Category: Market Action

The SEC Flash Crash Advisory Committee has been discussing the Flash Crash for some time now; speculation is intensifying:

Regarding market structure, Schapiro said more work needs to be done to shore up investor confidence and transparency amid advances in high-speed trading.

“We are examining trading or other obligations that might be required of today’s de facto market makers: the high-frequency traders,” said Schapiro during remarks at SEC Speaks, a conference hosted by the Practising Law Institute.

“We are asking if these firms should be subject to an appropriate regulatory structure, including with respect to their quoting and trading activities.”
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“Given the potential for trading algorithms to cause severe trading disruptions and shake investor confidence, we also are considering whether they should be subject to appropriate rules and controls,” she said.

One committe member is floating trial balloons:

Robert Engle, a Nobel Prize-winning finance professor at New York University, said in an interview that the regulator-appointed panel has not yet decided on its final recommendations, though he expects them to be made public at a February 18 meeting.

The focus, he said, should be that buyers all but vanished during the May 6 market plunge, abandoning investors when liquidity was most needed.

This could be fixed by allowing exchanges to boost the rebates it pays for standing buy and sell orders, and by squeezing more of the trading that takes place in anonymous “dark pools” into the public markets.
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Engle said he has pushed for rules that would come into effect when markets are under duress and in need of more liquidity, allowing exchanges to boost both the rebates they pay for orders as well as the fees they charge traders.

“You would have a peak-load pricing model, much like the way you use peak-load prices to adjust traffic across a bridge or freeway,” Engle said in a telephone interview from NYU’s Stern School of Business.

In discussions with a four-member subcommittee, the professor has also recommended a move seen for years by many in the industry as far more radical: a “trade-at” rule.

Such a rule would prohibit any of the dozens of U.S. venues and wholesale market makers from executing an incoming order unless it was already publicly displaying the best bid or offer in that particular stock, or unless it improved the price by a set amount.
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“The big banks that are internalizing their trades obviously would hate it,” Engle said. “But basically they already had this captive audience of relatively high quality trades that, it seems to me, ought to be part of the price discovery process,” which primarily takes place on the public exchanges such as the Nasdaq Stock Market.

In other words, trading information has now become a public good. I’ll have more to say about this sometime latter – because a CSA/IIROC discussion paper says the same thing. Back to Engle…

In a September 30 report that serves to inform the committee’s recommendations, the SEC and CFTC said a single $4.1-billion futures sale sparked the crash, and that it was exacerbated by computer-trading programs rapidly offsetting positions, and by the crush of sell-now orders.

While “Sunshine” laws have prevented the committee from regularly meeting, Engle said the subcommittee has discussed a bevy of sometimes esoteric market structure issues:

They include excessive quote traffic, trading curbs known as limit up / limit down, a record of all trading known as a consolidated audit trail, restrictions around unfettered “naked” access to markets, and co-locating computers next to exchanges. They also include high-frequency algorithmic trading, he said.

Still, there has been “very little” communication among the full, eight-member committee in the last few months, Engle added. “We haven’t had as much communication as would be desirable.”

The first paragraph seeks to promulgate the mythology that High Frequency Trading exacerbated the Flash Crash, which is a very difficult position to justify. I have taken the view (see the October PrefLetter) that the Flash Crash was merely a case of Market Impact writ large: a single trader sparked it and it was exacerbated not by HFT, but by morons’ Stop-Loss orders.

The bit about the Sunshine Laws makes me laugh!

Here’s an interesting, if self-interested, admission:

Over the past two years, the Bank of Canada, in partnership with OSFI, has developed a stress test that has been applied to all the banks.

Rather than relying on the banks’ own internal tests, OSFI and the central bank have created a “macro” test, White said, adding that the work has put this country at the forefront of such testing.

Some analysts argue some of the results of Canadian bank stress tests should be made public in the interests of transparency. But according to [OSFI Assistant Croupier Mark] White, such public disclosure puts pressure on regulators to present institutions in the best possible light.

