PrefBlog

The Federal Deposit Insurance Corporation has released its Quarterly Banking Profile, Second Quarter 2009, with the following headlines:

• Higher Loss Provisions Lead to a $3.7 Billion Net Loss
• More Than One in Four Institutions Are Unprofitable
• Charge-Offs and Noncurrent Loans Continue to Rise
• Net Interest Margins Show Modest Improvement
• Industry Assets Decline by $238 Billion
• The Industry Posts a Net Loss for the Quarter
• Non-interest Income Grows 10.6 Percent Year-Over-Year
• Margins Improve at a Majority of Institutions
• Net Charge-Off Rate Sets a Quarterly Record
• Noncurrent Loan Rate Rises to Record Level
• Institutions Continue to Add to Reserves
• Overall Capital Levels Register Improvement
• Industry Assets Decline for a Second Consecutive Quarter
• Small Business Loan Balances Declined Over the Past 12 Months
• Institutions Reduce Their Reliance on Nondeposit Funding Sources
• “Problem List” Expands to 15-Year High

The Fed and related US agencies have released:

a proposed regulatory capital rule related to the Financial Accounting Standards Board’s adoption of Statements of Financial Accounting Standards Nos. 166 and 167. Beginning in 2010, these accounting standards will make substantive changes to how banking organizations account for many items, including securitized assets, that are currently excluded from these organizations’ balance sheets.
The agencies are issuing the proposal to better align regulatory capital requirements with the actual risks of certain exposures. Banking organizations affected by the new accounting standards generally will be subject to higher minimum regulatory capital requirements. The agencies’ proposal seeks comment and supporting data on whether a phase-in of the increase in regulatory capital requirements is needed. It also seeks comment and supporting data on the features and characteristics of transactions that, although consolidated under the new accounting standards, might merit an alternative capital treatment, as well as on the potential impact of the new accounting standards on lending, provisioning, and other activities.

Comments on all aspects of the proposed rule are due within 30 days after its publication in the Federal Register, which is expected shortly.

Note to OSFI: This is how professionals do it. They release a draft and ask for comments.

The text of the proposal explains:

The Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) are requesting comment on a proposal to (i) modify their general risk-based and advanced risk-based capital adequacy frameworks to eliminate the exclusion of certain consolidated asset-backed commercial paper programs from risk-weighted assets and (ii) provide a reservation of authority in their general risk-based and advanced risk-based capital adequacy frameworks to permit the agencies to require banking organizations to treat entities that are not consolidated under accounting standards as if they were consolidated for risk-based capital purposes, commensurate with the risk relationship of the banking organization to the structure. The agencies are issuing this proposal and request for comment to better align capital requirements with the actual risk of certain exposures and to obtain information and views from the public on the effect on regulatory capital that will result from the implementation of the Financial Accounting Standard Board’s (FASB) Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 and Statement of Financial Accounting Standards No 167, Amendments to FASB Interpretation No. 46(R).

They point out:

In the case of some structures that banking organizations were not required to consolidate prior to the 2009 GAAP modifications, the recent turmoil in the financial markets has demonstrated the extent to which the credit risk exposure of the sponsoring banking organization to such structures (and their related assets) has in fact been greater than the agencies estimated, and more associated with non-contractual considerations than the agencies had expected. For example, recent performance data on structures involving revolving assets [footnote] show that banking organizations have often provided non-contractual (implicit) support to prevent senior securities of the structure from being downgraded, thereby mitigating reputational risk and the associated alienation of investors, and preserving access to cost-efficient funding.

Footnote: Typical structures of this type include securitizations that are backed by credit card or HELOC receivables, single and multi-seller ABCP conduits, and structured investment vehicles.

Question 2: Are there features and characteristics of securitization transactions or other transactions with VIEs, other SPEs, or other entities that are more or less likely to elicit banking organizations’ provision of non-contractual (implicit) support under stressed or other circumstances due to reputational risk, business model, or other reasons? Commenters should describe such features and characteristics and the methods of support that may be provided. The agencies are particularly interested in comments regarding credit card securitizations, structured investment vehicles, money market funds, hedge funds, and other entities that are likely beneficiaries of non-contractual support.

