The Reserve Bank of India’s Report
on Trend and Progress of Banking in India 2008-09 has a series of
charts (Chart VII.3 on page 250) comparing the volatility of the
overnight interbank interest rate in India with that of several other
(mature and emerging) economies.

India and Russia stand out in the charts for the ridiculously high
volatility in October 2008. The inability to keep the overnight rate
close to the policy rate in these two countries is so glaring that one
is forced to conclude that central banking was virtually suspended in
India and Russia for a few weeks in that period.

It is not that the mature economies were doing a great job of
liquidity management in those days. Only in August 2008, Willem
Buiter had gone to the Jackson Hole symposium to tell the
assembled central bankers that “The deviations between the
official policy rate and the overnight interbank rate that we observe
for the Fed, the ECB and the Bank of England are the result of bizarre
operating procedures …” (Page 531). If the mild volatility in
the US and Europe appeared bizarre to Buiter, I wonder what he would
say if confronted with the Indian data.

The US Justice
Department and the US SEC filed
insider trading complaints against the billionaire Raj Rajaratnam,
his Galleon hedge fund and several other friends and associates a few
days ago. All the interesting stuff (for example, the transcripts of
telephone conversations) are in the criminal complaints filed by the
Justice Department. If one reads only the SEC complaint, one would not
realize that there are several smoking guns here.

The fact that the whole thing was made possible by the FBI’s
use of informants and wiretaps appears to provide some support for a
controversial paper by
Peter Henning posted at SSRN last month. In this paper, titled
“Should the SEC spin off the enforcement division?,”
Henning argued that “To allow the SEC to regulate Wall Street
properly, splitting off at least a portion of the enforcement function
to an agency with expertise in prosecutions – the United States
Department of Justice – is at least worthy of consideration as
the government looks to increase regulation.”

One reason why the Department of Justice had all the advantages
here is that insider trading is very simple to understand. There is no
need for a PhD in finance to recognize insider trading if the
prosecutors have access to all the communications that are taking
place. But absent such access, insider trading is notoriously
difficult to prove. So here, wiretapping expertise beats finance
expertise hollow.

At another level, it was interesting to find that with all the
insider information that they had from multiple sources, the
defendants lost money trading AMD shares prior to its announcement of
the spin off of the fabrication facilities and a capital infusion by
Abu Dhabi. The complaint attributes it to a general decline in stock
prices due to the global financial crisis. The defendants bought AMD
stock beginning August 15, 2008, the Lehman collapse occurred in mid
September, the AMD announcement happened on October 7, 2008 and the
defendants sold stocks around October 20, 2008.

But the global financial crisis is not the whole story as seen from
the graph below. Even if the defendants had hedged their AMD long
position with a short position in the Nasdaq Composite index, they
would not have made money. Yes, AMD does outperform Intel over the
period, but not by a huge amount.

It appears from the graph that around the time that the defendants
were buying AMD on inside information, many others were also
buying. They could also have been buying on inside information or on
pure rumours. The graph reminds me of the old adage: “buy the
rumour, sell the fact.” It is also possible that the Abu Dhabi
deal was not as attractive as people initially thought and the prices
reacted to this reassessment. In other words, if Galleon had the
advantage of superior information, other traders might have had the
advantage of superior analysis. The complaint contains the transcript
of a telephone conversation where two defendants agree on a division
of labour: one of them is to collect the information and the other is
to analyze it. The second person probably was not up to the task.

I have a column
in the Financial Express yesterday about the SEC response
to its failure to detect the Madoff fraud and what this means for
other securities regulators worldwide. Some of my related blog posts
can be found here,
here
and here.

After its dismal failure to detect the Madoff fraud despite plenty of
warnings, the US SEC conducted a review by its own Inspector General
of what went wrong. This report published in August was uninteresting
as it explained it all away as incompetence and inexperience of the
staff concerned.

This explanation was not completely convincing given the detailed
information that people like Markopolos provided to the SEC over
several years. In any case, there is little point in a 450 page report
that reaches a conclusion that could be arrived at simply by applying
Hanlon’s Razor: “Never attribute to malice what can be adequately
explained by stupidity.”

