Prof. Jayanth R. Varma's Financial Markets Blog

Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

jrvarma@iima.ac.in

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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 07:25 on Wed, 18 Feb 2009     View/Post Comments (2)     permanent link

Tue, 17 Feb 2009

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 06:55 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:

• In three different tables (C2, E1 and E3), the report states that the market capitalization of India’s stock market at the end of 2007 was 317% of GDP. Though end-2007 was the height of the stock market bubble in India, 317% is still nearly twice as large as the real number. I suspect that somebody carelessly added up the market capitalization of the BSE and the NSE without correcting for the double counting resulting from most large companies being listed on both exchanges. (My preferred rough and dirty measure is the market capitalization of the BSE, but more refined estimates are certainly possible). I am sure that given more time for proof reading, this error would have been corrected.
• While discussing Korea, the report states (page 120): “Following the Lehman failure, the spread of CCS [Cross Currency Swaps] over interest rate swaps widened significantly, and both banks and corporate borrowers faced a sharp increase in the cost of swapping borrowed dollars into local currency.” My memory was that the problem was the reverse – in late 2008, Korean borrowers were swapping local currency into dollars to repay maturing dollar debt and it was the cost of doing this that rose sharply. Graph H11 confirms that this was indeed the case: the spread “widened” to a huge negative value (the graph shows that the CCS rate itself went to zero and then turned slightly negative). Again, a less hurried proof reading would I am sure have caught the error.

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:

• The existing takeover code envisages a takeover process which is run by the buyer. The acquirer initiates the process and decides when to make an open offer. When a company is trying to sell itself, we want a process which is controlled by the seller. The seller would like to set a deadline for submission, evaluate all competing bids and choose the winner. The new norms are designed to facilitate this and this is good.
• The takeover code proved inadequate to run a good auction of Satyam and if it failed in Satyam it could fail anywhere else where a company wants to sell itself. We should have recognized that and added a new chapter to the takeover code to facilitate this for all companies and not just for Satyam-like companies.
• I am uncomfortable with the provision in the new norms saying that once the Board has chosen a bidder and this accepted by SEBI, then somebody else cannot make a competitive bid. What SEBI is really saying is trust the board, trust Sebi to find out who is the best buyer. Once they have done that nobody else can appeal above the board, above Sebi directly to the shareholders. I find this fundamentally unacceptable. The company belongs to the shareholders – anybody must have the right to go directly to the shareholders.

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:

• Unfortunately, as bad a regulator as the SEC currently is, and the SEC certainly is a bad regulator, it is the best of a very sorry lot.
• ...the SEC is a group of 3,500 chicken tasked to chase down and catch foxes which are faster, stronger and smarter than they are.
• Amazingly, the SEC does not give its employees a simple entrance exam to test their knowledge of capital markets! ... Talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs, MBAs, finance PhDs and others with finance backgrounds need to be recruited to replace current staffers. ... I caution the SEC to avoid focusing on any one of the above professional certifications at the expense of the rest because all are relevant and necessary. ... Diversity will ensure that group think is kept at bay. ... Right now the SEC is overlawyered. Hopefully it can transition away from this toxic mix as quickly as possible.
• SEC staffers need to be encouraged to attend industry conferences ... [and] ... educational meetings. ... Either the SEC is anti-intellectual and intentionally maintaining staff uneducated about the capital markets or it is ignorant.
• SEC staffers ... with industry credentials [like CPA, CFA etc] ... are not allowed to have their designations printed on their business cards ... if the SEC allowed its few credentialled staff to put these credentials on their business cards, it would expose the overall lack of talent within the SEC.
• But if you walk into an SEC regional office, you won’t see any of these journals [Journal of Accounting, Journal of Portfolio Management, Financial Analysts Journal, Journal of Investing, Journal of Indexing, Journal of Financial Economics and so on]. ... Apparently all the SEC uses is Google and Wikipedia because both are free.
• If an SEC staffer doesn’t know derivative math, portfolio construction math, arbitrage pricing theory, the capital asset pricing model, both normal and non-normal statistics, financial statement analysis, balance sheet metrics or performance presentation formulas then they shouldn’t be hired other than to fill administrative or clerical positions.
• ... the SEC needs to recruit foxes in senior, very high paying positions that offer lucrative incentive pay for catching foxes and bringing them to justice. ... highly successful industry practitioners who have succeeded financially during their long careers.
• Compensation at the SEC needs to be both increased and expanded to include incentive compensation tied to ... enforcement revenues.
• It is my belief that SEC examiners are so inexperienced and unfamiliar with financial concepts that they are literally afraid to interact with real finance industry professionals and choose to remain isolated in conference rooms inspecting pieces of paper.
• ... most SEC Regional Offices are lucky to have even one Bloomberg terminal for the entire region’s use. Whereas your typical investment firm would have one Bloomberg per analyst, trader and portfolio manager.
• Fortunately, the US has two very competent securities’ regulators who do a truly fantastic job and at an unbelievably low cost. Unfortunately, they are the New York Attorney General’s office (NYAG) and the Massachusetts Securities Division (MSD). ... one alternative solution is to disband the SEC and give its budget to the NYAG and the MSD.
• ... consider moving the SEC out of Washington because Washington is a political centre and not a financial centre

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