Category: Interesting External Papers

Interesting External Papers

IIAC Releases Canadian Fixed Income Calculation Conventions

I only just noticed this two-week-old press release from the Investment Industry Association of Canada, but it’s a good one and long overdue!

Setting out the practices and formulas currently used for the calculation of prices, interest payments and yields on securities traded in the Canadian fixed income markets, the publication is a single comprehensive reference of conventions commonly used for bond valuations in Canada. It is available for free on http://www.iiac.ca.

Those who have suffered through endlessly repetitive disputes about the difference between “Annualized Internal Rate of Return” and “Yield to Maturity” in the posts Modified Duration and Yield from On-Line Calculator will be highly relieved to find an authoritative source for the conventions!

Interesting External Papers

Banks & Subordinated Debt

I ran across an interesting story today on the Cleveland Fed website: Credit Spreads and Subordinated Debt by by Joseph G. Haubrich and James B. Thomson.

Subordinated debt may be counted as part of Tier 2 capital by the banks, where it is senior to preferred shares (and everything else that’s in Tier 1) but junior to deposits.

One proposed means of injecting more market discipline into the banking sector is a subordinated debt requirement. It would compel banks to issue some debt that the government does not guarantee and that is paid off only after all depositors have been satisfied. A mandatory subordinated debt requirement was one of the reforms recommended in a 1986 study commissioned by the American Bankers Association. In addition, the Financial Modernization Act of 1999 requires that large banking companies have outstanding, at all times, at least one (though not necessarily a subordinated) debt issue rated by a commercial credit-rating agency.

Some experts argue that subordinated debt is unnecessary because equity capital already gives depositors and other bank creditors a layer of protection. But banks’ equity—that is, their stock—rises when their profits increase, so the prospect of higher equity can encourage them to take greater risks. Debt is more sensitive than equity to the loss aspect of risk because it lacks the upside inducement of higher profits. Subordinated debt thus gives a bank’s depositors and general creditors the same protection from losses as equity does, without creating the incentive to assume more risk.
…
Evidence on credit spreads and credit spread curves suggests that these sources of information could one day become useful to bank regulatory agencies. At this time, however, the evidence is too weak to justify imposing a mandatory subordinated debt requirement, especially if its purpose is to increase market discipline on banking companies and give bank supervisors better information about banks’ changing conditions. Before supervisors add credit spreads from subordinated debt to their dashboard of early warning signals of deteriorating bank conditions, much more work must be done on extracting useful, reliable risk indicators. So, despite some encouraging results, we need considerably more evidence on the value of credit spread information to regulators and markets before deciding to impose any new rule on how banks fund themselves.

By way of example, Royal Bank’s 2006 Annual Report shows $21.5-billion in Tier 1 Capital and $8.6-billion in Tier 2 Capital; the latter figure includes $7.1-billion in sub-debt.

Update, 2007-11-22: OFHEO is attempting to use sub-debt as a control feature on the GSEs, but it isn’t working out very well:

Those tests show that the market behavior of sub debt yields has changed as negative information has emerged about the Enterprises’ management and risks. However, the nature of the change has been to link sub debt yields more closely to Treasuries. That paradoxical development is consistent with investors having greater confidence that Fannie Mae and Freddie Mac or their federal regulator would reduce the Enterprises’ default risks, with greater liquidity in the Enterprise sub debt market in recent years, or with greater confidence in the value of the implicit federal guarantee associated with Enterprise debt.

Interesting External Papers

Where Did the Risk Go? – An Early Attack on the Ratings Agencies

I’ve run across an extremely interesting paper, Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions, written by Joseph R. Mason, an associate professor at Drexel University who has been mentioned here before in connection with his testimony to Congress, and Joshua Rosner, Managing Director of Graham Fisher & Company, a firm that provides “Independent research for institutional investors in financial service assets”.

The primary recommendation for public policy is:

Significant increases in public access to performance reports, CDO and RMBS product standardization, and CDO and RMBS securities ownership registration can help decrease the existing over-reliance on ratings agency inputs to rate and ultimately value the securities and reducing the valuation errors inherent in “marked-to-model” (rather than marked-to-market) portfolios. SEC Regulation AB was a (late) start for ABS and RMBS. Overall, however, the U.S. economy needs an efficient public CDO market that allows transparent openmarket pricing of market risk and outside research into new securities and funding arrangements.

