On Black Scholes Hedging

Further to yesterday's post about CB arb, a short note on hedging options.

If you sell an option at an implied vol of v, and the Black-Scholes assumptions hold (in particular the underlying is a diffusion with constant delivered volatility w, and you can trade instantaneously at zero spread) then the expected P/L of a delta hedged position depends only on v and w. In fact, as Dupire amongst others pointed out, it depends on v versus the gamma weighted delivered volatility. Thus, on average, if you sell an option at v, and v > w, you will make a profit. If you buy an option at v and v < w, you similarly expect to profit.

Two things can screw you up. Firstly this result only holds if the underlying is a diffusion. Therefore in the real world, with jumps, you can buy a 'cheap' option (i.e. one whose implied is less than realised) and still lose money on hedging. Secondly all the other imperfections (bid/offer spreads, variable interest rates, stock borrow costs etc.) hurt, so in practice you need at least a 2 vol point difference between realised and implied to have a good chance of a profit.

Thus, to return to yesterday, you will judge a CB to be cheap if the implied vol needed to recover the price of the CB is significantly less than your expectation of future delivered vol of the underlying during its life. If you are right, you can make money delta hedging the embedded option. Before 2004 or so CBs were often cheap - the issuers discounted them a bit to be sure of getting the issue off - and so CB arb could be profitable. The problem is that buying a CB to get the option is inherently deleveraged, since the option is only a fraction of the total (the rest being the bond floor). Hence callable convertible asset swaps. But that is a story for another day.

CB arb

FT alphaville comments on convertible bond arbitrage (in connection with VW, but that need not detain us here). A few points. First the article says CB arb had sizzled out post-2005 due to lack of issuance. Is that really true? I always thought it had sizzled out because CBs were more fairly priced, so it was no longer obvious that buying vol via the CB and delta hedging was a good idea.

Secondly, there was a surge in CB issuance earlier this year: financial companies sold more than $35bn of convertible bonds in the first nine months of 2008. A lot of this paper was presumably gobbled up by hedge funds keen to get back into the play. And for a while it went well. As the FT reported back in 2007:

Convertible arb has returned from the dead. Two years after investors abandoned one of the pillars of the traditional hedge fund portfolio, convertible bond arbitrage is once again attracting interest – and billions of dollars of new money.

Hedge funds specialising in convertible bonds produced their best performance since 2000 last year, returning as much as the previous three years combined.

That has all changed. The Barclays CB arb index was down 9.3% in September. But why? I am puzzled...

• Classic CB arb players are long the CB, short stock. This is a long vol position: rising vols should make money. Perhaps some of them were hurt by short selling bans or increased stock borrow costs, but that explanation not seem to explain the scale of the losses.
  
• Clearly leverage is more expensive and harder to come by. Advanced CB arb players bought CB options (the right to call the CB on an asset swap basis), though, and that is term leverage. You can't easily repo CBs (can you?) so repo squeeze isn't an issue. Again I don't see quite how this factor would impact CB arb specifically.
  
• Credit spreads have gone out, and that will have hurt those funds with naked credit longs, but many funds bought CDS protection on the credit, so again the size of the move is surprising.

So, does anyone know why September was so bad for CB arb?

Blood and guts on Wall Street

I don't usually post video links, but as it is Halloween and many market participants are white as Zombies...

Your friend Ted

Margin Revolution has an interesting piece on the TED spread. They take St. Louis FED data on the 3 month T-bill series and 3m Eurodollar deposits (rather than BBA Libor) to get a long term view of the TED spread.That does put the current travails in perspective slightly.

Whither volatility?

The VIX opened on Friday 24th at 89.03. What does that mean? Using the root-t rule (which is extremely questionable at the moment, admittedly) that scales to an average daily move of 5.6%. Now admittedly things have been volatile recently. But even taking the period from 6th-24th October, the daily move in the S&P was only 4.4%. If you didn't have any other reason to trade (such as hedging a short vega position that you are panicing about), you would only buy the VIX at 89 if you thought the average daily move in the next 30 days was going to be even higher than it has been over the last two weeks extreme though they were. I'm not saying that can't happen, but it does seem unlikely to me.

