Category: Market Action

American GDP grew at an annualized rate of 3.9% in the third quarter, but economists were not impressed. On a positive note, ADP Employment data was stronger than expected, which implies that next Friday’s jobs number shouldn’t be disastrous, at any event.

In other words: we’re confused! So what else is new?

The Fed cut to 4.50% today, as expected. When the market is unanimous, the Fed usually listens. Accrued Interest looks to the future and sees the potential for future cuts measured in terms of bank rescue rather than broader inflation/economic concerns.

The more things change … in 1993, the US had the steepest yield curve since the Civil War, as the Fed was busy bailing out the banks’ profitability (this was in the aftermath to the S&L crisis, remember). Then, in 1994, the music suddenly stopped and Orange County, among others, couldn’t find a chair. It will be most interesting to see how this cycle unfolds!

Well, thank heavens that month’s over! There have been a huge variation of the returns in the HIMIPref™ indices over the past month and the fund was unfortunate enough to have identified a broad pricing discrepency just as the panic got started. Returns this month are not a complete disaster, I hasten to add, but will have underperformed the index.

Mind you, the yield on the fund’s holdings is now well above the index and credit quality is great … so the faster that things normalize, the happier I’ll be! Results should be published on Saturday November 3, or Sunday at the latest.

There were thirty other index-included $25.00-equivalent issues trading over 10,000 shares today.

US Consumer confidence was reported to be way down today, while housing prices declined at an accellerating rate. Geez, this is sounding a lot like my September 25 post! Perhaps I should just keep a template full of gloomy news and copy-paste!

There was some very interesting news regarding the overall credit crunch today: it seems that Federal Home Loan Banks in the states are making massive loans to the marketplace, financing them by issuing their own paper:

Countrywide Financial Corp., Washington Mutual Inc., Hudson City Bancorp Inc. and hundreds of other lenders borrowed a record $163 billion from the 12 Federal Home Loan Banks in August and September as interest rates on asset-backed commercial paper rose as high as 5.6 percent. The government-sponsored companies were able to make loans at about 4.9 percent, saving the private banks about $1 billion in annual interest.

FHLBanks are kind of interesting. They are regulated not by the Fed, but by the Federal Housing Finance Board,

an independent agency within the executive branch of the federal government.
…
The Finance Board consists of a five-director board—one of whom is the Secretary of Housing & Urban Development (HUD) or the Secretary’s designee. The other four directors are appointed by the President and subject to Senate confirmation. 

In other words, it’s all political. They trumpet their 4.41% Capital to Asset ratio, but there is no indication that I can find – even in the Annual Report for FHLB Atlanta – of how this may be expressed in standard Basel Agreement terms, like “Tier 1 Capital Ratio”. I don’t know. I don’t know very much about this aspect of the US Financial system … and I’m willing to listen carefully to those who do … but this seems to me to be another grossly under-capitalized source of moral hazard, in addition to the GSEs.

A summary article in Voxeu led me to a CEPR Policy Insight which in turn was based on a lecture given 2007-10-1. Recycling of all kinds is very fashionable nowadays! At any rate, Axel Leijonhufvud has joined the debate regarding whether the Fed (and central banks in general) should target inflation alone, or should also pay attention to (potential / perceived) asset bubbles. He argues that the absence of US inflation in the early part of this decade was due not so much to the availability of cheap Chinese labour as it was to the willingness of the Chinese (and others) to accumulate dollar reserves.

So the trouble with inflation targeting in present circumstances is that a constant inflation rate gives you absolutely no information about whether your monetary policy is right.
…
It is a simple observation that the experience of Japan shows that inflation targeting will not by itself protect you against financial instability. The present criticism goes a step further. Inflation targeting might mislead you into pursuing a policy that is actively damaging to financial stability.

He criticizes SIVs, but I find his arguments a little facile. He does not distinguish between liquidity risk and credit risk (he’s not alone there!) and claims that they circumvent the Basel rules. The well-informed readers of this blog will know that while they used to circumvent Basel in the States, liquidity guarantees are now charged against capital. There is, of course, continuing controversy over whether the liquidity guarantees are expensive enough; I suspect that they’re not; and I have good reason to believe that the issue is currently under intense scrutiny by regulators world-wide. But he doesn’t actually say this.

He also claims that the “SIVs were, like hedge funds, highly-leveraged” … I don’t know exactly what he means by this; he may be considering only the very bottom tranche as equity and ignoring the tranching effects of mezzanine notes; it’s not clear. He speaks very highly of NN Taleb and the Black Swan phenomenon, feeling that the concept is not adequately reflected in risk management at large financial institutions. His final conclusion is that the fact that no big exogenous shock caused the current crunch shows that the world financial system is not well understood … which is comforting indeed to those of us employed by it!

In Canada, the most economically illiterate government since Trudeau elected to cut the GST to 5% and reduce the national debt by a mere $22-billion over the next five years while reducing other taxes as well. Perhaps the boomers will all die off without having ever paid for their government services! Interest on public debt is forecast to remain in excess of $30-billion annually; it’s currently 14% of federal revenue.

I have not yet seen any indication on whether there are any implications for interest-equivalency of dividends in the tax changes. Probably not, since it hasn’t been trumpetted.

It was a good day for preferreds today – good volume and the PerpetualDiscount index was actually up 0.1759% on the day, its third up day this month. Before breaking out the champagne, note that today’s gain is less than yesterday’s loss, so the index is still down on the week.

The spread between BAM.PR.M and BAM.PR.N widened some more, on good volume.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

 

Well! There I was, all set to attend David Berry’s contested hearing with RS, having spent all weekend choosing overly ripe tomatoes to hurl at any disingenuous Scotia executives with the effrontery to show up … and now I find that it’s been postponed! I have no idea what’s going on. Maybe RS has gotten a little embarrassed about being used as a pawn in a contract negotiation. Maybe somebody’s realized that if Jesus Christ Himself was subjected to the same level of scrutiny as Scotia has inflicted on Berry, then there’d be equal cause for firing, mudslinging and character assassination. Stay tuned!

Possible Fed moves this week are being discussed all over, with the consensus calling for a 25bp cut to 4.50% (and Bill Gross of PIMCO is calling for 3.50% in the near future). There is more than one report that the Fed is unhappy with such certainty, but I’m not convinced that this is the case. The Fed is adept at manipulating opinion; if they were truly unhappy with the forecasters, they would send a few hawks out to make speeches about the dangers of hyper-inflation. Poole has been given a lot of attention in the past few months; the WSJ has grilled him about his high profile.

