insurance regulations in several major countries around the world. What struck me while reading the report is the fact that the US appears as an outlier in its pervasive use of credit rating in all aspects of its financial regulations.

Surprisingly, the UK uses credit ratings very little apart from what is mandated by Basel-II. In particular, the UK does not use credit ratings at all in determining what securities a regulated entity can or cannot invest in. (Just in case, one worries that somebody in the FSA might have made a mistake while checking boxes in the survey questionnaire, the report states categorically, “ the United Kingdom Financial Services Authority (UK FSA) noted that credit ratings are not used in any of its three financial sectors for asset identification.”)

For a country like India whose regulations use ratings quite extensively, this is an opportunity for a hard rethink. The current global crisis has shown that rating agencies can horribly wrong. More importantly, the crisis has reminded us that even when ratings measure idiosyncratic risk well, they are a poor signal of systemic risk.

Posted at 10:38 on Thu, 18 Jun 2009     View/Post Comments (4)     permanent link

Fri, 12 Jun 2009

Bankers' pay and incentives

Much has been written about how (a) bankers’ pay is excessive and (b) the incentive created by these pay structures encourage risk taking. A lot of this discussion has treated bankers’ pay as a corporate governance problem without considering the special characteristics of banks. I was therefore delighted to read this paper by Bebchuk and Spamann which is like a breath of fresh air.

Bebchuk and Spamann point out that because of the excessive leverage of banks and the explicit and implicit support of the government, the shareholders are incentivized to support excessive risk taking. Therefore the standard corporate governance ideas of aligning the interests of managers with that of shareholders are useless when it comes to banking. They propose that regulators should step in and require that incentives be linked to the total value of the firm and not just the value of the equity.

Bebchuk and Spamann do not address the issue of bankers’ pay being excessive though that has a similar explanation. Deposit insurance and implicit government guarantees create the potential for huge rents in banking. The only way to extract these rents is by highly complex (and possibly deceptive) risk taking strategies that get past regulatory restrictions. Implementing these strategies therefore requires a great deal of expertise and skill which are in short supply. Therefore when shareholders try to extract rents by hiring smart people to implement complex risk taking strategies, most of the rents are in fact extracted by the managers themselves. To view this as a corporate governance problem is a mistake. It is a problem of government policy that encourages rent seeking.

Bebchuk and Spamann also correctly point out that the managers whose personal wealth has been destroyed by the collapse of their banks were not necessarily stupid or ex ante irrational. Ex ante, they could well have been responding correctly to the incentives that they faced and the probabilities that they estimated.

Posted at 16:02 on Fri, 12 Jun 2009     View/Post Comments (2)     permanent link

Tue, 21 Apr 2009

Away on vacation

I am away on vacation for about six weeks. I will not be posting on my blog till mid-June. Comments on my blog during this period will also be moderated only after I come back.

Posted at 12:13 on Tue, 21 Apr 2009     View/Post Comments (4)     permanent link

Mon, 13 Apr 2009

Satyam sale and the walk away option

Now that the government appointed Board of Satyam has sold a controlling stake to Tech Mahindra, it is useful to examine how the implicit walk away option can prove so damaging to the current Satyam shareholders and how it can be hugely beneficial to Tech Mahindra. This analysis confirms what I have been arguing for some time now: the decision to sell a partial controlling stake instead of selling the whole company was not in the interests of the shareholders.

The implied valuation of probably less than six months revenues for the transaction is quite low except for the unknown liabilities of the company in several US class action law suits. It is these unknown liabilities that make the walk away option hugely valuable. What makes walk away feasible is the fact that Satyam’s value is not in the form of tangible assets, but largely in the form of its customers and employees.

Over a period of two to three years, Tech Mahindra which is itself in the same industry could transfer the entire Satyam business to itself. This could be done as new contracts are signed or existing contracts are renewed. Over the same time frame, the employees of Satyam could also be shifted to the Tech Mahindra payroll. Once this process is complete, Satyam would have some cash and other assets and potentially huge liabilities.

The walk away option is that if the liabilities turn out to be larger than the cash and other assets, Tech Mahindra can walk away and put Satyam into bankruptcy. If the liabilities turn out to be small, then Tech Mahindra can merge Satyam into itself and absorb the surplus assets. Option pricing theory teaches us that the more the uncertainty (volatility) the greater the value of this walk away option. Since the uncertainty today is huge, the option is hugely valuable.

The fact there were (as some people put it) only two and a half bids for Satyam suggests that a number of potential bidders who thought that they would never exercise the walk away option (for reputational or other reasons) chose not to bid at all. Without the walk away option, the risks were simply too high.

There are two other reasons why Tech Mahindra would prefer to transfer the Satyam business to itself. First, it owns only 51% of Satyam and therefore earns only 51% of the revenues of Satyam. If the contract is renewed with the parent company itself, it gets 100% of the revenues. Second, Satyam commands a low valuation in terms of price-revenue multiples (less than 0.5 at the bid price) while Tech Mahindra commands a higher valuation (about 1.0). Moreover with the Satyam acquisition, Tech Mahindra would try to position itself in the league of the top tier software companies which command multiples of about twice revenues.

Even if we consider a price to revenue multiple of 1 for the parent and 0.5 for the subsidiary, a dollar of revenues at the parent adds a dollar to the market capitalization, while a dollar of revenue at the subsidiary adds only 0.25 to the parent’s market capitalization. The financial motivation for shifting business to the parent are very high even without the walk away option.

What this means is that while today’s sale is great for the employees and customers of Satyam and for the Indian software industry, it is not so great for the shareholders. They get very little money now (except for the 20% open offer) and might find after three years that they own shares in a shell company that has little or no value.

The shareholders would certainly have preferred a sale of 100% of the company that gives them cash now.

Posted at 17:30 on Mon, 13 Apr 2009     View/Post Comments (10)     permanent link

Tue, 07 Apr 2009

Lessons from Overend Gurney after 150 years

In 1866, the then privately owned Bank of England allowed the largest discount house in the world, Overend and Gurney to fail. In its time, Overend and Gurney was clearly far more systemically important in world finance than Lehman was when it failed. It was not the Lehman of its day, not even the Goldman, but something bigger. It was second only to the Bank of England itself. Its discount business was probably equal to the other big three discount houses (Alexander, Bruce Buxton and Sanderson) put together (W. T. C. King, “The Extent of the London Discount Market in the Middle of the Nineteenth Century” Economica, New Series, Vol. 2, No. 7 (Aug., 1935), pp. 321-326). Milne and Wood (“Banking Crisis Solutions Old and New”, Federal Reserve Bank of St. Louis Review, September/October 2008, 90(5), pp. 517-30) give an even bigger estimate: “its annual turnover of bills of exchange was equal in value to about half the national debt, and its balance sheet was ten times the size of the next-largest bank.”

Its failure caused a panic which used to be described (until the current crisis) as the last true panic in London. In the long run, however, the financial system was hugely strengthened by the decision not to create moral hazard by bailing out the insolvent Overend and Gurney in 1866.

I would like to end with quotes from two well known Austrian economists. First from Israel Kirzner: “every mistake made in the market by one entrepreneur represents an opportunity for another.” Second from Ludwig Von Mises “Those fighting for free enterprise and free competition do not defend the interests of those rich today. They want a free hand left to unknown men who will be the entrepreneurs of tomorrow.” The regulatory mistake of the last decade or more has been defending the interests of those rich today; this is a mistake that continues today with all the bail outs that we are seeing.

Posted at 10:55 on Tue, 07 Apr 2009     View/Post Comments (3)     permanent link

Wed, 01 Apr 2009

Do not blame the efficient market hypothesis

I have a piece in today’s Financial Express arguing that we should not blame the Efficient Market Hypothesis (EMH) for the current crisis. I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously.

In the run up to the G20 summit, several global regulators have put out blueprints for reforming global financial regulation – apart from the Turner review in the UK, we have had proposals by the US Treasury, the People’s Bank of China, former Fed Chairman, Alan Greenspan and several academics and practitioners.

Several of these proposals make eminent sense: greater capital requirements for banks and near banks; orderly bankruptcy process for systemically important financial institutions; more robust regulation and supervision.

The emerging consensus is however wrong in asserting that mistakes in financial regulation were caused by the belief in the Efficient Market Hypothesis (EMH). The Turner review says for example that: “The predominant assumption behind financial market regulation – in the US, the UK and increasingly across the world – has been that financial markets are capable of being both efficient and rational.... In the face of the worst financial crisis for a century, however, the assumptions of efficient market theory have been subject to increasingly effective criticism.”

I do not think that regulators were fooled by the EMH. The truth is the exact opposite; regulators were fooled because they did not take the EMH seriously. Had they done so, regulators would not have been as complacent as they were during the last decade. The EMH very simply states that there is no free lunch; whenever you see an abnormally high return, EMH warns us that there must be an abnormally high risk lurking behind it.

For example, an EMH believer would not have invested in a Madoff fund because according to the EMH, Madoff style returns are not possible. In fact, critics say that an EMH fanatic would not pick up a hundred rupee note from the road because according to the EMH, that note cannot be there – either the note is fake or somebody must already have picked it up. Yes, EMH can make you miss some investment opportunities, but it will also protect you from hidden and unknown risks.

What would the EMH have told Greenspan when he saw the profits of the financial sector rise from 15-20% of total corporate profits in the 1970s and 1980s to over 40% in the last decade? EMH would have told him that there are only two possibilities: either financial institutions were becoming impregnable monopolies or they were taking incredibly high risk. The former hypothesis could be easily ruled out because financial deregulation was making the financial sector highly competitive particularly when one considered competition from the shadow financial system and from foreign players. If Greenspan actually believed in the EMH, he should have been very very worried.

When banks tried to make money with “arbitrage CDOs” by tranching pools of securities in different ways, the EMH would have argued that the value of a pie does not depend on how it is cut. Investors and regulators who believed in the EMH would have been sceptical of some of those AAA ratings.

Again, when banks increased their leverage ratios to absurdly high levels, a regulator who believed in the Modigliani-Miller (MM) theory of capital structure would have mulled over Miller’s own words (way back in 1995): “An essential message of the MM Propositions as applied to banking, in sum is that you cannot hope to lever up a sow’s ear into a silk purse. You may think you can during the good times; but you’ll give it all back and more when the bad times roll around.”

