Government research warns of quarterly dumping by foreign banks

NEW YORK — A government research paper says foreign-owned broker-dealers are dumping an average of $170 billion in certain U.S. assets before the end of each quarter in order to appear safer and less levered.

The practice, driven by an effort to comply with overseas regulatory requirements, could hurt U.S. money market funds, as well as bond investors, according to the report by the Office of Financial Research (OFR), a unit of the Treasury Department.

The report, written for OFR by Benjamin Munyan of Vanderbilt University, is based on confidential regulatory data from the OFR and the Federal Reserve.

The paper concludes that broker-dealers with foreign parent companies are collectively dumping certain short-term borrowings by an average of $170 billion at the end of each quarter to better meet capital requirements, which are measured at the end of each quarter.

The report calls this practice “window-dressing,” and says no such practice was found by U.S. banks because U.S. banking regulators use a quarter-average measure of leverage ratios.

But the dumping — of an asset known as re purchase agreements, or repos — could affect U.S. money market funds and Treasury investors, the paper warned.

Repo agreements are a form of borrowing — usually overnight — that are a major source of liquidity for money-markets funds and institutional investors.

JPMorgan CEO Jamie Dimon and former Treasury Secretary Larry Summers have both warned of a liquidity problem that some experts have said could be linked to declines in repo funding.

The OFR paper said the selling by foreign banks could affect prices for U.S. Treasuries and other government bonds, which are a major form of collateral in the repo market.

The quarterly selling may also leave money market mutual funds with excess cash they cannot invest.

Despite being able to anticipate quarterly window dressing, money market fund manager were unable to find any investment for about $20 billion of cash each quarter-end before September 2013, the paper said.

The Federal Reserve’s reverse repurchase agreement program began at that time as a substitute investment for repo lenders during times of window dressing.

New faculty: Ben Munyan examines the growing field of ‘shadow banking’

When Benjamin Munyan left his hometown of Alexandria, Virginia, to pursue an undergraduate degree at Arizona State University, it wasn’t because he had any particular attachment to the Southwest. Rather, his mentors at the George Mason University lab where he worked during high school thought he’d enjoy getting involved in ASU’s groundbreaking research in chaos theory.

A math prodigy who won fourth place in the 2003 Intel International Science and Engineering Fair—which earned him $1,000 and a minor star named after him—Munyan originally wanted to study biochemistry. Shortly after starting college, however, he read Yale historian Paul Kennedy’s seminal book The Rise and Fall of the Great Powers and gained a better understanding of how global finance impacts the world. He soon switched majors to mathematics and economics.

Today Munyan, who joined Vanderbilt’s Owen Graduate School of Management as an assistant professor of finance after completing his Ph.D. this past spring at the University of Maryland, can be found in his office writing computer code mapping U.S. Treasury data to bank and investor activity.

“Ever since coming to Owen, I look out the window sometimes and think to myself, ‘Is this real?’” he said. “The members of Vanderbilt’s finance faculty are very well-known in the field, and it’s remarkable to be a part of this group.”

In graduate school, Munyan took note of the work being done by Craig Lewis, Madison S. Wigginton Professor of Finance at the Owen School, who was then serving as the chief economist at the U.S. Securities and Exchange Commission. One of the divisions that Lewis directed drew on academic research to detect hidden risks in the global financial system. That work fell in line with Munyan’s own research analyzing European banks’ efforts to hide as much as $170 billion in overnight-lending assets each quarter to get around stringent capital requirements.

A specialist in banking regulation and the growing field of shadow banking—an area where financial intermediaries engage in lending practices that fall outside the scope of regulators—Munyan says unknown risks in credit markets could cause problems similar to those experienced in 2008. “It’s important for researchers and policymakers to be able to identify and manage the risks that could spread across the entire financial system before they create a crisis,” he said.