At the end of September, however, the Inspector General released two
more reports (totalling 130 pages) indicating that incompetence might
not be the whole story. A survey carried out by the Inspector General
found that 24 percent of the SEC enforcement staff felt that cases
were improperly influenced or directed by management and 13% stated
that they had observed lack of impartiality in performance of official
duties.

In this article, however, I will focus on the Inspector General’s
recommendations (which the SEC has already accepted) for improving the
enforcement and inspections processes at the SEC. These
recommendations represent very significant changes in the mindset of
how to run these divisions not only at the SEC but at other regulators
worldwide.

The report recommends that 50% of the staff and management associated
with examination activities should have qualifications like the
Certified Fraud Examiner and Certified in Financial Forensics. This
recommendation is a sanitised version of what Markopolos recommended
when he testified to the US Congress in February about the SEC failure
to uncover Madoff despite his detailed complaints.

Markoplos argued that talented CPAs, CFAs, CFPs, CFEs, CIAs, CAIAs,
MBAs, finance PhDs and others with finance backgrounds need to be
recruited to replace current SEC staffers. He also claimed that SEC
staffers with credentials like CPA and CFA are not allowed to have
their designations printed on their business cards presumably because
if the SEC allowed its few credentialled staff to do so, it would
expose the overall lack of talent within the SEC.

The Inspector General recommends that all examiners should have access
to relevant industry publications and third-party database
subscriptions sufficient to develop examination leads and stay current
with industry trends. It also talks about establishing a system for
searching and screening news articles and information from relevant
industry sources for potential securities law violations.

This recommendation responds at least partially to Markopolos’s
testimony that most of the time all the SEC uses is Google and
Wikipedia because both are free and the SEC regional offices do not
have access to industry publications and academic journals.

The SEC estimates that it would cost $300,000-$400,000 annually to
provide data access in one room in each office; providing access to
each examiner will cost a lot more. It also estimates that it would
cost $3-4 million to implement the system for searching news reports
and other media, but this appears to be a one time cost rather than an
annual cost.

The Inspector General wants examiners to have direct access to the
databases of the exchanges, depositories, clearing corporations and
various self-regulatory organisations rather than having to get data
from these agencies as and when required. This is a huge change of
mindset because it blurs the distinction between the self-regulatory
organisations as first line regulators and the SEC as the apex
regulator. It moves the SEC into the regulatory frontline.

In line with this change, the SEC proposes to train its examiners in
the mechanics of securities settlement (both in the US and in major
foreign markets), in the trading databases maintained by the various
exchanges as well as in the methods to access the expertise of foreign
regulators, exchanges, and clearing/settlement agencies.

Turning to investigation, the Inspector General wants all
investigation teams to have at least one individual on the team with
specific and sufficient knowledge of the subject matter (like Ponzi
schemes or options trading) as well as access to at least one
additional individual who also has such expertise or knowledge.

During the last quarter century, many regulators elsewhere in the
world have looked upon the SEC as the gold standard in securities
regulation enforcement and have consciously or unconsciously fashioned
themselves on the SEC.

The lesson from Madoff is that the role model should not be the SEC of
recent decades but the SEC of the 1930s and 1940s under chairmen like
Douglas who believed that the management of the SEC was a higher form
of business management. Or perhaps, the role model should be the
modern New York Attorney General’s Office.

For regulators who are far behind even the current SEC in terms of
talent and resources, the SEC experience should be a wake-up call to
put their houses in order.

India’s national stock markets are closed
today because of elections in Mumbai where the main exchanges are
headquartered. It is true that Mumbai accounts for more than half of
the trading in the pan India stock markets, but still the question
does arise – do machines need a holiday on election day?

It is surely possible for the stock exchange servers to keep running
so that the rest of India can trade. Alternatively, the lower trading
volumes on a day on which Mumbai is closed provides a wonderful
opportunity to test the exchanges’ business continuity plan by
running the trading engine off the back up servers outside of
Mumbai.

