Archive for the ‘Banking Crisis 2008’ Category

Bank Sub-Debt Redemptions

Saturday, May 2nd, 2009

On an unrelated thread, Assiduous Reader GAndreone asked:

As the official guardian of the pref share patrimony what is your opinion on the recent redemption of sub-debt by both RBC and CIBC. RBC redeemed $1.0G @ 4.18% and CIBC redeem $0.75G @ 4.25%. In the case of RBC just this year alone they issued Net $1.576G of prefs @ 6.22%
These actions are not clear to me but they certainly maybe clear to you!

So, let’s review:

RY has recently redeemed some sub-debt:

Royal Bank of Canada (RY on TSX and NYSE) today announced its intention to redeem all outstanding 4.18 per cent subordinated debentures due June 1, 2014 (the “4.18 per cent debentures”) for 100 per cent of their principal amount plus accrued interest to the redemption date. The redemption will occur on June 1, 2009. There is currently $1,000,000,000 principal amount of 4.18 per cent debentures outstanding.

The redemption of the debentures will be financed out of the general corporate funds of Royal Bank of Canada.

According to their 2008 Annual Report (page 162 of the PDF), these bonds mature June 1, 2014; first par call June 1, 2009; and:

Interest at stated interest rate until earliest par value redemption date, and thereafter at a rate of 1.00% above the 90-day Bankers’ Acceptance rate.

Which leaves us with another puzzle, since Three-months BAs are now at 0.29% (!) and they had the opportunity to cut their interest rate costs by almost 70%; from $41.8-million annually to $12.9-million annually (assuming BAs are constant).

Similarly with CM:

CIBC (CM: TSX; NYSE) today announced its intention to redeem all $750,000,000 of its 4.25% Debentures (subordinated indebtedness) due June 1, 2014 (the “Debentures”). In accordance with their terms, the Debentures will be redeemed at 100% of their principal amount on June 1, 2009. The interest accrued on the Debentures to the redemption date will be paid through CIBC Mellon Trust Company in the usual manner. The redemption will be financed out of the general corporate funds of CIBC.

The 2008 CM Annual Report (page 131 of the PDF) shows the first par call being June 1, 2009, maturity 2014-6-1 … but they make us go to SEDAR to get the May 3, 2004, prospectus supplement, which says:

… until June 1, 2009. Thereafter, interest on the Debentures will be payable at a rate per annum equal to the 3-month Bankers’ Acceptance Rate (as herein defined) plus 1.00%,

Which leaves us with the same conundrum.

This behaviour was also discussed in the post National Bank Honours Sub-Debt Pretend Maturity.

It all stems back to the way the bond market really works. There are not many actual bond analysts in Canada – or the world, for that matter. Bonds are not bought – typically – after rigourous analysis of their terms and comparison with other opportunities. Bonds are bought because Joe at the brokerage has some to sell and says they’re pretty good. In the case of sub-debt, it is understood that the banks will call these issues on their pretend-maturity date, which is just before they go floating, or step-up to the penalty rate, or whatever. When brokerages calculate yields and spreads on these issues, they perform these calculations based on the pretend-maturity date.

This occurs because the value of sub-debt to the issuing bank changes (in Canada, anyway. Most other places, I think, have the same rules, but I haven’t done a survey) five years prior to maturity. On May 31, the issuers can count 100% of this sub-debt towards their Tier 2 capital. On June 1, they can only count 80%, and the rate declines by another 20% every year until formal maturity. Thus, four years and three hundred and sixty four days prior to maturity, the banks are (theoretically) paying full sub-debt prices for their debt, but only getting 80% of sub-debt value. Therefore, the theory goes, they will call, come hell or high water.

Deutsche Bank did the business-like thing and didn’t call their sub-debt on the pretend-maturity. The market ripped their faces off. Why? Because Joe at the brokerage had sold all that paper to his customers while telling them that the pretend-maturity would be honoured, and then it wasn’t. Deutsche made poor old Joe look silly – and worse, uninformed. It is preferable to go bankrupt than to break the comfortable rules of the bond-traders’ boys’ club.

It is clear that the current rules are not working; the rules for sub-debt need to be revised somehow. The most obvious first step is to change the rules so that fixed-floating sub-debt, or paper with a step-up, is simply not allowed (this would also, I hope, affect fixed-resets!). The absence of a clearly defined break in the investment terms might go a little way towards eliminating this type of expectation.