The Super-Conduit debate continues, with a report that:

the banks will earn 1% on structured investment vehicles of less than $5bn, and 1.5% for SIVs over $15bn
…
The prospectus also details what SIVs will receive for selling their assets to M-LEC. Qualifying SIV holders will be eligible for up to 94% of the value of the assets they sell in cash, or 89% cash and 5% in senior capital notes, in the form of medium- term notes, that will participate in part of the upside when the assets mature.

I have not yet seen this report confirmed by more usual sources – but I’m looking! I guess my reaction is dependent upon the interpretation of the word “value” in the above paragraph. If we can presume that “value” means “recent trading prices in small lots”, then I believe I have every right to refer to Super-Conduit as Vulture Fund … but if “value” means something else, then we’re back to uncertainty. We shall see!

Well … PerpetualDiscounts were whacked again today – and the Question Regarding BAM.PR.N I received today makes me wonder if we have reached the point of self-feeding gloom-and-doom, otherwise known as capitulation. Long Term corporate bonds yield about 5.8%, according to Canadian Bond Indices … at 5.65% Dividend, the perpetual discounts have an interest equivalent of 7.91%.

Ah well. Remember why you bought them! In the absence of default – which, for the the companies in the indices, seems no more likely than ever – I’m willing to cash the dividend cheques for quite some time.

There were twenty-eight other index-included $25.00-equivalent issues trading over 10,000 shares today.

CDOs (Collaterallized Debt Obligations) were in the news today, as Bloomberg reported that Moody’s cut a batch of ratings. The Bloomberg story doesn’t mention some important context, presumably since that would make the story less interesting. According to the unexpurgated press release:

it has downgraded $33.4 billion of securities issued in 2006 backed by subprime first lien mortgages, representing 7.8% of the original dollar volume of such securities rated by Moody’s. Of the $33.4 billion downgraded securities, $3.8 billion remain on review for further downgrade. Moody’s also affirmed the ratings on $258.6 billion of Aaa-rated securities and $21.3 billion of Aa-rated securities, representing 74.7% and 52.0% of the original dollar volume of such securities rated in 2006, respectively.
…
The Aaa- and Aa-rated securities that have been placed on review for possible downgrade are generally not expected to move by more than three notches. The most heavily impacted securities were originally rated Ba, Baa, or A. Rating migrations have been much more severe for the more deeply subordinated tranches of 2006 subprime deals.

Accrued Interest, which has an excellent primer on CDOs, has made a rather breathtaking suggestion:

the ratings agencies simply shouldn’t rate CDOs at all.
…
Furthermore, the ratings agencies could still model CDO deals in their Monte Carlo simulators for a fee. Investors could then run the Monte Carlo themselves, inputting default and recovery rates, default patterns, and correlation as they see fit. Rather than getting one or two perspectives on what the default/recovery/correlation patterns should be, investors could impose their own stresses.

I’ve discussed the results of such simulations in the post Loan Default Correlation.

Sadly, Accrued Interest’s suggestion doesn’t have a chance of working. As I keep reiterating here, investors (as a group, with lots of exceptions) do not want to do any analysis. And they don’t want to spend any money on useless, profitless credit analysis, or any time understanding what it is they’re doing. They want to buy something that goes up because it’s good.

There are no possible regulations that will enforce this. Adding more rules will not make this a better world. All market regulators should have a form letter: “Yeah, you’re #$%^! bankrupt because you’re #$%^! stupid.” to be sent by the busload to complainers. They should also be much more willing to pull investment management licenses on the basis of incompetence.

This last thing is hard to do. If my investment theme is that demographics are going to cause a boom in granola, I tell all my clients this, they give me money and I promptly blow it all levering up granola futures 100:1: this doesn’t necessarily make me incompetent. Wrong, yes, but being wrong is simply part of the investment management game (which is why my other theme in this blog is the chaotic nature of financial markets). If, however, they inspect my records and find that my carefully estimated granola consumption growth rate was a little off because I used “15” as a factor rather than as a percentage … well, then I’m incompetent and should be civilly liable and should lose my license.

Investment managers should be held strictly accountable for adhering to the Prudent Man Rule. But you know something? I think a lot of investment funds are run in the same way as Greek pension plans:

Board members of Greek pension funds are appointed by the government, labor unions and employers, often on a part-time basis, without specific professional or educational qualifications. The country has about 200 pension funds with assets of more than $44 billion, according to finance ministry estimates.

Quis custodiet ipsos custodes? While specific professional or educational qualifications are nice to have, I’m not as impressed by them as the reporter seems to be … but they are, at least, an indicator. With respect to the particular Greek Tragedy reported, I agree with:

C. Kerry Fields, a professor of business law at the University of Southern California’s Marshall School of Business in Los Angeles, said JPMorgan appears to have acted lawfully in its handling of the sale to North Asset Management and bears no responsibility for what happened later.

“The foolish people are the buyers because they paid so much,” Fields said.

What’s needed on pension boards are people with the guts to ask questions, the intelligence to Think Useful Thoughts about the answers and the ruthlessness to fire those who don’t measure up. Those are the qualifications I like.

On another front, Naked Capitalism reviews the political pressure for a Fannie Mae / Freddie Mac bail-out. We can only hope that this pressure is successfully resisted – as has been argued by James Hamilton of Econbrowser:

it is equally clear to me that the correct instrument with which to achieve this goal is not the manipulation of short-term interest rates, but instead stronger regulatory supervision of the type sought by OFHEO Director James Lockhart, specifically, controlling the rate of growth of the GSEs’ assets and liabilities, and making sure the net equity is sufficient to ensure that it’s the owners, and not the rest of us, who are absorbing any risks.

Fannie Mae & Freddie Mac (the “GSEs” – Government Sponsored Enterprises) walk like banks and talk like banks … but they are not regulated like banks because grandstanding politicians such as Charles Schumer want to have all the fun of providing services to constituents without having to bother with trivial little details like paying for them (which in this case means, one way or the other, ensuring that the GSEs are capitalized like banks).

We have seen in recent months how a problem that’s relatively small (US Sub-prime mortgages) in the grand scheme of things (the world financial system) can act as a flashpoint for a major paradigm shift (if that metaphor makes any sense). Let’s not increase the potential for a major bankruptcy by allowing the GSEs to lever up even further beyond the bounds of prudence.

On a somewhat related note, I was amused to see the tone Bloomberg adopted when reporting the continued decline of American home ownership:

Homeownership in the U.S. dropped for a fourth consecutive quarter, the longest decline since at least 1981, suggesting more Americans will miss their best chance of building wealth.
…
“Owning a home in this country has been a principal source of wealth creation for low- and moderate-income people,” said Nicolas Retsinas, director of Harvard University’s Joint Center for Housing Studies in Cambridge, Massachusetts. “In the absence of home equity, families will inevitably spend less.”

