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.

Wasteful Timmy

The Geithner plan, understandably, has generated many column inches since it was unveiled on Monday. There is little consensus among the commentariat, but the markets have taken it well. What should we take from Timmy's last (or at best next to last) stand?

First, it might actually work either by accident - because we are through the worst anyway and it doesn't hurt - or by design. It is certainly positive in the short term for the shareholders of American banks. And it betokens a reluctance to nationalise which, while negative for the taxpayer, is the kind of thing markets like.

Second, it is clearly an ineffective use of money. The government is providing nearly all the cash. If the same amount had been spent on recapitalising the banks, then there would be more leverage and hence more assets controlled for a dollar saved. Taxpayers should be outraged by this.

Third, it indicates that Geithner believes that an interestingly modern form of systemic risk is important: the risk that quasi-forced sales by one institution causes losses at others via mark to market. This plan achieves a de facto recapitalisation (albeit wastefully) via the ability for all banks to mark their assets to the purchase price in the plan. This means of course that the plan managers will be strongly encouraged to pay more than the market price for the assets: something they can afford to do given the government subsidy built into the structure.

In summary, then, the plan is far from optimal, but it will probably help a bit. The concern is that it won't be enough. If that happens, then Timmy will need a new job.

Update. Felix Salmon picks up an interesting quote from Sheila Bair. This makes it clear that the intent of the plan is to crush the non-default component of the credit spread:

They [the prices assets are bought into the plan] will still be, they will be market prices. We're just trying to tease out the liquidity premium. What's weighing on market prices right now is that people can't get financing to buy assets, they can't get financing to buy assets not many people want to buy, you don't want to buy. And then you have to hold on to them forever because there's nobody to sell them to. So, that's -- by providing that liquidity that's lacking now, we're hoping to get the prices up to what would really be a true market level.

They are doing this by removing all the risk - funding risk, liquidity risk, and credit spread volatility risk. It's an awfully expensive way to recapitalise the banks.

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.

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.

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.

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.

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.

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.

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.

On 'Fundamental Value'

There is a lot of talk at the moment about fundamental value. This mostly focusses on how good it would be if the market prices of assets rose back towards 'fundamental value', and what the government could do to assist that process.

There's only one problem. You can never know what the number is.

Consider a loan. Either it defaults, in which case you get some interest followed by recovery; or it doesn't, in which case you get scheduled P&I. In both cases the fundamental value is the PV of the cashflows. But you don't know whether it will default or not, so you can't combine the fundamental value on default with that for no default to get a single number.

In credit risk modelling we solve this problem by positing a probability of default, and then deriving that PD from spreads. But that's an argument that depends on the credit spread being fair compensation for default risk.

And of course ontologically it makes no sense to talk about a 'probability' of default. Either default happens or it doesn't and we only get one chance at finding out. Given that we can't take the same obligator, duplicate them a hundred times, and look at their performance on each occasion, we can never know that our 'probability' is correct. Thus there is literally no such thing as a 'fundamental value' in any scientific sense because we could never know whether we had such a thing.

What is a derivatives pricing model anyway?

I had a conversation about this last night and thought it was worth writing some of it down and extending it a little. So...

Let's begin with the market. For our purposes there are some known current market variables which we assume are correct. This could be a stock price, interest rates, a dividend yield -- and perhaps one or more implied volatilities.

Secondly we have a model. The model is often, but not always, standard, i.e. shared between most market participants. Let's start with standard models. Here the model is first calibrated to the known market variables.

At this point we are ready to use the model. There is a safe form of use and a less safe one. In the safe one we use the model as an interpolator. For instance we know the coupons of the current 2, 3, 5, 7 and 10 year par swaps (plus the interest rate futures prices and deposits) and we want to find the fair value coupon for a 4.3 year swap. Or we know the prices of 1000, 1050 and 1100 strike index options and we want to price a 1040 strike OTC of the same maturity.

The less safe use is when we use the model as an extrapolator. We want a 12 year swap rate, for instance, or the price of a 1200 strike option. That's not too bad provided we don't go too far beyond the available market data, but it is definitely a leap.

(Both of these, by the way, count as FAS 157 level 2.)