The MM theory implies that banks seek higher leverage mainly to exploit the subsidy provided to them in the form of deposit insurance and lender of last resort. Greater capital requirements for banks do not therefore have a significant social cost though they are costly to the shareholders and managers of the banks.

As Nouriel Roubini points out: “people are greedy in every industry, people in every industry try to avoid regulation sometimes with lies, sometimes by cheating or avoiding, whatever. But there’s only one industry, the financial industry, in which this thing leads, over and over again, to financial crisis. It happens for two reasons. One because banks have deposit insurance and deposit guarantees.... Two, we have lender of last resort support”.

The point is that regulators who believed in the EMH and the MM theory would have regulated banks far more tightly. Alan Greenspan claims that prior to 2007, the central premise was that “the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency.” Sorry, the EMH says no such thing. In fact, the theory says that if owners and managers can keep the profits and pass on losses to the taxpayers, they would be selfish enough to avoid keeping a sufficient buffer. The EMH would have disabused Greenspan and other regulators of the naïve assumption that bankers could be trusted.

Posted at 11:04 on Wed, 01 Apr 2009     View/Post Comments (11)     permanent link

Tue, 31 Mar 2009

Indian Financial Sector Self Assessment Report

Updated: Ajay Shah corrects me and points out that this is not a true FSAP but an imitation of the real thing. Even less reason to take it seriously. Incidentally, I think that the real FSAP itself is a waste of time if not worse. But that is beside the point.

The Indian financial press is today full of stories based on the Financial Sector Self Assessment Report prepared jointly by the Reserve Bank of India and the Ministry of Finance.

I think the coverage given to this self assessment report is quite disproportionate to its true significance because the report is prepared as part of the country’s participation in the Financial Sector Assessment Programme (FSAP) conducted by the IMF and the World Bank.

As anybody who has prepared or evaluated a self assessment report knows, it is critically important for such a report to demonstrate (a) an awareness of major weaknesses and (b) some thinking about possible measures to overcome them. If these are present in the self assessment, the external evaluator can and often does condone all the weaknesses!

By these standards, the self assessment report does an admirable job. But by the same token, it is silly to think that the report reflects the thinking of the RBI or the government on any of these matters.

Posted at 21:22 on Tue, 31 Mar 2009     View/Post Comments (2)     permanent link

Mon, 30 Mar 2009


Links to some interesting stuff that I have been reading

Posted at 19:58 on Mon, 30 Mar 2009     View/Post Comments (1)     permanent link

Fri, 27 Mar 2009

Obstfeld on FX Reserves and Panic of 2008

I have been reading an NBER Working Paper by Obstfeld, Shambaugh and Taylor Financial instability, reserves, and central bank swap lines in the panic of 2008. These are well respected authors, so I was quite disappointed to find that they have made several errors and missed several key features of what they call the “panic of 2008.”

Most important of these is the fact that currency depreciations during 2008 were driven to a very great extent by the foreign currency liabilities of the banks and of the corporate sector. This reality was staring them in the face in the form of Iceland, but they amazingly treated Iceland as an outlier and dropped it from all their analysis. They seemed to have forgotten that in risk management, the outlier is the data and everything else is a distraction. Iceland was an extreme case, but the short dollar position of banks and companies were a critical factor behind currency depreciations in the three large emerging economies that Obstfeld et al plot in Figure 1 (Russia, India and Korea).

Failure to consider the exposure of the banking system leads them to under estimate the reserve needs of emerging economies. They make the statement that countries like India “do have foreign reserves sufficient to allow them to act as crisis lenders to foreign governments.” This is simply not true.

Obstfeld et al make another mistake in asserting that for countries like Korea, the swap lines from the US Fed served only a signaling purpose because these countries had plenty of reserves and the magnitude of the swap line was not meaningful in relation to the reserves. This again is simply false. Earlier this month, the Wall Street Journal quoted a finance ministry official as saying that the Bank of Korea had drawn down more than half of the swap line and that it might need a second or third line. Korea is really short of reserves and it has also been reported that not all of its reserves are sufficiently liquid.

It is distressing to find such serious errors in a paper by economists of such high standing who have done so much of widely cited work in this field. I know a working paper is supposed to be for dissemination in preliminary form and is not necessarily subject to peer review, but still ...

Posted at 18:25 on Fri, 27 Mar 2009     View/Post Comments (0)     permanent link

Sat, 21 Mar 2009

Exchange competition and governance

The Mint has two articles on exchange competition and governance which quote me extensively. I made the following statements:

Competition is always good, but in the exchange space one must also ensure that this doesn’t go in a totally different direction, where the competition is on who’s the least governed exchange.

Where one trades is driven by liquidity more than anything else. People want the ability to trade and will chase liquidity. An exchange with a near-monopoly in a particular contract can raise margins and transaction charges significantly without losing much market share.

Even with a low ownership stake, one entity can control an exchange. And with an ownership cap, the threat of takeover is diminished, giving the entity in control a free run.

In other jurisdictions, the regulatory role of exchanges have been separated to non-profit entities to avoid conflict of interest. Such options could be considered in India.

Listing would improve accountability and lead to better disclosures. Besides, inspections and enforcements by the regulator could be strengthened.

My position is that competition is always good and the regulators should endeavour to get as much competition as possible and design a regulatory framework to deal with the consequences of competition. I believe that the “fit and proper” requirement that regulators consider while licensing regulated entities leads to unwarranted complacency. Regulators must assume that their regulatees are unfit and improper and frame regulations on this assumption. If this leads to a harsher regulatory regime than would prevail otherwise, so be it.

When I talked about listing, I had not read about the collapse of CLICO/CIB. With $24 billion of assets and 60 subsidiaries, operating in several fields, and spread over 20 countries – in the Caribbean, Central and North America and Europe, CLICO was one of the leading financial conglomerates in the Caribbean region before it failed. A couple of days ago, I read the speech of the Governor of the Central Bank of Trinidad and Tobago about the episode where he says:

For all its tremendous growth over the last several years, CLICO has remained a private company which has shielded the company from the kind of scrutiny (through, for example the submission of quarterly accounts) to which public companies are exposed.

I am veering round to the view that all systemically important financial intermediaries – banks, insurance companies, mutual funds, exchanges, operators of settlement and payment systems and so on – should be listed.

Posted at 16:09 on Sat, 21 Mar 2009     View/Post Comments (2)     permanent link

Sun, 15 Mar 2009

More on Sovereign Defaults

I blogged about sovereign defaults in November last year. Since then, I have been reading a lot about sovereign defaults with a focus on defaults by sovereigns who were great powers at the time of default. I have also been doing some reading about credit default swaps on sovereigns.

Turning first to sovereign defaults, I went back to the famous Stop of the Exchequer by Charles II of England in 1672. I regard Charles II as one of the greatest kings of England (one Royal Society is worth a few sovereign defaults!) What struck me was the brazen manner in which the sovereign proclaimed his default:

... his Majesty, being present in Council, was pleased to declare that ... his Majesty considering the great charges that must attend such preparations, and after his serious debates and best considerations not finding any possibility to defray such unusual expenses by the usual ways and means of borrowing moneys, by reason his revenues were so anticipated and engaged, he was necessitated (contrary to his own inclinations) upon these emergencies and for public safety at the present, to cause a stop to be made of the payment of any moneys now being or to be brought into his Exchequer, for the space of one whole year ... unto any person or persons whatsoever by virtue of any warrants, securities or orders, whether registered or not registered therein, and payable within that time, excepting only such payments as shall grow due upon orders on the subsidy, according to the Act of Parliament, and orders and securities upon the fee farm rents, both of which are to be proceeded upon as if such a stop had never been made.

... and that in the meantime ... his Treasury be required and authorized to cause payment to be made of the interest that is or shall grow due at the rate of six pounds per cent, unto every person that shall have money due to him or them ... so postponed and deferred.

English Historical Documents, 1660-1714 By Andrew Browning, p 352

Next I turned to the US abrogation of the gold clause in 1933. Investors in the US protected themselves from the debasement of the currency by demanding a clause requiring repayment in gold or in coins of specific weight and purity of gold. In 1933, the US abrogated this clause with a resolution that is again striking in its brazenness:

House Joint Resolution 192, June 5, 1933

Joint resolution

To assure uniform value to the coins and currencies of the United States and currencies of the United States. Whereas the holding of or dealing in gold affect the public interest, and are therefore subject to proper regulation and restriction; and

Whereas the existing emergency has disclosed that provisions of obligations which purport to give the obligee a right to require payment in gold or a particular kind of coin or currency of the United States, or in an amount in money of the United States measured thereby, obstruct the power of the Congress to regulate the value of the money of the United States, and are inconsistent with the declared policy of the Congress to maintain at all times the equal power of every dollar, coined or issued by the United States, in the markets and in the payment of debts.

Now, therefore, be it Resolved by the Senate and House of Representatives of the United States of America in Congress assembled,

That (a) every provision contained in or made with respect to any obligation which purports to give the obligee a right to require payment in gold or a particular kind of coin or currency, or in an amount in money of the United States measured thereby, is declared to be against public policy; and no such provision shall be contained in or made with respect to any obligation hereafter incurred. Every obligation, heretofore or hereafter incurred, whether or not any such provision is contained therein or made with respect thereto, shall be discharged upon payment, dollar for dollar, in any coin or currency which at the time of payment is legal tender for public and private debts.

These measures were challenged in the US Supreme Court which upheld them stating (Norman v. Baltimore & O.R. Co., 294 U.S. 240):

We are not concerned with their wisdom. The question before the Court is one of power, not of policy.

Contracts, however express, cannot fetter the constitutional authority of the Congress. Contracts may create rights of property, but, when contracts deal with a subject-matter which lies within the control of the Congress, they have a congenital infirmity. Parties cannot remove their transactions from the reach of dominant constitutional power by making contracts about them.

The Supreme Court also upheld the abrogation of the gold clause for the government’s own borrowing. The concurring opinion of Justice Stone in Perry v. United States, 294 US 330) was unusually blunt:

... this does not disguise the fact that its action is to that extent a repudiation of its undertaking. As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion, announced for the Court, that in the situation now presented, the government, through the exercise of its sovereign power to regulate the value of money, has rendered itself immune from liability for its action. To that extent it has relieved itself of the obligation of its domestic bonds, precisely as it has relieved the obligors of private bonds.