Fabulous Fab’s defence against SEC charges continues to grind along:

The Goldman Sachs trader is still fighting SEC litigation alleging he failed to tell investors in the Abacus CDO that hedge fund Paulson & Co. had helped pick out some of the underlying securities and planned to bet against them.

So, Fabrice Tourre is now demanding that Royal Bank of Scotland, hedge fund Magnetar and monoline ACA Capital produce documents relating to the case. And which, he argues, might help him refute the SEC’s claim that companies like ACA wouldn’t have participated in Abacus had they known of Paulson’s involvement.

There was a certain amount of excitement on the Canadian preferred share market today as OSFI’s refusal to grandfather extant Tier 1 Capital reverberated through the market. PerpetualDiscounts were up 30bp, FixedReset lost 13bp and Deemed-Retractibles gained an impressive 110bp.

Deemed-Retractibles? Those are the Straight Perpetuals (both PerpetualDiscount and PerpetualPremium) issued by BMO, BNS, CM, ELF, GWO, HSB, IAG, MFC, NA, RY, SLF and TD. I have added a hardMaturity entry to the call schedules for these issues, at par, effective 2022-1-31.

Who deems them to be retractible? Me. Who chose the issuers included in the list? Me. Who chose the hardMaturity date? Me. I will discuss and attempt to justify my analytical approach to this paradigm shift in the February PrefLetter, scheduled to be prepared as of the close this Friday, February 11, and made available to clients prior to the opening on February 14.

Similar entries have been made to the call schedules of FixedResets from these issuers, but I didn’t bother creating a new index since the overwhelming majority of these issues were overwhelmingly likely to be called anyway, with or without the advisory.

Note that since a REORG_TERMCHANGE entry type causes the analytics to discard prior trading data, all of the reported average volume figures have changed dramatically.

It’s not a bug, it’s a feature!

The Securities and Exchange Commission today charged three AXA Rosenberg entities with securities fraud for concealing a significant error in the computer code of the quantitative investment model that they use to manage client assets. The error caused $217 million in investor losses.
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The SEC’s order instituting administrative proceedings against the firms found that senior management at BRRC and ARG learned in June 2009 of a material error in the model’s code that disabled one of the key components for managing risk. Instead of disclosing and fixing the error immediately, a senior ARG and BRRC official directed others to keep quiet about the error and declined to fix the error at that time.
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The SEC’s order further found that ARG, BRRC, and ARIM made material misrepresentations and omissions about the error to ARIM’s clients. The firms failed to disclose the error and its impact on client performance, attributed the model’s underperformance to market volatility rather than the error, and misrepresented the model’s ability to control risks. BRRC did not have reasonable compliance procedures in place to ensure that the model would assess certain risk factors as intended.
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“Quant managers must be fully forthcoming about the risks of their model-driven strategies, especially when errors occur and the models don’t work as predicted,” said Bruce Karpati, Co-Chief of the Asset Management Unit in the SEC’s Division of Enforcement.

The Bank of Canada has released a working paper by Jason Allen, Robert Clark and Jean-François Houde titled Discounting in Mortgage Markets:

This paper studies discounting in mortgage markets. Using transaction-level data on Canadian mortgages, we document that over time there’s been an increase in the average discount, along with substantial dispersion. The standard explanation for dispersion in credit markets is that lenders engage in risk-based pricing. Our setting is unique since contracts are guaranteed by government-backed insurance, meaning risk cannot be the main driver of dispersion. We find that mortgage rates depend on individual, contractual, and shopping market characteristics. There is also an important amount of unobserved heterogeneity in rates, which could be attributed to search costs.

An Assiduous Reader directs me to a blog post titled The Absurdity of Making Brokers Into Fiduciaries:

The job of a broker is to sell product, that’s it. Somewhere along the way the public came to think that the broker’s job was to make them money. No, it never was. The job of a broker is to choose investments suitable for a client based on their risk tolerance, other security holdings, financial situation, including income and net worth, financial needs and investment objectives. That’s it. Nowhere does it say that the broker must act in the best interest of the client. And there’s a great reason for that.