Because this type of expectation is dangerous! It seems pretty clear that BAs+100 is a wonderful rate for banks to borrow five-year money, even with no Tier 2 allowance at all; but they are pseudo-honour bound to conduct business in a non-business-like fashion. I consider any unbusinesslike behaviour to be a destabilizing force on the financial system; and how come the banks are getting 100% sub-debt credit for the paper on May 31, when it is clear that if they don’t cough up the cash PDQ the market will squash them like a bug?

The trouble is, nod-and-wink behaviour is awfully hard to stamp out. If the regulators are truly interested in financial stability, I think they’ll have to come up with other ideas … up to and including elimination of the concept of maturity dates on Tier 2 capital completely (as well as, in Canada, the idiotic redefinition of Tier 1).

UK FSA Publishes Turner Report on Bank Regulation

Thursday, March 19th, 2009

The UK Financial Services Authority has announced that it has published:

Lord Turner’s Review and the supporting FSA Discussion Paper. These take an in-depth look at the causes of the financial crisis and recommend steps that the international community needs to take to enhance regulatory standards, supervisory approaches and international cooperation and coordination.

The Turner Review, as the report is called, starts with a very good review of ‘How did we get here from there?’, with a particular emphasis, of course, on the UK situation. For those interested in the US MMF initiatives, there is the comment:

The development of mutual-fund based maturity transformation was much less important in the UK than in the US: UK consumers do not to a significant extent hold mutual-fund investments as bank deposit substitutes. And while several UK banks set up SIVs and conduits, the scale was in general smaller than those of the big US banks. But US mutual funds and SIVs were very significant buyers of UK securitised credit: when they stopped buying, a large source of funding for UK credit extension disappeared.

There’s an attack on market efficiency … which is explicitly used as an argument for more wise and beneficial official influence of market prices:

  • Market efficiency does not imply market rationality.
  • Individual rationality does not ensure collective rationality.
  • Individual behaviour is not entirely rational.
  • Allocative efficiency benefits have limits.
  • Empirical evidence illustrates large scale herd effects and market overshoots.

There has been a recent, media-fueled resurgence of interest in financial models and their role in the crisis; the report contains a section on “Misplaced reliance on sophisticated maths”:

Four categories of problem can be distinguished:

  • Short observation periods…
  • Non-normal distributions…
  • Systemic versus idiosyncratic risk….
  • Non-independence of future events; distinguishing risk and uncertainty….

I suggest that these problems are not root causes, but symptoms. Believe me, the people who understood the models knew their limits very well. But in any large business, facts are used in the way the famous drunk uses a lamp-post: for support rather than illumination.

I have previously reviewed the problems inherent in estimating Loan Default Correlation. I suggest that the root cause of the problems in this process is the bigness of banks; there are too many layers of management eagerly telling their superiors what they want to hear, rather than making a Career Limiting Move and playing Cassandra. It is for this reason that there should be a surcharge on Risk Weighted Assets for size.

In fact, however, Lord Turner makes an almost sacreligious attack on market discipline – the Third Pillar of Basel II that I have attempted to defend from OSFI’s depredations. Lord Turner claims:

A reasonable conclusion is that market discipline expressed via market prices cannot be expected to play a major role in constraining bank risk taking, and that the primary constraint needs to come from regulation and supervision.

I suggest a more reasonable thing to try is disclosure … not disclosure from the banks, which is currently ignored, but disclosure by portfolio managers. Anybody with a licence to make discretionary trades for clients should be publishing returns – full and complete returns, which should then be published by the regulators (with spot checks for verification, same as with everything else that gets filed). In this way, we can hope to decrease the influence of salesmen in the industry; portfolio management is largely regarded primarily as an unfortunate regulatory cost to be minimized.

For purposes of this review, I’ve only skimmed over the first section. However, there is a section (2.9) of the more meaty sections of the report that brought tears of joy to my eyes:

Several commentators have argued for a clear separation of roles in which:
• Banks which perform classic retail and commercial banking functions, and which enjoy the benefits of retail deposit insurance and access to lender of last resort facilities, would be severely restricted in their ability to conduct risky trading activities.
• Financial institutions which are significantly involved in risky trading activities would be clearly excluded from access to retail deposit insurance and from [Lender of Last Resort] facilities, and would therefore face the market discipline of going bankrupt if they ran into difficulties.
The theoretical clarity of this argument has attracted considerable support.

