PrefBlog

The market weakened in the afternoon and collapsed in the last half hour:

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An article by Andrew Allentuck in Investment Executive titled What is safety worth to fixed-income investors? led me to a 2017 paper by Maxime Leboeuf and James Pinnington titled What Explains the Recent Increase in Canadian Corporate Bond Spreads:

The spread between the yield of a corporate bond and the yield of a similar Government of Canada bond reflects compensation for possible default by the issuing firm and compensation for additional risks beyond default. Using the approach proposed by Gilchrist and Zakrajšek (2012), we find that roughly two-thirds of the total 1.2-percentage-point increase in corporate bond spreads from July 2014 to September 2016—a period when oil prices were low—is due to higher compensation for possible default. Default risk explains most of the increase of spreads for energy and high-yield firms but explains almost none of the increase for financial and investment-grade firms. This suggests that liquidity risk and other factors beyond possible default affected spreads of financial and other investment-grade firms.

We are most used to thinking of financial repression as being applied by governments through a low-interest-rate policy, but as noted on June 2, 2015, for instance, another way is to require regulated entities to hold government debt. This sometimes has spectacular effects:

A trio of Canadian banks is facing the fallout from a debt restructuring in Barbados that will slash the value of hundreds of millions of dollars worth of government paper they collectively own.

Canadian Imperial Bank of Commerce, Royal Bank of Canada and Bank of Nova Scotia are the largest lenders in the Caribbean, and each has direct exposure to Barbados. The country is home to one of the region’s largest economies, but the government’s finances have deteriorated over time.
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To help turn the economy around, the International Monetary Fund is working with Barbados to formulate a financial rescue plan. As part of this effort, the government proposed a debt restructuring in September that would amend the terms of its existing domestic debt. On Sunday, Ms. Mottley announced the restructuring plan will proceed.

Through the restructuring, Canadian banks will face losses on their debt holdings because Barbados has forced them to hold a greater percentage of their reserves in government debt, to help fund its deficits. These securities must now be held for much longer, and their coupons will also be cut, so the lenders will receive much lower returns on their money.

The total impact on Canadian lenders is still being calculated, but the three affected banks hold a substantial amount of Barbados debt. As of January, 20 per cent of their Barbadian reserves had to be held in government debt.

PerpetualDiscounts now yield 5.69%, equivalent to 7.40% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little over 4.15%, so the pre-tax interest-equivalent spread is now about 325bp, a significant widening from the 315bp reported October 10.

Trump mouthed off about the Fed again:

U.S. President Donald Trump heaped more criticism on the Federal Reserve in an interview with Fox Business Network on Tuesday, extending his discontent beyond its chairman, Jerome Powell, whom he has frequently critiqued in public.

“My biggest threat is the Fed,” he said, according to excerpts released before the interview with “Trish Regan Primetime” airs. “I put a couple of other people there I’m not so happy with too but for the most part I’m very happy with people.”

I suspect that this is more of an attempt to buy political insurance in the event of an economic downturn than a serious move to undermine Fed independence. But what do I know?

Trump continues to attack the Fed:

President Trump responded to falling stock prices on Thursday by continuing to throw rocks at the Federal Reserve, which he has described as “crazy,” “loco,” “going wild” and “out of control” for slowly raising interest rates against the backdrop of a booming economy.

No other modern president has publicly attacked the Fed with such venom or frequency. Indeed, some scholars said the only close historical parallel was with President Andrew Jackson, who campaigned successfully in the 1830s to close the Fed’s predecessor, the Second Bank of the United States.
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“I think the Fed has gone crazy,” he told reporters on Wednesday afternoon. Later in the day, speaking with Fox News, he continued to increase the heat. “The Fed is going wild,” he said. “I don’t know what their problem is. They are raising interest rates and it’s ridiculous.”

“It’s not right,” he said Thursday. “It’s not necessary, and I think I know more about it than they do.”

I’m not sure how much support he’ll find for that last assertion!

