PrefBlog

The Bank for International Settlements has released its December 2009 Quarterly Review with:

• A review of current conditions
• Macro stress tests and crises: what can we learn?
• Monetary policy and the risk-taking channel
• Government size and macroeconomic stability
• Issues and developments in loan loss provisioning: the case of Asia
• Dollar appreciation in 2008: safe haven, carry trades, dollar shortage and overhedging

The review contained the following snippet of interest:

the market-implied price of credit risk also continued its downward trend, but to its pre-crisis level (Graph 11, left-hand panel).

The return to more normal credit market conditions was also reflected in corporate bond issuance (Graph 11, right-hand panel, and Highlights section).

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The methodology used to prepare the chart of market implied cost of risk has been summarized on PrefBlog.

The paper by Leonardo Gambacorta, Monetary policy and the risk-taking channel, has been highlighted by Bloomberg and makes the claim that ‘reaching for yield’ is not merely a retail problem:

This paper investigates the link between low interest rates and bank risk-taking. Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk. Using a comprehensive dataset of listed banks, this paper finds that low interest rates over an extended period cause an increase in banks’ risk-taking.

For instance:

The inertia in nominal targets at a time of lower interest rates may reflect a number of factors. Some are psychological, such as money illusion: investors may ignore the fact that nominal interest rates may decline to compensate for lower inflation. Others may reflect institutional or regulatory constraints.
…
More generally, financial institutions regularly enter into long-term contracts committing them to produce relatively high nominal rates of return. The same mechanism could be in place whenever private investors use short-term returns as a way of judging manager competence and withdraw funds after poor performance

In the short term, low interest rates reduce the probability of default of outstanding variable rate loans, by reducing interest burdens of existing borrowers. In the medium term, however, due to the higher collateral values and the search for yield, banks tend to grant more risky loans and, in general, to soften their lending standards: they lend more to borrowers with bad credit histories and with more uncertain prospects. Overall, these results suggest that low interest rates reduce credit risk in banks’ portfolios in the short term – since the volume of outstanding loans is larger than the volume of new loans – but raise it in the medium term.

The empirical exercise points to a number of other interesting findings. First, developments in housing prices prior to the crisis appear to have contributed to bank risk-taking. An inflation-adjusted house price growth rate that is 1 percentage point above its long-run average for six consecutive years leading up to the crisis increases the probability of default of the average bank by 1.5%. This result is in line with the view that the housing market had a substantial role in the crisis and that banking distress was typically more severe in countries that experienced a more pronounced boom-bust cycle in house prices.

Second, banks that experienced a higher growth rate of lending with respect to the industry average prior to the crisis proved to be riskier ex post. For example, lending of about 10% above average over the six years preceding the crisis caused an increase in bank probability of default by 3.9%.

Jeffery D Amato wrote a paper with the captioned title in the BIS Quarterly Review, 4Q05:

Credit default swap (CDS) spreads compensate investors for expected loss, but they also contain risk premia because of investors’ aversion to default risk. We estimate CDS risk premia and default risk aversion to have been highly volatile during 2002–2005. Both measures appear to be related to fundamental macroeconomic factors, such as the stance of monetary policy, and technical market factors, such as issuance of collateralised debt obligations.
…
To proxy for default probabilities, we use one-year EDFs™ as in the study by Berndt et al (2005). EDFs™ are constructed using balance sheet and equity price data under the principles of a Merton-type model for gauging the likelihood of default. Our data on EDFs™ are available at a monthly frequency for all but two firms in the CDX.NA.IG.4 index. Aggregate and sector EDFs™ are constructed as simple arithmetic averages of existing data on the constituents.
…
In order to see how we obtain measures of risk premia and risk aversion, note that CDS spreads can be roughly decomposed as follows:

CDS spread = expected loss + risk premium
= expected loss x risk adjustment

where

risk adjustment = 1 + price of default risk

The first equation above says that the CDS spread is approximately equal to expected loss plus a risk premium, where the latter is compensation paid to investors for enduring exposure to default risk. In the second equation, the spread is re-expressed in terms of risk-adjusted expected loss, where the risk adjustment varies proportionally with the price of default risk. The price of default risk has the interpretation as the compensation per unit of expected loss. It is an indicator of investors’ aversion to default risk: a positive price of risk means that investors demand that they be paid more than actuarial losses. Hereafter, we will use the terms “price of default risk” and “indicator of default risk aversion” interchangeably.

