Category Archives: Risk and risk management

Satyajit Das: Derivatives Regulation Dance

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” Cross posted from Wilmott

A question of values …

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.

New York Times’ Joe Nocera Blames Crisis on “Mania”, Meaning Victims

I often enjoy Joe Nocera’s take on Wall Street, but like some other well known financial writers, he has become overly close to his subjects. No where is this more evident than in a stunning little aside in an otherwise not bad piece on the Financial Crisis Inquiry Commision’s report, which points out that it is long on potentially helpful detail, short on analysis.

Here is the offending section:

But I wonder. Had there been a Dutch Tulip Inquiry Commission nearly four centuries ago, it would no doubt have found tulip salesmen who fraudulently persuaded people to borrow money they could never pay back to buy tulips.

Ian Fraser: Is the House of Lords’ Crisis Inquiry Putting the FCIC to Shame?

Yves here. Although this post deals with a specific aspect of the House of Lords inquiry, note how it focuses on mechanisms that led to bank insolvency, in this case, how dubious accounting produced exaggerated profit reports, and along with it, looting (as in paying out funds to insiders to a degree that put the survival of the firm at risk).

By Ian Fraser, a financial journalist who blogs at his web site and at qfinance.

The many inquiries into the financial crisis have turned over plenty of stones but have failed to find any smoking guns. But the House of Lords economic affairs committee’s inquiry “Auditors: market concentration and their role” is making strides in identifying and maybe rooting out the accounting shenanigans that lay at the heart of the crisis.

At a recent session of the HoL inquiry, UK-based investors said that IFRS (international financial reporting standards) had encouraged imprudent, reckless and even illegal behavior by UK and Irish banks, enabling them to deceive investors, boost executive bonuses and ultimately destroy their institutions at taxpayers’ expense.

State Banks, or, If You Can’t Regulate TBTF Banks, Why Not Compete Instead?

Once in a while, you’ll see stories pop up about state governments looking into setting up a state bank, Washington being the latest sighting, along the lines of the only state bank in the US, the Bank of North Dakota. And there’s good reason. The Bank of North Dakota has an enviable track record, having remained profitable during the credit crisis. Moreover, in the ten years prior, the bank returned roughly half its profits, or roughly a third of a billion dollars, to the state government. That is a substantial amount in a state with only 600,000 people. The bank was also able to pay a special dividend to the state the last time it was on the verge of having a budget deficit, during the dot-bomb era, thus keeping state finances in the black.

But the good financial performance is simply an important side benefit. The bank’s real raison d’etre is to assist the local economy. And it has done so for a very long time. It was established in 1919 as part of a multi-pronged effort by farmers to wield more power against entrenched interests in the East.

And the most important potential use of this type of bank in our era could again be to level the playing field with powerful interests, in this case, the TBTF banks.

Bill Black: Why our Fundamental Approach to Banking Regulation is Inherently Unsound

Our current approach to banking regulation exposes us to recurrent, intensifying financial crises. The good news is that because we reached an all time low in Basel II, Basel III almost has to be an improvement. The bad news is that Basel III has not reexamined the fundamental assumptions underlying the Basel process. As a result, Basel III will be a variant on the common ineffective theme of banking regulation designed by economists and the industry.

The Basel process is built upon three flawed assumptions.

1. Capital requirements are the ideal form of banking regulation.
2. Capital requirements can be set without establishing sound accounting.
3. Accounting control fraud is not a serious concern.

Capital requirements are the ideal form of banking regulation under conventional economic wisdom. The attraction of capital requirements to neoclassical economists is elegance. Their theory is that while private market discipline ensures that normal corporations are inherently safe, private market discipline poses an inherent dilemma for banks.

Ian Fraser: Myopic Metrics and Blind Alleys for High Finance – and Big Oil, too

By Ian Fraser, a financial journalist who blogs at his web site and at qfinance.

Hitching your wagon to flawed or “dozy” metrics is never a particularly good idea. We saw this in the build up to the global financial crisis. RBS’s obsession with earnings growth, whilst paying no attention to return on capital, is just one idiosyncratic example; spurious “credit ratings” of structured products are another, and pervasive. It was financial institutions’ blind faith in flawed metrics, and their penchant for burying risk, through the use of deceptive risk models such as Value At Risk, that, as much as anything else, encouraged a generation of bank CEOs to lead their institutions over a cliff.

