Credit card frauds

One of the world’s foremost experts on computer security,
Bruce Schneier, writes on his blog
about the recent theft of 130 million credit card numbers:

Yes, it’s a lot, but that’s the sort of quantities
credit card numbers come in. They come by the millions, in large
database files. Even if you only want ten, you have to steal
millions. I’m sure every one of us has a credit card in our
wallet whose number has been stolen. It’ll probably never be
used for fraudulent purposes, but it’s in some stolen database
somewhere.

Years ago, when giving advice on how to avoid identity theft, I
would tell people to shred their trash. Today, that advice is
completely obsolete. No one steals credit card numbers one by one out
of the trash when they can be stolen by the millions from merchant
databases.

I had read in the past about online thieves selling credit card
data for a few cents per thousand cards, but I did not realize that
things were so bad.

What is also interesting is that you do not need to use credit
cards in online transactions, or in some fraud prone South East Asian
country for your card number to land up in a stolen database. The
number gets stolen from large retail chains in the best of
countries.

Of course, Schneier is talking only about credit card numbers, so
with the increasing use of two factor authentication, it may take
something more to actually use the card, but that something more is
often surprising little.

Basel Committee captured

The extent to which the Basel Committee on Banking Supervision has been captured by the banking industry that it regulates is clear from Guiding principles for the replacement of IAS 39 that it released today:

The new two-category approach for financial instruments should not
result in an expansion of fair value accounting, in particular through
profit and loss for institutions involved in credit
intermediation. For example, lending instruments, including loans,
should not end up in the fair value category.

There should be a strong overlay reflecting the entity’s
underlying business model as adopted by the Board of Directors and
senior management, consistent with the entity’s documented risk
management strategy and its practices, while considering the
characteristics of the instruments.

The new standard should … permit reclassifications from the fair
value to the amortised cost category; this should be allowed in rare
circumstances following the occurrence of events having clearly led to
a change in the business model

The IASB should carefully consider financial stability when
adopting the timing of the implementation of the final standard.

The new standard should provide for valuation adjustments to avoid
misstatement of both initial and subsequent profit or loss recognition
when there is significant valuation uncertainty.

The new standard should utilise approaches that draw from relevant
information in banks’ internal risk management and capital
adequacy systems when possible (eg approaches that build upon or are
otherwise consistent with loss estimation processes related to bank
internal credit grades may be useful).

Is Basel saying for example that all through this crisis they have
been quite happy with the robustness of “the underlying business
model as adopted by the Board of Directors and senior
management” of the banks as well their “documented
risk management strategy and … practices”?

Change of address fraud

Floyd
Norris points to a FINRA
press release about a eight year long fraud at a Citigroup
brokerage office in California.

The $850,000 fraud was carried out by a sales assistant, which as
Norris points out, is about as low as you can be in a brokerage
office. The critical element in the fraud as detailed in the press
release was to change the address of the customer (using falsified
documents) so that account statements showing the unauthorized
withdrawals do not reach the customer. Of course, she was also smart
enough to chose customers who were unlikely to monitor their accounts
regularly and notice the absence of periodic account statements.

There is one thing here that I do not understand. The best practice
in the financial industry while recording a change of address is to
send a confirmation of the change to the old
address. I am fond of saying that responding to a change of
address request with a confirmation letter to the new address is a
matter of courtesy, and nothing will happen if this confirmation does
not go out. But sending a confirmation to the old address is an
elementary fraud precaution and under no circumstances should this
fail to happen. It is the last opportunity to the customer to stop the
fraud.

So did Citigroup not have a process for ensuring this standard
fraud control process? Or is sending a confirmation to the old
address not as well understood and practiced in the industry as it
should be?

Winding up Lehman Europe

While much has been made about the difficulty of winding up large
and complex financial institutions, it appears that it is the simplest
of structures that are the hardest to wind up. Giving some of
one’s things to another for temporary safe keeping on
“trust” is probably older than lending money (debt markets)
or selling equity interests in assets (stock markets) – it is
probably older than money itself. Yet it is the simple trust structure
that is proving so difficult with Lehman Brothers International Europe
(LBIE) in London.

