PrefBlog

Geez, I hate it when the Financial Post gets desperate for copy. They consult their Journalists’ Handbook, and see that if somebody says “white is white”, it’s an interesting angle to dig up somebody who’ll say “white is black”.

They did it last year and now they’ve done it again: a short piece titled The ‘risk’ of Preferred Shares, by John Greenwood, pointing out that dividends are not guaranteed.

You can almost hear the journalist’s leading questions, which are not reported:

What would happen if a bank were to skip a payment on its preferred dividend?

If a bank were to skip one, the market for the shares would “be vaporized,” said Blackmont Capital analyst Brad Smith.

How many banks would have to skip payments before the market was adversely affected?

“All that would have to happen would be for one bank to miss a payment and the whole market would shut down,” said another analyst who asked not to be named.

Particularly irksome is:

Some European banks have been forced to cut back on dividends after accepting government bailouts.

Can he name any? I’m sure there have been some preferred defaults, but I can’t remember seeing anything about government money being conditional on a preferred dividend cut. Common dividend cuts, sure, that has happened in the States too … let’s just say I want more details.

If he wants to talk about preferred share defaults, he can look at Nortel & Quebecor World right here in Canada!

The only saving grace is:

Preferred shares rank senior to common, so even if the dividend on the common is sacrificed, holders of preferred shares could still collect. According to Sherry Cooper, senior economist at BMO Nesbitt Burns, aside from National Bank, none of the major banks has cut a dividend since the Great Depression. (National chopped twice, most recently in the early 1990s.)

… but still, I find the article annoying in the extreme. Particularly since I don’t understand why the word “risk” in the title is in quotes!

Yes, preferred shares can have their dividend cut. We know that. But if somebody’s going to talk about it in the newspaper, can we PLEASE have some kind of indication of how likely they think that might be? As for myself, I consider the probability immeasurably small for Canadian banks right now …the banks are well capitalized and profitable … anything imminent would be in the nature of a black swan event, immeasurable by definition.

Let the banks here get into trouble and sure, I’ll be happy – eager! – to start taking a view on the chances of them getting into more trouble. But could we at least wait to see some actual signs of definite trouble before discussing the effects on the market of a skipped payment?

I mean, geez, what’s next? A banner headline announcing that a giant asteroid smashing into earth could ruin our whole day?

Bloomberg has reported:

For the first time, the market will have a committee of banks and investors making binding decisions that determine when buyers of the insurance-like derivatives can demand payment and could influence how much they get, industry leaders said yesterday at a conference in New York. Traders also will revamp the way the contracts are traded, including requiring upfront payments to make them more like the bonds they’re linked to.
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The plan doesn’t change contracts traded in Europe.
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In one of the most noticeable changes for traders, those who buy protection will pay an upfront fee depending on current market prices, and then a fixed $100,000 or $500,000 annual payment for every $10 million of protection purchased. Now, upfront payments are only required for riskier companies, and the annual payment, or coupon, on most contracts is determined by the daily market level.

Dealbreaker, bless its heart, is contemptuous:

We are looking forward to the world where the only finance products permitted go up forever, and where everyone makes above average returns.

I’m mainly confused, and hoping that the Bloomberg reporters simply got it wrong. A standard up-front fee for the buyers of protection? It makes no sense. The buyer’s risk is limited to the sum of the present value of the payments required. A five year contract with a 5% premium limits the buyer’s potential loss to 25% of the notional value. The tail risk of the contract is owned by the seller of the protection, who can lose 100% of notional on the very first day the contract is in existence.

Selling protection has capital implications roughly equivalent to owning the bond. I have no problem with the idea that CDS sellers post margin equivalent to what they would have to were the position an actual bond – but most of them do already. The trouble started when the AIGs and MBIAs of this world sold protection without posting collateral or taking a high enough capital charge for regulatory purposes.

And what’s this with a fixed standard rate of $100,000 or $500,000 per year for the premium (paid by the buyer to the seller) on $10-million notional? That’s 1% and 5%, respectively. I can see that it might be very useful to standardize tick sizes, so that all contracts will trade with, say 10bp ticks … but those premia don’t make any sense.

Note that with 10bp ticks (any size ticks, actually), virtually every contract would have a value at the opening, which would be settled by cash payment between buyer and seller at the time the contract is written. I don’t have any problems with that idea – it would make contracts more fungible, particularly if settled by a clearinghouse.

But we are in the hysteria phase of CDS demonization and the politicians need a pulpit. ISDA has released a mild demur – I can only hope they’re more vociferous behind closed doors.

