PrefBlog

Chalk one up for the License Raj! India has halted futures trading of some commodities:

Communist allies of Prime Minister Manmohan Singh want to ban futures trading in cooking oil, sugar and other commodities, saying speculators are driving up prices. Still, the order comes a week after a government-appointed panel found no evidence a 2007 ban on wheat and rice futures curbed prices of the grains….

In hard times, there is extreme pressure on politicians to Do Something. So they do. Whether or not the actions are useful is a mere quibble. They’d be better off cutting the kerosene subsidy.

Jon Danielsson writes a piece in VoxEU attacking the concept of model-based regulation:

Most models used to assess the probability of small frequent events can also be used to forecast the probability of large infrequent events. However, such extrapolation is inappropriate. Not only are the models calibrated and tested with particular events in mind, but it is impossible to tailor model quality to large infrequent events nor to assess the quality of such forecasts.

Taken to the extreme, I have seen banks required to calculate the risk of annual losses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies.

A very sexy topic nowadays and, to be fair, he is familiar with the proper solution:

I think the primary lesson from the crisis is that the financial institutions that had a good handle on liquidity risk management came out best. It was management and internal processes that mattered – not model quality. Indeed, the problem created by the conduits cannot be solved by models, but the problem could have been prevented by better management and especially better regulations.

This ties in with the International Report on Risk Management Supervision. Unfortunately, he doesn’t really have any good ideas to offer for future use:

What is missing is for the supervisors and the central banks to understand the products being traded in the markets and have an idea of the magnitude, potential for systemic risk, and interactions between institutions and endogenous risk, coupled with a willingness to act when necessary. In this crisis the key problem lies with bank supervision and central banking, as well as the banks themselves.

Very nice, but just a tad lacking in specifics, wouldn’t you say?

You can’t regulate common sense. As I have said before, I think that the current credit crunch represents a triumph of the current regulatory regime: there has been pain, there have been a few failures, and there has most definitely been a pricking of the bubble … but the financial system has withstood the shocks, bloodied and in need of capital, but not in bankruptcy court with a crowd of depositors forming a lynch mob. The Basel Accords need adjustment, not elimination.

In another vein, Luigi Spaventa argues for a Brady Bond style bailout:

In CEPR Policy Insight 22, I recommend the creation of a publicly sponsored entity that could issue guaranteed bonds to banks in exchange for illiquid assets, drawing on US Treasury Secretary Nicholas Brady’s solution to the Latin American sovereign debt crisis in 1989. This new entity, preferably multilateral, would value assets based on discounted cash flows and default probabilities rather than crisis-condition market prices.

As a firm floor is set to valuation and illiquid assets otherwise running to waste are replaced by eminently liquid Brady-style bonds, funding difficulties and, at the same time, the market liquidity problems besetting the banks’ balance sheets would be removed. Shielding the banks’ assets from the vagaries of disorderly markets is a necessary condition to dispel the uncertainty that prevents a proper working of credit markets.

Nope. I don’t buy it. The amount of moral hazard engendered by such a scheme – not to mention investment risk taken by a publicly funded body – is not justified by the scale of the current problems. Dr. Spaventa’s arguments that current procedures are inadequate:

For funding liquidity, emergency liquidity support from central banks has helped lower the temperature in the worst moments, but it is not a long-term solution. Setting a collateral value of illiquid securities does not provide a market for them and hence does not set a floor to their market prices; the collateralized securities remain on the intermediaries’ books, affecting the quality of their balance sheets. Capital increases are also insufficient to break the spiral, as injections of capital may prove inadequate only a few weeks after their announcement.

For market liquidity, suggested remedies are equally inadequate. Mandated full disclosure of losses might reduce uncertainty, but unless market liquidity is instantly restored, full disclosure of the situation at time t offers no guarantee that it will be the same at time t+1. Similarly, retreating from marking financial products to market or model during this time of crisis would face a number of difficulties.

are not impressive. On the capital-raising front, we have today AIG raising $12.5-billion, while there are rumours that CitiBank is going to sell assets.

What we have is a short term crisis brought about by the (over-) financing of long term assets with short term money … this is the root of just about every general financial crisis ever known. The only solution is the passage of time.

One problem with neo-Brady-Bonds is that there will be considerable difficulty regarding negotiation of price – that is probably what killed Super-SIV / MLEC. According to the Bank of England, announced write-downs now exceed expected credit losses. It’s bad enough for the banks to take a stiff haircut when lending the securities; they’re spinning off cash; as long as they can finance them, why should they negotiate a politically palatable horrible price?

Meanwhile, Accrued Interest reviews conflicting signals from the stocks, CDS & bond markets and concludes:

A better explanation is that the market is struggling to price a world where liquidity is improving but real economics are deteriorating. It felt to me like the market, especially stocks, had become a bit too optimistic in recent days, with some even talking like we won’t have any recession at all.

Don’t confuse economic data that’s “better than expected” with “good.” Now if you ask me where the stock and credit markets will be in a year, I’d say both will be better than today. Looking one year out, we’ll probably be through this recession, housing will have bottomed, and there will be much more earnings clarity. But in the near term, I think we need a little more of a recession concession.

A quiet day in the market. Prices drifted up, with spikes in the SplitShare and InterestBearing sectors, on little volume.

There were eleven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Thursday, May 8th, 2008 at 9:15 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.