Category: Market Action

Big excitement for US Municipals as Vallejo, California, intends to enter bankruptcy:

The city council’s unanimous decision makes the San Francisco suburb the largest city in California to file for bankruptcy and the first local government in the state to seek protection from creditors because it ran out of money amid the worst housing slump in the U.S. in 26 years.

The city of 117,000 is facing ballooning labor costs and declining housing-related tax revenue that have left it near insolvency. The city expects a $16 million deficit for the coming fiscal year that starts July 1. Under bankruptcy protection, city services would keep running. It would freeze all creditor claims while officials devise a plan for emerging from bankruptcy.
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The area has been one of the hardest hit in Northern California by the housing market slump. Home prices in Solano County, where the town resides, dropped 19 percent in January from the year before, according to DataQuick Information Systems, a firm which tracks real-estate markets in the state.

This ties in nicely with the report from Accrued Interest that MCDX has commenced trading:

From the people who brought you the ABX, now comes the MCDX, a basket of municipal credit default swaps (CDS). The index will begin trading on May 6 with three, five, and ten year tenors. Markit set the coupon for the MCDX last Thursday night at 35, 35, and 40bps respectively. It started trading today, and traded wider, closing at 42bps for the 5yr tenor and 48bps for the 10-year.

This is a potential game changer in the municipal market. First, we’ll go over what the MCDX is, and then how it might change municipals forever.

The MCDX is going to be very similar to the CDX or ABX indices currently trading. It will represent a basket of 50 equally weighted municipal CDS. You can see the list of credits here. These will be recognized by municipal traders as more or less the 50 largest regular issuers of bonds. There are a few AAA credits in there, but mostly AA and A-rated credits. If rated on Moody’s Global Scale, the one where Moody’s attempts to match muni ratings with corporate ratings, almost all of these issues would be AAA.
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buyer of protection on the MCDX has essentially bought equal amounts of protection on the 50 names in the index. So a $10 million notional trade in the MCDX is de facto $200,000 in protection on each of the 50 names. Should any of the names default, the buyer of protection would deliver an eligible obligation of the issuer to the seller of protection at par. Markit has provided a list of CUSIPs as examples of eligible obligations. Any bond which is pari passu with the listed CUSIP would be eligible.
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To date, trading in municipal CDS has been very light, and with good reason. Default rates of general obligation and essential service municipals are almost non-existent. There is a limited number of large and frequent issuers outside of these two categories. So demand from hedgers for specific names is light. There might be demand from speculators who want to bet on the contagion hitting munis. But such a buyer would prefer to make a generalized bet on municipal credit as opposed to picking out individual credits.

To me, this product sounds like just another speculative recipe for disaster.

In the first place, consider the theoretical underpinnings of the CDS market: if I buy a 5-year corporate for cash and then buy credit protection for it, then what I’ve got – to a first approximation, ignoring liquidity effects – is 5-year bank paper.

If I buy 5-year bank paper and sell credit protection, then I’ve got – first approximation – full exposure to the corporate bond.

But there are tax effects with munis, since their coupons are not taxable, which is why (in normal times) they trade through Treasuries. Buying bank paper and selling municipal credit protection means I have to worry about tax effects and cash flow differences. Hence, there is no natural seller of municipal credit protection.

The other problem with the contract is that it is entirely cash settled – there is no mechanism whereby I can exchange for physicals. If I take a position on a bond future, I can sit on it until the last delivery date, when I will either take or make delivery (I might be forced to take delivery earlier, if I’m long). This enforces convergence between the cash and futures markets. But nothing of the kind happens with MCDX … I cannot sit on my 100-million position and, when it comes due, elect to take or make delivery of 50 x 2-million CDS contracts of the underlying.

Why is this important? Well, we’ve seen what’s happened in the ABX markets, as the Bank of England has followed PrefBlog’s lead and pointed out that ABX prices are connected to reality only in the very loosest sense.

So … we’ve got a market that I predict will quickly become dysfunctional. Speculators and hedgers will be buying up vast quantities of contracts and forcing the prices to dizzying heights, probably with ludicrous gyrations. Those willing to take a short position from time to time might – if they restrain themselves and don’t over-lever – just might do very well out of this.

Accrued Interest follows up with yet more US municipal news:

UBS is exiting the muni business, and are looking to sell the unit. They were the #3 underwriter, so it would have to be someone quite large to buy the business. Let’s see, who among the large dealers doesn’t have much in munis? I know! Bear Stear–… Er… Actually I don’t know who the hell will buy UBS’ muni unit. If they do want to make a move they need to do it fast. Otherwise rivals will start picking off the best muni bankers one by one until finally there is nothing left of the unit worth buying. One reader and I had a off-line chat about this and he suggested that there could be a re-regionalization movement in municipals. In other words, a movement away from consolidation in New York and toward mid-sized dealers gaining more power in that market. Lately spreads (meaning commission spreads) have been wider, especially in secondary trading. If that keeps up, look for regional brokerages to benefit.

I know! As briefly discussed on April 22, Bank of Montreal has recently become “the sixth-largest bank qualified municipal bond dealer in the United States and the largest in Illinois” … they might be interested! Of course … they might be even more interested in becoming one of the rivals picking dealmakers off the UBS desk one by one …

There was a long discussion on April 29 about the Fed’s plans to pay interest on reserve balances; today Bloomberg reports that:

Fed staff started discussions this week with Congress about bringing forward the date that interest can be paid, the person said on condition of anonymity. Technical details of how the program would work, and what rate the Fed would pay, would likely need further study and discussion by the FOMC, the person said.

If the Fed paid an interest rate equal to the federal funds rate, commercial banks would avoid dumping any excess cash into the money market, which in the past has driven rates below the Fed’s target.

The New York Fed bank’s Open Market Desk is charged with buying and selling Treasuries with 20 Wall Street securities firms to keep the main rate close to the target set by the FOMC.

The desk has struggled to keep the federal funds rate stable as banks attempted to manage their reserves at a time when credit markets were seizing up.

On May 2, the federal funds rate ranged from 0.1 percent to 2.5 percent even though the target was 2 percent. On April 23, the rate fell as low as 1 percent and rose as high as 10 percent, compared with the then-target of 2.25 percent.