This is a principle with which I can whole-heartedly agree … although I will not guarantee  sweet accord when the details are hammered out! There should be no regulatory restrictions on the flow of information … it should be possible to publish all deal information without fear of adverse regulatory repercussions, but there is often some confusion on this point. The regulators should first make it plain that, while selling the investment to a non-qualified investor may be improper, publishing the advice is encouraged.

After that, let the market and the Prudent Man Rule do its work. I think it would be fairly easy to argue that a Prudent Man would review available information prior to making an investment. At which point we get into further problems … how much review is enough?

Consider a plain and ordinary S&P 500 Index Fund. How much of the fund material do you have to read before you can purchase some on behalf of a client? Do you have to read through and understand the annual reports of all 500 companies?

I suggest that the archetypal Prudent Man need only

  • understand what the S&P 500 is attempting to do, and
  • verify that the vehicle will track it ‘reasonably’ well, and
  • do so at a realistic cost

… but there will be legitimate disagreement over even this simple exposition! My continued vocal support for the primacy of the Prudent Man Rule should not be taken to imply that I believe it will be simple and unambiguous.

Interesting External Papers

Banks Advantage in Hedging Liquidity Risk

It has taken me far too long to find this reference! Therefore, I am re-posting under the Interesting External Papers classification the following (very slightly edited) comments from September 14!

Cushioning fear-driven liquidity shocks is the banks’ bread and butter:

This paper argues that banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP spreads increase, banks experience funding inflows. These flows allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings of liquid assets. Using bank-level data, we provide evidence that implicit government support for banks during crises explains the funding flows.

From the same paper, incidentally:

Banks’ functioning as liquidity insurance providers originated early in the development of the commercial paper market. In 1970, Penn Central Transportation Company filed for bankruptcy with more than $80 million in commercial paper outstanding. As a result of their default, investors lost confidence in other large commercial paper issuers, making it difficult for some of these firms to refinance their paper as it matured. The Federal Reserve responded to the Penn Central crisis by lending aggressively to banks through the discount window and encouraging them, in turn, to provide liquidity to their large borrowers (Kane, 1974). In response to this difficulty, commercial paper issuers thereafter began purchasing backup lines of credit from banks to insure against future funding disruptions (Saidenberg and Strahan, 1999).

Interesting External Papers

Loan Default Correlation

This post was originally intended to be part of the report of the BoE Financial Stability Report … but it got too interesting and too long! So here it is … an introduction to Loan Default Correlation:

Box 2 of the report, Valuing sub-prime RMBS, provides a primer on the pricing of loan pools. Of great importance is the correlation of the default probability … we might say, for instance, that a sub-prime borrower has a 15% chance of defaulting and be perfectly correct, as far as that goes. It would be a mistake to construct detailed probability charts of default proportion within the pool, however, because this 15% default probability is not an asystemic risk that can be diversified away – there is a great deal of systemic risk in the pool.

For instance, while 5% of the total 15% default probability might be due to factors unique to the individual borrower – he loses his job, or gets sick or whatever – 10% of the total might be a response to broader factors that will affect the entire pool in much the same way – an economic depression causes unemployment to rise sharply, a pandemic makes everybody get sick, or whatever.

Thus, correlation must be estimated. The Bank reports:

Scenario C is the same as Scenario B except that it also has a higher rate of default correlation. As Chart A shows, this increases the chance of extreme outcomes, raising the price of the BBB tranche and reducing the price of the AAA tranche.

Comparing Table 1 with Chart 1.9 suggests that expectations about both default rates and correlations may have increased during July and early August, as the prices of both junior and senior RMBS tranches fell sharply. Views about default correlation may subsequently have been revised down, however, with prices of senior tranches recovering while the prices of junior tranches have continued to fall.

The correlation of 5% used for their base-case and for their scenarios A and B is consistent with research presented to a Fed Conference by Cowan & Cowan; scenario C increased the correlation to 15%. The Cowan & Cowan reports states:

This paper presents the first formal study of default correlation within a subprime mortgage loan portfolio. We find generally that default correlations for the specific portfolio studied are insignificant until the portfolio is segregated into appropriate risk groups. We analyze six month default correlation using both actual default (foreclosure) and a more broad definition of delinquency which is consistent with previous literature. Contrary to our expectations, actual defaults generally result in higher default correlations than delinquencies. As anticipated, the magnitude of default correlation increases as the internally assigned risk grade declines.