The Bull must die

From the FED, Information on Principal Accounts of Maiden Lane LLC as at Wednesday, Oct 22, 2008

Net portfolio holdings of Maiden Lane LLC: $26,802M

Outstanding principal amount of loan extended by the Federal Reserve Bank of New York: $28,820M

So the FED is a couple of billion underwater. On October 16th, the assets were valued at $29,492M.

A Question of Etiquette

Is it acceptable to go to a Halloween party dressed as Dick Fuld, or is that just too scary?

Swaps spreads and other lunch toppings

Why, sometimes I've believed as many as six impossible things before breakfast said Alice. This quotation came to mind in the discussion of the 30y dollar swap spread in the FT recently:

“Negative swap spreads have been considered by many to be a mathematical impossibility, just like negative probabilities or negative interest rates,” said Fidelio Tata, head of interest rate derivatives strategy at RBS Greenwich Capital Markets.

Oh dear me. A mathematical impossibility is 2 and 2 adding to 5, or the sudden discovery of a third square root of 4. A physical impossibility is something that we think is impossible according to our current understanding of science: accelerating from rest to go faster than the speed of light, say.

Negative swap spreads are neither of those. They simply represent an arbitrage. An arbitrage is when you can make free money without taking risk. Ignoring for a moment the risk de nos jours - counterparty risk - swap spreads allow one to lock in a positive P/L if one can fund at Libor flat. Free lunches do not often exist in finance, but they do happen in particular when there are no arbitrageurs left standing. No arbitrage relies not on the theoretical possibility of a free lunch, but on enough people actually wanting to dine for nothing that prices move to stop the feast. At the moment there is such a shortage of risk capital that one can indeed find free food. So `impossible' things are happening not just before breakfast but all through the day. Bon appetit.

Chart of the day

This, originally from Bloomberg and then picked up by FT alphaville and many others, is attracting a lot of attention:Despite some rather histrionic claims that it `proves' the bailout is inadequate and much more money is needed, I am not so sure. For one thing, banks are deleveraging, so they will need less capital. For another, various tricks are being employed, such as the FED's forebearance of capital requirements for the Bear portfolio at JPM. So the argument that the system needs as much capital as before right now is not clearly correct. Of course, capital requirements will go up eventually. But at the moment I tend towards the idea that supervisors are willing to tolerate a less well capitalised banking system at least while the crisis lasts. The banks might need more capital than is available in the bailout in due course but I am not convinced that they need it immediately.

Basel 3

I have sniped, perhaps too much, at Basel 2. So it only seems reasonable to outline some alternative proposals, particularly as Lord Turner is apparently open to significant change. Here goes.

Scope. Capital charges should apply to assets, derivatives, and to asset/liability mismatch. In particular funding mismatch and the heavy use of confidence sensitive short term funding like repo should generate a capital charge.

Risk types. There should be capital for market risk, credit risk, counterparty risk and funding liquidity risk. If there is a need for an operational risk charge, it should be a simple expenditure-based requirement.

Models. Given the spectacularly bad performance of risk models, these should be banned for regulatory capital purposes. In particular no diversification benefit should be given. Total capital requirements should be derived by adding up the capital requirements for each risk type.

Asset Liquidity. This should be explicitly included in capital requirements, with market risk capitals being scaled by root t for assets whose liquidation horizon is longer than typical. (Implicitly the current horizon is ten days, so this is a good start.)

Haircuts. These should reflect a prudent move across the cycle. For equity indices, for instance, a reasonable capital charge would be the biggest loss resulting from an 8% move up or down in the index. [For any reg. junkies out there, what I am envisioning here is rather similar to the CAD 1 approach used before the 1996 market risk amendment.]

Anti-cyclicality. There should be a capital buffer over and above the calculated minimum, varying from 25% or more at the good points in the cycle to essentially nothing in a crisis. The availability and cost of leverage, volatility measures, and market returns should be used to determine where we are in the cycle.

Credit risk in the banking book. The revised standardised approach in Basel 2 is not too bad for corporate risk, but it is far too generous for retail and mortgage risk. It's badly designed for securitisations. Revisions will be needed to these capital charges.

Credit instruments in the trading book. These charges need to be completely redesigned.

One Night In New York

In my defense, I was on a train and running out of reading matter. So another lyric rewrite happened.

