Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Real Estate and Infrastructure Resolution in India

Prof. Sebastian Morris and I have written a working paper on Real Estate and Infrastructure Resolution in India. We argue that real estate and infrastructure is at the centre of a vicious doom loop sketched in the figure below.

Problems in real estate and infrastructure debilitates the financial sector through rising non-performing assets. A dysfunctional financial sector further weakens the economy through credit tightening. A weak economy devastates Real Estate and Infrastructure through the demand channel.
Problems in real estate and infrastructure debilitates the financial sector through rising non- performing assets. A dysfunctional financial sector further weakens the economy through credit tightening. A weak economy devastates Real Estate and Infrastructure through the demand channel.

This vicious circle needs to be broken decisively, but merely bailing out the failing/ failed developers would only further crony capitalism. Our proposal uses the financial markets for price discovery and resource mobilization, and is based on the sovereign covering the left tail risk in infrastructure and real estate. The mechanism has the potential to revive these assets with the government earning a handsome return, while being fair to all stakeholders.

Our rationale for the sovereign to absorb the tail risks posed by the doom loop are:

  • Being non-tradeable, real estate and infrastructure cannot fall back on a market outside the narrow demand territory. A tradeable sector asset like a steel plant has a floor asset value based on border prices of inputs and outputs even in a situation where domestic demand has collapsed. This truncates the left tail of the asset value distribution and mitigates the tail risks of the tradeable goods sector. There is no floor on Real Estate and Infrastructure asset values independent of the state of the domestic economy. There is no alternate value to assets in harness – all costs are sunk and non-deployable outside the business and the space.

  • Real estate and infrastructure are also exposed to sovereign risk (environmental regulation and government policy). Conversely, the government can unlock vast social and private values by removing distortions in the regulation of this sector.

This creates an opportunity for the sovereign to charge a fair insurance premium for providing tail risk cover, and thereby make a profit from the whole transaction in the long run. Our mechanism involves a second loss cover structure similar to the Maiden Lane transactions in the United States in the aftermath of the Global Financial Crisis.

We propose to use financial markets to discover fair prices of diversified pools of real estate assets. Diversified pools overcome problems of asymmetric information, and enable the use of standard valuation models like hedonic regression. More details are in the working paper.

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Abstraction bias or bias bias?

Last month, Steven L. Schwarcz put out a paper, Regulating Financial Guarantors: Abstraction Bias As a Cause of Excessive Risk-taking, arguing that financial guarantors suffer from abstraction bias:

Financial guarantors commit to pay out capital only if certain future contingencies occur, in contrast to banks and other financial firms that pay out capital—for example, by making a loan—at the outset of a project. As a result, financial guarantors are subject to a previously unrecognized cognitive bias, which the author calls “abstraction bias,” that causes them to underestimate the risk on their guarantees.

Reading this paper reminded me of Gigerenzer’s paper (The Bias Bias in Behavioral Economics, Review of Behavioral Economics, 2018, 5: 303–336) arguing that:

[behavioral economics] is tainted by a “bias bias,” the tendency to spot biases even when there are none.

Let us look at the examples that Schwarcz presents of “abstraction bias”:

  • The bond-CDS basis: Selling CDS protection (insuring a risky bond against default) is equivalent to buying the risky bond if we ignore the issue of how the purchase of the risky bond is funded. Therefore, in an idealized world, the CDS spread should be the same as the credit spread of the bond. Schwarcz argues that abstraction bias causes the CDS spread to be lower than the bond spread. Interestingly, Schwarcz concedes in footnote 89 that the discrepancy between the CDS and bond spreads has arisen only after the Global Financial Crisis. Does Schwarcz think that the Global Financial Crisis led to a rewiring of the human brain creating an abstraction bias where none exited before? The Jennie Bai & Pierre Collin-Dufresne paper that Schwarcz cites in footnote 89 tells a different story: it is all about funding risk and liquidity risk which did change after the Crisis.

