As I indicated on March 13, BoC Governor Mark Carney has delivered a speech reviewing the credit mess and “corresponding priorities for the official sector and market participants”. He commences:
The social and economic costs of the events in the subprime market are concentrated in the United States, while the financial costs are both widely dispersed and – relative to the scale of the system – readily absorbable. In short, as painful as they are to those affected, subprime losses have been important primarily because they have revealed deeper flaws in the financial system. While a number of underlying causes can be identified, I will concentrate on three in particular.
These three causes are:
- liquidity:
- fed overconfidence in ability to sell holdings at model-derived valuations
- encouraged “originate to distribute” securitization
- when vanished with ABCP, forced long-term assets onto books of investors and liquidity-guaranteeing institutions
- lack of transparency and inadequate disclosure:
- when problems emerged with structured instruments, it became apparent that many investors did not understand them
- opacity makes them hard to value, reducing liquidity
- uncertainty over holders feeds concerns on couterparty risk
- trust in Credit Rating Agencies has been shaken, amplifying stresses
- misaligned incentives:
- if (subprime) loan will be sold immediately, less emphasis on documentation and due diligence
- timing of trader compensation
- provision of funding at risk-free rates to trading desks
- insufficient recognition and compensation of risk-management professionals
- crowded trades result when, for instance, too many players have automatic signals based on credit ratings.
With respect to liquidity, Mr. Carney outlined the changes that Bank of Canada is making to increase its provision of such liquitidity on an emergency basis:
- Accepting ABCP as previously discussed
- Accepting Treasuries
- Possible formalization of term repos
He speaks approvingly of an IIF publication, Principles of Liquidity Risk Management:
The report noted that internal governance and controls are the keys to reducing liquidity risk for a firm since no formulaic approach will yield appropriate or prudential results across different firms. More specifically the Special Committee advocated that:
- Firms should have an agreed strategy for the day-to-day management of funding of all kinds of liquidity risks that they may need to manage.
- Such strategies should be approved by the Board of Directors and reviewed by it on a regular basis.
- Senior management should promote the firm-wide coordination of risk management frameworks.
The report also recommended that firms should have in place:
- Contingency plans to respond to the potential early warning signals of a crisis.
- Strategies and tactics in the normal course of business that prevent liquidity concerns from escalating.
- Possible strategies for dealing with the different levels of severity and types of liquidity events that could cause liquidity shortfalls, with the breadth and depth of these strategies incorporating recovery objectives that reflect the role each firm plays in the operation of the financial system.
- A clear understanding of the role of central bank facilities and the limits on these facilities.
With regard to regulation, the recommendations in the new report reflect approaches that could both facilitate liquidity management for firms and make the system more robust overall. These include issues of supervision concerned with:
- Home-host coordination.
- Harmonization of regulations.
- Principles-based” not “rules-based” liquidity regulations that, for example, focus on qualitative risk management guidance, rather than on prescriptive and quantitative requirements.
- Expansion and harmonization of the range of collateral accepted by central banks and settlement systems.
Frankly, the discussion of responses to liquidity and disclosure is little but platitudes, but he does indicate that regulators could reduce exemptions:
While issuers and arrangers have every incentive to improve the transparency of structured products, ultimately, disclosure guidelines are set – or not – by regulators. One lesson from the ABCP situation may be that blanket disclosure exemptions were too broad. At the same time, however, authorities should resist the temptation to bring forward overly prescriptive regulations. Rather, they should consider greater application of principles-based regulation. There is no point in regulators trying to anticipate every new product or to restrain their development. There is a point in encouraging issuers to ensure the adequacy of their disclosure within a principles-based framework and to bear the consequences if it is subsequently found wanting.
I will also point out that there is no point in requiring disclosure if nobody reads it. And then, on Credit Rating Agencies:
Going forward, securities regulators will want to see agency incentives aligned more closely with those of investors, and will ensure that agencies are quicker and more thorough in reviewing past ratings. Other regulators must also take responsibility for looking at the extent to which the mandated use of ratings has encouraged credit outsourcing, led to pro-cyclical price movements, and encouraged discontinuous crowded trades.