Liquidity is often discussed on PrefBlog. It may be becoming an issue in the Indian equity market:

Fund managers who’d hoped for private-equity type returns by discovering jewels buried in the haystacks of public markets were essentially souping up performance by forgoing liquidity. Now that the markets are punishing them for that recklessness, the search for the elusive alpha is over — in infrastructure; power; banking and finance; small-, mid- and micro-cap shares; transport and logistics; value stocks; state owned firms; business cycles; and every other fad.
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A rush for the exits may cause its own problems, especially when it comes to handling redemption pressures. On conservative estimates, it would take more than 30 days to offload a quarter of the net assets of one small Indian infrastructure fund, Bloomberg’s liquidity tools show. A fifth of a large tax-saver fund would need more than 180 days to dismantle, so thin is the liquidity of the stocks it holds. (By contrast, a typical index fund tracking the Nifty 50 can be
entirely liquidated in less than three days.)

More carnage and destruction today:

Initial hopes that the stock market would stabilize after Wednesday’s sharp sell-off were dashed on Thursday: U.S., Canadian, Asian and European stocks slid further, contributing to the most challenging atmosphere for stocks since February and raising questions about how long the rout will last – and how deep it will go.
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These concerns are reverberating worldwide. The S&P 500 fell 57.32 points, or 2.1 per cent, to 2728.36, one day after registering its worst decline in eight months. The Dow Jones Industrial Average fell 545.91 points or 2.1 per cent, to 25,052.83 − bringing its two-day decline to more than 1,300 points.

In Canada, the S&P/TSX Composite Index fell 200.27 points or 1.3 per cent, to 15,317.13. Britain’s FTSE 100 fell 1.9 per cent and Japan’s Nikkei 225 fell 3.9 per cent.

Carnage and ruin today:

Wall Street suffered its worst day in eight months on Wednesday, and the TSX didn’t do much better, suggesting that the new North American trade agreement and the parade of upbeat U.S. economic reports have taken a back seat to what investors fear is coming next: Rising borrowing costs and squeezed profit margins.

Global stocks were pummeled just days after U.S. indexes celebrated fresh record highs, amid simmering concerns about rising bond yields, increased trade tensions between China and the United States and speculation that corporate financial results will soon disappoint. U.S. technology stocks and Canadian energy names were among equities hardest hit.

The S&P 500 fell 94.66 points, or 3.3 per cent, to 2785.68, touching a three-month low. The Dow Jones Industrial Average fell 831.83 points or 3.2 per cent, to 25,598.74.

The turbulence occurred well beyond U.S. markets though. U.K. stocks fell 1.3 per cent and German stocks fell 2.2 per cent.

In Canada, the S&P/TSX Composite Index fell 336.65 points or 2.1 per cent, to 15,517.40. The latest dip continued a losing streak for Canadian stocks that began last week soon after political leaders tentatively agreed to the United States-Mexico-Canada Agreement (USMCA), removing a key concern over North American trade.

Wes Gray had some interesting remarks in the Globe, by which I mean I agree with them:

Despite heightened awareness around fees and their power to destroy long-term returns, Canadians saving for retirement are still parking their money in traditional mutual funds, the vast majority of which carry management expense ratios of 2 per cent or more. “Down in the States, if you had a fund that charged 2 per cent plus, you’d get murdered,” Mr. Gray said.
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In the U.S., everything’s getting more transparent. Canadians are pretty bright folks and yet their financial system is like North Korea. We know the reason – the banks control everything. Canada just seems so prime to move into the future but for some reason it’s slow on the uptake. A lot of it comes down to distribution channels where you never get to see the real fees. We would love to help people be more cognizant of fees and not just believing whatever the bankers are telling you.