  • Bond Insurance: Financial Guarantors like MBIA got into big trouble during the Global Financial Crisis by insuring mortgage backed securities against default. Schwarcz’s claim that they charged too little premium for taking on this risk is based on the following analysis. Consider a mortgage backed security that would have been rated BBB without bond insurance and compare (a) the premium for insuring the bond, and (b) the spread of the BBB bond over US government bonds. The fact that (a) is lower than (b) is cited as evidence of abstraction bias. But this is a wrong comparison because even after bond insurance, the resulting AAA mortgage security trades at a significant spread over US government bonds. The correct way of measuring (b) would be to take the spread of the BBB mortgage security over a AAA mortgage security. My sense is that if Schwarcz’s Appendix 1 is corrected in this manner, much of the discrepancy would disappear.

  • Standby Letters of Credit: I have great difficulty understanding the claim here because the author says:

    … standby letters evolved on a path-dependent progression from commercial letters of credit, which traditionally are prudent banking instruments.

    … there is evidence that standby letters of credit are much riskier than commercial letters of credit

    The problem is that both standby and commercial letters of credit involve the same alleged abstraction bias. Even if it is true that banks have lost more money on standby than on commercial letters of credit, I fail to see what that tells us about abstraction bias.

I got the feeling that Schwarcz picks up examples where there is significant tail risk that takes the form of a contingent liability. It is the tail risk that makes assessment and valuation difficult, but the author seems to think that it is all about abstraction instead.

Legal theory of finance redux

Six years ago, I blogged about Katharina Pistor’s Legal Theory of Finance, and observed that there seemed to be nothing novel about her claim that powerful institutions at the centre of the financial system tend to be bailed out while the small fry are allowed to die. But if one takes the politics out of the theory, the idea of the elasticity of law is an interesting insight. Pistor wrote:

Contracts are designed to create credible commitments that are enforceable as written. Yet, closer inspection of contractual relations, laws and regulations in finance suggests that law is … is elastic. The elasticity of law can be defined as the probability that ex ante legal commitments will be relaxed or suspended in the future

I was reminded of this when I read Emily Strauss’ paper Crisis Construction in Contract Boilerplate which describes how during the Global Financial Crisis, judges in the US interpreted a boilerplate contractual clause to reach a result clearly at
odds with its plain language. She writes:

In the aftermath of the financial crisis, trustees holding residential mortgage backed securities sued securities sponsors en masse on contracts warranting the quality of the mortgages sold to the trusts. These contracts almost universally contained provisions requiring sponsors to repurchase individual noncompliant loans on an individual basis. Nevertheless, court after court permitted trustees to prove their cases by sampling rather than forcing them to proceed on a loan by loan basis.

While the reasoning of these decisions is frequently dubious, they gave trustees the leverage to salvage millions – even billions – of dollars in settlements from the sponsors who had sold the shoddy loans, reassuring investors that sponsors would be forced to stand behind their contracts. However, as the crisis ebbed, courts retrenched, and more recent decisions adhere to the plain language requiring loan-by-loan repurchase. I argue that the rise and fall of decisions permitting sampling reflect a largely unexpressed judgment that in times of severe economic crisis, courts may produce decisions to help stabilize the economy.

This phenomenon is in many ways quite the opposite of Pistor’s theory. The dubious decisions referred to above went against some of the largest banks in the world while benefiting a large and disparate group of investors. While Strauss describes this as an attempt to stabilize the economy, it appears to me to be more of fairness and pragmatism trumping the express terms of the contract. But, at a deeper level, Pistor is right: the law can be very elastic in a crisis.

Reserve Bank of India’s flip-flops on floating rate benchmarks

Earlier this week, the Reserve Bank of India (RBI) issued a circular asking banks to shift from internal to external benchmarks for pricing their floating rate loans. This is the latest in a series of flip-flops by the regulator on this issue over the last two decades:

  • External benchmarks (2001 to 2010): The RBI Working Group of 2009 on Benchmark Prime Lending Rate described this period as follows in Chapter 4 of its report:

In … 2000-01, banks were allowed to charge fixed/floating rate on their lending for credit limit of over Rs. 2 lakh. … banks should use only external or market-based rupee benchmark interest rates for pricing of their floating rate loan products, in order to ensure transparency. … Banks should not offer floating rate loans linked to their own internal benchmarks or any other derived rate based on the underlying.

  • Internal benchmarks (2010-2019): Under the RBI Master Directions on Interest Rate on Advances floating rate rupee loans not linked to a market determined external benchmark used the following internal benchmarks:
    1. Between July 1, 2010 and March 31, 2016: the Base Rate.

