Two thirds of a fine horse?

Not really. But the assets in Whistlejacket, the defaulted SIV sponsored by Standard Chartered, were liquidated yesterday, and reached an average price of 67.1 cents on the dollar according to Bloomberg. That means that anything more than 2 to 1 leverage in an off balance sheet funding vehicle is too much...

How much capital does a bank need?

Probably the best answer is the least amount that gives comfort and confidence to debt holders, regulators, and other stake holders. But that is a moving target.

Over the last twenty years people like me have spent a lot of time trying to construct and improve capital models. At its simplest, a capital model uses some measure of risk to deduce how much capital is required for some portfolio. The problem is that many of these measures of risk have proved highly fallible, and thus capital has been systematically understated. Moreover, thanks (1) to leverage and (2) to the fact that losses are a deduction from capital, even small capital mis-estimates can emperil a bank in a crisis like the current one.

These chickens (or in Citigroup and Bank of America's case, flocks of giant mutant turkeys) are coming home to roost. Six of the largest nineteen US banks require more capital, according to the FED: and you can be sure other banks around the world do too.

What you can be sure of in these discussions is that the numbers are essentially arbitrary. No one really knows how much capital a bank needs at any given point, not least because risk based capital models have lost their credibility. Capital is adequate if and only if it keeps the relevant stakeholders happy: and risk based estimates no longer keep people happy. So don't expect the negotiations of the coming weeks necessarily to make sense. It will all be about the deal that can be done when everyone gets around the table.

Update. Matthew Yglesias, via Gary Becker, has a nice characterisation of what we can expect from capital, and indeed regulation in general:

The best you can hope from a regulatory regime is ... [a] fairly crude rule will improve on the outcomes generated by the unfettered market... when we're looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there's no danger there we should be very suspicious. We shouldn't count on being to fine-tune our results to perfection

Two down, one to go

Jacqui Smith, possibly the least competent Home Secretary since Henry Brooke (although there in Blunkett to consider for that title too, and that is pretty tough competition), has already announced that she will not be going ahead with a massive snoop project (although she wants the same functionality provided privately). The cancellation of the id card project is apparently being actively considered, and anyway the Tories have said that they will cancel them. And the Trident replacement may be on the block, along with a number of other large defense projects. This is all good.

It's just a shame we are still stuck with this:

Yes, the grandiose, ultimately useless (or at least currently without a use) and hideously expensive Olympic building projects sail on regardless. Our shameless pandering to the IOC continues. As Simon Jenkins says, while the ­citizens starve, the precious ones are fed. Still, at least some of these cuts are better than none.

Copula counterfactual

How different would the world be if David Li had written about a variety of different copulas rather than just the Gaussian one? (Do read the excellent Sam Jones piece that the link points to.)

Positions

A recent Bloomberg story reminded me that it has been months since I discussed the markets with a view to position taking. Sorry.

So... It seems obvious that high quality corporate credit (ex Financials) is a good place to be, especially with the decline of the Libor/govy spread. I tend to view medium durations, around 5 to 7 years, as attractive at the moment not least because they will profit from eventual curve flattening when things (finally, possibly after some years) get better. Fund short term if you can and you have a very high risk tolerance and _great_ liquidity risk management.

I'm not convinced equity markets offer anything at the moment. My gut is to be short, but there is a huge weight of money waiting to get into equity - goodness only knows why - and you could get crushed on a relief rally. So stay away.

In the ABS space, collateral is key. If you can do loan level analysis, then there are some serious bargains to be had, particularly at the top of the securitisation waterfall. The discriminating buyer, especially the discriminating buyer who uses the TALF, should make money.

In FX, I am still inclined towards short USD, despite the flight to quality risk. FX vol seems expensive: consider selling short dated vol.

That was your stupidly infrequent global macro update. Cheques behind the usual stone in Bishopsgate.

Competence and the consumer

I had a nasty shock the other day. There is a snake's head fritillary on my balcony that was looking rather nice, and I took a picture of it. The image was out of focus. Now, my digital camera is both sophisticated and perfectly capable of handling the conditions, so I wasn't pleased. But I forgot about it until I saw this post on DIY auto focus adjustment.

