Category: Market Action

Inflation is down, according to Statistics Canada:

The Bank of Canada’s core index advanced 2.4% over the 12 months to December, identical to the rise in November. The main contributors to the increase in the core index were higher prices for bread, cereal products and meat products. Price declines for purchasing and leasing passenger vehicles remained the primary downward contributor.

The seasonally adjusted monthly core index posted no change from November to December, after rising 0.6% from October to November.

PerpetualDiscounts were off again today, reducing their month-to-date return to +5.65%, having peaked on January 13 at +7.51%. The median pre-tax bid-YTW is now 6.95%, equivalent to 9.73% interest at the standard conversion factor of 1.4x, compared to long corporates, still steady at 7.5%. The pre-tax interest-equivalent spread is thus 223bp.

I went to a seminar on Risk Management today, presented as part of the Finance Experts Discussion Series @ Rotman.

Rather disappointing, really. Panelists were:

• Derrell Hendrix, CEO, RISConsulting and Founding Partner and CEO, Karson Management (Bermuda) Limited
• John Hull, Maple Financial Group Chair in Derivatives and Risk Management, Professor of Finance and Co-Director, Master of Finance Program, Rotman School of Management, U of Toronto
• Robert (Bob) Tapscott, interim CEO, RISConsulting

One of the RISConsulting guys – I forget which one – was of the view that transparency will save the world and drew comparisons to nuclear reactor design and operation. He did not address the problems inherent in forecasting financial markets – rather than designing and operating physical technology – nor did he explain whereby investors are presumed to be able to find the time to utilize such transparency. Hands up everybody who’s read through the entire annual report of every company in which they’ve invested!

Dr. Hull claimed that the world would be saved through reduction of perverse incentives, by which he means he wants deferred bonuses rather than immediate ones. He did not address the question of who in their right mind would willingly work for a deferred bonus, or what discounting rate a rational participant should apply to the deferred portion since eventual payment of the amount due is basically discretionary. I’d suggest 50%+. Counterparty risk is pretty extreme in such circumstances.

Limited / Deferred / Regulated compensation is getting a lot of ink nowadays. Econbrowser‘s James Hamilton is also beating that drum. Sigh. Time to move to Dubai, ’cause that’s where all the action’s going to be in ten years, at this rate.

Credit crunch commentary has now reached its most tiresome phase: it’s just being used as a vehicle to push along various long-standing agendas. The crisis itself is merely a tired rehash of the panic of 1825 and it’s BORING.

Good volume today, but the market was off a good bit, probably due – as much as anything in the markets is ever due – to a combination of rotten equities and heavy issuance.

Nice to see that Banco Santander has imported North American financial advisory practices to Europe:

Branch managers channeled customers with money from property sales or inheritances to private banking salespeople, lawyers for the investors said. A retired school teacher put 300,000 euros ($388,000), half her savings, in a structured product linked to Madoff, said Jordi Ruiz de Villa, an attorney at the Barcelona law firm Jausas. The vendor invested 325,000 euros of lottery winnings in a similar product and may have to return to street sales, according to lawyers at Cremades & Calvo-Sotelo in Madrid.
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Spanish securities law requires anyone offering investment services to “suitably evaluate” a customer’s experience and market knowledge and ensure that he or she understands the risks.

A decent day, with PerpetualDiscounts up a bit. Fixed-Resets were also up a bit, until the announcement of two new issues in the late afternoon obviated the need to buy them in the secondary market.

Econbrowser‘s James Hamilton is advocating executive compensation laws:

Lehman Brothers: $27 million for CEO Richard Fuld. The financial freeze that followed the collapse of Lehman is seen by many as the key event that turned the recession of 2007-08 into the frightening freefall currently under way
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What caused that principle to go so badly awry in the present instance? I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one’s way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss. For example, a subprime loan extended in 2005 would earn the lender a higher yield in the event that house prices continued to rise, but perform quite badly when the housing market turned down. By taking a leveraged position in such assets, the slightly higher yield became an enormously higher yield, and while the game was on, the short-term performance looked wonderful. If the agent is compensated on the basis of current performance alone, and the principal lacks good information on the exact nature of the risks, the result is a tragically toxic incentive structure.
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My interest in this issue is not so much to exact revenge on those who created our current problems, but instead to ask, how can we change the incentives so that this kind of problem is not repeated again? And that in turn leads me to wonder, why limit the proposals above only to a handful of companies?

