PrefBlog

A number of regulatory links today! In another post, I discussed Derek DeCloet’s column in today’s Globe, but there were other things.

In a column in VoxEU, Xavier Vives writes a fairly general description of the problem of informational asymmetry, without giving much of a prescription for a cure. I suspect that Dr. Vives supports the Financial Stability Forum’s recommendations on simultaneous public disclosure … but this is not clear.

He makes the assertion:

The problem has been aggravated by the lack of control of who was monitoring the subprime loans. In the old-fashioned banking system institutions would monitor loans, in the world of securitised packages the market failed to provide the monitoring because rating agencies did not do their job properly and fund managers took the risk knowing that the upside was to be cashed in bonus form and the downside protected by limited liability.

… but doesn’t back it up. It should be noted that the linked paper provides no evidence that the “rating agencies did not do their job properly”; that paper by Portes seems to be getting quite a number of links on VoxEU, for reasons that I simply can’t fathom. I’ll review it at some point – I didn’t at the time, simply because it was so thoroughly generic – but in this case I’ll content myself with stating that Dr. Vives’ phrasing is not consistent with his link.

I take issue with his “second aspect”:

A second aspect of the question, made evident in the present crisis, is that, if the central bank intervenes to help institutions that are not under its supervision, it may lack the necessary information to assess whether the origin of the need is a liquidity or a solvency problem. How does the Federal Reserve know when mounting the rescue operation of a non-bank financial firm, for example, that the institution is solvent? By helping an insolvent institution taxpayers’ money is put at risk and the disciplining effect of failure eliminated. The consequence is that the moral hazard problem is exacerbated and bank managers will feel more secure in the future to take excessive risks.

Well, the “non-bank financial firm” business seems to be a tangential reference to Bear Stearns – and in that case, they know about solvency by asking the SEC. Separation of supervisory and lender of last resort functions is standard throughout much of the world – Canada and the UK, for instance – and, while not ideal, isn’t necessarily all that terrible either.

I do agree that propping up an insolvent institution would represent a misuse of the discount window – or equivalent mechanism.

Still on VoxEU, Axel Leijonhufvud wrote a rather prescient piece on inflation targetting in June, 2007:

The sanguine view is that securitisation and credit derivatives have made the world of finance a safer place than it used to be and that, besides, liquidity is ample all around. But it is not likely that the world will stay awash in liquidity forever. At some stage, central banks will have to mop it up or see inflation do it for them. Securitisation and credit derivatives have certainly dispersed risk through the economy and away from the banks where it used to be concentrated. But by the same token, the system has taken on more risk and we know less about where large concentrations of risk-bearing may be located. Risk spreads have narrowed in part permanently because of these new risk-sharing technologies, but in part transitorily because of the extraordinary level of liquidity. Narrow spreads have in turn induced some institutions to assume high leverage in search of yield.

A number of very large failures – LTCM, Enron, Amaranth – have occurred causing nary a macroeconomic ripple, and this is frequently cited as proof of the resilience that recent financial innovations have imparted to the system. It may be, however, that the more appropriate conclusion to draw is that macroeconomic developments are more likely to trigger trouble in financial markets than vice versa.

In his current article, Central banking doctrine in light of the crisis, he joins the chorus blaming Greenspan for allowing the housing bubble in the 2001-05 period:

This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit.

He then argues that the elements of choice in monetary policy cast doubts on the policy of central bank independence:

Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.
…
When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.

It’s a tricky question! I am fully supportive of the de facto situation … the central banking chief is an unelected technician; he is appointed by the government; but the only power that the government has is to fire him – otherwise they have no say in anything. It depends a great deal on ensuring that the central banker is a paragon of integrity, not dependent upon his salary to keep food on the table.