Note that there are two ways that we realise P/L in derivatives. Either we trade them or we hedge them. If we are in the flow business then trading is important. We need to use the same model as everyone else simply because we are in the oranges business and we need to kInow what everyone else thinks an orange is worth. We take a spread just like traders of other assets, buying for a dollar and selling for a dollar ten, or whatever. The book might well be hedged while we are waiting to trade, but basically we are in the moving business. Swaps books, index options, short term single stock, FX, interest rate and commodity options, and much plain vanilla options trading falls into this camp.

In the hedging business in contrast we trade things that we do not expect to have flow in. Most exotic option businesses are an example here, as are many long dated OTC options. There is no active market here so instead we have to hedge the product to maturity. Thus here the model hedge ratios are just as important as the model prices. Valuation should reflect the P/L we can capture by hedging using the model greeks over the life of the trade. Thus standard models are more questionable in the hedging business than in the moving business since it is not just their prices -- which are correct by construction -- but also their greeks that matter.

Things start to get really hairy when we move away from standard models. Now we are almost certainly dealing with products where there is no active market (some kinds of FX exotics are a counterexample) and we do not even know that the model prices are correct. There is genuine disagreement across the market as to what some of these things are worth. Different models also produce radically different hedge ratios. How can we judge the correctness of such a model? The answer is evident from the previous paragraph: it is correct if the valuation predicted can genuinely be captured by hedging using the model hedge ratios. [Note that this does not necessarily give a unique 'correct' model.]

In summary then: for flow businesses we need interpolators between known prices and, to a lesser extent, extrapolators. For storage businesses we need models which produce good hedge ratios.

Tasting 100

I have been meaning for a while to blog about a post on VOX about wine pricing. To paraphrase heavily, Parker determines the en primeur price, but the price at maturity depends on how good the wine really is. Given that Parker isn't a really great judge of how a wine will mature, and weather charts are better than him, there is an arb. The most obvious example I remember is the 86s, which were clearly overpriced in their youth, and now have faded to over-oaked oblivion while the 85s are still going strong.

Ball of steel or brains of lead?

In what is either a strong buy signal for the market or a strong sell signal on the stock, MBIA has announcing that it was not changing its projection of losses on its mortgage-related exposures. The FT story is here. Yes, they had some bizarre FAS 159 gains (CNN is here and my take on the rules is here): yes, they resumed a share buy-back programme. But ignoring all that, if their actuarial loss estimates for RMBS have not changed, either that is a very useful datapoint on where realised default losses actually will be, or their actuaries are fools and it is time to short the stock again. It will be interesting to see which.

Update. John Dizard has pointed out the possible value in the monolines as a vulture play on the eventual losses on RMBS. I can see the idea, but I'd like to know more about the implied residual value of the monolines given the current equity price. Are they really cheap yet?

Ship, meet iceberg

Loath though I am to quote from a Murdoch publication - just look at the sad decline of the WSJ to see what being owned by him does to a paper - I do want to comment on something by Anatole Kaletsky yesterday. Fortunately it is an utterly wrong-headed piece which misunderstands fair value accounting. First the good bit:

the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to gauge - this liquidity and maturity transformation is, in fact, the main social function that a banking system provides.

Agreed. But here's the thing. Banks can only do that if people have the confidence to give them their money to lend to someone else. That depends, for the retail investor, on deposit insurance; and for the wholesale depositor, on credit quality. Both of those in turn rely on the bank being well capitalised: regulators demand it to reduce moral hazard, and market counterparties need it as part of their risk assessment.

Now how can we tell if a bank is well capitalised if it is allowed to pretend nothing is wrong until it actually suffers losses? That is what accrual is all about - the fiction that all is well while the ship steers at full speed towards the iceberg. At least fair value shows you what is ahead.

Fair Value and Insurers

CFO.com has an excellent post on Fair Value accounting. One quote in particular amused me:

James Tisch, who was effectively the sole voice of dissent on the first panel, complained bitterly that fair value accounting required reams of nearly incomprehensible disclosure information and often forced his company to make poor economic choices.

Tisch ... said that if insurance companies had to run mark-to-market accounting through their income statements, "[they] would essentially be out of business"

And that, as we have seen with the financial guarantee insurers, is clearly right. But perhaps if the insurers were forced to use fair value, they might deploy less leverage and pay a little more attention to what the market is telling them.

