More fishy financial engineering

September 1, 2009

Two interesting posts today over at FT alphaville regarding some fishy stuff being peddled to retail investors in Europe and Asia.

The first item concerns so-called accumulators which allow investors to purchase shares at a fixed price, normally at a discount.  The problem is that the structure of the program carries big losses for the investor as there is no downside floor on losses and gains are capped at a certain level.  Once again, the issue is: how are retail investors supposed to properly value the imbedded options in such a note?  They can’t.  Which means that the investment bank selling them is just ripping them off.

The second item is again regarding hybrid issues by large banks.  And here the problem is the same.  Banks are issuing capital, specifically targeting retail investors with bond structures with imbedded call options (for the issuer) and are taking full advantage of the fact that investors do not understand what these options are worth.  Although banks always called the bonds in the past, current market conditions made it sometimes beneficial for banks not to do so, hence the mini-scandal at Deutsche Bank mentioned in the article.

That being said, the problem remains the same.  Retail investors are buying products that they don’t understand or worse, they are buying products that they think they understand.  When push comes to shove, this will mean that they end up being ripped off, or that they end up talking on more risk that they think they are.


Urban Infrastructure P*rn

September 1, 2009

If you are one of those weird people that enjoy spending their spare time imagining what Toronto could look like 10, 20, or 30 years from time, some smart people chimed in today with very smart ideas.

Firstly, Dave Meslin posted some thoughts over at Spacing regarding Richmond Street.  Councillor Adam Vaughn recently weighted in over the fate of the famous entertainment district avenue with the idea of making it a two-way street   The premise of the idea was that allowing for 2-way traffic would slow-down cars driving by, making the neighbourhood more of a destination, as opposed to a simple urban highway, thereby making the area more attractive to shops and commerce.  Although I welcomed the idea of revisiting how some of the downtown streets are designed, I was not too sure about the specifics of this plan.  Then comes along Meslin suggesting that we keep the street one-way, but that we add separated two-way bike lanes.  Simply said, this is brilliant.  This is exactly where the city needs to incorporate cycling infrastructure in order of making cycling safer in the core of the city.

Basically, the way things stand now, biking in the city remains somewhat of an extreme sport.  Until we are willing to remove some car lanes in favour of bike lanes, this will remain so.  Adding bike lanes on Richmond and Adelaide would ensure that bike commuters have a safe access to the downtown core, thereby encouraging more people to get on their bikes and relieving some pressure off of the transit system.

Secondly, Spacing Torontoist posted a fantasy map designed by Derek Jensen of what transit could look like in 2040.

Fantasy TTC

Fantasy TTC

Obviously, this is very very ambitious.  That being said, unless we have actual plans for building better transit, all we will ever do is catch up for lost ground.  Jensen’s map clearly lays out what would be needed in order to facilitate transportation across the GTA and get more people off of their cars.  Yeah, then there is the issue of costs and all.  But it’s nice to dream once in a while.

Privatize the LCBO Already

August 29, 2009

For probably the first time since he replaced John Barber at the City Hall columnist, I find myself agreeing with Marcus Gee:

It is embarrassing for a city that calls itself progressive and world-class to plod along under a Depression-era liquor-control regime. Montrealers find it laughable. No other country I’ve visited leaves the retailing of liquor exclusively in the hands of a state-run monopoly.

And this is pretty much all that needs to be said.  I mean what the hell.  Do we really need the government to control alcohol sales? In 2009? Time to realize this makes so sense and move on.  Arguments claiming that the current regime help forestall alcoholism simply do not stand up to scrutiny.  And as far as public revenues go, the province can simply auction the rights to sell alcohol and/or increase taxes.  Please, lets grow up.

Tobin Taxes

August 28, 2009

I believe that I became interested in finance for the first while reading something about the Tobin tax when I was a teenager.  The idea was being pitched through a new organisation called attac.  I sort of forgot all about it while completing university, but the topic came up once in a seminar in financial engineering that I took in grad school.  The guy’s point was that it was completely unfeasible.

Anyways, via Justin Fox, I learn that the new head of the FSA brought up the subject during an interview with Prospect Magazine.  It did not take long for people to start freaking out;

Bankers, industrialists and London’s mayor have fiercely rejected Lord Turner’s argument that Britain’s “swollen” banking industry was destabilising the economy and needed to be cut down to size.

The backlash came a day after the chairman of the Financial Services Authority said the City watchdog should be “very, very wary of seeing the competitiveness of London as a major aim”.