New York, occidental setting
And the city don't know that the city is getting
The creme de la creme of the bank world
In a show with everything but Alan Greenspan
Time flies, doesn't seem a minute
Since the Tirolean spa had the bank boys in it
All change, don't you know
That when you play at this level there's no ordinary venue
It's Davos or Hong Kong or Tokyo or London
Or, or this place

One night in New York and the world's your oyster
The banks are temples but the stock ain't free
You'll find a God in every golden billion
And if you're lucky then the God's a she
I can feel the paper sliding up to me

One town's very like another
When your head's down over your Bloomberg, brother
(It's a drag, it's a bore, it's really such a pity)
(To be looking at the screen, not looking at the city)
What d'ya mean
You seen one crowded, polluted, stinking conference room
(Tea, men, warm and sweet, sweat)
(Some are set up in the Hank Paulson suite)
Get confirmed! You're talking to a tourist
Whose every move's among the purest
I get my kicks above the waistline, sunshine

One night in New York makes a hard man humble
Not much between despair and ecstasy
One night in New York and the tough guys tumble
Can't be too careful with your company
I can feel the devil walking next to me

Wall Street's gonna be the witness
To the ultimate test of cerebral fitness
This grips me more than would
A muddy old river or reviving vodka
Thank God I'm only watching the game, controlling it
I don't see you guys rating
The kind of bond I'm contemplating
I'd let you watch, I would invite you
But the lawyers we use would not excite you
So you better go back to your bars, your jobs
Your SPVs

One night in New York and the world's your oyster
The banks are temples but the stock ain't free
You'll find a God in every golden billion
A little flesh, a little history
I can feel the paper sliding up to me

One night in New York makes a hard man humble
Not much between despair and ecstasy
One night in New York and the tough guys tumble
Can't be too careful with your company
I can feel the devil walking next to me

On the value of uncertainty

Long, long ago, when I was responsible for the valuation of a lot of financial instruments at an investment bank, I used to set a lot of store in valuation adjustments. The basic idea is that the precise fair value of many instruments is uncertain. You value them at your best guess, and you take a valuation adjustment to cover the potential uncertainty. They are a kind of accounting error bar, if you like.

There are two main reasons to do things this way rather than simply to mark conservatively. The first is that value affects risk: if you mark as accurately as possible, your risk measures are as accurate as possible. [This is particularly an issue for derivatives since d (delta) / d (vol) is non-zero: marking to a 'conservative' implied vol gives you the wrong deltas.] The second is that the size of the valuation adjustments are an important signal to management about the size of the valuation uncertainty in the book. That in turn gives important information on illiquidity, marketability etc.

Borio in a fascinating BIS paper The financial turmoil of 2007- argues that firms should disclose these uncertainties, and that this disclosure would be a useful disclosure to the users of financial statements. I agree completely. The only problem is that many people currently think that some firms would be insolvent based on plausible error bars. But they don't know precisely who those firms are.

Peston picked off

Robert Peston, it seems, may be getting a dose of the scrutiny he has been afforded to the banks. The Observer reported on Sunday that Serious Fraud Office could launch an inquiry into his recent scoops. I don't have anything against Peston personally, but I do think he has shown a persistent lack of judgment in both his language and the amount of due diligence he has done before breaking stories. We’d all be staring into the abyss was his characterisation of the failure of the Lloyds/HBOS merger, for instance; while his first account of the Lloyds/HBOS deal suggested the price would be £3 a share (it turned out to be close to two). His accounts of government intervention into Northern Rock and into the wider banking system were market-moving: but did they amount to shouting `fire' in a crowded theatre? I definitely think there is a case to be answered, and I hope that he is forced to answer it. Responsible financial journalism is important; telling truth to power, more so. But telling half truths in purple prose for the purposes of self-aggrandisement is not a good thing, especially for someone with the broadcasting power of the BBC's business editor. He's also far too close to Gordon Brown to be clearly whiter-than-white independent. This is not a good state of affairs for the BBC.

The Last War

The WSJ has an interview with Anna Schwartz, Friedman's coauthor on A Monetary History of the United States. She has some interesting remarks.

Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of them, that would be an improvement."

