PrefBlog

Timothy Geithner of the Federal Reserve Bank of New York has delivered a fine speech, Reducing Systemic Risk in a Dynamic Financial System. He notes:

This afternoon, 17 firms that represent more than 90 percent of credit derivatives trading, meet at the Federal Reserve Bank of New York with their primary U.S. and international supervisors to outline a comprehensive set of changes to the derivatives infrastructure. This agenda includes:

• the establishment of a central clearing house for credit default swaps,
• a program to reduce the level of outstanding contracts through bilateral and multilateral netting,
• the incorporation of a protocol for managing defaults into existing and future creditderivatives contracts, and
• concrete targets for achieving substantially greater automation of trading and settlement.

Establishment of this clearing-house has been reported on Bloomberg; a later press release from the FRBNY gave further details.

Geithner nails the essential point:

supervision will have to focus more attention on the extent of maturity transformation taking place outside the banking system.

And goes further, to make the point I have been making for a while:

I do not believe it would be desirable or feasible to extend capital requirements to institutions such as hedge funds or private equity firms. But supervision has to ensure that counterparty-credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

To the extent that this reflects Official Thinking, I’m very relieved. We should not be concerned that Joe’s Hot Dog Stand and Mortgages is levered 40:1 … we should only be concerned with the amount of counterparty risk taken by the banks who lend to him.

I’m not entirely certain as to what I should make of the section:

The most fundamental reform that is necessary is for all institutions that play a central role in money and funding markets—including the major globally active banks and investment banks—to operate under a unified framework that provides a stronger form of consolidated supervision, with appropriate requirements for capital and liquidity.

To complement this, we need to put in place a stronger framework of oversight authority over the critical parts of the payments system, not just the centralized payments, clearing and settlements systems but the infrastructure that underpins the decentralized over-the-counter markets.

The Federal Reserve should play a central role in this framework, working closely with supervisors here and in other countries. At present the Federal Reserve has broad responsibility for financial stability not matched by direct authority, and the consequences of the actions we have taken in this crisis make it more important that we close that gap.

I will assert that brokerages are fundamentally different from banks and should have not just different rules, but a different supervisor … in the US, the SEC is doing as well as any other regulator and should not lose any authority. I worry about how much the Bear Stearns fiasco will be used a lever in a silly bureaucratic turf fight that might, ultimately, lead to a blurring of the distinction between the two components of the financial system. He does mention Bear Stearns, by the way, but doesn’t add anything new.

Carnage on the preferred share market today, with the TXPR Index down 0.61% and Claymore’s CPD about the same. Sunlife, comprising a little over 6% of CPD, got hammered.

There were twenty other index-included $25-pv-equivalent issues trading over 10,000 shares today.

The biggest financial news in recent days is the Moodys / S&P downgrade of two monolines, MBIA and Ambac. Accrued Interest opines that this is long overdue as far as the current balance sheet goes, but may be related to their low share prices and general unpopularity making it hard for them to raise capital. Naked Capitalism passes along some speculation that the ratings cuts will cause massive write-offs at the brokerages.

The two monolines insure more than $1-trillion of third party debt; competition is poised to take advantage … and the politicians are grandstanding:

The companies also face competition from billionaire Warren Buffett’s Berkshire Hathaway Inc., the largest shareholder in credit-rating company Moody’s Corp. Buffett started a new bond insurer in December and is charging more than MBIA and Ambac to guarantee payment on municipal debt while avoiding the CDOs and other securities that jeopardized their credit ratings.

Macquarie Group Ltd., Australia’s biggest securities firm, also plans to form a U.S. bond-insurance company. The Sydney- based company has been in talks with the New York State Insurance Department since April to provide bond insurance in the state, Superintendent Eric Dinallo said in an e-mailed statement today.

