Category Archives: pricing risk

How large is the taxpayer subsidy to Too-Big-To-Fail banks?

The issue came up yesterday when Fed Chairman Ben Bernanke testified before the Senate Banking Committee. Senator Elizabeth Warren cited a Bloomberg report that put the number at $83 billion to the 10 largest U.S. banks. The Bloomberg figure is extrapolated from the finding of an IMF study that the backstop provided to banks lowers their cost of borrowing by approximately 0.8 percentage points.

Matt Levine at Dealbreaker makes the provocative claim that “The Too Big to Fail Subsidy is Negative Sixteen Billion Dollars”. This comes in the second round of Levine’s tit-for-tat with Bloomberg. His original critique started off with a reasonable and incisive drill down into the numbers.[1] Now, after an effective rejoinder by Bloomberg, he abandons the two main points from his original critique and substitutes new ones.

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Is wholesale power trading as profitable a line of business as they say?

EDF Trading

Gregory Meyer, in today’s Financial Times, reports that banks are scaling back their trading in U.S. wholesale electric power markets. In his companion article, he quotes me saying that

The banks had the balance sheet, but the reality was it was the taxpayers that were giving them the balance sheet. It’s not clear we want the taxpayer subsidising proprietary trading in electricity or even hedging in electricity.

I am very circumspect about whether power trading operations are as profitable as they are often advertised to be. Here’s one reason why.

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No pain, no gain?

The Missing Risk Premium takes aim at a central premise of modern finance theory: extra return requires extra risk. The premise is so central that few of us involved in modern academic finance can even imagine a world without it. Eric Falkenstein insists that we do. This book is his challenge to us.

Falkenstein’s thesis is a radical one: extra risk does not yield extra return. Continue reading

Griffin’s Risk Management Superpower

 

The third installment of the feature film series Men in Black features the alien Griffin. Griffin possesses the critical ArcNet shield that can protect the earth against the impending Boglodite invasion. Griffin also possesses an amazing superpower: he can see the many possible futures in store for us. The movie’s writers, director and the actor playing Griffin, Michael Stuhlbarg, exploit this superpower to great comedic effect, first in a scene that takes place in 1969 at Andy Warhol’s Factory, and then later at Shea Stadium where Griffin visualize’s the Miracle Mets’ entirely improbable victory in the World Series later that year. Griffin’s superpower goes an important step further, and this is a key to how the comedy is written. Not only does he see the wide array of possible futures, but he understands, too, which futures are consistent with events as they play out, and which futures are suddenly ruled out by current events. He sees what mathematician’s call the filtration.

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The unorthodox model of risk pricing behind the UK EMR #6: it gets better

Earlier this week, the UK government submitted draft legislation on its Electricity Market Reform (EMR).  In a series of blog posts from last July, I critiqued the central premise underlying this insurance proposal. The touted benefits overlook the cost of risk passed along to UK taxpayers or ratepayers. They are based on a fanciful imagination of the costs of nuclear new builds, how risk factors into investment decisions, and the ease with which the relevant risks can be transferred at the stroke of a pen. Of course, so long as the government’s scheme remains an abstract plan, this critique remains a theoretical one. It will only be once an actual price insurance contract is laid on the table in order to finance an actual nuclear new build that the faults in the government’s scheme will reveal themselves in specifics. The new draft legislation includes a little more information, but not much. However, I did enjoy the footnote to a curious calculation, which reads: “The following simplifying assumptions have been made: that required debt returns are fixed as long as minimum cover ratios are met, and that equity investors’ hurdle rates do not vary with gearing/variability of prospective equity returns.” (emphasis added) That’s exactly the type of simplifying assumption one needs to make sense of the plan.

NERA Doubles Down

In a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs companies would face as the Dodd-Frank reform of the OTC derivative markets is implemented. NERA is working on behalf of a group of energy companies lobbying to avoid some of the law’s mandates. Last week, NERA filed a “Briefing Note” with the CFTC specifically addressing my criticism and explaining the reasoning that leads them to stand by their original numbers.

