Plus ca change… Finance Capitalists (still) rool ok?

by Duncan Lindo

A month or so ago the world seemed about to change: bankers were bad, Sir Fred was in hiding, AIG was being punished and a rethink of financialised capitalism seemed possible. Today the bad banker headlines are fading, banks’ results are improving and there’s talk of repaying TARP funds. In fact finance capitalists seem to be winning the struggle by some margin. Three news stories of recent weeks show that so far there has been no fundamental questioning whatsoever of financialised capitalism; indeed is anything the crisis is being used to usher in ever more market-friendly measures.

A review of fair value accounting led to a relaxation of the rules, resulting in less mark-to-market, but no fundamental questioning of the idea that market prices in financial markets are efficient and result in correct allocation of resources – despite the crisis. In a previous blog we explored how expansion of mark to market expands the “everything-for-sale” attitude with it’s short-termist outcomes and ever more power to the financial elites.

The so-called CDS big bang cedes some power from banks to other investment firms such as PIMCO. But let’s be clear here, PIMCO or any other investment firm are just as much interested in trading revenues as the banks. This is not a big bang it’s only a small shift. Are these really the hedgers / investors that the literature makes so central to the ability of derivatives to spread risks? I don’t think so. The contract changes all work in the direction of further standardisation in preparation for central clearing. This flies in the face of returning CDS to be a hedging tool. Credit transfer products such as CDS have become steadily more standardised over the last 20 years inviting ever increasing trading volumes for those who spend the day buying and selling. But a true hedger requires the opposite - a bespoke contract which they will hold until maturity. As explored previously “counterparty risk” is a red herring being used to usher in ever more trading / market friendly conditions.

These two stories trends are manifesting themselves in a slight upturn in the latest banks’ results. Banks have taken advantage of the relaxation of fair value accounting to report better numbers and are also reporting better trading revenues on wider bid-ask spreads. Strange world where large spreads are due to the low level of liquidity that is caused by the financial crunch which was caused by…..banks!

When the vast majority of economists are trained to believe markets work we shouldn’t be surprised that when markets fail (again) the response is to look past the facts and attempt to implement markets yet harder and faster. How long will it take for the realisation to sink in that something more fundamental needs to change? Well don’t hold your breath! It takes a long time to turn a tanker even as it hits a storm, what’s more there are powerful forces trying to ensure the route through the storm is to keep in the same direction but go even faster!

PS: Should we be surprised that the finance capitalists are winning the day when two of their number are holding the most relevant posts in the White House? As Stiglitz puts it: “America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street. Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

Mark to market madness

by Duncan Lindo

The news last week that only 2% of GE’s assets are market-to-market will have shocked some investors. What murky mischievous mark-to-model is being used to mask the mess that is the remaining 98% of assets (98% by what measure we might ask…). The stock has plummeted and now they’ve lost their 50year old AAA rating.

But wait..! GE doesn’t intend to sell these assets (not at these prices anyway the cynic might add) – so of what relevance is their mark-to-market (MTM). Whilst we’re right to worry about how they are valued why on earth should mark-to-market be better?

Firstly what happens when there is no market? As noted in a House Committee on Thursday: “Illiquid markets have resulted in great difficulty in valuing sizable assets”. The assumption of ever increasing markets for assets implicit in the spread of MTM across balance sheets is looking a little bogus. Most famously the secondary markets for mortgage assets have disappeared… albeit from a low base.

Blessed are the financial intermediaries
Perhaps given a bit more time it was hoped that MTM would become self fulfilling. As more of balance sheet value becomes subject to market valuation more opportunities have arisen for the derivative traders to sell hedging instruments to mute the volatility of market valuation. Thus markets for the assets appear. This is less chicken-and-egg than golden goose eggs for financial intermediaries inserted into yet another area of the economy. The alternative is the constant surveillance of the balance sheet for restructuring possibilities – selling businesses with high hedging costs. There are always investment bankers ready to advise you on that too. Everything market to market means everything for sale.

Procycliality
Market to market accounting is also pro-cyclical – even Hank Paulson admits it. The classic mechanism of bubbles through collateralised lending against rising market value of assets fuelled by leveraged buying and the deleveraging spiral that follows the burst. As soon as you admit herd behaviour, euphoria, bubbles then accounts based on market price look non-sensical. For the time being though it doesn’t look like the law-makers are ready to make the U-turn on the law. It’s pro-cyclical but… err… we don’t want to change it.

Symmetry and the Farce of Own Credit
“Fair Value” was also partly born of a desire for symmetry between buyers and sellers of instruments – an idea at odds with neoclassical theory which requires differing utilities in order for trade to occur! One consequence was billions of dollars of profit for banks during the crisis in the form of “Own Credit”. Holders of bank debt have marked down their assets as bank default probabilities rise (as measured by CDS spreads) taking losses; conversely arguments of symmetry under “fair value” accounting regulations have required banks to reduce the value of the equal and opposite liability resulting in a “profit” for the bank! The more the market writes down their debt the bigger the profits banks can book! The more debt they have the bigger this profit is! The incentives created are clearly crazy. Furthermore the balance sheet as a description of reality further distorted – e.g the distance between “retained earnings” and bank’s ability to pay dividend clearly increases. At least here it might be argued that MTM is anti-cyclical!