Hiding the pain

A couple of weeks ago I pointed out that while the US institutions have taken their write down medicine, raised new capital, and are busy getting on with trying to figure out what to do next, the Europeans have been much less assiduous in recognising their losses. Now Citigroup, via FT alphaville, comes up with a concrete example: Barclays. The corrected version of the Citi piece is said by the FT to include the following:

Barclays has reclassified some assets, most notably leveraged finance and CDOs, and accounts for them as if they were loans held to maturity. This means that these assets are not marked to market but impairment provisions are raised when the bank believes that there is a risk to the credit outlook. While this is an unusual treatment for leveraged finance, as the financing was originally intended to be sold down, the assets are at least primarily loans. The treatment is even more unusual for CDO exposures.

That four billion really does not look enough now, does it?

Update. It is not just CDOs. From the FT:

The debate has [also] focused on Barclays’ policy of accounting for leveraged loans by looking at the borrower’s financial performance rather than the price at which those loans are trading in the market.

This has puts it at odds with some US and European rivals, which value their leveraged loans on a mark-to-market basis. Most leveraged loans are trading at 80-90 per cent of their face value, with some changing hands for as little as 70 per cent.

Liability Fair Value

Tom Selling from The Accounting Onion was kind enough to point out his blog to me. Reading a post on FAS 157, it suddenly occurred to me that the implementation the audit firms have permitted of 157 on liabilities, based on the FASB staff position, isn't consistent with the conceptual framework of 157.

The standard says:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Suppose I run David's Broker/dealer, DBD. DBD bonds are liquid and so have an observable credit spread. If DBD credit spreads go out, DBD bond holders using fair value suffer losses which are reported in their P&L. But if DBD wants to buy back those bonds in an orderly transaction between market participants, DBD bond holders are very likely to force it to pay par plus accrued (at least if DBD is a going concern). Moreover it's illegal for DBD to buy its own bonds back in the secondary market in most jurisdictions so the value of the liabilities for DBD is not symmetrical with the value to the holders: it cannot take advantage of its elevated credit spread even if it has the money to buy back the bonds. Hence the staff position doesn't reflect economic reality, and what most people feel in their gut - that 157 gains on liabilities due to credit spread widening are bunk - really is true.

I'll end with a quote from the amusingly petulant comment the Basel Committee issued on IAS 39:

it would be wholly unsatisfactory if an entity which was insolvent in the sense of its assets being worth less than the par value of its liabilities nonetheless appeared to be solvent because the fair value of its liabilities was recognised on its balance sheet, with the fair value below nominal value...we recommend that the exposure draft’s guidance on the fair value option be revised ...[to] exclude the mark to market of own credit risk from the fair value option by limiting the mark solely to valuation changes due to general market movements

Rioja and the European Economy

I have two conjectures for today. The first is that Ambrose Evans-Pritchard needs to drink better Rioja. He presents a bearish blog in the Telegraph, backed by a second class Reserva. I would suggest at least a 904 GR for such musings, and ideally the Murrieta.

Secondly and rather more importantly, it can be suggested that the loss trajectory for European banks will be rather different from their American cousins. Suppose we believe Evans-Pritchard's loss figures: $123bn for Eurozone banks compared to $144bn for the US, and ignore for a moment the rather important distinction between bank and non-bank risk holders. (The US has far more of the latter.) My guess would be that most of the US risk is fair value accounted. So the Americans have taken or are in the process of taking their losses. Most of the European risk is probably accural, so losses will depend on the bank's projected loan loss reserves rather than current fair value. At very least that will spread them out over many years - remember RMBS is often 30 year paper. Moreover if actual experienced defaults are better than the current fair values predict then the losses will be lower.

One could argue that this cancer will eat away at the European banking system for many years, long after the Americans have taken their medicine and moved on. Or one could argue that right now it allows European banks to keep lending and hence to both protect Europe's economy from the worst of the losses and make themselves some money to pay for the losses. But certainly the bearish case for Europe is less convincing than that for the U.S.

Yesterday's Basel press release

On Wednesday the Basel committee announced some changes to the Basel II framework. The press release is fairly short on detail, but it does give some insight into the forthcoming detailed proposals. Let's take a look.

The Committee reiterates the importance of implementing the Basel II framework.

This is shorthand for 'please Mr. Fed would you implement our Accord?'

...the Committee will revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so called "resecuritisations" or CDOs of ABS.