Homeowners accumulate wealth faster than renters, with median net wealth for owners at $184,400 in 2004, compared with only $4,000 for renters, according to Federal Reserve figures.

Given the glee with which they regularly point out that everybody (except gullible investment managers) knew all along that housing was a bubble created by the Evil Credit Rating Agencies, the emphasis on these data is surprising! But they redeem themselves with an interesting factoid towards the end of the article:

Out of 297 townhouses in Springfield, Virginia, for sale last week, almost 80 were in the process of foreclosure or offered at a price lower than the mortgage balance, so-called short sales, said [Re-Max real estate agent Steve] Hawkins.

Two years ago there would have been about 50 such units offered in the same Washington suburb, with none in foreclosure, he said.

The long-term trend is clearly in homeowners’ favour – but, as the the WSJ reports, houses haven’t been doing too well lately:

 

On September 24 I noted that the US was testing pandemic preparedness, stressing the system with a simulated 49% absentee rate. The results are in and analysis is under way:

When asked “based on the lessons learned from the exercise, how effective are your organization’s business continuity plans for a pandemic,” 56% answered “moderately,” the next highest group was “minimally,” at 28%. Only 12% said their business continuity planning was very effective.

I have previously noted the various controversies about inflation measurement – but look at Argentina’s measurement problems:

Argentina’s benchmark inflation-linked bonds have tumbled 24 percent this year, making the country’s debt market the worst performer in the world, according to data compiled by JPMorgan Chase & Co. and Bloomberg.
…
Merrill Lynch & Co., the world’s biggest brokerage, estimates prices may be rising at a 17 percent annual pace, double the official rate.
…
Daniel Fazio, head of the employee union, said in February that a Kirchner political appointee had statisticians eliminate some details from the index and violate secrecy laws that prohibit the release of information during the data-gathering process. The union said federal prosecutor Carlos Stornelli is investigating the allegations. The prosecutor’s office has declined to comment.

I continued to work through the BoE Financial Stability report, but was sidetracked by a desire to investigate their “Box 2” further. What a great report that is! Crammed with information and references, but well written with a bias towards explaining the implications of important ideas from a policy perspective.

There’s a fascinating report that the credit rating agencies are being investigated for corrupt practices:

[Connecticut Attorney General Richard] Blumenthal’s office is investigating complaints that the ratings companies rank debt against issuers’ wishes, then demand payment, he said today. The state also is probing whether the companies threaten to downgrade debt unless they win a contract to rate all the issuer’s securities, as well as the practice of offering ratings discounts in return for exclusive contracts.

Quite the laundry list of charges! ‘Ranking debt against the issuers’ wishes’ is hardly a problem; ‘Demanding payment’ is not a problem [hint: say ‘No’]; ‘offering ratings discounts in return for exclusive contracts’ is not a problem; the only allegation that, if proven, is actually a Bad Thing is the threat to downgrade if they don’t get a contract for the entire issued portfolio.

I find the idea a little hard to swallow, frankly. Transition matrices are holy and I don’t think the agencies would put them at risk in order to make an extra nickel or two. It might possibly be a deliberate mis-interpretation (either by the rating agency salesman or the issuer) of a threat to downgrade unless more information is made available to the agency … but we will see. It’s worthwhile to note the recent General Electric / DBRS kerfuffle, reported on the DBRS site as:

Given the level of investor interest, DBRS believes it is important to provide clarity as to its decision to withdraw the ratings on General Electric Company (GE), GE Capital Canada Funding Company (GE Capital Canada), Heller Financial Canada and Heller Financial, Inc.

DBRS had recently been in discussions with GE to ensure that DBRS would continue to receive adequate resources, including time and attention, from GE to support DBRS’s ratings and that there would be no issue with DBRS assigning ratings to GE Capital Corporation (GECC), the guarantor of GE Capital Canada.

Ultimately, GE decided that it was not fully supportive of adding a third rating agency for GECC, and GE formally requested that DBRS withdraw all ratings related to GE.

It’s easy to see how a bad relationship could quickly get worse given worst-case interpretations of such negotiations. But we’ll see!

In technical news that some (wierdos) might find of interest, the NYSE is eliminating rule 80A, which was enacted as part of the volatility damping package deemed necessary after the crash of 1987:

Rule 80A (a) and (b) require that, for any component stock of the S&P 500 Stock Price IndexSM, whenever the NYSE Composite Index® (“NYA”) advances or declines by a predetermined value from its previous day’s closing value, all index arbitrage orders to buy or sell (depending on the direction of the move in the NYA) must be entered as either “buy minus” or “sell plus”.
…
The Exchange is making this change since it does not appear that the approach to market volatility envisioned by the use of these “collars” is as meaningful today as when the Rule was formalized in the late 1980s. Rule 80A addresses only one type of trading strategy, namely index arbitrage, whereas the number and types of strategies have increased markedly in the last 20 years and may as well contribute to the increase in or lack of volatility.

The rule has been applied 15 times on 13 days this year; the peak was 1998, with 366 occurances on 227 days.

And, holy smokes, I almost let an entire post go by without mentions SIVs! Naked Capitalism provides a round-up and some commentary; still quite convinced (perhaps correctly – who knows?) that Super-Conduit is a nefarious plot of some kind that is unlikely to attract investors.

The TD New Issue announced October 9 now has an estimated fair value of $23.76. It will not be a happy opening!

By one definition, Great-West and SunLife Financial are now distressed companies: GWO.PR.I closed at 19.90-98, 12×3 on volume of 47,085; SLF.PR.E closed at 19.92-18, 4×3, on volume of 11,750. I wonder what the Globe will have to say about this tomorrow?

Month-to-date, the PerpetualDiscount index is down 4.93% (on the week, it’s down 2.18%) and has gained on only two of nineteen trading days. On the other hand, the PerpetualPremium index has managed to grovel back over its 6/30 starting figure of 1,000.00, and is down only 1.89% on the month. On the other hand, there’s some very strange things going on in that index. What the HELL is CU.PR.B doing, being bid at 26.12 for a pre-tax bid-YTW of 5.17, when PWF.PR.I has the same coupon and a redemption schedule that differs by one month and one day, AND has a one-notch higher credit rating (DBRS) to put it into widows-and-orphans grade … and is bid at 25.31 to yield 5.71%?

However, as a participant on Financial Webring said today:

No, it’s because the market is an ass. Preferreds are retail driven with about half of the purchasers not even aware what they’re buying. We see it on this board all the time. They got lumped into the whole subprime/ABCP mess in my opinion by boneheads who think they have a connection to it. Down goes the price…………

Ah, Grasshopper, when you can take the pebble from my hand, it will be time for you to trade.