    2. Between April 1, 2016 and September 30, 2019 the Marginal Cost of Funds based Lending Rate (MCLR).

  • External benchmarks (2019 till next flip-flop?): This week’s circular states:

All new floating rate personal or retail loans (housing, auto, etc.) and floating rate loans to Micro and Small Enterprises extended by banks from October 01, 2019 shall be benchmarked to one of the following:

– Reserve Bank of India policy repo rate

– Government of India 3-Months Treasury Bill yield published by the Financial Benchmarks India Private Ltd (FBIL)

– Government of India 6-Months Treasury Bill yield published by the FBIL

– Any other benchmark market interest rate published by the FBIL.

These flip-flops reflect the failure of the central bank on two dimensions:

  • The failure to create a vibrant term money market with liquid benchmark rates creates dissatisfaction with external benchmarks. In 2009, the RBI Working Group justified the shift to internal benchmarks as follows:

Banks are finding it difficult to use external benchmarks for pricing their loan products, as the available external market benchmarks (MIBOR, G-Sec) are mainly driven by liquidity conditions in the market, and do not reflect the cost of funds of the banks. … Besides, the yields on some of the instruments may not suggest any representative pricing yardsticks given that they have limited volumes compared to the overall size of the financial market.

  • The failure to create a sufficiently competitive banking system means that internal benchmarks do not work well because in the absence of strong market discipline, banks do not use fair and transparent pricing of floating rate loans. The RBI Study Group that recommended the shift back to external benchmarks described the problem as follows:

First, the experiences with the PLR, the BPLR, the base rate and the MCLR systems suggest that interest rate setting based on an internal benchmark is not transparent as banks find ways to work around. Second, the interest rate setting based on an internal benchmark such as MCLR is not in sync with the practices followed in the modern banking system.

In the next few years, India needs to work on creating both a better banking system and better financial markets. One of the pre-requisites for this is that regulators should step back from excessive micro-management. For example, the RBI Master Directions require the interest rate under external benchmark to be reset at least once in three months while elementary finance theory tells us that if the floating rate benchmark is a 6-Months Treasury Bill yield, it should reset only once in six months. Either banks will refrain from using the six month benchmark (eroding liquidity in that benchmark) or they will end up with a highly exotic and hard to value floating rate loan resetting every three months to a six month rate. Neither is a good outcome.

No Easy Fixes for Limited Liability

US senator and presidential hopeful Elizabeth Warren (who also happens to be one of America’s most eminent bankruptcy scholars) has a proposal to make private equity firms liable for the debts of their portfolio companies by ending the limited liability protection that they currently enjoy. Another well known professor of bankruptcy law and financial regulation, Adam Levitin, has weighed in with an attack on the concept of limited liability itself.

Limited liability is a substantial, regressive cross-subsidy to capital at the expense of tort creditors, tax authorities, and small businesses. Limited liability is a relic of the underdeveloped financial markets of the Gilded Age and operates as an implicit form of leverage provided by law. But it’s hardly either economically efficient or necessary for modern business activity.

These extreme claims might have some basis in the Modigliani-Miller theory of corporate leverage, but Levitin does not substantiate them with serious evidence. In fact, the claims appear to be rhetorical in nature because Levitin goes on to say:

In any event the Stop Wall Street Looting Act rolls back limited liability solely for private equity general partners in a surgical manner such that doesn’t affect limited liability more broadly.

…, the problem with private equity isn’t limited liability per se. The problem is limited liability combined with other unique and unavoidable features of private equity. Limited liability plus extreme leverage means that there is a seriously lopsided risk/reward tradeoff that incentivizes excessive risk-taking.

The problem is that this limited excision of limited liability does not work in the presence of derivative markets because limited liability equity can be replicated by a call option. Owning the shares of a company with substantial debt is equivalent to holding a call option on the assets of the company with a strike price equal to the face value of the debt. This is essentially the Merton model of corporate debt (Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. The Journal of Finance, 29(2), pp.449-470.)

The converse is also true: it is impossible to ban derivatives without banning debt as I argued in a blog post a decade ago. Many proposals for fixing modern finance ignore the ability to replicate one instrument with another set of instruments.