While the formulations of spreads above isolate a “risk premium” and a “price of risk”, in principle there are two distinct types of default risk that may command a premium. One is cyclical variation in expected loss, which usually rises during economic downturns, when overall income growth is low. The other is the actual default of an entity and its impact on investors’ wealth due to an inability to perfectly diversify credit portfolios. In the literature, these are generally referred to as systematic and jump-at-default risk, respectively.

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The use of Moody’s KMV methodology to determine intrinsic default probability is similar to the Bank of England approach, but different from the recently published Bank of Canada liquidity research which, essentially, assigns a value of zero to the variable “price of default risk”.

The Investment Industry Association of Canada has released its 3Q09 Equity Market Report:

After a stellar start in Q1, preferred share issuance has also slowed down considerably with only $1.3 billion in financings recorded for the year. (Chart 2). This is largely due to reduced offerings from financial institutions who shored up their capital base in previous periods. Limited partnership issuance only reached $100 million on the quarter with only four deals coming to market during the period.

The Bank of England has released a working paper by Viral V Acharya, Hyun Song Shin and Tanju Yorulmazer titled Endogenous choice of bank liquidity: the role of fire sales:

Banks’ liquidity is a crucial determinant of the adversity of banking crises. In this paper, we consider the effect of fire sales and entry during crises on banks’ ex-ante choice of liquid asset holdings. We consider a setting with limited pledgeability of risky cash flows relative to safe ones and a differential expertise between banks and outsiders in employing banking assets. When a large number of banks fail, market for assets clears only at fire-sale prices and outsiders enter the market if prices fall sufficiently low. In such states, there is a private benefit of liquid holdings to banks from purchasing assets. There is also a social benefit since greater banking system liquidity reduces inefficiency from liquidation of assets to outsiders. When pledgeability of risky cash flows is high, for instance, in countries with well-developed capital markets, banks hold less liquidity than is socially optimal due to risk-shifting incentives; otherwise, banks may hold even more liquidity than is socially optimal to capitalise on fire sales. However, if there is a systemic cost associated with crises, for example, in the form of fiscal costs associated with provision of deposit insurance, then socially optimal liquidity may always be higher than the privately optimal one, and, in turn, regulation in the form of prudent liquidity requirements may be desirable. We provide some international evidence on banks’ liquid holdings that is consistent with model’s predictions.

Regretably, I don’t have a lot of time today to go into this further.

The Bank of Canada has released a Working Paper by Hajime Tomura titled Optimal Monetary Policy during
Endogenous Housing-Market Boom-Bust Cycles:

This paper uses a small-open economy model for the Canadian economy to examine the optimal Taylor-type monetary policy rule that stabilizes output and inflation in an environment where endogenous boom-bust cycles in house prices can occur. The model shows that boom-bust cycles in house prices emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post. These boom-bust cycles replicate the stylized features of housing-market boom-bust cycles in industrialized countries. In an environment where mortgage borrowers are occasionally over-optimistic, the central bank should be less responsive to inflation, more responsive to output, and slower to adjust the nominal policy interest rate. This optimal monetary policy rule dampens endogenous boom-bust cycles in house prices, but prolongs inflation target horizons due to weak policy reactions to inflation fluctuations after fundamental shocks.

As summarized in Section 2, cross-country data for industrialized countries indicate that the nominal policy interest rate and the CPI inflation rate have tended to decline during housing booms and rise after the peaks of housing booms. The model explains this observation as follows. When borrowers expect that future house prices will rise, they increase housing investments, which causes a housing boom. Since borrowers are credit-constrained, they work more to finance their housing investments during the boom. At the same time, when savers do not share the optimistic expectations of borrowers, they instead expect the boom to be temporary and increase savings for a future recession. The increases in labour supply and savings reduce real wages and the real interest rate, respectively. Given sticky prices, a resulting fall in the marginal cost of production lowers the inflation rate, and, in response to this, the central bank cuts the policy rate. When the optimistic expectations of borrowers are not realized ex-post, a housing bust occurs, and savings and labour supply decline. As a consequence, the inflation rate rises, inducing a monetary policy tightening.

Since borrowers are credit-constrained, they work more to finance their housing investments during the boom. sounds a little backwards to me. I would say that “Credit constrained borrowers can work more during the boom, which allows them to finance increased housing investments”. I don’t find the rest of the rationale very convincing, frankly.

The problem of the interplay between monetary policy and housing bubbles has been discussed on PrefBlog before; e.g. Taylor Rules and the Credit Crunch Cause, with David Pappell warning

The Fed should respond to inflation, not inflation forecasts, especially in an environment where large negative output gaps are causing forecasted inflation to fall.

