PrefBlog

I noted on March 18 that the “search” function was on the blink.

I needed to upgrade the version of WordPress that runs this site anyway … so, after carefully backing up the site’s contents, checking that I had everything, saying a little prayer and closing my eyes … I upgraded and everything seems to be working again.

Please let me know of any problems, or abnormally stupid-looking changes that you think might be accidental.

The auction for BCE.com which was mentioned last week has finished.

A last-minute flurry of bidding took the price up from USD 19,500 to USD 28,001. I’ll keep an eye on this to find out the identity of the winning “Bidder 15”, who entered the race at 8:44am today with an initial bid of USD 17,505.

The twenty trusts covered by the Montreal Accord have entered bankruptcy proceedings:

Twenty trusts received bankruptcy protection today in an Ontario court until April 16, giving investors time to review a plan drafted by a committee of some of the biggest debt holders. The proposal needs the support of a majority of noteholders, as well as investors holding a combined two-thirds of the debt.
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Crawford’s group had asked the Ontario Superior Court of Justice to call a noteholder meeting to approve the plan. Investors holding about C$21 billion of the notes have already agreed to the plan with some conditions, according to the filing.
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The restructuring includes a credit line of almost C$14- billion provided by institutional investors, foreign banks and Canadian lenders. Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Bank of Nova Scotia and Toronto- Dominion Bank indicated in a March 13 letter they would provide C$950 million to support the new notes as part of that credit line, court documents show.The group asked the court to appoint Ernst & Young Inc. as monitor in the restructuring. Investors will be sent information on the proposal and will hold meetings with noteholders in various cities.

The group said legal and banking fees paid to advisers including JPM Morgan Chase & Co. and Goodmans LLP are about C$80 million to C$100 million.

DBRS has downgraded the trusts to D[efault]:

DBRS has today downgraded to D 20 of the Affected Trusts under the Montréal Accord. This rating action was taken following the announcement that a filing has been made on behalf of each of the Affected Trusts under the Companies’ Creditors Arrangement Act (CCAA) and should not be seen as indicative of deterioration in the credit quality of the assets held by the Affected Trusts.
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In a number of press releases, commentaries and newsletters published since August 16, 2007, DBRS has stated that the credit quality of the majority of the assets held by the Affected Trusts remained strong. This continues to be true. Today’s downgrade reflects the fact that the Affected Trusts are now subject to a court-supervised process which, if successful, will see the obligations of the Affected Trusts be restructured per the terms of the Framework Agreement.
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As part of today’s filing, the Committee has submitted to the court a Plan of Arrangement and Compromise (the Plan). Details of the Plan will be sent to holders of the ABCP issued by the Affected Trusts. The court will be asked to issue a Meeting Order so that a meeting may be held at which noteholders will be asked to approve the Plan. Approval of the Plan requires the votes of a majority of noteholders voting at the meeting and of noteholders holding 66 & 2/3 of the aggregate principal amount of ABCP held by noteholders voting at the meeting. If noteholders approve, the Plan will be brought before the court for approval.

Frankly, the most interesting line I’ve been able to find is: Investors holding about C$21 billion of the notes have already agreed to the plan with some conditions, according to the filing. Conditions? Some conditions? What kind of conditions?

There is a document centre maintained by Ernst & Young, but the court filing is not included in the available documents.

Update, 2008-3-18: The court orders are now available, but the Purdy Crawford affidavit and First Report of the Monitor are not.

I can’t resist bringing this to the attention of Assiduous Readers.

Whenever I need to visit www.bce.ca, I invariably find myself at bce.com first … as I remember, this site used to be Berkeley Camera Equipment, had a link to bce.ca and also included a highly aggrieved account of how BCE’s lawyers tried to browbeat the owner into handing it over.

This site should not be confused with www.bceinc.com which is Brown Consulting Engineers.

Anyway, a visit to bce.com is now re-directed to an auction site … bidding for this domain closes March 21 at 3pm EST and has now reached USD 12,500.

Make a confounded nuisance of yourself! Bid now, bid often!