…
In a mark-to-market world, with leveraged, collateralized positions, investors need to make their own judgments about the creditworthiness, liquidity, and price volatility of the securities they own.
He did not address the question of the exemption from Regulation FD (in the States) and from National Policy 51-201 (in Canada) … while I certainly agree that investors should do their own due diligence and understand the credit risk they are talking on, their ability to perform an independent check of credit ratings is constrained by this regulatory policy.
… and he manages to come down on both sides of the fence with respect to trader compensation …
Many financial institutions have pay structures that reward short-term results and encourage potentially excessive risk taking. Investors should take the lead in demanding compensation structures that are more aligned with their interests. Others have suggested that the regulators themselves should make these determinations. While I think regulation of compensation within private institutions is entirely inappropriate, I do think that regulators need to consider carefully the incentive impact of compensation arrangements as they assess the robustness of risk-management and internal control systems.
All in all, an interesting, but not particularly meaty, speech.
Well, that was an interesting trading day, wasn’t it? I draw your attention to this excerpt from the Globe & Mail’s website:
“Mr. Martyn said there is concern that Canadian financial institutions may run into liquidity woes in the next week, a situation that could force them to merge.
“If they can not re-liquefy their balance sheets and need to, then they are in trouble,” he said. “So it is not inconceivable that in this cycle, one of the top six banks goes and merges with another one. Probably a forced merger.”
Is this comment as out to lunch as it sounds? Or is this a possibility? Secondly, if two Canadian banks should merge as has been suggested here, would that action not immediately trigger the necessity of redeeming all outstanding preferreds of both banks?
madequota
Before you wonder if I’m out to lunch with that second question, I draw your attention to this excerpt from the prospectus of BNS’s latest 5.6% pref offering:
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In the event of the liquidation, dissolution or winding-up of the Bank, the holders of the Series 17 Preferred Shares shall be entitled to receive $25.00 per share together with all dividends declared and unpaid to the date of payment before any amount shall be paid or any assets of the Bank distributed to the holders of any shares ranking junior to the Series 17 Preferred Shares. The holders of the Series 17 Preferred Shares shall not be entitled to share in any further distribution of the assets of the Bank.
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A merger could effectively be seen as a dissolution, or at least a winding up of one of the banks involved in the merger; hence, the necessity to redeem. I don’t know . . . what do you think?
madequota
I don’t put a lot of credence in doomsday scenarios for Canadian banks. And I can’t find performance data for Mr. Martyn’s firm, Davis Rea.
And I don’t think a merger would class as a dissolution or winding up, or that prefs would be redeemed at par … but for a definitive answer on that one you’ll have to see a securities lawyer!
I will note that if a merger was done as a plan of arrangement, preferred shareholders would have to vote in favour, as happened with Teachers/BCE.
To madequota’s question about bank mergers: although Bear Stearns common shareholders were killed by the JP Morgan acquisition, I bet pref and bond owners are probably breathing a big sigh of relief — even without redemption in the deal.
Likewise, if a Canadian bank got so distressed that it needed a takeover to survive, it would be, as James has noted for CIBC, the common shareholders who would take big punishment before the pref holders.
I may be alone in this sentiment, but I am reasonably impressed with the reaction of Canadian and US central banks as the liquidity crisis unfolds. They have obviously thought carefully in advance about what they may need to do and have done it (so far) exactly when required, with strong political support and understanding. As a result, market fallout, although negative in the aggregate, seems to be a lot better than it otherwise might.
This is completely unlike the situation for Northern Rock, where the UK government apparently had no plan, bumbled by suddenly guaranteeing everything (deposit insurance levels were very low), is now on the hook for C$110B and could not find a buyer. At least Bear Stearns went to a buyer and required “only” a $30B guarantee.
In addition, I find both Carney and Dodge “right on” in their analysis of causes and effects, and crystal clear in their thinking, unlike the one-dimensional panicky crap we seem to find on the internet (present company excluded, of course).