California Treasurer Bill Lockyer and Connecticut Attorney General Richard Blumenthal are among officials seeking a change in how Moody’s and S&P rate municipal bonds. States and local governments say they were forced to buy now worthless bond insurance because Moody’s and S&P “knowingly and systematically” ranked municipal issues lower than they should have. Reform may negate the need for bond insurance.

In an announcement late today, S&P is lowering the boom on monolines:

Standard & Poor’s took negative ratings actions on the bond insurance businesses of CIFG Guaranty, Security Capital Assurance Ltd. and FGIC Corp. as the companies struggle to address potential losses on securities they guaranteed.

CIFG, stripped of its AAA rating in March, was downgraded further today to A-, while SCA’s XL Capital Assurance Inc. and XL Financial Assurance Ltd. had their financial strength ratings cut to BBB-, the lowest investment-grade level. FGIC, owned by Blackstone Group LP and PMI Group Inc., had the BB ratings on its bond insurer placed under review for a possible downgrade.

The other major story of the past week has been Lehman’s search for capital:

Lehman, the fourth-largest U.S. securities firm, has already sold bonds and preferred shares to generate $8 billion in capital since February. Chief Executive Officer Richard Fuld is trying to reduce leverage, the firm’s ratio of assets to equity, to help offset a decline in the value of debt securities. Concern that Bear Stearns Cos. faced a cash shortage pushed the firm to the brink of bankruptcy in March.

Well, they have to raise capital and otherwise delever their balance sheet. In this environment, fundamentals don’t really matter a lot. Leverage doesn’t matter, asset quality doesn’t matter, profitability doesn’t matter … you just don’t want to be the weakest broker on the Street. Look what happened to Bear Stearns! And if Bear had been unable to cut some kind of deal on the fateful Sunday evening and been forced into Chapter 11 on Monday morning, the run on Lehman would have started instantly.

Naked Capitalism is decidedly unimpressed with Lehman’s disclosure.

Bloomberg has an amusing piece on the value of sell-side analysis:

Investors who followed the advice of analysts who say when to buy and sell shares of brokerage firms and banks lost 17 percent in the past year, twice the decline of the Standard & Poor’s 500 Index.

Buying shares on the advice of Merrill Lynch & Co.’s Guy Moszkowski, the top-ranked brokerage analyst in Institutional Investor’s annual survey, cost investors 17 percent, according to data compiled by Bloomberg. Deutsche Bank AG analyst Michael Mayo’s counsel to purchase New York-based Lehman Brothers Holdings Inc. lost 59 percent. Citigroup Inc.’s Prashant Bhatia still rates Merrill “buy” after its 56 percent retreat from a January 2007 record.

Granted, it’s only one year, but I do like to see even the slightest hint that the media is actually following up on the recommendations they report so breathlessly.

Naked Capitalism reports on the Lacker speech I mentioned yesterday, with a greater emphasis on the Fed’s independence:

But there has been another thread mixed in with this: resentment at the Fed salvaging the banking industry, with contingent and real costs, in the form of higher inflation, per Alford’s and Leijonhufvud’s analysis. Now that many of those actions may indeed have been the best among a set of bad choices (although I suspect economic historians will conclude the Fed cut rates too far too fast). However, the big issue is that they involved consequences of such magnitude that they should not have been left to the Fed. I was amazed, and was not alone, when Congress did not dress down the Fed in its hearings on the Bear rescue for the central bank’s unauthorized encroachment into fiscal action (ie., if any of the $29 billion in liabilities assumed by the Fed in that rescue comes a cropper, the cost comes from the public purse). So the frustration isn’t merely about outcomes, it’s about process, about the sense of disenfranchisement. And that will only get worse as this crisis grinds along.

The word “resentment” is critical and may have an effect on shaping policy in the future. It seems to me that, by and large, Americans are big fans of punishment:

One in thirty-two US adults are now under some form of correctional supervision. Although Americans only constitute 5 percent of the world’s population, one-quarter of the entire world’s inmates are contained in our jails and prisons, something that baffles other democratic societies that have typically used prisons as a measure of last resort, especially for nonviolent offenders.

