Category: Market Action

Australia has hiked the overnight right:

Reserve Bank Governor Glenn Stevens increased the overnight cash rate target to 3.25 percent from 3 percent in Sydney today. Only one of 20 economists surveyed by Bloomberg News forecast today’s move. The rest predicted no change.

The local currency jumped as Australia became the first Group of 20 nation to raise borrowing costs since the start of the global financial crisis more than a year ago. Rising job vacancies, retail sales and house prices, plus surging business and consumer confidence support Stevens’ view that the “basis for such a low interest rate setting has now passed.”

BIS has reported Bernanke’s most recent testimony. Not much new, but I was disappointed to see:

The current financial crisis has clearly demonstrated that risks to the financial system can arise not only in the banking sector, but also from the activities of other financial firms – such as investment banks or insurance companies – that traditionally have not been subject to the type of regulation and consolidated supervision applicable to bank holding companies. To close this important gap in our regulatory structure, legislative action is needed that would subject all systemically important financial institutions to the same framework for consolidated prudential supervision that currently applies to bank holding companies. Such action would prevent financial firms that do not own a bank, but that nonetheless pose risks to the overall financial system because of the size, risks, or interconnectedness of their financial activities, from avoiding comprehensive supervisory oversight.

Supervision should be narrowly focussed on banks, with an additional layer of less onerous restrictions on brokers. Interconnectedness is not a problem, as long as deals are adequately collateralized, either explicitly by the party ‘outside the wall’ of regulation, or by the bank inside the wall via capital charges.

To pretend that everything that moves can be regulated adequately will be incredibly expensive, stifling and, ultimately, ineffective.

Yet another poor day for preferreds, with PerpetualDiscounts down 33bp, although FixedResets gained 2bp. The declines were led by IAG.PR.A, possibly due to the new IAG straight 6% announced today. This issue now yields more than the new issue as well as having a more symetric risk/reward profile. The sellers will have to earn their 3%!

CreditSights has recommended against the CIT restructuring:

CIT Group Inc. bondholders should sell their investments as efforts by the 101-year-old commercial lender to restructure have “very little hope of succeeding,” according to CreditSights Inc.

CIT Chief Executive Officer Jeffrey Peek is seeking to cut at least $5.7 billion of debt through a swap of unsecured obligations for preferred shares and new secured notes maturing later. The New York-based commercial finance company is also asking creditors to approve a pre-packaged bankruptcy if it misses the exchange target.

“Currently CIT’s interest expense is too high, it cannot borrow economically to fund new business, and its liquidity is stressed,” CreditSights analysts Adam Steer, David Hendler and Jesse Rosenthal in New York wrote in an Oct. 4 report. “After digging through the details of the exchange offer and subsequent liquidity plans, we believe CIT’s plan has very little hope of succeeding.”

Investors that hold onto CIT bonds should accept the pre- packaged option, the analysts wrote.

Sub-prime mortgage packages are recovering from fire-sale prices:

Typical prices for the most-senior prime-jumbo securities rose 2 cents on the dollar last week to 84 cents, according to Barclays Capital data. Similar bonds backed by Alt-A loans with a few years of fixed rates increased 2 cents to 60 cents. The jumbo bonds are up from about 75 cents three months earlier, while the Alt-A bonds have climbed from 47 cents.

The debt has jumped from 63 cents for the jumbos and 35 cents for Alt-As in mid-March, as investors accept lower potential yields amid a rally across debt markets and traders anticipate demand from the U.S. Public-Private Investment Program. Investment funds, banks, insurers and Wall Street brokers have been among buyers, according to Scott Buchta, head of investment strategy at Guggenheim Capital Markets LLC in Chicago.
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Advantus Capital Management Inc., which oversees about $14 billion, is telling investors as it seeks more cash to buy devalued mortgage bonds they’d be better off with managers like it that aren’t part of the PPIP and thus have more freedom in selecting assets. The marketing underscores PPIP managers’ difficulty immediately raising the maximum amounts allowed and the possibility they may hold back on buying until prices drop.

PPIP managers Invesco, AllianceBernstein Holding LP and Marathon Asset Management LP have told potential investors they are targeting annual returns of at least 18 percent, according to a Sept. 2 memo by M. Timothy Corbett, chief investment officer of the Connecticut Retirement Plans and Trust Funds.

Amid the higher prices among eligible securities, “the likelihood of generating those types of returns are becoming remote, unless one were to take ever-riskier bets,” Dean Di Bias, high-yield mortgage portfolio manager at St. Paul, Minnesota-based Advantus, said in an interview last month.

Citigroup is sick and tired of doing all the paperwork for passive investors for free:

Citigroup Inc., the U.S. bank that got a $45 billion bailout last year, will revamp its North American brokerage business so that financial advisers charge ongoing fees instead of commissions on stock and fund sales.

The “strategic shift” will begin immediately, with the assignment of 600 bank-branch-based brokers to teams, New York- based Citigroup said today in a statement. Customers who think they’re better off paying commissions can do so by calling representatives at the company’s National Investor Center in San Antonio, the company said.

Frankly, I’m not sure what to make of changes in pending derivative collateral legislation:

House Financial Services Committee Chairman Barney Frank released a 187-page draft bill on Oct. 2 aimed at tightening oversight of the $592 trillion derivatives market. The measure, drawn from the Obama administration’s proposals, would require the most common and actively traded over-the-counter derivatives contracts to be bought and sold on exchanges or processed through a regulated trading platform.

