Saturday 28 February 2009

Incremental risk in the trading book 1

As part of a series on the new Basel Committee Trading Book proposals, notice first that the text contains quite a sophisticated notion of time horizon:
A bank’s IRC model must measure losses due to default and migration at the 99.9% confidence interval over a capital horizon of one year, taking into account the liquidity horizons applicable to individual trading positions or sets of positions. Losses caused by broader market-wide events affecting multiple issues/ issuers are encompassed by this definition.

This... implies that a bank rebalances, or rolls over, its trading positions over the one-year capital horizon in a manner that maintains the initial risk level, as indicated by a metric such as VaR or the profile of exposure by credit rating and concentration. This means incorporating the effect of replacing positions whose credit characteristics have improved or deteriorated over the liquidity horizon with positions that have risk characteristics equivalent to those that the original position had at the start of the liquidity horizon. The frequency of the assumed rebalancing must be governed by the liquidity horizon for a given position.

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Friday 27 February 2009

Fascinating

Corporates trading through their sovereign in the CDS markets, from Zero Hedge:I don't like the obvious trade (long protection on the corporate, short on the sovereign) where the corporate can easily raise liquidity offshore, but there are still some opportunities here.

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Thursday 26 February 2009

Snap reaction to RBS's use of the Treasury Asset Protection Scheme

Is £325 billion out of £2.4 trillion enough?

Update. In honour of this auspicious day, a picture of a game of Find The Lady, taken from the top of a bus. The unshaven gentlemen with the cap doesn't look much like Fred Goodwin, but one never can tell.

I've also played around with some of the numbers assuming the Asset Protection Scheme is a CDO. Unsurprisingly it is impossible to conclude that the premium RBS paid is fair: this is (another huge) taxpayer subsidy.

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Stress is bad for you

The FDIC calls this a stress test. Huh?
Seeking alpha suggests fair value in some parts involves a 36% decline from here. Given that downturns usually overshoot fair value, a reasonable stress test would involve at least a 40% fall, and probably 50%. The FDIC has bottled it.

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Wednesday 25 February 2009

Basel committee still clueless chumps

They say... CDOs of ABS (so-called "resecuritisations") are more highly correlated with systematic risk than are traditional securitisations. Resecuritisations, therefore, warrant a higher capital charge. Fine so far. But then look what they do:(The new capital charges are in the grey hatched columns.) So the capital charge for a senior charge of a AAA-rated CDO-squared will be 1.6% of notional (20% x 8%). Anyone who thinks this is adequate was clearly taught in the Jimmy Cayne school of Structured Finance.

Update. I'll try to post more on the Basel 2 revisions (and in particular the trading book changes) in a few days. Meanwhile here is some good sense from Adair Turner, via the FT:
Lord Turner told a hearing of the Treasury select committee that tougher measures would include requiring banks to hold up to three times as much capital against their trading assets.

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Tuesday 24 February 2009

Paying in the last resort

It is clear by now that the lender of last resort function - and especially the capital provider of last resort function - is valuable. How should the state be paid for this function?

The historical answer has been that this is a gift to the banking system, with the state attempting to recoup its investment (and perhaps even make some money) from the liquidity and capital that it provides. At the moment however it seems likely that some of these state investments will not give taxpayers a positive return, so it is reasonable to ask how else we could structure things.

One answer is that financial institutions should pay. The model here is deposit insurance: in the US, for instance, banks are charged by the FDIC, and these premiums are pooled together to support bank rescues where necessary. However it seems that these payments are not adequate, and so deposit insurance premiums are being increased - just at the worst possible time. It is easy to argue that they should have been higher in the past. In practice however banks' success at promoting deregulation and cost reduction in the good times means that fixed fee schemes are always vulnerable.

There is an alternative. Banks could be made to pay by writing call options on their own stock. Suppose every year a bank gives to their regulator, as payment for the lender of last resort and capital provider of last resort functions, one year at the money call options on 5% of their regulatory capital. The regulator then hedges these to lock in their value. The hedge is to short stock, so if the option ends up in the money, the regulator ends up selling the stock position. The profit from delta hedging these 'free' options is then available to recapitalise banks when needed, and so the taxpayer does not lose out (as much) when support is needed. The people who suffer are bank shareholders, but they only suffer dilution when the stock price is increasing, and anyway they are the ones who should be paying for the implicit support the state provides.