The FDIC has released a paper by Haelim Anderson, Daniel Barth and Dong Beom Choi titled Reducing Moral Hazard at the Expense of Market Discipline: The Effectiveness of Double Liability Before and During the Great Depression:

Prior to the Great Depression, regulators imposed double liability on bank shareholders to ensure financial stability and protect depositors. Under double liability, shareholders of failing banks lost their initial investment and had to pay up to the par value of the stock in order to compensate depositors.We examine whether double liability was effective at mitigating bank risks and providing a safety net for depositors before and during the Great Depression. We first develop a model that demonstrates two competing effects of double liability: a direct effect that constrains bank risk-taking due to increased skin in the game, and an indirect effect that promotes risk-taking due to weaker monitoring by better-protected depositors. We then test the model’s predictions using a novel identification strategy that compares state Federal Reserve member banks and national banks in New York and New Jersey. We find no evidence that double liability reduced bank risk prior to the Great Depression, but do find evidence that deposits in double-liability banks were stickier and less susceptible to runs during the Great Depression. Our findings suggest that the banking system was inherently fragile under double liability because of the conflict between shareholder incentive alignment and depositor market discipline; the depositor protection feature of double liability reduced the threat of funding outflows but may have undermined its effectiveness as a regulatory tool for reducing bank risk.
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In this paper, we study the effectiveness of double liability as a regulatory tool for reducing bank risk and as a safety net for protecting depositors. We begin by providing a simple model that characterizes two competing effects of double liability on bank risk-taking. The first is a reduction in moral hazard that results from shareholders’ increased skin in the game (Esty (1998), Grossman (2001), Mitchener and Richardson (2013), Koudijs, Salisbury, and Sran (2018)). However, double liability also reduces market discipline by depositors, who receive more protection from losses in the event of a bank failure. All else equal, this weakened market discipline may actually promote bank risk-taking.

Actually, the first question that occurs to me is: how seriously can we take the shareholders’ promise to pony up cash for a failed enterprise? Early in my career I was fascinated by the Husky Energy deposit receipt fiasco, in which deposit receipts were issued for $X at a time when the stock was trading at $2X (the remaining $X of the share purchase price was due about a year later; it was a forward contract, not an option!). The stock promptly fell below $X, resulting in a negative value for the deposit receipts and with much excitement trading began with negative prices … i.e., the purchaser of a receipt got the position AND a sum of money from the seller.

I’ve never been able to find anything on the internet about this, presumably because it happened before the internet existed. The regulators should be funding and publicizing a study on the matter, but you’re going to have to search a long time before you find a regulator with any interest in doing a decent job.

There were a LOT of defaults when the receipts came due; it proved to be difficult to find many of the purchasers whose only known address was a foreign post-office box. I wouldn’t put any credence in any promises to pay double liability unless there was a ferocious regulatory regime in which the depositaries required a matching cash deposit at all times, which kind of defeats the purpose of setting up the system as a ‘capital call’ in the first place.

PerpetualDiscounts now yield 5.65%, equivalent to 7.34% at the standard equivalency factor of 1.3x. Long corporates now yield a little more than 4.20%, so the pre-tax, interest-equivalent spread (in this context, the “Seniority Spread”) is now about 315bp, a slight (and perhaps spurious) widening from the 310bp reported October 3.

So, to answer Assiduous Reader MF, who asked:

I am surprised by the resilience of perpetual prices. I thought that with increased long bond rates that they would drop.

… PerpetualDiscounts are basically maintaining their spreads against long corporates, which is more or less what they should be doing. I expect some narrowing of spreads as overall yield conditions normalize, but we haven’t seen it yet!

Three cheers for well thought out financial controls!

Prosecutors in Copenhagen say it was an elaborate ruse, one that ultimately cost taxpayers more than $2 billion — a spectacular sum for Denmark, the equivalent of a $110 billion loss in the far larger American economy.

The country had fallen victim to a dubious financial maneuver at the intersection of the tax system and capital markets, a dizzyingly complex transaction known as a “cum-ex” trade.
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The trade is focused on one of the dullest, most overlooked acts in any financial system — the request for refunds on taxes withheld on dividends. Under Danish law, the government automatically collects taxes on dividends paid out by companies to their shareholders. If the shareholders live in the United States, they are eligible for a refund on some or all of those taxes.