For a variety of legal reasons, it is desirable for the disaster
recovery site of the exchanges to be located in a state different from
the one where the main site is located. This would provide a safeguard
against any one city or state imposing exorbitant taxes and other
levies on what is really a national market.

It is interesting to note that when it comes to the payment system,
the nearly universal global practice is to close the system only on
days which are holidays for the entire country or region. In the
Eurozone for example, the Target system closes only on days which are
holidays in every participating country. The Indian RTGS also closes
only on national holidays though the number of holidays is larger
than that of Target.

Stock markets (and more importantly, their regulators) globally
have been much more willing to close the markets. The worst
manifestation of this was after 9/11 when the US stock market remained
closed even after the US Treasury market re-opened though the loss of
lives in the Treasury market was more severe (I had a post
on this subject way back in 2005).

Exchanges world wide have often bailed out fat fingered traders who
punch in wrong buy or sell orders. I have blogged about this here,
and also about a rare contrary example here
and here. Such
bail outs create a moral hazard problem because traders have
insufficient incentives to install internal controls and processes to
prevent erroneous orders.

Instead of stopping this practice, the SEC has now stepped in
to formalize the moral hazard and has also set exceptionally low
thresholds for such bail outs:

In general, the new rules allow an exchange to consider breaking a
trade only if the price exceeds the consolidated last sale price by
more than a specified percentage amount: 10% for stocks priced under
$25; 5% for stocks priced between $25 and $50; and 3% for stocks
priced over $50.

I believe this move by the SEC reflects regulatory capture: those
who are harmed by trade cancellation are typically day traders and
other small traders who have little voice in the regulatory system,
while those benefited by the bail out tend to be large trading
firms. (The very term day trading is always used pejoratively –
when a large firm does it, the terminology changes to high frequency
trading which suddenly sounds a lot more respectable).

Three years ago, I wrote:
“Clearly exchanges can not be trusted with the discretion that
is vested in them. The rule should be very simple. Traders should bear
the responsibility (and the losses) of their erroneous trades.”
I wonder now whether the regulators can be trusted with the discretion
that is vested in them.

I have been arguing for some time now (for example, here)
that the financial crisis in the US is looking more and more like an
old fashioned banking crisis rather than a problem in the securities
markets. The IMF Global
Financial Stability Report released earlier this week provides
strong evidence for this.

Table 1.2 in Chapter 1 shows that out of the trillion dollar losses
projected for US banks, 64% would come from loans and only 36% from
securities. The losses on loans are estimated as 8.1% of the total
loans held by the banks while the losses on securities are 8.2% of the
securities holding. These practically identical loss rates demolish
the idea that we would not have had a crisis if the US had boring
banks which just took deposits and made loans.

For the world as a whole, the loss rate on securities (5.9%) is
significantly higher than loans (4.7%). Despite that, 67% of the $2.8
trillion losses come from loans and only 33% from securities.

The universal feedback that I got on my last
post on this subject was that it was very difficult to
understand. So let me try again.

At the outset, let me state that in my view the negative swap
spread is a result of market dislocation; I do not even for a moment
believe that it is really a rational market outcome. Yet, some people
are making the argument that the negative spread is rational and can
be explained in terms of default risk. I am therefore, trying to
analyze (and hopefully) disprove this claim; mere hand waving is not
enough.

Specifically, the claim being made is that the fixed leg of the
swap is less risky than the 30 year bond because there is no principal
payment at the end. So I begin by making the extreme assumption that
the 30 year bond can default, but all the promised payments in the
swap will be paid/received without default even if the government and
one or more Libor rated banks default.

My initial thinking was that:

1. Libor is the floating rate at which a Libor rated bank can borrow
2. The swap rate must be the fixed rate at which such a bank can
   borrow
3. The 30 year bond yield is the fixed rate at which the US can
   borrow
4. The T-bill yield must be the floating rate at which the US can
   borrow

If all this is true, then by assuming that the T-bill yield is
always less than Libor, it would appear to follow that the bond yield
must be less than the swap rate.

