PrefBlog

The Fed has announced that the alphabet soup of liquidity support will be with us for some time yet:

The Board of Governors approved the extension through October 30 of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Commercial Paper Funding Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), the Primary Dealer Credit Facility (PDCF), and the Term Securities Lending Facility (TSLF). The FOMC also took action to extend the TSLF, which is established under the joint authority of the Board and the FOMC.

These are tough times for Tier 1 Capital at the banks in the eye of the storm:

The market for securities with characteristics of both debt and equity that Citigroup Inc., Bank of America Corp. and other financial companies used to bolster their capital is in freefall on concern governments will stop banks that took public cash from paying interest. The hybrids, which typically count as regulatory capital to cushion against losses, fell 11 percent last month in the U.S., more than they did in all of 2008, according to Merrill Lynch & Co. index data. Citigroup and Bank of America bonds lost as much as 34 percent of their value.
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Only $694 million of preferred securities were sold in the U.S. since September, when the government closed the market by seizing Fannie Mae and Freddie Mac. That compares with about $44 billion in the first three quarters of last year, according to data compiled by Bloomberg.

$694-million preferreds [and in the States, remember, this figure will include what we call Innovative Tier 1 Capital] in 4Q08? Hell, up here in Canada we do that in a week!

It’s not often Canadians have the opportunity to lord it over the global titans, so let’s enjoy it while we can!

Econbrowser‘s Menzie Chinn writes a piece on multipliers that I can only hope Pussycat and What-Debt? will read:

For some people, the answer to every question is…a tax cut!
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I think the “wrong” kind of interventions include a slavish devotion to tax cuts — especially when the [Marginal Propensity to Consume] [3] could be argued to be low in the aggregate (although I still believe it would be relative high for liquidity constrained households).

Accrued Interest likes the “Bad Bank” idea but I continue to believe:

• All previous efforts to entice banks into selling “toxic assets” have failed
• Caballero’s idea of ‘tail-insurance’ is the best way forward.

Donato Masciantdaro and Marc Quintyn write a piece on VoxEU introducing their formal paper on bank supervision:

Our CEPR Policy Insight No. 30, released today, summarises the answers provided so far. One of the interesting features of the current supervisory landscape is the emerging dichotomy between the role of the central bank in supervision and the trend toward supervisory unification. In a majority of countries that have opted for a unified supervisor, the central bank has been given no role in supervision. On the other side of the spectrum, in those countries that stayed close to the “silo” approach to supervision, the central bank is the main (or sole) bank supervisor in a majority of cases. This phenomenon – that the degree of supervision unification seems to be inversely correlated with central bank involvement – has been labelled the “central bank fragmentation effect”

Similarly, Patrick Bajari, Chenguan Sean Chu and Minjung Park introduce their NBER Paper An Empirical Model of Subprime Mortgage Default from 2000 to 2007 in a VoxEU piece Quantifying the triggers of subprime mortgage defaults:

A decomposition using our estimation results indicates that the nationwide decrease in home prices accounts for roughly half the increase in default propensity of loans originated in 2006 compared to 2004-vintage loans. With home prices down by more than 20% from their peaks in many US cities, borrowers whose outstanding mortgage liabilities now exceed their home values can in effect increase their wealth by walking away from their loans. Our estimates indicate that, for a borrower who purchased a home one year earlier with a 30-year fixed-rate mortgage and no down payment, a 20% decline in home price makes the borrower 15.4% more likely to default than an otherwise identical borrower whose home price remained stable.

However, we also find that household illiquidity is an equally important factor behind the increasing propensity of borrowers to default. Our parameter estimates indicate that roughly half the increase in default probability for 2006-vintage loans relative to 2004-vintage loans can be attributed to deterioration over time in observed characteristics of the borrower pool. In particular, later borrowers tend to have lower credit scores and a higher probability of having undocumented loans or additional liens on their properties—indicators of a greater risk of illiquidity due to insufficient income or lack of access to other forms of credit. We also see an increase over time in the proportion of adjustable-rate mortgages among new originations. Adjustable-rate mortgages are generally chosen by more liquidity-constrained borrowers, and often come with large, periodic increases to monthly payments, forcing liquidity-constrained borrowers to default.
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Because we find empirical importance for both illiquidity and net equity as drivers of default, this suggests that effectively mitigating foreclosures would require either some combination of policies targeting each cause, or a single instrument that targets both. For example, loan modifications that merely increase payment affordability by extending loan lengths would not be very effective as a standalone measure, as they would leave borrowers’ equity positions unchanged. On the other hand, write-downs on loan principal amounts would address both causes simultaneously, with the reduction in loan size serving both to increase the borrower’s net equity as well as reduce monthly payments.