Finally, I looked at the world’s leading serial defaulter. “Spain defaulted on its debt thirteen times from the sixteenth through the nineteenth centuries, with the first recorded default in 1557 and the last in 1882.” (Reinhart, Rogoff and Savastano, “Debt Intolerance”, Brookings Papers on Economic Activity, 2003(1), 1-62)

I was most interested in the defaults of Philip II, who “failed to honor his debts four times, in 1557, 1560, 1575 and 1596.” (Drelichman and Voth, The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position, 1560-1598)

Drelichman and Voth find that:

Contrary to the received wisdom, we show that Philip II’s debts were sustainable for most of his reign. ... Overall, Habsburg Spain’s fiscal discipline was similar to that of other hegemonic powers, such as eighteenth-century Britain or twentieth-century America.

Philip II managed to run a primary surplus in every year of his reign for which we have data. The king never borrowed to cover interest. ... the average primary surplus increased throughout the period as the Crown strove to deal with the increasing interest payments.

With this as background, buying CDS protection on the leading sovereigns of today does not appear to me to be the madness that Krugman claims it to be: “A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?”

First of all, Alea blog points out “No, they are not crazy, the contracts will be honoured: 100%, guaranteed, for a simple reason, most sovereign CDS are packaged in fully funded credit derivatives first-to-default credit linked notes, therefore the protection buyer gets the cash upfront and is not exposed to the protection seller credit risk.”

He also points to the prospectus of one of these credit linked notes under which a Belgian bank could end up buying credit default protection against the Belgian government (and other governments) from a Belgian dentist. It would work perfectly. Of course, the Belgian dentist is exposed to default risk of the bank, but if the sovereign is solvent, it would probably backstop its bank and the risk of default is low in today’s moral hazard filled world.

Second, Credit Trader points out that the denomination of the CDS in Euros increases the value of the CDS significantly because it effectively becomes a quanto derivative. Third, the inclusion of the restructuring event as a default event makes a world of difference.

One of the scenarios that I consider plausible is that similar to the gold clause repeal, the US could decide that inflation indexed treasury bonds (TIPS) would be redeemed in nominal dollars and not inflation indexed dollars. I am not a lawyer, but I would imagine that this would pass master with the US Supreme Court just as the gold clause resolution did. I would also imagine that such an action would amount to a default event (restructuring) that triggers the CDS payment. That is why as I argued back in November, having the contract governed by a non US law is very useful.

Today, TIPS are a very attractive asset if investors could protect themselves against the US defaulting on its indexation obligation. Buying TIPS and then buying CDS protection on the US government appears to me to be a very sensible trade and not madness at all.

Posted at 17:03 on Sun, 15 Mar 2009     View/Post Comments (7)     permanent link

Thu, 12 Mar 2009

Has Barro solved the equity premium puzzle?

I have been reading the paper on stock market crashes and depressions by Barro and Ursua which among other things appears to solve the equity premium puzzle. The equity premium is called a puzzle because the historical return on stocks (over multi-decadal time frames) has exceeded that on bonds by too wide a margin to be justified by the higher risk of stocks in a standard utility theory framework.

The equity premium was a puzzle because the return on stocks is not too highly correlated with consumption and in a standard utility framework, the relevant risk is actually consumption risk. Crudely speaking, the risk is that you do not have enough money from your investments to support your consumption precisely when incomes are low and therefore the investment money is needed. I say crudely speaking because in the frictionless models of the permanent income hypothesis, consumption is supposed to be a function of wealth (including human capital) and not of income at all. A model of risk premiums which ignores liquidity constraints so brazenly might not be very satisfying to finance people, but that is a different issue altogether.

The solution proposed to this puzzle is essentially that the entire consumption risk of equities is a tail risk. It arises from the high probability that stock market crashes are accompanied (with a variable lag) by an economic depression. One big advantage of depressions over wars and other calamities as the explanation for the equity premium is that depressions make risk free bonds very attractive assets.

Of course, Barro has been saying this for a few years now, but now he has the cross country data to back him up. “Conditional on a stock-market crash [multi-year real returns of -25% or less], the probability of a minor depression (macroeconomic decline of at least 10%) is 30% and of a major depression (at least 25%) is 11%.” Taking this tail risk into account is sufficient to justify the observed equity premium for plausible values of risk aversion.

I think this is definitely a promising line of analysis. Of course, a major econometric problem is that the lag between the stock market crash and the economic depression is not uniform (in some cases, it is even negative due to measurement errors). Barro and Ursua therefore “focus on the 58 cases of paired stock-market crashes and depressions ... and ... calculate the covariance in a flexible way that allows for different timing for each case.”

I am sure that a lot of methodological refinements are needed to understand the phenomenon better, but I like this approach. For Indian readers, it is interesting to note that the sample includes one episode from India (apart from the World War): during 1946-1949, real stock prices fell 49% while real GDP fell 18% during 1947-1950. That makes the current crisis seem quite bearable!

Posted at 15:44 on Thu, 12 Mar 2009     View/Post Comments (0)     permanent link

Thu, 05 Mar 2009

Is there any such thing as macro-prudential risk?

I have been grappling with this question ever since reading The Fundamental Principles of Financial Regulation by Markus Brunnermeier, Andrew Crockett, Charles Goodhart, Avinash D. Persaud and Hyun Shin. All the authors are well respected economists; and Brunnermeier, Persaud and Shin, in particular, have been among those whose writings I have admired a lot during this crisis. Yet, I am not convinced about their concept of macro-prudential risk as opposed to the micro-prudential risk that traditional risk models are allegedly concerned with.

My problem is that at least since Markowitz, risk has always meant portfolio risk. The riskiness of any asset is the contribution that it makes to the portfolio in which it is held. For an equity portfolio, therefore the risk of a stock is its covariance with the portfolio which is the approximately the same as the beta if the portfolio is highly correlated with the market portfolio. In a value at risk (VaR) model for a credit portfolio, the marginal risk of a loan is equal to its expected loss conditional on the total portfolio loss being equal to the VaR level (see for example, Hans Rau-Bredow, 2002). This is true in particular of the Basel II models as well.

Brunnermeier et al are rightly worried about herding behaviour where many banks hold similar portfolios and are thus exposed to the same risks. But in this situation, each bank’s portfolio is highly correlated with the aggregate portfolio of the banking system. Thus Basel II and similar allegedly micro-prudential risk models are in fact capturing the macro-prudential risk of each loan. At this point, (following Brunnermeier et al) I am also ignoring the technical inadequacies of the Basel II risk models. The question being asked is whether conceptually they are addressing the right risk. I think they are.

One of the problems I had with Brunnermeier et al is that they seemed to be focused on the wrong conditional probability. They frequently ask the question: conditional on a bank failing what is the probability that there is a systemic crisis. They argue correctly that this probability is higher for a bank with a AAA portfolio than for a bank with a BBB portfolio. I think the correct question to ask is the reverse conditional probability: conditional on a systemic crisis, what is the probability that the banks in question fail. This probability is higher for the bank with a BBB portfolio and this is consistent with the Basel II risk weights.

At this point, it is also worthwhile to remember that the capital required for a AAA loan is far in excess of its unconditional probability of default. In fact, the unconditional probability of default is the “expected loss” which in Basel II is supposed to be covered by the credit spread and is not supposed to come out of the capital charge at all. The capital charge deals exclusively with the “unexpected loss” and is defined by conditionalizing on a systemic shock.

In short, I think today’s risk models are conceptually addressing macro-prudential risk because in any portfolio risk model these are the only risks that matter. Whether they are measuring these risks right is a totally different question (see my last blog post).

Brunnermeier et al have a long discussion about liquidity risk and maturity mismatches as a macro-prudential risk. The example of Northern Rock permeates this discussion. I think the diagnosis of Northern Rock as a liquidity risk which seemed to make sense in 2007 (I was guilty of this diagnosis myself) has been invalidated by developments in 2008. The silent run that banks like WaMu witnessed have shown that there is no safety for a bank in retail deposits. Nor is there safety in retail term deposits. All banks allow customers to prematurely encash their term deposits with modest penalties. In bank runs, people queue up to do exactly that as for example in the mini runs that we had on ICICI Bank in India. The behavioural maturity of core deposits is a meaningful notion in normal times; in periods of crisis, the behavioural maturity is zero. In wholesale markets, maturity is ill defined because of put and call features combined with step-up coupons. Normal maturity assumptions about these bonds have been invalidated during the current crisis. In short, maturity mismatch is not a well defined term during a systemic crisis.

In this context, I am perplexed by the irrational fear of bank runs among regulators and academics alike. We must not forget that frequent runs and near runs are the principal defence that we have against Ponzi schemes (both Madoff and Stanford were ultimately exposed by runs on them). Solvent institutions with normal access to central bank liquidity support can survive runs. Banks that cannot survive a run despite the central bank liquidity window are fundamentally flawed; they need to fail.

Posted at 21:40 on Thu, 05 Mar 2009     View/Post Comments (4)     permanent link

Tue, 03 Mar 2009

Risk Management Lessons for Derivative Exchanges

A few days ago, I finished a paper on Risk Management Lessons from the Global Financial Crisis for Derivative Exchanges. The abstract of the paper says:

During the global financial turmoil of 2007 and 2008, no major derivative clearing house in the world encountered distress while many banks were pushed to the brink and beyond. An important reason for this is that derivative exchanges have avoided using value at risk, normal distributions and linear correlations. This is an important lesson. The global financial crisis has also taught us that in risk management, robustness is more important than sophistication and that it is dangerous to use models that are over calibrated to short time series of market prices. The paper applies these lessons to the important exchange traded derivatives in India and recommends major changes to the current margining systems to improve their robustness. It also discusses directions in which global best practices in exchange risk management could be improved to take advantage of recent advances in computing power and finance theory. The paper argues that risk management should evolve towards explicit models based on coherent risk measures (like expected shortfall), fat tailed distributions and non linear dependence structures (copulas).