The market will normalize eventually. It always does. But DAMN, the waiting can be aggravating – and it probably wouldn’t irritate me so much if HIMIPref™ hadn’t indicated valuations were severely out of whack a little too early!

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

A bit more news came out regarding the Aastra lawsuit mentioned yesterday. In a Globe story:

Mr. Del Sorbo was an investment adviser to Aastra for about seven years, according to the lawsuit. During May and June, rising interest rates caused paper losses in the company’s bond and preferred share holdings. As a result, the company told Mr. Del Sorbo in June “that it wished to invest only in conservative, short-term, liquid securities with no exposure to interest rates and very low default risks,” the suit said.

As the portfolio was being reassessed, Mr. Del Sorbo talked about non-bank asset-backed commercial paper, “which he described as primarily baskets of residential mortgages with limited car loans and credit card debt, bundled together to produce a high-quality short-term investment product,” the suit said.

In July, Aastra put $8.5-million into an ABCP trust called Structured Investment Trust III, which was priced to yield 4.62 per cent.

That’s one of the issuers whose business was frozen under the Montreal Accord.

As it turns out, the underlying assets were about 94 per cent credit default swaps on long-term bonds, the lawsuit said. The claims have not been proven in court.

John Tobia, Aastra’s general counsel, would only say that “from our perspective, the pleadings speak for themselves.”

Finding Structured Investment Trust III on the DBRS website is a little tricky (they’re not exactly unique keywords, are they?), but one can quickly find the May 11 Press Release:

The Trust is a vehicle that is designed to purchase structured securities including CDOs.

The press release also states that Coventree is the sponsor, and a quick trip to Coventree’s site yields the conduit’s page which has links to the full rating report and the Information Memorandum. Coventree’s site also has Monthly Conduit Reports which are password protected; I can’t be bothered to get a password because, well, because I’m not putting $8.5-million into the thing. However, the Information Memorandum states:

The Financial Agent prepares a monthly Investor Report and makes this report available on-line to purchasers of Notes on a password-protected basis at http://www.nereusfinancial.com/. The Investor Reports contain information about the specific Purchased Securities held by SIT from time to time. Purchased Securities are obtained by SIT from Originators in major international credit default, CDO and associated markets. In order to secure optimum execution and terms, in accordance with prevailing practice in these markets, the identities of Originators are shared with the Rating Agency but are otherwise kept confidential by the Financial Agent.

It’s right there, in the summary, page 4, under the heading “Investor Information”. If anybody didn’t know what was in the thing, it’s because they couldn’t be bothered to find out.

Aastra’s counsel is quoted as stating that “from our perspective, the pleadings speak for themselves.”, but oddly, I don’t see the pleadings disclosed on their website; I guess they don’t really have a lot to say. Or maybe it’s just an oversight. Or something.

Speculation is building regarding next week’s Fed meeting, with a cut of 25bp being forecast by some. The November Fed Funds contract implies that this forecast has some general acceptance; trading at 95.54 today implying a projected effective rate of 4.46%. The actual trading rates for this month have been choppy, but it appears that the current 4.75% target is holding and being defended.

Meanwhile, the credit crunch continues, with another SIV indicating it is having difficulty financing:

MBIA Inc., owner of the world’s largest bond insurer, said a $1.8 billion structured investment vehicle it runs through its asset management business is having trouble raising money and is seeking funding alternatives.

MBIA has invested $15.8 million in the capital notes of Hudson-Thames Capital Ltd. and said it has no obligation to provide the SIV with liquidity support or guarantees. MBIA today reported its first quarterly loss ever after marking down the value of mortgage-related debt it guarantees by $342.1 million.

In what may or may not be interpreted as a positive sign (depending on what answer you want) US ABCP outstanding declined by only USD 4.6-billion in the past week – practically a rounding error. November could be interesting, however: there are persistent, if unofficial and unconfirmed reports that there will be a big whack of MTN paper maturing, that may well be very difficult to roll.

One of the more entertaining things I’ve read recently is an ‘I toldja so’ puff-piece by Nouriel Roubini – for instance:

In March, when this author wrote a long (30 pages), serious semi-academic research analysis – with Christian Menegatti – of why the housing recession had not bottomed out and why home prices would sharply fall further, this scholarly analysis was summarily and cheaply dismissed in the most crass terms (“the paper is really just a longer-than-usual blog”) by a popular blogger who had barely bothered even to read it. At least Daniel Gross – a very smart blogger – had the decency to literally eat pages of his own writings – as he had promised he would – when one [of] his financial predictions failed.

Cassandra’s Revenge!

I’ve updated the post regarding the BoE Financial Stability Report and will add more as I work through it. It’s good stuff, it really is; beautifully researched. If I made a special note of everything it contains that is interesting, my post would be longer than the report itself; those with an interest in this sort of thing are strongly encouraged to read the full publication.

As far as preferreds are concerned … PerpetualDiscounts continued to decline, much to my chagrin. One participant on Financial Webring Forum noted today:

I suppose this may have answered my question I had been pondering for some time about the recent MAPF sectoral allocation shift toward discount issues. The low coupon discounts seem like a bit of a trap to me, and although I hadn’t ruled out that you’d simply lost your mind, I suspect you know what you’re doing……………….

Well, it’s nice to know he presumed I had a mind to start with! As it is, I fear that results for the fund for this month will be summed up as “Too Soon”. As has been noted here in the past, sectoral shifts within the fund do not reflect an attempt at market timing; merely an analysis of the curve that shows that one sector has gotten out of whack with another. Over time, this works quite well; but not this time.

HPF.PR.B was down over 7% today, presumably due to yesterday’s downgrade. I suppose there are some non-PrefBlog-reading investors out there who considered the downgrade a surprise.

Good volume today, which is certainly meaningful. Just precisely what it means changes every time, of course, but in a month or so the technical analysts will be pleased to tell us what we obviously should have done.

There were thirty other index-included $25.00-equivalent issues trading over 10,000 shares today.

Well … there won’t be much today!

All my non-preferred-trading-and-carnage-watching time today was spent puzzling over Capital Tax … some bond investments are subject to capital tax and some other bond investments are not subject to capital tax. The difference is, ostensibly, to avoid double taxation; I suspect that the real goal is to

• raise money in a manner that will be invisible to Joe Lunchbucket
• provide employment for retired politicians

Friend Flaherty is, of course, too busy grandstanding with ATM fees, National Securities Regulators and the price of eggs & milk in Buffalo … no, scratch that, the price of eggs and milk in Buffalo SHOULD be cheaper than in Toronto, because otherwise farmers with quota might have to work for a living … the price of Harry Potter books in Buffalo to be worried about doing something useful. Like eliminating busy-work taxes that have economically negative effects.

