PrefBlog

Prof. Hamilton’s use of the unadjusted 10-year Nominal/TIpS spread, mentioned here yesterday, attracted some criticism in the comments to his post. The Cleveland Fed adjusts the raw data for (a) the inflation risk premium, and (b) liquidity premium.

The naive method of pricing real return bonds is:

Nominal Yield = Real Yield + Inflation Expectations (Wrong!)

If this were the actual equation, there would be no incentive for the issuers to issue the bonds; they would just go with nominals. However, the correct equation:

Nominal Yield = Real Yield + Inflation Expectations + Inflation Risk Premium (Right!)

adds a term. A buyer of nominals must not only forecast inflation, but (if he’s prudent) add a little bit extra just in case his expectations are wrong. By issuing real return bonds, the issuer can capture that Inflation Risk Premium for itself.

The liquidity premium doesn’t need a lot of explanation – especially in this environment, where the liquidity premium on some issues – especially US financials – is enormous. When you buy treasuries – or Canadas, to a lesser extent – you can trade a boatload of them without moving the price. Want a quote on 10-years, $50-million a side? The quote will come back at you with a ten cent spread. Why not? The dealer’s ‘phone is always ringing, he can keep turning over his inventory and earning the spread with ease, and he can alter the directional bias of his trades by shading his quote a few pennies one way or the other.

This is – ahem! – not the case with instruments of lesser liquidity. Therefore, you are willing to pay less for instruments of low liquidity (which increases the yield required) to compensate for the risk that you’re going to want to – or have to – sell them prior to maturity anyway and be subject to the tender mercies of the dealers and their book of inventory.

I have added a link to the Cleveland Fed’s calculations at the sidebar. Curious readers will see that the adjusted series is volatile and has been sharply increasing in recent months.

The implosion of the weaker monolines, Ambac and MBIA, continued today.

Michael Woodford of Columbia University wrote an interesting piece on the ideal methodology of central bank communication with investors:

All of the big-3 central banks (the Fed, Bank of Japan and the ECB) have experimented over recent years with more explicit forward guidance through their official communications. Generally it is through the use of “code words,” such as removal of policy accommodation at a “measured pace,” or the exercise of “strong vigilance” toward inflation risks.
…
I suspect that other central banks are becoming more cautious as well about the use of code words that are taken to directly indicate future interest-rate decisions, under the current rapidly changeable conditions in financial markets.

He suggests that the use of fan charts would be preferable. To my chagrin I have been unable to find a linkable example of a fan chart, but the name should be self explanatory. Draw your projection of … whatever … into the future. Draw in confidence limits at, say, 50%, 75% and 95% confidence. Colour them in. Voila! See, for example, Chart#3 in the Norges Bank 2006-03 Inflation Report.

At a 2006 Bank of Canada conference, such fan charts were lauded:

The Reserve Bank of New Zealand is the pioneer not only in inflation targeting but also in introducing and publishing explicit instrument-rate paths that can be interpreted as optimal instrument-rate plans. The bank has done so since 1998 (Archer 2004, 2005; Svensson 2001a). The Reserve Bank has for many years been alone in taking this bold step. However, Norges Bank, an enthusiastic and competent newcomer to the inflation-targeting camp, has recently started to publish explicitly optimal instrument-rate paths with uncertainty bands, together with criteria for optimal inflation and output-gap projections and other innovations in transparent monetary policy (Norges Bank 2005; Qvigstad 2005). This should be an example to other central banks.

There was a bit more speculation about BCE today:

Shares of BCE Inc. Canada’s biggest telecom company, continue to trade well below the offer price in its $34.8-billion buyout as investors remain worried the deal may be repriced, abandoned or face further delays.

The buyer group, which includes the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners and Merrill Lynch Global Private Equity, has offered $42.75 a share to take the company private.

However, its shares were at $36, down $1.01, on the Toronto Stock Exchange on Thursday afternoon, despite repeated assurances from both BCE and Teachers’ that the deal remains on track.

A BCE spokesman said on Thursday the company is still “looking forward to closing the deal” in the second quarter.

A Teachers’ spokeswoman was not immediately available for comment.

My guess is that the Teachers’ spokeswoman was in the Ladies’, throwing up. But what do I know?

Today’s response in the preferred market to the new BNS 5.60% Perpetual certainly makes my “frothy” correspondent of January 7 and January 8 look like a genius! The correspondent now feels that (a) long-term, prefs are a buy; (b) short term, it might be better to wait; and (c) if another issue comes out before the new issue settles, take the day off and buy a bottle of something tasty. 

Volume, rather surprisingly, was good, but by no means heavy. Make of that what you will.

There were thirty-two other index-included $25.00-equivalent issues trading over 10,000 shares today.

Rule #1 states that the world always looks more interesting than it really is, an idea mentioned in a previous post, The Bond Market is Excitable. James Hamilton of Econbrowser took a look at the retail sales numbers that had everybody so excited yesterday and yawned.