Posted at 16:48 on Tue, 03 Mar 2009     View/Post Comments (10)     permanent link

Mon, 02 Mar 2009

Did 7th January tell us about anything about the governance discount?

On January 7, 2009, when the fraud at Satyam was revealed, investors did not think of Satyam as an unfortunate exception; most of them thought of it as symptomatic of the problems that could be lurking in many other leading Indian companies. Stocks of several other companies fell dramatically on that day in a manner that did not seem to reflect industry specific shocks. Within the information technology industry itself to which Satyam belonged, some stocks with a reputation for above average corporate governance rose while some other stocks fell dramatically.

To those who believe in the strong form efficiency of stock markets, it is tempting to believe that the market was telling us something about the perceived governance weaknesses of some Indian companies. In this context, it is worthwhile to ask whether the reaction of the market on that day was a panic reaction that was reversed over a period of time.

On January 7, 2009, nine out of the fifty stocks in the S&P CNX Nifty Index fell by more than 10% while the index itself fell by 6%. The median stock in the 50 stock index fell by only 5% while the median price decline of these nine stocks was 15%. I looked at what happened to these nine stocks week after week up to the end of February. Far from reversing course, these stocks extended their losses. While the index fell by 11% and the median stock in the Nifty fell by 17% from pre-Satyam levels, the median fall for the nine stocks was 37%. That is right, the median of these nine stocks underperformed the index by a whopping 26%. Only one of these nine stocks fell less than the index; the other eight underperformed the index by margins ranging from 12% to 35%.

In the case of the real estate stocks, is it possible to argue that the fall was industry wide; though one could counter argue that in this case, the entire industry was perceived to be plagued by governance problems. In most other cases, the market perception about governance appears to be the dominant theme. Of course, even if we believe that the market is telling us something, we do not know whether what it is saying is right or not.

Posted at 20:57 on Mon, 02 Mar 2009     View/Post Comments (2)     permanent link

Impairment test equals integrity test

I have a piece in today’s Financial Express arguing that the impairment test in the year end financials is a test of the integrity of Indian corporate sector.

Corporate India faces a significant test of the integrity of its financial statements at the end of this financial year when it has to apply an “impairment” test to a variety of assets under accounting standard AS 28. If assets are impaired, they have to be written down and the loss has to be charged to the profit and loss account.

Though AS 28 came into effect for listed companies from the year 2004-05, this is the first time that a large number of companies will be confronted with potential impairment on a large scale. Under AS 28, the requirement to carry out an impairment assessment arises only when there are external or internal indications that an asset may be impaired. The significant worsening of the domestic and global economic environment, sharp declines in market prices and deterioration in the economic performance of many assets would trigger the application of the impairment test for several classes of assets during this year.

There are four important categories of assets where impairment is likely to have taken place. These are: (a) goodwill from recent acquisitions (particularly, international acquisitions), (b) mines and other natural resource assets, (c) commercial real estate, and (d) capacity rendered redundant by demand destruction.

Indian companies made large international acquisitions at high prices during the boom. The current market value of several of the acquired companies would be well below what was paid for them. Their current and forecasted operating performance would also be much worse than what was projected at the time of acquisition. This would normally lead to a heavy impairment charge.

Some kinds of acquisitions would probably escape this charge. For example, if a foreign company was acquired mainly for its brands and marketing network or for its technology, the acquired company might not have an independent set of cash flows that can be used for an impairment test. In this case, the impairment test may have to be applied to the entire consolidated business. Companies whose shares are trading above book value are unlikely to be in the situation where the entire business is impaired and so no impairment charge may be needed.

Commercial real estate is another prime candidate for an impairment test because of the steep correction in market prices. Here again, if the real estate was bought for corporate offices or for other purposes which do not produce identifiable cash flows, impairment charges may not result unless the whole business is impaired. Real estate that was bought for development or for letting out or for producing revenue directly (as in infrastructure projects or retail stores) would be prime candidates for impairment.

Similarly, the sharp fall in commodity prices could trigger impairment charges for many natural resource assets like mines in India or abroad that were bought at the height of the boom.

Finally, the global recession has created excess capacity in a variety of industries. New capacity is coming on stream while even the old plants are running below capacity. Many of these assets might have to face an impairment charge. In many cases, it may be possible to argue that the low capacity utilisation is a temporary phase. But in some industries, the demand destruction has been too large for such a sanguine view.

Companies whose shares are trading below book value are in a worse situation. Their entire business may be impaired and they may have to write down many assets including unproductive corporate assets (ranging from art collections to aircraft) which have seen huge declines in price.

Banks and financial companies are in a separate league because the treatment of their impaired loans and investment is governed by different regulations. These losses are bound to rise, too, but that is another story altogether.

Stock markets are forward looking and are likely to have already factored in the deterioration in asset values in their valuation. Recognising this known loss in the published accounts would not cause a further drop in share prices. On the contrary, markets are likely to reward companies which are honest about what has happened, reflect this reality in their accounting and have a realistic plan to deal with their problems.

Markets are more likely to punish companies that try to avoid an impairment charge by using various accounting subterfuges. Such companies would be telling the world that their accounts cannot be trusted at all and that they are Satyams in the making. That would force the market to assume the worst and mark down even assets that are not actually impaired.

Many companies, however, do not seem to understand this. They appear to be under the delusion that all would be fine with the world if only they can find a way to avoid admitting the impairment that has taken place. That is why I think that the impairment test could end up being an integrity test for Indian accounting.

Posted at 12:15 on Mon, 02 Mar 2009     View/Post Comments (0)     permanent link

Wed, 18 Feb 2009

SEC confirms Dalmady analysis on Stanford

Within hours of my posting about Dalmady’s analysis of possible fraud at Stanford International Bank, I received a comment on my blog telling me that I was spreading lies and that I should recant:

Try to do some investigative work instead of building upon lies ... When you want something successful to fail you present the perception, associate it with something negative (Madoff) and watch the masses panic ... You have now created the reality ... I hope you put as much energy in recanting this story as you do posting them ...

I did not lose sleep over this comment because by the time I read that comment, the SEC had filed its complaint against Stanford confirming most of what Dalmady had surmised.

I found the SEC complaint short on hard facts. Did I really know anything more on reading this complaint than I did after reading Dalmady? I am not sure.

And, there were some things in the complaint that did not sound right to me like the assertion that it is “impossible” for a large portfolio to produce identical returns of exactly 15.71% in two successive years. If exact means that there was no rounding at all in arriving at 15.71%, then it is in fact almost impossible. But then it is quite improbable that a really large portfolio would produce a return which is exact to two decimal places (with no rounding error) in even one year. The return on a $8 billion portfolio at around 15% would be over a billion dollars and would therefore have twelve significant digits when measured in dollars and cents. Suppose that the return in percent is also computed to twelve significant digits. The probability that only the first four significant digits (1, 5, 7, 1) are non zero and the other eight significant digits are zero would then be about 10^(-8) or about 1 in 100 million. Quite improbable!

But if what they mean is that the return rounded to two places was 15.71%, then that is not impossible at all. If the range of returns is say 5% (500 basis points), then the probability of the return being the same as the previous year’s return to two decimal places (one basis point) is 1/500 or 0.2%. Since the SEC examined at least 10 years of data (their example is of 1995 and 1996 returns), the probability that they would find at least one year in which this happened is 1/50 or 2%. Certainly, 2% is not my idea of impossible or even improbable.

Posted at 16:33 on Wed, 18 Feb 2009     View/Post Comments (2)     permanent link

Replacing the Maytas board is not warranted

I was interviewed by CNBC Awaaz today on the government decision to move the Company Law Board to replace the Maytas Board in connection with the Satyam scandal. I disagreed with the move though I was among the first to argue that the government should replace the Satyam board early last month (see here and here). The Maytas situation is different both because the urgency of the Satyam case is lacking and because there are serious conflict of interest issues.

Satyam presented a complete governance vacuum: the Chairman had confessed to a fraud, the promoters probably no longer held much of their shares, and the independent directors had lost all credibility. This is not the case in Maytas. Second, Satyam had value only as a going concern as the tangible assets were a small fraction of its enterprise value. Maytas on the contrary is in real estate which is almost as valuable in liquidation as it is on a going concern basis.

More importantly, the prime allegation in respect of Maytas is that money looted from Satyam ended up in Maytas. This means that the stage is set for litigation between Maytas and Satyam. The government by taking over both these companies is interposing itself into a commercial dispute between two companies. Since Satyam is a much more high profile case, the temptation would be there for the government to favour the Satyam shareholders over the Maytas shareholders. This alone is a strong argument for not allowing the government to appoint a new Maytas board.

What does make sense is for the Company Law Board (CLB) to forbid any mortgage or sale of property by Maytas. The CLB could also order an emergency meeting of the shareholders to elect a new board. This was not a feasible option in the Satyam case because of the urgency emanating from the intangible nature of its assets.

The power to replace the board is an extraordinary power to be exercised only in extraordinary situations. Power has a tendency to become addictive; having used it once, the temptation is to use it again and again even when the circumstances do not warrant it. This temptation must be resisted.

Posted at 12:55 on Wed, 18 Feb 2009     View/Post Comments (2)     permanent link

Tue, 17 Feb 2009

Dalmady: The blogging Markopolos?

A week ago, I blogged about Pellechia’s suggestion that Markopolos should have blogged about Madoff instead of taking his suspicions to the SEC. I mentioned then that the problem is that the blogger would fear regulatory action for “rumour mongering.” Now we do have Alex Dalmady blogging about another possible Ponzi scheme.

Dalmady is smart. His five page article in the Venezualan publication Veneconomy of January 2009 gets to the “case study” only after two pages of general discussion about scams and mentions the name of the entity (Stanford International Bank) only on page 4. His description of the whistleblower’s dilemma is very well put:

Another thing many can’t grasp is why these scams aren’t uncovered. The truth is that most of them are “found out” all by theselves or when the circumstances make it obvious. ... And it’s not just because the participants are happy while they are collecting profits. It’s that a good scam is really hard to detect and almost impossible to uncover without inside help.

Being “almost sure” is usually “not enough.” How do you blow the whistle when you’re “almost sure”? It’s preferable to not get involved and the skeptic will keep it to himself. Frankly, what does a whistle blower have to gain? So normally he’ll back away from the suspicious deal and leave things as they were.