As I said, it is not the broker’s job to make money for the client, his job is to give the client information on the asset and allow the client to make the decision. In my mind the suitability stuff shouldn’t even exist, brokers should be able to sell anything to anyone, because all they are is salesman. If you think your broker is anything but a salesman, think again. His job is to collect a commission. Now, if he gets you to stick around, trade more, and spend more on commissions by picking the right stocks at the right times, good for him. But to say that is his job, to say he should be held liable for acting in your interest, would be asinine.

Fortunately investors have the option of being serviced by portfolio managers – but most PMs are just jumped up stockbrokes anyway, so it doesn’t make as much difference as I thought it did ten years ago.

It was a mixed day on the Canadian preferred share market, with PerpetualDiscounts up 28bp and FixedResets losing 2bp. The Performance Highlights table is all positive, all PerpetualDiscounts and all insurers, which is kind of interesting. Volume was on the light side.

The decision by OSFI to eliminate, rather than grandfathering, extant Tier 1 Capital means Monday will be chaotic. Brace yerselfs!

There was rather an alarming headline, but a story in the Globe made some important points about junk:

Still, demand for these [junk bond] deals has quickly escalated after a decade of inactivity, and 13 new Canadian offerings worth over $3-billion ultimately hit the market in 2010.
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In theory, [Barry Allan, who runs Marret Asset Management] said, 100 per cent of the volatility in the price of a government bond stems from interest rate movements. (Though, sovereign risk is now toying with that assumption.) Investment-grade bonds fluctuate in a similar fashion, with 80 per cent of price movements related to interest rates.

In contrast, only 20 per cent of movements in the prices of high-yield debt are tied to interest rates.
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The sector is hot in Canada because income trusts have all but disappeared, said Greg Woynarski, co-head of fixed income at Scotia Capital, which now has five people dedicated to high-yield products. “Debt is becoming the new equity.”

Back when trusts yielded 5 to 8 per cent in annual distributions, they effectively served the same function for income-seeking investors that high-yield debt does today.

It was a day of average volume on the Canadian preferred share market, with PerpetualDiscounts gaining 14bp and FixedResets won 6bp. As a result the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) has gone negative – not necessarily a death knell for my conjecture that retail evaluates the relative attractiveness of these classes by comparing Current Yields, but it does make it more complex: the indices will have to be disaggregated to make it work (i.e., compare RY-RY, or TD-TD, not index-index).

In law school, you learn that a contract is holy. On the street, you learn that a contract is where you start:

New Jersey Governor Chris Christie said he doesn’t mind breaking promises to pensioners to close a $10.5 billion budget deficit — even if they sue.

“I have bigger issues than who sues me,” said Christie, 48, a Republican and former federal prosecutor who wants to end cost-of-living increases for retirees. “Get in line.”

Public workers in Colorado, South Dakota and Minnesota are already suing their states, which are among 18 that want to pare pension costs by increasing employee contributions, raising the retirement age or curbing cost-of-living increases.

“We believe it’s unconstitutional,” said Gary Justus, 63, a retired mathematics teacher in the Denver public schools who’s a plaintiff in the Colorado suit. “These are contracts that I and 100,000 other retirees worked for.”

BIS has released a working paper titled Messages from the academic literature on risk measurement for the trading book which I find very disappointing:

The artificial distinction between a “trading book” and a “banking book” refers to positions, but these positions need not be exposed to different sets of risk. If the risks associated with these books are distinct, even if they are not independent, then adding the VaR measures of these books will be conservative. If the risks associated with the two books are not distinct, (eg if the separation is due only to accounting rules), then adding compartmentalised VaR risk measures is guaranteed to be conservative only if all risks relevant to each book are accounted for. If not, the sum of compartmentalised risk measures may understate the risk of the combined portfolio risk.
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The last two sections 5 and 6 include management aspects, such as inter-risk aggregation and the borderline between the banking and trading books (which is discussed only briefly).

