PrefBlog

Accrued Interest worries that Fed purchases are distorting the Agency MBS market:

Obviously the Fed wants to buy the current coupon because that’s the one that influences current borrowing rates. But as a consequence, the Fed has become the overwhelming owner of the 4% and 4.5% coupons: 90% of the former and 80% of the later.
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And you have to expect the majority of the widening to hit low coupons, because that’s what Vanguard/the Fed will either be selling or what they will stop buying. At that point mortgage rates will rise, not in a disastrous fashion, but probably at least 50bps. Then what? The borrower within a 4.5% pool will be way out of the money, which will not only prevent any kind of refinancing from ever happening, but also impair his/her mobility. In other words, those MBS will repay extremely slowly for investors.

Andreas Hackethal, Michalis Haliassos and Tullio Jappelli write a piece for VoxEU that is sure to make it into the bibliography of countless DIY-Investing websites: Do financial advisors improve portfolio performance?:

Do financial advisors aid their clients in making wise investments? This column shows that investors who delegate their portfolio management achieve better results. But that’s due to the fact that advisors tend to be matched with richer, older investors. In fact, financial advisors tend to lower returns and raise risk relative to clients who manage their own investment.
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The budding literature on financial advice and its regulation is usually based on the premise that advisors know what is good for individual customers but have an incentive to misrepresent this and take advantage of their typically uninformed customers. In recent research (Hacketal, Haliasso, and Jappelli, 2009), we ask:

• •How do brokerage accounts run by individuals without financial advisors actually perform compared to accounts run by (or in consultation with) financial advisors?
• •Are financial advisors are indeed matched with poorer, uninformed investors or with richer, experienced but presumably busy investors?
• •Is the contribution of financial advisors to the accounts that they do run actually positive relative to what investors with the characteristics of their clients tend to obtain on their own?

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Our econometric analysis suggests that advisors tend to be matched with richer, older investors rather than with poorer, younger ones. Taking account of this sample selection bias yields the opposite result. Once we control for different characteristics of investors using financial advisors, we discover that advisors actually tend to lower returns, raise portfolio risk, increase the probabilities of losses, and increase trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own.
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One interpretation could be that advisors overcharge for their services. If they do, should they be regulated? Or should we be content with the idea that they do not tend to serve those lacking sophistication but those lacking time to make money on the market? But then, why do rich, older people pay so much for advice? Could part of it arise because these individuals would not have undertaken the investment themselves if it were not for the help of advisors?

The problem – and the worthy target of research – is that most financial advisors (whether registered with the regulatory authorities as such or not) are not, in fact, financial advisors. They are salesmen. Regulators should insist that, at a minimum, those with discretionary authority over investor accounts must prepare meaningful composites – two versions, one defined by sector of investment and, importantly, the other defined by the results of a KYC form – and that these composites be supplied to the regulators, subject to possible audit by the regulators and published by the regulators as part of the normal registration reporting.

Given that most advisory relationships are effectively discretionary, consideration should be given to forcing the same disclosure for these as well … but this is somewhat murky! What if the client doesn’t take the advice? What it the advice is taylored to what a client might actually do? If a client is convinced oil will triple to year end and insist on overweighting in oil producers, all an advisor can do is recommend the relatively safe ones … whatever “safe” means!

The full paper is available from the Centre for Economic Policy Research.

Jim Hamilton of Econbrowser discusses reports of planning for unwinding the Fed’s balance sheet and includes a chart of the Fed’s liabilities:

I mused on September 24 about the discount window and the importance of deposits in funding bank assets. In a normal bank-run scenario, short-term bank liabilities such as deposits are used to fund long-term bank assets such as mortgages and term loans. Liquidity crises come when the bank experiences difficulties rolling over its liabilities and in such a case, the theory goes, they refinance their assets at the Central Bank’s discount window instead.

In this crisis, they are selling their assets to the Fed and leaving the proceeds on deposit; in other words, instead of acting on the liability side of their balance sheet, the banks are taking action on the asset side, converting their long term assets into risk free deposits. I confess that I have not been able to draw any conclusions as yet regarding the costs, benefits and causes of this phenomenon and tied it in with the empirical evidence regarding the importance of a stable deposit base; I can only draw solace from the idea that I haven’t seen this discussed in detail anywhere else, either!