His conclusion is also well hedged: “be careful with animals that look like ducks that say that they’re something else. Because they could be that other something, although it’s very likely that they are just ducks.” Dalmady repeatedly invokes the Heisenberg uncertainty principle to say that one can never be sure of anything. He finally ends with an appeal in the postscript: “Please, do not accuse me of destabilizing the financial system.”

Dalmady followed that article up with a blog post on a site called of all things the Devil’s Excrement. His writings created quite a stir in the blogosphere with Felix Salmon for example posting about it here, here and here.

Post Madoff, there is greater willingness by bloggers to put their neck out and voice their suspicions about fraud. But the mainstream media is still running scared. The Financial Times for example gives this view of their internal decision processes at its Alphaville blog:

PM: Well, been looking at this SIB – Sir Allen Stanford story
PM: rather fruity
PM: Anyway – think we are cleared to publish our stuff now
NH: only taken 12 hours
PM: Not huge new revelations – beyond that printed elsewhere
PM: This was a very good pick up by a certain Long Room member
NH: it was fascinating stuff
NH: and if you want to know what we are talking about
NH: there are stories in Business Week
NH: and on Bloomberg
NH: if u are interested
NH: for our story we just need sign off from the editor now

The media knows that banks are treated with kid gloves because a bank run is supposedly such a terrible event. I think regulators and the broader society must learn to live with frequent bank runs and an occasional bank failure as the price of a healthy financial system.

One of my favourite quotations from Milton Friedman is his statement somewhere to the effect that banks are not regulated because they are different, they are different because they are regulated. All kinds of frauds (and incompetence!) find shelter behind that regulatory veil.

Posted at 12:25 on Tue, 17 Feb 2009     View/Post Comments (0)     permanent link

Mon, 16 Feb 2009

Rakesh Mohan (BIS) report on Capital Flows and Emerging Economies

The Committee on the Global Financial System (CFGS) of the Bank for International Settlements established a Working Group under Dr. Rakesh Mohan of the Reserve Bank of India (RBI) to study capital flows and emerging economies. The Group submitted a very interesting and valuable report last month.

The group was originally set up primarily to study the implications of capital inflows for emerging economies, but the changed environment has made it a very valuable study of how the global crisis is impacting emerging economies and how these economies are responding to the crisis. The Working Group should be commended for interpreting their mandate broadly and covering the events of 2007 and 2008.

Even to people like me who have been following recent developments in several emerging countries keenly, there is a wealth of fascinating data and case studies in the report. Most of us find it easy to follow what is happening in the US and in our own country. The experiences of other countries – especially emerging economies – is not well documented in the publicly accessible literature. The blogosphere is not exactly littered with Bloomberg terminals and Datastream subscriptions, and even those with access to these find that quality reporting and analysis is not readily available for non US economies.

The conclusions of the report are also well balanced and sensible recognizing the beneficial effects of capital flows – particularly foreign direct investment and foreign portfolio equity investment. It also lays stress on the development of the domestic financial sector including pension funds. There is a clear recognition that the price-stability focus of monetary policy can be undermined by paying too much attention to exchange rate objectives.

The group was clearly racing against time to finish the report as events pushed them far beyond their original mandate. As a result, the proof reading of the report has probably been a little spotty as well. I spotted a couple of errors that would almost certainly have been eliminated by a more leisurely proof reading process:

But this is mere nitpicking about a report that I enjoyed reading. I strongly recommend that all those interested in how emerging markets are coping with these troubled times should read the whole report especially Chapter H on the developments in 2008.

Posted at 15:56 on Mon, 16 Feb 2009     View/Post Comments (2)     permanent link

Sat, 14 Feb 2009

Takeover code exemption for Satyam

I was interviewed yesterday on NDTV Profit, UTV and CNBC on the new takeover norms for Satyam-like companies. The transcript and video of the CNBC interview and the video of the NDTV interview are available on their respective websites. I made the following main points:

While I did not explicitly mention it in the interviews, I was thinking of Wells Fargo offering a higher price for Wachovia after the regulators had sold it to Citi. Had the board been controlled by the regulator and had the shareholders also been shut out of the decision making, the Wells deal would obviously not have been possible.

Posted at 20:56 on Sat, 14 Feb 2009     View/Post Comments (0)     permanent link

Tue, 10 Feb 2009

What if Markopolos had blogged?

Ray Pellecchia writes on his blog that Markopolos could have stopped Madoff simply by writing a blog after his complaints to the SEC fell on deaf years. There is a serious problem with this suggestion – the SEC itself.

Regulators around the world may be too dense to understand the niceties of Madoff’s purported split strike conversion strategy, but they are smart enough to act and act quickly agaist somebody trying to spread what appear to be malicious rumours. (Please remember that there is no such thing as an anonymous blogger when the state is after you.)

The very fact that the SEC investigated the complaint and found no merit in the complaint would have made it evident that that blog post was just a baseless rumour. Add in the fact that Markopolos was a rival hedge fund manager and the grounds for acting against the rumour mongerer are plain as daylight. From whatever I have seen of regulators anywhere in the world, it would have been suicidal for Markopolos to write that blog.

This is an example of how a regulator makes things worse merely by its existence. Absent an SEC or an FSA or a SEBI, a Markopolos could stop a Madoff by blogging. Because such a regulator exists, Markopolos is powerless!

Posted at 17:46 on Tue, 10 Feb 2009     View/Post Comments (4)     permanent link

Thu, 05 Feb 2009

Towards a new takeover code

I wrote a piece in today’s Financial Express about aligning the takeover code more closely with market prices.

It has long been evident that the SEBI takeover regulations have been founded on a fundamental and deep rooted distrust of market prices. But it is only a high profile situation like Satyam that makes us realise that this distrust has made the regulations unworkable.

Sebi has announced that it “recognised the special circumstances that have arisen in the affairs of [Satyam] and concluded that the issue needs to be dealt with in the general context. Accordingly it was decided to appropriately amend the regulations/ guidelines to enable a transparent process for arriving at the price for such acquisition”.

I would argue that treating market prices with greater respect is perhaps the simplest solution to the problem which is by no means confined to situations of fraud like Satyam.

The takeover regulations stipulate that if any person wishes to acquire 15% or more of the shares of a company, then such an acquirer must make an open offer to the shareholders to buy at least 20% of the shares of the company. It is also stipulated that the open offer must be at a price which is the highest of (a) the average market price during the previous 26 weeks, (b) the highest price at which the acquirer has bought shares of the company in the previous 26 weeks and (c) the price at which the acquirer has agreed to buy shares from the promoters or other shareholders.

In the Satyam case, the problem is that share prices have fallen by more than 80% and the 26 week average is possibly much higher than what any acquirer would be willing to pay. The argument that is being floated is that the prices before January 7, 2009 were based on a fraudulent set of financials and therefore, those prices should somehow be disregarded.

Unfortunately, the problem extends far beyond Satyam. For about half of the BSE 500 companies, the last six month average share price is greater than the current market price by 40% or more. For two-thirds of the BSE 500 companies, the six month average exceeds the current market price by 25% or more. Normally, there is a control premium that an acquirer has to pay to take over a company and therefore the acquisition price is about 20-30% above the pre-bid market price.

In today’s situation, for somewhere between half and two-thirds of the top 500 companies, the takeover regulations mandate an offer price that is higher than a reasonable control premium. Sebi has unwittingly shut down the market for corporate control for about half of India’s largest companies. This is absolutely unacceptable.

Fraud is not the only reason why a company’s share price can fall dramatically. Changes in fundamentals of the company, the industry or the entire economy can lead to sharp falls in market prices. Within the BSE 500, for example, many of even the better companies in real estate, infrastructure, textiles, steel, metals, aviation and commercial vehicles are in the situation where the six month average price is 40% above the current market price.

The purpose of the takeover regulations is to create a healthy and vibrant market for corporate control which allows companies to become more efficient through acquisitions and restructuring. In today’s depressed conditions, this mechanism is needed more than ever.

Unfortunately, in India, there are some vested interests of merchant bankers and small investors who would like the takeover regulations to become a mechanism for providing a free lunch to minority shareholders. The same investors who clamour for ending fuel and food subsidies are eager to get their own free lunches through open offer pricing.

For the takeover regulations to serve their true purpose, they must give primacy to freely functioning markets and get away from the administered pricing regime that they have become today. To begin with, we should abolish the 26 week average for large liquid stocks where market prices are more reliable.

But even for small stocks, we should rely on the intelligence of the investors. After all, there is no regulation which requires new issues of shares to be made at prices linked to the last six months average share price to take care of market manipulation. We simply expect investors to make their own assessment before buying shares. Why can we not expect them to make their own assessment before selling shares?

Another funny thing is that a potential acquirer is not allowed to reduce the offer price in response to changed conditions. In the US, we have seen companies pay a break up fee and walk away from acquisitions when there is a severe adverse change in economic conditions. In India, we have designed the regulations to discourage hostile acquisitions: even if hostile acquirers discover serious problems, they can not easily walk away. We should allow bid terms to be negotiated by contract and not frozen by regulations.

Posted at 08:44 on Thu, 05 Feb 2009     View/Post Comments (5)     permanent link

Wed, 04 Feb 2009

Markopolos on the SEC

Last year, I blogged about the Markopolos submission to the SEC (way back in 2005) in which he argued that the Madoff fund was a Ponzi scheme. I wrote then that the Markopolos submission was extremely persuasive and well argued and was a good example of forensic economics. His prepared testimony to the US Congressional hearings is even better at explaining his deductions. He talks about how his army special operations background trained him “to build intelligence networks, collect intelligence reports from field operatives, devise lists of additional questions to fill in the blanks, analyse the data and send draft reports for review and correction before submission.”

The entire 65 page document is worth reading in full. What I found most interesting (after having read the 2005 submission) is what he has to say about the SEC. What happens when he turns his forensic mind at the SEC itself is really fascinating. He pulls no punches either in his diagnosis or in his recommendations:

I think that by and large Markopolos is on the right track though I disagree with a few of his recommendations. The question is whether any of this is likely to happen. Unfortunately, state failure is as endemic as market failure (if not more).