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Monday 23 February 2009

Legal risk, FX risk, and big moves

Suppose a bank buys an option written by a corporate. It ends up in the money. The bank hopes that the corporate will pay out.

But what if lots of other banks have bought the same type of option from lots of corporates. Very few of them hedged, and all the options are far in the money.

Now the banks have a systemic problem. Perhaps many of the corporates cannot afford to pay. In any case, their losses may be sufficient to cause government intervention. The banks may be caught in a storm of protectionism.

It seems, according to FT alphaville, that this is possible for the counterparties to Eastern European corporates on FX options. The corporates, in many cases I am sure with full understanding of the risks, sold zloty, koruna and forint downside as a Euro convergence play. All three of these currencies have fallen: the corporates have taken significant losses. And now, of course, the lawyers are getting involved.

The lesson, then, is that it is good to be right when selling options. Being a little bit wrong is bad. But if you are really really wrong, and lots of other people are too, that's fine, because the government will probably bail you out.

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Sunday 22 February 2009

Reinvigouration

An article by Polly Toynbee in yesterday's Guardian gave me pause for thought. She said:
Labour has lost its political talent. So long in power, ministers are now managers toiling in their silos, talking like policemen, devoid of political imagination.
This is clearly true. It's hard to think of any Labour politician today of ability, stature, and judgement. Mandelson has ability but no judgement. Brown is a wonderful number 2, hopelessly at sea as leader. And I certainly can't think of any other true talent. Blears? More of a squirrel than a politician. Smith? Fiddling your expenses is so depressingly low that she doesn't deserve to run a sixth form debating society, let along the Home Office. Miliband? Almost certainly complicit with torture. Certainly this generation of Labour politicians are not nearly as inspiring as Robin Cook, let alone Bevin, Atlee or Morrison. The only politician of the Left that comes close is Vince Cable and he's a liberal democrat. (Excuse me while I wash my mouth out with soap and water.)

This suggests a broader question. Is it actually possible for any party to stay in power in Britain for an extended period without using up its talent? The Tories didn't manage it either: just compare the last Major cabinet with the first Thatcher one. Perhaps the system is set up so it is close to impossible to both govern and renew the party.

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Saturday 21 February 2009

Expert advice

From an interview with Philip Tetlock on CNN money about prediction:
The better forecasters were ... self-critical, eclectic thinkers who were willing to update their beliefs when faced with contrary evidence, were doubtful of grand schemes and were rather modest about their predictive ability. The less successful forecasters were like hedgehogs: They tended to have one big, beautiful idea that they loved to stretch, sometimes to the breaking point. They tended to be articulate and very persuasive as to why their idea explained everything. The media often love hedgehogs.
One might add that hedgehogs who are successful in the short term tend to get promoted fast too, as are forceful as well as (accidentally) right. Eventually these people will fail, but by then they may be in a position of considerable power.

See here for a further discussion from the Big Picture.

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Friday 20 February 2009

Below 4000

It keeps getting worse in the equity markets:
Meanwhile in the credit markets, the terms of FED financing that are going to be available shortly (three years, ten to one leverage, non recourse, Libor plus 100) are so generous that one would be foolish not to load up. If one had any fresh capital, of course.

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Deputy what?

This is so far beyond sarcasm that I am going to report it straight. Bloomberg tells us:
Former Securities and Exchange Commission member Annette Nazareth is the leading candidate to become deputy U.S. Treasury secretary, according to people familiar with the matter.

Nazareth ran the SEC division of market regulation... when it designed a program to monitor whether Wall Street’s five biggest securities firms had adequate capital and liquidity.
This program worked so well none of the five are around in their prior form: two are bankrupt, one was forced to sell itself in a hurry, and two turned themselves into banks. Truly failure is its own reward.

(OK, I lied about the sarcasm.)