But mass incarceration in America remains a nonissue, largely because of a lack of any serious or effective discourse on the part of our political leaders. At most, election season brings out the kinds of get-tough-on-crime platforms that have already given us misguided Three Strikes and mandatory-minimum sentencing laws.

Throughout the credit crunch, the worry about effects on the economy – and the personal effects on the worrier – has been leavened by what can only be described as joy that traders, bankers, big investors and over-leveraged real-estate purchasers are getting wiped out. Part of America’s inheritance from the Puritans is a deep-seated belief that those who behave improperly should be punished, and much of the criticism of the Fed’s actions with respect to Bear Stearns feeds itself from this source.

Don’t get me wrong, here! I’m not proposing that mummy-government give everything a kiss and make it better! In the end, I am opposed to government infusions of capital – but I don’t take any joy in seeing people get wiped out because they stayed at the party for five minutes too long; nor do I approach the situation with the idea that since things have gone wrong, there must be a villain somewhere. Violent mood swings from euphoria to gloom may be undesirable in individuals, but are a normal and valuable element of financial markets.

Other elements of the “Fed Independence” debate were most recently mentioned on PrefBlog on May 26 and May 13. In times like this, we do not need grandstanding politicians getting in the way. Hire smart technocrats, pay them well, give them discretion – and periodically review the boundaries of that discretion.

Nicholas Bloom of Stanford has an interesting piece on VoxEU today, Will the Credit Crunch Lead to Recession?. His answer is yes:

So what is stopping Chairman Bernanke from acting to counteract this rise in uncertainty and forestall the recession? Well, as Bernanke also knows, the same forces of uncertainty that lead to a recession also render policy-makers relatively powerless to prevent it.

When uncertainty is high, firms become cautious, so they react much less readily to monetary and fiscal policy shocks. According to research on UK firms, which I conducted with two colleagues, uncertainty shocks typically reduce the responsiveness of firms by more than half, leaving monetary and fiscal policy-makers relatively powerless (Bloom et al. 2007).

So the current situation is a perfect storm – a huge surge in uncertainty that is not only generating a rapid slowdown in activity but also limiting the effectiveness of standard monetary and fiscal policy to prevent this.

Policy-makers are doing the best they can – making huge cuts in interest rates, dishing out tax rebates and aggressively pouring liquidity into the financial markets. But will this be enough? History suggests not. A recession looks likely.

It all makes sense, but I’m not sure about the direct equivalence of stock market volatility and delays in direct investment. Bloom states:

In recent research, I show that even the temporary surges in uncertainty that followed previous shocks had very destructive effects. The average of the 16 shocks plotted in Figure 1 (before the credit crunch) cut US GDP by two percent over the next six months (Bloom 2007).

One of his cited papers is on-line: The Impact of Uncertainty Shocks: Firm Level Estimation and a 9/11 Simulation, but such is my laziness that I haven’t read it yet.

I will admit that on first glance, the post on WSJ titled Bubble Proposal: Let Banks Pay for Their Own Bailouts looked like the silliest thing I’ve ever heard:

Borrowing from the world of carbon-emission trading, Ian Harnett, managing director of Absolute Strategy Research Ltd., suggests that governments set up a market in which banks buy the rights to expand their assets. The money banks pay would then be set aside by governments as a form of insurance. So, if the banks get it wrong, their money would be used to bail them, or the market, out, said Mr. Harnett, musing in London Thursday.

“Banks can buy the right to increase their asset base beyond what the regulator thinks is prudent. If you tax them upfront, you would force them to consider the expansion of their lending,” he said.

See the comments on the WSJ blog for examples supporting my “punishment” thesis!