The UK High Court has ruled that the normal scheme of arrangements
in bankruptcy do not apply to trust property:

51. On analysis Part 26 is concerned with the general estate of a
company. It cannot override ordinary trust principles. In the case of
creditors, whether actual, prospective or contingent, it deals with
persons who have claims which they can bring against the pool of
assets which comprises the general estate of the company. A
creditor’s claim ranks pari passu with other creditors’
claims against that general estate. It is perfectly comprehensible,
therefore, that Part 26 should provide that if those creditors wish to
rearrange or compromise their rights against the company, they should
be able to do so, by the requisite majorities, because, at the end of
the day, they all look to the company’s assets for satisfaction
of their pecuniary rights.

52. By contrast with that is the person who has placed his assets
with a trustee. There the position is totally different: the essential
feature of so doing is that the owner knows that he can have his
property, which remains his throughout, dealt with by the trustee in
accordance with the terms of the trust. The property is not vulnerable
to interference merely because the trustee becomes insolvent: the
trust remains. The fact that the trustee is a corporate trustee is
likewise immaterial to the integrity of the trust; no less immaterial
is that the trustee happens to be a company liable to be wound up
under the Insolvency Act 1986 (or the equivalent provision in Northern
Ireland), these being the types of company to which the court’s
jurisdiction under Part 26 applies where a compromise or arrangement
is proposed between a company and its creditors or any class of them:
see section 895(2)(b).

53. The fact that the proposed scheme is confined to persons who
have a pecuniary claim, however prospective or contingent that claim
may be (for example a claim for damages or compensation for the delay
in returning that person’s property), does not assist the
administrators. While the existence of that claim may provide the
basis for a scheme of arrangement directed to that and other pecuniary
claims against LBIE, it does not justify interference with the
underlying property rights of the property owner. Aside from the fact
that the property owner’s remedy (as beneficiary under the
trust) for breach of trust is principally directed to securing
performance of the trust, rather than to the recovery of compensation
or damages, the existence of the pecuniary claims does not affect, and
is certainly not the origin of, the owner’s property rights. To
suggest otherwise and to ground the intention of the scheme to
interfere with the owner’s property rights merely because that
owner also has a pecuniary claim against LBIE in view of the
possibility that LBIE has acted (or may yet act) in breach of trust is
to invert the position. Indeed, the scheme, if it is allowed to
proceed, risks turning the position of the beneficial owner on its
head: this is because under a trust it is for the trustee to justify
and account for his dealings with the trust estate whereas under the
scheme the onus will be on the owner to come forward, as a
dissentient, to explain and justify why that owner’s property
rights should not be dealt with and varied under the scheme.

What I found most amusing was the idea that when a hedge fund gives
collateral to a prime broker with unlimited right to rehypothecate,
“the owner knows that he can have his property, which remains
his throughout.” But then I am not a lawyer.

The court of course thinks that the absence of a scheme of
arrangement does not matter. The court has enough powers to sort
things out. By that argument, one does not need a scheme of
arrangement for creditors either – the courts can sort that out
too.

77. Establishing what client assets of any given client LBIE holds
or controls, what competing claims there may be to those assets by
other clients or by LBIE (or others) and how LBIE and the
administrators are to discharge their duties in respect of those
assets with a view to their due distribution to those entitled to them
are all matters where the court has, in the exercise of its trust
jurisdiction, well-developed processes to assist the accountable
trustee or other fiduciary. For example, the court is well used to
authorising a trustee to make distribution of a fund where there can
be no certainty that all of the claimants to it have been identified
and the trustee desires the protection of a court order in the event
that a further claimant should subsequently appear or matters
subsequently come to light which question the basis on which the
distribution is made. In one sense, dealing with the matter by
recourse to the court’s assistance in this way can be simpler
(and less costly) than the often complex processes involved in the
promotion of a scheme under Part 26.

78. At the risk of appearing glib, I do not consider that a
structured approach of this broad kind is beyond practical achievement
in the exceptionally difficult circumstances of LBIE’s
administration.

In short, it appears that the legal system in the foremost
financial centre in the world does not have a practical way of dealing
with the simplest and oldest financial contract – property held
under trust.

Securitization

I wrote a column
in the Financial Express today about the role of
securitization.

The global financial crisis began two years counting from the first
liquidity crisis in Europe and the US on August 9, 2007. Over these
two years, we have found that many of the conclusions that we came to
in the early days of the crisis were simply wrong.

In 2007, we thought that the problem was about subprime mortgages,
that it was about securitisation and that it was about CDOs
(collateralised debt obligations). Now we know that these initial
hasty judgments were mistaken. Defaults are rising in prime mortgages,
huge losses are showing up in unsecuritised loans, and several banks
have needed a bailout.