Some readers might surmise that I’m not in the best of tempers. Some readers might win a kewpie doll if they can do it three times running.

So … just time for one snippet of interesting financial news … there’s an ABCP lawsuit announced:

A potential flood of lawsuits over asset-backed commercial paper could hit courts in the coming weeks after Aastra Technologies Ltd. (TSX: AAH.TO) became the first to launch a legal action against adviser HSBC Securities for exposing the IT company to the troubled investment vehicle.

Aastra’s press release states:

Finally, as previously announced during the quarter, the Company currently holds $13.7 million of non-bank owned asset-backed commercial papers for which, currently, there is no active market. Of these investments, $8.5 million is invested in Structured Investment Trust III and was not repaid to the Company when it became due on October 10th while $5.2 million invested in Lafayette Structured Credit Trust is not yet due until October 30th of this year.

As a result of the developments above, Aastra commenced legal proceedings today against its investment advisor, HSBC Securities (Canada) Inc. and one of its employees, in the Ontario Superior Court of Justice seeking damages relating to investment advice provided with respect to Aastra’s purchase of the Structured Investment Trust III asset-backed commercial paper.

On August 23, they stated:

As of August 23, 2007, Aastra had $13.7 million, or approximately 11% of its cash and short-term investment balances, invested in asset-backed commercial paper.

So … a couple of observations … most of which are really queries:

• HSBC Securities? So it’s a stockbroker they’re blaming? What was his Money-Market track record? I wonder how much due diligence they did before hiring him.
• Frankly, 11% of a money market portfolio in ABCP doesn’t sound all that actionable to me. It’s aggressive, sure, but it doesn’t sound all that reckless.
• Every time the market goes down a nickel, the OSC gets bagfulls of complaints. The favourite story I’ve heard is of a guy who got angry with his advisor during the Tech Boom (not the Wreck … the Boom). He had a portfolio and received a total of sixteen (if memory serves) recommendations. Fifteen of them made money. One of them lost a little bit. His portfolio did quite well. The client went completely berserk over the one unfortunate recommendation and made life miserable for everybody, for literally years, with complaints.
• Is Aastra serious about the lawsuit, or just grandstanding for their shareholders? If they’re serious, they’ll post all the court documents on their website; if they’re grandstanding, they’ll just send out the occasional press release.

Prefhound commented on yesterday’s post regarding current market conditions and – to my gratification – did not cast aspersions on my observation that perpetual/retractible spreads were starting to look awfully juicy! I had hoped to comment further on these spreads today, but as it is, I will set some homework for the blog’s readers (BOTH of them! That means you, too, Dad!).

In my article How Long is Forever?, I compared a perpetual with a retractible by:

• Calculating the total return of the retractible to the Retraction Date
• Determining what price the perpetual would be on that date to provide the same total return
• Determining what yield would give rise to that price
• Laughing

Recent events have increased yields of the retractibles to the point where they’re not completely stupid any more … and increased the term to their presumed retraction/redemption date to the point where meaningful comparisons can be made (if the YTW is just six months off, you’re basically comparing the perp to cash, which is silly). There’s even enough that we can choose pairs for which credit quality will cancel – or, at least, cancel as much as one can for a perp.

So, here’s your homework: What will be the perps’ yield on the retractibles’ end-date in order for the two total returns to the end-date to be equal?

I’ll try to get to this … but maybe somebody else will get there first! Just for fun, I’ll do a really quick back-of-the-envelope calculation for the PWF.PR.J / PWF.PR.L pair:

• L gets about 1.4% more yield annually than J
• For six years
• Total 8.4% more return
• Therefore can withstand 8.4% capital loss and still break even
• Current bid price of L is 21.67
• Less 8.4% is 19.94
• Dividend is $1.275
• Therefore, yield on 2013-7-30 can be 1.275 / 19.94 = 6.39% and still break even

Now, I’m not going to suggest that this calculation automatically shows that PWF.PR.L is a screaming buy for everybody. Hell, they were down 4.58% today! But I do wonder how many people have actually performed the calculation and decided they want the safety of the retractible anyway!

Total carnage for preferreds today – I can only imagine that people saw the Merrill Lynch downgrade and decided that

• All financials were at risk
• The preferreds as much as the common

The PerpetualDiscount index hit a new 18-month low and now has a total return of about negative nine percent for the 15-odd months since 2006-6-30. And, for the first time, the PerpetualPremium index has gone below the 1,000.00 starting figure. I should have stood in bed.

There were twenty-seven other index-included $25.00-equivalent issues trading over 10,000 shares today.

More details are emerging regarding the SIV situation: FT-Alphaville has republished a Fitch graph showing the NAV of the SIVs it rates:

In this case, “NAV” is a measure of the asset coverage provided to the equity noteholders; therefore, when it’s below 100%, they’ve lost money. These numbers have no independent implications for the asset coverage ratios for the senior noteholders; that will depend on the original capital structure of the SIV.

Naked Capitalism discusses this and other tidbits from the SIV front. An anonymous Fed tipster is putting out the word that the Fed’s silence should not be misconstrued. The WSJ has published an extract from an interview with the head of the Basel Committee on Banking Supervision – he’s not impressed by the Super-Conduit idea. One question-and-answer brought tears of gratitude to my eyes:

Might Basel II’s reliance on rating agencies, for instance, come under consideration?

There are problems to be solved with rating agencies. … but you remain responsible at the end of the day, yourself, and you have to make your own assessments.

Fitch Ratings has published an initial review, dated September 20, and an update, dated October 12, of the SIVs it rates (the chart above is taken from the update). Credit Sights, an independent credit rating agency (that is, one paid by its subscribers rather than – gasp! – the issuers) that delights in being gloomier than the the issuer-paid credit rating agencies, has released a report (to paying clients) that claims:

Many structured-investment vehicles may be forced to close in the next few months as defaults by SIVs run by European hedge funds make it harder for others to avoid selling off their assets

So if Super-Conduit ever gets off the ground, there is every indication that it will have plenty of assets to choose from!

I mentioned the issue of bank purchases of ABCP held in their money-market funds on August 20 in the context of managerial independence, but there are other problems with the idea. Mainly, is a MMF a stand-alone investment vehicle, or is it a bank deposit? There are some US banks purchasing SIV paper from their MMFs; this is not a right and proper thing to do. I hope that the OSFI in Canada and the Fed in the US will nail these banks to the wall on their next audit; unless unitholders are taking ALL the risk of the investment, EVERY SINGLE PENNY, then the MMF is not a stand-alone vehicle.