Equally flawed metrics are now driving risky, and indeed sometimes even desperate, behavior in the oil and gas sector.

Roger Ehrenberg’s Prescription for Robbing a Bank (the TBTF Variety)

One of the continued frustrations of the post-crisis period is the lack of discussion of looting, which as described in a seminal paper by George Akerlof and Paul Romer, is when executives find it more profitable to gamble on bankruptcy, as in lever up their companies, pull out too much in cash (usually with the help of overly flattering accounting) and leave failed businesses in their wake. Akerlof and Romer noted that businesses with explicit or implicit guarantees were particularly well suited to this sort of extractive behavior, and they argued the savings and loan crisis was a prototypical example. In ECONNED, we argued that the producers and management of major capital markets players were engaged in a looting 2.0 in the runup to the crisis.

Roger Ehrenberg, who had a long career in derivatives and now runs an early stage venture firm. He describes how easy it is to, as he puts it, “rob a bank” or loot. His formula:

More Evidence of Undercapitalization/Insolvency of Major Banks

Even as we and other commentators have noted the underlying weakness of major bank balance sheets, which have been propped up by asset-price-flattering super low interest rates and regulatory forbearance, we still witness the unseemly spectacle of major banks keen to leverage up again. The current ruse is raising dividends to shareholders, a move the Fed seems likely to approve. Anat Admati reminded us in the Financial Times on Wednesday that we are about to repeat the mistakes of the crisis:

The Imagination Trade, or the Tinkerbell Market 2.0

I’ve refrained from discussing the stock market for quite some time, in part because this is not an investment website and in part because I find the netherworld of credit more interesting. But a big reason of late is that the stock market has become so utterly unhinged from fundamentals that anyone opining on it, other than momentum trades and technicians with particularly good crystal balls, is likely to look silly.

We seem to be in a toxic replay of what I called the Tinkerbell market in 2007 and 2008: if the officialdom can get enough people to applaud, the economy will live. They weren’t too successful back then, but the crisis has appeared to have upped the game of the Powers That Be in talking up the price of financial instruments. And having the Fed at ready to provide boatloads of liquidity should anything go awry appears to have put much of the world in “don’t fight the Fed” mode.

Market action is looking a tad manic, yet the dot-com mania proved that unwarranted optimism can persist far longer than cooler heads deem possible. Hedge fund leverage, for instance, is allegedly back to pre-crisis highs.

Should We Believe Jamie Dimon’s Crocodile Tears Over How Much Mortgages Have Cost Banks?

Jamie Dimon told the press on Friday that the mortgage crisis has been costly (but not TOO costly) for JP Morgan. From MarketWatch (hat tip Lisa Epstein):

J.P. Morgan Chase & Co. Chief Executive Jamie Dimon said Friday that the foreclosure process is a “mess” that’s cost the financial-services giant a lot of money.

Dimon also said litigation over troubled mortgage securities is “going to be a long, ugly mess,” but won’t be “life-threatening” for J.P. Morgan….

SIGTARP on Citi Rescue: Ignoring a Bomb That Has Yet to Be Defused

On the one hand, I must confess to a “I love the smell of napalm in the morning” response to reading the SIGTARP report on the extraordinary assistance extended to Citigroup, starting in November 2009. The well-documented, blow by blow account, taken from the perspective of regulators, dovetails neatly with the reports here and on other blogs during those fear-filled, gripping times. (As an aside, frustratingly, the media is treating some factoids in the account, such Citi’s reliance on over $500 billion of uninsured foreign deposits out of a $2 trillion balance sheet, as news, when it was noted repeatedly in the blogosphere, particularly here).

But on the other hand, the SIGTARP report is annoying, in that it fails to connect some critical dots, diminishes the importance of its key finding, and is far too complimentary to the officialdom.

Should We Buy Geithner’s Resistance to Naming “Systemically Important” Firms?

According to the Financial Times, Treasury Secretary Timothy Geithner is trying to duck the assignment given the Financial Stability Oversight Council under the Dodd Frank legislation, namely, that of identifying “systemically important” financial institutions:

Tim Geithner, the Treasury secretary, has questioned the feasibility of identifying financial institutions as “systemically important” in advance of a crisis, just as the regulatory council he chairs is supposed to start doing precisely that…