What is at issue? Dodd-Frank forces companies to margin swap trades that previously could be executed without margins. Does this impose extra costs on those companies? If so, how large are these costs?

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The True Cost of Government Guarantees — Take 2

As part of the fallout from last August’s bankruptcy of the Federally-backed solar firm Solyndra, the Obama Administration appointed Herbert Allison, a Republican banker and former Treasury official to review the Department of Energy’s loan guarantee program. His report was completed at the end of January and released earlier this week. It contains many useful observations and recommendations and is criticized as well for what it doesn’t contain.

I want to use this post to focus on one specific issue: the correct measure of the cost of a government loan guarantee. In an earlier post about a recent CBO report on the nuclear loan guarantees I described how the current, legislatively mandated method for calculating the budgetary cost significantly understates the cost because it ignores the full cost of the risk imposed on taxpayers. Future payouts on the guarantees are discounted at US Treasury rates, but the true cost of those future payouts should include a market risk premium. I used the CBO report to estimate that the underestimate of the cost of the guarantees for the new nuclear plant at Vogtle amount to $640 million. The Allison Report tells us something about the underestimate on other parts of the portfolio.

The key comparison is between the last column of figures in Table 4, where the cost is estimated using the legislatively mandated FCRA method that ignores the price of risk, and the last two columns of figures in Table 6, where the cost is estimated using the FMV or fair market value method that uses the market price of risk. In total, the FCRA subsidy cost is $2.682 billion whereas the FMV subsidy cost is between $4.970 and $6.839 billion. Taking the FMV cost as the benchmark, the FCRA cost ignores between 46 and 61% of the full cost to taxpayers because it ignores the price of risk.

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Phantom Costs to the Swap Dealer Designation and OTC Reform

The CFTC is working to finalize the rule defining swap dealers and major swap participants. Under the Dodd-Frank financial reform, the rules governing operation of the OTC derivative market operate in large part through codes of conduct imposed on these entities. As reported most recently by Silla Brush at Bloomberg, a number of companies are hoping that the rules will be redrafted so that they escape designation and the responsibilities that go along with it. To bolster their lobbying effort, these companies commissioned a report by the economics consulting company NERA to estimate the costs of applying the law to them. The Bloomberg story quotes me as saying that “the study exaggerates the costs of the rule.” Here’s a little more meat behind what I meant.

NERA calculates the cost of posting margin as follows. According to the 26 companies that sponsored its report, the average company would have had to post $235 million in margin. NERA estimates the margin account would have earned interest at a rate of 3.49%, pre-tax. According to NERA, the Weighted Average Cost of Capital (WACC) for the energy companies who sponsored its report at 13.08%, pre-tax. That is, in order to raise the capital needed to fund an extra $1 in the margin account costs the average company 13.08%, but that account only earns 3.49%. The difference is 9.59%. The idea is that a company is losing the difference, or 9.59%, on every $1 is has to post in margin. Multiplying 9.59% by $235 million per firm yields an annual cash flow shortfall of $23 million per firm, NERA’s estimated Annual Carrying Cost of Margin.

One big error in the calculation is the use of the 13.08% WACC figure as an estimate of what it would cost to fund the margin account. This is comparable to the error of discounting a specific project’s cash flow using the company’s WACC, ignoring the fact that the risk of the project may be very different from the average risk of the firm. Every introductory corporate finance textbook warns the reader against this mistake. The average WACC reflects the average riskiness of all of the different assets of the firm. It makes no sense to compare the average WACC against the expected return of a specific asset or project and claim that that is a rate of return shortfall. A manager who did that, would consistently see a shortfall in relatively safe projects and a premium in relatively risky projects, regardless of the actual NPV of each project. The NPV is determined by comparing the project’s expected return against the project’s own cost of capital, not against the firm’s average cost of capital. Only in the specific case that the project’s risk equals the firm’s average project risk, is the WACC coincidentally the right cost of capital. That is clearly not the case for the margin account. It is invested in relatively safe assets. In contrast, the NERA companies’ average WACC reflects investments in power plants, oil wells, and derivative trading operations, all of which can be expected to be much riskier. That is why NERA’s calculation is an exaggeration. It isn’t just off by a rounding error. The key number it uses has absolutely nothing to do with what NERA purports to measure.