The National Association of Manufacturers, U.S. Chamber of Commerce and the Business Roundtable, three of the biggest trade associations in Washington, lobbied Congress and the administration to exempt derivatives “end-users” from new rules and collateral requirements. End-users employ derivatives to hedge a risk to their operations, such as swings in interest rates, foreign currency shifts or changes in commodities prices.
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The draft would expand the administration’s exemption of end-users from collateral and clearing requirements. The administration proposal, released Aug. 11, would give a dispensation only to companies that use so-called hedge accounting. Frank’s proposal would exempt all end-user transactions and would let companies post non-cash items as collateral to satisfy margin requirements, Coleman said.

… but I’ll venture to suggest that it means lots of work for lawyers, anyway! It should also be noted that the change results in the ‘tax on derivatives use’ becomes a ‘tax on speculation’, which will hurt depth of market.

Barney Frank, by the way, thinks that since TARP equity-loans against good assets have worked out well, it’s time to extend the programme to bad assets:

House Financial Services Committee Chairman Barney Frank said he plans to introduce legislation next week to steer $2 billion in rescue funds repaid by U.S. banks to foreclosure relief for unemployed workers.

Funds from the $700 billion Troubled Asset Relief Program should be loaned to Americans without jobs and at risk of losing their homes, Frank said today in a telephone interview. Frank has said the program will be extended beyond its December expiration for foreclosure relief and to help community banks.

The SEC is continuing its search for infallable credit analysts:

When calculating net capital, broker-dealers are permitted to take a lower capital charge, called a “haircut,” for certain types of securities that are rated investment grade by an NRSRO.
As the Commission stated in proposing to remove references to NRSROs from the Net Capital Rule, broker-dealers are sophisticated market participants regulated by at least one self-regulatory organization. Accordingly, the Commission expressed its preliminary belief that broker-dealers would be able to assess the creditworthiness of the securities they own without undue hardship.30 In lieu of the references to NRSROs in the Net Capital Rule, the Commission proposed substituting two subjective standards for credit risk and liquidity risk. For the purposes of determining haircuts on commercial paper, the Commission proposed to replace the current NRSRO ratings-based criterion with a requirement that the instrument be subject to a minimal amount of credit risk and have sufficient liquidity such that it can be sold at or near its carrying value almost immediately.
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Notwithstanding the Commission’s belief that broker-dealers have the financial sophistication and resources to make these determinations,33 the Commission stated that it would be appropriate, as one means of complying with the proposed amendments, for broker-dealers that wished to continue to rely on credit ratings of NRSROs to do so.34
The majority of the commenters to the Commission’s proposal to remove references to NRSROs from the Net Capital Rule were opposed to the change.35 Generally, commenters stated that they preferred the existing rule because it is a bright line objective test that is relatively inexpensive to utilize.
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The Commission also requests comments on the following specific questions:

• • Are there factors other than creditworthiness and liquidity that should be required to be considered in determining the appropriate haircut for a proprietary securities position?
• • What would be the cost to broker-dealers to develop, document, and enforce internal procedures to evaluating the creditworthiness and liquidity of proprietary securities positions?
• • Do certain broker-dealers lack sufficient resources or expertise to independently assess the creditworthiness of securities?

I have no problem with allowing broker-dealers to assess credit risk themselves; this might even increase pressure to repeal Regulation FD, which is the most serious impediment to investors’ credit analysis. I don’t have any expectation of such analyses being better, however; merely different.

Another day of declines for preferred shares, with PerpetualDiscounts down 15bp on the day and FixedResets losing 6bp. The market is getting a little sloppier, according to HIMIPref™’s curve-fitting algorithms.

CIT has launched its restructuring:

Under the plan, CIT Group Inc. and CIT Group Funding Company of Delaware LLC (Delaware Funding) are launching exchange offers for certain unsecured notes. If the Company does not achieve the objectives of the exchange offers, it may decide to initiate a voluntary filing under Chapter 11 of the U.S. Bankruptcy Code. Therefore, the Company is concurrently soliciting bondholders and other holders of CIT debt to approve a prepackaged plan of reorganization. The Company has been informed by advisors to the Steering Committee that, subject to review of the offering memorandum, approximately $10 billion of outstanding unsecured indebtedness have already indicated their intention to participate in the exchange offer or vote for the prepackaged plan of reorganization.
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CIT has initiated a series of voluntary exchange offers designed to recapitalize its balance sheet and significantly reduce its debt in an out-of-court restructuring. Successful completion of the exchange offers will generate significant capital and provide multi-year liquidity through the material reduction of CIT’s outstanding debt.

Under the terms of the exchange offers, a tendering holder of an existing debt security would receive a pro rata portion of each of five series of newly issued secured notes, with maturities ranging from four to eight years, and/or shares of newly issued voting preferred stock. Consideration offered varies in amount and type based on issuer, maturity and position in the capital structure.

The exchange offers are conditioned upon achieving acceptable liquidity and leverage. These conditions require that the exchange offers cannot be consummated if the face amount of the Company’s total debt is not reduced by at least $5.7 billion in aggregate, with specific debt reduction targets for the periods from 2009 to 2012, as more fully described in the offering memorandum.