It looks a bit tricky, but actually it isn't. After an hour, I had recalibrated my Pentax's AF, and it is now much sharper. But what shook me - almost stunned me - was how far out the camera was. 260 microns. That's like trying to get to the Tower of London and ending up in Milton Keynes. My naive assumption that a piece of high end consumer electronics would be properly calibrated out of the box was obviously very foolish.

Of course, by the time I had got this done, the fritillary flower had fallen, but here's a 100% crop from an image of some blossom, taken with the newly calibrated AF:
I wouldn't say the focus is absolutely perfect, but it is an awful lot better than it was, and close to the best that is achievable without lab equipment.

It is interesting that things like my camera are limited not by their maximum performance, but by the competence of the factory and distribution system. Given that these problems get much harder for higher resolution cameras - see here for an extended discussion of calibrating medium format digital backs - you might want to pause before buying a camera with more than 10M pixels. It might be fine out the box, but it might well not be, and if it isn't, extracting the performance that the camera is capable of can be a tedious business.

Protect the worker, not the job

Jonathan Hopkin has a couple of good posts on job security, welfare, and the labour market here and here. He discusses the Danish solution to the problem that:

• Countries with flexible labour markets tend to grow faster, but
  
• Flexible labour markets produce large amounts of individual unhappiness when jobs are lost. They also tend to result in discrimination against some classes of worker, such as the over 50s.

The slogan of the Danish solution is the title of this post: protect the worker, not the job. That is, Denmark combines labour market flexibility - easy hiring and firing, with relatively little job protection - with relatively lavish welfare systems, education opportunities, and state pensions. It sounds like the best of both worlds - Italian fashion and Swiss trains in the terms of yesterday's post - but as Hopkin points out (and I elaborate) there are some things that you need to make it work. These include:

• An open, meritocractic job market, supported by strong anti-discrimination legislation (rather than in Hopkin's delightful jargon, the political-clientelistic system of much of Southern Europe);
  
• An extensive network of out-placement and other job seeker's services, and in particular a good adult education and retraining system;
  
• Generous unemployment benefits;
  
• Portable pensions and other work benefits which encourage a portfolio approach to careers rather than a job for life culture;
  
• Infrastructure which supports workers, like a good transport system, readily available child care, and good public health care;
  
• High levels of social trust so that the unemployed are genuinely job seekers.

In other words, you can't just say let's be like Denmark without doing a lot of politico-social systems engineering to make that possible. I very much doubt that however much Italy, say, wanted to emulate Danish success, they could (and of course the success of the ultimate political-clientelist, Berlusconi, suggests strongly that Italy does not want to do that).
Thinking that you can just change employment conditions and automatically get a Danish style success is the same class of error as the UK made in imposing student loans, or many countries are making with self select pensions. Even if rationally the policy solution makes sense, without education, culture and support systems around it to explain how to use it, the policy may well fail. Thus borrowing on a student loan may well be rational, but in the context of a (prudent) culture of avoiding debt, and perhaps a sense that university is not for the likes of us, the imposition of loans leads to higher education becoming a middle class ghetto. Similarly making people responsible for their retirement might be good classical economics, but how many of them have the financial education to make sensible choices?

Becoming French

Matthew Lynn, in a typically opinionated and wrong-headed piece on Bloomberg, thinks

The British economy is becoming increasingly French.

Why which he means

It will have a huge tax burden to carry, a state that is the dominant actor in the economy, and a system whose resources are managed more by some kind of national plan than the free hand of the market. The government is now explicitly emulating France, with its national champions.

Sadly this leaves out the good parts about the French economy: the generous welfare system; good education and health care; job security (at least for some); rational working hours for many. No, the UK isn't becoming French. It is becoming much worse: French for big companies, but American for ordinary workers. That's like having Italian railways and Swiss fashion.

Darling, darling man

He's actually done it. Top rate tax to rise to 50%. Well done Alistair.