I’ve learnt a little bit more about the structuring of the new BNS Perp-Reset issue … it’s quite a feather in the cap for Desjardins!

As some might know, Desjardins has made a big effort over the past few years to become a bigger force in the preferred share market – and they’re punching well above their weight in terms of trading volume. To accomplish this sort of thing, you’ve got to know who the clients are, persuade them to take your calls, understand their motivations so you don’t waste their time and be willing to listen to their feedback. Being able to execute trades at a good price is a very good thing too!

It’s my understanding that Desjardins has been quite successful in applying all this good trading stuff to the secondary market, but that the BNS new issue marks the first time they’ve been intimately involved in a primary offering.

The story I hear is that a lot of clients – and I don’t mean retail clients, I mean clients more like GGOF Monthly Dividend Fund, which has 61% of its $321-million invested in prefs – a lot of clients are getting fed up with straight perpetuals.

These clients want a little bit more diversification. Ideally they’d like retractibles, but due to the Tier 1 Capital rules and the accounting rules, there’s not going to be much of those issued any more. Maybe split shares would be OK, but some of these clients have an aversion to structured product and it’s hard to take a good-sized position in an issue with a total size of $35-million anyway. So … Desjardins listened and, I’m told, determined that there was a market for a good-sized liquid issue with the new structure, worked out in more detail what would sell at a price the issuer was willing to pay, got involved in discussions with OSFI about what would be acceptable as Tier 1 Capital and made the pitch to Scotia (not all steps necessarily in the order listed).

Scotia listened, everybody got on board and the deal happened.

And Desjardins has been rewarded, for the first time, with “Co-Lead Manager” status on the underwriting. A very good joint effort by the Preferred Share Department & Corporate Finance!

Another interesting thing I’ve been told is that OSFI will not accept “Ratchet Rates” as Tier 1 Capital – so the structure of all the BCE issues can’t just be ported over holus-bolus.

I haven’t changed my mind about the investment qualities of this particular issue … but if it starts an entirely new class of preferreds, that can’t be a bad thing. And I do have to correct my mistaken statement that Scotia invented the structure!

There seem to be a lot of people who will answer the headline question: “Yes!”

I recently responded to Menzie Chinn’s “Crony Capitalism” post, and highlighted my doubts there … now Econbrowser‘s James Hamilton has picked up on the theme (or acknowledged it, anyway) in a post about Bernanke’s Tightrope Act.

Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope– if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we’ll see a resurgence of inflation. I am increasingly persuaded that’s not an accurate description of the situation.
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The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter.

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

No, I don’t believe that Bernanke is walking a tightrope at all. But I do hope he’s checked out the net that’s supposed to catch him if he falls.

In a recent post about Inflation Expectations, I opined that the only way I could see to make the market data on Fed Funds and Treasuries consistent was to assume that expectations (of both the market and the Fed) were for an output gap of 5.6% … which is a shockingly fierce recession and, given that the data indicate a period of two years plus, would be labelled a depression by many. So I don’t really have any quarrels with Professor Hamilton’s deduction that the Fed is “worried that a recession in the present instance would precipitate major financial instability”; with, I presume, the major financial instability feeding back into the real economy until we find ourselves all naked and homeless.

But that’s not why I’m devoting an entire post to this response … my quarrel is with the unchallenging repetition of the assertion:

But I think the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

Let’s trace this back to the source document – always a fun exercise, I love the Internet! – starting with Mark Thoma’s post on his Economist’s View blog, Brad DeLong: Three Cures for Three Crises, dated December 31. Professor Thoma doesn’t provide any commentary with this post, but does link to a supporting WSJ blog post, Liquidity Threat Eases; Solvency Threat Still Looms.

I’ll side-track a little here … the WSJ blog links to a story in the Boston Globe:

The new rules impose surcharges of 0.75 percent to 2 percent for many conventional borrowers who have credit scores below 680, and who don’t have at least 30 percent for a down payment. Fannie Mae says the lenders may pass along those fees in a variety of ways.