It is accepted as pretty much a given that if the BoC governor at a given time was to be dismissed, the currency would tank and interest rates would skyrocket which – even to the most zealous investor advocate in parliament – would make it not worth firing him except for the gravest of reasons. But perhaps some thought should be given to ensuring a golden parachute that would withstand even the supremacy of parliament … I don’t know, frankly, what the current arrangements are.

And I’ll take a moment to snipe at the horrible political games-playing in the States, which has resulted in two vacancies out of seven places in the Federal Reserve Board of Governors.

Further to all the regulatory talk in this update is a post by Naked Capitalism, referencing some fashionable grandstanding by the EU:

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the “short-term” pay structure of modern capitalism has become deformed, causing firms to take on “excessive risk” without regard to the interests of stakeholders or society.

Geez, I’m getting old. I can remember when the short-term nature of quarterly reporting was on the verge of destroying the United States, leaving the (far-sighted and judicious long-term planning) Japanese as rightful masters of the universe.

Has anybody heard anything more about that? What happened to that story, anyway?

The other clipping republished by Naked Capitalism is with respect to a NYT interview with Kenneth C. Griffin:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

US brokerages are, from all the accounts I’ve heard, a lot more fun to work at than Canadian ones. In the US, if you have a good idea, you go to your supervisor … and bang! If he likes it you’ve got your funding and a deal: if it works, you, personally, will get rich. If it doesn’t, you’ll get fired. In Canada, of course, if you have a good idea, you write it up for Human Resources to look at and determine whether it’s culturally sensitive, if it harms the environment, and whether it will increase diversity and respect in the workplace. You wait a bit for their answer, then retire.

There are times – such as now! – when the free-wheeling nature of the US system got … er … a little out of hand, but we can be sure the regulatory wannabes will be only too happy to throw the baby out with the bathwater.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion.
…
In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

The first solution is just smarmy, and reminds me of everything I’ve heard about being on (Canadian) Unemployment Insurance … they make you go to moronic seminars lead by twerps who are congenitally unemployable outside government. When you point out an obvious stupidity, they just ask ‘if you’re so smart, why don’t you have a job, while I do?’.

I feel quite certain that Bear Stearns (and the SEC, its regulator) were convinced that they had, in fact, arranged their affairs such that the stop-gap support of the Federal Reserve would not be necessary. They were wrong, they’ve lost nearly all their investment. It’s called business. Business Risk, to be precise.

I’ll be perfectly happy to consider suggested changes to the regulatory regime, capital and liquidity calculations, and to proffer plaudits and criticism as I see fit. Until these suggested changes are available for discussion, however, I suggest that Mr. Griffin and his adulatory interviewer arrange their affairs to make him sound a little less like a smarmy twerp.

Exchange Traded CDS? The Exchanges have been trying to put such a thing together for years. I understand that some of the major brokerages are trying to put together a clearinghouse … but it’s really none of the government’s damn business. The regulators can impose reasonable margin and capital rules, sure; and it’s entirely reasonable that the margin requirements for a clearing-house counterparty will be somewhat less than those for even the strongest of individual counterparties; but determining that the Official Counterparty has a monopoly on trading is going way, way, way too far.

Will I be allowed to guarantee my nephew’s car loan, or will the Official Counterparty insist on doing it and charging a fee?

Getting back to preferred shares for just a moment (sorry!) what’s up with the DFN Rights Issue? Four rights and $24.25 get you one DFN and one DFN.PR.A. Prices are:

There are two monthly dividends yet to go … $0.10 each on DFN, $0.04375 each on DFN.PR.A. Total $0.2875. So it doesn’t really look as if there’s any good arbitrage possible … but given that the NAV as of April 30 was $24.81 ($24.63 fully diluted), it seems to me that the rights are cheap. Do your own homework, though, preferably involving the modelling of the underlying portfolio!

The preferred share market put in a good honest day’s work today with good returns and even some decent (and all too infrequent, lately) volume.

There were twenty-eight other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Tuesday, May 13th, 2008 at 11:17 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.