Derivative Dribble

HIGHLY RECOMMENDED: Washington Post takes us inside AIG-FP (”If they give back the money, then they will walk. And they will walk into the arms of AIG’s counterparties.”)

My latest for The Atlantic

HIGHLY RECOMMENDED: This Blog

Tuesday March 17, 2009

Fortune does a good job getting the facts straight about CDS

Friday March 13, 2009

Berkshire downgraded by Fitch

Thursday March 12, 2009

Gates back on top as crisis wipes out other billionaires

Monday March 9, 2009

Hilarious

Friday March 6, 2009

Alpha Ville on the ocean of looming corporate defaults

Thursday March 5. 2009

Citi drops below $1

My latest for the Atlantic

Wednesday March 4, 2009

FDIC might go insolvent

Tuesday March 3, 2009

Derivatives market remains profitable business for J.P. Morgan

Very interesting data on the multiplier effect from the CBO

Tuesday February 24, 2009

My latest article for the Atlantic

Monday February 23, 2009

FT on the prospect of a depression in Spain

Rick Santelli rouses traders over Obama’s housing plan

Sunday February 22, 2009

Citi in talks with U.S. Government over common equity stake

Thursday February 19, 2009

Must read: Buiter rips apart Obama’s housing plan

Saturday February 14, 2009

Collective decision making in animals and humans

Thursday February 12, 2009

New York edges closer to expanding rent control

Wednesday February 11, 2009

Rep. Kanjorski tells us how close to the edge we were

Treasury’s 6 and a half page plan to save the world

Tuesday February 10, 2009

Great article by the FT’s John Authers on the prospects of an equity bounce-back

Friday February 5, 2009

U.S. cuts almost 600,000 jobs

Wednesday February 4, 2009

My latest article for the Atlantic Business Channel

Tuesday February 3, 2009

E.U. pushes CDS exchange

Monday February 2, 2009

For my fellow music lovers: Classic Arts Showcase on YouTube

Consumers turn to thrift

Unemployment hits China

S&P says 200 defaults expected

Thursday January 30, 2009

Crash like this expected only once over next 34,000 years

Contraction bad, but better than expected

Wednesday January 28, 2009

John Authors on the perception of a bargain

Capacity drops in France and Italy

World growth worst in 60 years

Tuesday January 27, 2009

Japanese CDS spreads widen

The original Carlo Ponzi

Madoff Jr. gets busted in $400 million Ponzi scheme

Great article from Atlantic’s new business section

Monday January 26, 2009

Iceland’s government tumbles under pressure

Unemployment rate looms over banking sector

Redemptions slam hedge funds

Wednesday January 23, 2009

Obama thinks stimulus package could be ready mid February

Muni derivatives under investigation

Cocoa prices on the move

Very interesting John Authers video on the prospect of a slow down in China

Pope goes digital

U.K. officially in a recession

Wednesday January 22, 2009

Google beats the heard

N.Y. Times provides some perspective on the severity of the crisis

U.S. accuses China of currency manipulation

Tuesday January 21, 2009

Bank market capitalization, then and now

John Authers article and video on the second wave of banking turmoil

Black Rock’s profits plummet

Monday January 20, 2009

Obama sworn in

Reality might be a hologram

Banking crisis part II?

Thursday January 15, 2009

Volatility back on the rise

California to go insolvent in weeks

Big numbers for foreclosures in 2008

The wealthy slammed by the down turn

Testosterone and income

Roubini predicts more gloom

Bank stocks plummet

Mortgage rates hit record low

Wednesday January 14, 2009

Credit markets show signs of life despite rest of world

Martin Wolf takes on Obama’s stimulus package

CDS market predicts bleak future for sovereigns

Greece downgraded

Retail takes a nose dive

Banks need bigger TARP

Tuesday January 13, 2009

Citi gets closer to break up

Still no Russian gas flowing into E.U.

