PrefBlog

As I have previously noted, I am very pleased to see that we are finally having a debate on the cost of bank regulation. Less, more, whatever … but let’s get some idea of the cost before swallowing OSFI’s Kool-Aid and saying more is always better. I’ve highlighted the BoC study and the BIS report … so our first debater is Terence Corcoran, who wrote a column titled The high cost of bank regulation … the web version is encouragingly headed by:

CORRECTION: Terence Corcoran’s column, The High Cost of Bank Regulation, contained several factual errors regarding a Bank of Canada report on increased bank capital ratios.

An increase in capital of 2% results in a long-run annual impact on the level of GDP of -0.3%, or cumulative -6.0 % (or $92-billion) in present value terms, not -0.5 or -13.0% (or $200-billion). If the increase is 4%, the costs are -10% (or $153-billion) in present value terms , which does not equal $300-billion.

By avoiding future financial crises, the economy will benefit anywhere from 21.6% to 32.0% in present value terms, which is $332-billion to $492-billion. The chances of a financial crisis elsewhere is every 20 to 25 years if the probability is 4.5%, not every 60 years. The benefits to Canada were based on the reduced chance of a foreign crisis.

The impact of a Canadian crisis was based on the lower probability (1.7%) of a Canadian crisis. Finally, bank capital is made of equity, retained earnings, reserves, etc.

The Post regrets the errors.

Next debater, please!

The Congressional Oversight Panel has released – with very little press attention – its report The Global Context and International Effects of the TARP:

The dealings of Goldman Sachs with respect to the CDSs on CDOs that were eventually acquired by Maiden Lane III provide a compelling example of the effect of counterparty relationships on the flow of funds across borders, as 96.9 percent of the cash received by Goldman effectively flowed to non-U.S. institutions. (footnote) (These institutions, as well as other indirect foreign beneficiaries of the AIG rescue – entities that sold hedges on AIG to Goldman and benefited from not having to make good on that protection – are listed in Annex II.)

Footnote reads: According to recently released documents, there were 32 Goldman CDS counterparties that benefited directly from government assistance provided through the Maiden Lane III facility, and 31 of these entities are foreign. Each of the foreign entities listed below held a CDO for which Goldman had written CDS protection and entered into contracts with AIG laying off that risk. While Goldman was required to perform under its contracts whether or not AIG performed, when the government made the decision to pay AIG‟s counterparties at par –including Goldman – the following foreign entities were direct beneficiaries:…

And in Annex 2:

As the following data make clear, taxpayer aid to AIG became aid to Goldman, and aid to Goldman became aid to a number of domestic and foreign investors. In some cases, the aid was in the form of repayment in full of obligations that, without government help, could have ended in default. In other cases, the aid was in the form of guarantees that other parties did not have to pay because the government prevented any defaults.

AIG provided credit default swap (CDS) protection on a number of collateralized debt obligations (CDOs), which were the source of continuing collateral demands on AIG. As part of the AIG rescue, the CDOs underlying the CDSs were acquired by a special-purpose vehicle primarily funded by the government, Maiden Lane III. The entities set out in the table below held CDSs written by Goldman against the CDOs that were eventually acquired by Maiden Lane III. In order to sell those CDOs to Maiden Lane III, in most cases Goldman had to obtain them from these counterparties, so the Maiden Lane III funds effectively flowed to Goldman‟s counterparties. Nearly all of these second-level counterparties, both by number and dollar amount, were non-U.S. institutions, with European banks making up by far the largest contingent.

It will be remembered that the US Congress is almost the opposite of a sausage factory … what comes out of it may certainly be deprecated, but the research that goes into it is first rate (at some point I want to take a look for myself at exactly what they had in front of them when voting to invade Iraq – but that was an issue that never had the slightest amount of fact-motivation from the beginning).

It’s very odd, but I have not been able to find the conclusions regarding Goldman Sachs’ hedging reported on any of the lunatic fringe sites. I tried searching for the phrase “Investigation has concluded that Goldman Sachs was indeed well hedged in its dealings with AIG. Its risk management process was robust even to the events of September 2008, and if all financial firms had been half as competent in managing their exposures, the Panic of 2007 would have been a mere bad spell, a footnote in the history of banking.”, but I have not yet been able to find such a statement. I will post further on this subject when I find such a sentiment, or something approximating it, expressed on the sites of any of Goldman’s erstwhile critics.