In 2007, when the first problems emerged in CDOs, people thought
that these relatively recent innovations were the cause of the
problem. Pretty soon, we realised that a CDO is simply a bank that is
small enough to fail and conversely that a bank is only a CDO that is
too big to fail.

Both banks and CDOs are pools of assets financed by liabilities
with various levels of seniority and subordination. As the assets
suffer losses, the equity and junior debt get wiped out first, and
ultimately (absent a bailout) even the senior tranches would be
affected. In retrospect, both banks and CDOs had too thin layers of
equity.

Over the last two years, our understanding of securitisation has
also changed significantly. As global banks released their results for
the last quarter, it became clear that bank losses are now coming not
from securitised assets but from unsecuritised loans or whole loans.

The Congressional Oversight Panel (COP) set up by the US Congress
to “review the current state of financial markets and the
regulatory system” published its latest report a few days
ago. The report focuses entirely on whole loans and paints a very
scary picture. Losses on troubled whole loans in the US banking system
are estimated to be between $627 billion and $766 billion.

The COP report also states that “recent reports and
statistics published by the FDIC indicate that overall loan quality at
American banks is the worst in at least a quarter century, and the
quality of loans is deteriorating at the fastest pace ever. The
percentage of loans at least 90 days overdue, or on which the bank has
ceased accruing interest or has written off, is also at its highest
level since 1984, when the FDIC first began collecting such
statistics.”

It is becoming clear that what the US is witnessing is an
old-fashioned banking crisis in which loans go bad and therefore banks
become insolvent and need to be bailed out. The whole focus on
securitisation was a red herring. The main reason why securitisation
hogged the limelight in the early stages was because the stringent
accounting requirements for securities made losses there visible
early.

Potential losses on loans could be hidden and ignored for several
quarters until they actually began to default. Losses on securities
had to be recognised the moment the market started thinking that they
may default sometime in the future. Securitised assets were thus the
canary in the mine that warned us of problems lying ahead.

Until recently, it could be argued that securitised loans were of
lower quality than whole loans and that at least to this extent
securitisation had made things worse. But this statement is true only
for residential mortgages and not for commercial mortgages, where the
position is the reverse. Securitised commercial mortgages (CMBS) are
of higher quality than whole loans.

The COP report states: “While CMBS problems are undoubtedly a
concern, the Panel finds even more noteworthy the rising problems with
whole commercial real estate loans held on bank balance sheets. These
bank loans tend to offer a riskier profile as compared to CMBS,
suggesting high term default rates while the economy remains
weak.”

Two years into the crisis, therefore, we find that the initial
knee-jerk reaction against securitisation was a big mistake.

Securitisation doubtless redistributed losses throughout the world
so that losses from the US real estate emerged in unexpected places
– German public sector banks, for example. But securitisation
was not responsible for most of the losses themselves.

We must also remember the US home owner gets a bargain that is
available to few home owners elsewhere in the world – a 30-year
fixed rate home loan that can be repaid (and refinanced) at any time
without a prepayment penalty. This is possible mainly through
securitisation and deep derivative markets that allow lenders to
manage the interest rate risks.

In India by contrast, the home owner gets a much worse deal: most
home loans are of shorter maturity (20 years or less) and are usually
either floating rate or only partially fixed rate. The few ‘pure
fixed rate’ loans involve stiff prepayment penalties when they
are refinanced. It would be sad if we keep things that way because of
an irrational fear of securitisation.

Estimating the Zimbabwe hyperinflation

Hanke and Kwok have written a paper
in the Cato Journal estimating the hyperinflation in Zimbabwe in
November last year. They conclude that the monthly (not
annualized) inflation rate of 80 billion percent was the second
highest in world history (next only to Hungary in July 1946).

I was at first skeptical about the methodology that they use. Since
Zimbabwe stopped publishing inflation data during the period, Hanke
and Kwok rely on the share prices of the South African insurance and
investment company, Old Mutual, in the stock markets in Harare and
London. This involves making two assumptions:

• that the relative price of the Old Mutual share in the two
  countries provides a reliable estimate of the exchange rate of the
  Zimbabwe dollar; and
• the depreciation of the exchange rate is a good estimate of the
  inflation rate in Zimbabwe via purchasing power parity (PPP).

I thought that both assumptions are highly suspect for reasons that
I explain below.

