http://online.wsj.com/article/SB10001424052748704576204574529722299099570.html#articleTabs%3Dcomments
HEARD ON THE STREET
NOVEMBER 11, 2009, 1:30 P.M. ET
Contingent Capital's Tricky Path
By RICHARD BARLEY
Contingent convertibles may become a key part of the future bank-capital landscape, but their path to widespread acceptance is unlikely to be smooth. The nascent instruments this week suffered a setback in an arcane yet critical row over their inclusion in bond indexes used by investors around the globe. The outcome could be reduced investor appetite for the bonds.
Lloyds Banking Group is currently offering to exchange as much as £7 billion ($12 billion) of contingent convertibles for existing subordinated debt as part of a bigger £21 billion capital raising to free itself from the U.K. government's toxic-asset insurance plan. The notes have a fixed maturity but will convert into equity if Lloyds's core Tier 1 capital ratio falls to less than 5%.
Many bond investors, the traditional buyers of bank hybrid capital, don't want these bonds included in bond indexes because they are prohibited from owning equity. Bank of America Merrill Lynch, which compiles some of the most widely watched bond indexes, initially agreed, then changed its mind only to change it back again after the Association of British Insurers complained that investors might be forced to buy the notes because of their inclusion, but then be forced to sell upon conversion at a time of market stress. That is a brave but welcome decision. Barclays Capital also isn't including the notes in its corporate-bond indexes; iBoxx is making its mind up about them.
Lloyds's deal may work, as it is making investors an offer that is difficult to refuse--unexchanged bonds are set to have payments blocked by the European Commission as a condition of state aid. But the bond debate is a blow for any hope that contingent convertibles are the solution to banks' capital woes. It also underlines the limitations of the structure: While undoubtedly an improvement on traditional hybrid bonds, their success depends on a similar ambiguity over where they sit in the capital structure between debt and equity. That makes them an unlikely silver bullet.
Write to Richard Barley at richard.barley@dowjones.com
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
My Comment
What a sad commentary this is on the investment management industry, and a classic example of the tail wagging the dog. In deciding whether something is a good investment for the medium to long-term, there should be no consideration of whether it is in an index or not. That index inclusion is a major stumbling block shows how many of the fund managers, despite their high fees, have abrogated the most basic role of an investment manager.
Thursday, November 12, 2009
Monday, October 26, 2009
Mentioned in the right circles
I'm not sure whether the bloke in the cartoon is meant to be me - us blokes with beards look all alike.
http://www.chinadaily.com.cn/cndy/2009-10/20/content_8817570.htm
http://www.chinadaily.com.cn/cndy/2009-10/20/content_8817570.htm
Thursday, October 15, 2009
Feeling good
I suppose I should feel good that the other side of the court case for which i'm an expert witness has asked the judge to rule most of my evidence inadmissable. That means they're scared, right?
Monday, October 12, 2009
Capital buffers for market risk
The approach to estimating capital and the market risk of portfolios is a bit confused at the moment. If we think of capital as the buffer that we need to hold against some surprisingly bad event, then it makes no sense to estimate it by looking at current and past portfolios. The Board needs to tell the traders how much money it wants to put at risk from a trading portfolio. Then the risk model can assess the probability of this occurring given the current portfolio and current market conditions to ensure that the VaR limit is within the Board approved limits.
How does the Board come to its decision? Gut feel can be one way. Another would be to look at the historical risk positions that have been taken. Both approaches need to be reconciled.
How does the Board come to its decision? Gut feel can be one way. Another would be to look at the historical risk positions that have been taken. Both approaches need to be reconciled.
Wednesday, July 1, 2009
Risk management and the Foundation Trilogy
In the INARM actuarial blog, Dave Ingram made the following comment:
I had an interesting discussion over the weekend with someone about the original Foundation Trilogy.
It seems that those books provide a very good paradigm for risk management.
1. As mentioned by Steve, the "psychohistory" which I always envisioned as a massive computer model that looked into the future and made probabilistic predictions of likehood of possible courses of events. From this work a plan was developed.
2. A "Black Swan" event that was not anticipated by the models in book two - "The Mule" . This Black Swan event invalidates the original models.
3. A group of people, "the second foundation", who were charged with updating the model for actual events as they deviated from the original projection. As well as implementing corrective actions to bend events back towards achievement of the original goals.
Asimov anticipated an extremely important aspect of this prediction business. The working of the original plan and the adjustments of the second foundation were kept secret from the world at large. Asimov understood the impact of knowledge of the plan on the actions of the people.
These books were written in the early 1950's and there are several fundamental ideas that we have not yet fully understood or mastered in risk management.
This prompted my reply:
Very good points! Now for a short riff on this theme with insights into modern risk management practice.
Unfortunately "Second Foundation" wouldn't work as Asimov assumed for his fictional work. The problem is how can we maintain a proper risk management culture? Culture evolves much more quickly than physical characteristics because its transmission mechanisms - memes - have a much greater mutation rate than the genes, and the environment in which the memes multiply is much more chaotic than the physical world (except when meteorites hit). Hence the memetic repair mechanisms needed to keep the culture semi-stable (analogous to the genetic repair mechanisms to cull out egregious mutations) need to have attention paid to them. Three important repair mechanisms for risk management culture are regulation, shareholder influence on Boards, and separation of duties. None of these are included in the "Second Foundation", hence the starting point of my riff.
The information now coming out on Countrywide shows the importance of all these mechanisms for the maintenance of corporate culture.