But she's wrong. A toxic asset you don't know how to value and can't sell is completely utterly familiar to bankers. It's called a non-performing loan. And these assets can be sold. It is just that banks don't like the price at which deals - like Merrill with Loan Star - can be done. There are two solutions. Either sell at the market price and move on, if you can afford it, or recapitalise sufficiently so it is utterly obvious the bank can afford to hold to term, and wait and see what happens. The latter is cheaper as you don't have to pay an uncertainty premium, which is why the Brown/Darling plan rightly concentrates on recapitalisation.

Now we get to the usual free market bollocks:

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."

She can say that after Lehman? And still get an interview in a supposedly serious newspaper? That's simply embarrassing. The reality is that if senior obligators of large firms are too spooked right now, the system fails. So, let's remember that firms have a capital structure. We can, and should, screw equity holders of firms that made bad decisions. We can, and should, save senior debt holders in large banks (and anyone pari passu with them).

What Pleasure It Is To Be A Real Keynesian Now

Finally the tide seems to be turning. Bernanke is talking about the need for central bankers to be mindful of asset price bubbles. Darling is reprioritising spending to produce a classic Keynesian stimulus. But isn't it bizarre that we now have nationalised banks and privatised railways? If ever there was one industry that the state should control - must control - it is transport. (The revelation on Saturday that the reason Virgin trains are so crowded is nothing more than revenue optimisation only makes the case even more clear.) Now Alistair has (reluctantly and a little tardily) got the nationalisation bug, perhaps he could finally undo the evils of his predecessors and renationalise the tube and the railways. Let's hear no more about internal markets in the health service or in education. Now is the time for the state to spend for the sake of us all.

Credit Derivatives Unfairly Scapegoated

From Reuters:

Credit strategists at ING said on Thursday that credit derivatives were being unfairly blamed by politicians and commentators for the near meltdown of financial markets..."The CDS (credit default swaps) market is being used as a scapegoat for political and economic goals," ING credit strategist Jeroen van den Broek wrote in a note to investors.

Quite right too, and I have been saying so for months. This particular goat (sheep, whatever) is pretty safe.

Update. As per my earlier post, Reuters reports that the Lehman settlement is a non-event. There a nicely written elaboration from Felix Salmon on portfolio.com here, and a broader FT alphaville defense of derivatives here.

Two sensible comments

The first from Clusterstock:

Many of our financial institutions are insolvent. They aren't healthy victims of bank runs. They are ailing institutions barely kept alive by frantic rounds of capital raising. The lessons of the Great Depression simply don't apply here.

In fact, we're probably making things worse. Allowing insolvent institutions to fail and requiring worthless and worth less assets to be fully written down would provide transparency to the market. Instead, we're dedicated to the post-Lehman proposition of "Never Again." The various programs of our government continue to obscure asset pricing and conceal insolvency. This means that you can't trust the market to tell you which firms are failing.

Twisting the arms of bankers to lend to institutions that may be insolvent is a recipe for deepening the crisis. We've just been through a period of malinvestment--we spent too much borrowed money on junk. Borrowing more to spend on junk only digs us in deeper.

Bank lending won't get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won't help. More transparency, which means more write-downs and failures, is probably necessary if we're going to get through this.

I don't think we know enough about the current situation to know if this is true, but it certainly could be. Unfortunately the recent accounting changes make it harder to find out, too. The Japanese lost decade certainly suggests that keeping failed institutions on life support is the wrong approach - but equally Lehman showed that letting firms fail in the wrong way is catastrophic for market confidence. We need banks to be able to prove to the market's satisfaction that they are solvent, and prove that fairly soon. If the government recap gets us there, then fine. If not, even more drastic remedies are going to be needed.

Second, from an interview by Lord Turner in the FT:

Lord Turner said regulators would also now have to examine mark-to-market accounting, bankers’ bonus structures, the way in which financial institutions transfer risks, and the frameworks for regulating banks’ liquidity and capital.

He said the capital reserves imposed on banks last weekend were necessary to restore short-term confidence, and that the watchdog would have to work on a longer-term framework for setting capital.

He warned, however, that it could be some time before an international agreement could be reached. Some regulators believe it is necessary to scrap the Basel II framework, while others believe it can be adapted.