“The inter-bank interest rate is going to be stabilized with this policy,” said Marvin Goodfriend, a professor at Carnegie Mellon University’s Tepper Graduate School of Business and a former Richmond Fed policy adviser who has published research on interest on reserves.

Assiduous Readers will remember my prescription for the US mortgage market:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)
• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

… which was referred to on March 18. The call has been taken up (in part) by Thomas Palley, “an economist living in Washington DC” (hat tip: Naked Capitalism):

First, the capital gains exemption should be abolished for all new home purchases. Instead, the base cost of houses should be indexed to inflation so that homeowners are not taxed on inflation gains. Existing homeowners should be grand-fathered under current law to discourage selling to protect unrealized gains, which would destabilize the housing market.

Second, the ceiling (currently $500,000 per taxpayer) on mortgages qualifying for interest deductibility should be gradually lowered to zero over a ten-year period.
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Third, since everyone needs housing, the Federal government should phase in a refundable housing cost tax credit available to all, regardless of whether they own or rent.

I must admit, I don’t think the third point’s conclusion necessarily follows from the premise! But at least the issues are being aired.

There’s an interesting state of affairs at MBIA:

MBIA Inc. has yet to pass on $1.1 billion of capital to its insurance subsidiary, three months after raising the money to defend the unit’s AAA credit rating.

The cash, raised in a February stock sale, is being held at the parent company while Armonk, New York-based MBIA develops a plan for the company’s legal and operating structure, MBIA Chief Executive Officer Jay Brown said in a letter to shareholders released yesterday.

“Given the more than adequate liquidity in both our insurance and asset management businesses, there is no compelling reason to move this cash at this point,” Brown said.

MBIA was criticized by Fitch Ratings, which said on April 4 the decision raised the risk that the cash may not end up as capital for the insurance unit as MBIA had promised. While Fitch downgraded MBIA to AA from AAA, Moody’s Investors Service and Standard & Poor’s cited the capital raising as a reason for keeping the insurance unit at AAA.

Regulators are waiting for MBIA to contribute the funds, according to New York State Insurance Department Deputy Superintendent for Property and Capital Markets Michael Moriarty.

“It was never our expectation that the funds raised would go anywhere other than to the insurance subsidiary,” Moriarty said. MBIA spokesman Jim McCarthy declined to comment.

Jiggery-pokery, or simply flexibility? One way or another … if I was an MBIA counterparty, I’d be making sure their collateral was good!

And it looks like the big Wall Street dealers are going to have to lift their skirts a bit:

The U.S. Securities and Exchange Commission will require Wall Street investment banks to disclose their capital and liquidity levels, after speculation about a cash shortage at Bear Stearns Cos. triggered a run on the firm.

“One of the lessons learned from the Bear Stearns experience is that in a crisis of confidence, there is great need for reliable, current information about capital and liquidity,” SEC Chairman Christopher Cox told reporters in Washington today. “Making that information public can certainly help.”

We’ll see what the details are, but this is a good development for investors.

Unfortunately, due to complications arising from a symphony orchestra and a pretty girl, I am unable to report on the indices, issue performances or volume highlights tonight. Sorry, folks! Don’t you wish I had the HIMIPref™ indices all up to scratch, so that the bulk of the report generation would be a button-push? Me too. But I’ll update sometime tomorrow.

Update, 2008-5-8

There were eighteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Accrued Interest seems to have sparked a controversy, as his post from yesterday on the influence of recession timing on corporate spreads attracted some comment. He notes that his estimate of fair value (for spread due to default risk) of 34bp has been countered with an estimate of 140bp, and defends his figures while asking for backup from his interlocuter.

Fannie Mae lost a lot of money and has to return to the well:

it will raise $6 billion in capital as the worst housing slump since the Great Depression deepens.

The first-quarter net loss was $2.19 billion, or $2.57 a share, Washington-based Fannie Mae said in a statement. Analysts were expecting a loss of 64 cents a share, the average of 12 estimates from a Bloomberg survey.
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The government-chartered company, which sold $7 billion of preferred stock in December, may need as much as $15 billion to cope with delinquencies and foreclosures, analysts including Paul Miller of Friedman, Billings, Ramsey & Co. in Arlington, Virginia, said.

Naked Capitalism has republished extracts from a NYT article on Fannie and Freddie. There are concerns that their accounting is insufficiently conservative:

Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss.

Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure. But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.

Meanwhile, the level of Level 3 assets held by the major brokerages has been rising dramatically:

Merrill Lynch & Co. said so-called Level 3 assets climbed 70 percent in the first quarter, as the largest U.S. brokerage reclassified commercial mortgages and other assets as hard to value.

Merrill’s Level 3 assets, the firm’s most difficult to value, rose to $82.4 billion as of March 28 from $48.6 billion at the end of December, according to a regulatory filing today. The New York-based company’s ratio of Level 3 to total assets rose to 8 percent from 5 percent.
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Merrill’s Level 3 assets include mortgage-related holdings which sit within trading assets of $9.3 billion, according to the filing. Derivative assets accounted for $20.6 billion, loans measured at fair value for $12.5 billion, credit derivatives for $18 billion and private equity and principal investments for $4.3 billion, it said.

Other New York-based securities firms have also had a rise in Level 3 assets. Goldman Sachs Group Inc.’s holdings of the assets surged 39 percent to $96.4 billion in the fiscal quarter ending in February. Morgan Stanley reported a 6.1 percent increase to $78.2 billion.

Citigroup Inc., the biggest U.S. bank, yesterday said Level 3 assets rose by 20 percent in the first quarter to $160.3 billion.

Countrywide is cutting off some HELOC lines:

Countrywide Financial Corp. has suspended the home equity credit lines of almost all its Las Vegas customers
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Since January, Countrywide, Bank of America Corp., Washington Mutual Inc. and IndyMac Bancorp Inc. have frozen about 600,000 equity credit lines nationwide, said Michael Kratzer, president of a Bankrate Inc.-owned Web site that’s fielding consumer complaints. The lenders are targeting borrowers in cities where property values are falling, including Las Vegas, Chicago and Los Angeles, he said.