The key tools to achieve [elimination of Too Big To Fail status] will include:
• A regulatory regime for trading book capital (discussed in Sections 2.2 (ii) and (vi)) that combines significantly increased capital requirements with a gross leverage ratio rule which constrains total balance sheet size. Such a regime could include very major variation in capital requirements as between different types of trading activity, effectively achieving a distinction between market making to support customer service and proprietary position taking. The fundamental review of the trading book capital regime, proposed in Section 2.2 (ii), should consider the potential to achieve such distinction.

US MMFs Prefer Box-Ticking to Capital Injection

Wednesday, March 18th, 2009

The Investment Company Institute has announced:

that its Board of Governors has received a report from the Money Market Working Group and has unanimously endorsed the Group’s recommendations concerning new regulatory and oversight standards for money market funds.

John J. Brennan, Chairman of the Money Market Working Group and Chairman of The Vanguard Group, reported to the Board: “The recommendations respond directly to weaknesses in current money market fund regulation, identify additional reforms that will improve the safety and oversight of money market funds, and will position responsible government agencies to oversee the orderly functioning of the money market more effectively.”

The report itself is a miracle of the salesman’s art. Essentially, they propose to eliminate credit risk by regulation:

We also believe that credit ratings, while far from perfect, provide an important floor that constrains money market funds from taking undue risks to increase yield. We therefore recommend that the SEC retain ratings as a starting point for credit analysis.

Finally, we recommend that money market funds designate a minimum of three credit rating agencies that they will monitor for purposes of determining whether a portfolio security may be eligible for purchase. We anticipate that credit rating agencies will compete with one another to achieve this designation, and that this competition will enhance the quality of their analysis and ratings in this market.

I will certainly concede that a lot of the Commercial Paper vs. T-Bill premium is due to liquidity effects. But that does not mean that there is no credit risk.

There is always credit risk. Even beyond market forces, there is always the potential for fraud. Credit Rating Agencies can not, will not and should not be forced to pretend they can determine lack of fraud. Even auditors can’t do that, if the rot exists at a high enough level in a sufficiently complex company. Jesus Christ Himself could give an AAA rating to a security and have it default – remember, he screwed up on Judas.

Portfolio maturity. The maximum weighted average maturity (WAM) of fund portfolios currently permitted by SEC rule may have been too long at some times to accommodate extraordinary market conditions. In response to this observation, most money market funds voluntarily shortened their WAMs, which provided additional protection against interest rate risk. The Working Group believes that the WAM should be shortened from 90 days to 75 days for all such funds. The Working Group also recommends the adoption of a new WAM calculation (referred to in this Report as a “spread WAM”). Unlike the traditional WAM measure that allows funds to use the interest rate reset dates of variable- and floating-rate securities as a measure of their maturity, the new spread WAM requires funds also to calculate a WAM using only a security’s stated (or legal) final maturity date or the date on which the fund may demand payment of principal and interest. This new spread WAM could not exceed 120 days.

I wasn’t aware that US MMFs were permitted to use reset dates in lieu of maturity; the working group’s response demonstrates the intellectual bankruptcy of the typical salesman. We’ve been through two years of the most hellacious credit crunch in memory and people are still referring to pretend-maturities as if they mean something? It’s ludicrous.

Fixed Income is all about credit. The Money Market sector of Fixed Income is all about credit credit credit credit credit. If a portfolio manager – who finds himself virtually ignored in this trash – decides he is no longer comfortable with the credit quality of an issuer he holds, he always has the option of letting it run off the books … unless he was silly enough to buy a 100-year floating-rate note with a quarterly reset. (Such notes have been seen in putative Money Market Funds, by the way. Strange but true.)

I’m not going to get into any big arguments about whether 75 days is better than 90 days. My feeling is that it’s a cosmetic change … but it’s a relatively arbitrary number anyway, so I’m not fussy about it. But the limit on “Spread WAM” should be exactly equal to the limit on WAM.

We recommend that money market funds and other institutional investors in the money market provide the appropriate government body with nonpublic data designed to assist that body in fulfilling its important mission of overseeing the markets as a whole. We pledge to work with appropriate federal officials to implement such a regime for nonpublic reporting and monitoring.

I have quite enough problems already with Regulation FD, thank you very much! The idea that important credit information is to be reviewed not by me, but by a snivel servant clerk with a two-year college certificate in boxtickingology gives me absolutely zero comfort. If it needs to be known, it needs to be public.