When do algorithms violate the law

I enjoyed reading the judgement of the Federal Court of Australia on whether Westpac Banking Corporation’s computer operated home loan approval system (known as the automated decision system or ADS) violated Australia’s responsible lending laws. The judgement is fun to read, and that might itself be enough reason to read it since delightful court judgements are relatively rate. More importantly, this issue of evaluating algorithms for compliance is going to become increasingly important in the years to come.

The court threw out the case basically on the ground that the Australian Securities and Investments Commission (ASIC) had not done its homework well enough.

[ASIC] does not allege that the alleged defects in the ADS resulted in Westpac extending loans to any consumers who it ought to have found would be unable to meet their financial obligations under the credit contracts or who would be able to do so only in circumstances of substantial hardship. ASIC did originally make several such allegations in relation to specified loans but it abandoned these on the day before the trial commenced. This then is a case about the operation of the responsible lending laws without any allegation of irresponsible lending.

ASIC was claiming that Westpac’s ADS violated the responsible lending laws simply because the rules in the algorithm ignored some data or used imperfect measures for some variables. The court rejected this approach:

It is not enough to point to an individual rule in the ADS and to submit that it does not comply with Div 3. Westpac’s entire system (including manual assessment where referral is triggered) must be examined, and compliance with Div 3 gauged that way.

Of course, the Court is right on this point, and therein lies the challenge in regulating a financial world that is increasingly run on algorithms. It appears to me that financial sector regulators are by and large unprepared for this challenge.

Can India seize the Hong Kong opportunity?

As Hong Kong moves ever closer to a military denouement, India needs to think hard about the opportunity it could provide to its own fledgling offshore financial centre. Over the last several years, India has built the foundations for an offshore financial centre at GIFT City in Gandhinagar, Gujarat. A lot of physical infrastructure has been created, exemptions have been made from the normal exchange control regime, tax concessions have been provided, and some small beginnings have been made in offering offshore financial services. But the turmoil in Hong Kong presents opportunities of a vastly different order.

Is India willing to take the key steps that would make it an attractive option to businesses and individuals that may wish to relocate out of Hong Kong now or in the immediate future?

  • Are we willing to offer long term residence and work permits to those with an employment record in Hong Kong (and a citizenship of a friendly country)?

  • Are we willing to provide a legal and taxation regime that would allow Hong Kong based entities to re-domicile to an offshore financial centre in India with ease?

  • Are we willing to hire people with regulatory experience in Hong Kong to staff a unified regulator for our offshore financial centre?

  • Are we willing to facilitate global entities with substantial operations in Hong Kong that would like to set up an entity in an Indian offshore financial centre as a fall back option that could quickly take over operations currently carried out in Hong Kong?

QE through unlimited buying of foreign equities

After the global financial crisis, central banks have done many things that were previously considered unthinkable, and Switzerland and Japan have probably been more radical than most others. But as the eurozone slips deeper and deeper into the quagmire of negative yields, the Swiss National Bank and the Bank of Japan are now at risk of being perceived as paragons of sound money.

The situation in the eurozone is so bad that the entire yield curve (all the way to 30 years) is negative in Germany and Netherlands, and it is possible that the ECB will be forced to push policy rates even deeper into negative rates. Both the Swiss franc and the Japanese yen have been pushed higher and even Bitcoin looks like a safe haven currency if you look only at a one week price chart.

The pioneers of monetary easing are reaching the limits of their existing unconventional policies, and will have to turn to something even more unthinkable. To compete with the frightening scale of European easing, Switzerland and Japan have to find an asset class that can accommodate almost unlimited buying without running into capacity constraints, creating excessive market distortions, or provoking a severe political backlash. I think at some point they will very reluctantly be driven to the conclusion that there is only asset class that fits the bill and that is global equities.

A portfolio of global index funds can absorb a few trillion dollars of central bank buying without too much disturbance. Political backlash would be muted for two reasons. First, by buying index funds instead of buying assets directly, they avoid getting involved in the sensitive issues of corporate governance and control. Second, every politician likes a rising stock market. Even America’s tweeter-in-chief who sees currency manipulators wherever he looks will probably tolerate a weaker yen if it takes the S&P 500 index to new highs.

Perhaps – just perhaps – falling global equities provide an opportunity for some ordinary investors to front-run the Swiss National Bank and the Bank of Japan before these central banks get into the game.