There was a monster bond deal announced today:

GlaxoSmithKline Plc, Europe’s biggest drugmaker, increased the size of its bond offering by 50 percent to $9 billion, which would make it the largest U.S. corporate bond offering in six years.

The sale, scheduled to occur as soon as today, will be split between $2.5 billion of 5-year notes, $2.75 billion each of 10- and 30-year bonds, and $1 billion of two-year floating-rate notes, according to a person familiar with the transaction who declined to be identified because terms aren’t set.

GlaxoSmithKline also lowered the yields at which it is offering the debt. The fixed-rate notes are now all expected to yield 173 basis points more than similar-maturity Treasuries and the two-year debt is expected to pay interest of 62.5 basis points more than the three-month London interbank offered rate, according to the person.

The fixed-rate notes were earlier marketed at a spread of about 175 basis points to Treasuries and the floating-rate securities were expected to pay interest of 65 basis points more than Libor. A basis point is 0.01 percentage point. Libor, a borrowing benchmark, is currently set at 2.76 percent.

The offering is the biggest since General Electric Co.’s finance arm sold $11 billion of bonds in 2002 in the fourth- largest corporate offering ever, according to data compiled by Bloomberg.

Volume picked up in a down day enlivened by a Fortis new issue announcement.

There were twenty-six other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Sorry, folks! Words of wisdom are in short supply today, so I’m just going to supply the links.

What are Corporate Bonds Worth in a Recession – Accrued Interest, excellent!

Yahoo! offer abandoned – Bloomberg

Credit Crunch Hitting Main Street – Bloomberg

Target monetizing its credit card receivables – Bloomberg

Bank of America affirms committment to Countrywide – Bloomberg

There were fifteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Finally, there is a good crop of links today!

James Hamilton of Econbrowser remarks on a WSJ article about prime no-doc loans, which arose through a Countrywide “Fast and Easy” programme which generated no-doc / low-doc loans which were then sold to Fannie Mae, which has classified them as “Prime”. He has been taken to task in the comments (there are claims that this is not only not news, but isn’t even interesting, since the borrowers were approved due to high credit scores and low loan-to-value). Regardless of whether the story is simply an example of media hysteria, I am as concerned as he is about the big issue:

From page 102 of Fannie’s 2007 Annual Report, as of the end of 2007, the enterprise had leveraged $44 B in stockholders’ equity with $796 B in short- and long-term debt to acquire $761 B in mortgages either held outright or intended for resale or trading. I read that as an equity cushion against a 5.8% loss on the mortgages held directly (44/761 = 0.058). But in addition (page 1), Fannie has guaranteed $2.1 trillion in separate mortgage-backed securities it has sold to outside investors, for a ratio of core capital to total book of business of 1.6%.

From the beginning, my conception of a really big financial meltdown would be one that pulls one of the GSEs into insolvency. Please tell me why it can’t happen.

The GSEs have to start being regulated like banks; there’s no question in my mind about that.

Congress pressured the Fed to rescue the moribund Student Loans securitization market:

A month after the Federal Reserve rescued Bear Stearns Cos. from bankruptcy, Chairman Ben S. Bernanke got an S.O.S. from Congress.

There is “a potential crisis in the student-loan market” requiring “similar bold action,” Chairman Christopher Dodd of Connecticut and six other Democrats wrote Bernanke. They want the Fed to swap Treasury notes for bonds backed by student loans. In a separate letter, Pennsylvania Democratic Representative Paul Kanjorski and 31 House members said they want Bernanke to channel money directly to education-finance firms.

… and, somewhat surprisingly, the Fed responded:

The Federal Reserve announced today an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.
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In addition, the Federal Open Market Committee authorized an expansion of the collateral that can be pledged in the Federal Reserve’s Schedule 2 Term Securities Lending Facility (TSLF) auctions.
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The wider pool of collateral should promote improved financing conditions in a broader range of financial markets.

Bloomberg points out that securitized Student Loans are now eligible:

Fed officials also expanded the collateral they accept under the Term Securities Lending Facility to include AAA rated asset-backed investments. About 95 percent of outstanding student-loan securities are AAA, according to the American Securitization Forum.

In other political news, there are rumblings of tweaking capital requirements for brokerages, which is being puffed up as a major change.

Meanwhile, in deeply upsetting news, I have been advised that the Hershey’s January price increase has percolated through the system to the point where “Mr. Big” chocolate bars are having their price yanked from $1.25 to $1.35. This implies that my total cost of living has increased by 4%; PrefBlog’s future quality may be adversely affected due to malnutrition.

The Globe reports that a decision on ABCP will be delayed:

The judge overseeing the $32-billion restructuring of the seized-up market for asset-backed commercial paper wants to put off a ruling on the plan’s fairness until mid-May, saying he needs more time to review the complex case.

Ontario Superior Court Justice Colin Campbell, who was originally scheduled to rule on the fairness on Friday, said he would like to hold the so-called “sanction” hearing on May 12 and May 13, but could do it sooner in a pinch.

To give more time, the judge asked that a key standstill agreement with banks that prevents a meltdown in the market be extended. The current standstill expires May 9.

“I can’t think possibly how I can get a decision out by May 9,” the judge said.
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The deal, however, includes a controversial clause that would give all the players in the market immunity from lawsuits, something that has angered many holders and led to challenges in court that the judge wants more time to consider.

The lawsuits, if allowed, could run into many hundreds of millions, according to court documents filed Thursday. Aeroports de Montreal, Air Transat A.T. Inc., Cinar Corp., Labopharm Inc. and dozens of other companies laid out the claims they believe they have, which total at least $700-million.

As indicated by Assiduous Reader madequota in the comments to May 1, today was a pretty good day for prefs … but volume was lacklustre. Banks still need to raise cash and we haven’t seen an insurer come to market for quite some time … so there is considerable room for carping regarding the market’s ability to absorb new issues and bad news. Long corporates now yield a hair less than 6.00% so the dividend of 5.72% on PerpetualDiscounts (= 8.01% Interest Equivalent) represents a spread of 200bp … within the range of the last six months.

There were eleven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Today’s Workers’ Day, so I’m not doing much. Geez, if I get any lazier, I’m gonna have to become an investor advocate!