Pension funds hammered, seek Federal money

Release of TARP funds faces stiff opposition

U.S. imports plummet

Bernanke says fiscal measures not enough

Monday January 12, 2009

John Authers takes a look at sovereign default and the Euro

Proprietary trading winding down

Banks suspected in facilitating purchase of weapons for Iran

Barney Frank proposes drastic changes to TARP and Hope For Homeowners Act (a summary of the bill and the actual text can be found here)

A look at China

Sovereign downgrades looming

Friday January 9, 2009

Cash flowing back to emerging markets

No exit

Obama puts pressure on Congress over stimulus package

Congress points fingers at Treasury over TARP

Thursday January 8, 2009

Citi supports bankruptcy law reform

Very interesting article on government bonds

Dismal retail figures

Wednesday January 7, 2009

Gas supply to Europe cut

BofA finally sells stake in Chinese Bank

Rough month for employment

A closer look at Larry Summers

German bond auction fails: bad sign for sovereigns

Tuesday January 6, 2009

Pending home sales drop to record lows

Oil picks up steam

Monday January 5, 2009

Dim lights ahead

A bit of unexpected historical perspective on the credit crisis

Wednesday December 31, 2008

John Authers constructs a timeline of the disasters of 2008

Steepest drop ever for commodities

Muni market dries up as states face looming budget gaps

A brief history of numbers

Paulson says U.S. lacked tools to handle crisis

Tuesday December 30, 2008

Good series of video interviews of Roubini

All about numbers

U.S. home prices plummet 18%

Automakers consider change to supply model to prevent supply-side failures

The economics of climate change

Monday December 29, 2008

Retail bankruptcies and store closings on the rise

Corporate profits likely to continue losing streak

Conventional media outlets seek partnership with internet big wigs

John Authers sees gloomy future for equities

High hopes and big numbers

Tuesday December 23, 2008

U. Chicago points fingers at the bailout

Interactive applet rating financial big wigs

Monday December 22, 2008

Pound sinks to record low against basket of currencies

Toyota predicts first loss ever

Oil continues to slide despite OPEC cuts

Friday December 19, 2008

Mortgage interest rates drop

China blocks sale of assets

Sarkozy forces lending

Early Christmas for automakers

Thursday December 18, 2008

Gather ye rosebuds while ye may

Mining sector calls for unprecedented cut backs

Obama taps new SEC chief

Wednesday December 17, 2008

Tis dangerous on the high seas!

Deflation hits E.U.

Thrifty Texan to buy up banks

Public perception dims

More monoline madness

Tuesday December 16, 2008

Up to your ears

Free money!

Monday December 15, 2008

The long arm of Madoff

Derivative Dribble spots economic news faster than the MSM

Friday December 12, 2008

Bifurcation of the debt markets

Goldman predicts slow recovery for oil

California gets downgraded

The story of 2008

The ever entertaining Jim Rogers

India gets roped into the slow down

Senate puts the brakes on the Big 3

Thursday December 11, 2008

When fiat fails

It was a very bad year

This time the floor is falling

Wednesday December 10, 2008

The beginning of a market for toxic instruments?

Deflationary pressure in China?

Costly advice

John Authers looks back

Tuesday December 9, 2008

The title speaks for itself

Russia walks the sovereign plank: debt downgraded

OTC commodities central clearing house ready for launch

Corporate default rates set to rise

Monday December 8, 2008

BREAKING NEWS: Federal legislation proposed to regulate OTC Market

The invisible hand and the sovereign strangle

Video game nerds prove recession proof

Friday December 5, 2008

Economics at ground level

More truly awful news, this time it’s California

Distraction from all the bad news

Thursday December 4, 2008

Black Friday yields red November for retail

China Investment Corp won’t invest in U.S. financial institutions

$25 Oil

Wednesday December 3, 2008

CDS Index hits record level

Some rather awful news

Great explanation of Money Markets

Real yield on Treasuries dip into negative territory

Tuesday December 2, 2008

Bigger than the bail out

The ever increasing interest in CDS

Paulson v. Paulson

Monday December 1, 2008

BRIC nations to offer consumption through downturn

U.S. officially in recession

The Swiss financial throne under siege

Wednesday November 26, 2008

Banker’s Compensation

The space near zero

Shift from OTC to exchanges gains more momentum

Ship while you can

Tuesday November 25, 2008

The science of petty crime

New lending facility for instruments backed by consumer debt

Monday Novemer 24, 2008

Treasury pony’s up huge money

Buffett discloses info on Berkshire’s portfolio of financial weapons of mass destruction

More historical data on declines

Daily Liquidation

Citi gets early Christmas present and Paulson works another weekend

Friday November 21, 2008

Goldman predicts bleak outlook for U.S. Economy

One way ticket to safety

Thursday November 20, 2008

Slightly cooler heads in Iceland after IMF/Nordic bailout

The CDS Market becomes the new economic indicator

I’ve seen more and more of this type of analysis. The CDS market is becoming more and more relevant as an economic indicator. Keep up the good work Alpha Ville!