Clearly CDO squared products and CDOs of tranched ABS have been a major issue so this is reasonable. But CDOs of pass throughs have much less model risk and behave in a much smoother fashion so I hope these will not be tarred with the same brush.

It will strengthen the capital treatment of liquidity facilities extended to off balance sheet vehicles such as ABCP conduits.

The issue here is implicit support: legally many of these lines were low risk, but reputational concerns forced banks to provide support where it was not contractually required. Rather than charging for liquidity, which will simply encourage the use of non-bank liquidity providers, the committee should cap the benefit available for securitisation.

The Committee will strengthen capital requirements in the trading book... The Committee ... is extending the scope of its existing proposal guidelines for "incremental default risk" to include other potential event risks in the trading book ... (planned 2010).

This is so frustrating. The capital requirements in the trading book are already high compared with the banking book, and the incremental default risk proposals are hardly a model of cogency or risk sensitivity. If the trading book charges are imprudent then the banking book ones are far too low. They should also be revising the correlations in the IRB formula and increasing the risk weights for risk below BBB- in the revised standardised approach. And surely they can get their act together a little faster than 2010?

The Committee will monitor Basel II minimum capital requirements ... over the credit cycle... [and] will take appropriate measures to help ensure Basel II provides a sound capital framework

So no discussion of procyclicality and no acknowledgement of the need for anti-cyclical capital requirements especially for fair value assets. This is disappointing. Basel II seems to have become a self-sustaining industry where wholescale change is almost impossible. The extended timeframes and modest revisions are evidence that major regulatory change will need more impetus than just the biggest banking crisis in a generation.

In July the Committee will publish for consultation global sound practice standards for the management and supervision of liquidity risks.

What about capital for liqudity risk?

Weaknesses in ... valuation practices for complex products have contributed to the build-up of concentrations in illiquid structured credit products and the undermining of confidence in the banking sector. The Committee is taking concrete action to promote stronger industry practices in this area.

What pray might those be? If it doesn't trade, it isn't Level 1. Stronger practices whatever they may be need to acknowledge that fair value is often an estimate and that uncertainty in valuation will always be with us. This is fundamentally an investor education problem: equity holders suffer the same realised earnings volatility whether the asset is fair value accounted or not; hiding that volatility via loan loss provisions in the banking book just turns the spotlight away, it does nothing about the real risk. Supervisors seem to be aware of the issues with structured credit in a fair value context but reluctant to acknowledge that these risks are still there in an accrual context, just concealed by the accounting.


Are these changes going to help? A little, although putting a charity slot in the wall of the BIS might be more effective: there is much more that needs to be done, and done quickly.

The importance of non-deposit-taking financial institutions

I'm away from my desk at the moment so posting volume is reduced, but I do want to draw attention to an excellent piece by David Roche in the FT. Firstly he points out the importance of non banks to the liquidity of the US financial system:

The Federal Reserve has belatedly recognised that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and "real" economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI's create more "asset money" than banks but are much riskier institutions.

NDFIs, though, are not regulated as deposit takers, and in particular the broker/dealers benefit from SEC supervision. As David continues:

What is wrong is that the Fed is doing so without having oversight or supervision of the borrowers.

He then looks at both the size and the velocity of NDFI money:

Investment bank, hedge fund and broker balance sheets are about half the size of the commercial banks in the US and about one-quarter the size in Europe. Both assets and liabilities of NDFIs are dominated by repos, meaning that NDFIs lend and borrow based upon collateral of assets that are constantly marked to market. As asset prices fluctuate, leverage must constantly be adjusted.

This is related to the procyclicality of a leveraged fair value player as I discussed here. As David explains:

In a bear market, as asset prices fall, leverage is reduced. This causes lenders to ask for more collateral on existing loans and borrowers to sell assets so as to reduce the need for such loans and for additional collateral.

The opposite happens in a bull market when rising asset prices cause the balance sheets of NDFIs to expand. The liquidity this creates is used to invest in assets, boosting their prices and creating demand and collateral for more borrowing to make more investments.

So the balance sheets of NDFIs are highly geared to asset price cycles. They act in a pro-cyclical manner, reinforcing bull and bear market cycles and through them economic cycles. So the effect on "asset money" is greater than that of deleveraging by banks, which lend for a wider range of purposes than NDFIs.