Those in the industry worry many will be priced out of the market. O’Neil notes that about half her customers have credit scores less than 680. “It will definitely affect our business,” she said.

And few buyers ever pay 30 percent down payments. “That’s pretty insane . . . not a lot of buyers will be able to do that,” said Alex Coon, the Massachusetts market manager for online residential real estate brokerage Redfin. “It’s certainly not going to do any favors for the real estate market.”

To me, this story simply reinforces my belief that the US Mortgage market has been incredibly loose for quite some time. I mean … a 25% downpayment in Canada is standard, for heaven’s sake! But, to return to my argument …

The WSJ noted as support for the insolvency theme stated:

Nonetheless, as Lou Crandall, chief economist at Wrightson ICAP LLC said today, “Things are unfolding smoothly.” The first quarter is likely to start much as the fourth quarter did, with reduced concerns now that the statement date has passed.

Balance-sheet strains will continue to create concerns about the price and availability of short-term funds, Mr. Crandall said. But for the most part, “We’ve moved beyond … liquidity concerns. The focus has moved to that part of the financial fallout that central banks can’t address through technical operations.”

In other words, as 2008 begins, it’s solvency, not liquidity, that threatens the economy and the financial system. And at the root of the solvency threat is a likely decline in housing prices that will further undermine credit quality. Making banks more confident of their own ability to raise funds is not going to resolve a generalized shrinkage of lending driven by declining collateral values.

“In other words”? There seems to have been a great deal of interpretation and analysis glossed over in the rephrasing! Mr. Crandall is highlighting concerns over credit quality, sure, but

• credit concerns are a far cry from insolvency crises, and
• it is not even clear that he is referring to concerns about credit quality of the banks. From the quote, he could be referring to shadow-banks, non-financial corporations, investors or consumers

The apparent leap in logic might be justified by the complete WSJ interview of Mr. Crandall, but is certainly not justified by the quotations. And even if Mr. Crandall approves of the WSJ interpretation, there is no indication that this is anything more than one economist’s opinion – there is precious little data on display.

In other words, the WSJ supporting article doesn’t withstand scrutiny all that well – there’s no data and no argument. Just an assertion which may well be nothing more than an interpretation by the reporter.

And now we get to the source of this assertion – Prof. Delong‘s opinion piece. He defines three mechanisms whereby asset prices can fall:

The first — and “easiest” — mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices.
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In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
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The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger.

… which have different ideal policy responses. A liquidity crisis is easy to address:

The cure for this mode — a liquidity crisis caused by declining confidence in the financial system — is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.

This is the rule set out by Walter Bagehot more than a century ago: Calming the markets requires central banks to lend at a penalty rate to every distressed institution that would be able to put up reasonable collateral in normal times.

… while the second mode requires a policy response much like that used to recapitalize the American banking sector after the S&L crisis:

This kind of crisis cannot be solved simply by ensuring that solvent borrowers can borrow, because the problem is that banks aren’t solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.

In this case, applying the Bagehot rule would be wrong.

The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away, while the Bagehot rule — with its high lending rate for banks — would make matters worse.

… while the solution to the third mode reflects the “Resolution Trust” that was used to contain the S&L crisis:

When this happens, governments have two options. First, they can simply nationalize the broken financial system and have the Treasury sort things out — and reprivatize the functioning and solvent parts as rapidly as possible. Government is not the best form of organization of a financial system in the long term, and even in the short term it is not very good. It is merely the best organization available.

The second option is simply inflation. Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

This is all very interesting, to be sure, but which mode are we actually in? Prof. DeLong does not venture a firm opinion, but concludes:

At the start, the Fed assumed that it was facing a first-mode crisis — a mere liquidity crisis — and that the principal cure would be to ensure the liquidity of fundamentally solvent institutions.

But the Fed has shifted over the past two months toward policies aimed at a second-mode crisis — more significant monetary loosening, despite the risks of higher inflation, extra moral hazard and unjust redistribution.

As Fed Vice Chair Don Kohn recently put it: “We should not hold the economy hostage to teach a small segment of the population a lesson.”