It is of particular interest that they are particularly interested in money market funds as beneficiaries of non-contractual support. OSFI refuses to consider the question. I have repeatedly urged that money market funds be considered securitizations; another article on the topic is, by the way, in press.

Of further interest to Canadians is:

The agencies propose to eliminate existing provisions in the risk-based capital rules that permit a banking organization that is required to consolidate under GAAP an ABCP program for which the banking organization acts as sponsor, to exclude the consolidated ABCP program assets from risk-weighted assets and instead assess the risk-based capital requirement against any contractual exposures of the organization arising from such ABCP programs. The agencies also propose to eliminate the associated provision in the general risk-based capital rules (incorporated by reference in the advanced approaches) that excludes from tier 1 capital the minority interest in a consolidated ABCP program not included in a banking organization’s riskweighted assets.

The agencies initially implemented these provisions in the general risk-based capital rules in 2004 in response to changes in GAAP that required consolidation of certain ABCP conduits by sponsors. The provisions were driven largely by the agencies’ belief at the time that banking organizations sponsoring ABCP conduits generally faced limited risk exposures to ABCP programs, because these exposures generally were confined to the credit enhancements and liquidity facility arrangements banking organizations provide to these programs.

Additionally, the agencies believed previously that operational controls and structural provisions, as well as over-collateralization or other credit enhancements provided by the companies that sell assets into ABCP programs, could further mitigate the risk to which sponsoring banking organizations were exposed. However, in light of the increased incidence of banking organizations providing non-contractual support to these programs, as well as the general credit risk concerns discussed above, the agencies have reconsidered the appropriateness of excluding consolidated ABCP program assets from risk-weighted assets and have determined that continuing the exclusion is no longer justified. Under the proposal, if a banking organization is required to consolidate an entity associated with an ABCP program under GAAP, it must hold regulatory capital against the assets of the entity. It would not be permitted to calculate its risk-based capital requirements with respect to the entity based on its contractual exposure to the entity.

The Kansas City Fed has released the proceedings of the 2009 Jackson Hole Symposium on Financial Stability and Macroeconomic Policy.

Ricardo J. Caballero, last mentioned on PrefBlog in connection with tail-risk insurance, presented a paper titled The “Surprising” Origin of Financial Crises: A Macroeconomic Policy Proposal, which, rather oddly, has been encrypted. He argues that three elements are necessary to produce a financial crisis:

• Negative Surprise (not that sub-prime blew up, but that linkages were so strong and that transmission was so virulent)
• Excessive Aggregation of Risk in systemically important leveraged institutions
• Slow Policy Response

Dr. Caballero proposes the establishment of Tradable Insurance Credits, issued and backed by the Central Bank. In normal times, these would carry no pay-off; in times of crisis, the Central Bank would make them convertible and holders would have the option of, essentially, converting them into Credit Default Swaps. This addresses the risk of Knightian uncertainty that was addressed in Dr. Caballero’s prior proposals.

Stephen Cecchetti, Marion Kohler & Christian Upper presented a paper titled Financial Crises and Economic Activity, also encrypted. Pretty gloomy stuff – he suggests that even in a best-case scenario, it will take years to make up for the current loss of output. Dr. Cecchetti was last mentioned on PrefBlog on April 10, 2008.

Carl Walsh presented a paper titled Using Monetary Policy to Stabilize Economic Activity, in which he suggests that, overall, Price Level Targetting is superior to Inflation Targetting, due to its automatic stabilizing influence. He cautions, however, that changing horses in mid-stream (mid-raging-torrent might be a better metaphor in this economy) is not advisable. Price Level Targetting was the subject of the BoC Spring 2009 Review and the paper’s respondant was BoC Governor Mark Carney.

Auerbach & Gale presented Activist Fiscal Policy to Stabilize Economic Activity. They explicity exclude “automatic stabilizers” (e.g., Unemployment Insurance, Welfare) from the discussion, focussing more on discretionary fiscal stimulus.