The offering memorandum has been released: in essence, bond holders are being offered a discounted number of New Notes and a variable number of preferred shares. The proportion of notes to shares decreases as the term lengthens; bonds maturing after 2018-12-31 are not included in the Exchange offer (with two exceptions). The New Notes will each carry a coupon of 7%, be in USD, and will have maturities ranging between 2013 and 2017.

If the whole transaction – including conversion of the preferred shares into common – proceeds as planned, current bond-holders will own 94% of the newly outstanding common. Wipe-out! Of perhaps more long-term interest is the fact that current preferred shareholders will own 3.5% of the new common.

Here’s where it gets interesting. All classes of preferred stock will be converted into new common proportionately to their liquidation preference, but the New Preferred Stock has a ludicrous liquidation value of $1,300. Note that, for instance, holders of the Canadian Maple bonds, 4.72% of 2011-2-10, will receive $800 in New Notes and 2.03746 New Preferred, so the notional liquidation value of the total New Preferred will be almost $2,650 for which they are “paying” (via reduction of bond principal value) $200. Applying this gearing ratio to the value the Old Preferreds, it looks like the Old Preferred shareholders are, basically, also getting wiped out, getting 1/13 of their claim value back in common.

To put it another way, the pro-forma balance sheets (page 289 of the OM PDF) lists the current claims of preferred shareholders as $3,171-million and the post-reorg common equity at $8,000-million, of which the current preferred shareholders will own 3.5%, or $280-million. Ouch! One may presume that this will be a coercive exchange offer!

CIT is maintaining a restructuring web page, which probably won’t change all that much. Bloomberg has a story on market reaction:

CIT Group Inc. bond and credit- default swap prices show that investors are speculating the 101- year-old commercial lender’s debt exchange won’t prevent it from filing for bankruptcy.

Bonds due within the next few months dropped, moving closer in price to longer-dated obligations, a sign that bondholders aren’t convinced the company will be able to restructure outside of bankruptcy court as $1.15 billion of debt comes due by year- end.
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“We believe CIT may need to reduce its debt burden by approximately $9.3 billion to regain access to the unsecured capital markets,” CreditSights Inc. analyst Adam Steer said in an e-mail yesterday. By targeting $5.7 billion, “we question whether CIT is improving its profile enough,” he said.
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CIT’s $300 million of 6.875 percent notes maturing on Nov. 1 dropped 5.9 cents to 71.6 cents on the dollar as of 11:13 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The company’s $750 million of 4.25 percent notes due in February fell 2.5 cents to 68.5 cents on the dollar at 11:05, and the $675 million of 5 percent bonds maturing in February 2015 fell 0.5 cent to 64.25 cents on the dollar at 9:55 a.m.
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Credit-default swaps protecting against a default through Dec. 20 have jumped 8 percentage points in the past three days to 30 percent upfront, according to CMA DataVision, while contracts for five years have climbed 4.4 percentage points to 38.4 percent.

And it looks like the heavyweights in the bondholders’ steering committee (PIMCO, inter alia) are dead serious about avoiding bankruptcy problems:

CIT Group Inc., the 101-year-old lender seeking to avoid collapse, may receive a loan of about $6 billion as soon as next week from bondholders that provided $3 billion of emergency financing in July, according to a person familiar with the matter.

The funds are intended to finance a prepackaged bankruptcy in case New York-based CIT’s debt exchange offer fails, said the person, who declined to be identified because the loan hasn’t been completed. The original loan pays annual interest of at least 13 percent. The new financing may have a lower interest rate, the person said.

DBRS had some comments:

DBRS’s view this exchange offer as default under DBRS’s definition. The current debt is being exchanged for debt with less advantageous characteristics and an equity component, which DBRS does not view as full and like compensation. Moreover, given the sizable amount of the debt that is offered to be exchanged and the inclusion of the prepackaged bankruptcy plan option, DBRS views this proposal as coercive. Accordingly, the Long-Tern debt ratings have been lowered to “C” reflecting DBRS expectation that, upon completion of the exchange, the debt that is exchanged will be placed in a default status in accordance with DBRS policy. Conversely, should the exchange offer not be completed and CIT pursues bankruptcy, DBRS would place all debt and the Issuer Rating of CIT in a default status in accordance with DBRS policy. In the case that the Company is successful in executing the proposed exchange, any untendered Existing Notes will be rated at a level commensurate with the deeply subordinated position as any untendered notes would rank below the New Notes, the existing $3.00 billion secured credit facility, and a potentially enlarged secured credit facility. Upon completion of the restructure the New Notes will be assigned a rating by DBRS.

One very important and instructive thing about the whole affair is that there is no premium being paid for issues with a high coupon – only principal value is considered, the same way as in a regular bankruptcy. Remember this when investing in corporate debt! Low Coupons = Good.

Senator Warner is lithping that twaderth thould be thenthitive:

Goldman Sachs Group Inc. must be cautious about handing out record bonuses while the banking industry is still under distress or risk spurring an outcry from Congress, U.S. Senator Mark Warner said.

“I do hope that Goldman Sachs will be a little more sensitive to the optics of their actions,” Warner, a member of the Senate Banking Committee, said today in an interview on Bloomberg Television’s “Political Capital with Al Hunt,” to be broadcast today.

“They ought to be sensitive to the fact that the whole industry is still under a great deal of scrutiny,” said Warner, a Virginia Democrat. “You can end up seeing a reaction on the Hill if there’s not some of that sensitivity.”