No policymakers are yet considering the possibility that the financial crisis might turn out to be in the third mode.

Therefore, then, the implication that we actually are in a mode 3 scenario of falling asset prices is due solely to Prof. Hamilton’s analysis (or, perhaps, is inadverdent, implied only by an imprecise framing of the quotation). Prof. DeLong is merely asserting that the current Fed operations (as of Dec. 31, remember!) are due to a Fed opinion that we are in mode 2; Prof. DeLong hints, but does not assert, that we could be in mode 3.

With respect to Prof. Hamilton’s analysis, there is no argument to support an assertion that we are in a mode 3 scenario. If I read his conclusion correctly, Prof. Hamilton is asserting that Bernanke is terrified of entering a mode 3 crisis and is therefore increasing his response to a mode 2 crisis.

Naked Capitalism also reflects on Prof. Hamilton’s post and suggests:

The only defense Hamitlon can find for the central bank’s actions is that it may be deliberately stoking inflation to erode the value of America’s debt overhang.

… which misses the point. Monetary policy under a mode 2 response aims to increase the carry on assets via lower real rates, while it is only in mode 3 that the fires of inflation are deliberately stoked.

I agree with what I conclude is the central conclusion of Prof. Hamilton’s post:

I think part of the basis for Bernanke’s optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke’s textbook suggests that, for given inflation expectations, if output falls below the “full-employment” level, inflation should go down, not up.

But nowhere – nowhere! – in any of these posts is there support for the idea that financial system is insolvent. Hurt, yes. Insolvent, no.

I once heard an explanation of why economics is termed “the dismal science”. It’s because, you see, you can spend ten years of your life, full-time, working on a particular model of something … capturing inputs, backtesting sensitivity, creating theoretically acceptable models of transmission mechanisms … and finally, finally, have something that looks really good.

You walk down the street, show it to the first guy you meet, he says “What about taxes?”

You say “Oh …. bugger!” and go back to your office for another ten years. 

Inflation talk is all the rage now and the following paragraph by James Hamilton on Econbrowser caught my eye:

Greg Ip, Felix Salmon and Greg Mankiw are concerned that the 5-year TIPS-nominal spread has fallen relative to the 10 year, implying that the 5-year forward inflation rate (the so-called 5-year, 5-year break-even rate) has gone up. But I agree with the analysis by knzn and particularly Francisco Torralba that the facts are much less alarming than Ip’s graph might have seemed to suggest, and that the basic impression of stability of longer term expectations that one brings away from the graph I’ve plotted above is the correct one.

Well, let’s have a look at some fresh data:

So, as of February 20, the 5/5 Breakeven rate was (approximately) 2.51%, which is basically what it was on January 30, according to knzn. So far, so good: we’re getting a relatively constant number for the 5/5 BE. However, compare the data further with knzn’s calculations:

I snuck two extra columns into the time-series because they’re important. The 2-Year Nominal is generally accepted as being the market expectation of the average Fed-Funds rate through the period. (I had a quick look for some research regarding just how good a predictor it is, but didn’t see anything. Somebody must have created the spreadsheet at some time! Come on, now! Let’s see a scatter plot of 2-Year Nominal Treasury Yields vs. two-years-following cumulative Fed Fund returns! Anybody?)

Anyway … it seems to me that if we’re to take the 5/5 BE rate as an estimate of inflation expectations, then we are assuming that the market is rational. And if the market is rational, then the two-year Treasury must also be a rational estimate of Fed Funds expectations. So right off the bat, we see that the estimate of 2.5% inflation from 2013-18 is dependent upon a pretty low Fed Funds rate over the next two years.

It should be noted that the argument developed here is very, very approximate. There is a liquidity premium that should be accounted for with investments of different terms (and isn’t); there are segmentation effects (only a few institutions can get the Fed Funds rate directly; anybody can buy a treasury); there are preferred habitat effects (some players will not switch between reals and nominals no matter how many fancy graphs you show them). All of the other caveats noted by Francisco Torralba apply as well.

