Insider Trading by Underwriters

Robert Preston at BBC News reports
about the extraordinary insider trading that took place after the HBOS
rights issue flopped miserably and the underwriters were left holding
the bulk of the issue:

On Friday, Dresdner and Morgan Stanley both knew that existing
shareholders had shunned the rights issue, since they were organising
the share sale. But the market was only given the information this
morning.

That information was – in theory at least – highly price
sensitive. You’d think therefore that both Dresdner and Morgan
Stanley would be banned from dealing in HBOS on their own account till
the market had been told the extent of the rights take-up.

But apparently no such prohibition applied.

…

Well after the rights closed at 11am on Friday, they were both
allowed to take a short position in HBOS, to cover themselves against
a future fall in the HBOS share price.

So they duly shorted HBOS in massive size. I understand Morgan
Stanley took a 2.4 per cent short position in the mortgage bank –
which is huge.

If this story is true, it means that the UK Financial Services
Authority (FSA) has given up all pretence of being a referee rather
than a market player itself. The FSA’s stand against what it
called abusive short selling now sounds truly hollow.

US too turns against the shorts

The headline
on FT Alphaville says “America suspends capitalism” while
the Wall Street Journal’s Deal Journal suggests
that the regulators would simply have put a bounty on a short
seller’s head if only they knew that it could be done. They are
both referring to the emergency order of
the US SEC against naked short selling in 19 financial stocks
including Lehman Brothers, Fannie Mae and Freddie Mac. These orders
were issued under Section 12(k)(2)
of the Securities Exchange Act which provides that the SEC “in
an emergency, may by order summarily take such action … as the
Commission determines is necessary in the public interest and for the
protection of investors … to maintain or restore fair and orderly
securities markets.”

I can well see that a ban shorting Fannie Mae and Freddie Mac might
help the central banks of China, Russia and other countries which
together hold close
to a trillion dollars of these Agency bonds, but I fail to see how it
protects the US investors whom the SEC was set up to protect.

It was only last month that I commended
US regulators for not being as harsh on short sellers as the UK had
been. My praise was clearly premature. In addition to the ban on naked
shorting, the SEC was also talking
loudly about “enforcement investigations into alleged
intentional manipulation of securities prices through rumor-mongering
and abusive short selling.”

Incidentally, Aleablog
tells us that there is an ETF that allows one to short the US
Financials Index without being naked short at all. That post also
tells us June was the best month for short sellers since the dot com
bust seven years ago.

Y V Reddy on Indian Financial Stability

Reserve Bank of India Governor, Dr. Y V Reddy in a speech
at the Meeting of the Task Force on Financial Markets Regulation in
the United Kingdom earlier this month talked about how “India
has by-and-large been spared of global financial contagion due to the
sub-prime turmoil”:

The credit derivatives market is in an embryonic stage; the
originate-to-distribute model in India is not comparable to the ones
prevailing in advanced markets; there are restrictions on investments
by resident in such products issued abroad; and regulatory guidelines
on securitisation do not permit immediate profit
recognition. Financial stability in India has been achieved through
perseverance of prudential policies which prevent institutions from
excessive risk taking, and financial markets from becoming extremely
volatile and turbulent. As a result, while there are orderly
conditions in financial markets, the financial institutions,
especially banks, reflect strength and resilience.

First of all, I would have liked the word “yet” to be
added while talking about India being spared the turmoil because it is
too early to say whether India will emerge unscathed out of all
this. It has been my view that the global turmoil is first and
foremost about the bursting of an asset price bubble in real estate
and secondly about excessive leverage. The specifics of the financial
products involved – credit derivatives, financial guarantees,
securitization, CDOs and SIVs – are relatively less
important. India has not yet had an equally severe correction in
property prices though correction in the share prices of real estate
companies suggests that such a correction is in progress. I also think
that there is a high degree of leverage in Indian real estate and a
fair degree of sub prime lending too. One part of the sub prime
lending (unsecured personal loans) has already witnessed severe losses
mainly for finance companies. A 20% nation wide fall in real estate
prices in India is not inconceivable, and if that were to happen, the
consequences would be ugly for the financial sector.

Second, the idea that institutions in India are prevented from
excessive risk taking is quite incorrect. Indian banks can make bad
loans as easily as banks elsewhere in the world, and there is little
evidence that the culture of credit appraisal is particularly strong
in large parts of the banking system. Low levels of non performing
assets in an (until recently) booming economy prove nothing.

Third, the assertion that financial markets in India do not become
extremely volatile is plainly wrong. I would recall January 16, 1998
in the fixed income markets, August 20, 1998 in the currency markets
and January 21, 2008 in our equity markets as evidence of what can
happen in a single day in three different financial markets. Low
volatility during benign periods is irrelevant; what matters is the
volatility when things go wrong.

The speech refers to several counter cyclical policies of the
RBI:

• encouraging banks to create an Investment Fluctuation Reserve
• permitting them to transfer bonds to the Held to Maturity
  category
• increasing the risk weight for real estate loans, consumer credit
  and capital market exposures.

The first and the third are valid points and highly creditable. The
second is quite dubious as it only allowed banks to avoid mark to
market losses.