Unfortunately, this simple minded analysis is inadequate because it
assumes that interest rate risk and default risk can be nicely
separated from each other and do not interact. The interest rate risk
is reflected in the spread between Libor and the swap rate (a rising
yield curve) and also in the spread between T-bills and the long bond
(again, a rising yield curve). The default risk is reflected in the
spread between T-bills and Libor and also the spread between the long
bond yield and the swap rate. The world would be so simple if these
two risks were orthogonal to each other and did not come together in
crazy ways.

To understand this interaction, suppose that on the date of default
somebody makes good the default loss to us by paying us the difference
the par value of the bond and its recovery value. The default loss is
therefore eliminated. Does this mean that there is no loss at all due
to default? No, we are now left with the par value of the bond in our
hands, but that is not the same thing as receiving the remaining
coupons and redemption value of the bond. If we try to invest the par
value of the bond, we may not be able to earn the old coupon rate if
interest rates have fallen.

A default in a low interest rate scenario is in some ways similar
to a bond being called. In fact, a default with 100% recovery is
completely identical to a call. Conversely, a default in a high
interest rate environment has some similarities to a put; and the
similarity becomes an equality if recovery is 100%. Therefore, in
addition to the default risk, we need to consider the value of the
implicit call or put that takes place when the bond defaults.

The situation that I envisaged in my previous post was that if the
US government defaults only in a low interest rate environment, its
yield must include a premium not only for default losses but also a
premium for its implicit callability. The swap rate will be the yield
on a non callable bond, because the swap continues even if one or more
Libor rated banks default. I am assuming that the risk of the swap
counterparty defaulting is taken care of by sufficient collateral. If
the yield sweetener required for the implicit callability of the US
Treasury outweighs the extra default premium (the TED spread) embedded
in Libor, it is possible for the Treasury yield to exceed the swap
rate. I emphasize that I do not consider this likely, but it is a
theoretical possibility.

To demonstrate this theoretical possibility, I now present an
admittedly unrealistic numerical example where this happens. I assume
a default risk on US Treasury of about 15 basis points annually while
Libor contains 30 basis points of default risk embedded in it. From a
pure credit risk point of view, the Libor rated bank is riskier than
the US, but in my extremely artificial model, the 30 year swap rate is
only 4.06% while the 30 year US Treasury yield is 4.27% (roughly
similar to early September numbers). This happens because in this toy
model, Treasury default is perfectly correlated with interest rates
and amounts to callability of the bond. In this model, the yield on a
hypothetical default free 30 year non callable bond is only 3.76%
while the yield on a default free 30 year bond callable after 10 years
is 4.08%. This means that the hypothetical default free callable
yields more than the defaultable non callable swap. The defaultable
Treasury has to yield more than the default free 30 year callable to
compensate for default risk.

The precise model that yields the above numbers is as follows. The
US Treasury defaults with 10% probability exactly at the end of 10
years with a recovery of 55%. This corresponds to an expected default
loss of 4.5% or 15 basis points annualized over the 30 year life of
the bond (in present value terms, the annualized default loss is
obviously slightly different). The default free term structure over
the first 10 years is roughly similar to the actual US Treasury yield
curve in early September. The only two numbers we need are the 10 year
zero yield (3.59%) and the 10 year par bond yield (3.45%).

At the end of 10 years, there are two possibilities:

1. The US government defaults and the risk free rate remains constant
   at 0% (zero) over the next 20 years. The probability of this is
   10%.
2. The US government does not default and the risk free rate remains
   constant at 4.75% over the next 20 years. The probability of this is
   90%.

Note for the finance experts: all probabilities above are risk
neutral probabilities.

In this model default is perfectly correlated with interest rates
and a defaultable bond with 100% recovery would be the same as a
default free callable bond. This allows us to decompose the 51 basis
point spread (4.27% – 3.76%) of the US bond over a default free
non callable into two components: a callability component of 32 basis
points (4.08% – 3.76%) and a default loss component of 19 basis
points (4.27% – 4.08%). The swap is non callable and its entire
spread over the default free non callable bond of 30 basis points
(4.06% – 3.76%) is due to default risk. This default loss spread
is 11 basis points more than that embedded in US Treasury indicating
that it has higher default risk. This 11 basis points can be
interpreted as the average implied TED spread over the entire
period.

