Deep knowledge

The FT covers the case against the rating agencies and highlights the fact that there was knowledge within the institution about the reputational risk being taken. The FT suggests that this was profit-motivated, which is certainly part of the story. However, it may also be the case that these dispirit, lower-level voices could not be hear above the jingling of the tills ringing in new business. The challenge of governance is to give more weight to these voices.

he e-mails show signs of the agencies’ knowledge of the impending financial collapse. But in the interests of maintaining market share both S&P and Moody’s felt the need to continue their practices – even though many employees had misgivings.

“Screwing with (the model’s) criteria to ‘get the deal’ is putting the entire S&P franchise at risk – it’s a bad idea,” said one S&P employee. Another S&P employee described the drive for revenue and its effect on the relationship between banks and rating agencies as “a kind of Stockholm syndrome”.

Yet another captures that alleged conflict of interest almost perfectly: “Rating agencies continue to create an even bigger monster – the CDO market,” wrote an S&P staffer. “Let’s hope we are all retired by the time this house of cards falters.”

The agencies also failed to incorporate their growing awareness of fraud in the lending industry into their rating practices, as it was seen as a potential block to revenue.

In January 2007, an S&P analyst rating a Goldman Sachs CDO with subprime loans issued by Fremont Investment and Loan, which had just stopped using 8,000 of its brokers because they were agreeing loans with some of the highest delinquency rates in the country, asked superiors whether to take Fremont’s reputation into account.

Speculation

Pepy's diary 15th March 1666

So I to the office all the morning, and at noon to the ‘Change, where I do hear that letters this day come to Court do tell us that we are likely not to agree, the Dutch demanding high terms, and the King of France the like, in a most braving manner. The merchants do give themselves over for lost, no man knowing what to do, whether to sell or buy, not knowing whether peace or war to expect, and I am told that could that be now known a man might get 20,000l. in a week’s time by buying up of goods in case there should be war.

CDS

John Kay

But it strains language to breaking point to describe CDS transactions as anything but gambling. The traders in AIG’s financial products division were inheritors of the amusements of Edward Lloyd’s coffee shop rather than the values of Swiss farmers.

I am not sure that this is an accurate description. It seems to me that AIG was taking the risk from the Swiss farmers and receiving the income for total collapse that they did not believe could happen. However, when all the crops failed, AIG could not compensate the farmers and had to be bailed out by the government. There is speculative trading there, but it is not being done by AIG.

Theomdynamics

The first and second laws of thermodynamics: work uses energy and systems are inefficient. A good example with Google search in New Scientist. However, as if often the case when talking about thermodynamics and economics, there is no accounting for the fact that society, unlike the real world, can create something out of nothing.

Things like economies of scale and network effects have confounded people from Smith to Malthus to Marx. In this case, there is a need to compare the cost (lightbulb for one hour) against any possible benefit.

Currency swap

The FT reports that Greece may try to tap US investors with a US dollar-denominated bond, giving some evidence of institutional features that may justify currency swaps.

Greece’s most recent sales of euro-denominated bonds have attracted lower levels of interest and the government is now aiming to issue in dollars, targeting emerging market investors who are attracted by higher yields.

Bond model

Here are some links to research on the yield curve.

http://www.econbrowser.com/archives/2006/07/reading_the_yie.html

http://www.econbrowser.com/archives/2006/11/the_yield_curve_2.html

http://economistsview.typepad.com/economistsview/2006/09/globalization_a.html

http://www.econbrowser.com/archives/2009/04/the_yield_curve_6.html

http://www.econbrowser.com/archives/2006/04/the_yield_curve.html

http://economistsview.typepad.com/economistsview/2008/02/accounting-for.html

http://economistsview.typepad.com/economistsview/2005/06/speculation_on_.html

http://economistsview.typepad.com/economistsview/2006/01/why_is_the_yiel.html

Though funding costs are high, there is ample demand at the long end of the market. The FT reports.

Indeed, the first plea of Joanne Segars, the NAPF chief executive in its pre-Budget submission was to ask that borrowing be tilted to the long end of the market where it can do the most to alleviate funding woes for pensions. Already, government issuance of 20-, 30- and 50-year debt has risen sharply. In the fiscal year ending April 2010, issuance of conventional long-dated gilts soared to £33.9bn from £23.4bn just two years earlier. Thirty-year yields have risen, too, from 4.09 per cent at September 30 2009 to 4.52 per cent as at March 31 2010

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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.

Sussex history

Sussex history and Charles 2.

Moral Hazard and selection

Mark Thoma puts together an excellent item on moral hazard and natural selection. The banks do not even have to believe that what they are doing is risky. So long as the most successful continue to rise and the relative failures throw in the towel, risk will increase. There is also a good point about the nature of beliefs and the way that they are only over-turned after sufficient weight of contrary evidence.