Category: Interesting External Papers

Dr. Abraham Lioui of EDHEC has released a paper on the effectiveness of the much-ballyhooed short sales ban:

An in-depth study of the short-selling market calls into question both the reasons for the decision to ban short selling and the prejudices that weigh on those who short. According to recently published data (for the United States in particular), a large majority of short sellers are market makers who are hedging their bets on the options markets. They were not affected by the ban, which means that those who were using options to take synthetic short positions continued to do so. The others involved in short selling are mainly hedge funds. The average return over the last ten years for hedge funds that used short-sale, convertible arbitrage and long/short strategies was 3%, 4.75% and 7.00% respectively (Le Sourd 2009). One can hardly argue that they were over-informed and that they earned abnormal returns.

As a result, short sellers perhaps did not really merit the punishment that, by simply banning the shorting of the shares of financial institutions, the market authorities recently meted out. It also seems (and this study confirms it) that the shares that were the object of the ban were relatively unaffected by it. All the same, this drastic measure cast the market authorities in a particularly negative light. After all, the reasons for this measure are unclear, a lack of clarity that adds to the bewilderment of the market. The market, of course, reacted accordingly. The ban on short selling was followed by a sharp rise in the volatility of the markets, and on the stock markets concerned the impact of the ban was systematic; the impact on volatility was greater than that of the financial crisis. In general, the risk/return possibilities of investors worsened.

And although it is hard to substantiate the impact on the volatility of the shares, the rise in the volatility of these shares, which is undeniable, is a result of the rise in idiosyncratic risk and thus of the noise in the markets. As a consequence, share prices deviate yet more from their fundamental value. Finally, the desired effect on market trends has not been achieved (no reduction of the negative skewness of returns is being observed) and there is no evidence of the possible impact of this measure on extreme market movements. What is clear is that stock market indices now have components that are subject to different rules, differences that make them even less representative and relevant.

Broadly, the market seems to have reacted negatively to this ban; it views it as indicative of a deviation of the market authorities from their primary mission. It seems that these authorities are unable to manage the over-the-counter short sale market. The message for small investors is pessimistic as well. Finally, rather than opting for this facile response, greater efforts to democratise this market and to increase its transparency should perhaps have been made.

A lot of this is beside the point. The purpose of the short-selling ban was to demonstrate that regulators were Doing Something and Taking Decisive Action and Providing Adult Supervision. It succeeded admirably; no regulator has yet lost his job for not doing any of those things and public opprobrium is concentrated on Evil Bankers.

The IIROC report on the short-selling ban has been previously discussed on PrefBlog.

The Bank of Canada has announced the release of its April 2009 Monetary Policy Report:

In the January Update, the Bank projected a sharp recession in Canada, followed by a relatively muted recovery starting in the third quarter of this year. As a result of the more severe, synchronized nature of the global downturn, the recession in Canada is even deeper than anticipated. As well, the Bank now expects the recovery to be delayed until the fourth quarter of 2009 and to be more gradual than projected in January. Nonetheless, the Bank is still projecting a rebound to above-potential growth in 2010, albeit with a lower estimate of potential output growth. As explained in January, the recovery should be supported by a number of factors, including the timeliness and scale of the Bank’s monetary policy response; our relatively well-functioning financial system and the gradual improvement in financial conditions in Canada; the past depreciation of the Canadian dollar; stimulative fiscal policy measures; the gradual rebound in external demand; the strength of Canadian household, business, and bank balance sheets; and the end of the stock adjustments in Canadian and U.S. residential housing.

Inflation remains under control:

and they note that:

There was also a backgrounder on fan charts; these were recommended as a means of Central Bank communication by Michael Woodford of Columbia, as discussed on PrefBlog on January 17, 2008. These are used to indicate the degree of uncertainty in predictions:

The Cleveland Fed has released their Economic Trends, April 2009, with a variety of data and statistics.

Items of note are:

• February Price Statistics
• Financial Markets, Money, and Monetary Policy
• The Yield Curve, March 2009
• New Policy Moves and the Term Asset-Backed Securities Loan Facility
• International Markets
• China, SDRs, and the Dollar
• Economic Activity and Labor Markets
• U.S. Real Estate: Looking for Progress in Price Stability and Financing
• Real GDP: Fourth Quarter 2008 Final Estimate
• March Employment Situation
• An Overview of the Healthcare System

There were some good charts in the article on the TALF:

The TALF is designed to support the issuance of asset-backed securities (ABS) collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration.
…
Since the beginning of the financial crisis, however, those ABS markets have been under strain. With the strain accelerating in the third quarter of 2008, the market came to a near-complete halt—the chart below shows the dramatic drop in the issuance of new consumer ABSs.