I don’t know whether this marks the beginning of a trend or not, but there are two new posts out there complaining about executive pay amidst all the current shock and horror. Accrued Interest focusses on Countrywide CEO Angelo Mozilo, while Naked Capitalism republishes a more general article by Martin Wolf regarding bankers pay in general.

The latter essay espouses the popular ethic that this would be a much better world if only there were more rules. When considering the current devastation:

Up to now the main official effort has been to combine support with regulation: capital ratios, risk-management systems and so forth. I myself argued for higher capital requirements. Yet there are obvious difficulties with all these efforts: it is child’s play for brilliant and motivated insiders to game such regulation for their benefit.

So what are the alternatives? Many market liberals would prefer to leave the financial sector to the rigours of the free market. Alas, the evidence of history is clear: we, the public, are unable to live with the consequences.

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public. The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.

No, the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week (“Bankers’ pay is deeply flawed”, FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

I certainly agree with the need for a continuous update of regulation – I have argued for increased capital requirements for loan committments (e.g., liquidity guarantees for SIVs) and more recently, for recognition of the credit risk on bank-sponsored Money Market Funds. And while it is indeed “child’s play for brilliant and motivated insiders to game such regulation”, it is also child’s play for a bored routiner at the regulator to update regulation. Remember: bank regulation does not need to be perfect. It only needs to be good enough. To date, I have seen no evidence that it hasn’t been good enough.

However, as I made clear in my comments on Willem Buiter’s Prescription, I am a fan of the “narrow banking” approach – although my idea of “narrow” is a lot wider than Mr. Wolf’s! You want the regulated banking sector to be fairly wide: firstly because, in general, regulation is slow to change and we should, as a society, be putting potentially good ideas to the test quickly; and secondly because the shadow banking system should not encouraged to grow so large that it will seriously endanger the entire economy.

And finally, I take exception to the last sentence quoted: “By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.” No, Mr. Wolf. It is not the banks that are creating these gigantic incentives. It is the banks’ owners who are doing this. And if the owners of Citigroup and CIBC are so enthralled with the idea of paying fortunes of intergenerational size to bozos with no conception of risk control – why not let them?

On a related note, the monoline credit insurance agency Ambac Financial Group:

ousted its chief executive officer, slashed the dividend 67 percent and will raise more than $1 billion to preserve its AAA credit rating after announcing the biggest-ever writedowns by a bond insurer.

And remember those deeply subordinated MBIA notes, that I pointed out were really equities? They should have sold more!

MBIA Inc.’s surplus notes have tumbled as much as 12 percent since they were sold last week on concern that the world’s largest bond insurer may need to tap investors for more money.

The AA rated debt fell as low as 88.5 cents on the dollar today, according to bond traders. That’s the equivalent of a yield of 18 percent, data compiled by Bloomberg show. The notes were trading at 97.5 cents yesterday, according to Bloomberg data.

Perhaps not surprisingly, S&P will be re-evaluating the insurers:

because losses on subprime mortgages will worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

S&P is now assuming losses on 2006 subprime mortgages will reach 19 percent, up from 14 percent, as housing prices decline further than previously thought.

US headline inflation was in the headlines today:

Overall inflation in 2007 ran at its fastest rate since 1990, although core CPI inflation [excluding food and energy prices] moderated to 2.4% in 2007 from 2.6% in 2006.

By me, these figures indicate that there are no real inflationary problems – yet! – for the US, but there are two wild cards for the coming year: first, any Fed easing will increase the risk that inflation will again rear its ugly head; second, it is not apparent that the decline in the greenback relative to its trading partners has been fully reflected in these figures. It seems to me that there should be some curve steepening in the next while, particularly if central bank easing becomes the order of the day, as monetary policy controls the short end of the curve while inflation expectations rule at the long end.

James Hamilton of Econbrowser points out that:

The Fed bases its actions not on what inflation has been, but rather on what it anticipates for the future.

… and quotes a Bernanke speech that caused market excitement on January 10 when everybody else quoted a different part. Prof. Hamilton draws attention to:

Thus far, inflation expectations appear to have remained reasonably well anchored, and pressures on resource utilization have diminished a bit. However, any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future. Accordingly, in the months ahead we will be closely monitoring the inflation situation, particularly as regards inflation expectations.

Prof. Hamilton looks at two series: the 10-year Treasury yield and its spread against 10-year TIPS to conclude:

As long as those two series stay in their recent territory, the Fed thinks it has the maneuvering room to be aggressive about addressing the dangers of an economic downturn and financial collapse. And that’s why we’ll see at least a 50-basis-point cut in the fed funds target at the next meeting, despite the “highest inflation rate of the last 17 years”.

Further to yesterday’s note about Menzie Chinn’s post about automatic stabilizers, the Congressional Budget Office has release a report outlining the the political options (hat tip: WSJ Economics blog). It is interesting to note:

Automatic fiscal stabilizers also reduce the risk of recession. As the economy slows, slower growth of income, payrolls, profits, and production causes tax receipts to fall relative to spending––and causes outlays on programs such as unemployment compensation and Food Stamps to rise. That combination temporarily boosts demand for goods and services, thereby helping to offset some of the weakness in demand. The Congressional Budget Office (CBO) estimates that, since 1968, automatic stabilizers have added between 1 percent and 2.5 percent of gross domestic product (GDP) to the deficit during recessions, which translates to about $140 billion to $350 billion in today’s economy, and thereby helped mitigate past economic downturns. The automatic stabilizers already built into current law will partially offset any further weakening of the economy.