OK, be patient, I’m getting to the point! As noted on Econbrowser Taylor has used coefficients of 0.5 for output and 1.5 for inflation to determine appropriate policy responses to deviations from ideal conditions.

OK, now here’s where my argument starts getting a little hairy! We will assume that the change in CPI is zero. Based on recent observations, we can be pretty sure inflation is not declining; the argument in Econbrowser that inspired this post is that expectations haven’t changed, either. The hairy part of this is that inflation expectations five years out are not the same thing as currently measured (trailing) inflation and they’re not the same thing as expectations for next year, either! It’s fairly difficult to refute an argument that inflation is expected to do … something … for the next year and then return to normal (due to wise actions by the omniscient Fed) in time for 5/5 BE to be unchanged too.

But I’m making an argument about the consistency of economic models here, so we’ll assume that the (simplified) theory presented here is accurate: there is an expectation that inflation will increase by 20bp over the next five years. The appropriate policy response, therefore (based solely on the inflation term) is to increase Fed Funds 30bp.

But Fed Funds have not been increased by 30bp … they’ve been dropped 125bp. The difference between these two figures, 155bp, must (if we are to assume perfection of our models AND perfection of Fed policy) be due to a Taylor response to the output term, which has a coefficient of 0.5. This only resolves if we have an output gap of 3%.

The situation gets worse if we consider the two-year note to be a good predictor of Fed Funds under the expectations hypothesis: the yield is now 2.14% (it’s been sub-2% recently) so let’s add a tiny term/liquidity/segmentation premium and say the market expects Fed Funds to be 2.00% for the forseeable future, which is a drop of about 2.5% from mid-January, which  resolves to an output gap of 5.6%.

Assume that potential real GDP growth is 3%.

We conclude that one of the following must be true:

• Inflation expectations have in fact increased far beyond that shown by the simple model, or
• The two-year note yield is not an reliable forecast of average Fed Funds, or
• The Taylor rule has stopped working, or
• Simple models are not capturing all the interelationships, or 
• We’re going to have one hell of a recession … maybe a depression.

My bet is that both of the first two potential explanations are correct, with maybe a small contribution from natural scatter in Taylor Rule explanations. But I’ll bet a whole lot more on the idea that these models being discussed are just plain too damn simple.

And my point is … the markets are not just lacking in omniscience, they’re lacking in rationality. Don’t take the signals too seriously, or spend too much time obsessing over understanding what it’s trying to tell you.

Addendum: I will note, as I did on February 7 that the 5-year corrected market-derived inflation expectations measure is most certainly not flat:

The Cleveland Fed has updated its estimate of inflation expectations from TIPS … very interesting indeed. The breakeven rate is increasing slightly, but the analytical rate – which attempts to incorporate adjustments for the inflation-risk-premium and liquidity-premium – is skyrocketting. This epsiode [sic] will be very useful in determining the validity of these adjustments!

Presumably, a similarly derived correction to the 5/5 BE will have roughly the same size as the correction to the 5-BE. But I don’t know that for sure.

Also, note that segmentation plays a really strong role in some aspects of some markets. I’ll bet there are lots of players who would love to try on the arbitrage of long Fed-Funds / short 2-Year notes … but either can’t, or are scared of the rather special risks of shorting short Treasuries.

The OSC has announced it:

will hold a hearing to consider the Application made by David Berry for a review of a Market Regulations Services Inc. decision dated November 8, 2007.

The hearing will be held on March 6, 2008 at 10:00 a.m. on the 17th floor of the Commission’s offices located at 20 Queen Street West, Toronto.

There are ten elements to the application; I find the most interesting one to be the first, which asks for, among other things, better disclosure of the “materials relating to settlement negotiations between RS Staff and each of Marc McQuillen (‘McQuillen’) and Scota Capital Inc.”

The David Berry Saga was last reported at PrefBlog on December 12. Readers will remember that I am not impressed by Scotia’s business practices or by Regulation Service’s eagerness to be used as a negotiating tool.