Willem Buiter of Maverecon criticizes the Obama administration:

But it is on the economic front that the damage is really piling up. President Obama’s speech yesterday (the first anniversary of the collapse of Lehman Brothers) on the lessons from Lehman’s demise demonstrated once again that we are stuck with a president who knows little about economics and cares less. There was some perfunctory populist bank and banker bashing, but nothing concrete. Like most other political leaders in the financially benighted north-Atlantic region, president Obama will use the absence of international cooperation and the undesirability of unilateral action by any one country as an excuse to avoid radical reform of the cross-border banking and financial system. No doubt the French president, Mr. Sarkozy, will again threaten his by now traditional walk-out over some trivial issue, but the chances of international agreement on measures that could reduce the frequency and severity of future systemic crises are slim.

The US officials supposed to lead the systemic reforms of the domestic and international financial system are the same people who failed to recognise the emerging disfunctionalities that produced the crisis, who indeed were responsible for creating some of these disfunctionalities, who failed to prevent the crisis, who re-fought the battle of the 1930s (and insist on taking great credit for doing so) and left us with the moral hazard nightmare legacy of the end of the first decade of the twenty first century.

There’s been another entry in the bash-the-banker sweepstakes:

Chancellor of the Exchequer Alistair Darling, targeting what he calls “greed and recklessness” in Britain’s financial system, asked banks to curtail bonuses and said the rich will pay more in tax.

“It is right that those who earn the most should shoulder the biggest burden,” the finance minister told the ruling Labour Party’s annual conference today in Brighton, England. “We will introduce legislation to end the reckless culture that puts short-term profits over long term success. It will mean an end to automatic bank bonuses year after year.”
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Prime Minister Gordon Brown’s government is attempting to shore up support among voters by attacking bankers and suggesting the rich will have to foot the bill for the sharpest recession since World War II.

“This is a government on the cusp of losing the next election, and if banker-bashing is going to be popular they’ll do it,” said Simon Maughan, a banking analyst at MF Global Securities in London. “This is a classic case of knee-jerk political reaction to a crisis.”

Politics of division, politics of resentment, politics of envy … you never have to scratch the surface too deeply to find the Lord of the Flies. Mr. Darling did not, as far as I can tell, address the shortcomings of his regulatory authorities.

The Boston Fed has released a paper on social learning by Julian Jamison, David Owens, and Glenn Woroch, Social and Private Learning with Endogenous Decision Timing:

Firms often face choices about when to upgrade and what to upgrade to. We discuss this in the context of upgrading to a new technology (for example, a new computer system), but it applies equally to the upgrading of processes (for example, a new organizational structure) or to individual choices (for example, buying a new car). This paper uses an experimental approach to determine how people address such problems, with a particular focus on the impact of information flows. Specifically, subjects face a multi‐round decision, choosing when (if ever) to upgrade from the status quo to either a safe or a risky new technology. The safe technology
yields more than the status quo, and the risky technology may yield either less than the status quo or more than the safe technology. Every round, subjects who have not yet upgraded receive noisy information about the true quality of the risky technology. Our focus on the timing of endogenous choice is novel and differentiates the results from previous experimental papers on herding and cascades. We find that, in the single‐person decision problem, subjects tend to wait too long before choosing (relative to optimal behavior). In the second treatment, they observe payoff‐irrelevant choices of other subjects. This turns out to induce slightly faster decisions, so the “irrationality” of fads actually improves profits in our framework. In the third and final treatment, subjects observe payoff‐relevant choices of other subjects (that is, others who have the same value for the risky technology but independent private signals). Behavior here is very similar to the second treatment, so having “real” information does not seem to have a strong marginal effect. Overall we find that social learning, whether or not the behavior of others is truly informative, plays a large role in upgrade decisions and hence in technology diffusion.

I cheerfully admit to lack of familiarity with what the authors refer to as the “vast literature” on the “causes and patterns of the adoption and diffusion of innovations”, but it seems to me that you don’t have to squint too much to read “safe or risky new investment class” for “safe or risky new technology”.