There was heavy volume today and minimal overall movement in the market indices masked a surprisingly large amount of volatility in individual issues. MFC prefs were hurt again today – just look at that MFC.PR.D FixedReset, now yielding close to 5% to the call date from the bid price; there are currently five issues trading more than 200bp through that level! You can tell me that BMO is a better credit than MFC and I won’t blink; tell me it’s worth a spread of 200bp for four year money and we might have something to discuss! The strong performance by IAG is a little odd … not that there’s anything wrong with IAG, but those issues went ex-dividend today and it appears nobody noticed.

Nesbitt had a good day, volume-wise, but there is no information available to me regarding what kind of crosses they did … if they were internal crosses, for instance, (between different accounts under the same investment manager), then they won’t have got much commission out of it.

PerpetualDiscounts squeaked out a gain of 1bp, while FixedResets were up 9bp. The median average weighted yield-to-maturity on FixedResets is now a mere 3.16%.

PerpetualDiscounts now yield 5.77%, equivalent to 8.08% interest at the standard 1.4x equivalency factor. Long corporates now yield about 5.3% (!), so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 275bp, up marginally – and perhaps spuriously – from the 270bp reported on August 18.

The Bank of Canada has released a discussion paper by Zhongfang He titled Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy:

The author evaluates the effect of the Bank of Canada’s conditional commitment regarding the target overnight rate on longer-term market interest rates by taking into account the relationship between interest rates, inflation, and unemployment rates. By using vector autoregressive models of monthly interest rates, month-over-month inflation, and unemployment rates for Canada and the United States, the author finds that the Canadian 1-year treasury bill rates and 1-year forward 3-month rates have generally been lower than their model-implied values since April 2009, while the difference between the U.S. realized rates and their model-implied values has been much smaller. The author also studies the effect of the conditional commitment on longer-term government bond yields with maturities of 2, 5, and 10 years, and finds lower actual Canadian longer-term interest rates than their model-implied values, though their difference diminishes as the maturities become longer. The evidence appears to suggest that the Bank of Canada’s conditional commitment likely has produced a persistent effect in lowering Canadian interest rates relative to what their historical relationship with inflation and unemployment rates would imply. However, this finding is not statistically strong and is subject to caveats such as possible in-sample model instability and the dependence of the results on the choice of inflation variable.

Ontario will tinker with pension guarantees:

The fund, which provides pensioners with up to $1,000 a month if their private-sector plan fails to provide its full benefit, has been an albatross for the governing Liberals, who have repeatedly warned that it hasn’t been funded properly since its inception 30 years ago.

That looming threat came to a head last year during the global recession, when the government was faced with a fund that didn’t have enough cash to help thousands of workers at corporate giants like General Motors of Canada Ltd. and Nortel Networks Corp. that were poised to collapse into bankruptcy.
…
“These rules will help reduce – hopefully eliminate – the kind of moral hazard that I would associate with companies and employee groups agreeing to benefits without properly funding them.”

Mr. Duncan is also proposing some temporary relief for certain pension plans in the broader public sector by offering them more time to pay down solvency deficits, as long as they meet certain conditions, and a review of the pension system every five years.

This may be related politically to Nortel’s pension status:

On Sept. 30, 2010, the Nortel Defined Benefit Pension Plans will become orphans. The Financial Services Commission of Ontario (FSCO) will then take over as required by current law.

Unless the Ontario government takes prompt action, Nortel’s pensioners will then lose 36% of their pensions and possibly even more. A major part of their loss occurs because, under current regulations, FSCO will simply wind-up the pension funds by converting them to annuities. This forever locks-in the existing pension deficit and it adds major penalties, because the cost of annuities is presently at the worst they have even been in 25 years with no relief in sight.

In 2001 Nortel’s plan went from half a billion surplus to one billion deficit; to $1.8-billion in 2002 …

Manulife common (MFC-TO) got hammered today:

Manulife Financial Corp., North America’s third-largest insurer, decreased 5.4 percent to a 17-month low of $11.71. Bank of America Corp. analyst Steve Theriault yesterday increased his third-quarter loss estimate for the company to 94 cents a share from 37 cents a share, excluding certain items. Sun Life Financial Inc., Canada’s third-biggest insurance company, dropped 4.3 percent to C$24.17.