This ignores the very essence of the trading book, namely that it is used for trading. There is an army of prop traders (EVIL prop traders!) on the Street who could have explained this to the committee, but it would appear that the committee would prefer to ignore them.

The epitome of a prop trader is a high-frequency trader; a high-frequency trader is nothing more than a guy who has examined the “gut reactions” of prop traders, systemized them and created an expert system with a fast reaction time.

Now, let us assume that you’re a high frequency trader and you’re designing an algorithm to trade British Petroleum. Here’s my question: how much time do you spend worrying about peak oil, the growing influence of the Russion state, and the potential for increased regulation in the US? How much of your algorithm execution time considers such matters?

None. You couldn’t care less. The only reason your algorithm buys at a nickel is because there is good reason to believe that you can sell at a dime within, say, ten minutes. All that peak oil garbage is for investors, not traders. It’s a whole different time scale, with a completely different set of problems – an obvious fact which the committee chooses to ignore:

The accuracy of square-root of time scaling depends on the statistical properties of the data generating process of the risk factors. Diebold et al (1998) show that, if risk factors follow a GARCH(1,1) process, scaling by the square-root of time over-estimates long horizon volatility and consequently VaR is over-estimated. Similar conclusions are drawn by Provizionatou, Markose and Menkens (2005). In contrast to the results that assume that risk factors exhibit time-varying volatility, Danielsson and Zigrand (2006) find that, when the underlying risk factor follows a jump diffusion process, scaling by the square root of time systematically under-estimates risk and the downward bias tends to increase with the time horizon. While these results argue against square-root of time scaling, it is important to acknowledge that we were not able to find immediate alternatives to square-root of time scaling in the literature. Therefore, the practical usefulness of square-root of time scaling should be recognised.

As I have stated often before, the most important element of risk control for banks is to ensure that positions held in the trading book are, in fact, traded. Aged inventory should be encouraged to move to the banking book by steadily more punitive capital charges with the passage of time. This is, in fact, how smart trading houses keep their traders honest – the amount they’re charged for their use of capital, which affects their P&L, which affects their bonuses (EVIL bonuses!), progressively increases.

S&P cut Ireland again:

We are lowering our ratings on the Republic of Ireland to ‘A-/A-2’ from ‘A/A-1’ following our revision of the Irish Banking Industry Country Risk Assessment to Group ‘6’ from ‘4’.

We are keeping the ratings on CreditWatch with negative implications, reflecting our view of the uncertainties surrounding the size of Ireland’s additional capital needs for its largely state-owned financial sector.

We expect to resolve the CreditWatch placement by April, when we should be in a position to assess the impact of additional capital injections on the government’s debt dynamics.

Speaking of Europe, one of my favourite topics of reflection is the Law of Unintended Consequences:

Century-old controls on rents and evictions are stifling investment in Portuguese real estate and leaving the country with crumbling city centers as rental income fails to keep pace with maintenance costs, according to landlords and property industry groups. The government has pledged to introduce measures in March to streamline rules on rental properties as it seeks to jumpstart an economy that’s had one of Europe’s weakest growth rates over the last decade.

While legislation in 1981 lifted rent controls on new contracts and a 1990 law allowed landlords to set expiry dates on leases, more than half of Portugal’s rentals are subject to the older restrictions. That means most owners are still coping with contracts that never expire and rates that are frozen or limited to inflation adjustments, said Miguel Marques dos Santos, an attorney specializing in real estate at the Lisbon office of Garrigues. Even death isn’t always enough to break a lease because tenants can pass on a contract to their children, spouses or parents.
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The country had the third-most restrictive laws on eviction in 2009 among the 30 countries in the Organization for Economic Cooperation and Development, trailing only Sweden and Greece, the OECD said in a report published this year. It had the ninth- toughest rent-control restrictions.
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New development still attracts the vast majority of construction investment in Portugal, with only 6.2 percent going to renovation in 2009, according to Aecops. Only Romania spends less on renovations among the 14 European countries for which data was available, the European Construction Industry Federation said. The average is 23 percent.

