The Financial Services Authority of the UK has published an executive summary of a review carried out by its internal audit division into its supervision of Northern Rock. It has also published the recommendations of this review as well as a high level summary of the Supervisory Enhancement Programme that it has undertaken in response to the Internal Audit Report.
It is possible that the executive summary is a somewhat sanitized version of the report, but I did not find anything interesting in it. It is always possible to criticize the original supervisory process with the benefit of hindsight; the published summary does not to my mind rise above this to any clear evidence of supervisory lapses. Moreover if it is true that “the supervision of Northern Rock was at the extreme end of the spectrum within the firms reviewed in respect of these failings and that its supervision did not reflect the general practice of supervision of high-impact firms at the FSA,” then it does not make sense to embark on a major supervisory enhancement.
The decision that in future, “High-impact firms will be a key area of supervisory focus, regardless of probability of failure” is also a little puzzling to me. Impact and probability of failure should jointly guide the supervisory effort and the decision does not make sense unless it is believed that it is not possible to make a reliable assessment of the probability of failure.
Sun, 23 Mar 2008
It was perhaps pure coincidence but the timing was still delicious – just two days after the collapse and bail-out of the US investment bank, Bear Stearns, the Securities and Exchange Board of India announced that even institutional investors in the Indian stock market would have to pay margins to back their trades. SEBI was careful to say that the move was designed to create a level playing field since non institutional investors already pay margins. But the fact remains that the move will also make the market safer. Exchanges are designed to eliminate counter party risk by interposing a central counter party which relies on collateral instead of making assumptions about the solvency of its counter parties. Traditionally, it has been assumed that margins are needed only in derivative markets and not in cash markets that settle in a couple of days. The speed with which Bear Stearns collapsed suggests that this assumption is dubious. SEBI is right to margin all investors in the cash market as well.
Sat, 15 Mar 2008
Aleablog reports that the market is worried about the default risk of Warren Buffet’s Berkshire Hathaway – CDS spreads have widened from 20 basis points in November 2007 to almost 120 basis points in mid March 2008. I spent some time reading Buffet’s letter to shareholders as well as Berkshire Hathaway’s annual report for 2007.
What struck me was that Berkshire Hathaway is becoming more and more like a hedge fund than a mutual fund. The transformation has been gradual. In his 2002 annual report, Buffet famously declared that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”. He also wrote that “When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.”
What a difference five years makes! In the 2007 letter, Buffet writes that Berkshire had 94 derivatives that he managed himself (up from 62 the previous year). Buffet does not use derivatives for hedging – in his 2006 letter, he wrote that he buys derivatives when he thinks they are wildly mispriced. As at the end of 2007, Hathaway had derivatives positions with a notional value of about $50 billion. The biggest chunk of these ($35 billion notional) are written put options on equity indices. That reminds me of LTCM which too had written large amounts of put options on equity indices. Berkshire has sold credit protection for $5 billion of notional value of junk bonds – too small to remind me of the bond insurers. During the last few years, Berkshire has speculated on a wide range of currencies, though it has unwound most of them at a profit. That reminds me of George Soros.
There does appear to be a big difference between the big hedge funds and Berkshire – the absence of leverage. But, probe a little deeper, and even this is not so obvious. A large part of Bekshire’s investment portfolio comes out of the $59 billion float of its huge insurance business of which $46 billion comes from the reinsurance companies. Reinsurance is best thought of as written put options on non traded or illiquid assets.
Berkshire today is not the simple investment company that it was a decade ago. Today it is in the business of writing put options (financial derivatives and reinsurance) and investing the proceeds in stocks. What Buffet wrote about the activities of major banks in 2002 is gradually becoming true of Berkshire. Rising CDS premiums are perhaps not so surprising.
A report by the US President’s Working Group (PWG) on Financial Markets released on Thursday could well be the beginning of the end of credit rating. It says
Overseers should ensure that [institutional] investors (and their asset managers) develop an independent view of the risk characteristics of the instruments in their portfolios, rather than rely solely on credit ratings.
The PWG member agencies will reinforce steps taken by the CRAs through revisions to supervisory policy and regulation, including regulatory capital requirements that use ratings.
In a different context, the report also says that “U.S. authorities should encourage other supervisors of global firms to make complementary efforts to develop guidance along the same lines.”
There is therefore a serious possibility that global regulators would wean institutional investors away from the use of ratings and also reduce the regulatory role of ratings. If that were to happen, would the rating agencies survive only on the basis of retail investors relying on the ratings? I doubt that very much. Long ago when Eurobonds were bought by Belgian dentists, ratings were hardly influential. Bonds were bought on the basis of name recognition – companies like IBM, Coca Cola and Walt Disney could borrow easily because they and their products were well known.
It is true that when the rating agencies began life a century ago, they did not need a regulatory monopoly to prosper. But that was before Altman showed that creditworthiness could be easily measured using econometric models based on accounting information and before the Merton model showed that the stock price by itself provides adequate information.
Tue, 11 Mar 2008
The global turmoil of 2007-08 has been a crisis in slow motion that has allowed an astonishing amount of theory building and conceptualization to happen in real time even as the crisis is evolving. I think that the theorization is much greater both quantitatively and qualitiatively than what I saw during the Asian (and LTCM) crisis of 1997-98 which was also a crisis in slow motion. I have spend the last several days reading and digesting a part of the huge literature that has emerged. That explains why there have been no posts on my blog for a long time now. The sense that I get is that, at a deeper theoretical level, what has happened is not quite so puzzling though financial market participants find the crisis inexplicable.
I will not attempt to summarize all the excellent work that I have been reading – they all deserve to be read in full. I shall just provide the links:
- Leveraged Losses: Lessons from the Mortgage Market Meltdown by David Greenlaw, Jan Hatzius, Anil K Kashyap and Hyun Song Shin provides several alternative estimates of the aggregate losses from the mortgage market and reconciles the huge differences between what the ABX market is telling us and what vintage-by-vintage analysis suggests.
- The BIS Quarterly Review, March 2008 has several special articles related to the current turmoil. In particular, I would point to Credit fundamentals, ratings and value-at-risk: CDOs versus corporate exposures by Ingo Fender, Nikola Tarashev and Haibin Zhu
- The Banque de France has an entire Special issue on Liquidity in its Financial Stability Review of February 2008. My mind goes back to 1999 when the BIS Committee on Global Financial Stability produced a collection Market Liquidity: Research Findings and Selected Policy Implications in response to the LTCM crisis. It is indeed heartening to find that our theoretical understanding of liquidity is far superior to what it was then.
- The Senior Supervisors Group consisting of banking regulators from France, Germany, Switzerland, UK and US presented a report titled Observations on Risk Management Practices during the Recent Market Turbulence on March 6, 2008 to the Financial Stability Forum. This provides an insightful comparison of risk management practices in firms that were badly affected by the crisis and those that avoided severe problems. Since it is based on an indepth study of eleven of the largest banks and securities firms in the world and not any silly check-box ticking survey, the report is extremely valuable.
- Is the 2007 U.S. Sub-Prime Financial Crisis so Different? An International Historical Comparison" by Reinhart and Rogoff provides a much needed historical perspective on what is going on.
- I would also like to mention a paper that is a little older but highly relevant to what is going on today: Market Liquidity and Funding Liquidity by Markus K. Brunnermeier and Lasse Heje Pedersen.