It was announced yesterday that JPMorgan’s analytics will go open-source; but no details of licensing have yet been released.

Assiduous Readers will remember the puzzle of the Effective Fed Funds Rate. Fed Funds were trading at 0.25% at a time when excess balances were earning 1.00% from the Fed, which appears to allow a risk-free arbitrage.

A recent Fed Press Release and its attachment may provide a piece of the answer. First, a little terminology gleaned from the attachment … a small bank does not need to satisfy its reserve requirements directly with the Fed. It can deposit the necessary funds in a (presumably bigger) bank’s Fed account, in which case the small bank is the “respondent” and the big bank with the Fed account is the “pass through correspondent”. Got it? OK:

As noted above, Regulation D currently deems the entire balance in a pass-through correspondent’s account at a Reserve Bank to be the exclusive property of the pass-through correspondent and to represent a liability of that Reserve Bank to the pass-through correspondent exclusively. Therefore, the pass-through correspondent must show the entire balance in its Reserve Bank account on its own balance sheet as an asset, even if the balance consists, in whole or in part, of amounts that are passed through on behalf of a respondent.

Accordingly, when a correspondent’s respondents want to earn interest on excess balances by leaving them with their correspondent (which in turn passes those balances through to the Reserve Bank), the correspondent has a larger balance at the Reserve Bank. As a result, the correspondent has more assets on its balance sheet and a lower leverage ratio for capital adequacy purposes.

In contrast, when the correspondent sells the respondent’s federal funds on the respondent’s behalf, the respondent directs its correspondent to transfer funds to the entity purchasing federal funds. This transaction is effected by a debit to the correspondent’s account at a Reserve Bank and a credit to the purchaser’s account at a Reserve Bank. On the correspondent’s balance sheet, all other things being equal, the correspondent’s assets decline (as does its liability to its respondent) because the correspondent’s account balance at the Reserve Bank is lower and therefore its regulatory leverage ratio would be higher.

Since the implementation of interest on excess balances through the October interim final rule, the actual federal funds rate has generally averaged significantly below the interest rate paid by the Reserve Banks on excess balances, although this spread narrowed significantly after the FOMC established a range for the federal funds rate of 0 to ¼ percent on December 16. When the market rate of interest on federal funds is below the rate paid by the Reserve Banks on excess balances, respondents have an incentive to shift the investment of their surplus funds away from sales of federal funds (through their correspondents acting as agents), and toward holding funds directly as excess balances with the Reserve Banks, potentially disrupting established correspondent-respondent relationships. A correspondent could offer to purchase federal funds directly from its respondents and hold those funds as excess balances at a Reserve Bank; however, such transactions could result in a significant reduction in regulatory leverage ratios for some correspondents. The Board believes that the disparity between the actual federal funds rate and the rate paid by Reserve Banks on excess balances may partly be caused by the leverage incentives imposed on correspondent institutions to sell excess balances into the federal funds market rather than maintaining those balances in an account at a Reserve Bank.

To address this problem, the Fed is proposing to establish a new account type, an “Excess Balance Account”.

These excess balance accounts (“EBAs”) would contain only the excess balances of the eligible institutions participating in such accounts, although the participating eligible institutions (“EBA Participants”) would authorize another institution (“EBA Agent”) to manage the EBA on their behalf. The authorization of EBAs is intended to allow eligible institutions to earn interest on their excess balances at the excess balance rate in an account relationship directly with the Federal Reserve Bank as counterparty without disrupting established business relationships with their correspondents. Continuing strains in financial markets and the configuration of interest rates support the implementation of EBAs; however, the Board will evaluate the continuing need for EBAs when more normal market functioning is restored.

EBA Balances will not gross up the pass-through correspondent’s balance sheet.

Update, 2009-2-2: Economic Policy Journal commented in early December on a December 1 speech by Bernanke in which he noted:

In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target.
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Banks have an incentive to borrow from the GSEs and then redeposit the funds at the Federal Reserve; as a result, banks earn a sure profit equal to the difference between the rate they pay the GSEs and the rate they receive on excess reserves. However, thus far, this type of arbitrage has not been occurring on a sufficient scale, perhaps because banks have not yet fully adjusted their reserve-management practices to take advantage of this opportunity.

I am happy to see my ‘bureaucracy explanation’ front and centre!

