PrefBlog

Monday’s Globe & Mail had a book review by Adriana Barton (on page 3, no less!), Gorillas that we missed: The deceptive powers of perception regarding a new book by Christopher Chabris and Daniel Simons, The Invisible Gorilla: And Other Ways Our Intuitions Deceive Us.

The centerpiece of the book is an experiment in psychology:

It’s not a joke – it’s psychology’s famous “gorilla experiment,” used in schools, corporations and anti-terrorism units to show how blind we can be when we’re paying attention.

In the test, observers are asked to count basketball passes between two teams – half of them don’t see a woman in a gorilla suit walking into the action and thumping her chest.

It illustrates the phenomenon of “inattentional blindness”- how people can miss events occurring directly in front of them.

So why am a highlighting it on PrefBlog? Three of the six “distorted beliefs about our brains” are directly related to the investment business:

• Confidence: We equate self-assurance with competence, in ourselves and others.
• Knowledge: We mistake familiarity with subject matter for knowledge.
• Cause:We draw conclusions about a root cause based on the order and relationship of events.

Most successful brokers – and money managers, for that matter – exude confidence and spend a great deal of time “staying abreast of the market”, which in general has little, if any, effect on actual returns earned by actual dollars. The third point will be familiar to anybody who has ever watched a talking head confidently recapitulating the day’s market action in terms of the Knowledge he has so arduously gained.

I’ve ordered the book and look forward to reading it: it provides an academic sheen to my beliefs. I’m no more immune to perceptual bias than the next guy! I can only hope it reinforces my prejudices by as much as The Fortune Sellers did.

Additional reviews may be found in The Washington Post and National Public Radio, inter alia.

So – what’s happening with Fannie & Freddie? Nothing:

Fannie Mae and Freddie Mac, the mortgage-finance giants that are now wards of the government, are on their way to becoming the single-biggest cost to taxpayers from the financial crisis—ahead of the banks, auto makers, or even insurer American International Group.

But while Washington is on the cusp of enacting a broad revamp of the financial regulatory infrastructure, it’s in no hurry to touch Fannie and Freddie.

“The administration has put it on the ‘too hard’ pile,” says David Felt, a former senior lawyer at the companies’ federal regulator who presided over the government takeover of the companies in 2008.

Why address a problem when you can score cheap political points by vilifying bit players like Goldman Sachs?

Even when …:

Fannie Mae and Freddie Mac, the mortgage companies operating under U.S. conservatorship, will require additional government aid amid losses stemming from the 2008 credit crisis, the nation’s top housing regulator said in its annual report to Congress.

“While critical to supporting the ongoing functioning of the nation’s housing finance system, the enterprises would be unable to serve the mortgage market in the absence of the ongoing financial support,” said Edward DeMarco, acting director of the Federal Housing Finance Agency, said in the report released today.

Corporate debt is getting less liquid:

The gap between the cost to buy and sell corporate credit reached the widest in nine months in another sign that investors are increasingly wary of all but the safest government securities amid Europe’s sovereign debt crisis.

The bid-ask spread for credit-default swaps on U.S. investment-grade bonds surged to an average 8.86 basis points as of May 21 from 5.42 basis points a month ago, according to CMA DataVision prices. The difference jumped to a one-year high of 10.57 on May 7, from as low as 3.1 in 2007.
…
Global corporate bond sales are poised for the worst month in a decade, with companies issuing $48.4 billion of debt this month, down from $183 billion in April, according to data compiled by Bloomberg.

Undeterred by the political and market reaction to the partial short-sale ban, Germany is pressing ahead with a complete ban on short-sales:

Germany’s Finance Ministry proposed legislation extending a partial ban on naked short selling adopted last week to all German stocks and certain euro-currency derivatives.

The plan would ban naked short selling in stocks of all German companies listed on a domestic exchange and would also outlaw naked credit-default swaps on some euro-region bonds as well as certain euro currency derivatives, the ministry said in what it termed a “discussion paper,” distributed to banks and industry groups.

“The financial crisis has curbed confidence in the financial markets and has revealed the need for further substantial improvement of oversight rules,” according to the document. “The crisis has reached a new dimension with turbulence increasing on the European Union member countries’ bond markets and the volatility of the euro.”

They’d be better off if they paid attention to their own rules and committments:

With Greece’s debt crisis now exposing the weakness of fiscal oversight in the 16-nation economy, governments missed one or both of the European Union’s two budget requirements 57 percent of the time since they adopted the euro. Those rules limit debt to 60 percent of gross domestic product and budget deficits to 3 percent of GDP, as set out in the 1997 Stability and Growth Pact.
…
Of the economies that have been in the euro since it started trading in 1999, Belgium and Italy missed one or both of the targets in all 11 years. Greece failed in all nine years in which it used the euro. Finland and Luxembourg satisfied both goals every year.