Inventories Swell Kudos to Naked Capitalism!

Following the money supply

Wednesday November 19, 2008

More monoline downgrades

CDS markets predict bleak future

CDS clearing house seems likely

Tuesday November 18, 2008

Detroit gets coals for Christmas

Fun with economic data

Japan wins economic beauty contest

Historical perspective on volatility

CIA Factbook v2

Monday November 17, 2008

Highly recommended: Interviews with Jim Rogers

The dangers of subjective valuation

Good article, even though I disagree

New York City real estate falls from grace

Greetings from Earth!

Citibank throws garage sale

Japan in technical recession

Friday November 14, 2008

FDIC to insure home mortgages

Eurozone in technical recession

Pensioners driven to theft

Thursday November 13, 2008

More complex than a synthetic CDO

Derivative Dribble considers asking Fed for money

Germany in technical recession

Greenwich points to Wall Street

Would be CDS regulator vindicated (?)

Paulson pulls the TARP from under the market

Pounded

In The Shadows Of Geometry

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Understanding Obama’s Financial Overhaul

In Uncategorized on June 29, 2009 at 7:45 am

Also published on the Atlantic Monthly’s Business Channel.

Joe Nocera has said his peace with respect to Obama’s proposed overhaul of the financial system. And in doing so, he expressed disappointment with several aspects of the proposal. In particular, he is displeased that the proposal “doesn’t attempt to diminish the use of … bespoke derivatives.” That certainly sounds ominous. But it’s also not true.

The proposal calls for increased capital charges on bespoke trades, which is a strong incentive away from them. But frankly, I’m sick of writing about the proposal. So rather than regurgitate and parse the administration’s plans for financial regulation, I’d like to take a moment to get familiar with some of the key concepts at play in the proposal, so that you can read it and come to your own conclusions. The two core areas I focus on here are derivatives and regulatory capital. With an understanding of these two areas, you should be able to get a grasp on what the administration is thinking and what effects the proposal will have in practice.

OTC Derivatives

I write about OTC derivatives pretty often, so rather than reinvent the wheel, I’ll shamelessly reuse a piece of introductory text I have handy:

A derivative is a contract that derives its value by reference to “something else.” That something else can be pretty much anything that can be objectively observed and measured. That said, when people talk about derivatives, the “something else” is usually an index, rate, or security. For example, an option to purchase common stock is a fairly well-known and ubiquitous derivative. So are futures for commodities such as pork belly and oil. However, these are not the kind of derivatives that [the proposal] is talking about. [The proposal] is talking about OTC derivatives, or “over the counter” derivatives. This category of derivatives includes the much maligned “credit default swap” market, as well as other larger but apparently less notorious markets, such as the interest rate and foreign exchange derivatives markets. The key defining characteristic of an OTC derivative is that it is entered into directly between the parties. This is in contrast to exchange-traded derivatives, such as options to purchase common stock. Highly bespoke OTC derivatives are often negotiated at length between the parties and involve a great deal of collaboration between bankers, lawyers, and other consultants. For other, more standardized OTC contracts, commonly referred to as “plain vanilla trades”, contracts can be entered into on a much more rapid and informal basis, e.g., via email.

For the limited purpose of wrapping your head around the world of derivatives, think of all derivatives as being in one of three broad categories: (1) exchange-traded derivatives (e.g., options on common stock and futures on pork belly); (2) standardized OTC contracts (e.g., your basic credit default swap); and (3) bespoke OTC contracts (transaction specific, often more complex instruments).

In fairness to Nocera, he’s not the only one weary of the third category of bespoke derivatives. But that doesn’t make his fears justified. So why do firms use custom made derivatives instead of just settling for an exchange traded derivative or a standardized swap? Despite uninformed opinions to the contrary, there are a lot of legitimate reasons for using custom derivatives. The most basic reason is what’s known as basis risk. The term refers to the risk that the difference between two rates will change. In the context of OTC derivatives, it usually refers to the risk that a hedge is imperfect. For example, a commodity user, like an airline, would like to lock in the price of jet fuel delivered to a terminal near an airport in northern California. However, the only exchange traded futures contracts available track the price of delivery to the Gulf Coast. While we would expect these two rates – the price of delivery to CA and the price of delivery to the Gulf Coast – to be correlated, there are all kinds of events, e.g., supply disruptions, that can affect one price without affecting the other. As such, using an exchange traded future would expose the airline to basis risk. By using a customized product, the airline can more perfectly hedge its exposure to the price of local fuel.