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Thursday 19 February 2009

Monoline death watch

The slow slide continues. Following S&P and in response to MBIA’s restructuring plan, Moody’s downgraded MBIA to B- from BBB+ on Wednesday. The best bit is on Bloomberg:
Credit-default swaps tied to MBIA Insurance Corp. jumped 7 percentage points to 60.5 percent upfront, according to CMA DataVision in London. That’s in addition to 5 percent a year. It means it would cost $6.05 million initially and $500,000 a year to protect $10 million for five years.
Given more than half a chance of failing within five years, according to the CDS market, you would have thought it wasn't worth printing stationary for the new company. Maybe they could just cross out MBIS and write in National Public Finance Guarantee Corporation by hand.

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Wednesday 18 February 2009

Portents of the apocalypse

No, not a woman clothed with the sun, and the moon under her feet, and upon her head a crown of twelve stars. Even Victoria Beckham wouldn't wear that, even if she does occasionally forget to put on a shirt with her tie. Rather, according to the FT:
The US government may have to nationalise some banks on a temporary basis to fix the financial system and restore the flow of credit, Alan Greenspan, the former Federal Reserve chairman has told the Financial Times.
Scarcely before the rain of blood starts, we also find:
“We should be focusing on what works,” Lindsey Graham, a Republican senator from South Carolina, told the FT. “We cannot keep pouring good money after bad.” He added, “If nationalisation is what works, then we should do it.”
I advise taking wellington boots to work for the next few days: a plague of frogs could really mess up your brogues (or Louboutins, depending).

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A little light relief

"Knock knock"

"Who's there?"

"Maybe it's a big horse*."

"Maybe it's a big horse who?"

"Maybe it's a big horse I'm a Londoner that I love London town**."

[Hat tip the Guardian Diary.]

* Gratuitous Mark Wallinger reference.

** Classic footage here.

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Tuesday 17 February 2009

Is Timmy that inept?

If this WaPo story is really true, Geithner shouldn't be left in charge of a sweet shop let alone a bailout.

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"Not read" and the management of psychopaths

There is a story, probably just a rumour, that there used to be a man at the Bank of England who had a "not read" stamp. He would use it to stamp documents he wanted to be able to claim he had not seen before returning them to the sender.

The fact that this story is vaguely plausible is a big part of the problem with regulation. Epicurean Dealmaker suggests:
Staff the SEC, or whatever "Super Regulator" the government decides to deputize to oversee this mess, with a bunch of highly-paid, tough-as-nails, sonofabitch investment bankers. You will have to pay them millions, just like regular bankers. (You can tie their incentive pay to improvements in the value of securities held under TARP and TALF, if you like.) Pay them well, and investment bankers won't be able to treat them like second-class citizens at the negotiating table. Pay them like bankers, and your regulators won't hesitate to read Jamie Dimon or Lloyd Blankfein the riot act, because they won't give a shit about getting a job from them later.

Trust me, these are the kind of people you will need on your team: highly educated, financially sophisticated, psychotically hard-working, experienced professionals who know or can figure out CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit. Leading your enforcement and supervision teams you need a bunch of smooth, smart, plausible, grandiosely self-confident senior bankers who will not hesitate to tell Vikram Pandit to go fuck himself, his mother, and the cow she rode in on if he ever tries to fuck with the United States government, the US taxpayer, or the pizza delivery boy again. You know: psychopaths.
Of course he is right in that such people, properly empowered and paid, would indeed regulate quite well. They would get it in a way that most public servants don't. The same argument applies to the tax authorities: if you staffed them with ex tax lawyers and investment bankers who got to keep 10% of everything they saved the taxpayer, you would collect an awful lot more tax and there would be many fewer tax avoidance schemes.

So it would work. But no government would ever have the courage to try it. You would have to fire a lot of the current senior regulators or tax collectors, and completely re-engineer the culture. Mr. "Not Read" wouldn't last ten minutes in a psychopath-enabled regulator. Which is both the reason it should be done and the reason it won't be.

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Monday 16 February 2009

Real Solvency and Fantasy Solveny

There is a `the banks are insolvent' meme going around at the moment. It's rubbish, but something close to it may be true.

The reason it is rubbish is that solvency means assets > liabilities under the firm's accounting standards. This is clearly true for all the large banks.

What the commentators mean by `the banks are insolvent' really, then, is `under my idea of what accounting standards should be, the banks would be insolvent'. Clearly this is a little different, however rational the particular accounting counterfactual concerned is.