Despite Prof. Hamilton’s protestations, I consider this a classic example of American vindictiveness.

In the first place, it was not Fuld’s compensation that caused the credit freeze of 4Q08: it was the sudden withdrawal of $400-billion from money market funds that accomplished that little trick. No individual, no company and not even any industry is able – or willing – to withstand the cumulative effect of uninformed decisions by millions of retail customers.

To ascribe blame for the Credit Crunch on Wall Street policies is as superficial as blaming the Tech Boom and subsequent wreck on IPO specialists and Tech Funds. Retail was coming to them, insisting on get-rich-quick internet investments – and got them. End of story.

Our reaction to the Credit Crunch should be informed by our reaction to, say, a horrific and avoidable traffic accident. We can throw the book at the driver, if it makes us feel better. It won’t stop future accidents. We can improve the regulation of that particular intersection, with improved sightlines and signage; it might cut accidents at that corner, but won’t do a thing for the next block down the street. If we’re really serious about banning accidents, we have to ban cars; we will probably find that the cure is worse than the disease.

There are definitely some aspects of regulation that can be improved – removing the right of directors and shareholders to hire whoever they like at whatever it costs is not one of them – but to try and tame the business cycle with regulation is a fool’s game. As with the Great Moderation, as with the Soviet Union, that’s the sort of thing that works very, very well … until one day, quite suddenly, it doesn’t.

I will also note Dealbreaker‘s estimate of $1-trillion in fees paid in the course of the mortgage boom … so, in defense of the executives:

• if they’d turned down that kind of money, investors would have hired a pig more aggressive in getting to the trough
• what killed the investment banks was not so much their horrific losses, but risk-aversion by their lenders

Am I giving Wall Street a free pass? No. I pointed out in the post SEC & BSC that Wall Street covered its need to tick the “risk management” box by hiring people who didn’t know what they were doing and then ignoring what they said. But the way to get ahead in any large organization – whether it’s an investment bank, a regulator, government, or Honest Bob’s Financial Planning Boutique – is to figure out what your boss (and your clients) want to hear and telling it to them. No amount of well-intentioned regulation will ever change that.

On a related topic, US & International financials got cremated today:

Banks fell after the U.K.’s second bank-bailout plan in three months raised concern the financial crisis is deepening. The government of Prime Minister Gordon Brown said it will spend an extra 100 billion pounds ($142 billion) to support banks and increase its stake in Royal Bank of Scotland Group Plc (RBS:LN).

Royal Bank of Scotland American depositary receipts (RBS:US) plunged 69 percent to $3.33. ADRs of Lloyds Banking Group Plc (LYG:US), the U.K.’s biggest mortgage lender, tumbled 58 percent to $2.61.

JPMorgan Chase & Co. (JPM:US) retreated 21 percent to $18.09. Citigroup Inc. (C:US) lost 20 percent to $2.80. Wells Fargo & Co. (WFC:US), which Friedman Billings Ramsey Group Inc. said will probably cut its dividend during the first half of this year, sank 24 percent to $14.23.
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Bank of America Corp. (BAC:US) dropped the most in the Dow Jones Industrial Average, slumping 29 percent to $5.10. The biggest U.S. lender by assets needs at least $80 billion to restore capital to minimum levels required by regulators, according to Friedman, Billings, Ramsey Group Inc. analyst Paul Miller.
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MGIC Investment Corp. (MTG:US) slid 24 percent, the most since Dec. 1, to $2.13. The largest U.S. mortgage insurer posted a sixth straight loss and predicted an unprofitable 2009 as the deepening U.S. recession will cause more homeowner defaults. The company’s fourth-quarter operating loss of $2.06 a share was worse than the expected deficit of $1.14, according to the average estimate of six analysts surveyed by Bloomberg.
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Regions Financial Corp. (RF:US) lost 24 percent to $4.60, the steepest decline since Sept. 29. The Alabama bank that expanded in Florida a year before the mortgage market collapsed posted a fourth-quarter loss of 35 cents a share, excluding a goodwill charge. Nineteen analysts surveyed by Bloomberg estimated Regions would post a 9-cent loss for the quarter.