Crude oil spot and futures markets

There appears to be a lot of confusion about the relationship
between spot and futures markets for crude oil after Paul
Krugman set the ball rolling with his remark: “Well, a
futures contract is a bet about the future price. It has no, zero,
nada direct effect on the spot price.” Krugman led up to this
with an even more provocative example:

Imagine that Joe Shmoe and Harriet Who, neither of whom has any
direct involvement in the production of oil, make a bet: Joe says oil
is going to $150, Harriet says it won’t. What direct effect does this
have on the spot price of oil – the actual price people pay to have a
barrel of black gunk delivered?

The answer, surely, is none. Who cares what bets people not involved
in buying or selling the stuff make? And if there are 10 million Joe
Shmoes, it still doesn’t make any difference.

Such provocation was bound to elicit an extreme response and Peak
Oil Bebunked did just that with the oppposite claim:

Most crude oil is traded based on long-term contracts, and the
prices in those contracts are set by … adding a premium to, or
subtracting a discount from, certain benchmark or marker
crudes. … Originally, the benchmark prices were spot prices, but
over time … many key oil exporters shifted away from the spot
market, and began to use futures prices as the benchmark.

… Krugman and Birger are profoundly confused about the way the
international oil markets actually function. Futures aren’t a
paper bet on the direction of prices determined by some independent
process. Futures themselves *determine* the price of most physical oil
traded today. The futures price (+ or – the differential) literally
*is* the price of oil.

Peak Oil Bebunked left many commentators on his blog thoroughly
confused. One commentator for example wrote:

I always wondered about this. I figured the futures prices had to
adjust to the spot price (which was driven by actual oil) as the
contract expired. If they didn’t, a arbitrage opportunity would exist
that would correct the imbalance.

But given this explanation, I guess not. I guess the
“spot” prices adjusts to the futures price.

The downside to this approach is that supply/demand fundamentals
don’t necessarily determine the price.

Crude oil markets are pretty complex and Peak Oil Bebunked’s
description of this market is actually quite correct, but there is a
sense in which Krugman’s textbook model is not totally wrong
either. It is worthwhile understanding this market in some detail. For
concreteness, I will focus on the Brent Crude market.

The term Brent crude today refers to crude coming out of any of four
oilfields in the North Sea – Brent, Forties, Oseberg and Ekofisk
– collectively referred to as BFOE.

The most important market for physical Brent crude is the cash BFOE
market which is essentially a forward market. It is based on 21 days
advance declaration (though 15 day and other periods are also in
vogue). In July, a buyer and seller may conclude a transaction for
delivery in August without fixing even the approximate date within the
month. The buyer can choose the date later but has to give 21 days
advance declaration to the seller. It is the price of this contract
that most participants would regard as the price of physical Brent
crude oil. Price discovery does happen in this market though it is
heavily influenced by the futures price. Moreover, though this is a
market for physical crude, it is a forward rather than a true spot
market.

Let us then move to the closest that we get to a spot transaction
– the dated Brent crude market. The terms are usually FOB
– the buyer brings the vessel and the seller provides the berth
at the terminal and loads the cargo. Dated Brent is a market for a
specific cargo (typically 600,000 barrels) to be loaded at the
terminal close to Brent during say July 23-25. The middle day (July
24) is the scheduled day of loading, but the buyer can usually bring
the vessel to the terminal at any time within the three day period
known as the laydays. Dated Brent contracts are actively traded
between oil industry participants. Also, when a buyer gives an advance
declaration in the cash BFOE contract, it effectively becomes a dated
Brent contract.

Since the laydays span three days and the loading period itself
could be close to two days, there is considerable deviation in the
precise day of loading of the cargo even in the dated Brent
market. Similarly, if the buyer of an August cash BFOE contract gives
declaration for a date late in August, it is possible that loading
takes place only on say the 2nd of September. Contracts often allow
for further exceptions even beyond this if there is a curtailment of
production in the oilfield or for other reasons beyond the control of
the buyer or seller. These complications are natural in any genuine
spot market for a non financial asset.

The dated Brent market probably has very little impact on price
discovery for Brent crude. This is because these transactions are
concluded on a differential to the (forward) cash BFOE price. The
dated Brent for July 23-35 might for example be traded at August cash
BFOE plus 10 cents.

Finally, we come to what is by far the most important price of
Brent crude – the Brent crude futures at ICE. The ICE Brent
Futures is a deliverable contract based on EFP delivery with an option
to cash settle. Cash settlement is based on the cash BFOE market as
explained in the contract
specifications:

[T]he ICE Futures Brent Index … is the weighted average of the
prices of all confirmed 21 day BFOE deals throughout the previous
trading day for the appropriate delivery months. These prices are
published by the independent price reporting services used by the oil
industry. The ICE Futures Brent Index is calculated as an average of
the following elements:

1. First month trades in the 21 day BFOE market.
2. Second month trades in the 21 day BFOE market plus or
   minus a straight average of the spread trades between the first and
   second months.
3. A straight average of all the assessments published in media
   reports.