Posted at 20:16 on Wed, 04 Feb 2009     View/Post Comments (6)     permanent link

Mon, 02 Feb 2009

Open offer price: CNBC Interview

I was interviewed by CNBC today morning on whether the open offer pricing norms need to be changed to account for the steep fall in Satyam share price after the exposure of the fraud. The CNBC web site has the transcript and the video. The key passage from the interview is the following:

We need to make changes in the open offer which are not specific to Satyam but general enough to cover all cases. When we are talking about a company which is very liquid ... one should assume that what is happening in the market is a fair reflection of its fair value and simply allow people to buy at a price which is dictated by the market.

The whole idea of 26-week average ... essentially reflects a distrust of market prices – a belief that market prices can be manipulated. I think that belief is inapplicable when we are talking about a very liquid stock. So, I think the way we should move forward is to say ... 26 weeks average is not required when we are talking about a stock which is reasonably liquid.

We might say top 100 stocks, top 500 stocks or we might go by impact cost or we might say that anything on which the derivatives are allowed to trade where there is a reasonable degree of openness and resilience about the market price there is no need to average anything. The latest price is the measure of what the share is worth.

Posted at 17:16 on Mon, 02 Feb 2009     View/Post Comments (5)     permanent link

Thu, 22 Jan 2009

Open the books

I wrote a piece in the Financial Express today on the enhancements to corporate disclosure that are required in the aftermath of the Satyam fraud.

Ramalinga Raju was in jail two days after he confessed to a $1.5 billion fraud at Satyam and has remained there since then. By contrast, Bernie Madoff is still ensconced in his home more than a month after he confessed to a $50 billion fraud in the United States. Two days after the Raju confession, there was a new board of directors for Satyam taking charge of its assets and trying to preserve as much of shareholder value as possible. Meanwhile, Madoff has spent his time out on bail mailing a million dollars worth of jewellery as gifts to his friends and relatives, putting them beyond the reach of the investors whom he has defrauded.

On the whole then, the Indian government has done better than the low expectations that we have of our rulers, while the US has conformed to the images of crony capitalism that has characterised its bailout era.

But complacency would be a mistake on our part. Emerging markets are held to higher standards than developed markets, and it is essential to use Satyam as an opportunity to make a series of much-needed disclosure and governance reforms. The question to ask is not whether these reforms would have prevented Satyam; the relevant question is whether these reforms would help bolster investor confidence in the Indian corporate sector at a time when it has been badly shaken.

Much as the government might like to portray Satyam as an unfortunate exception, the fact is that most investors, both in India and abroad, think of it as symptomatic of the problems that could be lurking in many other leading Indian companies. Of course, companies will voluntarily increase their disclosure standards to signal that they have nothing to hide. But this by itself is not enough. Disclosure is most effective and useful to investors when it is carried out in a uniform way by many companies. This is where regulators have a role to play.

Increasing the quality of quarterly disclosures is very important. Satyam was, of course, subject to this requirement as a US listed company and it is conceivable that these disclosure requirements forced a confession in early January 2009 shortly before the results of the quarter ended December 2008 were to be unveiled. Absent the pressure of this disclosure requirement, it is not beyond the realm of possibility that the deception might have been kept up for another quarter till the year end in March 2009.

I have written in the past (FE, November 27, 2008) on the need to force companies to reveal the complete balance sheet and not just the income statement highlights on a quarterly basis. This needs to be pushed forward more rapidly. On the same lines, a more rapid move to international accounting standards is desirable. Certain key standards like AS 30 on financial instruments could be targeted for accelerated adoption and implementation.

Greater regulatory scrutiny of corporate disclosures is also essential. The Raghuram Rajan Committee on financial sector reforms (of which I was a member) has recommended that India should adopt a system of reviewing the accounting filings of companies on a selective or sample basis on the lines of what the SEC does in the US.

Equally important are measures to improve private sector scrutiny of corporate disclosures. In the US, the Edgar database of regulatory filings with its full text search capability and its XBRL based interactivity is a huge boon. It is difficult to see how private sector scrutiny of the kind carried out by could ever be done without Edgar. The dissemination of corporate disclosures by the exchanges and by Sebi on their websites does not come remotely close to what Edgar achieves in the US. We should make it a top priority to get our own Edgar style repository functional as quickly as possible.

I am also a proponent of combining regulatory review and private sector scrutiny in innovative ways. For example, a short seller who believes that there is something wrong with the accounts of a company should be able to demand a regulatory review by paying a fee to cover the regulator’s costs. Needless to say, the results of the review should be announced only publicly so that the short seller does not get any advance information. He would of course benefit from the price impact of the review findings on any pre-existing short positions.

I am invariably told that this scheme would be misused by people to embarrass their corporate rivals. My flippant response is that there is nothing wrong in harnessing corporate rivalry in such a constructive way to improve the credibility of corporate disclosures. More seriously, if a review leads to a clean chit, the public announcement of this would benefit the target company. This in itself would act as a disincentive against frivolous review requests by people endowed with deep pockets.

Posted at 07:03 on Thu, 22 Jan 2009     View/Post Comments (5)     permanent link

Wed, 21 Jan 2009

Basel is fighting the last war and that rather badly

The Basel Committee has put out a set of proposals for revising the Basel II capital requirements.

One of the things that Basel is now correcting is a discrepancy between the risk level of 99% that was laid down during the market risk amendment of 1996 to Basel I and the level of 99.9% that was laid down in Basel II in 2004 for the banking book. The proposed Guidelines for computing capital for incremental risk in the trading book require risk in the trading book to be measured at the 99.9% level and at a one year horizon. The Committee admits that:

Owing to the high confidence standard and long capital horizon of the IRC, robust direct validation of the IRC model through standard backtesting methods at the 99.9%/one-year soundness standard will not be possible. Accordingly, validation of an IRC model necessarily must rely more heavily on indirect methods including but not limited to stress tests, sensitivity analyses and scenario analyses, to assess its qualitative and quantitative reasonableness, particularly with regard to the model’s treatment of concentrations. Given the nature of the IRC soundness standard such tests must not be limited to the range of events experienced historically. The validation of an IRC model represents an ongoing process in which supervisors and firms jointly determine the exact set of validation procedures to be employed.

I think this is a futile attempt to preserve the 1990s era risk management technology (value at risk, linear correlations and normal distributions) embodied in Basel II. The only way to get to the 99.9% level in any plausible way is to use fat tailed distributions (say student with four degrees of freedom) explicitly and also to move to non linear dependence models (copulas); when one is doing all this, one might as well give up the theoretically discredited value at risk measure and move to a “coherent risk measure” like expected shortfall. Suggesting the use of stress tests as a way to arrive at the 99.9% standard is akin to changing the subject when you do not know what to say.

What I found even more troubling is the following statement in the other consultation document “Revisions to the Basel II market risk framework”

In addition, a bank must calculate a ‘stressed value-at-risk’ based on the 10- day, 99th percentile, one-tailed confidence interval value-at-risk measure of the current portfolio, with value-at-risk model inputs calibrated to historical data from a period of significant financial stress relevant to the firm’s portfolio. For most portfolios, the Committee would consider a 12-month period relating to significant losses in 2007/08 to be a period of such stress, although other relevant periods could be considered by banks, subject to supervisory approval. This stressed value-at-risk should be calculated at least weekly.

This document has been in the making for a longer period and perhaps reflects the Committee’s thinking at an earlier point of time – it still talks of 99% instead of 99.9%. That apart, what puzzled me is the belief that 2007-08 represented the ultimate in terms of financial stress. Since they say 2007/08 and not 2007/2008, it clearly refers to the financial year 2007-08 and excludes the severe stress in the second half of calendar year 2008.

More importantly, the idea that even calendar year 2008 is the ultimate in stress is debatable. There have been no sovereign defaults (ignoring Ecuador) while the big risk for 2009 and 2010 is certainly the possible default of a G7 sovereign and the related possibility of the break-up of the Eurozone. Risk managers who think that the worst is over in the current crisis are not worth their salaries today. I am shocked that the Basel Committee is encouraging this kind of shoddy thinking.

Posted at 13:51 on Wed, 21 Jan 2009     View/Post Comments (4)     permanent link

Sun, 18 Jan 2009

More on Siemens

I have not so far been posting links to my TV interviews though these days, videos and transcripts are often made available on the web sites of the TV channels. I am beginning to remedy that by posting links to the video and transcripts of an interview of January 15 on CNBC about the Siemens story that I blogged about two days earlier.

Some excerpts from the interview:

It doesn’t look fair at all – both the valuation and the entire manner in which it has been done. First of all, looking at the valuations, an IT firm being sold at six months of revenues looks quite absurd. We have the mainstream IT stocks trading at something like 2-3 times revenues, and this is half a year revenues, even by price earnings multiple, which looks very low about half of what mainstream companies sell at.

The other part of the problem is the process by which it is being conducted. The day Siemens announced that they were selling; they said nothing about the valuations, they said nothing about the financial performance of the subsidiary. Couple of days later, after all hell has broken loose, they come out with details about this and the information, which they disclose is even more troubling. It even gives an impression that the financial performance has actually been turned down – the revenues have fallen, the profit margin has collapsed and there is a situation in which somebody could give a low valuation to the stock.

The entire process looks really bad and when one looks at Satyam-Maytas, at least, on day one, they told us what the valuation was. Here on day one we were told nothing about the valuation, it is really troubling.

When you are talking about something which is really captive, the margin is entirely a function of transfer price. To believe that the kind of IT that Siemens does, they are really into relatively high value IT, and to believe that the profit margins are so low it strains credibility. Moreover, these are not third party prices; these are not arm’s length prices; these are internal transfer prices.

Posted at 21:45 on Sun, 18 Jan 2009     View/Post Comments (1)     permanent link

Tue, 13 Jan 2009

Siemens related party transaction

Two days after the Satyam fraud was announced, Siemens Limited, a 55% subsidiary of Siemens AG of Germany informed the stock exchanges that “the Board of Directors of the Company at its meeting held on January 09, 2009, has approved the divestment of its 100% stake comprising of 6,815,000 Equity Shares of Rs 10 each in its subsidiary Siemens Information Systems Ltd, Mumbai, to Siemens Corporate Finance Pvt. Ltd., a 100% subsidiary of Siemens AG, subject to receipt of all requisite consents, approvals.” In its press release, the company stated “This is pursuant to the change in structure of the global software business, where SISL businesses have also been aligned with the parent group. In the new model, SISL will serve as an internal software factory supporting the R&D and product development initiatives for business sectors globally. It will also focus on increasing its presence in the domestic market and continue to act as an offshore development centre for Siemens worldwide.”