Update, 2009-8-26: Mark Carney’s response to the Walsh paper have been published by BIS.

A kind soul has sent me an unencrypted version of the Caballero paper:

Coval et. al. (2008) argue that the correlation between economic catastrophe and default by highly rated structured products went largely unappreciated by investors, who seemed to treat ratings as a sufficient statistic for pricing. Highly rated single–name CDSs and structured product tranches traded at very similar spreads (their data is for September 2004 to September 20 2007), despite the fact that on average the structured product tranche would likely default in a much worse macroeconomic state.

Regardless of whether this correlation was underappreciated or not, the systemic consequence of this risk was that highly leveraged institutions were bearing more aggregate risk than would have been thought from simply observing the ratings of their assets. Having the highly leveraged financial sector of the economy holding the risk with respect to an aggregate surprise proved to be a recipe for disaster.
…
A standard advice stemming from the moral hazard camp is to subject shareholders to exemplary punishment (the words used by Secretary Paulson during the Bear Stearns intervention). This is sound advice in the absence of a time dimension within crises. With no time dimension, all shareholders were part of the boom that preceded the crisis and as soon as the bailout takes place the crisis is over; the next concern is not to repeat the excesses that led to the crisis. Punishing shareholders means punishing those that led to the current crisis, and it is better that they learn the lesson sooner rather than later, the righteous speech goes.

However, this advice can backfire when we add back the time dimension. Now, the expectation that shareholders will be exemplarily punished if the crisis worsens delays investors’ decision to inject much needed capital. As a concrete example, sovereign wealth funds were much less eager to inject equity into the U.S. financial system after the Bear Stearns exemplary punishment policy (March 2008) than they were before the policy, as illustrated in Figure 6. Some of the capital injections that did take place after this, such as UFJ Mitsubishi’s $9 billion investment in Morgan Stanley in October 2008, only took place after the U.S. Treasury assured them that the investment would not be wiped out in a future government intervention. Conversely, destabilizing speculators and shortsellers saw the value of their strategy reinforced by the policy of exemplary punishment.23 Moreover, from the point of view of future crises, memories of this intervention may also hamper any chance of a private sector resolution as new equity will be less likely to attempt to arbitrage the initial fire sales. In other words, once the within-crisis time dimension is considered, the anti-moral hazard strategy may morph into a current and future crisis enzyme.

An interesting paper by Bernadette A. Minton & René Stulz & Rohan Williamson is How Much Do Banks Use Credit Derivatives to Hedge Loans?:

Before the credit crisis that started in mid-2007, it was generally believed by top regulators that credit derivatives make banks sounder. In this paper, we investigate the validity of this view. We examine the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the extent to which the use of credit derivatives makes banks sounder.
…
Our evidence helps understand why the use of credit derivatives for hedging is limited. First, the market for credit derivatives is the most liquid for investment grade corporations and for countries. As a result, use of credit derivatives is going to be more intense for firms that have exposures to such credits, which we find to be the case. Second, for non-investment grade corporates, the market for credit derivatives is less liquid. Further, private information is more important for banks for loans to such corporates. As a result, hedging will be more expensive and banks will hedge such loans less. Using disclosures of banks, we find that banks that report hedging across credit ratings hedge relatively more credits that are less risky, which is consistent with our prediction. Finally, hedge accounting cannot typically be used for credit derivatives.
…
For 2005, we show that the total credit protection bought and sold by banks is roughly $5.5 trillion. In comparison, the net protection bought, which is a measure of hedging of credit risks, is roughly $0.5 trillion, or less than 10% of the overall credit derivatives gross positions of banks. While, the net protection bought is small compared to the loans of the banks that have positions in credit derivatives, the gross position of these banks is large compared to the loans they write. Consequently, since credit derivatives are used only to a limited extent to hedge loans, they can only make banks and the financial system sounder if they create few risks for banks when the banks take positions in them for other reasons than to hedge loans. Contrary to the optimistic view of regulators before 2007, the subprime crisis has shown that the dealer positions of banks in credit derivatives have substantial risks.