We do know that, absent capital controls, the relative share price
of the same company in different countries tracks the exchange rate
very closely. This was true as early as the eighteenth century (Larry
Neal, “Integration of International Capital Markets:
Quantitative Evidence from the Eighteenth to Twentieth
Centuries”, Journal of Economic History, 1985) and
it is even more so today. Even the well known paper of Froot and Dabora
(“How are stock prices affected by the location of trade,”
Journal of Financial Economics, 1999) found problems with
the pricing of twin stocks but not the prices of the same twin in
multiple markets.

At the same time, exchange controls can play havoc with this
assumption. For example, Indian ADR prices trade at large premia to
the underlying Indian shares. The difference between Shanghai and Hong
Kong share prices of mainland China companies reflects the same
phenomenon. These examples suggest that relative prices could be off
by nearly a factor of two in the presence of stringent capital
controls.

In the kind of lawlessness that prevailed in Zimbabwe, the margin
of error is I think higher. I would not be too surprised to find a
deviation of prices by as much as a factor of ten.

The second assumption about PPP is even more suspect. Under normal
conditions, PPP does not hold up too well except over the very long
run. Lothian and Taylor needed 200 years of data to demonstrate that
PPP does hold at all (“Exchange rate behavior: The recent float
from the experience of the last two centuries,” Journal of
Political Economy, 1996).

One would hope that to the extent that PPP is held back by sticky
prices, the extreme flexibility of prices during hyperinflation would
make PPP hold better. I think there is merit in this
argument.

However, in situations like Zimbabwe, the US dollar would probably
be valued more as a store of value than as a medium of exchange. The
exchange rate is then driven by asset market considerations rather
than goods market considerations. Extreme financial repression in
which the real rate of interest on Zimbabwe dollar could be hugely
negative (approaching -100%) would make the US dollar extremely
attractive. People would then buy the US dollar not on the basis of
what it is worth now, but on the basis of what it will be worth in
future. At the same time, it is impossible for a foreigner to go long
on the Zimbabwe dollar without assuming Zimbabwe sovereign credit risk
and legal risk.

Under these conditions, I would not be surprised if the exchange
rate undervalued the local currency by a factor of ten or more. Taken
together with the earlier factor of ten for the stock price, this
implies that Hanke and Kwok could be off by a factor of 100.

Surprisingly, this would make very little qualitative difference to
the results of Hanke and Kwok. The monthly percentage rate of
inflation in Zimbabwe that they estimate is roughly 80
billion. Revising it down by a factor of hundred would bring it down
to 800 million. That is still higher than the third highest rate on
record (Yugoslavia, January 1994) of 300 million. No plausible margin
of error in the opposite direction will bring Zimbabwe within even
shouting distance of the highest recorded hyperinflation (Hungary,
July 1946) which was 4 followed by 16 zeroes.

Put differently, to push Zimbabwe down to third place, the Hanke
and Kwok estimate would have to be off by a factor of 250. Much as I
dislike the smug confidence that Hanke and Kwok seem to have in
arbitrage relationships in a society where there is security of
neither life nor property, I find it difficult to argue that the
arbitrage relationships may be off by a factor of 250.

Comments recovered from black hole

I realized a couple of days ago that many of the comments on my
blog in June and July had disappeared into a black hole. I am still
trying to figure out what the problem was with my blogging software
(this did not affect the comments on the WordPress mirror).

In the meantime, I have now recovered most of these comments and
added them to the blog. I have also written some code to retrieve
orphaned comments and bring them up for moderation so that hopefully
this does not happen again.

As I have stated in the past, it is my intention to use moderation
only to filter out spam and not to filter out comments that I do not
like. So if you find your legitimate (non spam) comments not appearing
on the blog within a few days, please do point it out to me by
email.

Economics of counterfeit notes

There has been much alarmed discussion in the press about the
counterfeit Indian rupee notes allegedly being smuggled into the
country from across the border. As I see it, the barriers to
counterfeiting currency notes are economic and not technological.

Introducing more and more complex features into the notes does not
make counterfeiting impossible. What it does is to increase the scale
economies in printing by requiring larger and larger initial
investment and therefore larger and larger scale of production to make
the printing of counterfeits economical. Scale economies are not a
problem for the government itself because it anyway prints notes on a
very large scale.

Scale economies need not deter the counterfeiter; it only requires
the counterfeiter also to operate on a large scale. The problem for
the counterfeiter is that the distribution of counterfeit notes is
characterized by large diseconomies of scale.

It is pretty easy to distribute a few hundred counterfeit notes
with very little chance of detection. Distribution of a million
counterfeit notes however requires a distribution network that is very
difficult to set up and operate without being detected.