Let's look at some of the choices in the space of accounting methods.
  • Pure accrual accounting would value every asset and liability under accrual accounting, with whatever loan loss reserves the firm can get past its auditors being taken. Under this measure pretty much every bank is solvent.
  • Pure rigourous fair value would use fair value for everything, with prudent valuation adjustments being taken wherever there is uncertainty. Under this measure, many banks would be insolvent.
Most banks definitions of solvency are closer to the first than the second of these at the moment, of course. I suspect that most commentators who say that the banking system is insolvent are implicitly thinking of something like pure rigourous fair value. In any event, there are many, many accounting standards between these two extremes, of which any given bank's choice is one.

Two more things to note.

First, insolvency implies that the bank is not capitally adequate, but capital adequacy is a stronger constraint. It implies solvency* plus capital > capital requirements**. Losses challenge both solvency and capital adequacy as they erode capital, but the capital adequacy test is hit before the solvency one.

Second, solvency or insolvency have nothing to do with liquidity. A bank can be insolvent and perfectly able to fund itself (if that fact is well enough hidden) and highly solvent but unable to fund.

For further reading, see a good if long post by John Hempton here.

*Actually this is not quite true as the regulatory notion of solvency is not quite the same as the accounting one. Regulators apply a few (typically minor, in the big scheme of things) valuation adjustments to GAAP.

**The definition of Capital is much more country specific than that of Capital requirements. The `Basel 2 capital requirement' is close to being the same everywhere (although there are some differences in national implementations). But the definition of capital varies significantly, especially in the treatment of things like deferred tax assets, goodwill, and unrealised gains on held to maturity positions.

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Why I will never be a great FX trader

A Bloomberg headline: Japan Economy Shrinks 12.7%, Steepest Drop Since 1974 Oil Shock. Now, I would have thought that that was bad for the yen. But no. Scroll down a couple of headlines and you find: Yen Rises as G-7 Says Slump to Persist. Wrong again.

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Sunday 15 February 2009

Fodor foo-ey

Warning: (amateur) philosophy ahead.

I like Jerry Fodor's articles in the LRB. They are always well-written, provocative, and often wrong. Here is a recent example. Jerry is talking about whether physical things can increase your brain capacity, so that in particular if you lose your notenook (PDA, whatever), have you literally lost (a part of) your mind. To kick things off, he needs a dubious definition:
The mark of the mental is its intensionality (with an ‘s’); that’s to say that mental states have content; they are typically about things. And (with caveats presently to be considered) only what is mental has content.
What? Where did that come from, in particular the `only' clause? There is no motivation for it. It's just like saying that only brains can have frabble, and so my notebook can't be a part of my mind because it isn't frabbly. The key point being that frabble is meaningless and so by definition unfalsifiable.

Once Jerry has got away with his definition, his path is clear to disparage fancy electronics and humble paper alike:
That’s not, however, because iPhones are ‘external’, it’s because iphones don’t, literally and unmetaphorically, have contents.
In other words, privileging wetware-implemented connotations above other kinds is what allows Fodor to say that notebooks don't have contents, and hence can't be parts of brains. But there's no reason for such prejudice. I like my red hardback notebook because it is better than my memory: I would rather use it than my aging wetware for some things. It's deeply unfair to say that just because neurons are inside and paper is outside, neurons are somehow better. Just because we don't know how, exactly, we access internal memory there is no reason to claim that someone (in Jerry's case a female someone) doesn’t have to think about (or, in any literal sense, ‘consult’) her memories; she just has them.

There's a lot more of this kind of thing in the article, including the claim that only minds can entertain modal connotations (`what ifs'), all of which seem to me to follow from the initial act of wetware apartheid. C'mon, Jerry, notebooks might not have feelings, but they certainly sometimes have contents.

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Saturday 14 February 2009

Hedge this, sucker

At some point I might get around to looking at this in more detail, but just imagine for a moment that you were short downside gamma on Lloyds yesterday. Even if you were short - really short - you would almost certainly have taken a very nasty bath. So much for Black-Scholes hedging.