Update. OK, the continuation of any tax relief at all for pension contributions from higher earners is a disappointment, as is the pale green nature of what little he did do for the environment. Still, the budget is more bold than I expected. If Darling is rediscovering his balls, this can only be a good thing. Of course, it could just be a leadership bid post Gordon, but that's politics.

More on models

From Daniel Kahneman, via portfolio.com:

A group of Swiss soldiers who set out on a long navigation exercise in the Alps. The weather was severe and they got lost. After several days, with their desperation mounting, one of the men suddenly realized he had a map of the region.

They followed the map and managed to reach a town. When they returned to base and their commanding officer asked how they had made their way back, they replied, "We suddenly found a map." The officer looked at the map and said, "You found a map, all right, but it's not of the Alps, it's of the Pyrenees."

Quant funds and the field approximation

It has come to general attention recently that many quant funds have had a terrible few months: see here for more details. Specifically the momentum following funds have suffered badly from the crap rally of the last little while.

What is going wrong?

One way to see the issue is to consider a technique that sometimes works well in statistical physics. Don't panic, I promise there will be no hard maths. It's like this. Sometimes, you want to know how a given something behaves inside a solid. Let's make the something an atom (although it doesn't have to be). Say this is an atom of impurity in an otherwise pure crystal. How will this impurity affect things?

One could attempt to model the interaction of the atom of impurity with its neighbours, and their neighbours, and so on. If you could do those calculations, the results would be precise. But often you can't, because there are too many effects to consider, and too many other atoms which can exert an effect. So a good short cut is to first calculate the properties of a perfectly pure crystal, and then consider the impurity like a boat in the sea with these properties. You don't model each neighbour separately, in other words: you model the combination of their effects as one thing. This is sometimes called the field approximation, as you are calculating the field of the pure crystal, and then looking about how the impurity behaves in that field.

This works pretty well for one impurity, and it isn't too bad when there are many, providing the percentage of impurity atoms is low enough. But once the percentage of impurities starts rising to the point where one impurity interacts with another, the approximation starts to fail rather badly. Furthermore if the impurities change the way the crystal interacts with itself, then this also means that a new approach is needed.

And so it is with hedge funds. When there were few quant hedge funds interacting with a market that was mostly driven by real money, then the fund's model of market behaviour was reasonable. But as the percentage of trading activity that was hedge fund originated increases, that model becomes less and less tractable. I suspect that phase transitions are possible, whereby the market dynamics suddenly change for only a small increase in the percentage of fund activity. What's happening, then, is that we have too many hedge funds chasing too few arbs. Things won't get better until the capital allocated to quant funds declines significantly.

Payment for failure, German edition

From Bloomberg:

Dresdner Bank AG, the unprofitable lender acquired by Commerzbank AG, was sued by the former head of capital markets at its investment banking unit over his severance pay... Dresdner in-house lawyer Matthias Woldter told the Labor Court that Neumann can’t seek the severance payment because his unit contributed 5.7 billion euros to the investment bank’s record 6.3-billion-euro loss last year.

“The losses were incurred especially at the unit Mr. Neumann headed,” Woldter said. “His duty was to care for its short-, medium- and long-term profitability. He significantly failed in bringing that about.”

Tanja Karhausen, Neumann’s lawyer, said that the payments were due independently of the 2008 results.

Bankers wonder why they are so widely disrespected. Law suits like this are part of the reason. Individually it may make sense for this guy to sue. But collectively he is just helping to put another nail in the coffin of the reputation of banking.

Nuclear No Nos

Nuclear Power is not the answer. Two stories explain why.

First, there is the waste. We simply do not know how to deal with it, how expensive that will be, or even if we will ultimately be successful. This story in the Guardian provides some more context: I was interested to learn that the most hazardous industrial building in western Europe is at Sellafield, an English nuclear power plant. The second most hazardous one is there too. The estimate for the cost of cleaning this up is £50B - and we all know how accurate estimates like that tend to be (or those of us who are paying for the London Olympics in our taxes do anyway). I very much doubt Sellafield generated fifty billion worth of electricity in its whole life.