The Volcker proposals for MMF reform have been reported on PrefBlog and are addressed in section 8 of the report.

commentators suggest that this would reduce systemic risk by addressing some of the difficulties that money market funds encountered in 2008, as they tried to provide both liquidity and a stable NAV.

The Working Group strongly disagrees. Fundamentally changing the nature of money market funds (and in the process eviscerating a product that has been so successful for both investors and the U.S. money market) goes too far and will create new risks. As discussed below, there are substantial legal, operational, and practical hurdles to redirecting retail and institutional demand from a fixed to a floating NAV product. Indeed, because of the very real and well-ingrained institutional and legal motivations driving the demand for a stable NAV product, investors will continue to seek such a product.

One reason why the product is so successful for the industry is because the stable NAV encourages the unsophisticated to think of an MMF like a bank deposit. It ain’t. There ain’t no capital and there ain’t no federal insurance neither. If a floating NAV forces investors to think about this, so much the better.

These examples demonstrate that despite having floating NAVs, fixed-income funds can experience significant outflows if their investors are highly risk-adverse. The reason is that during periods of financial distress, markets for fixed income securities can become illiquid while the risk-averse investors in these funds are seeking to redeem their shares. As a result, investors’ demands for redemptions can outstrip the ability of fixed income funds—even those with floating NAVs—to meet such redemptions because assets cannot be quickly sold in an illiquid market.

Seems to me, then, that as a matter of prudence a MMF should have a significant allocation in goverments. I have no objection to allowing MMFs to hypothecate some securities, either to the commercial banking system or to the Central Bank (the latter applying a penalty rate) for the week or two that it will take them to mature.

The cost of requiring advisers to hold capital to any meaningful degree ultimately would be borne by fund shareholders or their advisers. To the extent that shareholders bear the costs, they would incur higher fund fees and lower returns. If advisers bear the costs, they may elect to exit the money market fund business and use their expertise to manage large private pools of capital that could serve as money market fund substitutes, or even create offshore subsidiaries to manage U.S. investors’ money, potentially increasing systemic risk.

This totally evades the issue. The fund industry has been getting a free ride due to public perceptions of rock-solid MMFs that have very little basis in fact. This crisis was caused by widespread perception that risk avoidance was free. If it is made plain that risk avoidance is, in fact, not free – that’s a step forward.

Fed to Open Spigots Further

Wednesday, March 18th, 2009

The Fed has announced:

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

Wow. They’re flooding the market with cash.

Update: Across the Curve comments that credit spreads are tighter and TIPS breakeven is wider.

Update, 2009-3-19: Commentary from Econbrowser

Update, 2009-4-3: Bernanke has given a speech titled The Federal Reserve’s Balance Sheet, in which he makes the point:

the provision of liquidity on a collateralized basis to sound financial institutions is a traditional central bank function. This so-called lender-of-last-resort activity is particularly useful during a financial crisis, as it reduces the need for fire sales of assets and reassures financial institutions and their counterparties that those institutions will have access to liquidity as needed. To be sure, the provision of liquidity alone cannot address solvency problems or erase the large losses that financial institutions have suffered during this crisis. Yet both our internal analysis and market reports suggest that the Fed’s ample supply of liquidity, along with liquidity provided by other major central banks, has significantly reduced funding pressures for financial institutions, helped to reduce rates in bank funding markets, and increased overall financial stability. For example, despite ongoing financial stresses, funding pressures around year-end 2008 and the most recent quarter-end appear to have moderated significantly.

With respect to Maiden Lane, et al., he states:

These extensions of credit are very different than the other liquidity programs discussed previously and were put in place to avoid major disruptions in financial markets. From a credit perspective, these support facilities carry more risk than traditional central bank liquidity support, but we nevertheless expect to be fully repaid. Credit extended under these programs has varied but recently has accounted for only about 5 percent of our balance sheet. That said, these operations have been extremely uncomfortable for the Federal Reserve to undertake and were carried out only because no reasonable alternative was available. As noted in the joint Federal Reserve-Treasury statement I mentioned earlier, we are working with the Administration and the Congress to develop a formal resolution regime for systemically critical nonbank financial institutions, analogous to one already in place for banks. Such a regime should spell out as precisely as possible the role that the Congress expects the Federal Reserve to play in such resolutions.

IMF Releases March 2009 "Finance & Development"

Friday, March 13th, 2009

The IMF has announced release of the March 2009 edition of Finance & Development.

One article caught my interest: What is to be Done:

What is clear from the latest crisis is that the perimeter of regulation must be expanded to encompass institutions and markets that were outside the scope of regulation and, in some cases, beyond the detection of regulators and supervisors.