The response of the stock market has been brutal: the stock fell almost 30% from Rs 298.00 to Rs 211.80 while the Nifty index fell by only 6% from 2920.40 to 2744.95. The press release does not mention anything about valuation or consideration, but clearly the market sees this as a valuable business being transferred to the dominant shareholder at a discount to its fair value. Investors are powerless here because unlike in the Satyam-Maytas case, here the parent company has a majority shareholding.

India should probably look at the UK model for dealing with such situations. Rule 6.1.4(3) of the UK listing rules, requires that a company that seeks listing of its equity shares in the UK should demonstrate that “it will be carrying on an independent business as its main activity.” In practice, rather than refusing to list an issuer that fails to satisfy this requirement, the UK regulator looks to see how a lack of independence will be managed. This means satisfying itself that an issuer that has a controlling shareholder is capable of carrying on its business independently of that shareholder.

For example, when the promoters of the Sterlite group in India listed their business in the UK as Vedanta Resources plc, the restrictions that they agreed to as a condition for listing included the following (Vedanta Resources plc, listing particulars, page 68-70):

Restrictions of this kind might have helped prevent the Siemens transaction provided they were coupled with a requirement that a related party transaction should be put to shareholder vote if say 10% of the shareholders so demand. The institutional investors with 25% shareholding would then have been able to demand a shareholder vote and then vote it down with Siemens AG unable to vote its shares.

Posted at 21:35 on Tue, 13 Jan 2009     View/Post Comments (2)     permanent link

Gold standard and Austrian economics

After I mentioned the gold standard in my last post on three centuries of UK interest rates, I received a number of comments relating to the gold standard and Austrian economics.

Mahesh asks about the advantages and disadvantages of going from a paper currency to the gold standard. I do not think of the gold standard as something to do with the physical commodity called gold; I think of it in terms of targeting the price level rather than the inflation rate.

Nowadays central banks target the inflation rate, not the price level. Suppose the initial price level was 100, the inflation target was 2% and actual inflation is 5%, then the central bank writes a suitably remorseful letter to the government explaining its failure to meet the target. In most cases, the government might accept and even endorse the explanation, though in the worst case, it may replace the head of the central bank. In either case, the inflation target for the next year would remain at 2%; the implied target for the price level at the end of the second year would be roughly 107 (105 plus 2% inflation).

Under the gold standard, essentially you are (implicitly) targeting the price level. In the above example, with desired annual inflation of 2%, the target price level at the end of two years is roughly 104. Since the price level at the end of the first year is already 105, implicitly the inflation target for the second year is -1%. High inflation in one year has to be compensated by deflation the next year. This is what we see during the gold standard era in the inflation graphs in my earlier post. During periods of war, there may be inflation for a few years, but this is acceptable if people believe that it will all be reversed in due course. You can even go off the gold standard temporarily if people believe you will come back to it.

Ideally in such a world, the detrended price level is a stationary process in econometric terms. In modern inflation targeting, the price level is a non stationary random walk (unit root process). For long term decisions, the reduction in volatility achieved by eradicating the unit root is huge.

The gold standard in practice also involved much lower inflation rates – most multi-decadal inflation rates are in the range of -½% to +½%. On a hedonic adjusted basis, this almost certainly implies persistent deflation, probably related to the inability of gold supply to keep pace with the growth of the global economy. I am not convinced that the trend rate of growth of the price level is hugely important so long as the detrended price level is a stationary process. If you worry about menu costs and money illusion, you may be less sanguine than I am.

In my view, the benefits of the gold standard had nothing to do with gold itself. I tend to regard gold as a (rational?) speculative bubble that has lasted five thousand years. The demonetization of silver in the late nineteenth century led to a collapse of the equally long lived (and equally rational?) silver price bubble. There is an ever present risk that the same could happen to gold one day. If the bimetallic ratio of 5-8 between gold and silver prices that prevailed for several millenia before the nineteenth century reflects the relative intrinsic worth of the two metals, gold could fall catastrophically. Of course, this might not happen in my lifetime nor in yours; that is why the bubble could be a rational speculative bubble.

Pravin asks whether inflation during the gold standard was due mainly to wars or government actions. Inflation could result not only from fiscal expansions but also from private sector credit expansions. Generically, I like to think of inflation in any one country under the gold standard as a deviation from purchasing power parity (PPP). Inflation would cause a departure from PPP, but since PPP asserts itself only over a period of a few years, this departure could persist for a short period, but in the medium to long term, the price level mean reverts to its old level.

Another complication is that even in a land with metallic money, one needs detailed historical evidence to determine whether the coins were accepted “by tale” or “by weight”. Until the nineteenth century, it was probably true that debased currency was accepted “by tale”, and therefore what appears to be silver (or gold) currency is actually fiat money.

As far as Austrian economics is concerned, I find Hayek, Schumpeter and Minsky to be most in accordance with my tastes. The gold standard is not to my mind among the more important ideas in Austrian economics. But then I am not an economist. I find that I am able to hold Keynesian, monetarist and Austrian ideas in my head almost simultaneously without getting a severe headache.

Posted at 13:23 on Tue, 13 Jan 2009     View/Post Comments (8)     permanent link

Mon, 12 Jan 2009

UK official interest rate at 315 year low

Last week, the UK reduced its interest rate to the lowest level ever in its 315 year history. I found this surprising since there is very little in terms of economic environment that the Bank of England has not seen in these three centuries. It is all the more puzzling when the interest rate graph is juxtaposed with a graph of inflation rates (see figures below).

BOE official rates


It is interesting to see that negative inflation rates are quite common prior to the twentieth century. The average inflation rate was negative in the entire nineteenth century. But even in this period, while interest rates went down to 2% on several occasions, they never dropped to the 1.5% level reached last week.

What is also interesting is that for 103 years from 1719 to 1822, the Bank of England did not change its rate even once. England lost an empire in one continent while gaining an empire in another; it fought the Seven Years War and the Napoleonic wars; inflation rates ranged from +30% to -23%, but interest rates remained fixed at 5%!

Deflation was quite common in the eighteenth and nineteenth centuries, and apparently was not damaging to growth. Perhaps, there is something pernicious about fiat (paper) money that makes inflation and deflation so scary. Under the gold standard, the price level had a tendency to mean revert so that high inflation was followed quickly by deflation; therefore even 30% inflation did not create inflationary expectations, and even 20% deflation did not create deflationary expectations.

Posted at 13:17 on Mon, 12 Jan 2009     View/Post Comments (5)     permanent link

Thu, 08 Jan 2009

Satyam: old lies and new truth or new lie?

This is my fourth post on the Satyam fraud, and what I am concerned about in this post is the willingness of people to believe a liar’s confession blindly. To my cynical mind, the fact that a person admits to have been lying for several years is reason to suspect that what is put forward as the new truth might just be a new lie.

What makes me more suspicious is that the “confession” actually paints the most benign picture possible. What the Satyam Chairman is saying that he never siphoned any money from the company. While many people suspected that Satyam profits were diverted to group companies, the former chairman is saying that the profits were never there. He is also trying to paint the Maytas deal as a last ditch attempt to save Satyam instead of the other way around.

My question is why should we believe all this. How credible is the claim that an IT business with a blue chip client list was not profitable? How credible is the attempt to exonerate everybody else? Should we consider the possibility that the problems were in other group companies of the promoters and that Satyam lost everything while trying to bail them out?

The finance profession is supposed to train one to be skeptical and cynical about everything. The lack of sufficient skepticism and cynicism is itself a cause for concern as it suggests that markets are still too trusting.

Posted at 10:34 on Thu, 08 Jan 2009     View/Post Comments (13)     permanent link

Wed, 07 Jan 2009

Satyam and accounting regulation

In 2002 after the Enron debacle in the US, I wrote (sections 9.3.1 and 9.3.2 of this paper) that though the US system of review of accounting filings by the SEC did not work in the case of Enron and other frauds, it was still necessary for India to have a system of review of accounting filings. What I proposed (for the US as well as for India) was a system where short sellers could force regulators to review any specific filing by paying a fee. I even estimated the fee that should be charged.

In the same paper, I also argued that a credible body to oversee the audit firms in India is also needed.

The Raghuram Rajan Committee (of which I was a member) did recommend regulatory review and audit oversight in its report (see page 139-140). It also recommended the use of XBRL in all accounting filing to facilitate the system of regulatory reviews.

I think the world also needs to figure out ways of making auditing a more competitive industry. In my Enron paper, I argued that it should become easier to create new audit firms and for auditors to advertise directly to shareholders.

Nakedshorts points out that three of the big four audit firms (PricewaterhouseCoopers, Ernst & Young and KPMG) are potentially in the dock as auditors of the Madoff feeder funds in the US. (PricewaterhouseCoopers were also the auditors of Satyam). If the post Enron experience (the demise of Anderson) were to be repeated post Madoff with no regulatory forbearance, it is not inconceivable that a majority of the big four auditing firms would cease to exist in 2009. Stunning as that would be, it would not be more surprising than the disappearance of the majority of the Wall Street investment banks in 2008.

In this context, we need to fundamentally rethink the industry structure of the auditing industry. More competition is absolutely critical.

Posted at 15:31 on Wed, 07 Jan 2009     View/Post Comments (4)     permanent link

Saytam: why government needs to act now

In my last blog post, I briefly stated what the government needed to do:

What I did not do was to highlight the urgency of the first step:

I think this needs action today or at the very least within 24 hours.

Posted at 14:37 on Wed, 07 Jan 2009     View/Post Comments (3)     permanent link

Satyam requires government intervention

The fraud that has been disclosed in Satyam Computer Services Limited comes at a time when the Satyam board has lost all credibility. This requires extraordinary action. Only a new board can investigate the fraud and run the company until a general body meeting is held to elect a new board.