Second, there is the lag. The UK will need lots more energy generation by around 2015. That's when the crunch comes. Even if nuclear is a good idea - which it clearly isn't - it can't be ready in time. Notice that if we have an election in 2010, 2015 might be only one parliament away. That should focus minds a little...

Regulating small firms

The current furore over FSA regulation of building societies is interesting. A whistle-blower alleges that

A culture of apathy and complacency marked the FSA in the period of its nadir, with anyone standing up against light-touch official policy criticised for rocking the boat and branded a troublemaker.

I have no idea of the truth of this, but three points are worth making.

• In a regulator, the status of staff depends to some extent on who they regulate. The big swinging dicks are the ones who regulate the biggest banks. Building societies are not glamourous, and hence the quality of regulator here may well have been lower than elsewhere.
  
• Many regulators are really quite bureaucratic. The scope for individual staff, especially line staff, to make decisions is limited. Anything of substance is likely to go up the chain of command. Therefore if there have been failures, it is the senior people who are likely to have been responsible.
  
• Building society supervisors are likely to be a conservative lot - even more conservative than bank supervisors. What they think is dangerous may be a rather large class - and one that includes some reasonable innovations.

Population and the future

Population is a hugely emotive topic. It seems that few people want to be told that they should not have many children as they wish. And certainly the history of population control is littered with oppression. But, as David Attenborough points out

The growth in human numbers is frightening. I've seen wildlife under mounting human ­pressure all over the world, and it's not just from human economy or technology. Behind every threat is the frightening ­explosion in ­human numbers. I've never seen a problem that wouldn't be easier to solve with fewer people

The mid point estimate for the Earth's population in 2050 is over 9 billion. To meet our climate change targets at 9 billion, we will have to cut average emissions per person by 72%. Put simply, the planet cannot stand the weight of our numbers. It is time to acknowledge this hard, horrible fact and start a debate about what to do about it.

The downside of decreasing population is that it will have a large impact on several key parts of the financial system. In particular, as Zoe Williams discusses, pensions policy is based on the possibility of intergenerational subsidies. Current workers pay for current pensioners, at least much of the time in some countries. It will not be politically acceptable for this to continue, especially when fewer current workers have to pay for more pensioners. Again, this is political dynamite and given the entrenched interests, it is hard to discuss the issue. Problems this hard tend to inspire little more than depression in me. Still, at least the depressed don't tend to breed.

Reading Wells' disclosures

Jonathan Weil has been over them carefully. Frankly, reading his article, one wonders (a) why the accounts were signed off and, (b) why anyone would want to buy any of the bank's securities given these tricks.

Systems thinking in the Crunch

Edmund Phelps has a very good article in the FT which harmonises with many of the preoccupations of this blog.

In countries operating a largely capitalist system, there does not appear to be a wide understanding among its actors and overseers of either its advantages or its hazards... Capitalism is not the “free market” or laisser faire – a system of zero government “plus the constable”. Capitalist systems function less well without state protection of investors, lenders and companies against monopoly, deception and fraud.

In order to understand a system, you need to understand its behaviour, and how changing the rules which constrain that behaviour constrain the dynamics. There is no more a 'right' set of rules for something as complicated as a market as a 'right' set for a mobile telephony or a ball game. Some rules produce more efficient or interesting behaviours: some suffer significant disadvantages.

In essence, capitalist systems are a mechanism by which economies may generate growth in knowledge – with much uncertainty in the process, owing to the incompleteness of knowledge.

Growth in infrastructure too: roads and factories and such like. The knowledge moreover is encapsulated in conventions, or rules of the system: a mobile phone is useless without a network of towers that it can communicate with. Capitalism attempts to solve a massive collection of coordination problems - and often (as with the worldwide phone system), it succeeds.