Given all the excitement regarding the issuance of covered bonds, it would seem that if bank-run MMFs are really “covered bank deposits” then the banks’ balance sheets should be grossed up by the size of their funds and capital adequacy determined from these figures. The National Bank, for example, has total assets of about $117-billion and a total of about $1.7-billion in various MMF vehicles: Money Market Fund, Treasury Bill Plus, US MMF, Corporate Cash Management, Treasury Management and Strategic Yield. Grossing up the balance sheet would not be the biggest charge in the world, but if the banks are going to give implicit support to their funds, it is a charge that should be taken in order to protect depositors.

Business Week has a fascinating story on the implosion of the two Bear Stearns hedge funds that triggered the whole crisis. I have updated my post on stress-testing of Australian mortgages with a report from Bloomberg that one of the largest mortgage insurers is being downgraded.

The decline in perpetual preferreds actually accellerated today; to me, the yields have gone beyond “wow!” and into “outlandish” territory … but those who are selling evidently disagree with me!

There are some proxy-variables in the yield curve analysis that lead me to suspect that there is a definite bias towards selling the newer issues – by which I mainly mean everything issued in the last year; this is a change from the situation last spring. I had mentioned at that point that liquidity appeared to be at a premium – and so it was, according to the analysis. I am beginning to suspect, however, that the yield curve needs some kind of – yech! – momentum indicator, because I am now hypothesizing that the liquidity premium was actually a proxy for a “recent issue premium”. Currently, I am analyzing a premium being paid for “cumulative dividends”; this might be a proxy for “recent issue discount”.

There’s always something new, something to be tested, that becomes apparent only in times of extreme stress. ‘Nature reveals her secrets best under torture’, and all that. If Bacon didn’t say it, then I will.

I should note – for those who might be alarmed at the idea that I don’t know everything already – that yield curve analysis is the least of my analytical worries right now. Fits to the curve are excellent; it’s diversification that has me concerned. The yield pick-up of Perpetuals over Retractibles is now so extreme it’s becoming harder and harder to justify any holdings of the latter at all!

There were twenty-eight other index-included $25.00-equivalent issues trading over 10,000 shares today.

Sometimes I wish that this blog would get more comments. At other times, I’m glad that I don’t have to make the decision ten times per day on whether a particular comment is so ad hominem that I have to zap it. Today is one of those other days!

Menzie Chinn of Econbrowser posted a graph for which the general outlines have been known for a long time by those who are following the subprime debacle:

…and it triggered a lot of nastiness in the comments when a (purported – I haven’t checked!) market professional asked, essentially, ‘What’s the big deal?’.

It continually surprises me to see just how much bitterness there is out there against investment managers. But – that’s the Internet! As far as graphs go, I like the one from Moody’s showing mortgage delinquency rates:

 

Bear Stearns has agreed to a deal with CITIC whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!

whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!whereby CITIC will take equity in Bear Stearns and Bear Stearns will, essentially, provide vendor financing. This should calm some fears about the future independence and financial viability of Bear Stearns going forward, and a joint-venture deal in Hong Kong with CITIC might even be profitable!Naked Capitalism has again done a good job of collecting media references to the Super-Conduit … and it looks like my speculation regarding the operation of this vehicle as a Vulture Fund is both right and wrong. Wrong because that’s not what the primary sponsors have in mind. Right because if it ain’t, there won’t be any secondary sponsors:

One key concern is over the process by which it is proposed that the fund will decide on prices to offer SIVs for their securities. The lead banks are proposing that prices should be determined according to quotes provided by dealers for small volumes of the particular security rather than large trades. Critics say this means prices will be artificially high. “Banks are being asked to finance a vehicle full of overvalued assets which is not very attractive,” said one banker. Critics believe it would be better to work with true market prices – however painful.

I will now speculate that buying good assets from distressed SIVs is exactly how the RBS / Cheyne deal will unfold … but we will see! Accrued Interest has clearly been puzzling over the sponsors’ motivations as much as I have … he has introduced the rather Machievellian possibility that it is actually a rescue of the bank Money Market Funds.

The fair value estimate for the TD 5.25% Perpetual New Issue has been updated to $24.05 as of the close today.

Perpetuals continued to decline today. Holders of the Royal Bank issues should note – before they have a heart attack at 9:31 tomorrow – that today, 10/22 was the last day of cum-dividend trading; tomorrow, 10/23, will be the first day of ex-dividend trading for the current dividend.

There were fifteen other index-included $25.00-equivalent issues trading over 10,000 shares today.

 The box-score for today is:

• Fear: 1 Treasuries way up
• Greed: 0 Equities way down
• Analysis: What?

In more interesting news, the media has reported somebody saying something intelligent about regulation:

“If you intervene in the system, the vultures stay away,” [Former Fed Chairman Greenspan] said. “The vultures sometimes are very useful.”

“When it breaks, it’s very abrupt and you just have to wait it out,” he added.

This was in an interview with Emerging Markets, which was in turn linked by the WSJ.

More rules will not stop market booms, busts or outright fraud. They can – sometimes – mitigate and contain the effects; I have previously suggested that rules for the capital treatment of liquidity guarantees be reviewed with an eye to ensuring the banking system, as a whole, can withstand bigger shocks than this piddly little liquidity crisis. But there are far too many people around who rush to revise the rule book every time something bad happens. Life sucks. Get used to it.

Specifically, Greenspan was opining on Super-Conduit:

But Greenspan argued that that a delicate market psychology could be speared by the move. “It could conceivably make [conditions affecting investor psychology] somewhat adverse because if you believe some form of artificial non-market force is propping up the market you don’t believe the market price has exhausted itself.

“What creates strong markets is a belief in the investment community that everybody has been scared out of the market, pressed prices too low and they’re wildly attractive bargaining prices there,” he said.

“If you intervene in the system, the vultures stay away,” he said. “The vultures sometimes are very useful.”

Well, I’ve speculated that Super-Conduit is the vulture; and that the aim of the exercise is to wipe out the junior note-holders of the shakier SIVs to leave only the strong still standing. This got a little support in an unsubstantiated, anonymous comment on Accrued Interest:

From Total Securitization:

“Citigroup Won’t Use Super SIV To Save Its Own

Citigroup officials, reacting to claims that the master liquidity enhancement conduit it is creating with JPMorgan and Bank of America will be used to specifically rescue Citi’s more than $80 billion SIV exposure, is expected to announce that it will not utilize the fund at all.”