[Emphasis mine.] It is most reassuring to see that the new head of the FSA is willing to contemplate scrapping Basel 2. The Basel 2 capital regime has served us very badly: it's pro-cyclical, imprudent in places and aggressively conservative in others, full of model risk, and far too complicated. Let's start with a clean sheet of paper, and demand that the rules be simple, demonstrably prudent but fair across risk types (and accounting methods), and as little dependent on models as possible.

Any old bonds

Any old bonds? Any old bonds?
Any, any, any old bonds?
You look neat. Talk about a treat!
You look so dapper from your napper to your feet.
Dressed in style, brand-new tile,
And your father's old repo on.
But I wouldn't give you tuppence for your old MBS,
Old MBS, old MBS.

This is one in a series of bad lyric interventions. In this case, inspiration comes from the ECB.

Being Boring

Contrary to the Pet Shop Boys, I came across a cache of old photos, and the markets were often boring. A graphic from the WSJ makes the point well:It is not the big swings that get you. It is the years and years of returns close to zero. Less than 2% for 15 years at the start of the century, then again from '66 to '82. What if the future of the S&P isn't dramatic further falls or steady rises but just ten years of boredom?

Update. Seeking Alpha has some more bear market background here.

Basel 2: Installing smoke alarms while Rome burns

I have detected a slightly more sarcastic tone than usual in my recent posts and I had resolved to be nicer. But then something like this comes along:

The Basel Committee/IOSCO Agreement reached in July 2005 contained several improvements to the capital regime for trading book positions. Among the revisions was a new requirement for banks that model specific risk to measure and hold capital against default risk that is incremental to any default risk captured in the bank’s value-at-risk model. The incremental default risk charge was incorporated into the trading book capital regime in response to the increasing amount of exposure in banks’ trading books to credit-risk related and often illiquid products whose risk is not reflected in value-at-risk. At its meeting in March 2008, the Basel Committee on Banking Supervision (the Committee) decided to expand the scope of the capital charge to capture not only defaults but a wider range of incremental risks, to improve the internal value-at-risk models for market risk and to update the prudent valuation guidance for positions subject to market risk of the Basel II Framework.

The details are here and here.

What's wrong with this? Well, at least three things. Firstly we still have VAR as the basis of market risk capital. Until Basel throws that out and comes up with something more prudent, probably based on stress tests, the Basel 2 market risk capital framework will rightly remain a laughing stock.

Secondly, not only have the supervisors kept VAR, they still believe that procyclical, miscalibrated risk models are a good idea, and they want more of them, even though they know banks cannot model the risks they are trying to capture:

Because a consensus does not yet exist with respect to measuring risk for potentially illiquid trading positions, it is anticipated that banks will develop different IRC modelling approaches. For example, a bank could develop a comprehensive asset pricing model incorporating both diffusion and jump processes for price movements over liquidity horizons

Finally, the proposed incremental capital charge is much higher for liquid, trading book assets than for held to maturity assets of the same risk profile in the banking book. That is simply wrong. So, Basel Committee, step away from the rule book: you have lost any credibility you might have had before the Crunch. Let's start again, ideally with a different set of rule makers. Perhaps the white rabbit is free.

Some data

I want to talk soon about the equity/credit dislocation I discussed earlier in the year and whether the events of the last few weeks have closed it. But first a few other market datapoints.

First Baltic Dry. This is one interesting indicator of economic activity. Bloomberg shows that the Greenspan Boom has now fully bust:Meanwhile Reuters reports that:

The spread curve of Europe's main credit derivatives index inverted for the first time in its history this week, indicating a higher cost for buying credit protection in the short term as dealers priced in the potential for a shock default by an investment grade company

Individual curves have been inverted in the past - Fiat had a massive inversion when the market was trying to guess whether it would fail quickly or get a bailout - but an inverted iTraxx curve is unprecedented.

The TED spread has contracted slightly, down from a high of 4.63% to 4.36%. If the bailout is working, we will see it come back in to 1.5% or less. But certainly the current level indicates interbank lending is still frozen.

And of course the Crunch has moved into the real economy. The IHT reports:

Former U.S. Federal Reserve Chairman Paul Volcker said... "I've seen a lot of crisis, but I've not seen anything quite like this one," ... "I don't think we can escape damage to the real economy. I think we almost inevitably face a considerable recession."