Well into the 20th century, scholars viewed economic advances as resulting from commercial innovations enabled by the discoveries of scientists – discoveries that come from outside the economy and out of the blue. Why then did capitalist economies benefit more than others? ... [Hayek] felt free to suppose that, thanks to the specialised insights each acquires, a manager or employee may one day “imagine” a commercial departure – one that could not be inferred or envisioned by people outside the individual’s line of work. Then he portrays a well-functioning capitalist system as a broad-based, bottom-up organism that gives diverse new ideas opportunities to compete for development and, with luck, adoption in the marketplace. That “discovery procedure” makes it far more innovative than the top-down systems of socialism or corporatism.

This is of course an important (and well understood) point. However most wealth, in the general sense, is created not by true blue skies innovation, but by inside-the-system thinking. 3G phones are possible because we already have second generation infrastructure: ABS only makes sense under some assumptions about road surfaces and driving conditions and so on. Thus the role of capitalism is not just to act as an evolutionary force allowing great new ideas to generate wealth. It must also provide infrastructure - pensions, banking, law, transport, health care and the rest - within which incremental development can take place. There are many non-optimal local maxima here: the US healthcare system is a good example. Phelps makes this point less forcefully:

Well-functioning capitalist economies, with their high propensity to innovate, could arise only when serviceable institutions were in place.

Note however that there is an inherent volatility in capitalism.

From the outset, the biggest downside was that creative ventures caused uncertainty not only for the entrepreneurs themselves but also for everyone else in the global economy. Swings in venture activity created a fluctuating economic environment.

You can have slow wealth creation with little variation, or faster wealth creation with significant setbacks. But we do not know how to generate fast low volatility wealth creation, even assuming that this was generally considered to be desirable. Moreover there has never been a broad discussion of how much volatility is tolerable. Is an economy that grows at 4% on average over the long run but suffers vicious multi-year recessions occasionally better or worse than one that grows at 3% with much shallower pullbacks?

Investors have proved terrible at addressing these issues not least because they were reluctant to admit to the possibility of setback which was baked into the dynamics of the system.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down.

We urgently need to develop a sense not just of the likely near term path of the economy, but also the possible paths - the kind of thing that it might do. If, as I suspect, highly undesirable paths are still somewhat likely, we need to rewrite the rules to make them much less probable.

Being Boring

I saw the Severn Bore over the Bank Holiday. It wasn't a particularly big bore, as these things go, but it was still impressive. The oddest thing of all, though, was that the cows in the field we were in all lined up to look at it.

Strained, but not entirely silly banking system metaphor no. 152

Happy Easter to all. Deus Ex will return on Monday or thereabouts.

Taleb - 3/10 (and that is being generous)

Let's score Nassim Taleb's latest set of ex cathedra pronouncements:

1. What is fragile should break early while it is still small. Nothing should ever become too big to fail.

Fair point. Score one.

2. No socialisation of losses and privatisation of gains.

Exactly. Otherwise moral hazard is enormous and banking is profitable with little risk. Score one.

3. People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.

No. Firstly nearly everyone who knows enough to be helpful was driving (or at least helping to navigate) the bus. And secondly most people even if they did not like the driving, weren't in a position to do anything about it. We cannot afford to get rid of all of our experts, even if they have been wrong in the past. Score zero.

4. Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.

It depends on the bonus. One year bonuses with no clawback based on mark to market profits clearly provide bad incentives. But multiyear bonuses with clawbacks based on realised gains may provide a good incentive. Score half.

5. Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to be countered by simplicity in financial products.

No. Balance complexity with appropriate technology. Complex products can be appropriate, simple products can be inappropriate. It depends. Score zero.

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it.

No. It is enough to ensure that risk takers genuinely bear the consequences of their actions and that there is sufficient capital in the system for the risks being taken. If you ban dynamite, tunneling gets much more expensive. You just want to be sure it is civil engineers not terrorists who have the dynamite. Score zero.

7. Only Ponzi schemes should depend on confidence.

Nonsense. No one knows what a financial system that is not confidence sensitive might be like. That is an unsolved problem in finance. Score zero (with the judge contemplating taking away a mark for idiocy).

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial.