Fitch affirmed MFC:

Fitch Ratings has assigned an ‘A-‘ rating to Manulife Financial Corporations (MFC’s) recently issued C$900 million 4.079% medium-term notes due Aug. 20, 2015. At the same time Fitch affirmed all of MFC’s existing ratings. (A full list of rating actions follows at the end of this release.) The Rating Outlook is Stable.
…
Within Fitch’s rating rationale are multiple considerations. If MFC were to materially deviate from any of these items, especially for an extended period, the ratings could be impacted. Included within these key rating rationale factors are the following:

–The annual 3Q’10 actuarial experience and methods adjustments of at least C$1 billion;
–MFC adjusted earnings of C$3 billion a year;
–Operating company Minimum Continuing Capital and Surplus Requirements (MCCSR) ratio above 190%;
–Holding company financial leverage not exceeding 20% on Fitch’s equity adjusted leverage basis;
–Current sensitivity to equity markets;
–Current volatility in earnings

…
–C$$350 million 4.1% class A, series 1, preferred stock at ‘BBB’;
–C$350 million 4.65% class A, series 2, preferred stock at ‘BBB’;
–C$300 million 4.5% class A, series 3, preferred stock at ‘BBB’;
–C$450 million 6.6% non-cumulative, preferred class A, series 4 stock at ‘BBB’;
–C$350 million 5.60% non-cumulative rate reset, preferred class 1, series 1 stock at ‘BBB’.

S&P says Ireland needs a little more green:

Ireland’s long-term sovereign credit rating was cut one step to AA- from AA by Standard & Poor’s, which cited the projected cost of supporting the nation’s financial sector.

“The negative outlook reflects our view that a further downgrade is possible if the fiscal cost of supporting the banking sector rises further, or if other adverse economic developments weaken the government’s ability to meet its medium- term fiscal objectives,” S&P said today in a statement.

S&P said its new projections suggest that Ireland’s net general government debt will rise toward 113 percent of gross domestic product in 2012. That’s more than 1.5 times the median for the average of euro zone sovereign nations, and “well above” the debt burdens the New York-based firm said it projects for similarly rated countries in the region such as Belgium at 98 percent and Spain at 65 percent.

The Canadian preferred share market edged a little higher today, with PerpetualDiscounts up 6bp and FixedResets gaining 10bp. Volume was above average. MFC’s preferreds were not immune to the woes of the common, with two issues figuring in the performance highlights – which were all losses today.

I should have mentioned this earlier … but it just seemed so trivial! S&P has announced:

the S&P/TSX North American Preferred Stock Index. The Index seeks to provide investors with the opportunity to achieve broad diversification and exposure to North American preferred stocks.

Preferred stocks are a class of securities that combine the characteristics of debt and common stocks. Their returns have low correlations with common stock returns and with bond returns, making them good diversifiers. While their expected volatility and returns lie between those of common stocks and bonds, their yields are typically higher than that of common stock, the bond market and the money market.
“Preferred stocks are attractive to investors in today’s low interest rate environment, due to their higher yields,” says Steve Rive, Managing Director at S&P Indices. “The S&P/TSX North American Preferred Stock Index will provide investors with a diversified and broadly representative exposure to this important segment of the market.”

The S&P/TSX North American Preferred Stock Index is comprised of a 50% equal weighting in the S&P/TSX Preferred Share Index and S&P U.S. Preferred Stock Index. The S&P/TSX Preferred Share Index is comprised of preferred stocks trading on the Toronto Stock Exchange that meet criteria relating to minimum size, liquidity, issuer rating, and exchange listing. The S&P U.S. Preferred Stock Index measures the yield and price performance of preferred stocks in the U.S. equity universe by using a rules-driven methodology. It is comprised of preferred stocks issued by U.S. entities that meet a set of defined criteria.

I don’t see the point of this. The US and Canadian preferred share markets are very different animals, with very different taxation profiles. My guess is that there will be an ETF announcement in the very near future. Thanks to Assiduous Readers MP and like_to_retire for reminding me that I’m supposed to report EVERYTHING about Canadian preferred shares, not just the news that investors might consider interesting or useful.