Owners of rent-controlled properties don’t get enough income to support their upkeep, leaving Lisbon and other cities pockmarked with crumbling structures, Aecops said. It estimates that about 36 percent of the country’s residential buildings are in need of repair.

“Some of these contracts date back to the 60s and pay as little as 5 euros per month for a four-bedroom apartment in the capital,” Luis Menezes Leitao, president of Portugal’s Association of Landlords, said in an interview.

The lack of incentives to invest in renovation has caused a chronic shortage of rental accommodation, which now represents less than 20 percent of Portugal’s total housing stock, Menezes Leitao said. That has forced people to buy property instead, boosting debt and pushing up home prices.

“They couldn’t rent, so they bought and borrowed too much money,” he said. “It’s a contributing factor in the current crisis.”

Volume was surpisingly good today, considering the number of little girls who took a snow-day off work, but price action was restrained. PerpetualDiscounts were up 1bp, while FixedResets were down 4bp, as the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) remained at zero.

PerpetualDiscounts now yield 5.26%, equivalent to 7.36% interest at the standard equivalency factor of 1.4x. Long Corporates have popped up to 5.6%, so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 175bp, a significant narrowing from the 190bp reported at month-end.

Mr Joseph S Tracy, Executive Vice President of the Federal Reserve Bank of New York, gave a speech titled A strategy for the 2011 economic recovery:

The Great Recession distinguished itself from earlier recessions in terms of its severity rather than its length. There was a decline in real output relative to trend of $1.1 trillion or 8 percent (Chart 1). This contraction brought the level of real output back to its level in 2006. In most recessions, consumption growth slows but remains positive. In this recession, there was an actual decline in consumption rather than just a slowdown (Chart 2). When households need to cut back on their consumption, they typically do so first with durable goods – for example, by delaying the decision to replace a car or to trade up to a nicer house. It is no surprise then that auto sales dropped significantly (Chart 3). Housing starts had been declining since late 2005, and the decline continued during the recession (Chart 4). Producers reacted quickly to the sharp decline in consumer demand, but inventories still rose sharply relative to sales (Chart 5).

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How many more stories like the following must we read before the current craze for paid government informants dies down?

An immigration officer tried to rid himself of his wife by adding her name to a list of terrorist suspects.

He used his access to security databases to include his wife on a watch list of people banned from boarding flights into Britain because their presence in the country is ‘not conducive to the public good’.

As a result the woman was unable for three years to return from Pakistan after travelling to the county to visit family.

The tampering went undetected until the immigration officer was selected for promotion and his wife name was found on the suspects’ list during a vetting inquiry.

Interesting opinion on the Canadian bond market:

In order to maximize value in their bond portfolios, investors should limit exposure to Canada’s corporate bond market, one of the most expensive and least diversified of its kind in the world, says Ed Devlin, executive vice president and portfolio manager at PIMCO Canada Corp.

“The fundamental problem with the Canadian corporate bond market is that there is are too many investors chasing too few issuers,” Mr. Devlin said in a recent note to clients.

He noted that 59% of Canada’s main corporate bond benchmark is concentrated in just 10 issuers. By comparison the percentage of the index concentrated in 10 issuers is 20% in the U.S., 26% in Great Britain and 35% in the Eurozone.

Just another reason to start marketting Maple bonds to Canadians … it will never happen. Maple issuers don’t make a point of hiring Canadian ex-regulators.

It was a good day on the Canadian preferred share market as PerpetualDiscounts were up 18bp while FixedResets gained 4bp. The Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) is now zero!

The market was well-behaved, with no entries at all in the Performance Highlights.

Moody’s has downgraded Egypt:

Moody’s Investors Service cut its rating on Egypt’s debt on Monday on concern about its public finances, becoming the second credit agency to turn negative since the country was plunged into political crisis.

