Prof. Jayanth R. Varma's Financial Markets Blog

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

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Fri, 30 Nov 2012

Nice Finance Quotes

I came across two nice quotes related to finance recently:

  1. “Risk is the pollution created by the process of making money. So where you find people making one you will surely find them hiding the other. ” — David Malone (Golem XIV) (h/t Deus Ex Macchiato).

    I think of this as a more forceful way of stating the “No free lunch” form of the Efficient Market Hypothesis in the post crisis world where there is no risk free asset.

  2. “Accounting is the beginning of all economic wisdom, but not the end.” — Willem H. Buiter and Ebrahim Rahbari, Target2 Redux: The simple accountancy and slightly more complex economics of Bundesbank loss exposure through the Eurosystem.

    In my experience, most finance MBAs are unwilling to accept the first half of the statement, while most accountants ignore the second half of the statement.

Posted at 15:10 on Fri, 30 Nov 2012     View/Post Comments (0)     permanent link


Mon, 26 Nov 2012

What is front running?

A recent order of the Securities Appellate Tribunal in India has raised quite a furore over the precise meaning of front running. The Tribunal ruled that Regulation 4(2)(q) of the Fraudulent and Unfair Trade Practices Regulations prohibit front running by intermediaries like stock brokers but not by others.

Many people argue (a) that front running by any entity should be prohibited, and (b) even in the absence of such a prohibition, front running is a fraud on the market that is covered by the general anti fraud regulations. I do not wish to make any comment on the particular case that was decided by the Tribunal, but do think that we should be careful about criminalizing any and all forms of front running. Front running by brokers and other intermediaries is a breach of fiduciary obligation that they owe their clients, but it is not self evident that every Tom, Dick and Harry on the planet has any fiduciary obligation not to front run orders that they expect other people to place. In fact, such form of front running is legal and common through out the world.

The most famous example of such legal front running occurred when the giant fund LTCM (Long Term Capital Management) was near its death in 1998. LTCM brought in Goldman Sachs to help raise new money to recapitalize LTCM. Goldman flatly refused to sign a Non Disclosure Agreement (NDA) when requested to do so, but LTCM was so desperate that they let Goldman do due diligence anyway. What happened thereafter is well described by many people. Here is the description from Sebastian Lullaby’s More money than God: hedge funds and the making of a new elite, New York, Penguin Press (page 239-240):

[Goldman's] proprietary trading desk was selling positions that resembled LTCM’s, feeding on Long-Term like a hyena feeding on a trapped but living antelope. The firm made only a qualified effort to defend what it was up to. A Goldman trader in London was quoted as saying: “If you think a gorilla has to sell, then you sure want to sell first. We are very clear on where the line is; that’s not illegal.” Corzine himself conceded the possibility that Goldman “did things in markets that might have ended up hurting LTCM. We had to protect our own positions. That part I’m not apologetic for.”

The critical point that separates Goldman’s actions from the zone of illegality is its refusal to sign the NDA. This very clearly highlights that the prohibition of front running is rooted in a fiduciary obligation – take that fiduciary duty away and there is nothing immoral or even illegal about trading ahead of somebody else. In fact, the practice is so widespread that in the finance literature, there is a technical term for it – predatory trading (Markus K. Brunnermeier and Lasse Heje Pedersen (2005) “Predatory Trading”, The Journal of Finance, 60(4), pp. 1825-1863). Brunnermeier and Pedersen identify several situations where this kind of front running occurs routinely:

This list is by no means exhaustive – there is a whole industry devoted to front running index mutual funds trading ahead of an index reconstitution or a commodity Exchange Traded Fund rolling over its futures positions to the next month.

Front running can happen even with much more imprecise forecasts of other people’s orders. A paper forthcoming in the Journal of Financial Economics (Sophie Shive and Hayong Yun “Are mutual funds sitting ducks?” available here or in working paper version here) shows that:

We find that patient traders profit from the predictable, flow-induced trades of mutual funds. In anticipation of a 1%-of-volume change in mutual fund flows into a stock next quarter, the institutions in the same 13F category as hedge funds trade 0.29–0.45% of volume in the current quarter. ... A one standard deviation higher measure of anticipatory trading by a hedge fund is associated with a 0.9% higher annualized four-factor alpha. A one standard deviation higher measure of anticipation of a mutual fund’s trades by institutions is associated with a 0.07–0.15% lower annualized four-factor alpha.