One can argue that the central banks screwed up allowing hedge funds, leverage, sub-prime et al to get out of control. Perhaps they could be better at anticipating irrational investor psychology. However, these quibbles are long term issues whose conclusions are not yet clear. We can debate them later, but for now, I’m impressed with the North American central banks. Without them, lunatics could be running the asylum.
hello prefhound, and thank you for the reply . . . I would tend to agree with your feeling for the relative stability of the central banks in Canada and the USA, but with a small caveat . . .
for some time now, both the BoC, and the Fed have redefined their role [until very lately anyway] as having a sole priority at the exclusion of virtually all else . . . and that is to ensure that the evil enemy known as inflation remains under total control. The last 2 years of Mr. Greenspan’s era, and the first bit of Bernanke’s, not to mention all of Dodge’s have been focussed squarely on virtually nothing other than inflation.
The bond market got so comfortable with this that bond trading [again until very recently] was trained to analyze the specific verbs and adjectives that would accompany rate decisions, all in the interests of being able to predict the inflation tone, since this was the only relative contributing factor to the direction of bond values.
This, to me has been the major shortcoming of the BoC, and the Fed. With the US mired in its’ assorted recessionary trauma, it seems that the enemy known as inflation would almost be a welcome sighting right now. After all, is it better for a home valued at $250K last year to be valued at $300K this year with a happy family living in it? or is it better for it to be valued at $150K with the family foreclosed, and living in grannie’s basement?
Before James or anyone else jumps in, and misinterprets what I’ve just said as being “inflation-positive”, let me just conclude by saying that inflation should be controlled, but not to the extent that the Fed and the BoC have allowed so much other activity to prevail unnoticed. Where did the Greenspan policy of quarter point rate hikes get the US in the end? They still seem to be above the acceptable inflation threshold, and with today’s [expected] full point cut, will probably be pretty much where they were before Mr. Greespan’s war on inflation started anyway.
madequota
With respect to possible inflation-positive bias by the Fed, see Brad Delong’s article, the commentary at Econbrowser and my response.
very well; and I draw your attention to this article from the G & M today:
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For Professor Bernanke, it’s back to school
BARRIE MCKENNA
00:00 EDT Tuesday, March 18, 2008
WASHINGTON — Ben Bernanke has likened the Great Depression to the Holy Grail of macroeconomics – an experiment in unravelling the mysteries of global economic collapse.
As an academic specializing in the Dirty Thirties, the former Princeton University economist ultimately concluded that U.S. banking authorities botched the Depression by letting panicked runs on banks wreck the real economy.
Years from now, a new generation of academics may similarly try to draw lessons from how Mr. Bernanke, now the U.S. Federal Reserve Board chief, handles the great credit collapse of 2007-08.
Determined not to let history repeat itself, Mr. Bernanke is battling the twin evils of fear and contagion with every weapon in the Fed arsenal. He’s orchestrated a bailout of investment bank Bear Stearns, opened the bank’s lending to other troubled stockbrokers, expanded loan terms to 90 days from 30 days, and tapped other sources of liquidity for the beleaguered banking industry.
And today, he and his Fed colleagues are widely expected to announce a sixth cut in its benchmark interest rate since August – possibly by a historic full percentage point to 2 per cent. That would add a massive jolt of interest rate relief to the teetering U.S. economy.
“Ben Bernanke is a Great Depression buff,” pointed out Sherry Cooper, chief economist and strategist at BMO Nesbitt Burns.
“He understands the risks of a run on banks and the importance of the Fed’s role as lender of last resort,” Ms. Cooper said.
By running to the rescue of investment banks and opening up the interest rate spigot, Mr. Bernanke is eager to avoid the same problems he dissected in his seminal 1983 paper, “Non-monetary effects of the financial crisis in the propagation of the Great Depression.”
Back then, credit dried up and economic activity came to a standstill when financial institutions failed. Mr. Bernanke’s M.O. seems to be: Inject lots of credit to keep the lending industry afloat.