He also floated the idea of higher capital reserve requirements and a global Tobin tax on financial transactions to choke off some of the banks’ “socially useless” activity.

Lord Turner’s critics said he had overstepped his remit as a regulator and risked damaging London’s standing as Europe’s leading financial centre.

Clearly the usual suspects will be objecting.  You cannot really expect bankers to be in favour of something that will cut into their revenues.  But what about the actual merits?

Stephen Gordon, an economics professor at Laval University in Quebec City, said he failed to see how taxing financial transactions would have prevented the financial crisis, which he attributes to excessive leverage and poor risk management. Prof. Gordon also pointed out that such a tax would have exacerbated the credit crunch by making capital even more expensive.

But the biggest knock against the Tobin Tax is rooted in pragmatism: All the world’s big economies would have to institute it to keep banks from simply doing business in jurisdictions that refused to apply the levy.

And probably this is right.  I don’t believe that the idea is a bad one, but it is probably not feasible in practice for 2 sets of reasons.  First, it would require international cooperation/coordination on scale never seen before.  Secondly, financial engineering would make evading taxes fairly easy, unless the regime was set-up in an incredibly complex way as to capture trades that replicate spot fx trades.  For a good explanation, I dug up an old paper from the federal reserve bank of San Francisco:

The second enforceability problem relates to the definition of the tax base. That is, how exactly is a foreign exchange transaction to be defined? Modern financial engineering is based on replicating one asset with combinations of other assets. At a minimum, the tax would have to be applied to forward, futures, and swap transactions in addition to spot transactions, since a spot transaction can be replicated easily by a combination of debt and forwards, futures, or swaps. In fact, the problem is even worse than this. Spot transactions could also be approximated by exchanging liquid securities (like T-Bills) denominated in different currencies.  Consequently, the tax would likely spread and eventually come to envelop large segments of what is traditionally regarded as the domestic capital market. This problem, more than any other, would likely kill the Tobin tax.

Don’t Listen to Libertarians

August 27, 2009

when it comes to trains at least.  So says Ryan Avent:

I respect Mr Cowen very much, but I think it’s long past time we stopped listening to libertarians on the issue of whether or not to build high-speed rail. Who will ask whether road construction remotely passes any of the tests they’re so prepared to push on rail? And if we begin charging an appropriate fee on drivers to maintain existing roads and reduce congestion, what do they all think will happen to land use patterns and transportation mode share?

This is in response to this post from Tyler Cowen at Marginal Revolution.  Ryan brings up the point that the criteria that we apply for assessing the viability of HSR are much more stringent than for anything else.  You basically calculate how much it costs to build and maintain the network and compare  that number to the revenues it will generate from passengers and ancilliary business.    And then you conclude that it’s cheaper to drive.  But no one factors in the cost of road building and maintenance in the comparison.  Or the cost of congestion.  Or the cost of traffic accidents and fatalities.  We just take it for granted that they are “free”.  If we were to charge tolls on all highways to reflect the actual cost of using them, I’m pretty sure we would come to realize that HSR can indeed be cost effective.  And this does not even consider the environmental impact of shifting from oil (cars) to electricity (trains).

I don’t know where studies about Canada that are similar to the one referenced in Tyler’s post can be found.  I would love to see the numbers applied to the Quebec-Windsor corridor compared to the cost of maintaining the 401/20 highway.

More high Speed Rail

August 27, 2009

Some more good train-related news coming out of La Presse in the last two days.

First, the SNCF – hired by the City of Québec to study the viability of high speed rail between Windsor and Québec – concluded that such a rail network would be viable.  Now, it happens that the SNCF will also be paid to issue a more in depth report on the greater consequences, environmental, economic and such, of a high speed rail network, so this conclusion was to be expected.  Still, having this report in hand is a step in a good direction.

Second, Montreal mayor Tremblay will be asking the federal government to leave 1 set of tracks in the corridor to the sole use of VIA.  Right now, freight trains have priority as the CP and the CN own the tracks.  This would potentially allow the creation of a network of fast trains, tentatively called ViaFAST,  which, although not as fast as TGV-style rail, could potentially reach a speed of 240 km/h and would be substantially cheaper to implement.

Although I would be more inclined to go down the road of proper high speed rail, it is great to see that the concept of better rail is getting some traction.  Interestingly, cities and their mayors seem to be pushing this forward, not the provinces, nor the federal government.  Maybe this will change come November.