ISDA has announced:

that J.P. Morgan has transferred to ISDA its CDS Analytical Engine. The CDS analytical engine, originally developed by the Quantitative Research group at J.P. Morgan, is widely used in the industry to price CDS contracts. ISDA will make the analytical engine available as open source code, thereby increasing transparency around CDS pricing.

“J.P. Morgan has invested a lot of intellectual capital in this analytical engine. Its willingness to assign this to ISDA for us to make it available as open source to the entire industry demonstrates our collective commitment to the integrity of the CDS product,” said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. “ISDA and its members are vigilant to public concerns around transparency. This is yet another measure of increased standardization in CDS.”

This is interesting, particularly given the politics that are swirling around the market. Making the code available to the public could be a first step towards listing some benchmark names on an exchange. As yet, though, the details of the open-source licence are not available.

Hat-tips: Alea via Dealbreaker.

Ed Clark, CEO of TD Bank, has gotten himself into a little trouble over some remarks made at the RBC Capital Markets Canadian Bank CEO Conference, Jan. 8, 2009, in Toronto.

He began by deprecating TARP:

I think we have the capital, but, as I said when I do the little arithmetic, that’s an issue. As you know – I mean, I have strong views on this. The United States comes along and it puts this TARP in and adds three points to the Tier 1 ratio. If we were in the United States today, our Tier 1 ratio would be about 12.5%, so you sit there and you say this is just a con game, a five-year retractable pref we’re going to call common equity, because the US government says, Basel was an interesting thought, but we overrule Basel. And so if we look at Wells Fargo, USB and PNC, our tangible common equity is 40% or 50% bigger than theirs. And that’s the way I run the bank, is everything starts with tangible common equity, and then you leverage that up in different structures and that’s – so you get that and then you try to maximize your return on risk-weighted assets, which means you maximize your operating ROE.

… which was interesting enough, but his comments on the safety of TD preferred shares – and by implication, other Canadian banks – have attracted attention:

I think Mr. Bernanke’s going to win. He’s going to say to the market, I’m going to make it so expensive for you to hold riskless assets that you will finally wake up and say you can take some risk.

And that’s really what happened in our preferred share issue, is that the average consumer sat there and said, well, this is 6.25%, but it’s actually 8% pretax, effectively government guaranteed, maybe not explicitly, but what are the chances that TD Bank is going to not be bailed out if it did something stupid? And so where else do I get 8% government investments right now? And I think suddenly the retail market came back in January and said, give me more of this, and so when we did our issue, they said, could you give us some more of this piece of paper?

And so I do think that we are going to be able to emerge out of this and say the Canadian bank will not only redefine Canadian banking, I think it will redefine Canada as to say, somehow you guys did it right. It’s not obvious, you don’t look that smart when we look at you, but somehow you stumbled your way through here and did this right.

And so, I think that’s worth fighting hard for, and if that means that when the shorts from the US arrive in Toronto and swagger down Bay Street and say, we’re going to short all the Canadian banks and teach you guys a lesson, we’re going to put you out of business, you have to take them seriously, fight back. But you don’t fight back by going on the market. And so if that means we have to raise non-common Tier 1 ratio to look pretty, I’ll do that. It’s stupid, but it’s good to the interests of my shareholders.

It’s an interesting passage. I certainly agree with the characterization of Bernanke’s strategy for fighting the credit crunch. I have recently highlighted the enormous build-up in excess reserves in the US, that are currently held at basically no interest at the Fed; a hopeful sign is a recent shrinking of the Fed’s balance sheet; and if the Fed keeps spreads where they are – or follows my recommendation to slowly increase them – then at some point greed will overcome fear.

The last part of the passage deals with the eternal financial markets question: lucky or smart? He obviously has a conflict of interest in being so firmly in the “smart” school and buttresses it with a little nationalist swagger; I’m going to retain my opinion of “lucky”. But you never really know.

It’s the middle piece of the passage, where he states in so many words that there’s an implicit government guarantee on TD’s (and presumably the rest of the Big 6) preferred shares.

It’s a shockingly irresponsible statement; one may hope that at the very least he has a highly uncomfortable meeting with the regulators (he won’t, of course, but it’s always pleasant to hope).

I will go so far as to agree that at this particular time, if any of the Big 6 disclosed that they were far too close to insolvency for comfort, there would almost certainly be a bail-out (although I’m less certain that preferred shareholders would get off scot-free). I think the global response to the Lehman insolvency has convinced policy makers that now is not the right time to apply doctrinaire free market principles.