Well, it ties in with my thought on Super-Conduit; but I don’t have a subscription to Total Securitization, so I’ll have to wait for those remarks to be reported elsewhere.

Cheyne and Rhinebridge officially defaulted on their commercial paper today:

Rhinebridge has $791 million of commercial paper and a portfolio with a face value of $1.1 billion, S&P said. The market value of the assets is now 63 percent of face value, having fallen $69 million since Oct. 16 alone, S&P said. Revaluations of CDOs of asset-backed securities have caused a “dramatic” fall in value, the rating company said.
…
Cheyne Finance’s managers said its assets are worth 93 percent of face value, enough to pay back all of its $6.6 billion of senior debt, S&P said. CDOs of asset-backed securities make up 6 percent of Cheyne Finance’s holdings.

The SIVs aren’t the only outfits being affected by the market revulsion to all things sub-prime – after announcing mark-to-market write-downs of $1.3-billion, Wachovia has discussed its earnings:

“Next line addresses other structured products [Total of $438MM]. Here we have the marks on warehouse positions and trading inventory, both of which we hold in trading portfolios. This includes the positioning Ken referred to in reference to sub prime mortgage exposure and AAA rated securities. $308 million is associated with sub prime securities [Their slides say $347 of the mark was related to subprime of which $308 was AAA subprime]. Basically there, we never would have expected that you see AAA securities trade so far so quickly from par.”

The same comments thread on Accrued Interest yielded the following revealing exchange:

Anonymous: IF my money market funds invest in this SIV I will sell them and buy one that doesn’t. Plain and simple.

Accrued Interest: A **TON** of investors have moved into government money market funds to ensure they don’t own any ABCP over the last 2 months. I think that’s the right move. Money Market funds aren’t a place to take any risk at all as far as I’m concerned.

In other – No Analysis Necessary. As soon as the dreaded words of power are spoken – SELL! It is no wonder that, as I mentioned yesterday:

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

To how many people does this make sense? Stick yer hands up!

I’ve said before that the danger of the credit crunch has not passed – that we’ve got a long way to go before we’re out of the woods (and, I hasten to add, I am not suggesting that market timing is the investor’s answer; analysis and diversification is the investor’s answer). Some of the specific risks to markets over the next six(?) months are outlined at the WSJ

This may be a little off-topic; but I want to point out that the benefits of diversification are everywhere:

The Utah scientists are trying to sell farmers on the idea that more bee diversity is needed, which was a hard sell because farmers had to pay more for wild bees. Now that honeybee prices are rising, farmers are more willing to try other species, James says.

Getting back to Canada and economic news for a moment, the Canadian CPI numbers were released today, and:

It was the highest year-over-year increase in the all-items index since May 2006, and the sharpest acceleration since February of this year.

Gasoline prices were the primary cause of an increase in the 12-month variation of the Consumer Price Index (CPI) in most provinces.

The year-over-year increase in gasoline prices (+12.7%) owed more to a sudden drop in last year’s prices than to any significant developments in the most recent month. Indeed, on a month-to-month basis, gasoline prices barely budged, rising a mere 0.8% from August to September 2007.

 

Of particular interest is:

On a year-over-year basis, consumer prices increased at a faster pace than the national average in only four provinces in September: New Brunswick (+2.9%), Manitoba (+2.8%), Saskatchewan (+3.8%) and Alberta (+4.6%).

In other words, inflation (such as it is) remains fairly well localized to the petro-provinces (with the exception of poor old Brunny). This suggests – to me – that there is nothing much in this report that would lead anybody to expect a rate-hike in the near future. Mind you, there are many who believe that the level was sufficiently high that we shouldn’t expect any lowering, either:

The Canadian dollar jumped 0.98 of a cent to 103.68 cents US – a level last seen in mid-1976 – after going as high as 103.71 cents US on expectations the higher CPI reading means the Bank of Canada won’t be lowering interest rates any time soon. The bank stood pat on interest rates Tuesday.

All this talk of inflation inevitably leads to the Fed. James Hamilton of Econbrowser attended a St. Louis Fed conference and reports that a hot topic of conversation was whether the Fed should operate according to a few simple and mechanical rules. Well, I haven’t read the papers yet, but my gut reaction is: “Sort of”. There should be enough mechanical rules so that Fed action is reasonably predictable; but none so binding as prevent reaction to special cases. Of course, there’s always going to be a lot of pressure to declare a special case so, as Poole said in his concluding remarks, central bankers need to be people of unquestionable integrity.

Mainly, though, I liked the graph:

Actual path of fed funds rate (black line), path predicted by a Taylor Rule that uses actual values of inflation and GDP (blue line), and path predicted by a Taylor Rule that uses forecasts of inflation and GDP (red line). Source: Orphanides and Wieland (2007).

Look carefully! Do you see the bit that has Greenspan blamed for the housing bubble? He was relying on forecasts, wasn’t he?

Another day of heavy volume for preferreds – and, er, yields were up! Yes, hold that thought firmly in your minds … yields, and therefore expectations of future returns, were up!

This is starting to get somewhat annoying. According to Canadian Bond Indices, long corporates are up 1.64% on the month, but prefs are getting killed … CPD is down a little over 1.5% month-to-date, perpetualDiscounts are down about 2.8%. Yield on long corporates is around 5.9% … about the same as it was on October 10, when I looked at spreads on One Bull Checks In. Since then, the perpetualDiscount yield has increased from 5.42% to 5.49%, and return for this index has been -1.28% (this doesn’t work out nicely with the Modified Duration in the range of 14.7 because of rounding errors and the obscuring effects of averages and outliers).

I think retail is mistaking preferreds for common again! And with things like CM.PR.D yielding 5.81% at the bid (interest equivalent of 8.13%) … well, they can mistake preferreds for common all they like, I guess!

There were thirty-four other index-included $25.00-equivalent issues trading over 10,000 shares today.

ABCP is in the news nowadays – and the Fed reports that outstandings are down another $11-billion over the week, as the unwinding / delevering continues. The total outstanding is now down about 21% from the July month-end figure.

The WSJ has published an article blaming the mess on London bankers, a piece of revisionism to which Naked Capitalism takes violent exception. Naked Capitalism has also reviewed the failure of Cheyne discussed here yesterday; the S&P Pre-sale report for Cheyne, dated May, 2005, has, perhaps, been accidentally left on the Web. Brad Setser applauds Naked Capitalism and points out that, for all the talk of globalization, a lot of US money is simply making a round-trip via London/Offshore right back to the US.