Briefly reviewing the results from actual defaults, we obtain a six month default correlation of 6.2% for CC-rated borrowers as compared with a miniscule 0.1% for AArated borrowers. If loans are grouped by occupancy type, the default correlation increases to 8.7% for second home loans and 2.6% for non-owner occupied homes. In contrast, classification by property type results in a maximum default correlation of 4.6% for multi-unit properties.

If default correlations are very low within subprime portfolios, then an expensive investigation of default correlations is not an efficient use of resources. However, our findings, combined with the findings of Loffler (2003) that lower grade portfolios are more sensitive to changes in default correlations, suggest that the industry needs to focus on this issue. Although it represents but one lender, it clearly provides sufficient insight to suggest a direction for further investigation. If, as Carey (2000) suggests, bad tail loss rates are understated by estimating portfolio loss distributions by equally weighting events in each database year, then our results should compel both subprime lenders and regulators to further investigate the impact of default correlation.

Interesting External Papers

Senate Hearings : The Empire Strikes Back

See? Accrued Interest isn’t the only blog in the world that can use Star Wars titles.

Following the last testimony reported here, that of Dr. Lawrence J. White, Moody’s stepped up to the plate. The testimony has been published by the Senate committee.

They first reviewed the process, including one very critical element:

It is important to note that, in the course of rating a transaction, we do not see individual loan files or information identifying borrowers or specific properties. Rather, we receive only the aforementioned credit characteristics provided by the originator or the investment bank. The originators of the loans and underwriters of the securities also make representations and warranties to the trust for the benefit of investors in every transaction. While these representations and warranties will vary somewhat from transaction to transaction, they typically stipulate that, prior to the closing date, all requirements of federal, state or local laws regarding the origination of the loans have been satisfied, including those requirements relating to: usury, truth in lending, real estate settlement procedures, predatory and abusive lending, consumer credit protection, equal credit opportunity, and fair housing or disclosure. It should be noted that the accuracy of information disclosed by originators and underwriters in connection with each transaction is subject to federal securities laws and regulations requiring accurate disclosure. Underwriters, as well as legal advisers and accountants who participate in that disclosure, may be subject to civil and criminal penalties in the event of misrepresentations. Consequently, Moody’s has historically relied on these representations and warranties and we would not rate a security unless the originator or the investment bank had made representations and warranties such as those discussed above.

They also make the point that the 2002-2005 vintages of Residential Mortgage Backed Securities (RMBS; “vintage” refers to the date the mortgage was given) are performing at or above expectations; it’s the 2006 vintage that is creating headaches. The following data is extracted from their figure 2:

Downgrade / Upgrade Percentage By Vintage (By Rated Original Balance)
  Subprime
Vintage Downgrade Upgrade
2002 2.3% 2.0%
2003 1.1% 2.7%
2004 0.3% 0.2%
2005 0.5% 0.3%
2006 5.4% 0%
2002-2006 2.2% 0.6%

Moody’s categorized their response to an observed deterioration in sub-prime portfolios as follows:

  • We began warning the market starting in 2003
  • We tightened our ratings criteria
  • We took rating actions as soon as the data warranted it:As illustrated by Figure 3, the earliest loan delinquency data for the 2006 mortgage loan vintage was largely in line with the performance observed during 2000 and 2001, at the time of the last U.S. real estate recession. Thus, the loan delinquency data we had in January 2007 was generally consistent with the higher loss expectations that we had already anticipated. As soon as the more significant collateral deterioration in the 2006 vintage became evident in May and June 2007, we took prompt and deliberate action on those transactions with significantly heightened risk.

Note that the first two points are also elucidated; I’m just highlighting their third point.

Their Figure 5 provides some detail that I’ve been trying to find for a while. Readers will remember the decomposition of the Bear Stearns ABS 2005-1 in this blog, and know that the highest rated tranche is the biggest, while the smaller tranches are relatively small. The tranches On Review or Downgraded (First & Second Lien Transactions combined) comprise 15.9% of the total by number, but only 5.4% by dollar value.

And, finally, they get to their actions to address the problems and their recommendations for others. Moody’s initiatives are:

  • Enhancements to analytical methodologies
  • Continued investments in analytical capabilities
  • Changes to credit policy function (this means increased separation of the reporting channels between the sales and ratings departments)
  • Additional market education
  • Development of new tools beyond credit ratings

I am sure they mean well by their last two points, but they won’t work. The market does not want to be educated and the market does not want any more detail – the reaction to their change in bank rating methodology proves that.