A tiny department in SKAT, run by one man, approved thousands of applications for refunds.
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After the financial meltdown, dozens of German banks desperate for a new source of profits eagerly facilitated cum-ex trades, fueled by capital from all over the world.

Traders made off with more than $11 billion, according to officials there. Cum-ex would reap fortunes from the governments in Austria, Belgium and Switzerland, too.
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In 2013, all that stood between Solo Capital and Denmark’s treasury was the bespectacled, gray-haired veteran of SKAT, Sven Nielsen. After two colleagues retired, he was the last person in the Dividend Department. Complicating matters, he lacked the tools to perform the most basic due diligence when reviewing refund applications.

The agency was in the midst of a yearslong and often disastrous overhaul, meant to digitize the system and reduce head count. The priority was helping Danish taxpayers, not foreign shareholders. Mr. Nielsen didn’t even have a database to check whether an individual pension plan actually owned the shares it claimed, said Lisbeth Romer, who was Mr. Nielsen’s boss until she retired in 2013.

“Sven’s job was reduced to bookkeeping, essentially, checking if a form was filled out properly,” she said. “A monkey could do it.”

I don’t get it, I really don’t. If the fraud is for a few million, OK. It happens. Figure out how it happened, plug the hole and try to catch the perpetuators. But $2-billion in a small economy? Didn’t anybody notice there was a tiny little discrepancy between the amount of dividend taxes withheld and the amount of the total claims on that money?

It reminds me of the Barings Bank fiasco, in which every single senior manager and executive solemnly swore that yes, they knew Nick Leeson, one single guy on a sleepy arbitrage desk, was making roughly 25% of the bank’s reported profit. No, they had no idea of how he was doing it. Clowns. They should be grateful I’ve considered them grossly incompetent, because they wouldn’t like the other choice so much.

The American jobs report yielded signs that the labour market has reached an inflection point:

The jobs report came in below expectations, but wasn’t a major headline grabber, even as unemployment dropped to its lowest rate since 1969, as the strong labor market is well known at this point.

The most notable aspect of the report was the strong sequential wage trends “that put wage growth on track to cross 3% in October, supported by broadening wage pressures across sectors,” writes Morgan Stanley ’s Robert Rosener.

… which had an effect on Treasuries:

Treasury yields hit fresh multiyear peaks on Friday, extending their weeklong ascent, after a key jobs report showed tightening labor markets were leading to wage gains—a bearish development for bond bulls.

The Bureau of Labor Statistics reported the U.S. had added 134,000 jobs in September, below the 168,000 jobs expected from economists polled by MarketWatch. July’s and August’s numbers were increased. The unemployment rate fell to 3.7%, its lowest level since 1969. While, the average hourly earnings rose 0.3%, after a stellar 0.4% gain the previous month.

The 10-year Treasury note yield … rose 3 basis points to a seven-year high of 3.227%, contributing to a weeklong climb of 17.1 basis points, its largest such rise since February. The 30-year bond yield … rose 4.2 basis points to 3.396%, extending its weeklong rise to 20 basis points, its biggest such climb since the week of President Donald Trump’s election.

The shorter-end of the bond market showed a more modest rise. The 2-year note yield … rose 0.8 basis point to 2.888%, its highest since 2008. The short-dated maturity posted a weeklong yield gain of 7 basis points. Bond prices move in the opposite direction of yields.

In Canada we’re still grinding away at unemployment:

Canada’s job market gained 63,000 positions in September, edging the unemployment rate lower to 5.9 per cent, and offsetting job losses in August, Statistics Canada reported Friday.

September’s increase in employment was largely driven by gains in part-time work, with part-time jobs up by around 80,000, the agency said in its monthly labour force survey.

And Five-year Canadas popped up to 2.49% to close the week.

The increase in yields must have been good for FixedResets, eh? Well … um … profit-taking! FixedResets were hit by profit-taking! Unless it was something else. Manulife issues got whacked … perhaps by those pesky short-sellers. No wonder Elon Musk hates them so much!