It depends. Allowing firms to increase leverage is insane, and no regulator I know is permitting that (unless you could accounting games which result in over-stating capital). But governments can and should increase their borrowing at times like these. Score half.

9. Citizens should not depend on financial assets or fallible “expert” advice for their retirement. Economic life should be definancialised. We should learn not to use markets as storehouses of value: they do not harbour the certainties that normal citizens require.

So what, prey, do you suggest people use to save for retirement? Given I know of no asset whatsoever that does not fluctuate in value, this is a real question. Score zero.

10. Make an omelette with the broken eggs. Finally, this crisis cannot be fixed with makeshift repairs, no more than a boat with a rotten hull can be fixed with ad-hoc patches. We need to rebuild the hull with new (stronger) materials; we will have to remake the system before it does so itself. Let us move voluntarily into Capitalism 2.0 by helping what needs to be broken break on its own, converting debt into equity, marginalising the economics and business school establishments, shutting down the “Nobel” in economics, banning leveraged buyouts, putting bankers where they belong, clawing back the bonuses of those who got us here, and teaching people to navigate a world with fewer certainties.

The sheer cliche density of that paragraph alone deserve a minus five.

Filling the hole

Alistair Darling faces a £39B in the budget. How can we fill it?

£14B from legalising drugs.

£20B from cancelling the Trident replacement that we don't need.

£5B from taxing non-doms and those earning over £100K.

Easy. My consultancy fee, if you are reading this Alistair, is a positively miserly 1%.

Entirely expected lawsuit of the day

From Bloomberg:

MBIA Inc. was sued by Third Avenue Management LLC... over claims the insurer’s split of its bond-insurance businesses hurts debt holders.

Three mutual funds managed by Third Avenue bought notes issued by MBIA Insurance Corp. in February 2008 based on assurances that the company was recapitalizing following losses in its structured finance insurance business...

MBIA, the largest bond insurer by outstanding guarantees, said in February it was transferring $5 billion in cash and its public finance business to another entity that has no obligation to the notes, Third Avenue said in its statement.

Strained, but not entirely silly banking system metaphor no. 151

Something for you to do

Willem Buiter, reneging on his earlier negativity on the IASB, quotes from a statement made on April 2, 2009 by the Trustees of the International Accounting Standards Committee Foundation:

Sir David Tweedie, Chairman of the IASB, reported to the Trustees that at their joint meeting last week the IASB and FASB agreed to undertake an accelerated project to replace their existing financial instruments standards (IAS 39 Financial Instruments, in the case of the IASB) with a common standard that would address issues arising from the financial crisis in a comprehensive manner. Though the IASB is consulting on FASB amendments related to impairments and fair value measurement, the Trustees supported the IASB’s desire to prioritise the comprehensive project rather than making further piecemeal adjustments.

This is good. They are not being rushed into anything, and they are not following the FASB in giving in to the banks. However it does make it vital that the IASB gets sufficient informed comment on fair value during its consultative process. I would encourage anyone who cares about these issues to visit the IASB page here, download the consultative document, and comment on it.

Finite reinsurance: a strange and sometimes manipulative thing

Thanks to AIG, the weird and wonderful world of finite reinsurance has come under broader scrutiny recently. (You may recall that a finite reinsurance policy between AIG and Gen Re was the method used to inflate AIG's earnings in the case that came to the courts in 2008.)

Now, thanks to the Big Picture, further amusing documents have achieved more general publication. I don't agree with much of the thrust of the post - which frankly contains altogether too much credit derivatives related hysteria. But the extra light on finite reinsurance is welcome.

When is finite reinsurance a valid business tool, and when does it verge on fraud? This is difficult to answer because finite reinsurance is a very sophisticated tool that can be used in myriad ways. But let me illustrate a good and a bad situation.