What does the market want? The market wants a very simple methodology so it can claim to have done a due-diligence without wasting more than five minutes on investment crap and someone to blame when something goes wrong, that’s what the market wants.

Moody’s recommendations for policies outside its control are:

  • Licensing or other oversight of mortgage brokers
  • Greater disclosure of additional information by borrowers and lenders
  • Tightening due diligence standards for underwriters
  • Stronger representations and warranties
  • Increased disclosure from issuers and servicers on the individual loans in a pool
  • Increasing transparency (in structured products)

Not very much, perhaps, but not very much change is needed.

Interesting External Papers

The Panic of 1907

I recently became embroiled in a discussion of the recent Fed Rate cut, in which a casual mention of J.P.Morgan and his role in resolving the Panic of 1907 became a surprisingly controversial issue.

I might put together a short piece at some point regarding the Panic – until then I will content myself with listing references:

Panic of 1907, Federal Reserve Bank of Boston

Tallman & Moen, 2007, Role of Clearinghouse Certificates

Moen & Tallman, 1999 Differentiation of 1907 Panic from others

Moen & Tallman, 1995, Comparison of New York vs. Chicago Clearinghouses in 1907

Wall Street, A History, Charles R. Geisst 1997, ISBN 0-19-511512-0

Update, 2007-10-15:

Tallman & Moen, 1990, Lessons from the Panic of 1907

The Panic of 1907: Lessons Learned from the Market’s Perfect Storm, R.F.Bruner & Sean D. Carr, ISBN 978-0-470-15263-8

Theodore Roosevelt (1858–1919).  An Autobiography.  1913. (Appendix A deals with the US Steel takeover of Tennessee Coal & Iron, which apparently became a political football).

Update, 2007-10-16:

Football indeed! Richard Jensen claims:

In October 1911, Taft’s Justice Department charged US Steel with antitrust violations in the TCI deal–leaving TR’s integrity under a cloud. That was the last straw for Roosevelt, as he decided to challenge Taft for the Republican nomination for president.

Update, 2010-7-6: Mr Joseph S Tracy, Executive Vice President of the Federal Reserve Bank of
New York, suggests that the Credit Crunch be referred to as the “Panic of 2007”, given all the similarities in the trigger.

Interesting External Papers

Stress Testing of Australian Banks: Housing Implosion

With all the news that Bernanke is a quant, I had a look at a paper presented in 2005 with data from 2003 titled Stress Testing Housing Loan Portfolios: A Regulatory Case Study:

Against the backdrop of sharply rising house prices and Central Bank warnings that housing credit growth was not sustainable, the Australian Prudential Regulation Authority (APRA) conducted a “stress test” to gauge the resilience of 120 Australian banks, building societies and credit unions to a substantial correction in the housing market. The stress test scenario mapped a 30 per cent fall in house prices to a substantial increase in default and loss rates. The results showed that all 120 institutions would remain solvent under the imposed conditions, however 11 institutions’ capital ratios fell below their regulatory minima. This paper details the stress testing methodology and traces through the various stages of the project, from background research, to stress test design, implementation, supervisory follow-up, public dissemination of the results and resulting policy changes.

The regulators are no more perfect than the credit rating agencies; models can always be improved; averages don’t mean much if you’re investing at the margins; and the world is always changing. But it is through such constant study and disaster simulation that the world is a much less exciting place than the newspapers would have us believe.

Update, 2007-10-23: It is interesting to note reports that:

Standard & Poor’s may cut the credit ratings of 207 Australian and New Zealand residential mortgage- backed securities while it examines the creditworthiness of the insurer of the underlying home loans.

S&P said Oct. 19 it may lower the credit rating of PMI Group Inc., and its Australian unit PMI Mortgage Insurance Ltd., after the second-largest U.S. mortgage insurer posted a $350 million third-quarter loss because of rising defaults on U.S. home loans.

… in light of section 7.2 of the report:

Given the heavy reliance of some ADIs on mortgage insurance, a logical extension of the project was to examine the resilience of the mortgage insurance industry to a similar stress scenario. The result of applying the stress test on LMIs revealed that LMIs would not fare as well as ADIs should the modelled stress event occur, and secondly that APRA’s minimum capital requirement for LMIs was inadequate. After more than two years of work to refine the LMI capital framework, a revised model was issued in February 2005 and is planned to come into effect on October 1 2005. Following the findings of the stress test and subsequent research and industry consultation, the proposed capital framework resulted in roughly a doubling of the minimum capital requirement and a far more risk sensitive model (with the key risk drivers being LVR, loan seasoning and loan type).