Moody’s … said the one-notch downgrade, to Ba2 from Ba1 with a negative outlook, was prompted by a significant rise in political risk and concern that the government’s response to mounting unrest could undermine Egypt’s already weak public finances.
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Moody’s joined peer Fitch Ratings, which cut the outlook on its BB+ country ceiling to negative on Friday, in saying the political turmoil would likely undermine Egypt’s economic reform programme.

There was a demonstration at Dumbass Square. I liked this guy’s sign:

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You don’t make a currency global by joining the UN and passing resolutions. You make a currency global by using it to settle international transactions:

HSBC Bank Canada said Wednesday it has completed the first Canadian trade using the yuan exclusively, as the Chinese currency continues to gain traction as an international reserve alongside the U.S. dollar. The deal was conducted for B.C.-based industrial auctioneer Maynards Industries.

Fabrice de Dongo, a spokesman for HSBC Canada, said HSBC made a direct payment in the yuan currency on behalf of Maynards to a company in China. Previously, the payment would have first been converted into U.S. dollars, used for the majority of global trade.
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China has only recently begun allowing international trade using its currency, beginning with a pilot program in 2009 involving five Chinese cities and member countries of the Association of Southeast Asian Nations. The program was expanded to include all foreign countries, including Canada, in June 2010.

Interest rate modifications don’t work too well with underwater mortgages:

The re-default rate for the Making Home Affordable Program averaged 20.4 percent after 12 months, 15.9 percent after nine months, 10.7 percent after six months and 4.6 percent after three months, according to a report released today by the Treasury Department.
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In December, 30,030 homeowners newly qualified for permanent modifications that reduce home payments to 31 percent of gross income, the department said today. A total of 58,020 permanent loan modifications have been canceled since 2009.
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The median loan balance was just over $232,196 after a modification and the median mark-to-market loan-to-value was 118 percent, meaning most homeowners had negative equity or were “underwater.” The median monthly payment reduction was more than $520 or about 40 percent.

It was a mixed and volatile day on the Canadian preferred share market as PerpetualDiscounts gained 17bp and FixedResets lost 4bp. Volume ticked up a bit to above average.

PerpetualDiscounts now yield 5.28%, equivalent to 7.39% interest at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.5%, so the pre-tax interest-equivalent spread is now about 190bp, a slight and perhaps spurious increase from the 185bp recorded on January 26.

ZLC, the BMO Long Corporate ETF, was not particularly exciting this month:

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Grecian-based multinationals being higher rated than the sovereign is old hat. Japan is another matter:

Toyota Motor Corp. and Canon Inc. are among 13 Japanese companies that will have higher ratings than their home country at Standard & Poor’s after the nation was downgraded.

Japan’s credit rating was cut for the first time in nine years as the world’s most indebted nation staggers under 943 trillion yen ($11 trillion) of borrowings, with the grade lowered one step to AA-. Toyota, the world’s biggest carmaker, and Canon, the largest camera maker, along with companies including mobile phone operator NTT Docomo Inc. and Nippon Telegraph & Telephone Corp., are rated a grade higher.

A nation’s rating doesn’t constitute a ceiling for a corporate rating, which instead depends on analysts’ judgment of inherent creditworthiness, according to S&P’s policy. Exporters that have significant overseas earnings and don’t rely on public authorities may be graded higher than the sovereign, the ratings firm said in a 2002 report.

The Bank of Canada has released a working paper by Garima Vasishtha and Philipp Maier titled The Impact of the Global Business Cycle on Small Open Economies: A FAVAR Approach for Canada:

Building on the growing evidence on the importance of large data sets for empirical macroeconomic modeling, we use a factor-augmented VAR (FAVAR) model with more than 260 series for 20 OECD countries to analyze how global developments affect the Canadian economy. We focus on several sources of shocks, including commodity prices, foreign economic activity, and foreign interest rates. We evaluate the impact of each shock on key Canadian macroeconomic variables to provide a comprehensive picture of the effect of international shocks on the Canadian economy. Our findings indicate that Canada is primarily exposed to shocks to foreign activity and to commodity prices. In contrast, the impact of shocks to global interest rates or global inflation is substantially lower. Our findings also expose the different channels through which higher commodity prices impact the Canadian economy: Canada benefits from higher commodity prices through a positive terms of trade shock, but at the same time, higher commodity prices tend to lower global economic activity, hurting demand for Canadian exports.