While this example is theoretically possible it is clearly
unrealistic. The purpose of my previous
post was to prove that under realistic assumptions, it is not
possible for the US Treasury yield to exceed the swap rate even if we
assume that the swap payments will continue without default even after
Treasury has defaulted. But that argument is necessarily abstract and
complex.

The fact that the 30 year US dollar swap rate is lower than the
interest rate on the 30 year US treasury bond was till recently
something that only fixed income specialists worried about. Sure, the
Across the Curve blog has
been putting NEGATIVE in capital letters in each of his daily blog
posts on the swap spread for several months now, but the mainstream
financial media did not bother much about it. Last week, however,the
Financial Times carried a detailed story (“Negative 30-year rate swap
spread linger,” September 9, 2009) on the subject.

Under the current view that financial markets have normalized, the
negative swap spread is an embarrassment because it suggests that even
a year after Lehman, simple arbitrage trades are not happening because
of a paucity of the balance sheets required to put on the
trades. Alternative explanations are being sought for the phenomenon,
and the report states that “questions are being asked in the
market about the assumption governing whether a 30-year swap is
riskier than a 30-year bond.”

In this post (necessarily long and highly technical), I shall try
to examine this question. I shall initially assume that the interest
rate swaps have no counterparty risk because of high degree of
collaterilization. This is very different from asserting that the swap
rate is a risk free rate.

I shall assume that the Libor rate on the floating leg of the
interest rate swap is a rate that includes a default risk component. I
shall also assume that the default risk inherent in Libor is greater
than that of US Treasury. More precisely, I shall assume that the TED
spread (the excess of Libor over the T-Bill yield at the same
maturity) is expected to remain positive. I shall also assume that the
positive TED spread reflects the greater credit risk of Libor as
compared to the T-Bill. Before the crisis, it was fashionable in the
CDS market to assume that Libor and swap rates were risk free rates
and the TED spread was due to liquidity and tax effects. I believe
that this claim is untenable today.

Since banks are afloat today with huge government support, I think
it is reasonable to assume that the government is more credit worthy
than the banks. But I do not assume that the US government is risk free
either. It too can default, but the probability of this default is
lower than that of the banks.

Libor is the borrowing rate of a bank with what is often called a
“refreshed Libor rating.” On every day that Libor is
polled, only a sample of “sound” banks is
considered. Therefore, the default risk inherent in three-month Libor
is that of a bank defaulting in the next three months given that it
meets the Libor creditworthiness standard today. Libor exceeds a
hypothetical three month risk free rate by a compensation for this
possibility of default.

Assuming that the interest rate swap itself has no default risk,
the fixed rate payer should be willing to pay a fixed rate that
exceeds the risk free rate because what he receives on the floating
leg is higher than the risk free rate. He should also be willing to
pay more than he would on a swap in which the floating leg was the US
T-bill yield instead of Libor because I am assuming that the TED
spread (T-bill yield minus Libor) is expected to be positive. The
T-Bill yield itself exceeds a hypothetical risk free rate because of
the the possibility of default by the US government.

Unfortunately, even from all these assumptions, it does not follow
that the 30 year UST yield should be less than the 30 year swap rate
without some further assumptions that we will come to at the end. The
problem is that the interest rate swap is not terminated by the
default by one or more of the Libor rated banks or by the default of
the US government. Several banks may fail and Libor may still be
computed the next day based on the few banks that remain. The floating
rate payer on the swap would have to make floating leg payments at
this Libor rate, and the fixed rate payer would have to make fixed leg
payments at the fixed rate.

The holder of the 30 year bond however will not continue to receive
coupons if the US government has defaulted. To eliminate the default
risk of the US Treasury, we must consider a hypothetical asset swap on
the 30 year bond. Consider an asset swap in which (a) the owner of a
newly minted bond sells it to an asset swap buyer at par, (b) the
buyer agrees to make fixed rate payments at the coupon rate of the
bond, and (c) the seller agrees to make a floating rate payment at
Libor +/- a spread.