There is an increasing amount of retail option trading:

Volume in the U.S. has tripled since 2004 to a record 3.61 billion contracts in 2009, while trading by individual investors in the same period has increased fivefold at Fidelity Investments, the world’s largest mutual-fund firm. Sophisticated online software and the growth in training offered by industry groups and brokerages, such as Charles Schwab Corp. and TD Ameritrade Holding Corp., are enabling individuals to execute advanced techniques on home computers that had been the province of professionals.
…
The number of contracts traded at Schwab, the largest independent brokerage by client assets, rose 9 percent in 2009 from 2008, according to Randy Frederick, the San Francisco-based company’s director of trading and derivatives. TD Ameritrade, based in Omaha, Nebraska, had a 3 percent growth rate in clients trading options from October 2009 to March 2010, according to spokeswoman Fran Del Valle.

But at least the ban is creating jobs!

Germany’s unilateral move to curb speculative trading of government bonds and some naked short selling last week forced lawyers to work long hours to interpret rules enacted with less than a day’s notice.

The nation’s financial regulator, BaFin, has been posting guidance about the rules online, while lawyers toiled over what countries the rules apply in, what constitutes a “naked” deal and whether the ban covers derivatives.

“The situation has been tough for all of us, lawyers and regulators alike,” said Jochen Kindermann, a capital markets lawyer at Simmons & Simmons in Frankfurt. “The step was dropped on us like a bomb and no one really had any time to prepare.”

Woes in Europe coule lead to a new bank crisis:

European leaders must now address debt sold by nations such as Greece and Spain to avoid a costlier bank bailout later, said JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon.

“If they don’t fix the problem now, they’re still going to have to fix it later by bailing out their banks,” Dimon said at the Japan Society’s annual awards dinner in New York last night. “If they have to bail out their banks, it will be far worse than making that sovereign debt good.”
…
“A lot of that sovereign debt is owned by European banks, so when these countries have problems, so will their banks,” Dimon said, answering a question from former Federal Reserve Chairman Paul Volcker, who is now an economic adviser to President Barack Obama.

Europe’s looming debt crisis shouldn’t come as a surprise, Dimon said, because European Union nations have failed to live up to promises to keep their deficits and outstanding debt within target levels.

I have crossed SEC Commissioner Luis A. Aguilar off my Christmas card list. He is using very inflammatory language:

The financial crisis and its enormous costs to society were the direct result of years of deregulation, and they have sounded the alarm for change. The perils of fragmented regulation may also be seen in the May 6th market break — the so-called “flash crash.” This market breakdown and the difficulty in determining how and why it occurred are yet further stark reminders of the dangers of weak oversight of our tightly interconnected financial markets.

“Direct result”? I haven’t seen any proof of that. “[D]ifficulty in determining” the cause of the flash crash? It’s been three weeks, buddy. Note, however, that I will agree that we might never know The Reason. Even as we may never know The Reason why Greek bonds are so cheap when all the politicians have already said everything’s OK.

It is clear that the public is clamoring for significant reform and expects Washington to deliver.(5) Against this backdrop of deregulation and confusion, it is apparent that Wall Street and Main Street are in a tug-of-war to see who wins the legislative debate. This struggle will continue as the House and Senate financial reform bills are reconciled in conference. Throughout this debate, the voices of Main Street investors have been few.

Setting up the debate as Main Street vs. Wall Street is a cheap rhetorical trick – not something I would expect to hear from an SEC Commissioner. His footnote justifying his word “clamoring” is a poll with the question “Do you support or oppose stricter federal regulations on the way [banks and other financial institutions] / [Wall Street firms] conduct their business?” Does he really consider such a poll to be justifiable as a driver of public policy? And I must say, I find it surprising that the public is clamouring for stricter regulation, while at the same time the “voices of Main Street investors have been few”. Which is it?

By contrast, the voices from Wall Street are active, well-organized, well-financed, and extremely well-connected. And they are quick to argue that one proposed reform or another would certainly lead to undesirable effects.6 They argue this even though their powers of foresight failed utterly to anticipate the severity of the financial crisis before they were swept up in it.

More cheap rhetoric. Note that he is claiming that the Credit Crunch proves the financial sector knows nothing about anything, despite the fact that regulators and central banks are heavily implicated.

As with penalties, I think that the SEC has been too often willing to compromise on remedial sanctions because they can be a sticking point in settlement negotiations. Defendants and respondents fight hardest against accepting these sanctions is because they are, in many ways, the most meaningful measures we have to protect investors.