Yeah and –what you gonna do about it?
You’ll notice that I’ve spent 500+ words knocking MTM accounting with not one constructive suggestion.. well… as Hank P agrees.. it’s tricky. Any ideas out there???

A definition of financialisation (one among many):

by Duncan Lindo

I wanna tell you a story:
It is a sunny day in early 2007. Robin Banks slips into the hushed corridors of the plush building in mid-town Manhattan that houses his wealth manager. It’s time to try one of these hedge funds.

Robin decides to invest $1milllion and his private bank is willing to lend him $3million more against his stake giving a total investment of $4m. Of course the private bank will charge some interest and a fee for arranging the purchase of the hedge fund stake.

The hedge fund they choose is big on structured credit trades – Collateralised Debt Obligations (CDOs) are the hottest deal in town. First thing, the hedge fund takes its 2% upfront fee. Because they understand the statistical models better than the rating agencies, they decide to go for the riskiest part of the CDO. They buy exposure to the equity tranche of a credit default swap (CDS) Index in derivative format from an investment bank. A fairly standard instrument and therefore one that their investment bank will sell to them for a 5% deposit (initial margin). Robin’s $1m which became $4m becomes $4m ÷ 5% = $80m of equity tranche exposure.

Over at the investment bank they can make money between the price at which they sold the risk and the price at which their models value it - but to capture the profit they need to hedge. Their pricing models tell them that with correlation trading as low as it is their delta hedge is 18.75. So to hedge their exposure to changes in the price of the CDS Index they need 18.75 x 80 = $1.5 billion of the index itself. The investment bank calls their most trusted market maker and starts to work an order for $1.5bn of index – a big order but should be manageable over a day or so. Robin’s 1million became 1.5bn!!

The market maker is more than happy – for such an order he can widen his bid-ask spread and should make 4-5bps running or approx 0.2% of $1,5bn.

Laying off that much risk though moves the market slightly. Across the room the index arbitrage desk notices that the spread between the price of the index and the combined price of the constituents is wide enough for him to put on a trade. It will pay off when the price of the index and the constituents come back into line – even if it’s at maturity. He trades the index and gets to work trading the underlying, single name CDS.

The single name CDS market makers know the index guy and get to work passing the risk to their clients – taking their bid ask. In a few of the less liquid names their hedging trades are enough to move the price of the CDS. Upstairs on the convertibles trading desk, someone notices that the new price for the credit risk (automatically input into their models) tells them that in order to remain hedged they need to trade…so they call their market maker….across the road an equity trader notices the price has changed…time to re-hedge, so they call their market makers…

CDS Central Clearing – will it really help?

by Duncan Lindo

“Credit Swap Clearing House to be running by year end” claim the headlines. But is the current lack of CDS central clearing really the cause of our multi trillion dollar financial crisis? If central clearing had been in place between 2001 and 2007 would it have averted the crisis? The only reasonable answer is no.

The authorities are reacting to the failure of markets by simply trying to implement markets twice as hard. Moreover we are witnessing a scramble between regulators to talk tough, act decisively and win the mandate for post-2008 regulation with little thought about what needs regulating and how.

Two of the largest alleged benefits are reductions in credit and operational risk but the advantages over the OTC market are slight and the impact on the causes of the crisis minimal. Prevention of a systemic chain of derivative counterparty defaults is a noble aim – but collateral agreements meant even Lehman’s default did not trigger such an event – 200mUSD of losses per bank is estimated not 20-40bnUSD per bank. A central clearer or an exchange should improve discipline and reduce operational risk – but the OTC market has shown it can clear up its act (e.g. tear ups, compression, clearing up confirms etc) and there’s nothing to suggest operational risk in the CDS market is systemic.

On these issues you might argue central clearing is marginally better than not but it’s hard to argue they are really fundamental to trillion dollar losses.

Transparency and prices are other areas mentioned. Apparently “buyers and sellers will know what they buying and selling” on an exchange (what an extraordinary thing that they collectively invested trillions of dollars without knowing that before!). In fact might not the reassurance of a clearing house further discourage active investigation and analysis by investors?
The same goes for prices. A clearing house will determine prices for every contract every day but very few of the outstanding contracts trade every day. The exchange will have to invent (“model”) the missing prices. It seems very likely that a clearing house publishing prices will only reduce the incentive for participants to use their own analysis and judgement. Isn’t this exactly the opposite of what is required?

Credit Risk Transfer started as bespoke, private and negotiated deals between those bearing credit risk (e.g. bank loan desks) and investors. Deals took time, details were analysed. Over time, and with the help of the dealers, the contract has become more standardised, information more social, markets more liquid; easier to trade in fact. In the moments before the crisis break there were many buyers and sellers, many transactions, much information about underlying corporate credits: few would have argued (in particular for standard corporate credit) that the market was not efficient. Yet the price was simply wrong. Risk premium was far too low.

The reaction to this market failure is to try even harder for the market. A clearing house is yet another step in the march of standardisation, liquidity and faster, easier trading. Is that really going to improve the quality of prices?