On the opposite side there is a paper showing that hedge funds short stock ahead of expected sales by mutual funds experiencing large redemptions (Joseph Chen, Samuel Hanson, Harrison Hong, Jeremy C. Stein (2008) “Do Hedge Funds Profit From Mutual-Fund Distress?”, NBER Working Paper No. 13786)

In short, finance is an ugly world very similar to the African Savannah where the lion lives only if it can outrun the slowest gazelle and the gazelle lives only if it can outrun the fastest lion. We may not like it, but I am not sure that it is practical or desirable to criminalize all this.

I repeat that I am not expressing any view on the case that was before Tribunal; I am only responding to suggestions that any and all forms of front running should be criminalized.

Posted at 17:20 on Mon, 26 Nov 2012     View/Post Comments (7)     permanent link


Is finance dumbing us down?

Gerald Crabtree’s scary paper on “Our Fragile Intellect” (h/t Paul Kedrosky) has only one sentence about finance, but it is a damning one:

Needless to say a hunter gather that did not correctly conceive a solution to providing food or shelter probably died along with their progeny, while a modern Wall Street executive that made a similar conceptual mistake would receive a substantial bonus.

I have absolutely no idea whether Crabtree’s speculations about the genetic fragility of human intelligence are correct or not, but I am certain that the problem of moral hazard in finance is a real one.

Meanwhile, finance students who complain about the technical complexity of modern finance may do well to ponder Crabtree’s claim that “life as a hunter gather required at least as much abstract thought as operating successfully in our present society”. Computing the right way to hedge a complicated derivative is hard, but as Crabtree would say “non-verbal comprehension of things such as the aerodynamics and gyroscopic stabilization of a spear while hunting a large dangerous animal” is probably as hard or harder.

Posted at 13:35 on Mon, 26 Nov 2012     View/Post Comments (0)     permanent link


Mon, 19 Nov 2012

Irrational but arbitrage free

Last month I blogged about the Palm-3Com episode as an instance of prices being horribly wrong without there being an arbitrage opportunity (“free lunch”). Last week John Hempton of Bronte Capital had a blog post about Great Northern Iron Ore Properties (GNIOP) whose overpricing is extremely easy to establish. The post concludes by saying:

Because that is so well known the stock has a 20 percent borrow cost -- roughly offsetting the profit you will get from shorting it. In that sense there is a rational market. But that is the only sense there is a rational market. People own this. They will lose money.

Great Northern Iron Ore Properties is a trust set up in 1906 by the Great Northern Railway for regulatory reasons (apparently under the Hepburn Act of 1906, no railroad was permitted to haul commodities which they had produced themselves).

The 1906 agreement states that the Trust shall continue for twenty years after the death of the last survivor of eighteen persons named in the Trust Agreement. I would imagine that this provision has something to do with the rule against perpetuities. Anyway, the last survivor of these eighteen persons died on April 6, 1995 and the Trust terminates twenty years later or April 6, 2015.

All this is very clearly disclosed on the GNIOP website and in SEC filings. It is clear therefore that investors in GNIOP will get dividends for a couple of years and then a final dividend in 2015; these dividends can be estimated within reasonable bounds and discounting this short stream of dividends gives the fundamental value of GNIOP. But a careless investor who applies a PE multiple to GNIOP wrongly assuming a perpetual stream of dividends would arrive at an absurdly high valuation and would consider the stock hugely undervalued. Apparently some investors (humans and computers) who use simple stock screens based on PE ratios are eagerly buying the stock making it overvalued in relation to the true short stream of dividends.

Rational investors see a free lunch and step in to short the stock. Markets abhor free lunches, and the stock borrow rises to the point where it eliminates the free lunch. This is not enough to correct the distorted price.