Only in this way will dedicated and intelligent ex-regulators be able to compete for cushy jobs at shadow-banks.

To avoid overburdening useful markets and institutions it is important to identify carefully the specific weaknesses that wider regulation would seek to address (so-called market failures). This could be achieved by a two-perimeter approach. Many financial institutions and activities would be in the outer perimeter and subject to disclosure requirements. Those that pose systemic risks would be moved to the inner perimeter and be subject to prudential regulations.

I’ve argued for this all along: what we need is a rock-solid banking system, surrounded by a more exciting investment banking industry, surrounded in turn by a wild-n-wooly world of shadow banks and hedge funds.

There are several ways of [mitigating procyclicity], but a simple one would be to make capital requirements countercyclical—the amount of capital required to support a given level of assets would rise during booms and fall during busts. Ideally, these countercyclical capital regulations would not be discretionary, but built into regulations, becoming an automatic stabilizer that during upturns would enable supervisors to resist pressures from either firms or politicians to let things continue on their upward trajectory.

it would also be helpful to apply a maximum leverage ratio—such as high-quality capital divided by total assets—including off-balance-sheet entities, as a relatively simple tool to limit overall leverage in financial institutions during an upswing.

This echoes today’s BIS release – not entirely by chance, I’m sure.

Although fair value accounting methods, requiring institutions to value assets using current market prices, serve as a good benchmark in most situations, the crisis made it apparent that in periods of deleveraging, they can accentuate downward price spirals. If a firm has to sell an asset at a low price, other firms may have to value similar assets at the new low price, which may encourage the other firms to sell, especially if they have rules against holding low-valued assets. Thus, accounting rules should allow financial firms with traded assets to allocate “valuation reserves,” which grow to reflect overvaluations during upswings and serve as a buffer against any reversions to lower values during downturns. Similarly, values of assets used as collateral, such as houses, also tend to move with the cycle. More room is needed in the
accounting rule book to allow the reporting of more conservative valuations, based on forward-looking and measurable indicators.

This will be somewhat controversial, to say the least. The SEC specifically went after hidden reserves in the first half of this decade, on the grounds that profit-smoothing, not prudential management, was the objective.

Any form of bookkeeping can be abused. What’s important is disclosure.

Many of the new structured credit products were supposed to distribute risk to those who, in theory, were best able to manage it. But in many cases, supervisors and other market participants could not see where various risks were located. What’s more, risks often were sliced and diced in ways that prevented the packagers of the risks and the purchasers from thoroughly understanding what risks they had sold or acquired. Moreover, the underlying information used to price such complex securities was not easily available or able to be interpreted.

Easy to fix. Repeal Regulation FD. A credit rating agency will, I’m sure, refuse to rate structured investments on the basis of what is currently public information. No Rating = No Sales. Repeal of the exemption allowing rating agencies access to material non-public information will … well, it won’t change anything, but at least there’ll be less whining next time.

Data on prices, volumes, and overall concentration in over-the-counter markets also need attention because they are typically not recorded in ways that allow others to see transaction information, limiting liquidity in periods of stress. A clearing system can be used to collect (and to net) trades, allowing participants and others to see how much total risk is being undertaken.

Ex-regulators will also be able to find jobs at clearing sytems – a major leap forward for prudential regulation!

The sooner markets can discern the direction new regulations are taking, the sooner investors can consider the new environment. Because many investors expect heavy-handed regulatory reforms, they are waiting before deploying their funds in various institutions and financial markets. The uncertain regulatory landscape makes it difficult to gauge which business lines will be productive and which may be regulated out of existence.

Hear, hear!

Bernanke Opines on Financial Regulation

Tuesday, March 10th, 2009

Bernanke made an important speech today on the future of financial regulation:

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances. However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States. The details of the story are complex, but, broadly speaking, the risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets. In certain respects, our experience parallels that of some emerging-market countries in the 1990s, whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad.

I’ll buy it … but he’s skating around the responsibility of the Fed. If, in fact, there was a lack of prudence in the investment of capital, the implication is that monetary policy was too loose. It also implies fiscal policy was too loose.

Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.