All of this is negative for equity. I'm with FT alphaville's bull-bears: Monday was not the bottom.

The IASB buys a fog machine

Yesterday, a most propitious day for stocks, the IASB chose to announce that they will permit a new wave of opacity to sweep over company accounts. Notice that it is retrospective. This is a very negative development if we ever want to get out of this mess. The taxpayer deserves to at least know what we are bailing out and what condition the banks we now own are in.

Tim Congdon has completely lost it

On the news at 1, sounding mildly crazed, he said: There was nothing wrong with Northern Rock. No, Tim, nothing but a run that would have led to bankruptcy if the Bank of England had not intervened as Lender of Last Resort. Honestly, these monetarists are so dangerous giving them a media platform at the moment is roughly akin to shouting fire in a crowded theatre.

Update. He's at it again, saying to the BBC: "The way the government is going about it, they are effectively stealing from the shareholders. The long-run result will be to destroy the competitiveness of Britain's most important industries,". Again, no. Without government intervention, the shareholders would have nothing. There would be nothing to steal. The state is in fact being very generous letting shareholders keep any of the banks. It is probably politically expedient so to do, but it isn't necessary. Without the state, HBOS and RBS would have been toast today. You can't be competitive if you are insolvent.

Update. Did the BBC suddenly declare it discredited economist month? They had Madsen Pirie on the news this morning, decrying Keynesian stimulii. Of course he doesn't want us to try it; of course the whole nauseating troop of monetarists are trying to get publicity: if spending our way out of recession does work, any vestige of reputation they might have left will disappear.

Credit Derivatives Still Not Spawn of the Devil

Let me offer an analysis of much of the media coverage of credit derivatives recently.

"Credit derivatives traders eat babies. Now XYZ event will tip the financial system further into chaos thanks to these dastardly instruments..."

(XYZ = Fannie/Freddie credit event, Lehman credit event, ...)

"On the eve of the auction for XYZ we spotlight the satanic unregulated* credit derivatives market..."

[The event happens. Settlement is orderly.]

"XYZ event was OK, we suppose, but the NEXT event will truly cause the end of the world thanks to the inexorable evil of credit derivatives."

The DTCC has an antidote. I doubt many bloggers or mainstream journalists will read it.

* Where by 'unregulated' we mean of course 'unregulated apart from the regulation'.

Redeploying intellectual capital

From Market Pipeline:

If paying the bankers (a lot) less or taxing them (a lot) would certainly be more desirable from a moral point of view ... would it be harmful in terms of economic efficiency, as many economists suggest? Is there a risk of discouraging the most talented to work hard and innovate in finance? Probably. But it would almost certainly be a good thing. A study on Harvard graduates showed that those who work in finance earn almost 3 times more than others. The temptation for young talent to work in this sector is enormous – 15% of 1990 Harvard graduates are working in finance, compared with only 5% of the class of 1975. More generally, the massive deregulation of the financial sector, which began in the 1980s, and the opportunity to make extraordinary profits have been accompanied by an increase in the number and qualifications of employees in this sector. Again, according to Philippon and Resheff, one has to go back to 1929 to see such a gap between the average education of an employee in the financial sector and one in the rest of the economy. The complex financial products, but also the evolution of standards in the social sectors over the past 30 years, have made the financial sector particularly attractive to any graduate, intelligent as he or she may be.

What the crisis has made bluntly apparent is that all this intelligence is not employed in a particularly productive way.

It is hard to disagree with this. If some of those 10% extra Harvard graduates in finance had gone into alternative energy, or transport planning, or medicine, would they have done more good (however you want to define it)? One's visceral reaction is that they would, especially once you factor in all the unproductive professions that go along side finance: tax lawyers, particularly.

Good banks lending on rational terms are important. New financial products can help investors and borrowers meet on terms that are better for both. But just as we don't need many of the 'innovations' that are foisted upon us by politicians -- ID cards spring to mind -- so investors should have been sensible enough to say no thank you to the worst excesses of financial creativity. No one needed a Libor squared swap in 1994: similarly no one needed a CPDO or CDO squared in the 2000s. Just say no to pointless, counterproductive innovation. It will help the innovators do something more useful with their lives.

What do we want from the banking system?

