PrefBlog

A Financial Times article titled Flash Crash Threatens to Return with a Vengeance leads me to a paper by Dave Cliff and Linda Northrop titled The Global Financial Markets: an Ultra Large Scale Systems Perspective. The jargon in the abstract is priceless:

We argue here that, in recent years, the global financial markets have become a complex adaptive ultra-large-scale socio-technical system-of-systems, and that this has important consequences for how the financial markets should be engineered and managed in future. The very high degree of interconnectedness in the global markets means that entire trading systems, implemented and managed separately by independent organizations, can rightfully be considered as significant constituent entities in the larger global super-system: that is, the global markets are an instance of what is known in the engineering literature as a system-of-systems (SoS). The sheer number of human agents and computer systems connected within the global financial-markets SoS is so large that it is an instance of an ultra-large-scale system, and that largeness-of-scale has significant effects on the nature of the system. Overall system-level behaviour may be difficult to predict, for two reasons. First, the constituent (sub-) systems may change their responses over time, either because they involve human agents as key “components” within the system (that is, the system is actually socio-technical), or because they involve software systems that evolve over time and “learn from experience” (that is, the system is adaptive). Second, even when given perfect knowledge of the constituent systems that combine to make up the SoS, the overall system-level behaviour may be difficult or impossible to predict; that is, the SoS may exhibit emergent behaviour. For these reasons, the global financial markets SoS can also rightly be considered as a complex adaptive system. Major failures in the financial markets SoS can now occur at super-human speeds, as was witnessed in the “Flash Crash” of May 6th 2010. Events such as the Flash Crash may become more commonplace in future, unless lessons are learned from other fields where complex adaptive socio-technical systems of systems have to be engineered for high-integrity, safety-critical applications. In this document we review the literature on failures in risky technology and high-integrity approaches to safety-critical SoS engineering. We conclude with an argument that, in the specific case of the global financial markets, there is an urgent need to develop major national strategic modelling and predictive simulation capabilities, comparable to national-scale meteorological monitoring and modelling capabilities. The intent here is not to predict the price-movements of particular financial instruments or asset classes, but rather to provide test-rigs for principled evaluation of systemic risk, estimating probability density functions over spaces of possible outcomes, and thereby identifying potential “black swan” failure modes in the simulations, before they occur in real life, by which time it is typically too late.

To my gratification, the authors highlight the inadequacy of the official SEC report:

The SEC/CFTC report was met with very mixed responses. Many readers concluded that it left more questions unanswered than resolved, and a subsequent much more detailed analysis of the time-series “tapes” of market event data conducted by Nanex Corp.1 offered an alternative story that many market practitioners found more plausible: see Meerman et al. (2010) and Easley et al. (2011) for further details of the extent to which the CFTC/SEC version of events is disputed.

The times they are a-changin’! The Meerman reference is:

M. Meerman, et al., (2011). Money and Speed: Inside the Black Box. Documentary produced by VPRO (Dutch public broadcaster), available as an iPad application. http://itunes.apple.com/us/app/money-speed-inside-black-box/id424796908?mt=8&ls=1#

I don’t recall ever seeing a citation of an iPad application in a scholarly text before! The Easely paper has been previously mocked on PrefBlog.

The Hungarians have nerve, whatever else might be the case!

Hungary’s chances of obtaining a bailout receded after lawmakers approved new central bank regulations that prompted the International Monetary Fund and the European Union to break off talks this month.

Parliament in Budapest stripped central bank President Andras Simor of his right to name deputies, expanded the rate- setting Monetary Council and created a position for a third vice president. A separate law approved earlier today makes it possible to demote the central bank president if the institution is combined with the financial regulator.

Hungary received its second sovereign credit downgrade to junk in a month when Standard and Poor’s followed Moody’s Investors Service in taking the country out of its investment grade category on Dec. 21. The forint has fallen 15 percent against the euro since June 30, making it the world’s worst- performing currency in the period.
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The new central bank regulations “seriously harm” the country’s national interests, allow for political intervention in monetary policy and threaten economic stability, the Magyar Nemzeti Bank said today. The laws have led to the “indefinite postponement” of talks on a financial aid package, the central bank said in a statement posted on its website.

While a possible Hungarian agreement with the IMF and the EU on an assistance package would boost confidence, the Cabinet can do without it, [Prime Minister Viktor] Orban told MR1 radio in an interview today.

“If we have an IMF safety net, then we face the coming period with greater self-confidence and greater security,” Orban said. “If we don’t reach an agreement, we’ll still stand on our own feet.”

It’s always helpful to have your own currency that can be devalued at will!

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts losing 24bp, FixedResets up 5bp and DeemedRetractibles winning 27bp. Volatility was reasonable. Volume was pathetic.