We shall see how it all works out!


Update, 2008-5-23: This exercise was discussed at a Bank of Canada conference reported in the Spring, 2008, Review. Interestingly, the author observed:

Conversely, having banks undertake the exercise themselves provided a number of valuable insights, particularly into the way banks run their businesses and how they think about the risks they manage.

For those institutions where stress testing is an integral part of their risk management framework, the stress test scenario formed the basis for a discussion of the effect of the event on individual business units and the linkages across businesses. Some banks, for example, reacted to the weaker domestic growth and large depreciation in the exchange rate by assuming a shift of resources from business units which focussed primarily on domestically oriented industries, such as service industries, and the household sector, to those that were more export oriented. For these banks, the stress test was a useful means of communicating senior management’s risk appetite across the various levels of the firm (with the results being signed off by the Board of one bank). These banks were more likely to use a mix of quantitative and judgemental assessments.

This echoes the main observation of the International Report on Risk Management Supervision … the firms that have done best (least badly?) during the Credit Crunch are the ones in which communication between departments is most efficient.

Interesting External Papers

The Discount Window: Good or Bad?

The WSJ blog noted some arguments regarding the Fed’s discount window, which the Fed has encouraged the big banks to use, with some obviously orchestrated success.

A very interesting article by Anna J. Schwartz addresses historical misuse of the discount window to prop up insolvent institutions rather than simply provide emergency liquidity. She argues that the discount window should be eliminated … for all my laissez-faire ideals, I find that a little hard to swallow. Her argument rests on the footnoted phrase:

Credit-worthy banks can borrow at market rates, large ones in the Fed Funds market, small ones from their correspondent banks.

That sounds to me like an overgeneralization. When fear takes over, I am more inclined to agree with Larry Neal and his diagnosis of informational asymmettry exemplified, he says, in the Panic of 1825. Few lenders even have the desire to determine creditworthiness – especially if they have potential obligations that they may have to meet – and those few that do may set the “creditworthy” bar uneconomically high.

I agree with her whole-heartedly, however, when she decries the extended provision of credit to an insolvent institution.

Interesting External Papers

Breaking News from 1825

I mentioned the Panic of 1825 briefly yesterday.

More detail is available from the St. Louis Fed: main article by Larry Neal and commentary by Michael D. Bordo.

The more things change …

These problems started with the Treasury itself, confronted by the difficulties of servicing the huge government debt accumulated during the Napoleonic Wars … They were compounded by the response of the London capital market, which produced a bewildering array of new financial assets to its customers to replace the high-yielding government debt now being retired.
…
Only as more information came in or as investors began to pull out of higher risk investments and seek safer, better quality assets did price differences begin to show up.
…
The credit collapse led to widespread bank failures (73 out of the 770 banks in England and even three out of the 36 in Scotland) and a massive wave of bankruptcies in the rest of the economy, reaching an unprecedented peak in April 1826. The Bank of England and the London private banks joined forces for once by blaming both the speculative boom and the subsequent credit collapse on excessive note issue by the country banks. They argued that the ease of note issue had encouraged the more careless or unscrupulous partners in country banks to invest in highrisk, high-return financial ventures such as the Poyais scrip that were being offered on the London capital market.
…
Asymmetric information is the term applied to the usual situation in which borrowers know more about the actual investment projects they are carrying out than do the lenders. Lenders, knowing this, charge a premium proportional to the uncertainty they feel about the borrowers in question. This situation, in turn, creates an adverse selection problem, in which higher-quality borrowers are reluctant to pay the high interest rates imposed by the market, while lower-quality borrowers are willing to accept the rates and to default if their ventures fail.
…
The coup de grâce occurs when higher-risk borrowers are asked to provide collateral for additional loans, and the financial collapse decreases the value of their collateral. The outcome is a general wave of bankruptcies.

Update, 2007-09-20: It is interesting to contrast the 1825 bail-out of the banking house of Sir Peter Pole with the 2007 bail-out of Northern Rock. In testimony to parliament, BoE Governor King stated:

U.K. banking laws prevented the central bank from a covert rescue of Northern Rock Plc, which it would have preferred.“The bank would have preferred to have acted covertly as lender as last resort, to have lent to Northern Rock without publishing it,” King told a parliamentary committee in London today. “As a result of the market abuses directive (of 2005) we were unable to carry that out.”