There’s been a lot of talk about inflation lately – misplaced, I think, because fiscal deficits will not affect inflation until they’re monetized, while all the cash that the Fed is laying out (for financial assets) is remaining on its balance sheet. If the private banks start spending that cash without the Fed immunizing this activities … well, then we might have problems. Until then, I’m listening more to deflation talk:

Executives at Kroger Co., the largest U.S. supermarket chain, blamed deflation for a 7 percent drop in earnings in the second quarter, while falling prices for food, gasoline, and electronics left August sales unchanged at Costco Wholesale Corp.
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“Deflation is definitely a threat right now,” Nobel laureate Joseph Stiglitz, 66, a professor at Columbia University in New York, said in a Sept. 22 interview. “The combination of the deflation threat and the sluggish recovery should keep the Fed on hold for quite a while.”

Consumer prices are experiencing deflation, with the consumer price index sliding for six straight months from year- earlier levels, the longest stretch of declines since a 12-month drop from September 1954 to August 1955, according to the Labor Department.

So far, the core consumer-price index, which excludes food and energy, is facing disinflation, a slowing in the pace of increase. The core index rose 1.4 percent in August from a year earlier, down from 2.5 percent in September 2008.

Ignoring the very attractive possibility of deflation, the preferred share market had another crummy day today, with no winners in the performance highlights, PerpetualDiscounts losing 15bp and FixedResets down 2bp. Volume was also off considerably, with only 28 index included issues trading 10,000 shares or more … still quite respectable, according to long term averages, but a sharp decline from what we’ve been getting used to lately.

I have updated the post FRB Boston Paper on Use of Funds from Housing ATM with new related BoC research focussing on the Canadian Boom of the late eighties.

The Committee of European Banking Supervisors has issued a press release, CEBS’S PRESS RELEASE ON THE RESULTS OF THE EU-WIDE STRESS TESTING EXERCISE:

Supervisory authorities and central banks in the EU routinely conduct stress testing exercises in the context of their regular risk assessment of the banking sector and as a way to assess the risks facing individual institutions.

Gee, if they’re that routine, why does the headline refer to “the” EU-Wide Stress Testing Exercise?

ECOFIN Ministers and Governors were provided today with a presentation by CEBS of the outcome of the EU-wide stress test on an aggregated basis.

Under the baseline scenario, reflecting current macro-economic projections, the banks’ aggregate Tier 1 capital ratios will be well above 9%, compared to the present Basel minimum requirement of 4%.

Ministers and Governors noted that, should economic conditions be more adverse than currently expected, this would have significant impact on the potential losses for the banks concerned. Under such adverse scenario, the potential credit and trading losses over the years 2009-2010 could amount to almost € 400 bn.

However, the financial position and expected results of banks are sufficient to maintain an adequate level of capital also under such negative circumstances. Notably, the aggregate Tier 1 ratio for the banks in the sample would remain above 8% and no bank would see its Tier 1 ratio falling under 6% as a result of the adverse scenario.

This resilience of the banking system reflects the recent increase in earnings forecasts and, to a large extent, the important support currently provided by the public sector to the banking institutions, notably through capital injections and asset guarantees, which has augmented their capital buffers.

Glad to hear that the resilience of the banking system reflects the recent increase in earnings forecasts. News like that does my heart good.

Not the best of starts for the bright new quarter: PerpetualDiscounts were down 32bp while FixedResets gained 5bp, even as PWF announced a new issue priced tight to the market. The TCL FixedReset and GWO Straight both settle tomorrow; it will be very interesting to see just how well the latter performs.

Volume was strong, dominated by FixedResets.

I’ve been wondering when there would be some more news on CIT! Here’s a rumour:

Citigroup Inc. and Barclays Capital are offering to provide financing to CIT Group Inc., the commercial lender that’s struggling to avert bankruptcy, according to people familiar with the situation.

The 101-year-old company’s bondholders are also seeking to provide about $2 billion in loans as a restructuring deadline approaches tomorrow, said the people, who declined to be identified because the negotiations are private. New York-based CIT may choose other options, the people said.

CIT said in July it may seek court protection from creditors after Chief Executive Officer Jeffrey Peek failed to win a second government bailout and had to turn to bondholders for $3 billion in rescue financing. The company said in an Aug. 17 regulatory filing that it has to come up with a plan “acceptable” to the majority of a bondholder steering committee that provided it with the emergency cash by Oct. 1.

More rumours:

CIT Group Inc., the 101-year-old commercial lender, is planning to start a debt exchange offer that will include a so-called pre-packaged bankruptcy option, a person familiar with the matter said.

The company plans to start a voluntary swap “within days,” said the person, who declined to be identified because talks are private. At the same time, New York-based CIT proposes that debt holders vote on a pre-packaged bankruptcy plan in case the exchange fails, the person said.

The preferred share market closed the month on a sour note, with PerpetualDiscounts down 13bp and FixedResets losing 7bp. Index figures are still unofficial, but I make PerpetualDiscounts down 1.20% total return for the month and FixedResets up 0.21%. Volume was good on the day, led by the TRP new issue and dominated by other FixedResets.

PerpetualDiscounts closed yielding 5.80%, equivalent to 8.12% interest at the standard equivalency factor of 1.4x. Long Corporates now yield a smidgen under 6.0%, so the pre-tax interest-equivalent spread is now about 215 bp, a widening of 10bp from the 205bp reported September 23 and at the high end of “Credit Crunch Normal”.