Big Tech 2019 = Big Finance 2005 = Big Risk?

That is the title of my post today in the sister blog on computing. In 2005, Big Finance was at the top of the world, but in 2008, it all came crashing down. It appears to me that Big Tech which enjoys a similar situation of dominance today also suffers from the same kind of hubris that destroyed Big Finance a decade ago. A change in fortunes could be as fast and as brutal as was the case with Big Finance a decade ago. Prudent risk management today demands that individuals and organizations take steps to protect themselves against the risk that one or more of the Big Tech companies would go bust or shutdown their services for other reasons.

A petty money dispute holds market to ransom

I am not a lawyer, and so it is with much trepidation that I write about a petty dispute that has been holding the Indian market to ransom. I venture to write only because I am convinced that the issue is not really about legal technicalities, and in any case the entire money dispute is quite petty and trivial compared to the broader issue of market integrity and the sanctity of key market infrastructure.

The facts of the dispute are well brought out in an order issued in May 2019 by the Securities Appellate Tribunal. The genesis of the dispute lies with a brokerage firm, Allied Financial Services, that allegedly stole about $50 million worth of its clients’ securities and pledged them as collateral with its Clearing Member, ILFS Securities, to support an options trade that they had done on the National Stock Exchange (NSE). On the strength of this collateral, ILFS Securities, deposited cash margins with NSE Clearing to support the trade done by Allied. After receiving complaints of fraud, the Economic Offences Wing (EOW) froze the collateral lying with ILFS Securities. When the time came to settle the trade, ILFS Securities asked for annulment of the trade. Even if the trade is annulled, ILFS would have to return the option premium and the benefit to them would be a only marginal reduction in the quantum of loss. ILFS Securities’ gain of probably $5-10 million would of course be the loss of the counter parties to the trade.

I deliberately call this a petty dispute because for some of the institutions involved, $5 million or even $50 million is quite likely a rounding error on their balance sheets. Even for the smaller entities, it is not by itself a bankruptcy threatening event. We are not talking about a poor investor whose lifetime savings could be wiped out by the dispute; we are talking about some big institutions which might be somewhat better off or somewhat worse off depending on which way the dispute is resolved. We are also not talking about recovering money from the alleged fraudster; the dispute is all about allocating the losses among different victims of the alleged fraud.

The tragedy is that as a result of this petty dispute, there has been a stay on the settlement of the trade. If not resolved soon, this settlement failure risks causing serious damage to the integrity and reputation of India’s largest stock exchange and its clearing corporation.

The core function of a stock exchange and its clearing corporation is to allow complete strangers to trade without doing any due diligence on each other. If you do an OTC trade or bilateral trade, you have to worry about whether your counter party is trustworthy. On the other hand, when you sell some shares on an exchange, you do not even bother to ask who was the buyer because it does not matter. The whole function of the exchange is to make that question (whom am I trading with) irrelevant and thereby create a national (or even global) market. OTC markets are a cosy club, while exchanges are open to one and all. At the centre of this magical transformation is the clearing corporation that becomes the counter party to all trades (novation) and thereby insulates buyer and seller from each other.

It is this core promise of the clearing corporation that has been called into question by the way this petty dispute has been allowed to fester and linger. A shadow has been allowed to fall on the sanctity of a key market infrastructure. I do not blame the judiciary for this tragedy because the judiciary adjudicates only issues that are brought before it. And it is the money dispute that has come before the judiciary because all the big and mighty entities involved have the wherewithal to hire the best lawyers to argue that this trivial dispute is the most important thing in the world.

The burden of preventing this tragedy lies primarily with the regulator who has the responsibility and mandate to draw the judiciary’s attention to the systemic issues and national interest involved in the smooth functioning of our market infrastructure. A $5 or even $50 million dispute should not be allowed to threaten the integrity of a $2 trillion stock market. As I said, I am not a lawyer, but I find it hard to believe that SEBI would not receive a patient hearing in the highest courts of the land if it made an earnest plea on its statutory duty to protect the investor interest and the public interest. Instead, it has confined itself to narrow legalistic arguments about who has the power to annul a trade and under what conditions. It has allowed the disputants to frame the debate instead of seeking to change the frame of the debate.