There were mixed results on the Canadian preferred share market today, as PerpetualDiscounts gained 25bp while FixedResets lost 4bp. Volume returned to average levels.

Towers Perrin has released its December 2010 Pension Finance Watch:

Strong equity returns dominated pension financial results in December, as the Towers Watson Pension Index moved up 3.5% to 70.7. The index was still down 1.3% for the full year, however, as positive equity returns were more than offset by the growth in liabilities resulting from falling interest rates.

They also released a report on Treasury Infl ation-Protected Securities (TIPS): A primer on infl ation-linked bonds and their relative value as an inflation hedge:

Inflation derivatives are another option when constructing an infl ation hedge. Recent academic research has shown that TIPS have historically been underpriced relative to a synthetic TIPS portfolio of nominal Treasuries and inflation swaps.** Beyond costs, these are also very complex markets with different risks and liquidity features than the cash/physical market. While there are some managers who are capable of handling such a mandate, because of cost, liquidity and counterparty risk, inflation derivatives are likely to be most suitable for clients
who have an explicit infl ation-linked liability they want to immunize in a highly customized manner.

** Why Does The Treasury Issue TIPS? The TIPS–Treasury Bond Puzzle, Matthias Fleckenstein, Francis A. Longstaff, Hanno Lustig September 2010

BIS has released its Core Principles for Effective Deposit Insurance Systems.

The Federal Crisis Inquiry Commission has released the Financial Crisis Inquiry Report. It’s all the Fed’s fault:

Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner.

The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines?

Jonathan Ratner of the Financial Post reports an interesting fact in Canadian investment-grade bond market shines:

The total return of 6.92% was primarily a result of an average shift of 55 basis points in the yield curve. That was the biggest curve shift of any broad investment-grade index tracked by Bank of America Merrill Lynch, although the United States (-48 bps), Europe (-48 bps) and U.K. (-43 bps) were close behind.

The Canadian market also had fairly long duration on its side in 2010, BofAML analyst Preston Peacock said in a note to clients. At 6.78 years, the Canadian Broad Market Index is about two years longer than the United States and roughly 1.5 years longer than the Euro market. Only the Sterling market at 8.49 years has a longer duration than Canada and was the only outperformer with a 7.95% return in 2010.
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While all sectors of the Canada Corporate Index saw healthy excess returns in 2010, banking (+0.81%) and insurance (+0.88%) had the lowest relative performances. Together, the account for about half the index.

The banking sector, which has a weighting of roughly 40% in the index, didn’t exactly have a bad showing, so its hard to say it dragged down overall index performance. However, the group did lag the 1.31% return of the global bank sector.

Mr. Peacock explained this is due to the 46% allocation to subordinated debt in the Canadian Dollar Bank Index compared to 32% globally. The Canadian group did not sell off as much as its global peers previously and therefore saw less of a bounce-back.

Sub-debt as currently constituted is a bond, since holders can petition into bankruptcy – they will not be bonds under the new regime.

It was a positive day on the Canadian preferred share market amidst continued heavy volume as PerpetualDiscounts gained 9bp and FixedResets were up 7bp.

Brookfield has announced:

that it has agreed to issue approximately 15,300,000 Class A Common Shares (“Class A Shares”), on a bought deal basis, to a syndicate of underwriters led by RBC Capital Markets, CIBC World Markets, TD Securities Inc. and Scotia Capital Inc. (the “Underwriters”) at a price of C$32.85 per Class A Share (the “Offering Price”) for aggregate gross proceeds of C$502.6 million (the “Offering”).

