Financial Sarcasm Roundup for 01/28/16

Hatred and love are powerful emotions. Sarcasm is not an emotion but it may be even more powerful.

The Federal Reserve made markets nervous yesterday. I say tough luck for wimpy stock market experts. Big players have had it too easy with ZIRP subsidizing their gambling. Moving toward a more historically normal interest rate environment means crybaby institutional investors will lose money. Just look at the confused commentary coming from Wall Street's idiots. They don't remember what normal feels like and their bond trading desks are full of Millennial whipper-snappers who think credit is always free.

The US Treasury alerts us to derivatives clearinghouse risks. That sure throws some cold water on the theory that transparency and mark-to-market pricing would make derivatives less threatening to the economy. The Fed and SEC have planned for trading halts and fund backstops. Now they need to think about liquidity backstops for clearinghouses. I suspect that will be a bridge too far in a crisis, so AIG-style instant firm resolutions will be the preferred risk mitigation tactic instead.

China's statistics chief is in trouble. Beijing couldn't keep their numbers frauds hidden forever and now they need a public scapegoat in true Manchurian style. The news may fool a few Western investment firms (the ones that don't understand China) into thinking things will get better when the head stats guy is replaced. A couple of high-profile career terminations won't stop the Chinese stock market's slide.

I try really hard not to hate people, even if they deserve it. Hateful people deserve sarcasm instead.

The Haiku of Finance for 03/29/14

Adjusting swap price
Mark to market and disclose
Complicated math

Using And Misusing XVA Swap Pricing Adjustments

Welcome to the world of swap pricing.  I have never touched swaps in the real world.  Studying their construction during my MBA program was certainly intriguing.  Institutions using swaps in moderation can hedge their exposure to swings in interest rates, commodities, and currencies.  Pricing them realistically means adjusting for the possibility of counterparty defaults.  Adjustments used to be confined to credit valuation adjustments (CVAs) but now encompass a whole family of "XVA" alternatives.  Risk Magazine in 2013 recognized the key role that banks play in using XVAs to price derivatives.

Capital markets quants have choices to make among XVAs.  The original CVA and debit valuation adjustment (DVA) formulations were mirror images of each other.  They balanced a swap's accounting on the mark-to-market exposure statements of both swap counterparties.  Adding a cost adjustment to the DVA builds a funding valuation adjustment (FVA) that provides further clarity on how lending costs for an uncollateralized transaction affect swap exposures.  This very detailed Shearman and Sterling article describes how the legal treatment of these FVAs under Basel capital requirements may differ between US and EU regulatory regimes.

The FVA takes derivative game-playing to a whole new level.  The concept's creators explain it in this Risk Magazine article, "Funding strategies, funding costs."  I don't see the point in adding a second layer of complexity to an already complex process for adjusting derivative prices.  More complex systems are more fragile.  We learned that the hard way in 2008 when investment banks underestimated their own weaknesses.  Adding a replacement valuation adjustment (RVA) to the other layers makes things even more complex, although I can see the usefulness of using it as the only adjustment layer for swaps that have downgrade triggers.

FASB 159 allows corporations to use XVAs to adjust their financial statements.  This takes the debate over smoothing earnings to a whole new level of unreality.  Analysts need to look at MD&A footnotes more closely to see whether systemically important financial institutions (SIFIs) use XVAs to play games with their numbers.  CME Group has an excellent KPMG white paper on principles for managing CVAs.  It is silent on how credit support annexes (CSAs) should net out exposure.  Mark-to-market accounting leaves banks vulnerable to swings in swap valuation that XVAs cannot mitigate.  This makes it imperative for central counterparties (CCPs) displaying derivatives to disclose CSA details.  The CSAs set boundary conditions within which XVAs adjust; disclosure shows the world where mark-to-market accounting will cause a swap to breach its boundary.

Some institutions forget moderation and fall for investment banks' wild pitches.  The i-banks' quants are supposed to use XVAs to think through the market's effects on swap pricing.  They should not use these adjustments to gouge unsophisticated clients out of a few more basis points.  Industry bodies need to pitch in.  The Global Financial Markets Association (GFMA) and the International Capital Market Association (ICMA) should work out some robust guidelines for financial institutions that employ XVAs.  Applying the same guidelines across derivatives markets for interest rates, commodities, and currencies gives the "law of one price" stronger meaning for global investors.  It will also keep bank trading desks within their Basel limits and internal risk appetites.  

S&P Ratings Business Under Fire From Australia

S&P just can't catch a break.  They came under the US Department of Justice's scrutiny while competitor Moody's escaped attention.  Now an Australian judge has found S&P liable for the ratings it gave to poor investments.  More rulings like this in the developed economies will make rating complex securities almost impossible due to liability exposure.  I say "almost" because a ratings agency will have to place such severe limits on its assessments as to make a firm opinion meaningless.

The old principle of caveat emptor is slowly succumbing to a culture of settling scores.  Investments are risky and more complicated investments carry more risk.  Whatever hides inside all of the moving parts of derivatives can blow up the whole instrument.  Sophisticated investors should know this but they feign ignorance when they think litigation can compensate them for bad judgment.  The courts should be a remedy for fraud, not stupidity.

I have no sympathy for investment banks who knowingly package garbage into an security and misrepresent it as a good deal.  Those people are liars and phonies.  The prevalence of such behavior on Wall Street's sell side should be sufficient warning to institutional investors that complex derivatives are at best unnecessary and at worst a disaster waiting to happen.  Ratings have always been mere icing on the cake.  The cake itself has always been of questionable nutritional value.

McGraw Hill Financial (MHFI) doesn't have to throw away S&P just yet.  The unit's index services are a very important brand in the financial sector.  Capital IQ is indispensable to countless traders and analysts, until of course something with deeper Big Data analytics comes along.  Potentially mortal wounds to credit rating services don't have to destroy an entire enterprise.

Nota bene:  Alfidi Capital does not rate derivatives.  If the Alfidi Capital Blog or research reports describe a stock, bond, or other security, such a description is always in the context of what I do with my own money.  In other words, my opinions are only useful for my own decisions and not for anyone else's situation.  

The Limerick of Finance for 07/08/12

Currency strategists do declare
Further euro decline should be rare
Traders do disagree
I will do so with glee
More pain is still due over there

Freight Rate Derivatives: An Investment Idea Whose Time Has Come

Derivatives are best used to hedge risk, not to make bets on underlying macroeconomic moves.  Futures and forward contracts have been around for ages to allow dealers in raw materials to lock in prices.  The time has arrived for shippers to avail themselves of similar instruments to manage risk in freight prices.  Freight rate derivatives are ready for prime time.

It takes more than just demand from shippers to make these derivatives viable.  You need indexes against which bourses can measure a derivative's value; the World Container Index from Drewry and Cleartrade now exists.  You need counterparties ready to underwrite derivatives; some shippers are starting to take the other side of contracts. 

The market for freight rate derivatives won't be fully mature until major investment firms take on large roles in underwriting and the derivatives are regulated and traded on exchanges.  Like all derivatives, they are subject to abuse by traders who misuse them or misrepresent their risks to investors. 

Derivatives offer shippers a tool that can complement traditional long-term delivery contracts.  This is a welcome development.