Another point Dave. Random statements - like mentioning the Foundation Trilogy - are an extremely effective way of getting thought patterns into new pathways - an essential thing for a risk manager (as distinct from a compliance manager).
I had an interesting discussion over the weekend with someone about the original Foundation Trilogy.
It seems that those books provide a very good paradigm for risk management.
1. As mentioned by Steve, the "psychohistory" which I always envisioned as a massive computer model that looked into the future and made probabilistic predictions of likehood of possible courses of events. From this work a plan was developed.
2. A "Black Swan" event that was not anticipated by the models in book two - "The Mule" . This Black Swan event invalidates the original models.
3. A group of people, "the second foundation", who were charged with updating the model for actual events as they deviated from the original projection. As well as implementing corrective actions to bend events back towards achievement of the original goals.
Asimov anticipated an extremely important aspect of this prediction business. The working of the original plan and the adjustments of the second foundation were kept secret from the world at large. Asimov understood the impact of knowledge of the plan on the actions of the people.
These books were written in the early 1950's and there are several fundamental ideas that we have not yet fully understood or mastered in risk management.
This prompted my reply:
Very good points! Now for a short riff on this theme with insights into modern risk management practice.
Unfortunately "Second Foundation" wouldn't work as Asimov assumed for his fictional work. The problem is how can we maintain a proper risk management culture? Culture evolves much more quickly than physical characteristics because its transmission mechanisms - memes - have a much greater mutation rate than the genes, and the environment in which the memes multiply is much more chaotic than the physical world (except when meteorites hit). Hence the memetic repair mechanisms needed to keep the culture semi-stable (analogous to the genetic repair mechanisms to cull out egregious mutations) need to have attention paid to them. Three important repair mechanisms for risk management culture are regulation, shareholder influence on Boards, and separation of duties. None of these are included in the "Second Foundation", hence the starting point of my riff.
The information now coming out on Countrywide shows the importance of all these mechanisms for the maintenance of corporate culture.
Another point Dave. Random statements - like mentioning the Foundation Trilogy - are an extremely effective way of getting thought patterns into new pathways - an essential thing for a risk manager (as distinct from a compliance manager).
Tuesday, June 9, 2009
Credit Default Swap auctions
Here's a summary of CDS auctions I've incorporated into my yet-(never?)to-be-released book on Financial Risk Management. Nice to know how they work.
CDS Auctions[1]
A method for gauging an official price at which to settle CDS contracts is not the only rationale for an auction. There are a number of credit market indexes that are used as the basis for various derivative contracts. An auction gives a reference price that can be included in all indexes and so reduces basis risk for people who have matched physical and derivative positions via a number of different indexes.
The auction proceeds in two rounds and all prices are based on a par value of 100.
In the first round brokers submit a bid and offer on their own behalf and that of their clients The bid-offer spread may not differ by more than 2. If desired, a request can be made to buy or sell a physical amount of bonds – this amount may not be in excess of the party’s market position. If the highest bid is higher than the lowest offer then both quotes are removed from the pool; this step is the repeated. When all bids are below all offers the unweighted average of the highest 50% of bids and lowest 50% of offers is calculated. This is the inside market midpoint. The net sum of the requests to buy and sell physical instruments is called the open interest. If the open interest is zero then the inside market midpoint is the final auction settlement price for physical and derivative contracts. Otherwise round 2 starts, which clears the open interest.
Dealers can then submit any number of limit orders (size and price) for physical instruments, with a limit of ±1 of the inside market midpoint. If the open interest is to sell bonds then the limit on the buy orders is a dollar above midpoint, if the open interest is to buy then the limit on sell orders is one dollar below the midpoint. The open interest is then matched against the limit orders and the clearing price is the final auction settlement price for all physical and derivative instruments.
[1] This information is summarised from Helwege et al http://ssrn.com/paper=1407272
CDS Auctions[1]
A method for gauging an official price at which to settle CDS contracts is not the only rationale for an auction. There are a number of credit market indexes that are used as the basis for various derivative contracts. An auction gives a reference price that can be included in all indexes and so reduces basis risk for people who have matched physical and derivative positions via a number of different indexes.
The auction proceeds in two rounds and all prices are based on a par value of 100.
In the first round brokers submit a bid and offer on their own behalf and that of their clients The bid-offer spread may not differ by more than 2. If desired, a request can be made to buy or sell a physical amount of bonds – this amount may not be in excess of the party’s market position. If the highest bid is higher than the lowest offer then both quotes are removed from the pool; this step is the repeated. When all bids are below all offers the unweighted average of the highest 50% of bids and lowest 50% of offers is calculated. This is the inside market midpoint. The net sum of the requests to buy and sell physical instruments is called the open interest. If the open interest is zero then the inside market midpoint is the final auction settlement price for physical and derivative contracts. Otherwise round 2 starts, which clears the open interest.
Dealers can then submit any number of limit orders (size and price) for physical instruments, with a limit of ±1 of the inside market midpoint. If the open interest is to sell bonds then the limit on the buy orders is a dollar above midpoint, if the open interest is to buy then the limit on sell orders is one dollar below the midpoint. The open interest is then matched against the limit orders and the clearing price is the final auction settlement price for all physical and derivative instruments.
[1] This information is summarised from Helwege et al http://ssrn.com/paper=1407272
Vale Peter Bernstein
Bernstein's Against the Gods is a must read for anybody interested in the study of risk. And that means everybody - it is a very easy read.
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