Congratulations to Assiduous Reader beluga, who won yesterday‘s over/under contest on the TRP new issue volume!

The Ontario Securities Commission has released the 2009 Compliance Team Annual Report.

Lots of volume, with 61 issues in the HIMIPref™ indices trading over 10,000 shares, but not much price action today, with PerpetualDiscounts down 5bp and FixedResets losing 7bp. A bit more volatility than yesterday, with ten issues showing in the Performance Highlights table.

The big news tomorrow will be settlement of the TRP monster issue – I will be most interested to see how many shares trade. I make the over/under line to be a million shares … place yer bets in the comments!

Accrued Interest worries that Fed purchases are distorting the Agency MBS market:

Obviously the Fed wants to buy the current coupon because that’s the one that influences current borrowing rates. But as a consequence, the Fed has become the overwhelming owner of the 4% and 4.5% coupons: 90% of the former and 80% of the later.
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And you have to expect the majority of the widening to hit low coupons, because that’s what Vanguard/the Fed will either be selling or what they will stop buying. At that point mortgage rates will rise, not in a disastrous fashion, but probably at least 50bps. Then what? The borrower within a 4.5% pool will be way out of the money, which will not only prevent any kind of refinancing from ever happening, but also impair his/her mobility. In other words, those MBS will repay extremely slowly for investors.

Andreas Hackethal, Michalis Haliassos and Tullio Jappelli write a piece for VoxEU that is sure to make it into the bibliography of countless DIY-Investing websites: Do financial advisors improve portfolio performance?:

Do financial advisors aid their clients in making wise investments? This column shows that investors who delegate their portfolio management achieve better results. But that’s due to the fact that advisors tend to be matched with richer, older investors. In fact, financial advisors tend to lower returns and raise risk relative to clients who manage their own investment.
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The budding literature on financial advice and its regulation is usually based on the premise that advisors know what is good for individual customers but have an incentive to misrepresent this and take advantage of their typically uninformed customers. In recent research (Hacketal, Haliasso, and Jappelli, 2009), we ask:

• •How do brokerage accounts run by individuals without financial advisors actually perform compared to accounts run by (or in consultation with) financial advisors?
• •Are financial advisors are indeed matched with poorer, uninformed investors or with richer, experienced but presumably busy investors?
• •Is the contribution of financial advisors to the accounts that they do run actually positive relative to what investors with the characteristics of their clients tend to obtain on their own?

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Our econometric analysis suggests that advisors tend to be matched with richer, older investors rather than with poorer, younger ones. Taking account of this sample selection bias yields the opposite result. Once we control for different characteristics of investors using financial advisors, we discover that advisors actually tend to lower returns, raise portfolio risk, increase the probabilities of losses, and increase trading frequency and portfolio turnover relative to what account owners of given characteristics tend to achieve on their own.
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One interpretation could be that advisors overcharge for their services. If they do, should they be regulated? Or should we be content with the idea that they do not tend to serve those lacking sophistication but those lacking time to make money on the market? But then, why do rich, older people pay so much for advice? Could part of it arise because these individuals would not have undertaken the investment themselves if it were not for the help of advisors?

The problem – and the worthy target of research – is that most financial advisors (whether registered with the regulatory authorities as such or not) are not, in fact, financial advisors. They are salesmen. Regulators should insist that, at a minimum, those with discretionary authority over investor accounts must prepare meaningful composites – two versions, one defined by sector of investment and, importantly, the other defined by the results of a KYC form – and that these composites be supplied to the regulators, subject to possible audit by the regulators and published by the regulators as part of the normal registration reporting.

Given that most advisory relationships are effectively discretionary, consideration should be given to forcing the same disclosure for these as well … but this is somewhat murky! What if the client doesn’t take the advice? What it the advice is taylored to what a client might actually do? If a client is convinced oil will triple to year end and insist on overweighting in oil producers, all an advisor can do is recommend the relatively safe ones … whatever “safe” means!

The full paper is available from the Centre for Economic Policy Research.

Jim Hamilton of Econbrowser discusses reports of planning for unwinding the Fed’s balance sheet and includes a chart of the Fed’s liabilities:

I mused on September 24 about the discount window and the importance of deposits in funding bank assets. In a normal bank-run scenario, short-term bank liabilities such as deposits are used to fund long-term bank assets such as mortgages and term loans. Liquidity crises come when the bank experiences difficulties rolling over its liabilities and in such a case, the theory goes, they refinance their assets at the Central Bank’s discount window instead.

In this crisis, they are selling their assets to the Fed and leaving the proceeds on deposit; in other words, instead of acting on the liability side of their balance sheet, the banks are taking action on the asset side, converting their long term assets into risk free deposits. I confess that I have not been able to draw any conclusions as yet regarding the costs, benefits and causes of this phenomenon and tied it in with the empirical evidence regarding the importance of a stable deposit base; I can only draw solace from the idea that I haven’t seen this discussed in detail anywhere else, either!

