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, 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