Crisis, margin and profits

The FT reports the fall back in margins towards pre-crisis levels.

The trouble is, with margins near pre-crisis levels again for products like rates and forex, the free lunch enjoyed by the smaller boys is being taken away. Scale once more is king. Banks down the order in certain flow products should be asking themselves serious questions. Even including the crisis, the top five banks in equities, for example, have increased their market share by 10 per cent since 2006. As the level of concentration increases again, expect more money – not to mention heat – to be generated in the biggest dealing rooms.

Swaps and noise

Here is an example from the FT about how arbitrage opportunity may be squeezed by noise.

In the wake of the financial crisis, the use of collateral backing derivative trades in order to appease counterparty credit concerns has continued to expand.

This means that once a swap trade is executed, more margin is required if the trade starts losing money.

This daily management of margin also makes it harder to maintain an arbitrage over time as the value of any trade between swaps and Treasuries changes constantly.

Analysts at Credit Suisse say: “This makes it increasingly harder to hold arbitrage strategies to termination as arbitrageurs are forced to realise not just gains but also losses through margin calls resulting in frequent stop outs [forced exits from the trade].

The risk that the trade will move further in the wrong direction before convergence is achieved will limit those willing to take the risk and create some sort of threshold on arbitrage. This may be like a threshold error correction model similar to that seen in PPP.

Growth and bubbles

Here is a section on bubbles and the growth rate by Nick Row.

Shorting bonds

A small FT item on shorting the bond market. There are a number of different ways to do this: futures, repos or CDS.

Shorting bonds can be done using futures or repos [repurchase agreements], or credit default swaps. The last method is not ideal, warned Mr Inker. “There is the risk of governments declaring your contract invalid.” A number of politicians have called for restrictions on CDS trading.

This is a strategy designed to enhance yield in a low interest rate world. Risk-reward is in favour of high yields.

Informal contracts

John Kay summarises the difference between informal and explicit contacts echoing ideas about the need for flexibility in relationships that cover the question of where the firm should end and the nature of the legal background to firm formation: Coase and Williamson highlight some of these issues as informal and adaptive relationships may be more easily managed within the firm.

Lawyers for American companies spent hundreds of billable hours drawing up contracts to which no one ever referred. Their Japanese counterparts engaged in complex business relationships with no formal agreements at all, or ones that covered a single sheet of paper. But the commercial relationships that emerged in Japan’s car industry were more successful in securing component reliability and managing just-in-time inventory than those hammered out by the hard-nosed negotiators of Detroit.

La Porta, DeSilanes, Shliefer and Vishney "Legal Determinants of External Finance" seem to suggest that a more flexible legal system can also better deal with the heterogeneity of conflicts.

Banking, risk and regulation

Excellent article on risk and regulation that looks at the key issues of failure in safe securities and repo markets.

The financial crisis of 2007-09 featured large-scale losses to financial institutions from assets such as AAA rated tranches of mortgage-backed securities. Simultaneously, markets for collateralised borrowing (“repos” or repurchase agreements) froze or experienced severe stress. Investors lending in repo transactions started charging large “haircuts”. In other words, repos could be rolled over only with successively high levels of over-collateralisation, which disrupted the financing model of broker-dealers and in fact caused Bear Stearns to fail in March 2008.

The moral of the story is that regulators need to impose tighter constraints, such as higher capital requirements, on activities such as holdings of AAA rated tranches and repo financing of risky assets where there is a conflict of interest between the privately optimal and socially optimal choices. Bankers will fight such a proposal. But it should be well understood that they have all incentives to ignore the attendant systemic risk

Minsky and risk

Rajiv Sethi: An Ecological Perspective on Financial Market Reform speaks about Minsky and the way that risk was built at financial institutions.

Swap rates

The FT on the relationship between government issuance and swap rates.

In normal market conditions, yields on government bonds, such as US Treasuries, UK gilts and German Bunds, trade at a discount to swap rates. This is because swap rates are based on a funding rate that is linked to the interbank lending market. This rate is higher than the repo rate used for financing government bonds. Swaps are money market instruments whereas Treasuries reflect triple A sovereign risk.

Toxic asset

Track a toxic asset with NPR.

Remember those complicated bonds full of home mortgages? The ones that almost brought down the economy? A team of reporters with NPR's Planet Money used $1,000 of their own cash to buy a tiny piece of one — and plan to track it until it dies

Extreme value

Arthur Charpentier shows very clearly the way that mean square error and average absolute error can diverge as outliers appear.

(I allowed negative income for simple calculations and have a nice design). We concluded that gap significantly different between the standard deviation (L2) and the absolute difference (L1) simply means that there are probably outliers in the database (outliers defined "significantly different" means " outliers ").

Lehman

The FT looks at the Lehman repo transactions but what stands out is the huge increase in risk-taking.

Lehman’s rapid growth saw net assets increase by 48 per cent, or almost $128bn, from the fourth quarter of 2006 through the first quarter of 2008. But the bulk of the assets, according to the report by court-appointed examiner Anton Valukasreleased on Thursday, were in illiquid assets that could not easily be sold. Such assets nearly doubled to $175bn in that same time frame

The repo issue is that this was used to disguise the extent of the leverage and the precarious financial position that the investment bank had engineered. If they were conducting this financial engineering, they were aware of the increase in risk that was being taken.