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Friday 13 February 2009

Sociologists do models, kinda

From Reflexive Modeling: The Social Calculus of the Arbitrageur by Daniel Beunza and David Stark:
Modeling entails fundamental assumptions about the probability distribution faced by the actor, but this knowledge is absent when the future cannot be safely extrapolated from the past...

By privileging certain scenarios over others, by selecting a few variables to the detriment of others, and in short, by framing the situation in a given way, models and artifacts shape the final outcome of decision-making. This ... is the fundamental way in which the economics discipline shapes the economy, for it is economists who create the models in the first place...

...models can lead to a different form of entanglement. In effect, models can lock their users into a certain perspective on the world, even past the point in which such perspective applies to the case at hand. In other words, models disentangle their users from their personal relationship with the actor at the other side of the transaction, but only at the cognitive cost of entangling them in a certain interpretation.
Despite the focus on relatively uninteresting models (merger arb), this is an interesting paper for anyone interested in how traders really use models.

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Thursday 12 February 2009

48% down, 52% to go

When you said thousands, you meant 6

Paul Kedrosky has a nice comment on the Obama take on nationalisation. Obama first, from ABC Nightline tonight:
Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.
As Kedrosky says, this is at best disingenuous and at worst outright cowardice. Obama is afraid of what the Republicans will say if he does what he suspects is the right thing, and nationalises. The Thousands argument is clearly nonsense - just nationalising Citi, JPM, BofA, Wells, GS and MS would go a very long way towards resolving the problem. And the last two may not need it. So instead of both resolving the crisis and saving the taxpayer money at the cost of employing the N word, we instead have the Geithner compromise, three ineffectual prongs that run a serious risk of failing to prick the crisis.

Update. Maureen Dowd also puts it nicely. She has a nice opening to an article in the NYT. So much for the savior-based economy. She's right. As she says, there is
a weaselly feel to the plan, a sense that tough decisions were postpone...

Geithner is coddling the banks, setting it up so that either we’ll have to pay the banks inflated prices for poison assets or subsidize investors to pay the banks for poison assets... Geithner prevailed over those who wanted to kick out negligent bank executives and wipe out shareholders at institutions receiving aid.
Just as Gordon Brown's association with James Crosby, Fred Goodwin and Shriti Vadera is currently proving difficult and embarrassing, so I predict will Obama's promotion of Geithner will come back to haunt him.

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Wednesday 11 February 2009

The Geithner plan so far...

...this sums it up reasonably


OK, that was perhaps unfair. But it is a little short on details, and what he did say is not enormously reassuring. There are three steps Geither detailed in his announcement.

First, a stress test for everyone big enough to matter, and TARP 2 capital for those that need it based on the results of that test. Fair enough, although I would want to be sure that the original shareholders were being sufficiently diluted.

Second, a bad bank, which you, lucky investor, can participate in. But how it will price the assets it buys is currently shrouded in mystery.

Third, a massive expansion of the Term Asset Backed Securities Loan Facility to get the securitisation markets going again (or at least to get them 100% financed by the FED). Clearly Geithner believes that we need securitisation, and that these markets are key to getting credit flowing again. You could read this as quantitative easing (but I'd still prefer it if he repaired a few bridges and such like).

Thus far, then, it is hard to form a comprehensive judgement on the plan. I do think, though, that the lack of tighter controls on compensation is bad, that nationalisation is a necessary step before deploying the bad bank, and that this public/private partnership idea is just screwy. But what do I know.

Update. Because I have a childish streak, I just had to apply cornify to Geithner's website. Well, someone had to.

There, isn't that better looking? Doesn't it fill you with optimism and hope?

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Tuesday 10 February 2009

What a wonderful day to bury bad news

Lockhart is an amateur though: he should have waited until Geithner was speaking to announce that Fannie and Freddie may need another $200B. There were some temporary imbalances that made their numbers pretty dramatic he said. Yeah, right.

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Bad banking


Willem Buiter suggests that Many high-profile, large border-crossing universal banks in the north Atlantic region are dead banks walking - zombie banks kept from formal insolvency only through past, present and anticipated future injections of public money.I think this is over-stated. We simply do not know if they are solvent or not. We do know that without state support many of them cannot raise funding, but that is different from insolvency.