But I can’t resist commenting on US Pension Bonds:

Pension bonds are making a comeback, as states and cities from Alaska to Philadelphia bet they can use the proceeds to help fill deficits in their retirement funds and still generate a higher return than what they pay in interest.

Officials may sell a record $35 billion of the securities this year after offerings declined since 2003, according to data compiled by Bloomberg. Connecticut issued $2.2 billion of pension debt last month, paying an average rate of 5.88 percent on money state officials project will earn 8.5 percent when invested.

Hmmm … leveraging up a pension account to hell-‘n’-gone … I have to agree with Jon Corzine:

“It’s the dumbest idea I ever heard,” said New Jersey Governor Jon Corzine, the Democrat and former chairman of investment bank Goldman, Sachs & Co.

Naked Capitalism republishes a Financial Times commentary on the CDS basis:

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”

We need more people trading the basis, that’s what we need! Unfortunately, shorting cash bonds is fraught with peril and expense on the borrowing front, so straightforward arbitrage will not happen … what needs to happen is more real-money bond investors willing to write covered CDS as a synthetic bond. As has been noted, though, there are counterparty and convergence problems with such a process so, if it ever happens, it will be the province of big, big shops who can afford to set up a specialty unit.

Avinash Persaud writes in VoxEU on a topic close to my heart: The Inappropriateness of Financial Regulation. He argues that the root of the problem is:

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

… but cautions that …

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact.

Instead he suggests that:

• Capital charges (when computing regulatory ratios of financial strength) should be contra-cyclical (rising when credit risk is cheap and vice versa)
• regulation should be based on asset-liability mismatches, not bank/non-bank.
• “requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out.”

The first item sounds great, but might be a little difficult to apply in practice. Who decides whether risk is cheap or expensive? The weakness of the current system is also its strength: it provides a rules-based framework.

I disagree with the second item. Shadow banks are wonderful and the sector should be encouraged, to ensure the banks don’t get too fat on the fruits of regulation: insurance, central bank access and cheap financing.

The third item sounds like an attempt to intervene in the current UK debate on deposit insurance. The principle is great … let deposit insurance premia vary according to financial strength, as measured by standard capital ratios. I believe – although I’m not sure, and frankly, today I’m too damn lazy to check – that CDIC premia in Canada do vary, at least to some extent.

“Gummy” has announced a new spreadsheet that allows intraday updating of home-made indices. But watch out for dividend ex-dates!

There’s some fairly unclear reporting about BoC Governor Carney’s Senate appearance today. Bloomberg says:

The central bank would be hard-pressed to rescue financial institutions as the U.S. Federal Reserve did with Bear Stearns Cos. earlier this year, Carney hinted.

“People bear the cost of their decisions,” he said. “In the case of financial institutions which would have taken excessive risk, the people who bear the consequences of that are the shareholders and the senior management. There should never have been any doubt about that.”

The Bloomberg story also says, by the way:

Carney said potential losses from the global credit crisis are hard to gauge, because financial institutions have used derivatives to estimate the value of some assets that are difficult to trade. The derivatives have “implied default probabilities” that are “substantially higher” than history would indicate and thus may be overstated, he said.

… which is just what I’ve said about the IMF report. The Bloomberg story was picked up essentially unchanged by the Financial Post. As far as I can tell, the Globe doesn’t mention the Bear Stearns speculation, even in the story about acceptable collateral. The Canadian Press story says:

Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

“If you cannot make a judgment (on the value of an asset), you should not own the security,” Carney told a Senate committee Thursday.

“There is very high value if a situation came about to ensuring the shareholders and senior managers bear the full consequences of their actions,” Carney said.

“The Bank of Canada has a role to become lender of last resort, but we would do that on the advice of the Superintendent of Financial Institutions that the institution is solvent, not because the institution needed money.”

Carney said the central bank would come to the rescue of a chartered bank in the case of a temporary liquidity problem, if the institution had sufficient capital to be considered viable.

But he added if investors and managers thought there would always be a safety net, they would be encouraged to take inordinate risks in order to maximize profits.

What got me interested in this was the implied criticism of the Fed in the first quoted sentence, Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

So … did he actually mention BSC or is this merely reporter’s interpretation? Further, he’s saying that they’ll be the lender of last resort to solvent institutions … but BSC was solvent at the time according to all the information I have (which is confirmed by the SEC, which serves the same role that OSFI would serve in such a case) … so there’s no real contradiction there, in the remarks which are directly quoted. The rest is all standard Central Banker Talk and doesn’t need further interpretation.

A good, solid, positive day for the preferred share market. Volume was a little unusual – there were six issues trading in excess of 100,000 shares, but volume breadth was down.

There were ten other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Professor Dennis Snower reminds us on VoxEU that the effects of the credit crisis will be with us for a while, due to influences that both lag and interact:

• reduced interbank lending leads to less firm & household lending leads to reduced consumption and investment leads to reduced sales of goods and services leads to lower stock market valuations leads to lower interbank liquidity.
• unpaid mortgages leads to increased foreclosures leads to forced sales leads to lower prices leads to increased foreclosures.
• decreased household wealth leads to lower consumption leads to lower profits leads to lower investment leads to lower employment lads to lower labour income leads to lower consumption
• reduced US lending rates leads to a lower dollar leads to higher import prices leads to inflation leads to lower consumption and investment

Cheery fellow, isn’t he?

With respect to lagging effects, a Reuters story picked up by Calculated Risk quotes S&P:

“Due to current market conditions, we are assuming that it will take approximately 15 months to liquidate loans in foreclosure and approximately eight months to liquidate loans categorized as real estate owned (REO),”

The Fed announced:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

You, too, can be a Fed Watcher! According to me, the most telling change from the March 18 Statement is that April is missing the March sentence “However, downside risks to growth remain.” By me, I’d say the Fed’s done cutting. But what do I know? At least the Bear Stearns guy agrees with me. The fear is, as has often been mentioned here, that cuts in the Fed Funds rate are very broad in effect – perhaps too broad, they may be pushing on a string.

Accrued Interest, while careful not to get too precise, thinks that the 2-year note is cheap:

Unless the Fed’s favorite inflation gauges start rising, or the Fed really believes inflation expectations are rising, there will be no impetus for hikes any time in 2008.