Posted at 20:54 on Mon, 19 Nov 2012     View/Post Comments (0)     permanent link


Mon, 12 Nov 2012

On rating Rembrandts

No, this post is not about the masterpieces of the Dutch painter Rembrandt van Rijn, but about the Rembrandt CPDO (Constant Proportion Debt Obligation) notes created by the Dutch bank ABN Amro in 2006. The Federal Court of Australia ruled last week that:

S&P’s rating of AAA of the Rembrandt 2006-2 and 2006-3 CPDO notes was misleading and deceptive and involved the publication of information or statements false in material particulars and otherwise involved negligent misrepresentations to the class of potential investors in Australia ... because by the AAA rating there was conveyed a representation that in S&P’s opinion the capacity of the notes to meet all financial obligations was “extremely strong” and a representation that S&P had reached this opinion based on reasonable grounds and as the result of an exercise of reasonable care when neither was true and S&P also knew not to be true at the time made. (Summary, Para 53)

The judgement is indeed very long – Felix Salmon says that Jayne Jagot’s judgement “runs to an astonishing 635,500 words, or almost 1,500 pages: it’s literally longer than War and Peace”. I agree with Felix that the judge does a remarkable job of understanding this complex instrument and the analyzing the intricacies of rating it. She has obviously benefited from the testimony of numerous experts, but she still deserves full credit for the clarity of her analysis of the key drivers of the performance of a CPDO. The court is thus able to arrive at a cogently argued conclusion that “S&P’s modelling and assignment of the AAA rating was not such as a reasonably competent ratings agency could have carried out and assigned in all of the circumstances.” (Summary, Para 27)

There is a wealth of information in the judgement about the modelling of CPDOs, but from the point of view of legal liability of the rating agency, there are three crucial hurdles to overcome:

The court deals with each of this with forcefully, but I am sure there will be a great deal of debate whether the views of the court are correct. On the investors’ responsibility to perform their own credit assessment: the court says:

I consider the proposition that a prudent person must not invest in any product they do not themselves understand problematic. It suggests that a prudent person could never take and rely on advice. It suggests that a prudent person who had been advised that a particular investment should be made must reject the advice if they themselves are capable of understanding the advice but incapable of understanding the way in which the investment operates. It is the equivalent of saying that only people who truly understand the principles of flight should be allowed to travel by plane. It seems to me that the rigidity of the proposition is a recipe for imprudence. Prudent people do not assume they know or can know everything. They do not assume that they are best placed to assess every fact, matter or thing. They do not assume that their own limitations dictate what can and cannot prudently be done. Prudence does not involve solipsism. (Para 1472).

Prudent people seek to identify others who are best placed and have demonstrated they can be trusted to assess relevant facts, matters and things. ... All of the councils relied on: – (i) the belief that LGFS’s conduct had induced that LGFS, as specialists in local government financial markers and investments, had applied its expertise to the CPDO and assessed it to be a suitable investment for councils to make, and (ii) the belief that S&P had applied its expertise as a body specialising in assessing the creditworthiness of financial products and had concluded that this product warranted the highest possible rating of AAA in respect of interest and principal. The councils’ beliefs to this effect were reasonable in the circumstances and, indeed, were correct. For the councils to refuse to invest in these circumstances, by reason only of the fact that they did not understand how the product operated, does not accord with the dictates of prudence. (Para 1473).

On the issue of the court becoming the regulator of rating agency methodology, the judgement says:

It is also not the case that the councils “seek to place the Court in the untenable position of being the regulator of rating agency methodology”. This is an inaccurate description of the issues in this case. As will be apparent from the discussion and findings below this is not a case about alternative methods of rating, questions of reasonable qualitative judgment or whether one or other method or judgment is to be preferred or is superior to another. This is a case about what S&P did and did not do and whether any reasonable ratings agency could have so conducted itself. It is not a case about the appropriateness or otherwise of a rating. It is case about negligence and misleading and deceptive conduct. (Para 2482)

On the argument that rating agencies are not insurers, the court says:

The imposition of a duty of care in this case does not transform S&P into an insurer of investment performance. It does no more than ensure that S&P, if it chooses to earn money from holding itself out as having specialised expertise in ascertaining the creditworthiness of structured financial products, knowing that it can do so because many potential investors do not have or cannot practically access the same expertise, exercises reasonable care in the assigning of ratings to structured financial products. The criterion for potential liability in respect of such a duty of care is not the performance of the product. The performance of the product determines the potential for loss and thus completion of the potential cause of action. But breach of the proposed duty cannot be determined by reference to the performance of the product. As S&P correctly said the assigning of a rating of a structured financial product embodies a forward-looking opinion about creditworthiness assigned at a particular time. The ratings agency either did or did not exercise reasonable care at that particular time. (Para 2799)

But I am not a lawyer, and my interest is not in legal liability but financial modelling. I have been asking myself a more fundamental question – could this note have been rated at all (not a AAA rating but any rating at all)? The Australian court does conclude that the Rembrandts were securities and not derivatives for the purposes of the Corporations Act, but economically they are more derivatives than bonds. As the court put it: “However else it might be described, the CPDO was ultimately an extraordinarily complicated bet on the future performance of two CDS indices over a period of up to 10 years.” (Summary, Para 9). The risk in the Rembrandts is market risk rather than credit risk. Yes, the derivatives are credit derivatives, but the Rembrandts could be cashed out at a 90% loss of principal not because there were too many any defaults on the names underlying the credit derivatives, but because of the movement of the credit spread. Counter-intuitively, this could happen if the credit spread were too low rather than too high.