Willem Buiter of Maverecon criticizes the Obama administration:

But it is on the economic front that the damage is really piling up. President Obama’s speech yesterday (the first anniversary of the collapse of Lehman Brothers) on the lessons from Lehman’s demise demonstrated once again that we are stuck with a president who knows little about economics and cares less. There was some perfunctory populist bank and banker bashing, but nothing concrete. Like most other political leaders in the financially benighted north-Atlantic region, president Obama will use the absence of international cooperation and the undesirability of unilateral action by any one country as an excuse to avoid radical reform of the cross-border banking and financial system. No doubt the French president, Mr. Sarkozy, will again threaten his by now traditional walk-out over some trivial issue, but the chances of international agreement on measures that could reduce the frequency and severity of future systemic crises are slim.

The US officials supposed to lead the systemic reforms of the domestic and international financial system are the same people who failed to recognise the emerging disfunctionalities that produced the crisis, who indeed were responsible for creating some of these disfunctionalities, who failed to prevent the crisis, who re-fought the battle of the 1930s (and insist on taking great credit for doing so) and left us with the moral hazard nightmare legacy of the end of the first decade of the twenty first century.

There’s been another entry in the bash-the-banker sweepstakes:

Chancellor of the Exchequer Alistair Darling, targeting what he calls “greed and recklessness” in Britain’s financial system, asked banks to curtail bonuses and said the rich will pay more in tax.

“It is right that those who earn the most should shoulder the biggest burden,” the finance minister told the ruling Labour Party’s annual conference today in Brighton, England. “We will introduce legislation to end the reckless culture that puts short-term profits over long term success. It will mean an end to automatic bank bonuses year after year.”
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Prime Minister Gordon Brown’s government is attempting to shore up support among voters by attacking bankers and suggesting the rich will have to foot the bill for the sharpest recession since World War II.

“This is a government on the cusp of losing the next election, and if banker-bashing is going to be popular they’ll do it,” said Simon Maughan, a banking analyst at MF Global Securities in London. “This is a classic case of knee-jerk political reaction to a crisis.”

Politics of division, politics of resentment, politics of envy … you never have to scratch the surface too deeply to find the Lord of the Flies. Mr. Darling did not, as far as I can tell, address the shortcomings of his regulatory authorities.

The Boston Fed has released a paper on social learning by Julian Jamison, David Owens, and Glenn Woroch, Social and Private Learning with Endogenous Decision Timing:

Firms often face choices about when to upgrade and what to upgrade to. We discuss this in the context of upgrading to a new technology (for example, a new computer system), but it applies equally to the upgrading of processes (for example, a new organizational structure) or to individual choices (for example, buying a new car). This paper uses an experimental approach to determine how people address such problems, with a particular focus on the impact of information flows. Specifically, subjects face a multi‐round decision, choosing when (if ever) to upgrade from the status quo to either a safe or a risky new technology. The safe technology
yields more than the status quo, and the risky technology may yield either less than the status quo or more than the safe technology. Every round, subjects who have not yet upgraded receive noisy information about the true quality of the risky technology. Our focus on the timing of endogenous choice is novel and differentiates the results from previous experimental papers on herding and cascades. We find that, in the single‐person decision problem, subjects tend to wait too long before choosing (relative to optimal behavior). In the second treatment, they observe payoff‐irrelevant choices of other subjects. This turns out to induce slightly faster decisions, so the “irrationality” of fads actually improves profits in our framework. In the third and final treatment, subjects observe payoff‐relevant choices of other subjects (that is, others who have the same value for the risky technology but independent private signals). Behavior here is very similar to the second treatment, so having “real” information does not seem to have a strong marginal effect. Overall we find that social learning, whether or not the behavior of others is truly informative, plays a large role in upgrade decisions and hence in technology diffusion.

I cheerfully admit to lack of familiarity with what the authors refer to as the “vast literature” on the “causes and patterns of the adoption and diffusion of innovations”, but it seems to me that you don’t have to squint too much to read “safe or risky new investment class” for “safe or risky new technology”.

Not much of a day for price movement in the preferred share market, with only four issues making it to the price change highlights table (three of them negative; all of them PerpetualDiscounts), while more broadly, PerpetualDiscounts were down 6bp while FixedResets lost 2bp. Volume was good though, dominated by FixedResets.

Apparently the G-20 will save the world from greedy bankers:

President Barack Obama and other Group of 20 leaders meeting in Pittsburgh are uniting behind a plan to force banks to tie compensation more closely to risk and tighten capital requirements, U.S. officials said. Treasury Secretary Timothy Geithner said there’s a “strong consensus” to tackle global imbalances. At the same time, divisions remain on how to overhaul control of the International Monetary Fund.

That’s a hoot, it really is. “Tie compensation more closely to risk”? “Risk” as defined how and by whom? It seems to have escaped the attention of the press that the Basel Committee (comprised of wise and omniscient bureaucrats) has been attempting to define “risk” in quantitative terms for over twenty years and the current crisis shows they’re not very good at it – no better than the bankers themselves.

But now, it’s done:

Group of 20 leaders said they will crack down on risk-taking by banks and better align economic policies as they turned from crisis management to delivering a new set of rules for the world economy.
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“We cannot tolerate the same old boom-and-bust economy of the past,” Obama said after the talks. “Never again should we let the schemes of a reckless few put the world’s financial system and our people’s well-being at risk.”
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“They’re trying to ensure that bubbles don’t build up again,” said Kenneth Rogoff, a former chief economist at the International Monetary Fund and a professor at Harvard University. “There’s an element of genuine concern about pay policies, but they may also satisfy some of the public bloodlust.”