This combination of scale economies in production and scale
diseconomies in distribution imply that there is often no viable scale
of operation for a private counterfeiter. The total expected cost of
manufacturing and distributing the counterfeit note approaches the
face value of the note itself.

Counterfeiting by a foreign government is only slightly
different. To the extent that they can use the equipment used in their
own note printing operations, counterfeiting may be economically
viable for them at lower print runs. More importantly, if their goals
are not purely economic, the profitability of the operation is not an
issue.

However, the problem of the distribution channel is still an
issue. The experience of German counterfeiting of UK currency notes
during the second world war suggests that the technical quality of the
counterfeiting is not the real problem. How to get the notes into
enemy territory in large scale is the critical issue. The German
experience suggests that using the espionage network to put the notes
into circulation only compromises the espionage network itself.

Often, the goal of putting counterfeit notes into circulation in
enemy territory is not to make a profit but to disrupt the
enemy’s economy by making people distrust their own
currency. The strategy of the Indian government and the RBI to deal
with the problem of counterfeit notes quietly and without spreading
panic is therefore a very sensible one.

For a profit motivated rogue government, the most attractive
currency to counterfeit is the US dollar. An estimated 70% of US
dollar notes circulate outside the US; many users of the currency are
not very familiar with it; the design of these notes is relatively
stable; and finally, dollar resources are very valuable in
international trade.

Anecdotal evidence suggests a greater percentage of counterfeit US
dollar notes (at least outside the US) than in most other
currencies. Yet the percentage of counterfeit notes is still quite
manageable. I think therefore that the fears that are being expressed
in the Indian press about counterfeit rupee notes are excessive.

Madoff and his AS/400

The brain behind Madoff’s huge fraud has been revealed
– it was the well known IBM AS/400 minicomputer. Well, that is a
bit of an exaggeration, but only slightly so. The SEC complaint
against a key Madoff lieutenant, Frank DiPascali, turns out to be a
long litany of the accomplishments of his AS/400.

Printing millions of pages of trade confirmations (one for each
stock and for each account for every fictitious trade) was one of the
major uses of the AS/400. DiPascali also used a random number
generator program to break up the massive trades into orders of
various sizes and prices and to randomly distribute the trades across
different times. Apart from the AS/400, Madoff also had a fake
computer trading platform set up in the office, just in case somebody
wanted to witness real time trading.

For all its prowess, the AS/400 could not generate trade blotters
and order tickets. Perhaps, doing this with credible execution times,
counterparties and executing brokers would have needed more powerful
machines (and tick level price feeds not to mention top quality
programmers) of the kind employed by the hedge funds that do high
frequency trading today.

I get the sense that while Madoff was an early adopter of
technology, he did not keep pace with it in the later years. As
investors started demanding faster trade confirmations, the amount of
time that DiPascali could look back to construct the profitable phony
trades became shorter and shorter. I suspect that even if the market
crash of 2008 had not blown up the Ponzi scheme, it would have become
harder and harder to keep the ruse going with the aging technology
that Madoff and DiPascali had available to them.

High frequency trading and rebates

High frequency trading is very much in the news these days with
controversies about flash trades, rebates and so on. In this context,
this
paper by Foucault, Kadan, and Kandel is very interesting (hat tip
Aleablog). It
develops a model which explains why it may be optimal for exchanges to
pay market makers for trading (in the form of rebates) while charging
market takers for trading.

The paper discusses the determinants of what they call the
make-take spread – the difference between the (possibly
negative) fees charged to market makers and the (positive) fees
charged to other traders. I found it more convenient to think in terms
of the take-make spread (or the negative of the make-take spread)
which can be interpreted as the subsidy to market makers.

The paper shows that a reduction in the tick size increases the
optimal subsidy to market makers. They argue therefore that
decimalization might have been an important factor in the emergence of
rebates to market makers.

The subsidy for market makers is greater when there is a small
number of market-makers relative to the number of market-takers. Quote
driven markets tend to be dominated by a small number of market-makers
and the rebates offered by these exchanges is in line with the
predictions of the paper. The fact that order driven markets do not
subsidize limit orders relative to market orders is also consistent
with their model because these markets are characterized by large
number of participants using limit orders.

While these are useful contribution, the paper still left me uneasy
at the end. Why are quote driven markets unable to attract a large
number of market makers when order driven markets have no difficulty
attracting millions of limit order users? Is there something
fundamentally wrong with quote driven markets that make them
inherently anti-competitive leading to a cosy oligopoly of market
makers?