… a conclusion supported by the KC Fed paper discussed in KC Fed: Monetary Policy Amidst Deflationary Pressures. The problem was also discussed on Econbrowser in the post The Taylor Rule and the Housing Boom, which discusses the paper Dr. Taylor presented at the 2007 Jackson Hole conference, Housing and Monetary Policy

It strikes me that the Taylor Rule’s greatest strength, simplicity, is also its greatest weakness. Policy failure can result from misestimation of either of the two input variables. For policy purposes, it might be worthwhile to see how well other estimations that measure approximately the same thing can be added into the mix so that, for instance, inflation could be estimated not just by the CPI, but also with raw housing prices; the output gap supplemented by raw unemployment figures, and so on. Hell, I use 23 valuation parameters to assess the value of a preferred share, each of them taking a slightly different look at the problem.

The Autumn 2009 Bank of Canada Review contained an article by Alejandro Garcia and Jun Yang titled Understanding Corporate Bond Spreads Using Credit Default Swaps that, frankly, has me rather puzzled.

They state:

We use credit default swaps to decompose the spreads on Canadian corporate bonds because, as discussed in the next section, their lower susceptibility to liquidity effects makes them a much purer measure of default risk.
…
CDS contracts are commonly used to extract proxies for default risk for several reasons. As contracts, not securities, CDSs are far less sensitive to liquidity effects, since securities are in fi xed supply, while the supply of CDSs can be arbitrarily large. Because of this reduced sensitivity, CDSs provide a better measure of default risk. As well, it is less costly for investors to liquidate CDSs prior to maturity than to liquidate a corporate bond, since investors simply enter into a swap contract in the opposite direction. Further, CDSs are not likely to become “special” like treasury bills, or “squeezed” like corporate bonds. In principle, therefore, CDSs should contain mainly default information about the reference entity. However, they are not totally immune to liquidity effects, since search costs may be high for illiquid CDS contracts.
…
In this model, investors demand a return for holding corporate bonds that includes the risk-free rate, the default risk of the issuer, and the liquidity premium associated with the security. Similarly, investors demand compensation for selling the CDS that includes the risk-free rate and the default risk associated with the reference entity (bond issuer). Note that, in the model, we assume that the bond yield includes compensation for liquidity and default risk, whereas the CDS includes compensation only for default risk.

They derive the following decomposition. It should be noted that their phrase “average investment grade firm” is a little general, since they only had data for six companies, all BBB:

My problem is that I don’t understand their methodology. It ignores arbitrage – which means that you cannot capture the liquidity component by buying the bond and buying protection – and it would appear to blow up when confronted with the problem of positive basis trades, which (as observed by Choudhry) are are most common; negative basis trades became more common during the Crunch due to funding risk. For example:

BMO Capital Markets: Negative Basis Trades:

We recently executed a number of negative basis trades for clients involving auto companies when bond spreads were trading significantly wider than the CDS cost of protection. Investors were typically able to earn net spreads in excess of 25 bps after hedging both their interest rate risk and credit risk. This net spread offered a very attractive return for the risk resulting from this combination of transactions, i.e. a better than senior bank debt spread for assuming credit risk exposure that is meaningfully lower than direct bank exposure since the investor only looks to the bank CDS counterparty if the bond issuer fails.

Negative basis opportunities arise from time to time, but tend not to last for very long – investors who are able to act quickly are the big beneficiaries. We are active in the market, highlighting negative basis trade ideas for interested investors.

I have sent a query to the authors and will update this post if I get an answer.

Update: The methodology’s seminal paper by Longstaff (better link) examines CDS & bond yield spreads for Enron, which occasionally went negative, particularly towards the end. He notes:

It is important to acknowledge that our empirical approach of using a bracketing set of bonds does not eliminate all measurement error. This may partially explain why some of the percentages shown in Figure 3 for the size of the default component (particularly for the cases in which the Treasury and Refcorp curves are used) are in excess of 100.

It strikes me that dismissing negative basis as measurement error is cheating.

Doubt has been cast on the methodology by the results of Mahanti, Nashikkary & Subrahmanyam

Recent research has shown that default risk accounts for only a part of the total yield spread on risky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portion of the spread is a premium for liquidity. We investigate this possibility by relating the liquidity of corporate bonds, as measured by their ease of market access, to the basis between the credit default swap (CDS) price of the issuer and the par-equivalent corporate bond yield spread. The ease of access of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts, after controlling for other realized measures of liquidity. Additionally, we document the positive effects of liquidity in the CDS market on the CDS-bond basis. We also find that several firm-level variables related to credit risk negatively affect the basis, indicating that the CDS price does not fully capture the credit risk of the bond. In a similar vein, we document that bond-level variables related to features of the contract that may be related to credit risk, such as the presence of covenants, have a negative impact on the CDS-bond basis. These findings are consistent with the presence of frictions in the arbitrage mechanism between the CDS and bond markets, due to the costs of shorting” bonds.