A few desiderata, to assist in the reform process.

Safety, at least for retail deposits. People want to know that their money is safe and available at short notice.

Availability of credit at a fair price. It should be possible for all, individuals and corporates, to borrow at a spread that reflects the risk (in both directions - not too high nor too low). Financial institutions can make profit in this process, but that profit should not be unreasonably high. Therefore we need some measure of competition in lending.

Return requires risk, and that risk should sit with the risk taker alone. If you want a higher return than government bonds, it should be perfectly clear that you are taking a risk to get that return, and hence if things turn sour, you and you alone should bear the consequences of that decision*. Risk takers should not be allowed to take risk in ways that endanger more than themselves - low altitude parachute jumps over uninhabited desert are OK; driving at 100 mph in built up areas is not.

Ummm, I am sure there is more, but aren't those the most important things? Right now I am a bit like the financial system -- suffering and not working very well -- thanks to a nasty coldy flu thing. I hope my recovery will be easier and faster than finance's. And certainly I hope less radical surgery will be required.

* That extra 1% return on an Icelandic bank account came with a risk. Live with it.

If the US defaults, people will still want soup

From the Economist a couple of CDS spreads:

Campbells Soup 17 basis points

United States of America 19.8 basis points

(And Morgan Stanley is over 2000, if you can get it.)

Lessons from 2001

The last time there was this big a market rout, I learnt a few lessons.

• Vol is really expensive. Sell it around the money. But the wings are dangerous. I like being short vega in this kind of environment, but to get longer on big market falls or rallies.
  
• Whipsaws happen. Live with it and plan your rehedge frequency accordingly: failing to capture the whipsaw if you are long gamma loses you a lot of potential upside. Look at your 1%, 2.5%, 5% and 10% deltas, not just the instantaneous one.
  
• Gamma holes can kill you at any strike within 30% of the money. Fill them as cheaply as you can.
  
• Correlation structures break down completely in environments like this one. Be especially careful of assumptions about cross gamma or strategies like dispersion trading that rely on stable correlations.

And if that doesn't work, pull up the drawbridge.

Today's Favourite Blog

FT alphaville is consistently good value, as is The Big Picture. I like Alea and frequently value the insights of IBEX salad and The London Banker. Calculated Risk is OK on real estate (if sometimes misguided away from it) and Paul Krugman is the man in many regards. Long and Short Capital is amusing, and Dealbreaker is good for gossip. But despite all this linky goodness, the site of the day has to be Sad Guys on Trading Floors.

Santander is in Spain, Darling

So WTF is Abbey, part of Banco Santander, doing on the rescue list? Let the Spaniards look after their own problems.

Too stupid Darling

Al is not smart enough for this one, I think, but...

...if you *did* want to get more for the taxpayer in a government bail out of the banking system, you'd leak the fact of a bailout but not confirm it for a day, so stocks fell, and you got more of the bank for your money.

Fannie & Freddie sub recovery bigger than senior

From Reuters, initial indications for today's auction:

	Fannie	Freddie
Senior	92.4%	93.75%
Sub	92.65%	93.8%

Remember, kids, while senior unsecured recovery can't be lower than sub in the actual bankruptcy hearings, it surely can in a CDS auction.

Update. Final results in:

	Fannie	Freddie
Senior	91.51%	94%
Sub	99.9%	98%

Alea suggests that the recovery mismatch is due to a cheapest to deliver effect as the zeros are deliverable into the senior swaps (list of deliverables here). Personally I think it is partly because there is a lot more liquidity on the sub than the senior. In particular naked shorts played with the sub (partly to hedge nationalisation risk). A lot of those are short covering now, whereas the senior was typically a credit risk management trade rather than speculation.

One more alarmist, not strictly relevant but funny quote

In order to save the banking system it was necessary to destroy it.

The Reason Program

In Dirk Gently's Holistic Detective Agency (currently being repeated on Radio 4), Reason is an artificial intelligence program:

"Reason constructs plausible steps to connect any set of unlikely premises to justify any decision."

"What would you use it for?"

"Anything that would otherwise look like a botched mess of lousy planning by the criminally stupid."

"Like the current government attempts to bail out the banking system?"

"If you know what to look for, the pattern of the algorithms is unmistakeable."