The FRBNY has released a staff report about a fascinating idea by Marco Del Negro, Fabrizio Perri, and Fabiano Schivardi titled Tax Buyouts:

The paper studies a fiscal policy instrument that can reduce fiscal distortions, without affecting revenues, in a politically viable way. The instrument is a private contract (tax buyout), offered by the government to each individual citizen, whereby the citizen can choose to pay a fixed price up front in exchange for a given reduction in her tax rate for a prespecified period of time. We consider a dynamic overlapping-generations economy, calibrated to match several features of the U.S. income and wealth distribution, and show that, under simple pricing, the introduction of the buyout is revenue neutral and at the same time can benefit a significant fraction of the population and lead to sizable increases in labor supply, income, consumption, and welfare.
…
The baseline buyout we consider is a reduction in the marginal tax rate of at most 5% offered at a price of roughly $4500, which ensures revenue neutrality.

The FRBNY also released a staff report by James Vickery and Joshua Wright titled TBA Trading and Liquidity in the Agency MBS Market:

Most mortgages in the United States are securitized through the agency mortgage-backedsecurities (MBS) market. These securities are generally traded on a “to-be-announced,” or TBA, basis. This trading convention significantly improves agency MBS liquidity, leading to lower borrowing costs for households. Evaluation of potential reforms to the U.S. housing finance system should take into account the effects of those reforms on the operation of the TBA market.
…
Consistent with the view that liquidity effects were important during this period, the timing of the increase in the jumbo-conforming spread corresponds closely to the collapse in non-agency MBS liquidity and mortgage securitization during the second half of 2007. Furthermore, this spread remains significantly elevated even today, despite normalization in many measures of credit risk premia.

I know a man who considers one thing to be an infallible contrarian indicator: when the little guy gets in … :

The amount of money flowing into bond funds is poised to exceed the cash that went into stock funds during the internet bubble, stoking concern that fixed- income markets are headed for a fall.

Investors poured $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000, according to data compiled by Bloomberg and the Washington-based Investment Company Institute.

Concern that the global economic recovery is faltering, with the U.S. growing at a slower-than-forecast 2.4 percent pace in the second quarter, is prompting investors to pile into fixed-income securities of all types even with some yields at record lows. The new cash has helped fuel a rally and drove yields on investment-grade U.S. corporate debt down to a record 3.79 percent last week, while two-year U.S. Treasury yields fell to an all-time low of less than 0.5 percent.

There’s increased chatter about century bonds:

“With credit spreads rallying, it’s the perfect environment for issuers to get away with 100-year bonds,” said one banker who has been selectively pitching the idea to institutional investors. “There is a natural trend to go long, so the obvious extension of that is to move past the 30-year bucket.”

As investors move “out on the curve” to longer-dated issues, the amount of three-year corporate debt offerings has fallen by 50% compared to 2009. The pace of 30-year issuance has risen by 30%, according to Dealogic.

New York State may be reducing return assumptions for its pension funds:

New York state’s $132.6 billion pension fund, the nation’s third-largest, will cut the assumed rate of return on its investments to less than the 8 percent it has used for a decade.

A reduction to 7.5 percent or 7.75 percent is likely, said Robert Whalen, a spokesman for Comptroller Thomas DiNapoli. The move “will increase the required contributions from the state and local governments but will keep the fund as strong as it is now,” Whalen said.

The plan, which covers 1 million current and retired workers, had assets equal to about 107 percent of its future liabilities, according to the fund. New York was one of only four states with pension systems in 2008 that fully funded their future obligations, according to a study by the Washington-based Pew Center on the States.

By way of comparison, the Ontario Teachers’ Pension Plan states:

A typical teacher retiring in 2009 has 26 years of pension credit and is expected to receive a pension for 30 years, plus a survivor may be paid after that. Working teachers can expect to collect their pensions for longer than they contributed to the plan.
…

FUNDING VALUATION ASSUMPTIONS (percent)
	2009 Filed	2009 Preliminary
Rate of return	5.00	4.90
Inflation rate	1.35	1.35
Real rate of return	3.65	3.55

The assumptions for 2010 are nominal 5.5% less inflation 2.55% equals real 2.95%. Since:

The OTF and the Ontario government adopted a Funding Management Policy in 2003. Under the policy:

• If assets are equal to or up to 10% greater than liabilities, the plan is in balance and no change is required.
• If assets are more than 10% greater than liabilities, the plan has a surplus that can be used to reduce contribution rates or improve benefits.
• If liabilities are greater than assets, the plan has a shortfall. The OTF and the government can address a shortfall by increasing contributions, invoking conditional inflation protection for pension credit earned after 2009, changing other benefits members will earn in the future, or adopting a combination of these measures.