The Financial System and Canadian Banks

August 26, 2009

In light of the fact that over the past two years the Canadian financial system has proved very resilient compared to its international peers, there has been a lot of talk as to why this has been the case.  See here and here for example.

Yesterday VoxEU had a post on the subject based on new research done at the IMF.  The authors’ full study can be found here.

As far as I know, this is the first rigorous study on the subject.  And their conclusion is very interesting:

Our paper analyses the pre-crisis balance sheet structures of the largest commercial banks in OECD countries and relates them to bank performance during the turmoil. Our regression analysis shows that incidents of bank distress can be explained rather well based on just three pre-crisis accounting-based financial ratios: a critically low (below 4%) equity-to-asset ratio, insufficient balance sheet liquidity, and a funding structure that relied less on a stable deposit base and more on wholesale funding. 

Empirically, the funding structure, as measured by the depository funding to total asset ratio, is the most robust predictor of bank performance during the turmoil.

The authors evaluated both the asset side and liability side of the equation and concluded that the most important factor in shielding the Canadian banks was their greater reliance on deposits instead of wholesale funding.  It was not some special cultural attribute of Canadian risk managers, or some all-seeing power of OFSI.  That being said, on the asset side, they do point out that the regulatory environment did play a role.  From the paper:

Canadian banks were indeed distinguished by limited exposure to troubled U.S. assets. There are a number of possible explanations for this beneficial outcome: sound risk management, regulation that discourages non-core foreign activities (see next section), and potentially low gains from diversification into a closely correlated economy. There is no doubt that limited exposure to troubled U.S. assets has contributed to the stability of Canadian banks during the turmoil.

In addition, the fairly sheltered competitive environment also resulted in a more robust financial structure.  Again from the study:

The Canadian banking sector is dominated by six large banks with an integrated nationwide branch network. The national franchise is highly profitable and valuable, and banks are keen to preserve it, thereby avoiding excess risks that could compromise the franchise. Customers value the capabilities of a nation-wide bank branch network, and the demand for it serves as a barrier to the contestability of Canadian banking services especially in deposit and debt card products. Limited external competition reduces pressures to defend or expand market share, again reducing incentives to take risks.

This last point is very interesting.  We can probably infer that, all else equal, having a less competitive environment results in rent-like profits for the banks at the expense of their consumer base.  However, because of this, banks did not need to be bailed out by the government, a cost that would have been ultimately borne by taxpayers.  In other words, and if I am reading this right, the lack of competition in Canada acts as a sort of tax on savers, where the revenue raised served to protect the financial system.  And since this is a tax on savings, it would be progressive, as richer citizens would tend to have more money saved in the banks.

Whether that’s correct or not, this is a very interesting paper well worth a read.  I’m sure we’ll see more on the subject in the coming years as regulators try to develop a better regulatory environment 

Via Free Exchange

-update.  Felix Salmon adds some thoughts about banking structure.

Hybrid securities and retail investors

August 25, 2009

FT Alphaville links to a story appearing today in the FT regarding Deutsche Bank’s latest attempt to shore up it’s capital ratio by raising funds through retail markets.  The bank will be issuing so-called hybrid securities that allow the bank to call the bonds as early as 2015.

It appears that there is strong demand as the coupon being paid out are quite attractive compared to other yields available in current market conditions.  CIBC did something similar back in the winter.

On the one hand, I guess it is good news that banks are able to push up their capital ratios;  this should inspire confidence as to the strength of the financial system going forward.  On the other hand, the fact that retail investors are being targeted for complex products is worrying.  There is just no way that most retail investors are able to properly value the options imbeded in such securities.  As such, you got to have a feeling that the banks are targeting the retail investors because they know they’ll be able to fleece them in a way that would never cut it with institutional investors.

Being dense about trains

August 25, 2009

I’m pretty sure we’ll be hearing similar arguments from opponents when Ignatieff starts proposing high speed rail.

Russian novels are hard

August 25, 2009

Matt Yglesias thinks Ted Poe is confusing War and Piece with Anna Karenina.

This reminds me that Russian classics are not easy.

Executives at Paramount Pictures announced Monday that production had finally wrapped on The Brothers Karamazov, a new film adaptation that concludes at the precise moment most readers give up on the classic Russian novel.

The 83-minute film, which is based on the first 142 or so pages of Fyodor Dostoevsky’s acclaimed work, has already garnered attention for its stunning climax, in which the end credits suddenly appear midway through Katerina’s tearful speech about an unpaid debt.