In this context, let us walk through a clean up process. Suppose that the state decides that a bank can no longer continue as is. The bank is seized. Its business and deposits are spun off, either as a depositor-owned cooperative (actually my favourite answer) or if need be as a new good bank. That leaves the old toxic assets. What should happen to them?

The problem is two fold. Many of these assets are illiquid and impossible to value. Moreover they cannot be funded on a stand alone basis. In order to prevent a collapse of financial asset values, the state can, and should, assist in funding these assets at a reasonable rate. So... put the assets and liabilities into a new vehicle, aka a bad bank. Do not comingle assets and liabilities from different banks: have one bad bank per rescue.

Any given bad bank will have mismatched funding, in general. Now comes the problem. What do we do with debt which matures before assets? To make this concrete, suppose that the bad bank contains $100M of 5 year loans, funded with $10M of shareholder's funds, $40M of short term senior notes, and $50M of 5 year bonds*. The loans will not all pay, and the equity is likely worth nothing, but we do not know that yet.

The notes mature in three months. But they cannot be paid in full because the government at that point the central bank would have to step in to provide more funding for the vehicle. I don't see any alternative to maturity extending the note holders out to five years, at which point we will know how much the loans are really worth. At that point we can allocate funds according to seniority, with the state getting paid first, followed by the senior debt holders, followed by the equity holders if there is anything left. But should the extended debt pay interest, and if so, at what rate?

It does worry me slightly that this is inequitable between the note holders and the bond holders. The bond holders expect to get paid in five years, and they will be (albeit not necessarily getting par). The note holders expect to get paid in three months, and they have to wait five years too. Seniority matters, but maturity doesn't in this model.

Moreover, what should we do about off balance sheet commitments in this model? If the loans had been swapped to floating, say, matching floating rate liabilities, then we may need these instruments. Yet at the moment, anyway, all derivatives would terminate on take-over. And what about committed lines of credit?

I only make these points because it is really not clear to me what the clean up regime for banks should look like, and what is genuinely equitable to the holders of all the different types of claim that there may be. Designing a new insolvency regime is a non-trivial matter, especially if you want both to avoid moral hazard and to avoid unjustified appropriation.

Update. *It would be more realistic to say $10M of 5 year bonds and $40M of government loan, since typically we will have sold the deposits which are funding some of the assets on.

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Monday 9 February 2009

Sensible but unlikely to happen

Equity Private is smart - I don't always agree with her, but when she's describing things rather than satirising them, she often makes a lot of sense. And so it is with a recent dealbreaker post on flat rate tax here. She points out the utter waste of effort involved in the current tax system, the tax dodges for the rich (but not the poor, who cannot afford the professionals who can find them), the idiocy of so many deductions. Combine that with the scandal of corporate tax optimisation uncovered in the last few days by the Guardian, and you have a powerful case for a radical simplification of the tax system. But the entrenched interests are too powerful: I will lay quite a lot of money that it won't happen.

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Lacking brutality


Information Arbitrage thinks, and I agree, that the Geithner plan due tomorrow will fail.
Why? Excessive complexity. For a plan of this magnitude to work, it needs to be straight-forward, easy to understand, clearly communicated, brutally transparent, and ruthlessly executed.
Certainly the bailouts have revealed that the US system is not good at generating simple, easy to execute schemes. Remember how the first TARP went from 3 (admittedly ridiculous) pages to 451 pages in its legislative passage? You can't govern effectively if you have to throw ten pages of stimulus at every single interest group in order to get something passed.

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Prop trading tech

A friend of mine is dipping a toe into writing code to support prop trading. So, in the spirit of telling tales out of school, let me make some observations about this business.
  • The users don't know what they want. And they cannot spare the time to tell you even their incoherent and ill-posed ideas about what they think they want.
  • As soon as they get something, what they think they want changes.
  • What they want also changes are the market moves, as new research comes out, and as their ideas turn out to be worthless.
  • The less the analytics depend on one particular paradigm, the better. Flexibility is the key to profitability.
  • Expect that things will work for a while, then fail. This means you need to build in `does it still work' measures which might help avoid sailing over a cliff.
  • Risk measures are nonsense, often, but you have to provide them anyway. Try to give both conventional (often silly but expected) and less conventional (more useful but unconventional) risk measures.
  • Remember that model error is onmi-present and that over-fitting is very common. Expect the model to fail unpredictably and catastrophically.
None of this is a problem as long as you are expecting it. Just don't think that IT development for prop trading is linear...

