Archive for July 10th, 2008

Revisiting concerns in credit derivatives markets

July 10, 2008

When I first wrote the report raising concerns over Credit Default Swaps, people asked I don’t understand why will there be a crisis. Then there were a series of developments that raised similar concerns (here and here).

Now, in a recent testimony by Patrick M. Parkinson, a Deputy Director in Fed we get similar concerns. Though, he downplays the concerns but one can clearly see that there are number of issues with settlement and honoring of so many CDS contracts. And the testimony highlights NY Fed has been doing a lot of work to make the clearing and settlement systems, the crisis undid the entire good work.

Although these achievements were impressive, the financial turmoil during the summer of 2007 convinced prudential supervisors and other policymakers that further improvements in the market infrastructure were needed.  Specifically, CDS backlogs grew almost fivefold from June to August 2007, reversing much of the previous improvement.  Although the backlogs subsequently receded, this episode demonstrated that backlog reductions were not sustainable during volume spikes.  Moreover, it underscored that, in many respects, the post-trade processing performance of the OTC derivatives markets still lags significantly the performance of more mature markets and still has the potential to compromise market participants’ management of counterparty credit risks and other risks

Mr Parkinson also suggets exchange trade credit derivatives (ETCD) and establishing a central counterparty system to clear trades. He says ETCD is a good idea but:

However, they should not lose sight of the fact that one of the main reasons the credit derivatives market and other OTC markets have grown so rapidly is that market participants have seen substantial benefit to customizing contract terms to meet their individual risk-management needs.  They must continue to be allowed to bilaterally negotiate customized contracts where they see benefits to doing so.

This ETCD is being discussed in India as well after RBI put a hold to allowing credit derivatives. However, it will not be very easy to just have ETCD. OTC will also have to be allowed and this is where problems begin. It isn’t just about allowing the trading of CDS, you need to think about clearing and settlement as well. Somehow, most debates don’t cover this issue at all.

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Endowment effect is seen best in housing market

July 10, 2008

Endowment effect is one of the most important concepts in behavioral economics. It was shown by Richard Thaler and it is amazing how much you see it in everyday life

In sum it says, people value a product more once they own it.  In an experiment Thaler found students assign a lower price to a coffee mug when asked how much will they buy it for. The same set of students increase the price substantially when asked how much will they sell it for. This was not in line with the standard economic theory as prices should be same on both the sides.  I call this difference between buyer and seller perception of price as endowment spread.

I see this endowment effect happening so much in current housing market in Mumbai. Sometime back this endowment spread was a lot lower and transactions were happening. Now with much higher prices, the spread has become much larger and not enough transactions are happening.  As a buyer you want lower prices and would want prices to correct. As a owner/seller you want higher prices and prices to go up further. But still because of the endowment effect, sellers are not lowering their prices. Unless, market fundamentals deteriorate substantially, the spread will not contract.

There is already news in the market that prices are slipping but it is only in the news. The builders/sellers continue to raise their prices. I am wondering whether they would behave the same way if they were buyers instead.

What I also find questionable is the various surveys that report the per square feet in various areas of Mumbai. They give a range say Rs 4000- Rs 6000 per sq ft. but you hardly get any deal in the lower range, no matter what the area, quality etc. Everyone just quotes near the top end rate.

I also keep thinking whether we should allow trade in houses the way we trade in equities, bonds etc. In a bullish growth phase, the house prices go up big time and devoid many people to buy their own homes. It is only in growth times, when incomes are higher, can people buy homes. But can’t. In times of bearishness, people have to stick onto their jobs and even if prices are lower,it is difficult to buy. Everyone wants to buy a house and it has to be affordable.

With persistent endowment effect, it has been a long wait for any price correction. And we know how dangerous rising housing prices can be. Unfortunately, no one seems to be working at ensuring some standards in housing markets.

Zimbabwe currency carries an expiry date

July 10, 2008

Zimbabwe’s hyperinflation situation is well-known. Currently it is at 100,000 %. I came across this picture of the ten million dollar note where their Central Bank has given an expiry date for the note. Yes, it says the note is valid till 30 June 2008.

Assorted Links

July 10, 2008

1. WSJ Blog points to a new joinee on ECB GC. It also points to a new paper on US current account deficit

2. IDB asks are MFIs social?


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