PerpetualDiscounts now yield 5.12%, equivalent to 6.66% interest at the standard equivalency factor of 1.3x. Long Corporates now yield 4.6%, so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 205bp, unsurprisingly unchanged from the figure reported December 28.

And that’s it for another year!

Italy sold some debt – possibly with some assistance:

Italy auctioned 7 billion euros ($9 billion) of debt to bring the total raised this week to almost 20 billion euros, underscoring how the European Central Bank is helping the world’s fourth-biggest borrower tap markets.

Today’s sale by the Treasury in Rome fell short of the 8.5 billion-euro target even as borrowing costs declined from last month. Italy sold 9 billion euros in bills yesterday at about half the rate of the previous sale last month in its first auction since the ECB loaned 489 billion euros to banks to ease credit amid the region’s debt crisis.
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The euro fell to its lowest against the dollar since September 2010 and 10-year Italian notes slid after today’s sale, keeping their yield above 7 percent, the level that led Greece, Ireland and Portugal to seek bailouts. Short-term securities rose.

The Frankfurt-based central bank bought Italian bonds today, according to two people with knowledge of the transactions who declined to be identified because the trades are confidential. An ECB spokesman declined to comment when contacted by phone.

Italian 10-year bonds (.IT10) stayed lower after the auction. The 10-year yield was 7.01 percent at 3:41 p.m. Rome time, pushing the difference with German bunds to 514 basis points. The five- year yield was down seven basis points at 6.16 percent, as investors pointed to the ECB as buoying the shorter-term debt.

The Treasury sold today 2.5 billion euros of securities due in 2014, less than the 3 billion euro maximum for the sale, to yield 5.62 percent. That was down from 7.89 percent at the previous sale on Nov. 29. The Treasury priced 2.5 billion euros of its 5 percent 2022 bond to yield 6.98 percent, compared with 7.56 percent on Nov. 29. Italy also sold about 2 billion euros of bonds due 2021 and a floating-rate security due 2018.

Thailand is contemplating monetizing its bank bail-out debt:

Thailand’s government will today press the central bank chief to take on $35 billion of legacy debt from bank bailouts as Prime Minister Yingluck Shinawatra looks for fiscal scope to finance flood defenses.

Bank of Thailand Governor Prasarn Trairatvorakul meets with cabinet members in Bangkok over the proposal to shift the debt to the BOT’s balance sheet. Deputy Prime Minister Kittiratt Na- Ranong said yesterday the step would save the government as much as 65 billion baht ($2 billion) in annual interest costs that could be used to fund anti-flood measures.

Japan is being more sensible:

Japan’s ruling party compromised on a plan to double the sales tax by 2015 to help reduce the world’s largest public debt, delaying implementation by six months to help lawmakers meet a campaign pledge.

The proposal by Prime Minister Yoshihiko Noda would raise the sales tax from 5 percent to 8 percent in April 2014 and to 10 percent in October 2015. The agreement, reached late yesterday, must be approved by a government panel led by Finance Minister Jun Azumi before discussion with the opposition.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts up 11bp, FixedResets winning 13bp and DeemedRetractibles down 12bp. Volatility was good. Volume continued to be lousy – not surprisingly, given the time of year.

Fairfax isn’t having much luck with its lawsuit:

James Chanos’s Kynikos Associates LP and Daniel Loeb’s Third Point LLC won dismissal from an $8 billion lawsuit accusing the two hedge funds of spreading negative information to drive down Fairfax Financial Holdings Ltd. (FFH)’s stock price.
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In September, Hansbury dismissed billionaire Steven A. Cohen and his Stamford, Connecticut-based SAC Capital Advisors LP from the case.

“One must establish that the defendants purposely availed themselves of the State of New Jersey and that the alleged improper conduct was expected or intended to be felt within the State of New Jersey,” Hansbury wrote. He said Fairfax didn’t do that.
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Fairfax said the funds coaxed John Gwynn, a former insurance analyst at Morgan Keegan & Co. in Memphis, Tennessee, into giving them his negative Fairfax reports before they were published. It also said they hired an outside analyst, Spyro Contogouris, to spread false Fairfax information.

I don’t know. Obviously, there needs to be some way to get legal redress for libel, if libel has occured. But mainly, my reaction to this is the same as my reaction to things like criminalizing Armenian genocide denial, criminalizing criticism of the Egyptian armed forces and criminalizing criticism of the Thai monarchy, to name but a few: if you need to go to law, it implies you don’t believe your facts and arguments are sufficient.

How about that ECB balance sheet, eh?:

The European Central Bank’s balance sheet soared to a record 2.73 trillion euros ($3.55 trillion) after it lent financial institutions more money last week to keep credit flowing to the economy during the debt crisis.