I can present some more support for my conception of Super-Conduit as Vulture Fund:

AAA-rated mortgage-backed securities selling at 85 or 90 cents on the dollar

asset-backed commercial paper backstopped by real assets and a full bank credit backstop yielding more than unsecured commercial paper issued by the same bank—in other words, the real assets as collateral viewed by market participants as a negative rather than a positive,

3-month LIBOR (the interbank deposit rate in London for dollars) as high as 100 basis points above the fed funds rate target—certainly possible if the monetary authorities were in the process of tightening monetary policy aggressively, but nearly inconceivable given the widely held expectation that the central bank would likely be cutting interest rates,

Treasury bill rates rising and falling 100 basis points in a single day, and

nearly a failed Treasury bill auction—total bids were barely sufficient to cover the amount the Treasury was offering. This near-miss occurred despite the fact that money market mutual fund investors were fleeing to rather than away from Treasury securities.

And, reported in the context of a $1.2-billion whoopsee by Rhinebridge Plc:

SIVs worldwide have been forced to sell about $75 billion of assets in the past two months to repay maturing debt as investors balked at buying securities linked to money-losing subprime mortgages.
…
As of late August, 79 percent of Rhinebridge’s holdings were in the U.S. and 80 percent in mortgage-backed bonds, Fitch Ratings estimated in an Aug. 22 report. Eighty-three percent of the assets had the highest-possible AAA rating, Fitch said.

Even Warren Buffett has opined on Super-Conduit!

Buffett said he was skeptical about the U.S. Treasury’s plan to create an $80 billion fund to buy distressed assets from structured investment vehicles linked to home lending.

“I don’t see any way that pooling a bunch of mortgages, changing the ownership, is going to change the viability of the mortgage instrument itself — whether people can make the payments,” he said. “It would be better to have them on the balance sheets so everyone would know what’s going on”

I hesitate to question the wildly popular Oracle of Omaha publicly, but I don’t see Super-Conduit as being merely a vehicle to change ownership – I see it as a matter of wiping out the old equity-holders and injecting new equity while keeping the note-holders happy and senior.

However, the Super-Conduit plan seems to be having trouble attracting supporters; this may be an indication that the potential players see it more as Citibank bail-out than as a vulture fund; or it may simply indicate that potential players would rather be vultures all by themselves. Without disclosure of every nuance of the negotiations, it’s hard to guess! 

Nouriel Roubini writes a very gloomy assessment of the chances for a major 1987-style stock market collapse and concludes:

To avoid such a meltdown, we need many reforms: better regulation and supervision of mortgages and of financial institutions, including the lightly or unregulated hedge funds; more transparency on who is holding which risky assets; better risk management by investors; avoidance of a bailout of reckless lenders and investors; a more competitive market for ratings as the small set of only three rating agencies seriously misread very complex and risky instruments; and hopefully a modest and soft—rather than hard—landing for the U.S. economy.

In other words: it would be a really wonderful world if only there were more rules in it! I won’t reiterate my past arguments against Regulation Nirvana; I’ll just say again that regulators should ensure there is a solid banking system at the core of financial operations, then let the rest of us play with it as we will. And strengthen the concept of fiduciary responsibility, so that those who recklessly violate Prudent Man rules end up wearing the losses.

Default Risk has published a paper on Equity Implied Ratings:

Fitch’s Equity Implied Ratings and Probability of Default (EIR) model is estimated to provide a view of a firm’s credit condition given its current equity price and available financial information.

This is an enhancement that I have been longing to bring into HIMIPref™ … perhaps someday!

There aren’t many bank runs nowadays and some credible analysis of the Northern Rock run is getting done. Two major conclusions: Northern Rock was overleveraged and UK Deposit Insurance is inferior. Deposit insurance in the UK covers:

100% of the first £2,000 (about $4,100) and 90% of the next £33,000 (about $ 67,500)

Various forms of deposit insurance were reviewed by BIS in 1998; I am somewhat surprised to learn that deposit insurance is something of a novelty in Europe:

While most commentators see some merit in the idea of deposit insurance, there is more disagreement as to whether deposit protection schemes should be explicit or not. Most commentators seem to accept the former position. One part of the argument is that, in the middle of a crisis, olicymakers will be forced to offer explicit protection to everyone. Thus, the costs to taxpayers may be very high. In contrast, Demirgüç-Kunt and Detragiache (2000) seem to argue that poor design can make the explicit protection route even more costly. This design issue is returned to below. Explicit deposit insurance schemes are certainly much more widespread than they used to be. The first nationwide system was introduced in 1934 in the United States, but other countries only began to follow in the postwar period. This trend accelerated in OECD countries in the 1980s, culminating with the introduction of limited deposit insurance in the European Union in 1994.

The argument against deposit insurance is moral hazard:

Erlend Nier and Ursel Baumann find, in a cross-country study, that enhanced disclosure by banks seems to induce banks to limit their risk of default by keeping higher capital buffers for given asset risk. Their results also suggest that market discipline is stronger for banks that are funded by uninsured liabilities and weaker for those that benefit from wide deposit protection schemes or other safety nets. The latter may therefore be introducing a degree of moral hazard.

I don’t buy it. The average retail investor is doing well if he can balance his chequebook – how can he be expected to analyze the soundness of a bank during a crisis? He’s going to know nothing and know he knows nothing; he will therefore withdraw his deposits and contribute to a run.

The North American system of providing full deposit insurance on amounts up to $100,000 per institution per person is a good solution; but as I have previously mentioned, the CDIC doesn’t have enough cash in the till to be credible during a genuine crisis. They should have at least enough to recapitalize their largest member completely and the Royal Bank has capital of about $26-billion. And further, not a single dime of the CDIC’s reserve fund should be invested in Canada!

Menzie Chinn of Econbrowser continues to worry about the prospects for the national debt:

… following her assault on the implausible economic assumptions of the Bush administration:

But real change in American fiscal policy will not happen until they become very close to hitting the wall. And, for all the dollar drama, they’re a long way from that point. It will be interesting to see if record lows against the Euro become an issue in the 2008 elections. Oil at USD 90 ain’t going to help the economy much!

Remember the Moody’s mass downgrade of October 11? In a fascinating development, Global DIGIT (last mentioned October 16, with a full post regarding its suspension of dividends) has announced:

As at October 3, 2007, the reference portfolios of Global DIGIT contained 8 of the securities downgraded by Moody’s.

The total exposure to downgraded instruments is $463-million – out of a total portfolio of $1.4-billion. Whoopsee!

Very good volume in the preferred share market today, but the perpetual indices resumed their descent.

There were forty-six other index-included $25.00-equivalent issues trading over 10,000 shares today.

Update: Typographical error on RY.PR.G yield corrected. Revised number is approximate.