Beyond his work in financial markets—the global economy’s “plumbing,” as he calls it—Munyan is also a history buff who recently took up woodworking. “It’s one of those things,” he said, “where you can zone out and think about a problem.”
Ryan Underwood, (615) 322-3469

New faculty: Ben Munyan examines the growing field of ‘shadow banking’

‘Fear Index’ Grabs Headlines as Stocks Swing: Volatility gauge yields clues on how investors are insuring their portfolios

When Robert E. Whaley settles into his home office, you can count on two things: His television will be tuned to CNBC, and he’ll be tracking the stock market’s “fear index” on his computer.

Mr. Whaley, a professor of finance at Vanderbilt University, may not be a household name. But chances are you’ve heard of the volatility index he designed, known to market watchers as the VIX.

The VIX is the most popular measure of expected short-term volatility on Wall Street. The index is computed in real time on trading days, and when it shoots up, it suggests investors fear market prices are about to move wildly.

The historical average of the VIX is around 20. Lower numbers signal that investors are confident in the strength of their investments. Higher numbers signal investor anxiety. For example, during the 2008 financial crisis, the index hit a dizzying 80, and last month, it made news when it spiked above 50 for the first time since 2009 before returning to near its long-run average.

“What you’re scared of is a drop in the value of your pension fund,” said Mr. Whaley. “The higher the VIX gets, the more fear you have the market will drop.”

The VIX reflects investors’ sentiment by tracking how much they are paying for “out-of-the-money” stock options—particularly “put” options, which provide a cushion against falling market prices.

Mr. Whaley compared it to buying insurance for a beach house.

“If a hurricane is forming and there is potential for the hurricane to hit land in the next few weeks, you are likely to pay a whole lot for insurance,” he said. “You want to protect the value of the home.”

If investors fear a storm is brewing in the stock market, they could sell their stock, but with trading fees and other costs that would be expensive. Or they could opt to protect their investment.

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“Instead of selling your stocks, you can go out and buy insurance, and the insurance you would buy would be put options on the S&P 500.” Mr. Whaley said.

A “put” option gives someone the right to sell stock at an agreed-upon price by a certain date. The stock price specified in the contract is called the “strike” price. And if it is lower than the market value of the underlying stock, the options are “out of the money.” (A “call” option is the opposite; it gives someone the right to buy stock at an agreed-upon price by a certain date.)

“VIX is driven by the price of out-of-money calls and puts, but the calls don’t really matter,” Mr. Whaley said. “If you look at trading activity in the market, it is predominantly puts. You’re only concerned about the downside risk.”

Put options benefit investors in the event that the market price of a stock tumbles below the strike price. If it does, the investor who bought the put will collect the difference between the two values.

For example, suppose the market price of the S&P 500 portfolio was $1,951 per share, and the strike price of a put option was $1,950. If the market price falls below that threshold to, say, $1,945 before the option contract expires, the investor who purchased the put will collect $5 per share. (This doesn’t account for the cost to purchase the put option.)

If the market price doesn’t fall below the strike price before the contract expires, there is no payout.

“If the stock stays above $1,950, you’d have a situation you have with any insurance,” Mr. Whaley said. “You pay for it and never collect. You lose the premium. What you bought is the satisfaction that if there had been a drop, you would have been covered.”

Options contracts are sold by market makers who accept risk to facilitate trading. The fees they charge for the options contracts offset their own risk of having to pay off investors if the stocks do tank. So when nervous investors begin to clamor for puts, market makers raise the price.

That is what sends the VIX skyward.

“The more demand, the higher the price, and the higher the prices, the higher the VIX,” Mr. Whaley said.

Investment firms like Zacks notice the VIX, but because they look further into the future, the level of the fear gauge doesn’t alter their overall strategy, according to Bryant Sheehy, who is business development director for Zacks.

“It’s more of a way to add some sexiness to editorial articles,” he said, referring to headline-grabbing shifts in the VIX. “It’s one more data point we can mention to talk about a tough market and what opportunities are now coming up.

But for speculators—the storm chasers of the stock market—the VIX serves as a weather vane, pointing out when they should plunge into the market in search of short-term trading profits.

“Volatility is opportunity, not risk,” said Tim West, who publishes market analysis on, a social network for investors and traders. “Most people get that backwards.”