But today’s prize-winning essay – give that man a kewpie doll! – is from Thomas Philippon, who eschews slogan-shouting while asking the question Are bankers paid too much?:

Evidence from a new century-long dataset suggests that the key factors driving relative wages in the financial sector have been regulation and corporate finance activity, followed by financial innovation. Over the past decade, however, “rents” account for 30% to 50% of the sector’s wage differential. In this sense, financiers are overpaid.

Our investigation reveals a very tight link between deregulation and human capital in the financial sector. Highly skilled labour left the financial sector in the wake of Depression era regulations, and started flowing back precisely when these regulations were removed. This link holds both for finance as a whole, as well as for subsectors within finance. Along with our relative complexity indices, this suggests that regulation inhibits the ability to exploit the creativity and innovation of educated and skilled workers. Deregulation unleashes creativity and innovation and increases demand for skilled workers.

The second set of forces that appear to have a large influence on the demand for skills in finance are non-financial corporate activities: in particular, IPOs and credit risk. New firms are difficult to value because they are often associated with new technologies or new business models, and also for the obvious reason that they do not have a track record. Similarly, pricing and hedging risky debt is an order of magnitude harder than pricing and hedging government debt. Indeed, we find that increases in aggregate IPO activities and credit risk predict increases in human capital intensity in the financial industry. Computers and information technology also play a role, albeit a more limited one. Contrary to common wisdom, computers cannot account for the evolution of the financial industry. The financial industry of the 1920s appears remarkably similar to the financial industry of the 1990s despite the lack of computers in the early part of the sample.

Not a great day for prefs.

Spend-Every-Penny is urging Canadian investors to ignore banks’ capital ratios:

“We have said that we’ll do what’s necessary to protect the Canadian banking system,” Mr. Flaherty reiterated on Saturday from Davos during a conference call with reporters.

It seems like only a few months back he was saying that his government would no more run a deficit than a man could have a baby.

With a hat-tip to Econbrowser, a graph from Calculated Risk puts the current crash in perspective:

Click for big

Volume was off today – month-end window dressing is done for another three weeks? – and PerpetualDiscounts eased off slightly. Recent increases in the Canada 5-year yield have triggered legitimate expectations (subject to volatility!) of five-year calls in the Fixed-Reset market.

I’m very annoyed with DBRS. I had been hoping they would come to some resolution of their mass reviews of Split Corporations (two of them: October and December), but here we are at month-end and … nothing.

So we’ll go through February with, for instance, FBS.PR.B sporting an asset coverage just a hair over 1.0:1 and still rated Pfd-2(low). As a portfolio manager, of course, I couldn’t be happier – such a grossly mis-rated issue in the universe increases my chance to outperform – but as an index calculator, it’s very annoying. It will be in the Split-Share sub-index for at least another month.

The concept of incentive is under continued attack:

NYSE Euronext Chief Executive Officer Duncan Niederauer said today in Davos that “some compensation models need to be completely overhauled.” He added that this would be difficult to legislate and companies will have to take the lead.

“While a number of people clearly do create wealth by brain power, by use of the company’s balance sheet and by other resources, other people have been receiving incentives for basically turning up,” Barclays Plc Chairman Marcus Agius said at the World Economic Forum. “That I don’t think is very smart. An incentive system properly designed and fairly calibrated is absolutely fundamental.”

Interesting charge/countercharge in the Money Market Fund world:

James “Jes” Staley, head of JPMorgan Chase & Co.’s investment unit, said the $4 trillion money-market fund industry is the “greatest systemic risk” to the financial system that hasn’t been adequately addressed.
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JPMorgan’s Staley blamed money funds for Lehman’s collapse and the near bankruptcy of Bear Stearns Cos. last year. The funds, which typically hold highly rated, short-term debt instruments, were forced to pull their money from the firms when they saw signs of trouble, he said.

“The people who brought down Lehman and almost Bear Stearns weren’t the banks, they were the money funds,” Staley said.

David Glocke, head of taxable money-market investments at Valley Forge, Pennsylvania-based Vanguard Group defended the industry.

“I’m aware there are those who want to blame the money- market industry for taking away the punch bowl,” he said. “But issuers need to maintain diverse sources of funding.”

The G-30 report on MMFs has been discussed on PrefBlog. The interesting thing about Mr. Glocke’s remark is that – taken at face value – it appears to accept that MMFs are a portfolio management monoculture; it would be highly surprising is the same thing were to be said, for instance, about an equity issue … but, of course, equities only go down due to short selling, so the short-seller can get one of them bonus thingies, right?

PerpetualDiscounts closed the month with a marginal loss, closing to yield 6.85%, equivalent to 9.59% at the standard 1.4x equivalency factor. Long corporates now yield about 7.6%, so the pre-tax interest-equivalent spread is now at about 200bp.