Look back at the 2-year Treasury. The long-term spread between short-term inter-bank lending rates and Treasury rates is about 40bps. So if Fed Funds were going to remain at 2.25% for the next 2 years, fair value for the 2-year Treasury would be 1.85%. So with the 2-year actually in the 2.30% range, the market seems to be expecting Fed Funds to average something like 2.70% over the next 2-years.

Feels to me like that expectation is a bit high. If the Fed holds at 2% for 9 months, the Fed would have to hike 112bps immediately thereafter for Funds to average 2.70%. The hike would have to be more extreme if we used a discounting method rather than a straight average.

I’m not sure how much this analysis should be trusted, because the 2-year / FF spread is very sensitive to economics (it would be most interesting to know precisely how good a predictor of future Fed Funds rates the two year note is. I’m sure this has been looked at – post a link in the comments if you have one). AI has been taken to task in the comments …

Meanwhile, Carney said in Ottawa:

We at the Bank project that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to the Bank’s new projection for inflation; these risks appear to be balanced.

In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basis-point reduction announced last week, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada.

Month end was no great shakes, with routine volume and few significant price changes. Of note was W.PR.H which, after a day of weakness, fell out of bed completely in the last hour.

And that’s another month! CPD finished the month with the same NAVPS as last month: $17.60, total return zip, zero, zilch. My actively managed fund did much better, returning … somewhere between 0.50% and 1.00% … the precise value, in all its four-decimal-place glory, will be posted on the weekend.

There were sixteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

OK, finance geeks, there’s a big treat for you today! I’ve had a little look at the Fed’s push to accellerate payment of interest on reserve balances:

The Fed got the authority to start paying interest in October 2011 under the Financial Services Regulatory Relief Act of 2006, signed into law on Oct. 13, 2006. The reason for the late implementation was budgetary. Paying interest on reserves will reduce the amount of income the Fed earns on its securities portfolio and remits to Treasury each year. Congress pushed back the date of implementation to minimize the near-term impact on the deficit.

The cost isn’t astronomical. The Congressional Budget Office estimated that the cost in the first year would be $253 million, rising to $308 million by the fifth year, for a total $1.4 billion over five years.
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The Fed has already raised the issue with Congress, although it hasn’t made a formal push. Getting Congress to agree to swallow the cost a few years early in principle shouldn’t be hard since Congress has already set aside its adherence to the principal of “Paygo” — that all revenue reductions and cost increases need to be offset elsewhere. The Fed could also further reduce the cost by arranging to pay interest only on excess reserves — the amount that exceeds the required minimum.

The idea of paying interest on reserve balances was mentioned briefly on PrefBlog in the post US Fed and Negative Non-Borrowed Reserves, which was largely a copy/paste from January 29, 2008. The former post has just been updated, by the way, with a note from the Fed confirming that negative non-borrowed reserves is a mathematical triviality.

As mentioned there, the Fed has advocated interest payments on reserves for a long time:

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed’s revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.

The Fed didn’t put a number on this additional expense but, as noted above, the Congressional Budget Office did … roughly $250-million to $300-million annually.

The Fed’s arguments in favour of the idea are two-fold, based on ideas of market efficiency and considerations of monetary policy implementation, as described by then-governor Laurence Meyer in 1998:

Reserve requirements are now 10 percent of all transaction deposits above a threshold level. Requirements may be satisfied either with vault cash or with balances held in accounts at Federal Reserve Banks. Depositories have naturally always attempted to reduce such non-interest-bearing balances to the minimum. For over two decades, some commercial banks have done so in part by sweeping the reservable transaction deposits of businesses into nonreservable instruments. These business sweeps not only avoid reserve requirements, but also allow firms to earn interest on instruments that are, effectively, equivalent to demand deposits.

In recent years, developments in computer technology have allowed depositories to begin sweeping consumer transaction deposits into nonreservable accounts. In consequence, the balances that depositories hold at Reserve Banks to meet reserve requirements have fallen to quite low levels. These consumer sweep programs are expected to spread further, threatening to lower required reserve balances to levels that may begin to impair the implementation of monetary policy. Should this occur, the Federal Reserve would need to adapt its monetary policy instruments, which could involve disruptions and costs to private parties as well as to the Federal Reserve. However, if interest were allowed to be paid on required reserve balances and on demand deposits, changes in the procedures used for implementing monetary policy might not be needed.
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The prohibition of interest on demand deposits distorts the pricing of transaction deposits and associated bank services. In order to compete for the liquid assets of businesses, banks set up complicated procedures to pay implicit interest on what are called compensating balance accounts.
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The payment of interest on required reserve balances could remove the incentives to engage in such reserve avoidance practices.

These arguments were largely repeated by then-governor Donald Kohn in 2004:

In conclusion, the Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

One gets the feeling that the Fed, if required, could supply an entire bibliography of its attempts to obtain this authority! So could the Treasury!

They finally got their wish in 2006:

Law Passed to Pay Interest on Reserves, Effective in 2011
The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve banks to pay interest on reserve balances and gave the Board of Governors authority to lower reserve requirements on all transaction deposits (applied to deposits above a certain threshold level) to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent. These changes are not effective until October 2011.

I must confess failure in attempting to determing whether Fed Funds Loans are currently themselves reservable. The Reserve Maintenance Manual doesn’t cite these transactions explicitly. Sorry!

Now, there is some concern that this move will reduce interbank lending:

Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

… and, of course, we can always rely on Naked Capitalism to highlight scary bits.

One of the objectives in paying interest on reserve balances is, in fact, to ensure that reserve balances are still held, as explained by Governor Kohn in 2003:

However, if interest rates were to return to higher levels, sweep activity could intensify again and potentially become a concern. To prevent the sum of required reserve and contractual clearing balances from dropping even lower and to diminish the incentives for depositories to engage in wasteful reserve-avoidance activities, the Federal Reserve has long sought authorization to pay interest on required reserve balances and to pay explicit interest on contractual clearing balances. H.R. 758 would provide such authorization. With interest paid on required reserve balances, some sweep programs would likely be unwound, and new programs would be less likely to be implemented, thereby helping to boost the level of such balances. Eliminating such wasteful reserve-avoidance activities would also tend to improve the efficiency of the financial sector.