Not much of a day for price movement in the preferred share market, with only four issues making it to the price change highlights table (three of them negative; all of them PerpetualDiscounts), while more broadly, PerpetualDiscounts were down 6bp while FixedResets lost 2bp. Volume was good though, dominated by FixedResets.

Apparently the G-20 will save the world from greedy bankers:

President Barack Obama and other Group of 20 leaders meeting in Pittsburgh are uniting behind a plan to force banks to tie compensation more closely to risk and tighten capital requirements, U.S. officials said. Treasury Secretary Timothy Geithner said there’s a “strong consensus” to tackle global imbalances. At the same time, divisions remain on how to overhaul control of the International Monetary Fund.

That’s a hoot, it really is. “Tie compensation more closely to risk”? “Risk” as defined how and by whom? It seems to have escaped the attention of the press that the Basel Committee (comprised of wise and omniscient bureaucrats) has been attempting to define “risk” in quantitative terms for over twenty years and the current crisis shows they’re not very good at it – no better than the bankers themselves.

But now, it’s done:

Group of 20 leaders said they will crack down on risk-taking by banks and better align economic policies as they turned from crisis management to delivering a new set of rules for the world economy.
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“We cannot tolerate the same old boom-and-bust economy of the past,” Obama said after the talks. “Never again should we let the schemes of a reckless few put the world’s financial system and our people’s well-being at risk.”
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“They’re trying to ensure that bubbles don’t build up again,” said Kenneth Rogoff, a former chief economist at the International Monetary Fund and a professor at Harvard University. “There’s an element of genuine concern about pay policies, but they may also satisfy some of the public bloodlust.”

Public bloodlust is the key point – and way to whip up the old politics of resentment & envy, Mr. Obama! Now I understand what “Change” means … it means “Change in Targets”.

Banks were told to avoid “multi-year guaranteed bonuses” and a “significant portion of variable compensation” must be deferred, paid in stock, tied to performance and subjected to clawbacks if earnings flop. The G-20 stopped short of endorsing a French proposal to introduce specific caps on pay.

About the only good thing to be said for this is that it will lead a stampede of talent out of the regulated banks and into the hedge-fund sector. Technology’s made it very easy to blur the lines – there’s no reason why a hedge fund can’t call a market in any security and trade it off the exchange in an institutional pool.

Being buck-a-dime on ten-year governments may be less sexy than activist investment management, but it can be much more profitable.

If they can, the profits and share price of banks from Goldman Sachs Group Inc. to Barclays Plc will fall with their scope to invest and trade, said former Bank of England policy maker Charles Goodhart.

“Regulation almost certainly means the size of the banking industry will contract and its rates of return will go down,” said Goodhart, professor emeritus of banking and finance at the London School of Economics.

This will help hedge funds – and other shadow banks – raise capital.

FixedResets outperformed big-time today, returning +14bp against PerpetualDiscounts’ loss of 22bp, while also dominating the volume table on another day of very good volume.

Bank of England Governor Mervyn King had some apocalyptic things to say:

two British banks got within hours of a liquidity shortfall on Oct. 6, 2008, and the day after as the U.K. financial system came to the brink of collapse.

“Two of our major banks which had had difficulty in obtaining funding could raise money only for one week then only for one day, and then on that Monday and Tuesday it was not possible even for those two banks really to be confident they could get to the end of the day,” the BBC cited King as saying in an interview to be broadcast later today.

King was referring to Royal Bank of Scotland Group Plc and HBOS Plc, the BBC said. Prime Minister Gordon Brown’s government pledged to invest about 50 billion ($82 billion) pounds in the banking system on Oct. 8, 2008, to save it from meltdown in the aftermath of Lehman Brothers Holdings Inc.’s bankruptcy declared that September.

This meltdown-through-funding scenario ties in the the IMF conclusions on the resiliency of Canadian banks, but I confess that the entire mechanism of such a failure is somewhat opaque to me.

It was to prevent such crises of funding that Central Banking was invented; the Federal Reserve was created explicitly due to the funding difficulties that were at the centre of the panic of 1907 – so why should funding, in and of itself, be such a critical element?