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Sunday 8 February 2009

80% off

No, not the closing down sale at one of Britain's many bankrupt retailers, although it could be. Rather it is the fall in property prices from the peak in one of the exurbs of Fort Myers, Florida. The NYT story is here. But mull on that number for a second. 80%. Then consider putting -0.8 in the HPI vector, and think what that will do for the price of even prime RMBS.

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Saturday 7 February 2009

Unravelling the Credit Crunch

My new book on the Credit Crunch went off to my editor today. Here's a contents list:

1 What Happened?
1.1 U.S. Residential Property: The Crunch Begins
1.2 Old and New Style Banking
1.3 What Happened in the Markets: The Second Stage
1.4 Après Lehman le Déluge: The Third Stage
2 Understanding the Slime
2.1 Mortgage Structures and Borrowers
2.2 How Mortgages Were Made
2.3 Mortgage Lending During the Greenspan Boom
2.4 A Story of the ODM: Countrywide Financial
3 Financial Assets and Their Prices
3.1 Securities
3.2 Markets and Prices
3.3 The Liquidity of Financial Assets
3.4 What’s In It For Me?
4 Liquidity and Central Banks
4.1 The Basis of Old-Style Banking
4.2 Liability Liquidity
4.3 Central Banks
4.4 Central Bank Policy in a Crunch
4.5 A Tale of Two Central Banks
4.6 A Twenty First Century Run: Northern Rock
5 The Crash of 1929 and its Legacy
5.1 The Crash of 1929 and the Great Depression
5.2 Political Reactions
5.3 The New Deal
5.4 The RFC and Other Rescuers
5.5 The Evolution of Freddie and Fannie
6 Securitisation and Tranching
6.1 Securitisation
6.2 The Securitisation of Subprime Mortgages
6.3 Models and Hedging
6.4 Model Risk
6.5 Where did it all go wrong?
6.6 The Write-downs
7 The Legacy Fails
7.1 The Growth, Distress, and Rescue of Fannie Mae and Freddie Mac
7.2 Financial Services Modernisation in the 1990s
7.3 The End of the Broker/Dealer
7.4 Lessons from the Failure of the Broker/dealer Model
7.5 Compensating Controls
8 Structured Finance
8.1 Credit Derivatives
8.2 ABS in Structured Finance
8.3 Structured Finance in the Boom Years
8.4 Insurance In Form And Name
8.5 The Rescue of AIG
8.6 Off Balance Sheet Funding
9 Municipal Finance and The Monolines
9.1 Municipal Finance
9.2 The Monolines Do Structured Finance
9.3 Insurers and Finance: A Toxic Mix?
9.4 Auction Rate Securities
10 The Rules of the Game
10.1 Accounting andWhy It Matters
10.2 Regulation and Regulatory Capital
10.3 The Consequences of Basel 2
10.4 Regulation away from Basel
10.5 Understanding Earnings
10.6 Japan’s Lost Decade
10.7 A Comparative Anatomy of Financial Crises
11 Changes and Consequences
11.1 Transmission
11.2 The Provision of Credit to the Broad Economy
11.3 What Worked and What Didn’t
11.4 Central Banks, Regulators and Accountants
11.5 Experimental Finance
11.6 The Financial System from 2009

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Friday 6 February 2009

Something you already knew

This week's no shit Sherlock award goes to... Treasury Overpaid For TARP Investments. What is more interesting, though, is utterly spurious precision being treated as fact. Yes, I am sure Treasury overpaid, but saying things like Treasury paid $254 billion for assets worth approximately $176 billion implies that with a bit of due diligence, we could find the 'right' value. And we really can't.

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Thursday 5 February 2009

An embarrassing lack of ambition

Paul Krugman, who I normally have a lot of respect for, writes:
The figure above plots ... It’s not a perfect fit — this is economics, not physics,...
(Emphasis mine.) Honestly, what other academic discipline could dismiss the inaccuracy of a theory with an airy `this is not physics?' Economists wonder why many people think that they are little better than cultists. Krugman's piece displays a large part of the reason: economists can't predict much and they are not even embarrassed by that.