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The Bank of Canada has announced that the Bank of Canada Review: Autumn 2009 is now available, with the following articles:

• Bank of Canada Liquidity Actions in Response to the Financial Market Turmoil
• Understanding Corporate Bond Spreads Using Credit Default Swaps
• Agency Confl icts in the Process of Securitization

The second article is sufficiently important (by which I mean “important to me”) that it will be reviewed in its own post.

Pegged Orders were first discussed on PrefBlog in a review of Jeffrey MacIntosh’s essay in the Financial Post. A discussion paper published by IIROC, Dark Pools, Dark Orders, and other Developments in Market Structure in Canada requests commentary on potential regulation of this order type; and the order type was also discussed in the November 2009 edition of PrefLetter.

David P. Brown of the University of Wisconsin and Craig W. Holden of Indiana University wrote a paper in 2005 titled Pegged Limit Orders that is of great interest:

Limit orders face mispricing risk – the risk of executing at a stale limit price after an innovation in public valuation, because limit-order traders generally do not continuously monitor market conditions. We analyze the impact of pegged limit orders that automatically adjust the limit price in a hybrid market. We find the direct effect is to increase limit-order profits, reduce dealer profits, and increase market-order losses. However, the indirect effect is to increase the quantity of limit orders submitted. A numerical calibration finds that when dealers supply relatively little liquidity, there is a net benefit to market orders as well.

Well, relatively little liqudity supply from the dealers is a major attribute of the preferred share market, so let’s look at this a little more. They define two types of risk assumed when entering a limit order:

There are two kinds of risk facing limit orders. 1 One is execution risk – the limit order quantity executed is random. A second is mispricing risk – a limit order may execute after an innovation in public valuation (e.g. a public news item) at a mispriced limit price, because limit-order traders generally are off the exchange and do not monitor market conditions continuously. We analyze whether mispricing risk can be reduced by creating pegged limit orders that automatically adjust the limit price, even in the absence of direct intervention by the limit-order trader.

Mispricing risk is especially important during market crashes.

They design a model, play with it, and find:

Initially, we analyze the direct effect of a design change from Regular LOs to Market-PLOs, and then to Quote-PLOs (holding limit-order quantities fixed). We find:

• • an increase in limit-order trader profits (Quote-PLOs > Market-PLOs > Regular LOs), because updating limit prices avoids states in which limit orders execute at a loss following a public value innovation,
• • a reduction in dealer profits (Quote-PLOs < Market-PLOs < Regular LOs), because dealers suffer in two ways: (1) dealers cannot profit by picking off mispriced limit orders and (2) updated limit orders are more effective in competing with the dealers for the incoming flow of market orders,
• • a reduction of market-order trader profits (or equivalently an increase in their losses) (Quote-PLOs < Market-PLOs < Regular LOs), because market orders lose the opportunity to pick off mispriced limit orders.

Which sounds very reasonable. A Market-PLO is linked to a market index, whereas a Quote-PLO is linked to the quote on a particular security.

Next, we analyze the indirect effect of a design change, allowing limit-order traders to choose the optimal quantities to submit. We find an increase in the quantity of limit orders submitted (Quote-PLOs > Market-PLOs > Regular LOs), because designs which avoid mispricing are more profitable. For marketorder traders, we find that the indirect effect is opposite the direct effect and increases market-order trader profits (Quote-PLOs > Market-PLOs > Regular LOs). This is because a greater quantity of limit orders reduces the probability of exhausting the total depth supplied by limit orders and dealers at the inside spread, and trading at prices outside the spread. Finally, we perform a numerical calibration exercise to analyze the combined impact of the direct and indirect effects on market-order trader profits. We find that under conditions when dealers endogenously choose to supply relatively little liquidity, then the indirect effect dominates and market-order traders benefit. Conversely, under conditions when dealers endogenously choose to supply a relatively large amount of liquidity, then the direct effect dominates and market-order traders lose. Empirically testable predictions of the model are that the introduction of pegged limit orders should cause a jump in limit order use, the cost of trading using market orders should decline in stocks where dealers supply relatively little liquidity, and overall volume should increase.