Other regional banks also slipped. PNC Financial Services Group Inc. (PNC:US) sank 41 percent to $22. Sovereign Bancorp Inc. (SOV:US) fell 18 percent to $2.
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State Street Corp. (STT:US) had the biggest drop in the Standard & Poor’s 500 Index, sliding 59 percent to $14.89. The world’s largest money manager for institutions said 2009 operating profit will be little changed from last year after fourth quarter earnings fell 71 percent.

Other asset-management firms also declined. Bank of New York Mellon Corp. (BK:US) fell 17 percent to $19. Northern Trust Corp. (NTRS:US) slid 14 percent to $43.93. Legg Mason Inc. (LM:US) fell 18 percent to $17.34. American Capital Ltd. (ACAS:US) dropped 20 percent to $3.66. Calamos Asset Management Inc. (CLMS:US) slid 16 percent to $5.29.

Not a bad day, altogether. SplitShares got whacked, not surprisingly given their dependence on financial common stock. But if the decline in PerpetualDiscounts was credit-related, then why were Fixed-Resets up? Volume continues to be quite good. BNS.PR.T closes tomorrow … and then there will be no more new issues announced but not closed!

Not much news, in light of the holiday in the US and preparations for tomorrow’s Obama-rama.

Willem Buiter writes a piece with a rather startling message: Time to Take the Banks Into Full Public Ownership.

He points out the Bagehot prescription of readily available expensive liquidity can have an unfortunate side-effect:

But if the state’s financial assistance is priced punitively or has other painful conditionality attached to it, existing shareholders and management will do everything to avoid making use of these government facilities. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible – to get the government out of its hair. Such a bank will therefore be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity (sometimes in the form of deposits/reserves with the central bank) to regain its independence from the government. Still independent banks will hoard liquidity to stay out of the clutches of the government.

I believe that this mechanism is at work in a powerful way both in the UK, the US and in continental Europe. Hans Werner Sinn in a recent Financial Times OpED piece pointed out that the German rescue package for banks was fatally flawed for precisely this reason: the acceptance by banks of an injection of public sector capital brings with it a cap on managerial salaries. Rather than accepting a cap on their salaries, managers would prefer to totter along with an under-capitalised bank and restrict the scope and scale of their lending operations.

However, I am unconvinced that the alternatives he suggests are really any better:

By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.

There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles.

The implicit presumption is that government will be able to do it better. I’m not so convinced; political control over the lending process will – inevitably – mean a relaxation of lending standards to handicapped black lesbians and other disadvantaged groups, on the basis of their disadvantage and political advantage, not ability to pay. We are seeing movement towards of this conditionality in the States already, a by-product of TARP’s cheap money:

House Financial Services Committee chairman Barney Frank, D-Mass., on Friday released proposed legislation to reform the TARP and increase program accountability. Under Frank’s proposed makeover of the TARP, the second half of the $700 billion funds will be “conditioned on the use of a minimum of $50 billion for foreclosure mitigation.” His language would require Paulson to develop a comprehensive plan to prevent and mitigate residential mortgage foreclosures by March 15, 2009. The required elements of the plan include a guarantee program for qualifying loan modifications under a systematic plan and bringing down the costs of Hope for Homeowner loans “either through coverage of fees, purchasing H4H mortgages to ensure affordable rates, or both.” The plan would also need to establish a program for loans to pay down second lien mortgages that are impeding a loan modification, grant servicer incentives and assistance to stimulate modifications, and include the purchase of whole loans for the purpose of modifying or refinancing them.

I suggest that a better alternative to full nationalization that addresses Mr. Buiter’s concerns is to give the funding government a fair bit of call protection on its capital injection, while allowing the subject banks to operate on a business-like basis. The current terms do not allow this:

Our current understanding is that that the preference shares to be acquired by the government will rank pari passu with existing Tier 1 instruments in payment and in liquidation. The new preference shares will carry a 12% coupon and will be callable after five years. Banks selling preference shares to the government may not pay dividends on common equity while any of those preference shares remain outstanding. This clearly gives the banks an incentive to repay the government preference shares as soon as possible.