Public bloodlust is the key point – and way to whip up the old politics of resentment & envy, Mr. Obama! Now I understand what “Change” means … it means “Change in Targets”.

Banks were told to avoid “multi-year guaranteed bonuses” and a “significant portion of variable compensation” must be deferred, paid in stock, tied to performance and subjected to clawbacks if earnings flop. The G-20 stopped short of endorsing a French proposal to introduce specific caps on pay.

About the only good thing to be said for this is that it will lead a stampede of talent out of the regulated banks and into the hedge-fund sector. Technology’s made it very easy to blur the lines – there’s no reason why a hedge fund can’t call a market in any security and trade it off the exchange in an institutional pool.

Being buck-a-dime on ten-year governments may be less sexy than activist investment management, but it can be much more profitable.

If they can, the profits and share price of banks from Goldman Sachs Group Inc. to Barclays Plc will fall with their scope to invest and trade, said former Bank of England policy maker Charles Goodhart.

“Regulation almost certainly means the size of the banking industry will contract and its rates of return will go down,” said Goodhart, professor emeritus of banking and finance at the London School of Economics.

This will help hedge funds – and other shadow banks – raise capital.

FixedResets outperformed big-time today, returning +14bp against PerpetualDiscounts’ loss of 22bp, while also dominating the volume table on another day of very good volume.

Bank of England Governor Mervyn King had some apocalyptic things to say:

two British banks got within hours of a liquidity shortfall on Oct. 6, 2008, and the day after as the U.K. financial system came to the brink of collapse.

“Two of our major banks which had had difficulty in obtaining funding could raise money only for one week then only for one day, and then on that Monday and Tuesday it was not possible even for those two banks really to be confident they could get to the end of the day,” the BBC cited King as saying in an interview to be broadcast later today.

King was referring to Royal Bank of Scotland Group Plc and HBOS Plc, the BBC said. Prime Minister Gordon Brown’s government pledged to invest about 50 billion ($82 billion) pounds in the banking system on Oct. 8, 2008, to save it from meltdown in the aftermath of Lehman Brothers Holdings Inc.’s bankruptcy declared that September.

This meltdown-through-funding scenario ties in the the IMF conclusions on the resiliency of Canadian banks, but I confess that the entire mechanism of such a failure is somewhat opaque to me.

It was to prevent such crises of funding that Central Banking was invented; the Federal Reserve was created explicitly due to the funding difficulties that were at the centre of the panic of 1907 – so why should funding, in and of itself, be such a critical element?

This brings us back to the Northern Rock episode, where the announcement of liquidity support by the BoE actually made matters worse; I have previously speculated that this reflects public distrust of public institutions. If this is the case, then the fundamental assumptions of Central Banking will have to be revised – the discount window has been the most important tool in their box.

What? Public Institutions, civil servants and policitians at fault? Can’t be! It must be the fault of the Credit Rating Agencies:

Moody’s Investors Service, Standard & Poor’s and Fitch Ratings face scrutiny today by insurance regulators examining the role of the firms in evaluating fixed- income securities.

State insurance regulators are meeting in Maryland to examine the firms’ role in rating bonds held by insurance companies. A second hearing scheduled today, by Edolphus Towns, chairman of the House Oversight and Government Reform Committee, was postponed to Sept. 30. The panel will look at ratings companies amid allegations of continued conflicts of interest from a former Moody’s analyst.
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“The fundamental issue is if the bar is always moving, that makes it very difficult,” Connecticut insurance Commissioner Thomas Sullivan said in a telephone interview. “Magically overnight, what we thought was AAA is no longer AAA. That’s a big problem.”

Assiduous Readers will remember that actual market participants felt that a volatility scale would be a good adjunct to ratings, but this solution was disdained by regulators. Of some interest in the Bloomberg story was:

Moody’s originally declined to participate in the [NAIC] meeting but relented after New York’s regulator suggested scaling back the rating firm’s authorization if it skipped the session.

Congressional Hearing

The congressional hearing was postponed after the panel obtained an internal Moody’s staff memo written by Eric Kolchinsky, a former analyst at the firm, expressing his concern with how the company rated securities, said committee chairman Edolphus Towns. The panel didn’t have enough time to incorporate the information into the hearing, he said.

A Moody’s representative was invited to the session but didn’t come, Towns said.

“They basically didn’t show up, they ignored us” Towns said in an interview, referring to Moody’s. “I guess they didn’t realize we have subpoena power.”

See? Congressional sessions have subpoena power, but regulators have something even better: extortion.

The Fed has released the Shared National Credits Report:

Credit quality declined sharply for loan commitments of $20 million or more held by multiple federally supervised institutions, according to the 32nd annual review of Shared National Credits (SNC).
The credit risk of these large loan commitments was shared among U.S. bank organizations, foreign bank organizations (FBO), and nonbanks such as securitization pools, hedge funds, insurance companies, and pension funds. Credit quality deteriorated across all entities, but nonbanks held 47 percent of classified assets in the SNC portfolio, despite making up only 21.2 percent of the SNC portfolio. U.S. bank organizations held 30.2 percent of the classified assets and made up 40.8 percent of the SNC portfolio.