So, Luis? All that means is: Stop Regulatory Extortion. Now. If you think somebody’s done wrong – don’t settle without an admission of guilt.

In the meantime, I consider it a disgrace that such a senior regulator be using such inflammatory language and indulging in such public advocacy. New directions, whatever they might be, are the responsibility of politicians to decide, advised in a judicious and neutral manner of what the effects – and unintended consequences – of proposed changes might be.

I am saddened to see that Queers against Israeli Apartheid has been excluded from the Pride parade:

Pride Toronto’s Board of Directors voted Friday to ban the term from all Pride-related events, Councillor Kyle Rae confirmed.

No one from Pride Toronto would comment Friday, although they said a news conference will be held Tuesday.

The group Queers Against Israeli Apartheid, which has marched in Toronto’s annual Pride parade for the past several years, has angered people who feel the name is discriminatory, anti-Semitic and anti-Israeli.

Discriminatory? Anti-Israeli? So what? Anti-Semitic? Those who feel that criticizing Israel – however wildly, inaccurately or vehemently – is equivalent to anti-Semitism have feelings that simply don’t matter. However, there’s a loop-hole:

“the Pride committee has voted to ban the use of the term Israeli apartheid at all Pride-related events.”

They’ll probably rename themselves “Queers against Israeli Genocide”, or something equally inflammatory.

The disgrace is that this has happened as the result of a bureacratic decision (on the part of city bureaucrats to threaten funding) – there has been no legislative, judicial or quasi-judicial involvement whatsoever. But then, city bureacrats are running amok, about to ban soda pop at arenas and community centers.

All this is going to backfire, the same way official disapproval of pornography fueled the growth of the Internet. You know why Harry Potter (and, to a lesser extent, Twilight) was such a sensational success? It’s because, after a steady diet of politically correct bilge, somebody sat down a wrote a story (and wrote it well, which is the hard part) with villains and conflict. Most kids, I am sure, embarked on the voyage with a suspicion that somewhere along the line Voldemort and Potter would discuss their differences, resolve them, hug and become best friends. And if they had, JK Rowling might well have done well – but not great.

Want to make community centres irrelevant? Simply make them irrelevant to people’s lives and ban soda.

On another day of relatively light volume, PerpetualDiscounts gained 10bp and FixedResets lost 6bp.

Gensler’s testimony regarding the May 6 Bungee Jump is available:

CME Globex has stop logic functionaility that protects against cascading stop orders – the domino effect of one stop order triggering others. Globex’s stop logic functionality pauses trading for five to ten secons – five seconds in the case of the E-Mini contract – when the trading engine recognizes that it has a series of resting stop orders that could lead to a cascade and move the market up or down beyond a specified amount. On May 6, the stop logic functionality occurred on two currency futures contracts and when the E-Mini contract hit bottom.
…
On May 6, trading volume was very high. Usually, high volume indicates high liquidity. On this day, however, high volume could have been a misleading indicator of liquidty to market participants and their pre-programmed algorithms. Higher trading volume, when it is associated with high price change, may not be a good indicator of liquidity because many orders could have been executed at falling prices. This particular high trading volume was accompanied by significant fluctuations in trading volume. Further, the daily trading activity did not result in a significant number of futures contracts held by market participants at the end of May 6. This implies many investors participated in the market intraday, but on balance few investors increased their positions by the close of trading.
…
The two other measures of liquidity we reviewed – the bid offer spread and the depth of the limit order book – suggest that liquidity was dislocated. When the CME’s stop logic functionality took effect on the E-Mini contract, the bid ask spread had widened significantly. This means the liquidity was lower and the transaction costs were higher.

Click for big

Click for big

One of the top ten most active trading accounts by gross volume between 2:00pm and 3:00pm only entered orders to sell. That trader entered the market at around 2:32pm and finished trading at roughly 2:51pm. The trader sold just less than half of its contracts as the market went down and just more than half as the price level rose.

We understand that this particular market participant sought to hedge its stock portfolio in the futures market by selling a pre-determined amount of futures through an executing broker’s automated execution system. In this circumstance, we further understand that the trade was executed through an executing broker’s algorithm that was meant to limit market impact by limiting volume at an average of nine percent of the volume traded during the period.
…
From 2:30 pm to 3:00 pm, however, this market had 10 times higher volume than the average daily trading volume for the same intraday time period over the previous month, without the concurrent increase in liquidity. On May 6, it took about 21 minutes for the participant to execute their sell order. In markets with average volume, it would have taken significantly longer – perhaps hours.

The Canadian preferred share market had a day of low volume, especially when compared with levels of the past two months. Sell in May and pay and pay? PerpetualDiscounts were up 2bp and FixedResets gained 6bp.