Assuming that the asset swap is risk free, the asset swap seller
now has a risk free stream of payments equal to the coupon of the 30
year UST bond. If it were true that the floating leg payment would be
equal to the T-bill yield, then we can immediately conclude that the
30 year bond must yield less than the fixed rate of the 30 year interest
rate swap. If not an arbitrageur would enter into an asset swap as a
seller and simultaneously enter into an interest rate swap as a fixed
rate payer. It would be left with two sources of profit from these two
swaps:

1. the fixed rate it receives on the asset swap would exceed the
   fixed rate that it pays on the interest rate swap because the 30 year
   bond yields more than the swap rate
2. the floating rate it pays on the asset swap (T-bill yield) would
   be less than what it pays in the interest rate swap (Libor) because
   the TED spread is expected to be positive.

If US Treasury were risk free, it is evident that the floating leg
would be equal to the T-Bill yield. We just add a notional exchange of
principal at the end (which simply cancels out). The fixed leg must be
worth par because it is economically the same as the newly minted 30
year Treasury (par) bond. Therefore the floating leg payment including
the notional payment must also be worth par, but this “floating
rate bond” can be worth par only if the floating rate is the
risk free rate which is the T-Bill yield.

This equivalence breaks down when US Treasury can default. To
understand this consider a modified asset swap which terminates
without any termination payments if and when US government
defaults. In this case, it is easy to see that the modified asset swap
floating leg must equal the T-Bill yield. The case where the US
government does not default has already been analyzed above, so
consider what happens if there is a default.

In this case, we add a notional exchange between the swap buyer and
the swap seller not of the principal value of the bond but of the
recovery value of the defaulted bond. With this notional payment
included, the fixed leg again is the same as the US treasury bond. It
must therefore be worth par because the Treasury bond is a par
bond. The floating leg must therefore also be worth par which means
that it (including the notional payment at default of the recovery
value) must be a par floater. But the T-Bill yield is precisely the
yield on a par floater of the US government.

With this understanding in place, let us now return to the only
possible explanation for the swap rate being less than the UST rate in
a perfect market – the asset swap floating leg must exceed Libor
(or the asset swap spread must be positive). In this case, in a
perfect market the fixed leg (which is the UST bond yield) must also
exceed the swap rate – the asset swap seller receives a larger
fixed leg than in an interest rate swap but also pays a higher
floating rate.

So the position is that for the current interest rates to be
consistent with a perfect market, the asset swap spread should be
positive while we know that the modified asset swap spread (the one
that terminates on default by the US government) is the negative of
the TED spread and is therefore expected to be negative. The
difference between the asset swap and the modified asset swap is that
after default by the US government, the modified swap terminates while
the ordinary asset swap subsists.

Everything now depends on what Libor is likely to be after the
default by the US government. If Libor is expected to be high, the
asset swap seller would have to make large floating rate payments in
return for the fixed rate payment from the asset swap buyer. The
subsisting swap would therefore be a liability to the asset swap
seller and he would therefore insist on paying a lower (more negative)
spread in the asset swap than in the modified asset swap where this
liability would not exist. This would imply that the asset swap
floating leg would be even lower than the T-Bill yield and therefore
much lower than Libor. The 30 year UST yield must therefore be less
than the swap rate.

For the 30 year US yield to be higher than the swap rate in a
perfect market therefore the asset swap must be beneficial to the
asset swap seller after the default by the US government. This can
happen only if interest rates are very low after default. I do not
find this very plausible. I would expect sovereigns to default on
local currency debt after inflation has been tried and found to be
wanting. With double digit inflation, one would imagine Libor also to
be in double digits and the asset swap would be a huge liability to
the asset swap seller who would be receiving something like 4.5%
fixed. Considering this liability, the asset swap spread should be
less than the T-bill yield which in turn is less than Libor.