Sober second thoughts about the idea’s practicality, however, convinced me that (to some degree) the proposal is already in effect – and there’s even a General Guidance for Developing Differential Premium Systems available from the International Association of Deposit Insurers c/o Bank for International Settlements:

Deposit insurers collecting premiums from member financial institutions which accept deposits from the public (hereafter referred to as “banks”) usually choose between adopting a flat-rate premium or a system that seeks to differentiate premiums on the basis of individual-bank risk profiles. Although flat-rate premium systems have the advantage of being relatively easy to understand and administer, they do not take into account the level of risk that a bank poses to the deposit insurance system and can be perceived as unfair in that the same premium rate is charged to all banks regardless of their risk profile. Primarily for these reasons, differential premium systems have become increasingly adopted in recent years.

Differential premia are in effect at the FDIC:

the FDIC Board adopted a new risk-based deposit insurance premium system effective January 2007. The assessment approach adopted relies on an institution’s supervisory ratings, financial ratios, and long-term debt issuer ratings. For most institutions, supervisory ratings will be combined with financial ratios to determine assessment rates. For large institutions (over $10 billion in assets) with long-term debt issuer ratings, assessment rates will be based on supervisory ratings combined with debt ratings.

The adopted rule allows for some pricing discretion by the FDIC with respect to certain large institutions, recognizing that proper assessment of the risk of large complex institutions cannot always be adequately measured using a formulaic approach. In such cases, other market information, as well as additional supervisory and financial information, will be used to determine whether a limited adjustment to an institution’s assessment rate is warranted. All of this additional information will help ensure that institutions with similar risks pay similar rates.

The CDIC also charges differential premia:

The CDIC Differential Premiums By-law (“By-law”) came into effect for the premium year beginning May 1, 1999. The By-law undergoes regular reviews (including a 2004 comprehensive review) and has been amended on numerous occasions following consultation with member institutions, their associations and regulators. The By-law and its amendments are provided under the Tabs titled “Differential Premiums By-law” and “Amendments to Differential Premiums By-law”, respectively.

Whether the differential premia are, in fact, differential enough is another matter entirely – and there’s not much by way of disclosure to allow for an informed judgement on the matter. But … the framework is in place.

Long corporates now yield something like 6.05%, so the 5.73% dividend on PerpetualDiscounts, x1.4 Equivalency Factor, equals 8.02% interest equivalent, implies that the preferred spread continues to hang in at around 200bp.

Good volume for RY issues today, but no trend to the prices. The yields relative to the discount-to-call-price don’t make a lot of sense to me either:

If you accept my estimate in my article about convexity which stresses the asymmetry of the risk/reward potential for issues trading near(er) par, you will understand my confusion … RY.PR.H and RY.PR.W look quite expensive! At least … they do relative to their deeper discount siblings, which have the same credit risk, but offer the potential for capital gains that won’t be quickly called away should interest rates decline. But such is life in the preferred share market.

There were twenty-one other index-included $25-pv-equivalent issues trading over 10,000 shares today.

Finance Geeks will be pleased to learn that I have finished my post Expected Losses and the Assets to Capital Multiple. All other will simply let their eyes glaze over and look forward to a resumption of PrefBlog’s regular schedule of news and snarky comments.

Bear Stearns controversy is reaching new heights:

Richmond Federal Reserve Bank President Jeffrey Lacker, challenging Chairman Ben S. Bernanke’s unprecedented actions to stem a financial panic, warned that lending to securities firms raises the risk of future tumult.

“The danger is that the effect of the recent credit extension on the incentives of financial-market participants might induce greater risk taking,” Lacker said in a speech to the European Economics and Financial Centre in London. That “in turn could give rise to more frequent crises,” he said.
…
Bernanke and New York Fed President Timothy Geithner have defended the central bank’s extraordinary moves as preventing a cascading financial panic. A growing group of Fed bank presidents, who are charged with direct supervision of financial institutions, are saying limits now need to be drawn around the Fed loan facilities.
…
If investors anticipate an official intervention to limit losses in “situations of financial stress,” firms will be less likely to take “costly” measures to protect themselves, Lacker said.