In addition, the Company has granted the Underwriters an over-allotment option, exercisable in whole or in part for a period of 30 days following closing, to purchase up to an additional 2,295,000 Class A Shares at the Offering Price, which, if exercised, would increase the gross offering size to C$578.0 million.

The Class A Shares will be offered by way of a short form prospectus to be filed in all of the provinces of Canada and on a private placement basis in the United States pursuant to an exemption from the registration requirements of the United States Securities Act of 1933, as amended.

As previously announced, the Company has acquired 113.3 million common shares of General Growth Properties, Inc. (“GGP”) from The Fairholme Fund for aggregate consideration of approximately US$1.7 billion. The proceeds of the Offering, together with the proceeds of the Company’s previously announced offering of preferred shares, means that the Company’s purchase of the common shares of GGP is financed almost entirely with permanent equity, thoroughly enhancing the Company’s ability to pursue additional investment opportunities. The Offering is expected to close on or about February 15, 2011 and is subject to receipt of all necessary regulatory approvals.

The SEC has released Study and Recommendations on Improved Investor Access to Registration Information About Investment Advisers and Broker-Dealers:

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act” or “Act”) was signed into law on July 21, 2010. Section 919B of the Act directs the Securities and Exchange Commission (the “Commission” or “SEC”) to complete a study, including recommendations, of ways to improve the access of investors to registration information about registered and previously registered investment advisers, associated persons of investment advisers, brokers and dealers and their associated persons and to identify additional information that should be made publicly available. The Act specifies that the study include an analysis of the advantages and disadvantages of further centralizing access to registration information, and identify data pertinent to investors and the method and format for displaying and publishing the data to enhance the information’s accessibility and utility to investors. The Act requires the Commission to complete the study within six months after the date of enactment of the Act (i.e., by January 21, 2011), and to implement any recommendations within eighteen months after completion of the study.

If recommendations must be implemented, can they still be called “recommendations”?

Section VII proposes several recommendations. For the near-term, i.e., within the eighteen-month implementation period, the Staff makes the following recommendations: (1) unify search returns for BrokerCheck and IAPD to help investors more easily obtain the data they need to make informed decisions regarding financial services providers; (2) add a search by ZIP code or other indicator of location to BrokerCheck and IAPD to increase the utility of the existing databases; and (3) enhance BrokerCheck and IAPD by adding educational content to make the data currently available more useful to investors.
The Staff also recommends that, subsequent to the eighteen-month implementation period, Commission staff and FINRA continue to analyze, including through investor testing, the feasibility and advisability of expanding BrokerCheck to include information currently available in CRD, as well as the method and format of publishing that information; and that Commission staff continue to evaluate expanding IAPD content and the method and format of publishing that content, including through investor testing. Section VIII concludes the study.

The FOMC Release was ‘steady as she goes’. No dissent from Hoenig this time – he’s no longer a member!

Volume ticked up to “very heavy” levels in the Canadian preferred share market today with mixed returns, as PerpetualDiscounts lost 11bp while FixedResets gained 3bp.

PerpetualDiscounts now yield 5.28%, equivalent to 7.38% interest at the standard equivalency factor of 1.4x. Long corporates now yield about 5.55%, so the pre-tax interest equivalent spread (also called the Seniority Spread) is now about 185bp, a slight and perhaps spurious decline from the 190bp reported on January 19.

European politicians have a problem when talking about the potential for sovereign default – nobody believes them:

Most global investors predict at least one nation will leave the euro-area within five years and that Greece and Ireland will default, sentiment that is intensifying pressure on policy makers to strengthen their response to the debt crisis.

As the World Economic Forum’s annual meeting gets underway, 59 percent of respondents in a Bloomberg Global Poll said one or more of the 17 euro nations will quit by 2016, including 11 percent who see an exit within 12 months. Respondents were divided over whether Portugal would default, while a majority expressed confidence in Spain.

It was a mixed, downish day on the Canadian preferred share market, as PerpetualDiscounts gained 3bp while FixedResets lost 14bp … that brings the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) down to 6bp! Volume continued at elevated levels.