Achieving more effective supervision of large and complex financial firms will require a number of actions. First, supervisors need to move vigorously–as we are already doing–to address the weaknesses at major financial institutions in capital adequacy, liquidity management, and risk management that have been revealed by the crisis. In particular, policymakers must insist that the large financial firms that they supervise be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis. In that regard, the Federal Reserve has been looking carefully at risk-management practices at systemically important institutions to identify best practices, assess firms’ performance, and require improvement where deficiencies are identified. Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management, and financial condition, and be held to high capital and liquidity standards.[footnote]

Footnote:Such an approach would also help offset the incentives for financial firms to become too big to fail.

This is good, and I am particularly encourage by the reference to high capital standards and offsetting the incentives for financial firms to become too big to fail. I have argued before – and I will argue again – that there should be a sliding scale of regulatory charges to capital based on size; and to prevent games-playing this should be calculated as an increment to Risk-Weighted-Assets. If, for example, a factor of (Lesser of (a) 1.0, or (b) pre-increment RWA / $250-billion) were to be applied to RWA, then any firm growing beyond $250-billion in RWA will find itself needing more and more capital to operate; smaller, regional, banks will be in the sweet spot.

Second, we must ensure a robust framework–both in law and practice–for consolidated supervision of all systemically important financial firms organized as holding companies. The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company. Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.

He’s still angry about AIG, as mentioned on March 3.

Third, looking beyond the current crisis, the United States also needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm, including a mechanism to cover the costs of the resolution.

I’m not such a big fan of this point. With all the best intentions, it will create a Regulator of Everything. His primary example is the jawboning by the New York Fed – led by his former underling and current boss – on CDS clearinghouses, which may well be a good solution, but should not be a mandated solution. The mandated solution should be realistic capital charges for exposure and concentration; let the private sector determine whether the overhead of a central clearinghouse is worthwhile.

In light of the importance of money market mutual funds–and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses–policymakers should consider how to increase the resiliency of those funds that are susceptible to runs. One approach would be to impose tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity. A second approach would be to develop a limited system of insurance for money market mutual funds that seek to maintain a stable net asset value. For either of these approaches or others, it would be important to consider the implications not only for the money market mutual fund industry itself, but also for the distribution of liquidity and risk in the financial system as a whole.

“Money Market Fund” is a term defined in Ontario securities law and I’ll assume the situation is similar in the states. It should be a simple matter to bring MMFs under the supervision of bank regulators so that they are regulated as banks, and required to have (and to disclose regularly) the usual amounts of Tier 1 and Total Capital.

Because banks typically find raising capital to be difficult in economic downturns or periods of financial stress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment. We should review capital regulations to ensure that they are appropriately forward-looking, and that capital is allowed to serve its intended role as a buffer–one built up during good times and drawn down during bad times in a manner consistent with safety and soundness.

I couldn’t agree more. Higher capital charges for new – or expanded – relationships should be implemented. Or, perhaps, just apply a surcharge for year-over-year increases in (Risk Weighted) assets.

How could macroprudential policies be better integrated into the regulatory and supervisory system? One way would be for the Congress to direct and empower a governmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system. The elements of such an authority’s mission could include, for example, (1) monitoring large or rapidly increasing exposures–such as to subprime mortgages–across firms and markets, rather than only at the level of individual firms or sectors; (2) assessing the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (3) analyzing possible spillovers between financial firms or between firms and markets, such as the mutual exposures of highly interconnected firms; and (4) identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole. Two areas of natural focus for a systemic risk authority would be the stability of systemically critical financial institutions and the systemically relevant aspects of the financial infrastructure that I discussed earlier.

I wonder if at this point in the speech he was coughing theatrically and pointing at himself?

Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority; others have expressed concern that adding this responsibility would overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, as well as on how the necessary resources and expertise complement those employed by the Federal Reserve in the pursuit of its long-established core missions.

It seems to me that we should keep our minds open on these questions. We have been discussing them a good deal within the Federal Reserve System, and their importance warrants careful consideration by legislators and other policymakers. As a practical matter, however, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role.

* cough, cough *

Financial crises will continue to occur, as they have around the world for literally hundreds of years. Even with the sorts of actions I have outlined here today, it is unrealistic to hope that financial crises can be entirely eliminated, especially while maintaining a dynamic and innovative financial system. Nonetheless, these steps should help make crises less frequent and less virulent, and so contribute to a better functioning national and global economy.

Thank you, Mr. Bernanke! Expectations of a New Millennium of Bank Regulation are far too high at the moment. Shit happens. Get used to it.

