Monday, 11 January 2010

Example of Kaupthing: Market Efficiency at Work

One of the reasons I enjoyed Johnsson's book Why Iceland? so much is the insider view into what drove the failure of Icelandic banks in 2008. The machinations of savvy players show us how market efficiency works, how the search for excess profits or so-called alpha, and the attainment thereof, is actually the source of market efficiency.

Jonsson's story on page 63: The weak position of the Kaupthing bank relative to other banks was noticed first in 2005 by a trader named Herleif Havik at the Petroleum Fund of Norway. He began doing what he perceived to be a kind of low- or no-risk pair of trades, by selling Credit Default Swap (CDS) protection on Barclays bank while buying the same protection on Kaupthing. The reason was apparently that Barclays and Kauthing debt traded at the same premium. Havik figured that Iceland could not, in the event of a crisis, offer the same back-up to Kauthing as Britain could to Barclays. To do the buying and selling of CDS, it was not necessary to actually hold any of the debt and in fact, Jonsson says the PFN did not own any Kaupthing bonds. Havik's trades attracted attention and drove up CDS premiums on Kaupthing. Other financial players began to focus on Iceland. The weakness of the business model of the Icelandic banks had been noticed.

It was by detecting the mis-priced bonds of Kaupthing (aka market inefficiency) and exploiting it that the market forced an eventual and brutal return towards efficiency.

The incident leaves questions to ponder:
  • Was PFN, a state-controlled fund no less, and Havik somehow morally to blame for doing so, since the dénoument has left Icelanders suffering?
  • Is naked CDS trading bad or merely the equivalent of buying a put or a call? e.g. Bad - SEC chairman Maison Fleury; OK - Derivatives Dribble)
  • Was the pendulum swing the other way, all the way to bankruptcy of all the Icelandic banks, the only way back to efficiency, or was it too far?
Market inefficiency and mis-pricing after the event is much easier to tell than beforehand. One of my favorite quotes is "Half the money I spend on advertising is wasted; the trouble is I don't know which half." (attributed on Wikipedia to John Wanamaker) It is not necessary to assume that every security is correctly priced at every moment to believe in market efficiency, nor does one need to deny that significant chunks of securities like whole stock indexes are correctly priced at any one time. Market efficiency means fair pricing, neither systematically biased too high or too low. Only after fact do we find out which it was - high or low - and there may be a good lag before that happens.

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