The United States Government Accountability Office released a September report to Treasury, Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges:

Treasury faces two near-term challenges in managing the growing government debt: the rise in total outstanding debt and the shortening of the average maturity of the debt profile.3 Treasury’s total outstanding debt increased by $2.3 trillion (25 percent increase in federal debt) since the onset of the economic recession in December 2007. In actions Treasury described as in accordance with normal operating procedures, Treasury increased short-term borrowing to address its massive and immediate borrowing needs. As a result, the average maturity of Treasury’s debt decreased as the percentage of marketable debt maturing within 1 year increased from 35.6 percent to 41.1 percent between September 2007 and June 2009.

Click for big

Click for big.

Another ex-ante study, noted that if the TIPS program were as liquid as the market for off-the-run nominal Treasuries, Treasury would have realized total cost savings from the TIPS program of $22 billion to $32 billion. Over the short run, economists recognize that an assessment of TIPS program’s relative costs depends on whether Treasury or the investor is the beneficiary from differences in expected and actual inflation. The time horizon of the analysis affects the results since, over the long run, the average amount by which actual inflation exceeds expected inflation will roughly equal the average amount when the opposite is true.
…
23William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer, “The Case for TIPS: An Examination of the Costs and Benefits,” FRBNY Economic Policy Review (July 2009); and Dean Croushore, “An Evaluation of Inflation Forecasts From Surveys Using Real-Time Data,” Federal Reserve Bank of Philadelphia Working Papers (December 2008).

The next part is interesting … I didn’t know that!

In addition, technical market factors closely linked to liquidity effects appear to have contributed to the decline in breakeven inflation rates. Lehman Brothers owned TIPS as part of repo trades or posted TIPS as counterparty collateral. Because of Lehman’s bankruptcy, the court and its counterparty needed to sell these TIPS, which created a flood of TIPS on the market. There appeared to be few buyers and distressed market makers were unwilling to take positions in these TIPS. As a result, the TIPS yields rose sharply.

The conclusion is:

GAO recommends that, in the context of projected sustained increases in federal debt, the Secretary of the Treasury take steps to increase TIPS liquidity and reduce their cost to Treasury: increase issuance, issue longer-dated maturities, and conduct more frequent auctions. Also, the Secretary should continually review the appropriate composition of the TIPS program and consider: the impact of Treasury’s public statements and TIPS issuance on TIPS liquidity, how different analytical perspectives are valuable for evaluating cost, how TIPS can diversify Treasury’s investor base, and how TIPS impact the cost of nominal securities.

However, the Treasury Borrowing Advisory Committee stated in its November 4th Report:

There was lively debate among the Committee members regarding the GAO Report published September 2009 entitled “Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges.” Committee members could not come to broad agreement on the findings of the report. While Committee members acknowledged the benefits of TIPS as a debt management tool, some members reiterated their higher cost to date versus nominal Treasury securities.

So take your choice.

I have previously highlighted the slides for the TBAC presentation.

My attention was drawn to the latest efforts of the Treasury Borrowing Advisory Committee by a Bloomberg story:

The 13-member committee of bond dealers and investors that Treasury Secretary Timothy Geithner depends on for advice, and includes officials of Pacific Investment Management Co. and Goldman Sachs Group Inc., highlighted the surge on page 36 of a 67-page report on Nov. 3. On the same page, they showed inflation expectations are subdued based on gauges watched by the Federal Reserve. In their discussions, the group noted that a second year of government debt sales approaching $2 trillion may weigh on investors as the Fed stops buying notes and bonds.

The presentation is on-line. Lots of fascinating charts, including the two highlighted ones:

Option Skew…

…and forward inflation…

This looks like good stuff – and I believe I’ve highlighted some of their work before, in the context of five-year TIPS elimination – that I want to chew on for a while … but I’m knee-deep in PrefLetter at the moment … and then there’s some urgent programming … then a couple of letters …

How might an investor exploit a high-real-rate-low-inflation scenario? Answer that, win a kewpie doll.

Update: The report to the Treasury Secretary is online:

With regard to TIPS, the Committee recommends increasing TIPS issuance from $58 billion in 2009 to $70-$80 billion in 2010. The auction schedules for both 5 and 10-year TIPS would be maintained, although sizes would increase. However, 20-year TIPS issuance would be replaced with 30-year TIPS, on the same auction schedule, with larger sizes. The Committee felt that this would both lengthen the average maturity of Treasury’s debt, while attracting investors interested in longer duration inflation protection. In the medium term, the Committee felt that the market could support increases in both auction sizes and frequency, growing gross TIPS issuance to $100-$130 billion per annum. These actions maintain, if not increase, the proportion of TIPS to total marketable debt outstanding.