Citigroup Suspends Preferred Dividend; Offers Exchange to Common

Monday, March 2nd, 2009

Citigroup has announced:

it will issue common stock in exchange for preferred securities, which will substantially increase its tangible common equity (TCE) without any additional U.S. government investment. The transaction is intended to build Citi’s TCE to a level that removes uncertainty and restores investor confidence in the company.

Citi will offer to exchange common stock for up to $27.5 billion of its existing preferred securities and trust preferred securities at a conversion price of $3.25 a share. The U.S. government will match this exchange up to a maximum of $25 billion face value of its preferred stock at the same conversion price.

This transaction could increase the TCE of the company from the fourth quarter level of $29.7 billion to as much as $81 billion, which assumes the exchange of $27.5 billion of preferred securities, the maximum eligible under this transaction. Citi’s Tier 1 capital ratio is 11.9 percent as of December 31, 2008, and is among the highest of major banks. This ratio is not impacted by this transaction.

Based on the maximum eligible conversion, the U.S. government would own approximately 36 percent of Citi’s outstanding common stock and existing shareholders would own approximately 26 percent of the outstanding shares. All investors’ new stakes will be determined following the exchange.

In connection with the transactions, Citi will suspend dividends on its preferred shares. As a result, the common stock dividend also will be suspended. The company will continue to pay the distribution on its Trust Preferred Securities and Enhanced Trust Preferred Securities at the current rates.

Bank Stress & Dividends

Wednesday, February 25th, 2009

The Fed has announced its formal stress-testing policy, with a handy FAQ.

Q8: What will be the source of capital if supervisors determine that a banking organization requires an additional capital buffer?

A: An institution that requires additional capital will enter into a commitment to issue a CAP convertible preferred security to the U.S. Treasury in an amount sufficient to meet the capital requirement determined through the supervisory assessment. Each institution will be permitted up to six months to raise private capital in public markets to meet this requirement and would be able to cancel the capital commitment without penalty. The CAP convertible preferred securities will be converted into common equity shares on an as‐needed basis. Financial institutions that issued preferred capital under Treasury’s existing Capital Purchase Program (TARP 1) will have the option of redeeming those securities and replacing them with the new CAP convertible preferred securities.

Meanwhile, fresh from his claim that:

“They’re not going to cut the dividend at BMO,” I told Berman, with all the confidence that comes from having an RRSP that’s overweight oil and gas. “There’s no way any of these big banks chop the payout.”

See, I know my Canadian banking history. Only one domestic player has cut its common stock dividend in recent memory – National Bank, after taking a pasting on corporate loans. The bank spent years in the penalty box as a result. No board wants to join this hall of shame.

Andrew Willis has urged:

None of the five big banks have cut common share dividends since the Great Depression.

I don’t know if history will be made in this downturn.

But I do know that at least one blue-chip board – at Bank of Montreal – should cut the dividend in half.

I will forestall Assiduous Reader Norbert Schlenker and point out that Scotia chopped dividends in WW2.

Anyway, I mention this because ANZ Bank has cut its dividend and so have a lot of US Insurers. Precautionary common dividend cuts are becoming socially acceptable.

Will BMO or others cut their dividend? I’m dubious. They are, at least, still covering their dividend with earnings and while number two and three might come pretty quickly, I don’t think anybody wants to be number one in the line-up. But, frankly … I don’t care a lot! I’m a pref guy!

Why Banks Failed the Stress Test

Thursday, February 19th, 2009

Andrew G Haldane: Why banks failed the stress test – Speech by Mr Andrew G Haldane, Executive Director, Financial Stability, Bank of England, at the Marcus-Evans Conference on Stress-Testing, London, 9-10 February 2009.

It’s wonderful! We’ll start with sigma-rigging:

Back in August 2007, the Chief Financial Officer of Goldman Sachs, David Viniar, commented to the Financial Times:

“We are seeing things that were 25-standard deviation moves, several days in a row”

To provide some context, assuming a normal distribution, a 7.26-sigma daily loss would be expected to occur once every 13.7 billion or so years. That is roughly the estimated age of the universe.

A 25-sigma event would be expected to occur once every 6 x 10124 lives of the universe. That is quite a lot of human histories. When I tried to calculate the probability of a 25-sigma event occurring on several successive days, the lights visibly dimmed over London and, in a scene reminiscent of that Little Britain sketch, the computer said “No”.