Another way of looking at it is that the Rembrandts were a bet that the risk premium embedded in the credit spread (more precisely the CDS spread) could be harvested in a “safe” manner. If the credit spread were say 1% while the expected default losses were only 0.20%, the notes would be expected to make 0.80% annually by selling CDS (before accounting for leverage which could be as high as 15:1). In finance jargon, the Rembrandts were betting that the risk neutral expected default loss (say 1%) is much higher than the real expected default loss (say 0.20%) and the balance is just a risk premium. The complexity of the CPDO structure is all about (a) making this a leveraged bet and (b) dynamically adjusting the leverage ratio to deliver a bimodal outcome where either the investor gets back full principal with a coupon 1.90% above the risk free rate or gets cashed out at a 90% loss of principal. To a finance theorist, there is something absurd about a risk free (AAA) instrument yielding 1.90% above the risk free rate. It is almost axiomatic that there is no risk free way of harvesting risk premia.

It appears to me that such instruments should not be rated at all. Analyzing the probability of loss in the Rembrandt makes no sense when it does not take into account the fact that the loss in case of default is 90% and not the much smaller losses in AAA corporate bonds. Comparing the loss probability of the Rembrandt with that of a AAA corporate bond over a ten year horizon is meaningless since unlike AAA rated corporate bonds which default only after several years, the biggest risk of loss in a CPDO like Rembrandt is in the early years when the leverage is very high. A 0.28% probability of loss over ten years might be consistent with a AAA rating, but a AAA rated corporate bond also has less than 0.01% default probability over the first two years and not 0.06% as one might expect if one tried to spread the 0.28% out equally over ten years.

Posted at 15:33 on Mon, 12 Nov 2012     View/Post Comments (1)     permanent link


Sat, 03 Nov 2012

Parochialism of national and global exchanges

I blogged three years ago about how Indian exchanges pretend to be national in their scope, but shut down when conditions in their home city make it convenient to take a holiday. Their equally parochial regulators are also complicit in this. (I have been critical of the 9/11 closures in the US as well).

This week as hurricane Sandy hit the east coast of the US, it was the turn of the big US exchanges with global footprints to reveal their parochialism. Their regulator was also happy to endorse the decision of these exchanges to shut down. It was left to a former Chairman of the US SEC, Arthur Levitt to state the obvious:

If you’re going to have a stock exchange, it should have a backup facility of some sort so that regional events don’t cause its closure, ... This should not happen to the world’s most prominent exchange.

The response of the NYSE CEO was that Arthur Levitt “maybe a little out of date with the facts.” No it is the exchanges and their regulators who are out of date with the facts – somebody forgot to tell them that modern exchanges are not trading floors subject to the vagaries of the local weather, but electronic networks which can be rerouted very easily. And no, the difficulty of New York brokers to get to their offices is no excuse for shutting the national exchange. By this logic, they should have shut the NYSE when hurricane Katrina struck New Orleans; surely, brokers based there would have had great difficulty reaching their offices.

In my experience, backup sites in the financial industry are a big joke. Typically, these systems are set up only to satisfy check box ticking regulators who require them to have back up sites, but do not bother to check whether these are actually adequate. Many of these backup systems have significantly less processing capacity than the main site. Moreover, they are not designed to run the full suite of software that runs on the main system. Given the willingness of spineless regulators worldwide to shut down national financial market places at the drop of a hat, this reluctance to spend money on genuine backup sites is fully rational.

I am convinced that regulators should simply force each institution to operate out of its backup site on a few random days each year. They should get very minimal notice (otherwise, they would fly down their entire management team to the backup site to make it work). Accountable algorithms that I blogged about recently are ideal to ensure that the dates are indeed randomly chosen.

Posted at 19:43 on Sat, 03 Nov 2012     View/Post Comments (2)     permanent link