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

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Sat, 29 Dec 2012

We assume ...

The Basel Committee on Banking Supervision (BCBS) issued a Consultative Document on "Revisions to the Basel Securitisation Framework" earlier this month. Under "Key assumptions and theoretical underpinnings", I found this gem:

Another important assumption embedded in the RBA recalibration is that the same ratings for structured finance and corporate exposures imply the same expected loss rates for investors. One implication of this is that it is assumed that rating agencies will “fix” or have fixed the errors in rating methodologies for structured finance that were revealed during the recent crisis.

Just to put that assumption in perspective, the plot below shows the difference in default rate over the last three decades (and not just during the crisis) between Asset Backed Securities (ABS) or structured finance and corporate paper with the same ratings. The source for the underlying data is Standard and Poor’s via a recent paper by Gorton and Metrick (Table 8) that I hope to blog about soon.

Chart of Default rates of Structured Finance versus Corporate bonds

I used to make the assumption that the regulators will “fix” or have fixed the errors in regulatory capital calculation methodologies for structured finance that were revealed during the recent crisis. That assumption must now be abandoned.

Posted at 22:01 on Sat, 29 Dec 2012     View/Post Comments (1)     permanent link

Mon, 24 Dec 2012

Mutual funds bailing out affiliated funds

Two years ago, I blogged about a paper showing that mutual funds support the share prices of their parent banks in Spain. The authors of that paper (Golezyand and Marinz) however argued that Spain is a country “where this type of activities are not closely monitored nor severely prosecuted and punished by the authorities”. In reality, however, this kind of behaviour knows no geographical boundaries.

Pinto and Schmidt study mutual funds in the United States and show that when a mutual fund has difficulty selling illiquid shares in response to redemption pressures, other funds in the same family very conveniently buy the shares and avoid a fire sale. The buying fund (usually a larger and more liquid fund in the same family) suffers a performance loss by absorbing these shares without a sufficiently large price discount.

The takeaway is that if you a buying an illiquid mutual fund, you should buy a fund run by a large mutual fund family to benefit from the liquidity insurance provided by its affiliates. But if you are buying a liquid mutual fund, then you should avoid funds that belong to large families to avoid the performance drag arising out of supporting its affiliates.

Posted at 15:36 on Mon, 24 Dec 2012     View/Post Comments (0)     permanent link

Sat, 22 Dec 2012

Are bond market bubbles quiet or loud?

Harrison Hong and David Sraer have a nice paper on quiet bubbles at NBER. They argue that while equity bubbles are very loud (high trading volumes in the bubble stocks), debt market bubbles are very quiet (trading volumes actually decline in bubble bonds). This prediction of their theoretical model is vindicated in the empirical data about bond trading volumes during the 2003-2007 credit boom.

In the theoretical model, the quietness of the bubble is driven by the limited upside in bond prices which makes heterogeneity of beliefs less important. By contrast loud equity bubbles arise from large disagreements about fundamentals coupled with short sale restrictions.

This characterization is both interesting and plausible. But, I think that it ignores the relative importance of the primary market in bonds as compared to equities. The annual issuance of stocks is less than two days’ trading in the secondary market which means that the primary market can be ignored in any discussion of the loudness of an equity bubble. In corporate bonds however, the annual issuance is 82 days of secondary market trading, and this is by no means negligible. (Both these pieces of data are from Dealbreaker). Issuance of bonds is analytically the same as shorting of bonds, and a large primary market also serves to attenuate short sale restrictions in the bond markets.

It appears to me that bond market bubbles are very loud when looked at in terms of a rise in issuance activity. It is perhaps for this reason that most attempts to measure credit market bubbles focus on the growth in the amount of credit outstanding which is entirely a measure of the primary market activity.

A closely related point is that the limited upside in bond prices means that a lot of leverage is required to exploit any divergence of opinion. This too leads to increased issuance of debt (typically short term) which leads to increased fragility of the financial system. This implies that bond market bubbles also pop very loudly.

Posted at 10:59 on Sat, 22 Dec 2012     View/Post Comments (0)     permanent link

Mon, 17 Dec 2012

Single stock futures and promoter share pledges

I participated in a discussion on CNBC TV18 about the trading of single stock futures on companies whose promoters have pledged a significant portion of their shareholding. (You can watch this show here (Part 10) though I participated only by audio).

The discussion was about a proposal that companies whose promoters have pledged a significant fraction of their shareholding should be punished by stopping trading in single stock futures in the shares of these companies. My views were as follows:

  1. Allowing trading of single stock futures should not be seen as a mark of prestige for the company or any form of a reward or seal of approval. The single stock future exists to meet the need of investors and not the needs of the companies or of the exchanges.
  2. Single stock futures are the easiest way to short shares, and so banning single stock futures would be a mild form of banning short selling. Short selling is an absolutely essential counterweight for the leveraged long. Restricting short selling when the promoters are leveraged long would essentially be a way of bailing them out and protecting them from sharp falls in their share prices.
  3. Large leveraged longs create a cliff risk for the share price – if the price falls far enough to produce large margin calls for the leveraged buyers, then the price can just fall off a cliff due to distress liquidation of the pledged shares by the lenders. The answer to this is more stringent margins when cliff risk is high either because of a large leveraged long position (or on the opposite side, because of a large short interest).

Posted at 21:18 on Mon, 17 Dec 2012     View/Post Comments (2)     permanent link

Sun, 09 Dec 2012

The absurdity of the leveraged super senior trade

The Financial Times has a couple of stories (behind a paywall) about the Leveraged Super Senior (LSS) trades of Deutsche Bank during the financial crisis. Grossly oversimplified, the story is roughly on the following lines:

What I find interesting in this whole sequence of events is the sheer absurdity of almost every step in this.

All this reminds me of those fallacious mathematical proofs that use division by zero to prove that 1 equals 2. All these proofs work by creating a significant amount of needless complexity in the midst of which the audience does not notice that somewhere in the long chain of reasoning, you have actually divided by zero. The same thing is happening here; you need a significant amount of complexity to ensure that the regulators do not observe that some risks have slipped between the cracks unobserved waiting to be picked up by the unwary taxpayer.

Posted at 17:03 on Sun, 09 Dec 2012     View/Post Comments (0)     permanent link

Thu, 06 Dec 2012

When regulation collides with free speech

In a ruling earlier this week that has implications for regulations in other fields (including finance), the US Court of Appeals (second circuit) concluded that “the government cannot prosecute pharmaceutical manufacturers and their representatives under the FDCA for speech promoting the lawful, off-label use of an FDA-approved drug.” The US Food and Drug Administration when approving a drug for certain (on-label) purposes does not prohibit physicians from prescribing the drug for other (off-label) purposes, but prohibits the drug companies from marketing the drug for off-label purposes. The Court ruled that the FDA could ban off-label use if it chose to, but could not permit such use and then require some parties to keep quiet about it:

... prohibiting off-label promotion by a pharmaceutical manufacturer while simultaneously allowing off-label use “paternalistically” interferes with the ability of physicians and patients to receive potentially relevant treatment information; such barriers to information about off-label use could inhibit, to the public’s detriment, informed and intelligent treatment decisions. (Page 44)

Financial regulators are also in the habit of regulating speech in all kinds of situations – the US SEC’s infamous quiet period rule is a good example. The Circuit Court ruling quotes a Supreme Court judgement that “regulating speech must be a last – not first – resort”. This is something that all regulators particularly in the financial sector must bear in mind.

Posted at 14:06 on Thu, 06 Dec 2012     View/Post Comments (1)     permanent link