… and proceed to …

A few years ago, ahead of the present crisis, the Bank of England and the FSA commenced a series of seminars with financial firms, exploring their stress-testing practices. The first meeting of that group sticks in my mind. We had asked firms to tell us the sorts of stress which they routinely used for their stress-tests. A quick survey suggested these were very modest stresses. We asked why. Perhaps disaster myopia – disappointing, but perhaps unsurprising? Or network externalities – we understood how difficult these were to capture?

No. There was a much simpler explanation according to one of those present. There was absolutely no incentive for individuals or teams to run severe stress tests and show these to management. First, because if there were such a severe shock, they would very likely lose their bonus and possibly their jobs. Second, because in that event the authorities would have to step-in anyway to save a bank and others suffering a similar plight.

All of the other assembled bankers began subjecting their shoes to intense scrutiny.

You don’t build a career by telling your boss what he doesn’t want to hear. This is why regulatory capital charges must be progressive, so that larger firms are more conservatively capitalized than smaller.

Update, 2010-8-5: See also FTU.PR.A Provides 11-Sigma Update … but remember WFS.PR.A

Willem Buiter on Bank Guarantees

Sunday, February 15th, 2009

Willem Buiter once again provides an entertaining analysis of the crisis, with a blog post titled Save banking, not the bankers or the banks; the case of ING. The source of his ire is a Dutch bail-out of ING, which he terms a “guarantee”:

The assistance takes the form of a back-up guarantee facility for a portfolio of $39bn (face value) worth of securitised US Alt-A mortgages. Under the deal, the state shares with ING any gains and losses on this portfolio relative to a benchmark value for the portfolio of $35.1 bn. The shares of the state and ING in any gains/losses are 80% and 20% respectively.

The bank pays a guarantee fee to the state. The state document I saw did not specify the magnitude of the guarantee fee, or how it was arrived at.

The state pays ING a management and funding fee. Again, I don’t know the amount or how it was arrived at (it would be cute, however, if the guarantee fee and the management and funding fee just happened to cancel each other out!).

The other relevant conditionality is that ING is to provide 25 bn euro of additional credit to businesses and households and that there will be no bonuses for 2009 and until a new remuneration policy is adopted. The CEO was told to fall on his sword.

I strongly disagree with the characterization of the facility as a guarantee. According to me, a guarantee will have an asymmetrical reward profile, whereas this has a payoff diagram that looks a whole lot more like 80% ownership. This isn’t a guarantee: this is a futures contract.

Buiter has complaints about the strike price of the contract:

The guarantee is a good deal for ING and a bad deal for the tax payer because the market valuation of the Alt-A portfolio did not imply the 10% discount (from $39 bn to $ 35.1 bn) that was used to define the reference value for the guarantee, but a 35% discount (from $39 bn to $25.4bn). It is possible that the hold-to-maturity value of the portfolio (the present discounted value of its current and future cash flows, discounted at an interest rate that is not distorted by illiquidity premia, is $35.1 bn or more. Possible, but not likely.

It is possible that the guarantee fee appropriately prices the risk assumed by the state. Until I see the numbers and can verify the assumptions on which they are based, I consider it possible but not likely.

Dr. Buiter prefers a good bank / bad bank solution, blithely skipping over the question of asset value determination:

The good bank would take the deposits of ING and purchase any of the good assets of ING it is interested in.

The valuation of these good assets would not represent a problem, because part of the definition of ‘good asset’ is that there either is a liquid market price for it or, in the case of non-traded assets, that the buyer can determine their value in a straightforward and transparent manner. It is possible that none of the existing assets of ING would be bought by New ING. In that case, the assumption of ING’s deposit liabilities by New ING would be effected by a loan from the state to ING, and the asset-side counterpart on New ING’s balance sheet to the deposits acquired from ING could be a matching amount of government debt.

This, to me, misses the point. As I see it, the problem is not so much that certain assets have gone bad, but that banks are over-levered and – more importantly – confidence has been lost. It is the problem of overleverage that the contract addresses, in an attempt to restore confidence.

I agree with him wholeheartedly, however, on the dangers of social engineering and political grandstanding:

Often government financial assistance to banks imposes conditionality, costs and constraints on the bank’s management and existing shareholders without taking full ownership and control of the bank. Examples are; onerous financial terms; constraints on bonuses and other aspects of executive and board remuneration; constraints on dividend pay-outs and share repurchases; constraints on new acquisitions and on foreign activities; guidance and direction on how much to lend and to whom. All these encumbrances last until the state has had its stake repaid.

This creates terrible incentives encouraging banks that are already in hock to the government to hoard liquidity and hold back on new lending activities to get rid of the government’s interference.