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Valuation uncertainty

A great data point from S&P via the New York Times:
The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency.

The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.
Or as a friend of mine put it, `if you wanna throw the dart at the board and give me an HPI vector, I can tell you what the bond is worth. But who the hell knows what's the right HPI?' Given that future house price inflation cannot be known today, he has a point.

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Wednesday 4 February 2009

Gordon tells the truth

I don't usually link to videos, but...

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The new face of the possible

Warning: this is a change from our usual programming. If you are not interested in the theory of interacting systems, you might want to skip it.

One of the things that has really changed with the widespread use of computer models is the achievability of perfection. What do I mean? Well, one big difference between a computer model and reality is the ability to restore state. That is, to make the world just like it was earlier. The undo button. You really can, in a model (and by `model' I include programs like Word or Excel, computer games, and so on as well as more obviously model-like things) undo the result of some action as soon as it goes wrong. That is much much harder in the physical world, as anyone who cooks or does DIY will affirm. What this changes is the how hard it is to do some difficult things.

Suppose you have a 1 in 1000 chance of getting something right. What that thing is doesn't matter - think of making the perfect Bearnaise, or building a shed, or jumping just right so that Lara Croft navigates over a chasm. In the real world, it may take many many tries before you get it right. The amount of time required is considerable. In a computer model, though, if you save frequently, you can just restore from the last good point. So if that 1 in 1000 is the result of three separate 1 in 10 actions, then you can treat each separately. As soon as you get one of them right, you never have to do it again, as you can restore the state just after you succeeded. This dramatically changes the amount of time needed to do difficult tasks that rely on a sequence of smaller but still hard-to-do things. (It changes the hardness in particular from multiplicative time in the number of steps to additive time - as any complexity theorist will tell you, that is huge.) At least in a virtual world, perfection really is sometimes possible.

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Tuesday 3 February 2009

Your banking system -- free

Interfluidity has a long an excellent post on bank rescues and nationalisations here. I won't reproduce the main ideas, interesting though they are, because I want to comment in particular on one particular proposal:
The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen
I don't really like this idea because artificial time periods, like a year, simply add stress to the market. Nevertheless it does solve the problem that the government doesn't necessarily know how to run a bank. And given that everyone did not contribute to the bailout, why should everyone get shares? No, instead why not provide an incentive to pay your taxes? Divest the banks over three or four years, and each citizen gets shares in proportion to the tax they pay.

One last point. Size matters. What we need is a banking system with lots of small banks, so no one is too big to fail. (See Baseline Scenario here for more on this.) So when we spin off the privatised banks, we should create many small ones. Banks like Citi, RBS, BofA, or LloydsHBOS are far too large. Given that retail is the most politically sensitive (for which read 'bailout deserving'), the retail arm of each of those should be turned into at least 4 separate banks. I'm less concerned by how wholesale is treated - just split it up in some rational way. And then set capital requirements based on size so it is very hard for banks to get big again.

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Monday 2 February 2009

Steps to making a bad bank

For a lot of reasons, I think a bad bank without prior national-isation is a bad idea. But if you were going to do it (as lots of people now seem to think is likely - see FT alphaville here for a summary), what would you do?
  • The key problems are valuation and moral hazard.
  • For valuation, establish a reasonable lower bound on the asset, such that it is rather unlikely to be worth less than x. Buy the asset for x in cash.
  • To give the banks some incentive, give them a warrant granting them some participation in the upside over x when the asset is sold or in its long term cashflow, if it cannot be sold. The participation rate should not be too high: 50% at most.
  • The state will need to backstop the bad bank in case the total value turns out to be less than the sum of the xs. Moral hazard considerations require that the state gets a return for its risk.
  • Therefore for each dollar notional sold to the bad bank, the banks will be required to hand over, for nothing, warrants on their common stock. The conversion ratio can be debated, but given the likely adverse selection issues, it should be reasonably penal.
  • And of course there should be limits on executive compensation, requirements to lend and so on as part of the price of participating.

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