Essentially, therefore, the underlying for the Brent futures is the
cash (21 day) BFOE market. The standard textbook model of cash-futures
arbitrage implies that the futures price cannot deviate too much from
this underlying “spot” price. Even if we regard cash BFOE
as a forward rather than spot contract, it is linked to its underlying
which is dated Brent. The moment the buyer of cash BFOE gives
declaration, he effectively turns his contract into dated Brent
crude. Arbitrage would therefore tie cash BFOE down to dated Brent. At
this level, Krugman’s argument that a futures contract is a bet
about the future price is not without merit.

But things are much more complex than this because long term
contracts for crude in regions far away from the North Sea are based
on Brent futures price plus/minus a differential. ICE claims that the Brent
contract “is used to price over 65% of the world’s traded crude
oil.” On the other hand, BFOE is only a miniscule part of the
total crude oil production in the world. This is the point that Peak
Oil Bebunked is making. Brent futures are far more important and
influential than any of the markets for physical crude. Most price
discovery actually happens in the futures market and the physical
markets trade on this basis. In an important sense, the crude futures
price is the price of crude.

Crude is a particularly nasty example, but similar phenomena exist
even in financial assets. Much of the price discovery in stock markets
happens in the index futures market. Individual stocks are priced
taking the broader market index as given. If the index has fallen 5%
on a day and a specific stock has not traded so far, a person
contemplating placing a bid for this stock would implicitly price it
off the index futures price taking into account the beta of the stock
and any stock specific information. Yet the index futures contract is
settled using the cash index value and is therefore itself tied down
to the cash market through cash-futures arbitrage. This is not
inconsistent with the fact that the major element of price discovery
happens in the index futures market.

Non-use of ratings in SEC regulations

I am not fully satisfied with the 222 page proposal
that the US SEC has put forward for eliminating the use of credit
ratings in various regulations. It is certainly commendable that the
SEC has done a comprehensive job of identifying all regulations that
refer to ratings and then systematically eliminated every one of
them. Moreover, in many cases, the SEC has also identified meaningful
alternatives to the use of ratings. My disappointment is in relation
to the two or three truly critical uses of rating in the SEC
regulations.

The first is in capital requirements for broker dealers where the
existing regulations specify different levels of haircuts for their
proprietary positions in debt securities with different levels of
credit rating. A good solution to this problem could have provided the
template for eliminating the use of ratings in Basle 2 as
well. Instead what the SEC proposes is:

We are proposing the substitution of two new subjective standards
for the NRSRO ratings currently relied upon under the Net Capital
Rule. For the purposes of determining the haircut on commercial
paper, we propose to replace the current NRSRO ratings-based
criterion — being rated in one of the three highest rating categories
by at least two NRSROs — with a requirement that the instrument be
subject to a minimal amount of credit risk and have sufficient
liquidity such that it can be sold at or near its carrying value
almost immediately. For the purposes of determining haircuts on
nonconvertible debt securities as well as on preferred stock, we
propose to replace the current NRSRO ratings-based criterion — being
rated in one of the four highest rating categories by at least two
NRSROs with a requirement that the instrument be subject to no greater
than moderate credit risk and have sufficient liquidity such that it
can be sold at or near its carrying value within a reasonably short
period of time.

We further believe that broker-dealers have the financial
sophistication and the resources necessary to make the basic
determinations of whether or not a security meets the requirements in
the proposed amendments and to distinguish between securities subject
to minimal credit risk and those subject to moderate credit risk. The
broker-dealer would have to be able to explain how the securities it
used for net capital purposes meet the standards set forth in the
proposed amendments.

Notwithstanding our belief that broker-dealers have the financial
sophistication and the resources to make these determinations, we
believe it would be appropriate, as one means of complying with the
proposed amendments, for broker-dealers to refer to NRSRO ratings for
the purposes of determining haircuts under the Net Capital Rule.

The last paragraph above means that while technically the SEC gets
ratings out of its rule book, for all practical purposes nothing
really changes. Broker dealers would use ratings exactly as before
with the full blessings of the SEC.

The SEC has a similar non solution in the second place where
ratings play a critical role. Money market funds are allowed to value
their holdings at amortized cost rather than fair value on the ground
that regulations restrict their investments to short term debt
securities in the two highest short-term rating categories. The
proposal is to rely on a determination of “minimal credit
risk” by the board of directors of the fund. In the context of
the large losses that many money mutual funds have taken during the
sub prime crisis, I would have thought that the logical thing to do
would have been to mandate fair value accounting for money market
funds and treat them like any other mutual fund.

The third critical use of rating and rating agencies is in the
field of disclosure. Rating agencies are exempted from the prohibition
of selective disclosure under Regulation FD. The SEC proposes to
maintain this exemption. I think this exemption is inconsistent with
the stand of the ratings agencies that their ratings are
“editorials”. Similarly, the SEC permits but does not
require issuers to disclose credit ratings in their offer documents.
The SEC’s proposal leaves this substantially unchanged. My problem
here is that if ratings are editorials, then they should be permitted
to be disclosed in offer documents only in the same way and to the
same extent that other editorials, research reports or expert opinions
are permitted to be disclosed.