The company needs a new governance regime. One option is that the existing board meets for the sole purpose of co-opting a new set of directors and then the old board withdraws from the scene. The second option is for the government to step in. This is a fit case for section 398 and 401 of the Companies Act which give broad powers to the Company Law Board acting on an application by the government to make orders for “the regulation of the conduct of the company”s affairs in future ”.

I think this is also a fit case for an investigation under section 234(7) and 235 of the Companies Act.

Posted at 12:58 on Wed, 07 Jan 2009     View/Post Comments (2)     permanent link

Sun, 04 Jan 2009

44 years of inflation adjusted stock prices in India


Above is a plot that I have put together of the real (inflation adjusted) stock price index in India from 1965 to 2008. The plot is on a log scale – each horizontal grid line represents a doubling of the real stock price.

I have divided the sample into three periods and it is obvious that all the action happens in the middle period from 1985 to 1994. On a point to point basis, practically the entire increase in real stock prices happens during this period.

The compound annual growth rates on point to point basis are: 0.57% (1965-1984), 18.95%(1985-1994) and 0.33% (1995-2008). Since point to point comparisons are misleading, I have also plotted exponential trend lines (straight lines on the log scale plot) for each of the three time periods. These trend lines also tell the same story of huge growth during 1985-1994 and tepid growth before and after. The compound annual growth rates from the trend lines are: 1.78% (1965-1984), 17.62%(1985-1994) and 6.39% (1995-2008).

This is not really surprising. Most of the movement towards a free market economy took place during the Rajiv Gandhi prime minister-ship in the mid/late 1980s and the Manmohan Singh finance minister-ship during the early 1990s. Since then, reforms have been at a glacial pace. India learned the wrong lessons from the Asian Crisis and seems to be learning the wrong ones again from the current crisis.

Notes on the data

Posted at 12:37 on Sun, 04 Jan 2009     View/Post Comments (3)     permanent link

Sat, 03 Jan 2009

India in a ZIRP world

I wrote a column in the Financial Express today about why Indian interest rates need to come down much more when the world interest rate is going down to zero.

While discussing the magnitude of interest rate cuts in India – the RBI cut repo rate and reverse repo rate by 100 basis points each and CRR by 50 basis points on Friday – we need to remember that the entire developed world appears to be converging to a zero interest rate policy (ZIRP). This is a completely unprecedented situation and points to interest rates much lower than what we are accustomed to seeing.

India is an open economy and even the capital account is quite open for all practical purposes. Indian interest rate policies are therefore strongly influenced by global interest rate. A comparison of the Indian repo rate and the US Fed Funds Target since 2000 shows that Indian tightening and easing follows US tightening and easing with a lag. Essentially, an open economy forces the RBI to follow what the “world central bank” does; and the only flexibility that it has is to delay its response by a few months.

Now, the US has pushed its interest rate down to virtually zero. Japan has also done the same, and the European Central Bank is also being dragged down that path much against its wishes by the sheer strength of global forces. In that situation, how low should Indian interest rates go?

plot of spread between the Indian repo rate and the US Fed Funds target

The plot above shows the spread between the Indian repo rate and the US Fed Funds target with key tightening and easing episodes demarcated on it. Because of the lag between US and Indian central banks, this spread fluctuates a lot.

For example, in July 2006, the US had completed its tightening cycle and India was still half way through its tightening cycle. The spread between the two rates fell to an abnormally low level of 1½% with the Fed Funds target at 5¼% and the Indian repo rate at 6¾%. Over the next nine months, India tightened by another 1% to 7¾% while the US rate remained unchanged at 5¼%. In April 2007, with both central banks having completed their tightening cycles, the spread was 2½% which can be regarded as a “natural” spread between the rates in the two countries reflecting differences in the respective inflation rates and other structural characteristics of the two economies.

In September 2007, the US began easing interest rates in response to the financial crisis. At that time, the crisis in the US appeared very remote to us, and India left rates unchanged for several months. Then earlier this year, the RBI raised interest rates by 1¼% to 9% in response to the inflation scare which gripped the country at that time. The spread between US and Indian rates rose to an extraordinary level of 7½% in October 2008.

Since then, India has been easing more sharply than the US and the spread came down to 6½% by the end of 2008. But this is still a very high spread. If we consider the April 2007 spread level of 2½% as a “natural” spread, then the Indian repo rate needs to come down to well below 3%.

That is a much steeper cut than what RBI has made. But even that might be an underestimate of what would be needed. The US has gone beyond zero interest rates to a regime of quantitative easing which pushes long rates down to low levels. Since it is not possible to make interest rates negative, quantitative easing achieves the same effect of negative interest rates by expanding the balance sheet of the central bank.

This means that to achieve the same spread against the “effective” (quantitative easing adjusted) interest rate in the US, Indian rates would have to come down even more. Similarly, European interest rates are lower than what they appear to be because the expansion of the ECB balance sheet has some of the characteristics of quantitative easing.

I believe that the RBI should cut its interest rates very rapidly to a level consistent with global interest rates for four reasons. First, the prospect of further cuts in rates in future makes long term government bonds a one way bet – they are today the most attractive asset for any bank on a risk adjusted basis. There is no point exhorting banks to lend when the central bank rewards “lazy banking” through the gradualism of its interest rate policy.

Second, India can afford a fiscal stimulus only if interest rates have first been brought down to very low levels. Otherwise, the weak fiscal capacity of the state is wasted on paying an excessive interest rate on its borrowings.

Third, the weakening of the currency caused by low interest rates is a stimulus that the economy needs very badly.

Finally, since many economists now project inflation at 2% or so by the end of this fiscal year, steep rate cuts are needed to prevent real interest rates from becoming excessive.

Posted at 07:50 on Sat, 03 Jan 2009     View/Post Comments (7)     permanent link

Fri, 02 Jan 2009

Fair value accounting

Earlier this week, the US Securities and Exchange Commission (SEC) released a 259 page study on mark to market accounting as required by the TARP related legislation. The study contains a lot of useful data about the extent of mark to market accounting in the US financial sector as well as the extent to which fair value accounting uses opaque valuation methods (Level 3, often called “mark to myth”).

The key takeaway is that for all the “modernization” of the financial sector that we read about, mark to market accounting covers less than half of all assets of the large financial firms. The percentage of assets where fair value changes impact reported profits is even lower at 25%. It is only the (erstwhile?) broker dealers who have practically all their balance sheet in fair value or in short term assets whose historical cost is practically the same as fair value. The insurance companies have a large percentage of fair value assets, but insurance is an industry where the valuation of liabilities matters more than the valuation of assets. For banks, less than a third of assets is at fair value.

The percentage of fair value assets which is in Level 3 is not too bad at around 10%. What I found more troubling is that around three-quarters of fair value assets are Level 2, leaving only about 15% for Level 1. This is a measure of how little of the financial sector assets are traded in exchanges or other liquid markets as opposed to opaque OTC markets. This is another respect in which the “modernization” of the financial sector has been much more limited than I would like.

The characterization of financial institutions as storehouses of illiquid and opaque assets is as true today as it was decades ago.

Posted at 14:44 on Fri, 02 Jan 2009     View/Post Comments (1)     permanent link

Thu, 01 Jan 2009

More on teaching finance

My last piece on teaching finance the hard way received a large number of interesting and valuable comments and I shall try to respond to them in this post.

Sahil is right that the quality of finance teaching leaves a lot to be desired. In my view, however, this is a result of the rapid growth of the financial sector in recent years. My simplistic way of looking at this is that if a fraction h of the people in a profession become educators and each educator can educate k people in a year, then the sustainable rate of growth of the profession is given by the product hk. In recent years, we have tried to grow the finance profession much faster than hk.

There are two ways to do this. First is to increase h by bringing in people who are not good educators. I recall a similar thing happened in the software field a few years ago. A programmer friend of mine went to an IT institute to enroll in a course, and they took him on as a faculty member instead. The second route is to increase k by reducing the depth and number of courses that a person is required to take before qualifying as a finance professional. Such an approach leaves the keen student thoroughly dissatisfied as Sahil explains in his comment.

As the growth rate of the financial sector slows down, I see this problem solve itself. It should now be possible for fewer (and hopefully better) teachers to teach in greater depth to smaller classes as I suggested in my last post.

I agree with Gaurav that Minsky is somebody that all finance professionals should have read. I recall reading Minsky before I had studied any serious finance and my impression is that this is a book that any serious student can read on his or her own and I doubt whether a course is needed on this. If at all it is to be taught, I think this is more economics than finance; perhaps, it should be taught along with a course on Austrian economics. (Yes, Paul Krugman thinks that “the Austrian theory of the business cycle is about as worthy of serious study as the phlogiston theory of fire”, but I do read the Austrian Economists’ blog).

Balu Kanchappa complains that finance case studies prepared at management schools have lot of bias in favour of institutions and context – the writers of the case studies focus more on ‘practice’ than ‘principles’. What the case writers do is less important than what happens in the class discussion. The case method is about applying theories to specific situations and so a large amount of detail is required. There is advantage in using cases from different geographies and different time periods so that students acquire the ability to apply broad principles to any context in which they might have to work.

Finance Guy takes issue with my reference to the mass market. What I had in mind was what I have described above as k. I was not talking about the quality of the students at all. There was a problem in the quality of the faculty (the expansion of h) and there was a problem in terms of the interest of the students in the subject. I do not think that there ever was a problem with the quality of the students. When I talked about the mass market, I was referring to the attempt to increase k by having broad brush courses that cover a large number of topics superficially. This makes it impossible to cover topics in depth.

At a personal level, I would also like to add that to a crass materialist like me, “mass” is not a pejorative term at all. Also, I have no desire to contribute to the production of “leaders”; in fact, my deep preoccupation with free markets is partly a rebellion against leadership of all kinds.

Both Finance Guy and Hemchand believe that there is a role for intuition and gut feeling in finance. This may or may not be true, but intuition is not something that can realistically be taught, and my post was about the teaching of finance. I was not and am not writing about what skills you need to succeed in finance.

Finally, I do not believe in the “infallibility” of models; on the contrary, the thing that I like most about models is that they describe their own fallibility and limitations explicitly and openly. And, I like to use models in the plural implying that there are several models each of which has a different restricted domain of applicability rather than one grand “theory of everything”.

Posted at 20:16 on Thu, 01 Jan 2009     View/Post Comments (1)     permanent link