Under the TALF, the Federal Reserve Bank of New York will provide nonrecourse funding to any eligible borrower owning eligible collateral. On a fixed day each month, borrowers will be able to request one or more three-year TALF loans. As the loan is nonrecourse, if the borrower does not repay the loan, the New York Fed will enforce its rights to the collateral.
Th ree requirements are intended to protect the Fed from the risk of losses. First, the ABS must have the highest investment-grade rating category from two or more major nationally recognized statistical rating organizations. Th is requirement should reduce the risk that the ABSs accepted will fall dramatically in value. Second, borrowers will pay a risk premium set to a margin above the Libor (usually 1 percent). Th ird, “haircuts” ranging from 5 percent to 15 percent will be fi gured into the loans. Th at is, the amount the TALF will extend a loan for can be only as high as the par or market value of the ABS minus the haircut. Th is requirement means that if the borrower defaults on the loan and the Fed seizes the collateral, the Fed loses nothing unless the value of the collateral has fallen more than the haircut.

The Federal Deposit Insurance Corporation has announced the release of the 4Q08 Banking Profile, containing two feature articles:

• How the Recession is Unfolding across Four US Regions
• Alternative Financial Services: A Primer

The guts of the full report is the report of banking system statistical information, which begins with the cheery sentence:

FDIC-insured institutions reported a net loss of $32.1 billion in the fourth quarter of 2008, a decline of $32.7 billion from the $575 million that the industry earned in the fourth quarter of 2007 and the first quarterly loss since 1990. Rising loan loss provisions, large writedowns of goodwill and other assets, and sizable losses in trading accounts all contributed to the industry’s net loss. More than two-thirds of all insured institutions were profitable in the fourth quarter, but their earnings were outweighed by large losses at a number of big banks.

Chart 2 looks like it was prepared by a graphic artist who didn’t really know what the data meant, but the important information can be puzzled out:

Assiduous Readers will remember I have taken a certain amount of glee in pointing out that the story so far is still not as bad as the Recession of 1990 (you young whipper-snappers) … but we’re getting there, at least in the States:

… with the result that those who blithely assumed refinancing risk are feeling a little nervous:

Note that the release of the statistical data has been previously discussed on PrefBlog.

The IMF has released its Global Financial Stability Report for April 09 (hat tip: Menzie Chinn of Econbrowser), in which they highlight some work by Sergei Antoshin on corporate bond spreads.

Box 1.5 on page 51 of the PDF is hardly a full academic treatise, but we can take things as they come:

This study attempts to model corporate bond spreads based on a cash-flows approach to explain the underlying key drivers. The equilibrium spreads are ultimately determined by cash flows or internal funds available to bond issuers and bond buyers. The study identifies factors affecting the cash flows from operating, investing, and financing activities across the major classes of bond issuers and bond holders. The drivers are intended to represent expected profitability, uncertainty, and liquidity constraints. The model displays linkages among financial strains in major sectors of the economy, asset returns, financial and economic risks, macroeconomic activity, and losses in the system.

Previous studies of corporate spreads have found it difficult to explain the sharp increase in spreads during the recent crisis. The conventional approach is to regress spreads on a broad range of macroeconomic and financial variables. Large residuals arising from these models are attributed to an unexplained component driven by illiquidity premia. In this study, spreads are modeled by explicitly accounting for illiquidity premia and funding strains.
…
The capital flows framework developed in this study allows one to capture explicitly the effects of stress in various economic sectors on corporate spreads. The analysis suggests that corporate spreads can be largely explained by the fundamentals and risks related to both uncertainty and financing constraints. Policy implications should be drawn with caution, since, as with any regression analysis, the equations display measures of correlation rather than causality. For example, if the LIBOR-OIS spread were to decline by 50 basis points—possibly as a result of some policy action—it would be associated with a roughly 100 basis point decline in corporate spreads. This provides some perspective on the scale of challenges and potential benefits for policymakers contemplating intervention in the market for corporate finance.

I’m suspicious of the high degree of parameterization and the relatively short period shown in the graph; there’s not really a lot of meat given in the box to determine whether the author’s genuinely on to something or not.

The Kansas City Fed has released its 1Q09 Economic Review, with articles:

• Has Multi-Market Banking Changed the Response of Small Business Lending to Local Economic Shocks?
• Do U.S. Consumers Really Benefit from Payment Card Rewards?
• Recession Catches Rural America
• Developing a Liquid Market for Inflation-Indexed Government Securities: Lessons from Earlier Experiences by Pu, Shen, whose work on long term relative return of stocks vs. 20-year Treasuries has been previously highlighted on PrefBlog

Again, the Kansas City Fed has copy-protected their PDF … perhaps some kind soul will unlock it for me and send me a copy. One source of liquidity is steady, predictable supply of new issues.

I haven’t had much time to look at this Public Policy Discussion Paper, but Christopher L. Foote, Kristopher S. Gerardi, Lorenz Goette, and Paul S. Willen seem to have taken a good look at the data – and listened to it!

It is interesting that the Boston Fed is releasing this paper on Good Friday – could it be that management is not 100% enthralled at the political incorrectness of the conclusions?