At this point, most of the bozo pundits would say, “just move all the customized trades onto an exchange!” That’s a fine idea, but it has the unfortunate feature of being impossible. In order to have an exchange, you need a lot of liquidity, or simply put, a lot of people trading perfectly fungible assets. The reason you need perfectly fungible assets is that it allows buyers and sellers to be matched on a rapid basis without any communication between them. Without a lot of people trading perfectly fungible assets, you don’t have a market where you can easily buy a new position or sell your current position, and therefore, you cannot have an exchange. Because bespoke derivatives are often one-off deals, hedging extremely specific risks, there is no market where they can be traded, for the simple reason that they are all unique and only useful to the parties to the original transaction. And so, bespoke derivatives are useful products that cannot always be substituted with exchange traded or standardized OTC products.

What Is Regulatory Capital?

There’s a lot of talk about regulatory capital in Obama’s proposal. So what is regulatory capital? In short, it has to do with how banks finance their operations. Banks are businesses. And like all businesses, they have investors that contribute money to the business. In the parlance of banking regulation, the money that investors contribute is called capital. This capital can come in various forms, despite the fact that it’s all cash. The form of the capital is determined by what the investor expects in return for his capital contribution. For example, equity capital comes from investors who expect to share in the profits of the bank. That is, after all of the bank’s expenses and debts are paid, the equity investors get their share of what, if anything, is left over. Capital could also come in the form of debt. The bank’s debt investors, commonly referred to as creditors, expect regular payments in return for their investment, regardless of whether or not the bank generates a profit. As such, they get paid before any of the equity investors get paid. Because of this, we say that debt is higher in the capital structure of a bank than equity. But of course, life is a lot more complicated than simple debt and equity. And so, banks make use of a broad range of financing that falls in different places along a continuum from pure senior debt (the top of the capital structure) to pure subordinated equity. As money gets generated by the bank’s activities, that money gets pushed down the bank’s capital structure, paying investors off in order of seniority.

In the magical world of academia, capital structure isn’t supposed to matter much. But as Michael Milken reminds us, in the real world, capital structure matters, a lot. Firms that finance their activities with a lot of debt will have high fixed obligations, since creditors don’t care if you make a profit or not. They invested on terms that assured them payment, come hell or high water. And while they might not be as intimidating as the Goodfellas, creditors have a lot of power over firms that fail to pay their debts. These powers range from seizing assets pledged as collateral to forcing bankruptcy upon the firm. Obviously, these kinds of events are disruptive to a firm’s business activities. And as this crisis has taught us, the business activities of banks are pretty important. Fully aware of this, the world developed what are known as regulatory capital requirements. What these requirements do is place restrictions on the capital structure of banks based on the riskiness of the bank’s activities. As you would expect, the rules that implement these restrictions are very complicated. But the general idea is fairly intuitive: as the riskiness of the bank’s activities increases, the bulk of the bank’s financing should move down the capital structure, towards equity. This makes sense, since a bank that is running a high risk operation shouldn’t be promising too many people regular income, since by definition, their cash flows are unstable. As such, a high risk bank should make greater use of equity, since equity investors only expect their share of the profits, if and when they appear.

Most of the developed world has adopted some version of the bank capital regulations known as the Basel Accords, written by the Bank For International Settlements. Under the Basel rules, assets are assigned a weight, which is determined by the asset’s riskiness. “No risk” assets, such as short term U.S. Treasuries, are assigned a weight of 0%. High risk assets can have weights over 100%. The rules then look to the capital of the bank and break it up into three Tiers: Tier 1, Tier 2, and Tier 3. Tier 1 is comprised of pure equity and retained earnings, the absolute bottom of the capital structure; Tier 2 is comprised of financing that’s almost equity, or just above Tier 1 in the capital structure; and Tier 3 is comprised of short term subordinated debt, or the lowest part of the capital structure that can be fairly characterized as debt. Anything above Tier 3 doesn’t count as capital for the purposes of the rules.

When a bank buys an asset, they are generally required to assign a capital charge to that asset equal to 8% of the value of the asset multiplied by its risk weight. Half of the capital they set aside must come from Tier 1. So for a $100 loan with a risk weight of 50%, the bank that issued or bought the loan would need to set aside 8% x 50% x $100 = 8% x $50 = $4 worth of regulatory capital, at least half of which must come from Tier 1.