The lesson from MF Global for the management of a prop trading unit.

Much has been said about MF Global, the US brokerage and clearing group that filed for bankruptcy in late October. In March 2010, when Jon Corzine was brought in as the CEO, MF Global’s franchise in brokerage and clearing operations was strong, but had tallied a string of losses. Corzine was tasked with cutting expenses and returning those operations to profitability. But that wasn’t good enough for him. He wanted to transform the firm into a major league investment bank, expanding into market making in fixed income instruments as well as adding asset management, advisory and capital market services. Corzine also sought to transform proprietary trading into a major source of profit for the firm.

Proprietary trading was something more to Jon Corzine than simply another line of business. He personally stepped in to make an outsized bet on the Eurozone sovereign debt crisis. The firm took a long position in bonds of financially stretched European countries with loans secured by the bonds themselves. To avoid the risk of refinancing, MF Global arranged the trade to be funded until the maturity of the bonds. If everything went according to plan, for a ten percent haircut on the collateral, the spread between the EU high bond yields and the overnight rate would generate €400-€500 million in profit for the company.

As Aaron Lucchetti and Julie Steinberg, of the Wall Street Journal report, MF Global’s Chief Risk Officer, Michael Roseman, warned of the dangers of the trade: he “contended MF Global didn’t have enough spare cash to withstand the risks of its position in bonds of Italy, Spain, Portugal, Ireland and Belgium. He also presented gloomy hypothetical scenarios of what could happen if MF Global’s credit rating was downgraded because of the exposure.” Nevertheless, Corzine held firm and the Board did not restrain him.

MF Global’s lenders grew worried over the summer as the collateral lost a good deal of value. They demanded the company post additional margin, and when the company was unable to do so, they called the loans. With no additional credit available to the firm, MF Global had no choice but to liquidate the portfolio at very disadvantageous prices, for the market for bonds of highly indebted European countries is very illiquid. Ultimately, the bad bet forced the company into bankruptcy.

There are many lessons that can be drawn from the collapse of MF Global. One that we would like to highlight has to do with the proper place of prop trading in a larger business. We see no problem with standalone prop trading units – hedge funds, as they are sometimes called. When the prop traders are gambling using their own balance sheet, they are forced to fully bear any risk of failure. But when the prop traders share a balance sheet with other lines of business – like MF Global’s brokerage and clearing operations – the danger arises that they are gambling using the capital of other units without paying for it. When MF Global’s bet went bad, it lost more than the price of that bet. It wiped out the long-term health of the brokerage and clearing franchise. That is a dead weight cost produced by having the two operations share a balance sheet.

Was that potential cost factored in when taking the original bet? We doubt it. Measuring the capital at risk from proprietary trading is a difficult task. Traders habitually underestimate the risks of their trades and the capital required to run their operation. MF Global structured it’s repo-to-maturity deal to seemingly hedge out key risks, thereby benefitting from an accounting trick that kept its bet off of its balance sheet and out of sight of the market. But that accounting treatment ignored the huge liquidity risk created by the need to hold onto the position to maturity. That liquidity risk put the entire balance sheet of the firm on the line. Ultimately, one of MF Global’s regulators, FINRA, flagged the risk and demanded more capital, forcing more disclosure.

One way to discipline traders is to give them their own balance sheet. With no one to blame but their operation, the tradeoff between risk and return is more carefully scrutinized. A stand alone balance sheet isn’t the only tool for disciplining traders, but it is certainly the most reliable. Companies that decide, for whatever reason, to put the proprietary trading unit onto the same balance sheet with other activities, had better have superior disciplinary tools at their disposal than what MF Global had.

Risk free rates and value: Dealing with historically low risk free rates

Aswath Damodaran, at NYU, has a nice post on the right and wrong ways to implement valuations in the light of the historically low interest rates on Treasuries and other sovereign debt. The trick is to think through the consequences on all elements of the valuation.

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