The five year call-protection makes sense; the restriction on common dividends does not. And, what’s more, these should be public issues, with a prospectus, stock-exchange listing and government guarantee of successful issuance.

Floaters did poorly today, perhaps in a last minute panic about tomorrow’s BoC rate announcement amidst speculation that there will be a 50bp cut to 1.00%. I will be interested not so much as to what happens to the Bank Rate as what happens to prime – I can’t see a cut of more than 25bp in prime whatever happens, but … I’ve been wrong before!

The day was enlivened somewhat by reports of excited groupies at the Financial Forum and by the closing quote of BNS.PR.S at 26.00-99.99. Whatever happened to the good old days of bid-without? There is still no indication of what SunLife wants to do with its holding; but surely at some point Sections 711 & 712 of the TSX Company Manual will become applicable:

Sec. 711.

TSX will normally consider the delisting of securities of a listed issuer if, in the opinion of TSX, it appears that the public distribution, price, or trading activity of the securities has been so reduced as to make further dealings in the securities on TSX unwarranted.

Sec. 712.

Specifically, participating securities may be delisted if:

(a) the market value of the listed issuer’s issued securities that are listed on TSX is less than $3,000,000 over any period of 30 consecutive trading days; or
(b) the market value of the listed issuer’s freely-tradable, publicly held securities is less than $2,000,000 over any period of 30 consecutive trading days; or
(c) the number of freely-tradable, publicly held securities is less than 500,000; or
(d) the number of public security holders, each holding a board lot or more, is less than 150.
Non-participating securities will be subject to (b) above as well as Section 711

Still and all, you know, I’m sorely tempted to buy 100 shares at 99.99, just so I can insist on delivery!

PerpetualDiscounts were off a bit today, closing to yield 6.85% dividends, equivalent to 9.59% interest at the standard 1.4x conversion factor. Long corporates are still at about 7.5%, so the pre-tax interest-equivalent spread remains at around the 210bp level achieved on January 9.

Another piece of history gone! Across the Curve notes that Treasury has called the 13.25 of May 2014:

I recall that bond as the last bond to trade at 14 percent. It was issued as a 30 year bond in May 1984. In those days the treasury issued callable long bonds but the call protection was 25 years. Anyway, on the settlement day May 15 1984 the owners threw up all over their shoes and the futures market was down limit. The new bond traded to 14 percent in the cash market. The rest is history as its successor sees nothing but buyers today in the 2.80s.

The New York Fed has endorsed the recent TMPG initiative to charge for fails:

The Federal Reserve Bank of New York endorses the Fails Charge Trading Practice published today by the Treasury Market Practices Group (TMPG) and strongly encourages its adoption by all market participants. The Fails Charge Trading Practice provides a feasible method for market participants to implement the TMPG’s previously announced recommendations for addressing widespread settlement fails in the U.S. Treasury market. The New York Fed is convinced that universal adoption of the trading practice is a crucial step in alleviating the chronic fails problem that currently threatens to constrain Treasury market liquidity and function. The New York Fed will adopt this new trading practice in its own market operations.

Accrued Interest provides some interesting colour on Agencies & MBS, observing:

MBS suffer from a severe negative convexity problem. MBS investors have essentially sold short an interest rate option to the underlying mortgage borrowers. Those borrowers are now almost universally in the money. Many borrowers will have difficulty actually refinancing (more on that below) but regardless, the price for MBS securities will have difficulty rising above $104 or so with an embedded in-the-money option with a $100 strike.

To see what I mean, notice the price spread across the coupon stack (using Fannie Mae 30-year MBS for February settlement):

4.5% Coupon: $101.938
5%: $102.750
5.5%: $103.203
6%: $103.656
6.5%: $104.500
This is the current dollar price for a mortgage security with the indicated coupon.

Tomorrow is the last day of trading of TXPR prior to its rebalancing, which is effective at the opening on Monday 19th. Those with an interest in some of the lower volume issues affected (e.g., ACO.PR.A, NSI.PR.C, NSI.PR.D) may wish to put in stink-bids and stink-offers,as it is possible (possible!) that CPD and other indexers may be willing (or forced!) to trade at a spread to market.