So regulatory capital requirements are a matching game between a firm’s assets and its capital structure. The more capital a firm has to set aside to purchase an asset, the fewer assets it can purchase. This means that heightened regulatory capital requirements will restrict a firm’s ability to generate returns on its capital. Well aware of this, Obama’s proposal uses regulatory capital as a tool to push firms away from certain practices. For example, as mentioned above, the proposal calls for increasing the capital charge for bespoke trades. It also threatens firms that are “too big to fail” with the spectre of overall heightened capital requirements. While Nocera thinks this is an empty threat, not everyone is so confident. But in any case, go read it yourself, at least the summary, and come to your own conclusions.

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The Shadow Banking System That Operated In Broad Daylight: Part I

In Uncategorized on June 22, 2009 at 9:49 pm

Also published on the Atlantic Monthly’s Business Channel.

Mark Thoma and Brad Delong are completely entrenched into the position that this crisis was brought on by the nefarious “shadow banking system.” In fairness to Thoma, he is trying quite sincerely to argue his point, and I think my disagreement with him stems mostly from my objection to labeling particular aspects of the financial system as “shadow banking.” That said, I do take issue with a few of his substantive points. Rortybomb does a fine job summarizing the recent history of this debate, highlights some of the strengths of Thoma’s position, and also clarifies the debate by providing a reasonable framework for what it is that people are referring to when they talk about the “shadow banking system.”

As for Delong, his argument takes the form of an excursion through unmitigated nonsense, as he boasts his deep knowledge of comic books, and little else. As such, in this post, I’ll begin with Delong’s argument, since it is completely unfounded. In the next post, I’ll take on Thoma’s position, as it warrants more attention and represents an opinion held by a lot of intelligent people. I just happen to disagree.

So here goes Delong:

[C]ommercial banks–with their massive retail savings deposits–have for the most part come through this all right. In fact, the possession of lots of inertial commercial savings and checking deposits that they did not have to worry might flee provided JPMorgan (with the retail banking assets of Chase) and the bank formerly known as NationsBank (with the retail banking assets of Bank of America) with competitive advantages that allowed them to pick up the assets of Bear Stearns and Merrill Lynch at what they thought were bargain prices.

Wow, those are some seriously important-sounding terms there. We’ve got “massive retail savings deposits,” “competitive advantages,” and don’t forget those “inertial commercial savings and checking deposits.” How could deposit taking banks fail with all that going for them? Surely, deposit taking banks are doing swell! And, they are, with the noted exception of the seemingly endless list of failures that have occurred at deposit taking banks over the last 2 years. But there are even more inconvenient aspects of the observable universe that Delong must tackle before we can accept his deposits-cure-all theory of banking. For example, U.S. banks and bank holding companies are currently receiving all kinds of direct and indirect support from the U.S. government through the alphabet soup of liquidity and guarantee programs that have been set up since the crisis got underway. Also, it is my understanding that European banks, while more leveraged than their U.S. counterparts, rely much more on deposits than U.S. banks do. Yet, the European banking system is suffering a crisis that rivals our own by several measures.

Delong’s position seems to be just another manifestation of the idea that, somehow, good old fashioned banking is the answer. Deposits and lending, and that’s it. None of this fancy stuff. That has a nice ring to it. It’s sentimental, makes us think that our parents are smarter than us, and it has an almost sanctimonious aspect to it, in that it suggests that if we part with some of the more luxurious aspects of finance, we can have some more stability. However, history has a few counterexamples to this position, one being the Great Depression.

While others chalk this crisis up to SIVs, CDOs, and a bunch of other acronyms they really don’t understand, I see it in much simpler terms: banks, and others in the financial system, all made the same bad bet based on unsustainable assumptions. Sure, some of them made this bet using sophisticated means, and that itself is a topic worth exploring. But the root cause of all of this, in my opinion, is underestimating risk. This underestimating had heavy assistance from some very regulated entities and markets. As such, I reject the argument that the “shadow banking system” caused this crisis for two reasons: first, everyone that mattered and could do something about what was going on knew full well what was going on. So how is it productive to ascribe such a mysterious sounding name to something that people were fully aware of? And second, the root cause of this crisis is, in my opinion, much easier to grasp once we reduce all of the complexities to simpler constructs, and think in terms of what risks entities and markets were exposed to, and for that limited purpose, ignore the means by which they were exposed to those risks.

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Charles Davì

Derivative Dribble

Truly Derivative Dribble

Understanding Obama’s Financial Overhaul

The Shadow Banking System That Operated In Broad Daylight: Part I

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