Payment of explicit interest on contractual clearing balances could result in an increase in the level of these balances; some depositories are currently constrained in the amount of such balances that can earn usable credits because of their limited use of Federal Reserve services. Moreover, payment of explicit interest would help to maintain the level of clearing balances at a time of rising interest rates. At present, some depositories pay for all their Federal Reserve services with credits earned on clearing balances; these institutions would not be able to use their additional credits if interest rates were to rise. If enough institutions were in this position, contractual clearing balances might drop below levels needed to be helpful for the implementation of monetary policy. With explicit interest, the level of balances on which interest could be effectively earned would not be limited to the level of charges incurred for the use of Federal Reserve services. Therefore, these depositories would not be impelled to reduce their balances when interest rates rise.

In other words, the Fed wants to be able to influence the market via the Fed Funds rate (as well as through reserve requirements, the discount rate and the hoped-for rate paid on reserves), but it won’t be able to do so if there is no Fed Funds market. In addition to the projected business efficiencies to be gained by allowing interest to be paid on demand deposits, the Fed hopes, by paying interest on the balances, to encourage participants to participate in the market in the first place.

There has been an interesting dust-up in the normally sedate world of analyst reports on Canadian banking … Citibank says Royal Bank of Canada might have billions in credit losses this quarter and Royal Bank says that’s horse-patootie. The analyst report is here (hat tip:Yahoo Message Boards). Citibank, by the way, is raising yet another $3-billion equity.

Via Bloomberg comes news that Markit is establishing a Municipal CDS Index. Whether or not contracts on this index will have a delivery option is unclear – I sure hope it does! Markit, by the way, is engaging in a live test of their disaster recovery plan:

Due to a flood in the London Bridge area which has caused an evacuation of the entire More London business district, Markit Group London is currently operating from its Disaster Recovery (DR) site. We appreciate your support whilst we strive to maintain full delivery of our products and services.

… good luck to them!

The Royal Bank new issue closed successfully, but had little impact on the overall market, in which volumes were normal and significant price changes rare.

There were seventeen other index-included $25-pv-equivalent issues trading over 10,000 shares today.

An article in VoxEU draws attention to Chapter 3 of the IMF April 2008 World Economic Outlook, specifically Chapter 3, The Changing Housing Cycle and the Implications for Monetary Policy:

The main conclusion of this analysis is that changes in housing finance systems have affected the role played by the housing sector in the business cycle in two different ways. First, the increased use of homes as collateral has amplified the impact of housing sector activity on the rest of the economy by strengthening the positive effect of rising house prices on consumption via increased household borrowing—the “financial accelerator” effect. Second, monetary policy is now transmitted more through the price of homes than through residential investment. In particular, the evidence suggests that more flexible and competitive mortgage markets have amplified the impact of monetary policy on house prices and thus, ultimately, on consumer spending and output. Furthermore, easy monetary policy seems to have contributed to the recent run-up in house prices and residential investment in the United States, although its effect was probably magnified by the loosening of lending standards and by excessive risk-taking by lenders.

In other words, a well developed mortgage market has had the effect of increasing the liquidity of real-estate, and this effect must be explicitly considered when setting monetary policy.

I have to quibble with their table 3.1, which states that the average term of a Canadian mortgage is 25 years; it may be the average amortization, but the average term will be a lot closer to 5 years … perhaps much less, depending on the call provisions embedded in floating rate mortgages. Those who have endured my grumbling over the financing of long-term assets with short-term debt will note that financing houses with 5-year mortgages is a good example!

Box 3.1 is interesting, indicating (from IMF analysis) that while the US housing market appeared to get about 15% ahead of its fundamentals in the period 1997-2007, the crown is held by Ireland, with a 30+% pricing gap! Canada was negative – so those of us who are “property rich” can breathe a sigh of relief directly proportional to our trust in IMF analysis.

And, skipping along to the practical conclusions:

This chapter also examines the implications for monetary policy of changes in mortgage markets. First, it suggests that monetary policymakers may need to respond more aggressively to housing demand shocks in economies with more developed mortgage markets—that is, with higher LTV ratios and thus, presumably, higher stocks of mortgage debt. They may also need to respond more aggressively to financial shocks that affect the amount of credit available for any given level of house prices. Hence, the model would “predict” a more aggressive reduction of interest rates in the United States compared with the euro area in the face of recent turmoil in the credit markets—and this is in line with what has occurred so far.

Today’s fascinating fact is brought to you by Professors Kish & Robak in a paper published in September 2000:

Attaching a call feature to new debt for any reason was the norm for most of the twentieth century. For example, the majority of new bonds issued prior to 1986 contain a call provision. But over the past ten years, we observe that the number of call options on new debt is now a minority component. The intent of this study is to reproduce the work of Kish and Livingston (1992) for the period 1987-1996. The major structural change that occurred in the debt market warrants the reproduction of this study for the recent decade. For the 1977-1986 period, the ratio of callable to non-callable bonds is approximately 4:1, whereas the ratio during the 1987-1996 period approximates 0.5:1.

Thirty-year treasuries used to be callable after 25-years. One possibility that the authors did not examine was the possibility that embedded options may have simply been unbundled and are sold to the corporation as part of the underwriting package – which would certainly achieve the same sort of interest-rate protection to the company (albeit without the capital-structure flexibility) while giving the dealers some more chance to turn over their inventory. I honestly don’t know the answer to that question.

Main Man Flaherty was self-promoting again today:

Flaherty said the Canadian banks will establish and adopt leading practices for disclosure within 100 days, and expects the Bank of Canada to play a leadership role in some areas.

The minister said he plans to meet with the banks again “before the summer” to review the progress.

Sadly, there was no word regarding whether the seniority of Bankers’ Acceptances would ever be properly disclosed.

In what may well be related news, former World Bank President James Wolfensohn said:

said he’s “pessimistic” on the outlook for financial markets and predicted losses from the global credit turmoil may climb to $1 trillion.
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“It does seem to be a major adjustment on any level,” Wolfensohn said, after addressing the European Pensions and Savings Summit 2008. “There may be a $1,000 billion worth of losses in it somewhere.” He said he “cannot recall anything similar, certainly in the last 30 to 40 years that I’ve worked.”