Lacker in his remarks distinguished between “fundamental” runs on financial institutions where creditors have good economic reasons to question their investments, and “non-fundamental” runs typified by panics.

Types of Runs

He said a case can be made for intervention to stem disorderly non-fundamental runs. He doesn’t see a case for action when a crisis is unavoidable based on a deteriorating credit or business plan. “Instances of run-like behavior since last summer appear to be attributable to real fundamental causes,” Lacker said in his speech.

In the case of Bear Stearns, Lacker said in the interview that it’s hard to tell whether the New York-based firm’s crisis was due to fundamental reasons or a creditor panic.

In Lacker’s actual speech he said:

Researchers have found it useful to distinguish between what I’ll call “fundamental” and “non-fundamental” runs. Non-fundamental runs are of the self-fulfilling variety; if all depositors who do not need their money right away believe that other such depositors will not withdraw their money, then no run occurs. In another potential equilibrium, the belief that other patient depositors will withdraw nonetheless induces all patient depositors to withdraw, thus confirming their beliefs. Fundamental runs occur when people seek to remove their money from an intermediary because they have information that makes them mark-down their valuation of the intermediary’s assets; waiting is not a reasonable option (that is, not an equilibrium). This distinction is important because the two types of runs have very different policy implications. Preventing a non-fundamental run avoids the cost of unnecessarily early asset liquidation, and in some models can rationalize government or central bank intervention. In contrast, in the case of runs driven by fundamentals, the liquidation inefficiencies are largely unavoidable and government support interferes with market discipline and distorts market prices.
…
However, in most instances of runs that we have observed — for example, the wave of U.S. bank runs in the Great Depression — careful analysis has shown that banks that experienced runs tended to be in observably worse condition than those that did not.3 That is, there usually appears to be some fundamental impetus behind a run.
…
… significant concerns were circulating publicly regarding mortgage-related assets on Bear Stearns’ balance sheet, making money market counterparties (short-term investors) reluctant to continue dealing with the firm.

It’s a good speech, worthy of reading in full. I will certainly agree that institutions that experience runs are observably worse than ones that do not – the markets are not wholly irrational! However, you don’t need to watch the markets for very long before you conclude that markets are excitable and will make mountains out of molehills at every opportunity.

I think we’re now in the “political football” of Bear Stearns discussion and that we’ll remain there for quite some time … at least until the new president, whoever he is, makes a policy decision and attempts to sell it. It looks to me – from the careful avoidance of any mention of the SEC in any of the Fed representatives’ discussion of the Bear Stearns affair – that the Fed wants to take over supervisory authority of the investment banks. By not mentioning SEC supervision – and what I would call the certainty that Bernanke called Cox at some point during the critical weekend and asked ‘Is it solvent?’ – the Fed’s turf-fighters will create the impression that there’s nobody minding the store at all. It also seems to me that the SEC is constrained from defending its turf due to fear of the disingenuous observation ‘But BSC was going BK!’

We can only hope that – whoever the actual supervisor ends up being – the rules continue to recognize a distinction between banks and investment dealers. Layers, that’s what we need, layers! Banks – safe! Investment Banks – risky! Hedge Funds – Wild!

Added: I came under a certain amount of eerily familiar sounding criticism in the comments to Accrued Interest’s Bailouts, Wall Street, and the Bad Motivator for daring to suggest that Bear Stearns was probably solvent at the time of its demise. It’s not a particularly strong addition to my argument, but I will suggest that Bernanke is far too rigorous a central banker to bail out an insolvent institution. See, for example, US Bank Panics in the Great Depression, with particular attention to the references in the last paragraph of the conclusion. Also, see The Discount Window: Good or Bad? for some of the current thinking.

A poor day in the markets as prices declined with a decline in volume to average levels.

There were sixteen other index-included $25-pv-equivalent issues trading over 10,000 shares today.