I’m not sure if it makes much sense for banks to systematically hedge their loan exposures through CDS. It seems to me that the whole point of being a bank in the first place is to hedge your issuer-specific risk through diversification and excess margin.

This is interesting in light of the CIT affair. When CIT drew down its credit lines – as reported on PrefBlog on March 20, 2008, CDS spreads spiked up to 27% up front and 500bp p.a. instantly – I recall, but cannot substantiate the existence of, rumours to the effect that this was due to bank buying.

This would make more sense, since CIT was drawing on credit lines with a pre-arranged spread. The Boston Fed looked at this issue. It is also my understanding that a lot of new lines are being negotiated as a spread off of CDS levels, which strikes me as a much better use of CDS by banks.

I can only hope the authors will re-examine the issue as data from the Credit Crunch trickles in!

James Hamilton of Econbrowser has announced a new paper he has co-authored: The Market-Perceived Monetary Policy Rule:

We introduce a novel method for estimating a monetary policy rule using macroeconomic news. Market forecasts of both economic conditions and monetary policy are affected by news, and our estimation links the two effects. This enables us to estimate directly the policy rule agents use to form their expectations, and in so doing flexibly capture the particular dynamics of policy response. We find evidence that between 1994 and 2007 the market-perceived Federal Reserve policy rule changed: the output response vanished, and the inflation response path became more gradual but larger in long-run magnitude. In a standard model we show that output smoothing caused by a larger inflation response magnitude is offset by the more measured pace of response. Our response coeffcient estimates are robust to measurement and theoretical issues with both potential output and the inflation target.
…
Our baseline results for the 1994-2007 sample suggest the market perceives that the Federal Reserve gradually responds to inflation and real activity. Similar to previous literature working on post-Volcker data, we find the Federal Reserve follows the Taylor Principle, a greater than one-for-one response to inflation. We also find evidence that the market-perceived monetary policy rule changed over our sample. During the 1990s market-perceived policy responded robustly to output and quickly to inflation; during the 2000s market-perceived policy doesn’t respond to output and responds at a more measured pace to inflation, though its long-run inflation response is greater than before. We quantify the importance of the inflation response path and long-run magnitude in a standard model, and find that raising the long-run magnitude is effective at lowering inflation volatility while making the path more gradual is counterproductive. Our baseline results were found to be robust to alternative possible specifications.

The Bank of Canada Review, Summer 2009 has been released, with the articles:

• Collateral Management in the LVTS by Canadian Financial Institutions
• The Complexities of Financial Risk Management and Systemic Risks
• The Changing Pace of Labour Reallocation in Canada: Causes and Consequences
• BoC-GEM: Modelling the World Economy

The question of Collateral Management, addressed in the first article, sprang to prominence at the height of the Credit Crunch in 4Q08, when the “eligibility premium” – the yield differential between two securities identical in all respects except that one was eligible to be used as collateral with the central bank, the other not – exploded from its normally immeasurably small levels.

The LVTS [Large Value Transfer System] is a real-time, electronic wire transfer system that processes large-value, time-critical payments quickly and continuously throughout the day. Participants in the LVTS use claims on the Bank of Canada to settle net payment obligations. To secure the payments that are sent through the LVTS, collateral is required.
…
The Bank originally accepted only Government of Canada (GoC) securities as collateral, but since it expanded the list in November 2001 to include a larger variety of securities (e.g., municipal securities and commercial paper), pools of collateral pledged by individual FIs to the LVTS have diversified significantly. Thus, while GoC-issued securities constituted about 55 per cent of the discounted value of securities pledged in 2002, they made up less than 30 per cent in early 2007
…
The results of this study are important for policymakers such as the Bank of Canada, which is concerned both about the effi cient functioning of fixedincome markets and about the credit risk it ultimately bears in insuring LVTS settlement. Given these new insights into the behaviour of FIs, future changes in collateral policies, in particular those regarding the eligibility of assets as collateral, can be designed more effectively.

Ongoing monitoring of and research into collateral management practices is required to keep abreast of
the changing behaviours at fi nancial institutions and within an evolving financial environment. Future
research will examine collateral management in more detail, with a particular focus on changes resulting from the recent fi nancial crisis and the ensuing increase in Government of Canada debt issuance.