This brings us back to the Northern Rock episode, where the announcement of liquidity support by the BoE actually made matters worse; I have previously speculated that this reflects public distrust of public institutions. If this is the case, then the fundamental assumptions of Central Banking will have to be revised – the discount window has been the most important tool in their box.

What? Public Institutions, civil servants and policitians at fault? Can’t be! It must be the fault of the Credit Rating Agencies:

Moody’s Investors Service, Standard & Poor’s and Fitch Ratings face scrutiny today by insurance regulators examining the role of the firms in evaluating fixed- income securities.

State insurance regulators are meeting in Maryland to examine the firms’ role in rating bonds held by insurance companies. A second hearing scheduled today, by Edolphus Towns, chairman of the House Oversight and Government Reform Committee, was postponed to Sept. 30. The panel will look at ratings companies amid allegations of continued conflicts of interest from a former Moody’s analyst.
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“The fundamental issue is if the bar is always moving, that makes it very difficult,” Connecticut insurance Commissioner Thomas Sullivan said in a telephone interview. “Magically overnight, what we thought was AAA is no longer AAA. That’s a big problem.”

Assiduous Readers will remember that actual market participants felt that a volatility scale would be a good adjunct to ratings, but this solution was disdained by regulators. Of some interest in the Bloomberg story was:

Moody’s originally declined to participate in the [NAIC] meeting but relented after New York’s regulator suggested scaling back the rating firm’s authorization if it skipped the session.

Congressional Hearing

The congressional hearing was postponed after the panel obtained an internal Moody’s staff memo written by Eric Kolchinsky, a former analyst at the firm, expressing his concern with how the company rated securities, said committee chairman Edolphus Towns. The panel didn’t have enough time to incorporate the information into the hearing, he said.

A Moody’s representative was invited to the session but didn’t come, Towns said.

“They basically didn’t show up, they ignored us” Towns said in an interview, referring to Moody’s. “I guess they didn’t realize we have subpoena power.”

See? Congressional sessions have subpoena power, but regulators have something even better: extortion.

The Fed has released the Shared National Credits Report:

Credit quality declined sharply for loan commitments of $20 million or more held by multiple federally supervised institutions, according to the 32nd annual review of Shared National Credits (SNC).
The credit risk of these large loan commitments was shared among U.S. bank organizations, foreign bank organizations (FBO), and nonbanks such as securitization pools, hedge funds, insurance companies, and pension funds. Credit quality deteriorated across all entities, but nonbanks held 47 percent of classified assets in the SNC portfolio, despite making up only 21.2 percent of the SNC portfolio. U.S. bank organizations held 30.2 percent of the classified assets and made up 40.8 percent of the SNC portfolio.

The 2009 review covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers. Loans were reviewed and categorized by the severity of their risk–special mention, substandard, doubtful, or loss–in order of increasing severity. The lowest risk loans, special mention, had potential weaknesses that deserve management attention to prevent further deterioration at the time of review. The most severe category of loans, loss, includes loans that were considered uncollectible.

Treasury’s wish-list of bank capitalization rules included many references to Tier 1 Financial Holding Companies, a concept I criticized – special status will only cause problems, I said. It would seem that Paul Volcker agrees:

Former Federal Reserve Chairman Paul Volcker criticized the Obama administration’s plan to subject “systemically important” financial firms to more stringent regulation by the Fed.

Volcker told lawmakers today that such a designation would imply government readiness to support the firms in a crisis, encouraging even more risky behavior in a phenomenon known as “moral hazard.”
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“The danger is the spread of moral hazard could make the next crisis much bigger,” said Volcker, who serves as an outside economic adviser to Obama. Volcker has criticized key elements of the Obama administration regulatory plan in recent public statements, and his remarks today largely reprised those criticisms.

I am particularly impressed by his reference to the next crisis … it is rare to fin a figure with any political clout not subscribing to the view that the New Millennium will arrive as soon as we get those pesky Credit Rating Agencies under control.

Good volume, soft returns in the preferred market today, with PerpetualDiscounts down 11bp on the day while FixedResets lost 8bp. This may be related to all the new issuance … there are, presumably, people still selling to make room for the monster TRP FixedReset settling September 30 and there was a (long awaited) new straight issue announced by GWO.