The International Monetary Fund predicts that losses from the crisis, including those tied to commercial real-estate, may total $945 billion and says global economic expansion may be the slowest since 2003 this year. Wolfensohn said the fund’s loss forecast of about $1 trillion is now a “consensus estimate.”

Now, I don’t want to give the impression that I’m taking serious issue with any scary kind of number anybody wants to throw around. I don’t have easy access to the source data and I wouldn’t have time to look at them carefully even if I did. But we’re seeing in Canada that Flaherty is using the credit crisis in general and ABCP in particular to promote a federal securities regulator. And there are problems with the consistency of calculations in the IMF report. It seems to me that if I was a typical bureaucrat and I thought that scaring people to death would advance my own regulatory agenda, I’d ensure that my estimates erred on the generous side … that’s an old trick.

You can’t trust anybody.

Volume was lightish today, but enlivened by some activity in SplitShares … some managers, perhaps, adjusting positions after Friday’s downgrades? Market direction was mixed with a downward bias … we’re not far off the trough, you know! Total return on CPD (as an indicator) hasn’t been much more than zero since the mark was set in November – so things could prove interesting.

There were eleven other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Lots of speculation and exhortation in the air about the Fed FOMC meeting next week! Econbrowser‘s James Hamilton wants the rate constant at 2.25%:

…there is a compelling case that by rapidly bringing the yield on short-term Treasury bills well below the prevailing inflation rate, the Fed has played a role in the significant depreciation of the dollar and increase in the dollar price of virtually every storable commodity that we’ve seen since the beginning of January.
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If the Fed surprises the market with a pause, we should have unambiguous confirmation or refutation of the hypothesis that the Fed has been contributing to the commodity price run-up within 48 hours of the FOMC’s announcement. That knowledge in itself would also be extremely valuable– valuable to the Fed in calculating how to chart its course from here, and valuable in terms of making clear to the public why sometimes higher interest rates are the better choice for public policy.

Accrued Interest, however, is watching the unemployment numbers with more interest:

I think the worst of the liquidity crisis is past us, but we still have a weak economy will still be dealing with housing-related problems for a while. That will probably keep the Fed in a easy money mode for a while, which will be supportive of interest rates generally.

The thing to watch is primarily inflation data. I think bad housing data is mostly priced in (today’s rally supports this thesis), and while it could turn out worse than currently expected, inflation is actually the more important element for rates. Food and energy inflation has been problematic for a while, but the leakage into core inflation measures has been mild so far. The Fed has been gambling that it could afford to cut rates to improve liquidity because weaker employment would take care of the inflation problem.

If either employment is not as weak as currently expected and/or unemployment fails to contain inflation, the Fed will make a U-turn on rates.

Traders of 2-Years are betting there will be a pause:

“There’s been quite a shift in bond-market sentiment over the past few weeks,” said Nick Stamenkovic, a fixed-income strategist at RIA Capital Market Ltd. in Edinburgh. “The market has become increasingly confident that the worst is over for the financial sector and that the Fed is nearing the end of its easing cycle.”

Government bonds have lost 1.3 percent in April, indexes compiled by Merrill Lynch & Co. showed. The last time the securities declined was in June, when they fell 0.5 percent. The drop is the steepest since July 2003, when they shed 1.9 percent.

The two-year U.S. Treasury note yield rose to a three-month high of 2.50 percent today, before trading at 2.39 percent by 10:40 a.m. in New York, according to bond broker BGCantor Market Data. It has risen 65 basis points in the last two weeks. Yesterday’s government auction of $19 billion of five-year notes drew the least demand since 2003.

And, while financial companies are having to pay up for term money, they are able to issue in size:

Citigroup Inc. and Merrill Lynch & Co. led $43.3 billion of U.S. corporate bond sales, the busiest week on record, as financial companies sold debt at the highest yields since May 2001.

Sales compare with $31.2 billion last week and an average this year of $18 billion, according to data compiled by Bloomberg. Citigroup, the biggest U.S. bank by assets, sold $6 billion of hybrid bonds in the company’s largest public debt offering, while New York-based securities firm Merrill Lynch raised $9.55 billion by issuing debt and preferred securities.

On the other hand, the 30-day Fed Funds Contract is showing expectations of a hair over 2.00% until September, in line with the consensus reported by the WSJ of ‘one more, then stop’. Finally, the Cleveland Fed’s analysis of the options on this contract show an overwhelming expectation of 2.00%, with the “2.25% prediction” coming out of nowhere to take second place from the once strongly challenging “1.75% prediction”. We shall see!

There is a good story on Credit Rating Agencies published by the New York Times magazine:

Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

It’s all reasonably fair minded – as reasonable as one can expect, these days! The author saves himself the unpleasant experience of PrefBlog’s wrath by prefacing his suggestion that the Fed, inter alia bring credit analysis in house with the word “if”.

It’s all craziness. There is no good way to forecast credit. It’s all forecasting, as prone to error and changing circumstances as any other forecast … you do the best you can and diversify, by name, by asset class, by any other source of risk exposure. The only solution for such apparent failures of forecasting as sub-prime and Canadian ABCP is to say something along the lines of … “You put all your money in this stuff and now it’s all gone? Well, you’re stupid. Go away.” But it won’t happen.

My other quibble with the author’s conclusion is:

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future.

How about … rely on your own credit analysis or don’t buy it?

The vote on the Canadian ABCP restructuring has, apparently, approved the proposed plan, although with some reservations:

However, Jeffrey Carhart, a representative for the ad hoc committee read a statement prepared by the group disputing part of the plan that could potentially release certain financial institutions from lawsuits over selling ABCP to their clients.

“Those who are voting Yes by proxy are preserving their ability to argue both the validity and fairness of the planned release” from legal challenges, Carhart read.

… and the final (?) hurdle comes next week:

Mr. Crawford acknowledged that the committee has “some work to do next week” to face the legal challenges, which the judge overseeing the restructuring will consider at a fairness hearing scheduled for next Friday. Without the judge’s approval, the plan cannot go ahead.