The second article is also of interest, although I suspect that it is merely another volley in the battle for the BoC to extend its influence to macro-prudential regulation and frustrate the designs of OSFI upon the turf:

Banking theory has made very limited inroads into the theory and practice of risk management, where modelling has been dominated by the frictionless, efficient-market model masquerading under the title of financial engineering.
…
For example, in 1998, Salomon Brothers (as related in Bookstaber 2007, Chapter 5) were using a model of the yield curve, the so-called two-plus model (two random factors plus a constant—with the constant signalling shifts in Federal Reserve policy). The model had worked well to produce a steady stream of arbitrage profits over several years. In 1998, these profits changed to a stream of losses as the fixed-income arbitrage group struggled with what seemed to be a change in the underlying model. It seemed that another random factor had appeared, leaving the group holding residual risks, which were causing large losses. The risk manager struggled to help the group, but in the end, it was shut down. The exit had to be disguised and undertaken over several weeks, since Salomon’s large positions in the market were affecting bond liquidity and could entice arbitrageurs to exploit the company. The worst-case scenario would have occurred if Salomon’s sales had driven down prices, leading other traders to dump bonds and driving prices even further down, thus exacerbating Salomon’s losses. Bookstaber argues that this exit by Salomon’s large bond-arbitrage group made the market less liquid and increased the difficulties faced by Long-Term Capital Management (LTCM) later in the year, when its bond-arbitrage position became untenable after the Russian bond default (another unmodelled risk).
…
In all the above models, three major risks stem from model misspecifi cation through either: (i) choosing the
wrong number of random factors; (ii) inappropriate random factor distributions (e.g., normal, symmetric
distributions rather than skewed distributions), and/or (iii) using poor parameter estimates for the coefficients or factor loadings on risky factors. These risks should be tested regularly by back-testing the models llooking for systematic deviations from the model using actual data), and checking the history of trades and the profi t/loss outcomes on exposures. Because all models are merely approximations, losses and profits on exposures should be expected. In a well specified and calibrated model, however, the history of profits and losses will expose biases. Any detected biases should be examined, and appropriate action taken. Although this is easy to state as a general principle, in reality, the management and estimation of risks is far from perfect, especially in periods of high volatility, where correlations can change rapidly.

The Bank of Canada has released a study on the effects of last fall’s short-sale ban, titled Short Changed? The Market’s Reaction to the Short Sale Ban of 2008:

Do short sales restrictions have an impact on security prices? We address this question in the context of a natural experiment surrounding the short sale ban of 2008 using a comprehensive sample of Canadian stocks cross-listed in the U.S. Among financial stocks, which were singled out by the ban in both countries, we observe a significant increase (74 bps) in the difference between the U.S. share price and the Canadian share price. We also observe an impressive and surprising migration of the trading volume from the U.S. to Canada among financial stocks during the ban. Both price and volume effects are reversed after the ban and neither effect manifests itself among the nonfinancial stocks. Our findings support the view that prices reflect a more optimistic valuation when pessimistic investors are kept out of the market by binding short-sales restrictions (Miller (1977)). Our findings also imply that pessimistic investors were more preponderant in the U.S. than in Canada, which is corroborated by the fact that the short interest ratio for our sample stocks was much larger in the U.S. than in Canada prior to the ban.
…
Our findings lend support to an international version of Miller’s (1997) price optimism model in which the degree of pessimism manifested by investors varies across markets. According to Miller’s (1997) model, short sales constraints drive stock prices above their equilibrium value by preventing pessimistic investors from impounding their negative views on the stock price by selling the stock short. In the dual-market setting characterizing the present experiment, an expanded version of this model implies that, under short sales constraints in both venues, a cross-listed stock would trade at a higher price in the market where pessimistic investors are more prevalent and it would trade at a lower price in the market where pessimistic investors are less prevalent.
…
Our findings also lend support to an international version of
the Bai, Chang, and Wang (2006) model in which short sales are either motivated by allocational or by
informational considerations. From this perspective, the price increase that we observe in the U.S. relative to Canada among our treatment group stocks during the ban implies that a greater proportion of short selling activity in U.S. cross listed stocks was driven by allocational, i.e. uninformed investors, than in Canada during our sample period. In summation, our paper contributes to the literature in two important ways. First, by demonstrating, via a natural experiment crafted around cross-listed stocks, that short sales constraints do cause stock prices to trade above their equilibrium value as Miller’s (1977) price optimism theory suggests and, second, by showing how critical the ability to conduct short sales is to arbitrageurs as a mechanism to enforce the law of one price across markets.