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“Inject lots of credit to keep the lending industry afloat.” . . . In a very twisted way, is this not what started the problem in the first place? The good news is, there’s no mantra about inflation fighting here!
madequota
Perhaps not quite as simple as all that. Central banks do lots of things behind the scenes other than their headline inflation-fighting stance. For example, in Canada, they got all the banks and other major financial participants to develop daily clearing and large transaction systems superior to those in most (all?) parts of the globe. Hardly any US banks can do same-day clearing with other banks.
The Fed led the bailout of Long Term Capital Management 10 years ago. Recent actions are not novel, in my view, just part of maintaining confidence in the financial system — avoiding domino effects.
Investors are more to blame than the Fed — chasing leverage and “promised” returns. Who took to heart any of the LTCM lessons about leverage and models blowing up under stress? Who reduced their hedge fund exposure as a result? Not too many, then. Perhaps more will now.
I saw other sub-prime lenders blow up in the mid-1990s — Conseco? — so credit crunches are not that novel. Indeed, if you look at the baa – aaa spreads, or baa – 10-year treasury for 20-30 years (from the Fed), you will see several periods lasting more than a year, of wide wide and volatile spreads — some wider than what we see now.
I could even argue that government bailouts (even if they do cost taxpayer’s money, which is not yet certain in this credit crunch) are not the one-sided waste of taxpayer’s money that many irate bloggers suggest. The “taxpayers” benefitted from lower than rational interest rates on their mortgages and other debts for years in advance of the credit crunch. Now it is payback time.
The net effect of Fed actions (and a crossover to a service economy) has greatly moderated the standard deviation of GDP growth. Most of us would not like the world of financial armageddon (bad monetary and fiscal policy) that unfolded in the great depression, and we are not likely to get it.
thank you for that reply! I do realize that central banks are supposed to have a far wider agenda than the headline inflation item, and I am aware of many of their functions beyond this. As you pointed out, the Canadian clearing system is a BoC item that noone ever really talks about.
In recent times however; and I’m directing this primarily at the US Fed, their structure has lent itself to an almost surreal “headline-driven” media event, which unfortunately supercedes any of the other key functions of the central bank. Look at their system of enlisting “regional Fed Presidents”. The unfortunate reality of this system is that most of these individuals have the public’s eye and ear, and feed right into it. On the subject of inflation-fighting, I’m amazed at the rhetoric that [until recently] spewed like venom from the lips of Janet Yellen, Richard Lacker, Walter Poole to name a few. Inflation hawks most of them, and determined not only to sleigh the evil dragon, but to make sure that the public knows it was he (or she) that was the saviour.
Anyway, I’m starting to ramble; thanks again for the replies; much appreciated.
madequota
[…] was referred to by BoC governor Carney in his speech to the Toronto Board of Trade that has been reviewed on PrefBlog. He was referring to credit ratings and changes thereof, but the principle is the same: Finally, it […]
[…] The problems with regulation is due to the extraordinary confidence placed in the credit ratings agencies – and in the ability of the marketplace to value credit in a sober and analytical manner – by the regulators. Basel I placed far too high confidence in the credit ratings of a bank’s holdings as a measure of its risk, and some regulators did not impose an assets to capital multiple cap on the banks under their supervision as a safety check. Among other things, this meant that there was an entire marketplace for AAA tranches with all the buyers buying the same thing for the same reasons … and that engendered a huge amount of “cliff risk”, sometimes referred to as “crowded trades” (as indicated by BoC Governor Carney in March). […]
[…] The problems with regulation is due to the extraordinary confidence placed in the credit ratings agencies – and in the ability of the marketplace to value credit in a sober and analytical manner – by the regulators. Basel I placed far too high confidence in the credit ratings of a bank’s holdings as a measure of its risk, and some regulators did not impose an assets to capital multiple cap on the banks under their supervision as a safety check. Among other things, this meant that there was an entire marketplace for AAA tranches with all the buyers buying the same thing for the same reasons … and that engendered a huge amount of “cliff risk”, sometimes referred to as “crowded trades” (as indicated by BoC Governor Carney in March). […]