Lending to euro-area banks jumped 214 billion euros to 879 billion euros in the week ended Dec. 23, the Frankfurt-based ECB said in a statement today. The balance sheet increased by 239 billion euros in the week and was 553 billion euros higher than three months ago.

Those keeping score may wish to compare this number to the evolution of the Fed balance sheet.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts losing 14bp, FixedResets up 12bp and DeemedRetractibles winning 18bp. Volatility was quite good, with a lot of variety in terms of both issuers and preferred share types. Volume was pathetic, as might be expected for the Christmas-New Year’s period.

PerpetualDiscounts now yield 5.11%, equivalent to 6.64% at the standard equivalency factor of 1.3x. Long corporates now yield about 4.60%, so the pre-tax interest-equivalent spread (also called the Seniority spread) is now about 205bp, unchanged from December 21.

John Paulson, the hedgie whose incisive analysis of the economy and uncanny ability to lay his finger on the pulse of the market made him and his clients billions during the subprime episode, has run out of luck:

John Paulson, the billionaire money manager mired in the worst slump of his career, lost 10.5 percent in his Gold Fund this year even as the metal heads for its 11th straight annual gain, according to people familiar with the fund’s performance.

The fund, which invests in mining stocks and other gold- related securities, remains the best performer in Paulson’s $28 billion fund family this year. His Paulson Advantage Fund, which seeks to profit from corporate events such as takeovers and bankruptcies, has fallen about 35 percent.

DBRS has confirmed Fairfax at Pfd-3:

DBRS has today confirmed the Senior Unsecured Debt rating of Fairfax Financial Holdings Limited (Fairfax or the Company) at BBB and its Preferred Shares rating at Pfd-3. The trends are Stable. The confirmation reflects the fact that the Company has continued to enjoy strong earnings despite negative underwriting results stemming from ongoing competitive market conditions in commercial insurance markets and adverse catastrophic claims from the tsunami in Japan, earthquakes and storm activity. Strong investment results, including both interest and dividends and gains on investments, continue to distinguish Fairfax’s unique in-house investment management operation, funded through premiums taken in by its insurance operating subsidiaries, although maintaining underwriting profitability is a strategic priority. With an investment bias, Fairfax is able to avoid the worst of the cyclicality inherent in the property and casualty (P&C) insurance industry by choosing not to write policies where inadequate pricing would only give rise to additional underwriting losses.
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Financial leverage is increasingly taking the form of more tax-efficient preferred share capital and borrowings at the holding company rather than at the operating subsidiaries. With 100% control of its major operating subsidiaries, the holding company’s cash position is more secure since the upstream dividend flow from its operating subsidiaries has become more predictable, albeit subject to regulatory approvals, especially given excess regulatory capital at all its major operating subsidiaries. Financial leverage, given the Company’s cash position, excellent liquidity and underlying strong regulatory capital ratios, is well within the limits of the assigned rating category.
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Nevertheless, despite the strong investment management track record of the Company, accompanied by growing sophistication around enterprise risk management, the underlying competitive and volatile nature of the underlying insurance business, including the increasing risk of catastrophic claims, suggests that the upside potential for Fairfax’s ratings remains limited.

Fairfax is the proud issuer of FFH.PR.C, FFH.PR.E, FFH.PR.G and FFH.PR.I, all FixedResets.

It was a strong day for the Canadian preferred share market, with PerpetualDiscounts up 23bp, FixedResets gaining 11bp and DeemedRetractibles winning 29bp. Volatility was quite good, well-skewed to the upside. Volume was light.

I’ve been taking a correspondence course in Conversational Furrin for the past while so here goes! Police nab your dad! And Poppa swears anew when your niece is bad!*

* That’s furrin for Merry Christmas and Happy New Year!

The national securities regulation pipe-dream is over:

The Supreme Court of Canada has stopped the federal government’s initiative for a single national securities regulator in its tracks. While the court suggested that the door remained open to a single national regulator achieved through federal-provincial co-operation, the near-total victory achieved by the provinces gives the scheme’s provincial opponents no incentive to participate.

A national securities regulator would be nice. It would also be nice if it rained soup and snowed marshmallows.

Part of the problem – as far as I’m concerned – is that the idea was oversold. Various idiots claimed that things like the ABCP market freeze would never have happened if only we had a national regulator, which is egregious nonsense. A national regulator would make the system more efficient, by making it possible for issuers and other market participants (such as myself) to get national clearance with one filing and one fee. Full stop.

Long ago, I suggested it would make far more sense for interested provinces to combine their regulatory activities – a modest goal, but one with the potential for actually happening. If the OSC were to merge with, say, the PEI Securities Commission then I would be better off. Marginally, yes, but measurably, also yes.