In a ruling this week, the judge said that the corporate challengers had raised “very forceful arguments” about “a very serious issue of law” – whether the plan to extend immunity from lawsuits is legal.

I’ll just bet the corporate challengers have raised very forceful arguments! In some cases, it would appear that glorified bookkeepers recklessly overinvested in the asset class … the investing corporations could well be looking at a few investor lawsuits themselves.

On another topic, the Ontario Teachers Pension Plan has released its 2007 results (hat tip:FWF). Very impressive! Most debates regarding the value of active management implicitly consider all active managers to be equal, which is not the case … active management needs to be marketted, with the result that (i) marketers are in control of the process, not investment managers, and (ii) even investment managers must give some thought to explaining their choices. The split is not passive/active, but passive/active-captive/active-marketted. I have no data, but I’m willing to bet a nickel that active-captive, as a class, handsomely outperforms its benchmarks.

There were twenty-one other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Willem Buiter has commented on the BoE liquidity operation discussed by PrefBlog on April 21:

The Bank of England is now wholeheartedly committed to acting as market marker of last resort for systemically important securities for which the markets have become illiquid, not to say defunct, since the start of the crisis in August 2007.

Dr. Buiter’s phrase “market maker of last resort” was introduced in his post from last August.

The market maker of last resort function can be fulfilled in two ways. First, outright purchases and sales of a wide range of private sector securities. Second, acceptance of a wide range of private sector securities as collateral in repos, and in collateralised loans and advances at the discount window.

I cannot help but feel that this phrasing is imprecise, because “Market Maker” implies a transfer of ownership; in the current agreement, the participating banks continue to bear the risk of the instruments used to collateralize their loans. Dr. Buiter argued last August that injection of liquidity in the market sector where it was needed most to the participants who wanted it most would achieve desirable effects with less disruption to the general market than across-the-board reductions in the lending rate:

Central banks have not been doing the job of market maker of last resort effectively, indeed they have barely been doing it at all. Following the stock market collapse of 1987, the Russian default of 1998 and the tech bubble crash of 2001, all that the key monetary authorities have done is (1) lower the short risk-free interest rate and (2) provide vast amounts of liquidity against high-grade collateral only, and nothing against illiquid collateral. The result has been that the ‘resolution’ of each of these financial crises created massive amounts of high-grade excess liquidity that was not withdrawn when market order was restored and provided the fuel that would produce the next credit boom and bust. By focusing instead on illiquid collateral, it should have been possible to achieve the same effect with a much smaller injection of liquidity.

This point, that overall liquidity changes can be minimized by a more careful targetting of liquidity injection, was mentioned on PrefBlog on March 31, quoting Xavier Vives. I haven’t seen anybody use the phrase “a rifle, not a shotgun” yet, but I’m sure it will be if the Central Bank actions become a political issue.

Anyway, back to Dr. Buiter’s remarks:

The “£50 billion bail-out for banks” headline of that fount of orginal analysis, the (free) London paper, is rubbish. The Special Liquidity Scheme is priced quite unpleasantly for the banks. The so-called fee (the difference between 3-month libor rate and the 3-month General collateral gilt repo rate) will be quite hefty, because it reflects not only bank default risk (libor is the rate for unsecured bank lending) but also liquidity risk. In addition, the haircuts (discounts) applied to the Bank of England’s valuation of the RMBS, covered bonds and credit card ABS ranges from 12 percent, for the shortest maturity to 22 percent for the longest maturity. That valuation will either be based on observed market prices that are independent and routinely publicly available or on the Bank of England’s own calculated prices. As most of the assets are illiquid, the prices of these assets will for the foreseeable future be set by the Bank of England. In that case it will also apply a higher haircut to the valuation. In addition, Bank officials have told me that should any of the assets lent by the banks to the Bank fall, during the life of the swap, below the required AAA rating, these assets will have to be replaced by AAA-rated securities.
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The UK scheme prices what amounts to a collateralised loan of Treasury bills by the Bank of England quite harshly. And appropriately so. There is no eartly reason for giving the banks a tax payer handout. The banks and their borrowers made the mistakes. They and their borrowers should pay the price.

He contrasts this with the valuation of securities accepted by the Fed:

All this is a lot more sensible and likely to minimise adverse selection than the insane valuation of the collateral offered by US Primary Dealers to the Fed at the Term Securities Lending Facility and the Primary Dealer Credit Facility. The collateral is priced by the clearing bank acting as agent for the Primary Dealer! If ever a scheme was designed to encourage collusion between Primary Dealer and Clearer to dump useless securities at inflated prices on the Fed, this is it.

I hadn’t been aware of that nuance! I am in complete agreement with Dr. Buiter: valuation should be performed by the Fed – with input and advice from the brokers and clearing banks, of course, but the final say should rest with the lender.

And finally, Dr. Buiter points out another nuance:

Unlike the US, where mortgages are non-recourse debt, the UK does not have mortgages that are non-recourse.

The standard terms on US mortgages are ridiculous and the standard provision of non-recourse loans is just one of the problems.

In a new development, a trader has been nailed for spreading false rumours:

Paul Berliner, 32, sought to profit by messaging traders at brokerages and hedge funds on Nov. 29, claiming Alliance Data’s board was meeting to discuss a reduced offer by Blackstone, the Securities and Exchange Commission said today in a suit at federal court in Manhattan. The shares plunged 17 percent in half an hour that day.
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Berliner, who was shorting the stock to profit from the drop in price, made more than $25,000 before the shares recovered, according to the SEC. He didn’t admit or deny the agency’s claims in agreeing to forfeit his gains, plus interest, and pay a $130,000 fine.

The trivial amounts for which a trader will put his reputation on the line never fails to astonish me … one can only imagine that the real-world repercussions for talking like an idiot to other idiots are not really all that harsh.

The story does not address what, if anything, happened to the morons who traded stock on the basis of an unverified text message. If they were acting as fiduciaries, one can only hope that their licenses will be yanked soon.

The market was off a bit today in what has now become normal volume. There were a few good crosses of the more liquid, high quality, perpetualDiscounts.

There were fifteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.