Abstract:

This paper takes a skeptical look at a leading argument about what is causing the foreclosure crisis and what should be done to stop it. We use an economic model to focus on two key decisions: the borrower’s choice to default on the mortgage and the lender’s choice on whether to renegotiate or “modify” the loan. The theoretical model and econometric analysis illustrate that “unaffordable” loans, defined as those with high mortgage payments relative to income at origination, are unlikely to be the main reason that borrowers decide to default. Rather, the typical problem appears to be a combination of household income shocks and an unprecedented fall in house prices. Regarding the small number of loan modifications to date, we show, both theoretically and empirically, that the efficiency of foreclosure for investors is a more plausible explanation for the low number of modifications than contract frictions related to securitization agreements between servicers and investors. While investors might be foreclosing when it would be socially efficient to modify, there is little evidence to suggest they are acting against their own interests when they do so. An important implication of our analysis is that policies designed to reduce foreclosures should focus on ameliorating the immediate effects of job loss and other adverse life events, rather than modifying loans to make them more “affordable” on a long-term basis.

… and I was pleased that somebody has finally observed:

Estimates of the total gains to investors from modifying rather than foreclosing can run to $180 billion, more than 1 percent of GDP. It is natural to wonder why investors are leaving so many $500 bills on the sidewalk. While contract frictions are one possible explanation, another is that the gains from loan modifications are in reality much smaller or even nonexistent from the investor’s point of view.

We provide evidence in favor of the latter explanation. First, the typical calculation purporting to show that an investor loses money when a foreclosure occurs does not capture all relevant aspects of the problem. Investors also lose money when they modify mortgages for borrowers who would have repaid anyway, especially if modifications are done en masse, as proponents insist they should be. Moreover, the calculation ignores the possibility that borrowers with modified loans will default again later, usually for the same reason they defaulted in the first place. These two problems are empirically meaningful and can easily explain why servicers eschew modification in favor of foreclosure.

Turning to the data, we find that the evidence of contract frictions is weak, at least if these frictions result from the securitization of the loan.

The Investment Industry Association of Canada has released its Debt Market Report for 4Q08.

Corporate issuance has fallen off a cliff:

… and Money Market trading is showing some interesting trends:

If I don’t give myself a way of finding this article quickly, I’m going to go out of my mind! I think this is a very good exposition of the stocks/bonds conundrum, and regularly spend half an hour looking up the reference – no more!

How Long is a Long-Term Investment? was written by Pu Shen of the Kansas City Fed and published in the Spring 2005 edition of their Economic Review.

Unfortunately, the source-file is copy-protected (why do they do that?) but I can recommend this article as part of the asset allocation process; it has many fascinating graphs. The laboriously re-typed conclusion is:

This article confirms the conventional wisdom that in the United States stocks historically have been safer than long-term government bonds for investors with long holding periods. But the article also shows that the conventional wisdom has only been true for investors who held their portfolios for more than 25 years. For practical purposes, that may be too long a holding period for most investors. Over the years, for investors who have held their portfolios for shorter periods, both stocks and bonds were exposed to substantial risks, and stocks did not necessarily outperform government bonds. This implies that in making asset allocation decisions, investors should think carefully about how long they will be able to hold their portfolios undisturbed and how much risk they are willing to bear.

Update: A little bird has sent me an unlocked version of the paper, so I can reproduce my three favourite graphs:

The Bank for International Settlements has announced the release of Working Paper #279, The pricing of subprime mortgage risk in good times and bad: evidence from the ABX.HE indices by Ingo Fender and Martin Scheicher.

This paper investigates the market pricing of subprime mortgage risk on the basis of data for the ABX.HE family of indices, which have become a key barometer of mortgage market conditions during the recent financial crisis. After an introduction into ABX index mechanics and a discussion of historical pricing patterns, we use regression analysis to establish the relationship between observed index returns and macroeconomic news as well as market-based proxies of default risk, interest rates, liquidity and risk appetite. The results imply that declining risk appetite and heightened concerns about market illiquidity—likely due in part to significant short positioning activity—have provided a sizeable contribution to the observed collapse in ABX prices since the summer of 2007. In particular, while fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, those backed by AA and AAA exposures have tended to react more to the general deterioration of the financial market environment. This provides further support for the inappropriateness of pricing models that do not sufficiently account for factors such as risk appetite and liquidity risk, particularly in periods of heightened market pressure. In addition, as related risk premia can be captured by unconstrained investors, ABX pricing patterns appear to lend support to government measures aimed at taking troubled assets off banks’ balance sheets—such as the US Troubled Asset Relief Program (TARP).

The authors observe:

With market liquidity vanishing and entire market segments becoming largely dysfunctional, factors other than credit risk became increasingly important drivers of observed prices. This, in turn, rekindled earlier doubts concerning the validity of currently available models for the pricing of credit risk, particularly for portfolio instruments such as mortgage-backed securities and other complex securitisations.

The results presented in this paper suggest that declining risk appetite and heightened concerns about market illiquidity have provided a sizeable contribution to the observed collapse in ABX prices since July 2007. While fundamental factors, such as indicators of housing market activity, have continued to exert an important influence on the subordinated ABX indices, the AA and AAA indices have tended to react more to the general deterioration of the financial market environment, such as declining risk appetite and market liquidity. These results underline the well-established view that risk premia are important components of observed prices for default-risky products, and that the relative importance of non-default risk factors will tend to increase in periods of strong repricing of credit risk. This suggests that theoretical pricing models that do not sufficiently account for these factors may be inappropriate, particularly in periods of heightened market pressure.