(OK, OK, I have made one minor change to the script, but I think Douglas Adams would have approved.)

How to ungum the interbank market

I should have thought of this: FairEconomist did (via NakedCapitalism). The answer is of course for the central bank to require a certain amount of interbank lending as collateral at the window. There's no reason not to make interbank receiveables eligible given the other things that are, and by requiring that banks use them, the Central Bank forces their clients to lend.

On Boldness

There is a some talk at the moment of a historic opportunity - an opportunity to refound the economy on sounder principles, to shackle the banking system in the service of society, to rebalance the inequalities between the very rich and the very poor, or at least between the hedge fund manager and the minimum wage drudge. While the forces of reaction are by no means slain - the CEO of Deloitte did a nice job this evening of warning about the dangers of actually changing anything that might offend his clients - I do indeed think the political obstacles against change are lower than at any time since the 30s.

But the problem today is the same as it was 80 years ago: the only people who know enough to produce workable alternatives are so invested in the old order that they are unlikely to be radical. There are many, many bad alternative solutions so we really need to deploy the best talent possible in making policy. That means that the new order is, sadly, likely to look a lot more like the old one that it needs to.

Update. It seems the Big Picture is thinking along the same lines.

MBIA sues Countrywide

Confirming the insurance industry habit of substituting claims adjustment for underwriting diligence, MBIA is suing Countrywide according to Housing Wire:

The breach-of-contract lawsuit, filed in New York State’s Supreme Court, suggested that Countrywide developed a “systematic pattern and practice of abandoning its own guidelines for loan origination,” in effort to inflate its market share during the mortgage-lending boom. MBIA accused Countrywide of knowingly negotiating riskier loans “no matter the cost to borrowers, investors or guarantors like MBIA.”...

Overall, the case involves 10 residential mortgage-backed securitizations of more than $14B in mortgage loans.

This is going to be interesting. On the one hand, it seems obvious that mortgage quality did decline in the last years of the Greenspan boom. But can MBIA really prove that Countrywide abandoned its own loan underwriting standards - rather than simply changing them to adjust to `market conditions' - and that that was a breach of contract of the financial guarantees? If it can, we are going to see a lot more wriggling from the wrappers, and the lesson from Hollywood Funding - that insurers can't always be trusted to pay when you think they have written protection - will be driven home to a lot more people.

My favourite of the nicknames for Ms. Palin

Bible Spice

Zombienomics

I've been a little busy recently so this will be brief. One scary part of the bailout bill was the clauses suspending mark to market. Firstly the idea of government intervening in accounting is a bit worrying: there is a long tradition in the US of the SEC telling firms what the FASB really meant, but Europeans tend to take a dim view of this sort of thing. But what they are suggesting will only increase uncertainty about who has really lost what. Time has more, but my tuppence is that the devil is in the detail of establishing fair value. You don't need to suspend FV per se, just give people more leeway about what counts as a sighting of that mysterious horse with the horn on its forehead, fair value, when the forest is burning.

20/20 New York Hindsight

Only four years too late, the New York Times has an article on the SEC CSE regime and how it didn't do enough to constrain the broker/dealer's risk taking. It's nice the Times is finally getting around to this kind of thing, but no one was interested in financial regulation and the scandal that was the US broker/dealer capital regime when there actually were some big broker/dealers around to take advantage of it.

AIG as a Regulatory Capital Arbitrage Shop

FT alphaville has the details in a most impressive post.

Funding or capital?

I don't believe this post but I think it is interesting... John Hempton maintains that the US banking system has, or at least could soon have if it retained earnings, enough capital. [My first worry is that while this might be true on aggregate, some institutions are undercapitalised, and the market does not know who is know because they do not believe banks marks and they think there are hidden losses.]

He then maintains that the problem is funding. That is, given the banks reliance on wholesale funding, it is the inability to borrow that is sending the system to hell in a handcart - or at least sending the TED spread to 3%. Given the central bank liquidity flooding the system I don't believe this part either. I do think Hempton is right about confidence being key, but surely the cheapest way to buy some of that it to fix the underlying mortgages. Still, it is an interesting argument and I'd like to see a three way debate between John, the proponents of 'recapitalise the system' and those who think mortgage mods are the way to go.