The 2009 review covered 8,955 credits totaling $2.9 trillion extended to approximately 5,900 borrowers. Loans were reviewed and categorized by the severity of their risk–special mention, substandard, doubtful, or loss–in order of increasing severity. The lowest risk loans, special mention, had potential weaknesses that deserve management attention to prevent further deterioration at the time of review. The most severe category of loans, loss, includes loans that were considered uncollectible.

Treasury’s wish-list of bank capitalization rules included many references to Tier 1 Financial Holding Companies, a concept I criticized – special status will only cause problems, I said. It would seem that Paul Volcker agrees:

Former Federal Reserve Chairman Paul Volcker criticized the Obama administration’s plan to subject “systemically important” financial firms to more stringent regulation by the Fed.

Volcker told lawmakers today that such a designation would imply government readiness to support the firms in a crisis, encouraging even more risky behavior in a phenomenon known as “moral hazard.”
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“The danger is the spread of moral hazard could make the next crisis much bigger,” said Volcker, who serves as an outside economic adviser to Obama. Volcker has criticized key elements of the Obama administration regulatory plan in recent public statements, and his remarks today largely reprised those criticisms.

I am particularly impressed by his reference to the next crisis … it is rare to fin a figure with any political clout not subscribing to the view that the New Millennium will arrive as soon as we get those pesky Credit Rating Agencies under control.

Good volume, soft returns in the preferred market today, with PerpetualDiscounts down 11bp on the day while FixedResets lost 8bp. This may be related to all the new issuance … there are, presumably, people still selling to make room for the monster TRP FixedReset settling September 30 and there was a (long awaited) new straight issue announced by GWO.

Today was Equity Through Education Day, a day on which institutional investors are encouraged to trade through BMO Capital Markets with commissions donated to charity. So far CAD 6.6-million in commissions has been skimmed off the hapless beneficiaries of participating institutional accounts, enabling institutional PMs to feel good about themselves.

Sadly, the website – again! – does not explain how discretionary participation (the kind they are attempting to encourage with their ads) can be squared with a PM’s duty to his client, or regulatory requirement to seek best execution. I’ve never understood that.

Realpoint, a CMBS credit rating agency last discussed on September 9, has been approved by NAIC:

The ruling by the National Association of Insurance Commissioners means state regulators can rely on Realpoint in determining how much capital must be held by insurers, Scott Holeman, spokesman for the group, said today. Realpoint provides analysis to bond buyers through subscription, while S&P and Moody’s are paid by companies that issue securities.

Realpoint started the process as reported June 15, when fears of a mass downgrade of CMBS by S&P led insurance companies to seek their ‘license to invest’ from more optomistic firms.

And there’s even more news on the credit rating front! First, William Galvin, Secretary of the Commonwealth of Massachussets is checking the quality of some ratings:

Massachusetts is reviewing DBRS Ltd.’s grades on investments tied to life insurance policies because they might be inflated like the discredited mortgage bonds at the center of the recession.
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“Bundling the policies to create another investment opportunity closely parallels the subprime mortgage market and subsequent meltdown, whose effects investors are still reeling from,” said Galvin, the state’s chief financial regulator, in the statement.

Regulators have said ratings companies were too generous in assigning top credit grades to securities comprised of bundled subprime mortgages before the financial crisis showed many of them were more prone to default than the ratings suggested.

Well, with respect to the last paragraph, hold on a minute! That’s certainly been implied, but I’m not sure whether the regulators have actually gone so far as to state definitely that the ratings were too high. Galvin’s quote, besides conflating two unrelated securities, is also ungrammatical. Was he drunk?

However, help is at hand: Government-Developed Credit Ratings:

“We at the National Association of Insurance Commissioners are studying the viability of creating our own rating agency, a not-for-profit one,” Connecticut Insurance Commissioner Thomas Sullivan said in a telephone interview today.
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“The fundamental issue is if the bar is always moving, that makes it very difficult,” Sullivan said. “Magically overnight, what we thought was AAA is no longer AAA. That’s a big problem.”
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Insurers, which are suffering from downgrades of their holdings, have urged regulators to seek alternatives. Rating cuts to structured securities in insurance portfolios have triggered increased capital requirements.

The American Council of Life Insurers has asked the NAIC to ease its standards after RMBS rating cuts pushed up carriers’ capital needs fivefold to $11 billion in the six months ended June 30. The ACLI is proposing regulators use “third party” predictions of credit losses on RMBS in place of their reliance on ratings firms.

The NAIC currently conducts some credit analysis on insurers’ investments through the group’s Securities Valuation Office in New York. The deliberations for a new ratings business at the NAIC are still preliminary.

“We’re in the formative stages,” Sullivan said. “Anything’s possible. Financing, legal hurdles, structure; all those things need to be dealt with and we’re examining all of them.”

I can’t wait.

Volume was very good today (possibly quarter end window-dressing / rebalancing, possibly triggered by the YPG.PR.C closing, maybe even clearing the decks for the massive forthcoming TRP settlement), with FixedResets seeing a good spike in volume with lots of blocks. That didn’t do prices much good, though, with PerpetualDiscounts down 11bp on the day and FixedResets losing 2bp.

PerpetualDiscounts closed with a weighted mean average YTW of 5.77%, equivalent to 8.08% at the standard equivalency factor of 1.4x. Long Corporates have backed up to just over 6.0%, so the pre-tax interest-equivalent spread is now about 205bp, a very slight – and possibly completely technical – tightening from the September 16 value and well within its September and Credit Crunch range.