Leaks from the talks on the voluntary-ha-ha Greek debt writedown are getting interesting:

Greece’s creditors are resisting pressure from the International Monetary Fund to accept bigger losses on holdings of the indebted nation’s government bonds, said three people with direct knowledge of the discussions.

Lenders want the 70 billion euros ($91 billion) of new bonds the government will issue in return for existing securities to carry a coupon of about 5 percent, said the people, who declined to be identified because the negotiations are private.

The IMF is pushing for creditors to accept a smaller coupon in order to reduce Greece’s debt-to-gross domestic product ratio to 120 percent by 2020, a key element of the Oct. 27 agreement by European Union leaders, the people said.
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As part of Greece’s 130 billion-euro second bailout, investors would take a 50 percent hit on the nominal value of 206 billion euros of privately owned debt. Exchanging bonds for securities with a 5 percent coupon would leave investors with a 65 percent loss in the net present value of their holdings of Greek government debt, the people said.
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The sides have also agreed that the deal should include collective action clauses that would ensure lenders participate in the swap, the people said.

Vega Asset Management LLC resigned this month from a committee of Greek creditors negotiating the debt swap with European authorities, because the Madrid-based hedge fund refused to accept a net present value loss exceeding 50 percent, according to a Dec. 7 e-mail sent to other panel members, which was obtained by Bloomberg News.

It will be interesting to see how a collective action clause will be worded in order to preserve the fiction that the participants are volunteers!

Someone at the Financial Times points out:

The European Central Bank’s lending of €489-billion to more than 500 banks was nothing short of a feeding frenzy.
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The money — and there is another three-year loan offer in February — should ease the pressure on banks to dump assets at firesale prices to raise cash.

But the hoarding suggests the funds will instead flow to that traditional parking space for spare cash; euro zone government bonds.
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There is of course an irony in the fact that banks’ ditching of their sovereign holdings in the last year is partly to blame for the rise in government borrowing costs. There is then further irony in that the market freeze which produced Thursday’s feeding frenzy was in part the result of worries about banks’ exposure to sovereign debt. Buying more government bonds does nothing to square this vicious circle, it just buys some breathing space to repair balance sheets and restore public finances. Investors and taxpayers can only hope politicians and bankers use the time wisely.

Fed action on mortgage bonds is showing some benefits:

Mortgage rates for 30-year U.S. loans dropped to the lowest level on record amid signs the housing market may be set for a turnaround.

The average rate for a 30-year fixed loan fell to 3.91 percent in the week ended today, the lowest in data dating to 1971, from 3.94 percent, Freddie Mac said in a statement. The average 15-year rate matched last week’s previous all-time low of 3.21 percent, according to the McLean, Virginia-based mortgage-finance company.

The U.S. housing market, under pressure from tight lending standards and foreclosures that depress values, is showing signs of improvement. Purchases of previously owned homes rose to a 10-month high in November as the inventory of unsold properties shrank to the lowest level in six years, the National Association of Realtors reported yesterday.

Whether those benefits are worth the cost is, of course, a matter for debate, but at least there are some benefits!

It was another strong day for the Canadian preferred share market, with PerpetualDiscounts up 6bp, FixedResets winning 29bp and DeemedRetractibles gaining 20bp. Good volatility – all winners, including a healthy contingent from the insurance sector, which has been badly beaten down lately. Volume was on the high side of average.

The ECB is bailing out Europe:

The European Central Bank will lend euro-area banks a record amount for three years in its latest attempt to keep credit flowing to the economy during the sovereign debt crisis.

The Frankfurt-based ECB awarded 489 billion euros ($645 billion) in 1,134-day loans today, the most ever in a single operation and more than economists’ median estimate of 293 billion euros in a Bloomberg News survey. The ECB said 523 banks asked for the funds, which will be lent at the average of its benchmark interest rate — currently 1 percent — over the period of the loans. They start tomorrow.
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Yields on government bonds in Italy and Spain fell in the days after the ECB announced the loans on Dec. 8 as banks bought the securities to use them as collateral in today’s tender. French President Nicolas Sarkozy has suggested banks could use the loans to buy even more government debt.

Simon Derrick, chief currency strategist at Bank of New York Mellon Corp, said the loans amount to quantitative easing “through the backdoor.”

It was a strong day for the Canadian preferred share market, with PerpetualDiscounts up 13bp, FixedResets gaining 11bp and DeemedRetractibles winning 30bp. Volatility was good. Volume was average.

PerpetualDiscounts now yield 5.11%, equivalent to 6.64% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.6% so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 205bp, a slight tightening from the 210bp reported December 14.