Thus it appears to me that a 30 year swap rate less than the 30
year UST yield is consistent with perfect markets only if we are
willing to make either of the two assumptions:

1. The TED spread is expected to be negative implying that banks are
   safer than the US government; or
2. A potential default by the US government would happen in an
   environment of very low rates where Libor would be very low.

I find both these assumptions implausible and would believe that
the phenomenon that we are seeing in 30 year swaps is due to the
limits to arbitrage arising from inadequate capital and leverage.

One final question that might trouble the reader is the assumption
that there is no counterparty risk in the swaps even when the
sovereign itself has defaulted. Actually, if we simply assume that all
the swaps terminate on default by the US government, the above
arguments still go through. The fixed rate payer in the interest rate
swap makes money before the default. If at this point, he is allowed
to pack up his bags and go home, that is fine in this model.

This has been a difficult piece of analysis for me and I would
welcome comments, suggestions and corrections.

I have a column
in the Financial Express today on the anniversary of the
Lehman failure.

As we examine what we have learnt in the year since the collapse of
Lehman Brothers, the most important lesson for Indian policymakers is
that for macro risk management purposes, India must now be regarded as
having an open capital account.

From a micro-economic perspective, India has a plethora of exchange
controls that often force businesses to go through several contortions
to perform what would be very simple tasks in a completely open
capital account. But from a macro perspective, these regulations only
serve to impose some transaction costs and frictions in the
process. Exchange controls have ceased to be a barrier – they
are only a nuisance.

Large capital inflows and outflows do take place through three
important channels which are not subject to meaningful cap –
inward portfolio flows, outward foreign direct investment and external
commercial borrowing. In addition, foreign branches of Indian banks
and foreign affiliates of Indian companies have relatively
unrestricted access to global markets. Through all these channels,
Indian entities can build up large currency, liquidity and maturity
mismatches in foreign currency.

Each one of these global linkages was well known to perceptive
observers for a long time, but it took the Lehman collapse to
demonstrate the strength of these linkages taken together. Policy
makers were taken by surprise at the ferocity with which the storm in
global financial markets hit Indian markets.

We must now wake up to the reality that as in the case of East Asia
in 1997, the power of the corporate lobby has ensured that capital
controls have disappeared in substance while remaining deeply
entrenched in form. I believe that in India today, there are only
three effective capital controls that have macro consequences.

First, Indian resident individuals cannot easily borrow from
abroad. This ensured that Indian households did not have home loans in
Swiss francs and Japanese yen unlike several countries in Eastern
Europe. In India, the corporate sector has had the monopoly of
speculating on the currency carry trade. From a socio-political
perspective, this mitigated the impact of the crisis, though it is
doubtful whether the macro-economic consequences were important.

Second, Indian companies cannot borrow in rupees from foreigners as
easily as they can borrow in foreign currency. This contributed to
large corporate currency mismatches which were a huge source of
vulnerability during the Lehman crisis.

Third, it is difficult for foreigners to borrow rupees and
therefore speculation against the rupee is more effectively carried
out by Indians than by foreigners. Currency speculation by foreigners
typically takes the form of portfolio inflows and outflows. This has
potential macro prudential consequences, but it was not a material
factor in the Lehman episode.

This, therefore, is the first lesson from Lehman – Indian
regulators should now think of India as having an open capital account
while framing macro risk management policies.

The second lesson is that, as Mervyn King put it, global financial
institutions are global in their life, but national in their
death. Each nation has to take steps to ensure that failure of foreign
institutions does not disrupt its domestic markets.

The collapse or near collapse of several large US securities firms
did not pose any threat to the solvency of Indian equity markets
because of the margin requirements that we impose on FIIs. Under the
doctrine that each country buries its own dead, foreign creditors of a
bankrupt FII can lay claim to this collateral lying in India only if
there is something left over after the claims of Indian stock
exchanges and other Indian entities have been satisfied.

In this context, the existence of a large over the counter (OTC)
derivative market in India where foreign banks trade without posting
margins is a huge systemic risk. Lehman was a bit player in the
interest rate swap and other OTC markets in India. As such, its
collapse did not create a major disturbance. However, the failure of a
large foreign bank which is very active in the OTC market would be
very serious indeed.