Another day of pretty good volume. PerpetualDiscounts were off again … but having survived 4Q08, I’m decidedly unimpressed by any overall move of less than a point.

Donato Masciandaro writes an opinion piece on VoxEU: Basel 3: Supervising the credit giants with progressive capital ratios:

The too big to fail rule therefore represents an authentic paradox – in the presence of risk of systemic crisis, the rule must be temporarily adopted to prevent the crisis from actually worsening, but if it is not credibly revoked, it pushes the system towards an unstable and inefficient oligopoly.

But can the too big to fail rule be revoked after the financial crisis ends? It may be difficult since the law has never been written, but it is always imminent in oversight procedure. But if government insurance against the insolvency of large banks is difficult to abolish, the government could try making them pay. Defining the correct plan for such a distinctive kind of insurance would not be simple, but the current situation could certainly be improved upon. Now, large banks could reasonably believe that they are covered by a subsequent implicit insurance in case of an insolvency risk. Banks do not pay a corresponding initial premium, however, as the prudent regulation plan does not mention bank size, at least from this point of view.
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New ideas are needed: capital coefficients that, equal to other risks, consider the “irresponsibility risks” that could increase bank sizes out of proportions, for example. Thus, non-proportional capital coefficients which are progressive in relation to the activity volume are needed, possibly divided into size groups. In order to “put a price” on government insurance in favour of credit giants, non-conventional regulatory solutions need to be explored, striving to remain in line with the foundation of a market with prudent regulation. It is not simple, but it would be better than pretending that the problem did not exist.

I support the idea; particularly if it is paired with the idea of weighting risk-weighted-assets differently according to either the “trader” (investment bank, dealer) or “investor” (regular bank) regime chosen by the entity.

Action today was dominated by settlement of three new issues (bank fixed-resets), each of which made it into the volume tables, unsurprisingly. PerpetualDiscounts were off.

BMO is buying AIG’s Canadian life insurance business. Nice to see the balance sheet of a Canadian bank being put to work.

Professor Axel Leijonhufvud has written a two part series on Vox (commencing yesterday) in which he concludes in part:

Two elements of a reconstructed system of regulatory control may be suggested.

First, re-impose effective reserve requirements on deposit-taking banks and extend them to all types of institutions that carry demand liabilities (e.g. money market funds).

Assiduous Readers will remember that I have called for bank-sponsored money market funds to be consolidated in their sponsors’ balance sheets for risk measurement purposes.

The ABCP soap-opera appears to be finally grinding to a resolution as the restructuring has received final approval. Investor Advocates will be pleased to learn that regulators now have judicial imprimatur to restrict investments even further:

Judge Campbell urged regulators to be more watchful about complicated products such as ABCP in the future.

He questioned whether investors and investment advisers “truly understood” what they were selling, and he went on to “urge regulators to sort out what investments should be available to whom.”

Soon only mutual funds will be legal for retail because, you know, you’re just not smart enough for anything else. The government says so, and they’re here to help you.

PerpetualDiscounts returned to their winning ways today.

You know what the trouble with TARP is? I’ll tell you what the trouble with TARP is. The trouble with TARP is there’s not enough box-ticking and there’s not enough feel-goodism and there’s not enough publicity for regulators. Fortunately, the FDIC is taking proactive steps to proactively rectify these shortcomings in a proactive manner:

• The FDIC expects that state nonmember institutions (or their parent companies) will deploy funding received from these federal programs to prudently support credit needs in their market and strengthen bank capital.
• In order to assess how participation in these federal programs has helped the institution support lending and/or support efforts to work with existing mortgage borrowers to avoid unnecessary foreclosures, FDIC-supervised institutions should implement a process to document how these funds were used. State nonmember institutions should describe their utilization of this federal funding during bank examinations and are encouraged to summarize such information in published annual reports and financial statements. Including such information in public reports will provide important information for shareholder and public evaluation of participation in these programs.

All good things must come to an end, usually pretty soon, and the PerpetualDiscount winning streak was halted today. Just a whisker, but a loss never-the-less. Split-shares were hit hard, presumably due to stock market declines.