You know who the smartest people in the world are? Harvard grads are the smartest people in the world:

When Larry Estrada graduates from Harvard Business School next week, he’ll begin work at Goldman Sachs Group Inc. He’ll do so only after taking an oath.

Estrada, 30, joined about 150 fellow business school students and faculty worldwide to campaign for the acceptance of an MBA ethics pledge modeled on the Hippocratic Oath taken by doctors. The aim is to get as many as 6,000 graduates at 50 MBA programs to swear they won’t put personal ambitions before the interests of their employers or society.

See how smart they are? They know what’s in the best interests of society. I consider myself lucky if I know what’s in my own best interests – but then, I’m not smart enough to go to Harvard.

It is possible that the carried interest loophole in US tax law may be plugged – finally!:

Managers of investment partnerships typically are paid 2 percent of fund assets as an annual management fee and 20 percent of the profit earned for investors above certain levels. While the management fee is taxed as income, the share of profit, known as carried interest, is taxed at the lower capital-gains rate, currently 15 percent and slated to rise to 20 percent in 2011.

A summary of the still-unreleased legislation said it would allow carried interest that reflects return on invested capital to continue to be taxed at capital gains rates.

For other funds, “the bill would require investment fund managers to treat 75 percent of the remaining carried interest as ordinary income,” the summary said.

Common equities had a bad day:

The Standard & Poor’s 500 Index plunged 3.9 percent to 1,071.59 at 4 p.m. in New York, its biggest drop since April 2009. The Stoxx Europe 600 Index lost 2.2 percent and the S&P GSCI Index of commodities tumbled to the lowest since October. The losses accelerated even as the euro rallied as much as 1.5 percent to $1.2598 after earlier flirting with a four-year low. Ten-year Treasury yields sank to the lowest level of the year, down 15 basis points at 3.22 percent.

The Canadian preferred share market continued its slow slide on relatively (by recent standards) modest volume, with PerpetualDiscounts down 11bp and FixedResets losing 8bp.

More on Basis Alpha:

The Basis fund’s main contention is that the fund’s managers were misled by Goldman when it purchased two $50 million tranches of Timberwolf, a $1 billion CDO that Goldman took to market in March 2007, according to Mapley and other people familiar with the situation.

The Basis fund sank money into Timberwolf in June 2007, after the one-time $500 million fund claims it got assurances from Goldman’s mortgage trading desk that the market for CDOs had stabilized after falling sharply.
…
Mapley said he has been told Goldman sold the Timberwolf securities to the hedge fund at a significantly higher price than what similar mortgage-linked securities were selling for at the time. Basis’ managers were not aware that Goldman’s mortgage trading desk was actively shorting CDOs and other subprime mortgage-linked securities at the time of the Timberwolf deal, he said.

That’s it? That’s the basis of the complaint? These guys are clowns.

The German attempt to distort markets hasn’t got much political support:

The euro is at risk and Europe may be facing its greatest challenge since the founding of the European Union, [German Chancellor Angela Merkel] said. The consequences are “incalculable” if leaders fail to act.

For all that, a Europe-wide ban on naked short-selling is “doubtful,” Eddy Wymeersch, Europe’s top market regulator, said in a telephone interview. The Netherlands and Finland said they have no plans to implement similar measures to Germany.

France, which lined up with Germany on market regulation before the last two G-20 summits, doesn’t plan to follow Germany in banning the use of contracts to speculate on European sovereign debt, Finance Minister Christine Lagarde said.

“We haven’t envisioned doing it,” Lagarde told reporters in Paris. France has banned “naked short sales” on equity markets since September 2008. Portugal’s financial regulator said it was keeping its restrictions on naked short selling that date back to 2008.

It is important that member states act together and that we design a European regime to avoid regulatory arbitrage and fragmentation,” EU Financial Services Commissioner Michel Barnier said in an e-mailed statement.

A ban in Germany alone will likely be ineffective, former U.K. Finance Minister Nigel Lawson said in an interview with Bloomberg Television.

“People will find ways of getting round it, move to other jurisdictions,” Lawson said. “It can only be workable for a very, very short time.”

What’s worse, there are fears that Lucas van Praag, Worlds’ Greatest Corporate Spokesman, is losing his touch.

Volume on the Canadian preferred share market was merely elevated today and volatility was muted as PerpetualDiscounts were up 2bp and FixedResets were down by the same figure.

The yield on PerpetualDiscounts is now 6.39%, equivalent to 8.95% interest at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.65%, so the pre-tax interest-equivalent spread is now about 330bp, a mild (and perhaps spurious) increase from the 325bp recorded May 12.