It is absolutely imperative to move the OTC markets to centralised
clearing to eliminate this source of systemic risk.

The final lesson from Lehman is that the idea that emerging markets
are somehow very different from mature markets has been rudely
shaken. The most mature economies of the world have had an
“emerging market style” financial crisis. In the past, the
US did not think that it had anything to learn from crises in emerging
markets, and was therefore completely unprepared for what happened
after Lehman. In retrospect, the US belief in its own exceptionalism
was a colossal mistake.

India must also abandon any belief we might have in our
exceptionalism and learn from the experiences of other countries so
that we do not have to learn the same lessons at first hand.

A short while back, I blogged
about the OIG report on the SEC investigation of Madoff. One of the
interesting nuggets in this report is about how the leading hedge
fund, Renaissance Technologies, analysed and dealt with their Madoff
exposure way back in 2003. It struck me as a good example of prudent
risk management.

The first internal RenTec email about its Madoff exposure contains
a brief description of the red flags, but what interests me is the
risk analysis:

Committee members,
We at Meritage are concerned about our [Madoff]
investment. …

… you have the risk of some nasty allegations, the
freezing of accounts, etc. To put things in perspective, if
[Madoff] went to zero it would take out 80% of this year’s
profits.

Sure it’s the best risk-adjusted fund in the portfolio, but
on an absolute return basis it’s not that compelling (12.16%
average return over [the] last three years). If one assumes that
there’s more risk than the standard deviation would indicate,
the investment loses it[]s luster in a hurry. It’s high season
on money managers, and Madoff’s head would look pretty good
above Elliot Spitzer’s mantle. I propose that unless we can
figure out a way to get comfortable with the regulatory tail risk in a
hurry, we get out. The risk-reward on this bet is not in our
favor.

In one short email, you have several lessons in risk analysis:

• Worst case scenario: Madoff goes to zero
• Risk sizing relative to risk appetite: 80% of profits.
• Analysis of tail risk, separately from the historical
  volatility.
• Analysis of liquidity risk (freezing of accounts).
• Concern about regulatory risk (Spitzer).

What is interesting is that this email led to a flurry of emails
analysing the red flags in Madoff at great length, collecting data
from published sources and from conversations with market
participants. At the end of it all, there was disagreement about the
course of action between those who wanted to exit the position
completely and those who drew comfort from the fact that Madoff had
survived an SEC investigation. Finally, they decided to reduce the
exposure by 50% (perhaps as a hedge fund they had the risk appetite to
lose 40% of profits in a worst case scenario, when the investment
looked attractive otherwise).

What is also interesting is that these smart hedge fund managers
thought that the one regulator who was likely to catch Madoff was the
New York Attorney General, Spitzer. Markopolos also thought that the
New York Attorney General was the best financial regulator in the
country (see my blog post here).

Of course, the RenTec people come across as having a self
confidence bordering on hubris. At one point, they analysed
Madoff’s stock trading and determined that “the prices
were just too good from any mode of execution that we were aware of
that was legitimate. … And we would have loved to figure out how he
did it so we could do it ourselves. And so that was very
suspicious.” They finally decided that Madoff could not be doing
what they were not able to do themselves: “Well, I knew it
wasn’t possible because of what we do.”

I can quite imagine the RenTec people thinking that there was no
way Madoff
with his AS400 could do what RenTec could not do with the 60th
largest supercomputer in the world.

Yet, there is no reason we should not learn from a bunch of
arrogant people.

As an aside, I thought that the internal RenTec emails were the
best leads that the SEC got. These were not complaints and were not
even intended to be read by SEC – they just got picked up during
an SEC examination of RenTec. There was clearly no motive, no hidden
agenda. The SEC was peering into the unedited thinking of some of the
smartest hedge fund managers in the world.

As another aside, the very fact that these internal emails got
picked up as a lead for investigation of another entity conflicts with
the idea that the SEC is so badly incompetent. My
Hanlon’s Razor is taking some dents.