This paper joins the collection – I have previously reported the IIROC Report on Short Selling Ban and The Undesirable Effects of Banning Short Sales.

The Investment Industry Association of Canada has released its New Issues & Trading Equity Report for the Second Quarter.

Preferred shares are not highlighted in the text, but the table shows $2.8-billion in deals for the second quarter, down from the $4.4-billion of 1Q09, but with a YTD total 88.4% in excess of 1H08.

Econbrowser‘s James Hamilton has announced:

Do current fed funds futures prices signal a belief by market participants that the Fed may begin raising interest rates early next year? My latest research paper suggests not.

The expectations hypothesis of the term structure of interest rates posits that an investor could expect to receive the same return from buying a 6-month T-bill as from rolling over two 3-month T-bills. Although this is an appealing hypothesis, it has been consistently rejected by empirical researchers, including Campbell and Shiller (1991), Evans and Lewis (1994), Bekaert, Hodrick and Marshall (1997), and Cochrane and Piazzesi (2005) among many others. What that literature has shown is that when the 6-month yield is higher than the 3-month, on average you’d do better with it than with rolling over the 3-months. Typically the term structure slopes up, and typically you earn a higher return from longer term securities.

In a new paper coauthored with Hitotsubashi University Professor Tatsuyoshi Okimoto, we show that arbitrage should force the predictable excess returns on bonds of longer maturities to show up as predictable gains from taking the long position in fed funds futures contracts. The average upward slope to the term structure of interest rates should imply an average upward slope to the interest rates associated with fed funds contracts of increasing maturity. One might then want to adjust these futures rates to obtain an unbiased market expectation, as suggested in a recent paper by Piazzesi and Swanson.

I’ve been interested in this topic for a while (due to the prevalence of covered call writing strategies in SplitShare corporations) and now (with a hat tip to Financial Webring Forum) I’ve found a study on historical index performance, Passive Options-based Investment Strategies: The Case of the CBOE S&P 500 BuyWrite Index:

This paper assesses the investment value of the CBOE S&P 500 BuyWrite (BXM) Index and its covered call investment strategy to an investor from the total portfolio perspective. Whaley [2002] finds risk-adjusted performance improvement based on the BXM Index in individual comparison to the S&P 500. We replicate this work with a longer history for the BXM Index and with the short but meaningful history of the Rampart Investment Management investable version of the BXM. We use the Stutzer [2000] index and Leland’s [1999] alpha to assess risk-adjusted performance taking the skew and kurtosis of the covered call strategy into account. Additionally, we compare standard investor portfolios to portfolios where BXM has been substituted for large cap assets and find significant risk-adjusted performance improvement.

The compound annual return of the BXM Index over the almost 16-year history of this study is 12.39%, compared to 12.20% for the S&P 500. Risk-adjusted performance, as measured by the Stutzer index, is 0.22 for the BXM versus 0.16 for the S&P 500 [monthly]. Leland’s alpha is 2.81%/yr. The tracking error of the Rampart investable version of the BXM (1.27%/yr) is found to be credible evidence of the investability of the BXM Index.

Known sources of BXM return are reviewed and behavioral factors that may have enhanced BXM performance are considered.

Surprisingly – to me – performance relative to the S&P 500 seems to have held up through the massive gyrations of this spring:

Five Year Chart

One Year Chart

The CBOE has a web page devoted to their BXM index. There is another index created through cash covered put writing.

Update, 2009-9-29: Assiduous Reader prefhound has commented on BXM on another thread.