… one cannot help but wonder if the relatively low return assumptions are simply yet another way of back-dooring some extra benefits to the plan members.

BIS has commenced publishing property price statistics. Oddly, there are no data available for Canada.

The Bank of Canada has released a working paper by Hajime Tomura titled Liquidity Transformation and Bank Capital Requirements:

This paper presents a dynamic general equilibrium model where asymmetric information about asset quality leads to asset illiquidity. Banking arises endogenously in this environment as banks can pool illiquid assets to average out their idiosyncratic qualities and issue liquid liabilities backed by pooled assets whose total quality is public information. Moreover, the liquidity mismatch in banks’ balance sheets leads to endogenous bank capital (outside equity) requirements for preventing bank runs. The model indicates that banking has both positive and negative effects on long-run economic growth and that business-cycle dynamics of asset prices, asset illiquidity and bank capital requirements are interconnected.
…
The model, however, also shows that if a deterioration in asymmetric information in the asset market increases the illiquidity of bank assets significantly, then banks need to raise more bank capital during the liquidity crisis to prevent self-fulfilling bank runs. This result implies that the counter-cyclical capital buffer will not help to free up bank capital as designed in a liquidity crisis.

The (alleged) G-20 protesters had their day in court today:

Over 300 people facing G20-related charges appeared at a Toronto courthouse Monday, a legal tidal wave resulting from the largest mass arrests in Canadian history.

The court’s hallways are only designed to hold 176 people. Officers have been tasked with regulating the intake of defendants to ensure the building doesn’t break fire code. The court’s legal aid office brought in extra staff, including French-speakers.

I don’t know the name of the petty, vindictive ratshit who decided to make the scheduling an extra-judicial punishment … but I have a message for him: You have held the courts in contempt, and you have done more damage to the rule of law than any of those charged. Asshole.

It was a mixed day on good volume for the Canadian preferred share market, with PerpetualDiscounts gaining 23bp and FixedResets losing 5bp; the change narrowed the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) slightly to 44bp.

Was the Panic of 2007 bogus? I have previously highlighted doubts about the ABX index validity (as has, famously, Fabulous Fab) … Richard Stanton and Nancy Wallace supply another interesting paper, The Bear’s Lair: Indexed Credit Default Swaps and the Subprime Mortgage Crisis:

ABX.HE indexed credit default swaps on baskets of mortgage-backed securities are now the main benchmark used by financial institutions to mark their subprime mortgage portfolios to market. However, we find that current prices for the ABX.HE indices are inconsistent with any finite assumption for mortgage default rates, and that ABX.HE price changes are uncorrelated with changes in the credit performance of the underlying loans. These results cast serious doubt on the suitability of the ABX.HE indices as valuation benchmarks. We also find that ABX.HE price changes are significantly related to short-sale activity in the option and equity markets of the publicly traded builders, the commercial banks, the investment banks and the government sponsored enterprises (GSEs). This suggests that capital constraints, limiting the supply of ABS insurance, may be playing a role here similar to that identified by Froot (2001) in the market for catastrophe insurance.
…
We collect detailed credit and prepayment histories from 2006{2008 for all of the roughly 360,000 individual loans underlying the ABX.HE indices, and use these data, plus current prices, to infer the market’s expectations for future defaults. Using both a simple, “back-of-the-envelope” model (in which all defaults and insurance payments occur instantaneously) and a full CDS valuation model calibrated to the historical loan-level performance data, we find that recent price levels for ABX.HE index CDS are inconsistent with any reasonable forecast for the future default performance of the underlying loans. For example, assuming a recovery rate of 21%, the AAA ABX.HE prices on June 30, 2009 imply default rates of 100% on the underlying loans. In other words, if recovery rates exceed 21% (a value well below anything ever observed in U.S. mortgage markets), there is no default rate high enough to support observed prices. We also find that changes in the credit performance of the underlying loans explain almost none of the observed price changes in the ABX.HE indices. These results cast serious doubt on the use of the ABX.HE indices for marking mortgage portfolios to market.

The Canadian preferred share market advanced modestly on good volume today, with PerpetualDiscounts gaining 2bp and FixedResets up 7bp.

MFC issues maintained their presence in the volume highlights; probably continuing portfolio rebalancing after the DBRS downgrade.