But. But! These preferreds Mr. Clark is flogging are perpetual. Interest rate may be mitigated – with corresponding increase in reinvestment risk – but the credit risk is perpetual. Twenty years ago, Mr. Clark’s smart bank was on the verge of insolvency, having hired too many MBAs to accumulate More Bad Assets in Mexico, Brazil and Argentina.

Could it happen again? Why not? Even if we allow Mr. Clark’s assertion that TD is very smart, I’m reminded of an investment aphorism (source unknown, at least to me): Only buy businesses that an idiot could run, because eventually an idiot will.

If, ten years forward, TD Bank does something stupid at a time when the collapse of a rinky-dink little Canadian bank will not have global systemic implications … it could fail. And I will remind investors that Tier-1 eligible preferred shares are perpetual, and the word “perpetual” includes “ten years forward”.

So anyway, he’s been taken to the woodshed by a bravely anonymous “government official”, reports Bloomberg:

Toronto-Dominion Bank Chief Executive Officer Ed Clark was “absolutely wrong” to suggest the bank had the implicit promise of a bailout under any circumstances, a senior Canadian government official said.

There are “no guarantees” for companies that make “stupid decisions,” said the official yesterday in Ottawa, who spoke on condition he not be identified.

… or, at least, as close to the woodshed as we’re likely to get.

Why isn’t Spend-Every-Penny making this statement? Why aren’t the regulators demanding an instant and grovelling retraction?

The Investment Industry Association of Canada has released its 3Q08 Debt Trading and Issuance Report, noting:

Long-term borrowing costs for corporations also increased and, as a result, corporate bond issuance recorded its lowest financing totals in 6 years – $10.8 billion – down $13.2 billion or 55% from the previous quarter (Chart 2).

The third quarter saw only one lonely Maple bond issued, worth a mere $200-million … but that represents an increase from the second quarter!

Jim Hamilton of Jim Hamilton’s World of Securities Regulation has posted a piece on regulatory initiatives that are at the discussion stage: Former Fed Chief Volcker Unveils Plan for Reforming Financial Regulation:

Former Federal Reserve Board head Paul Volcker has unveiled a plan for the reform of the regulation of the financial markets that envisions a macro prudential regulator and more robust regulation of credit rating agencies.
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In addition, money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation, government insurance, and access to central bank lender-of-last-resort facilities.

Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.

I am unable to find primary sources for this assertion, but I’ll keep trying!

This would be a good move, given the effects of the Lehman bankruptcy:

It was the $785 million of losses on Lehman’s securities that pushed the value of the assets of a major money market firm below their $1 per share paid value, described as “breaking the buck.” This caused $400 billion to be taken out of money market funds in a matter of days, while the rest of the funds were frozen in anticipation of further withdrawals. Banks were relying heavily on these funds for their commercial paper and the result was a spiral of illiquidity.

Assiduous Readers will recall my Collateral Proposal of last year:

In practice, banks guarantee the credit quality of the Money Market Funds they sponsor. This guarantee should be reflected when computing their capital ratios.

Update, 2009-1-21: The paper was Financial Reform: A Framework for Financial Stability [new link, updated 2009-6-22], as reported by the Washington Post. The precise wording of the recommendation is:

a. Money market mutual funds wishing to continue to offer bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value (NAV) at par should be required to reorganize as special-purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.

b. Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortized cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.

I was at the Financial Forum today, as previously announced, and was really pleased at the size of the thronging crowd of adoring fans who came out to learn a little bit about preferred shares.

I wasn’t able to get to all of my slides, but the presentation will be on the Canadian Moneysaver website shortly … and I’ve also uploaded it here (Microsoft PowerPoint file).

As previously announced, I will be presenting a seminar at Financial Forum in Toronto:

Preferred shares can complement bonds in taxable fixed-income portfolios. A wide variety of characteristics allows a preferred share portfolio to be tailored to the individual needs of the investor, but this very variety can lead to the “tyranny of choice”, in which the necessity of choosing between various options leads investors to avoid the sector entirely. In this seminar, you will learn to assess the characteristics of different preferred shares, how to compare the prices of these shares and how to put together a portfolio that meets your needs … with very attractive tax savings compared to bonds and GICs!

Break-out seminar session Friday Jan 16/09 5:00-5:45 pm at the Toronto Financial Forum.

The very useful website canadianBondIndices.com (linked in the right hand panel, under “Canadian Fixed Income Data”) is temporarily unavailable.

I am advised that this is a mere technical issue with a change in DNS provider and that the site should be available again in the near future.