Good finite reinsurance. Suppose a company has a liability with a known size but uncertain timing. Asbestos-related claims are a commonly cited example: the firms knows it will have to pay workers for past exposure to asbestos, and it can estimate the size of those claims reasonably well, but it does not know when the claims will be presented as the sickness has a long and uncertain gestation period. The uncertainy thus created weighs on the share price, even though the company has every intention of paying and the resources to do so. Therefore it purchases a finite reinsurance policy whereby it pays a premium equal to (roughly) the present value of the expected claims to a large, well capitalised reinsurer. The reinsurer takes two risks: one small (that the claims will be larger than expected: this is unlikely as typically the risks insured under finite schemes have rather little uncertainty in claims); and one larger (that the claims will be presented earlier than expected, and hence the invested premium will not have grown sufficiently for them to make a profit). From this we see that finite schemes are often about transferring timing or investment risk rather than the risk of uncertainty in claims.

Bad finite reinsurance. Consider the effect of the scheme above though. Before the reinsurance, the firm had a known hit to earnings in the future but with uncertain timing. Afterwards, it has a stream of expenses - the premium payment or payments on the policy - but no uncertainty. Earnings have been smoothed. Clearly we can extend that effect more broadly via policies which pay out money in the future for an appearance of risk reduction today (buying surplus for an insurer, i.e. flattering their capital position) but where all of the risk comes back in later years, or via policies which move current profits into later years, smoothing earnings. Accounting rules do not permit you to arbitrarily reserve whatever amount of current earnings you like against some future risk, especially a very unlikely and hard to quantify one, but finite reinsurance policies achieve the same effect.

Finite reinsurance can therefore be used, quasi-legally, to manipulate earnings for many companies. It can also be used to manipulate insurance companies' capital position. If ever there was an area of finance crying out for better regulation, I'd say it was insurance.

The continuing equity/credit disconnect

I have written several times before about the equity credit disconnect of the last few years and its implication for capital structure arbitrage models. Recently, the disconnect has reappeared, as this chart of the day from Bloomberg illustrates:If there are any CSA funds left after the earlier dislocation, this would theoretically be a great time to go short equity long credit. The trouble is we now know that these dislocation can last for considerable periods, and reversion to anything close to the theoretical relationship is not guaranteed. Does this sound the death knell for capital structure models?

Correlation is not causality

From the social science statistics blog via Naked Capitalism, an amusing illustration of this truth:

The FASB buckles

Narrowly winning the award for most depressing news of the week (the runner up being Gillian Tett getting an award - and not one for most ignorant commentator on credit derivatives in a mainstream newspaper), Bloomberg announces:

The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules... The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities.

This is just terrible news for readers of financial statements, investors, and financial stability.

Update. You have to love Willem Buiter sometimes. His latest is entitled How the FASB aids and abets obfuscation by wonky zombie banks. Zombies are scary enough. But wonky zombies? Are they going to explain the dynamics of the money supply to you before they eat you? Or would that be wonkish zombies? Seriously, though, it is a good post: I recommend it. My only remark is that Willem is not sanguine about the IASB, whereas I am slightly more hopeful that they will not fall further into sin.

If you go down to the Bank today, part 2

Again, my favourite first:

If you go down to the Bank today, part 1

My favourite first:

Another failure to call

From the FT:

Mizuho Financial, Japan’s second largest bank, has opted not to repay a $1.5bn junior security at the first opportunity, adding to the list of [4] institutions globally that have not repaid similar debt and potentially aggravating some of its investors.

The instruments are perpetual subordinated bonds with calls and no-steps, paying 8.375%. This will further spook Tier 2 and hybrid Tier 1 investors.

Merkel, Sarkozy join protesters

In a sensational development, Angela Merkel and Nicolas Sarkozy have stormed out of the G20 summit meeting and joined protesters demonstrating in front of the Bank of England. Coverage from the Guardian's new Twitter service is here, and further background is here. This follows earlier threats by Sarkozy that he would leave the summit if he doesn't feel members are seriously addressing business regulation, and Merkel's NYT interview on Monday in which she stressed her opposition to the American stimulus package. Rumours that statues of Merkel and Sarkozy surrounded by demonstrators will feature in the planned Economist theme park are currently unconfirmed.