With the rather exciting headline Big banks consider defying rate cut, Heather Scoffield and Tara Perkins of the Globe noted:

Some of Canada’s big banks are contemplating holding their prime rates steady in the face of a rate cut by the Bank of Canada, a move that could destabilize the country’s monetary policy.

The central bank is expected to cut its key interest rate by a quarter of a percentage point on Jan. 22. But since the global credit crunch has driven up the cost of borrowing for commercial banks, some are questioning whether they should match the central bank’s move, banking sources say.

The comments on this story are, as usual, a hoot. Given that banks are now paying higher rates than non-financial corporations (due to credit concerns) and that RBC’s (for instance) cost of funds is so low:

Deposits include savings deposits with average balances of $46 billion (2006 – $46 billion; 2005 – $46 billion), interest expense of $.4 billion (2006 – $.4 billion; 2005 – $.3 billion) and average rates of .9% (2006 – .8%; 2005 – .6%).

… it is perhaps not as surprising as it might be otherwise that overnight vs. prime will decouple – at least to a limited extent. The credit crunch is affecting the markets in new and exciting ways!  Mind you – I have checked Bank of Canada data for the past ten years and the difference has only fleetingly been different from 175bp … so such a change, if effected, will be a relative novelty. Some may wish to review  BoC Working Paper 2003-9:

Although the magnitude of the impact differs between the models, the CPF and CF models respond similarly to the tighter credit conditions. As expected, the tightening of credit conditions leads banks to reduce lending and increase the loan rate. Firms react by cutting back on external funds to finance intermediate-good inputs, which causes in a fall in production. The central bank allows the deposit rate to also rise as it injects money (i.e., creates an inflation expectation) to offset the negative consequences of credit shocks. The restriction of credit impacts negatively on aggregate supply, as firms cut back on production, leading to a fall in final output. In an attempt to accommodate the deterioration in credit conditions, the monetary authority reacts by injecting more liquidity into the economy. The rise in liquidity plus the negative shift of the aggregate supply curve combine to push up the inflation rate.

The persistence of credit shocks is estimated to be quite high (i.e., rz = 0.7817). The result is that the tighter credit conditions generate persistent movements in all variables. In each case, we find that the variables do not return to their steady-state values even after 10 quarters. The implication of this result is that a worsening of credit conditions can be very persistent and have a lasting impact on economic activity. There could also be a persistent increase in the inflation rate if the monetary authority offsets the credit shock by infusing additional liquidity into the economy.

As the Banks’ researchers noted in 1994:

Banks try to avoid frequent changes in the prime rate, and they fund prime-related loans more often with 1-month or 3-month term deposits than with overnight deposits.

Most readers will be aware that the Bill/BA spread has gone completely nuts over the last six months … is it really all that surprising that the Overnight/Prime spread is at risk?

PerpetualDiscounts managed to return to their winning ways … barely! Volume was steady.

There were twenty other index-included $25.00-equivalent issues trading over 10,000 shares today.

Well, stores didn’t sell anything in December (which attracted a lot of comment, so investors thought they’d fill the need. And the equity infusions just kept coming:

Citigroup, the biggest U.S. bank, is getting $14.5 billion from investors including the governments of Singapore and Kuwait, former Chairman Sanford Weill and Saudi Prince Alwaleed bin Talal, the New York-based company said today in a statement. Merrill, the largest brokerage, will receive $6.6 billion from a group led by Tokyo-based Mizuho Financial Group Inc., the Kuwait Investment Authority and the Korean Investment Corp.

Wall Street banks have now raised $59 billion, mostly from investors in the Middle East and Asia, to shore up balance sheets battered by more than $100 billion of writedowns from the declining values of mortgage-related assets. Citigroup was propped up in November by a $7.5 billion investment from the Abu Dhabi Investment Authority. New York-based Merrill was helped by a $5.6 billion cash infusion last month from Singapore’s Temasek Holdings Pte. and U.S. fund manager Davis Selected Advisors LP.

As was reported on January 11, the capital to bail out Countrywide is actually domestic, but Bank of America is by no mean immune to the shift in fortunes:

Bank of America Corp., the second- largest U.S. bank, plans to cut 650 jobs from its corporate and investment bank and sell the prime brokerage unit that caters to hedge funds.

The bank is slashing its so-called structured products business, which packaged and sold real estate loans to investors, and will reduce investment banking in Europe and the U.S., Chief Executive Officer Kenneth Lewis said in a meeting with reporters today in New York.

Meanwhile, Menzie Chinn of Econbrowser attempts to cheer us up by reminding us of the preferred government response to recessions:

One reason to favor temporary modifications to automatic stabilizers, as opposed to permanent changes in the tax code, is that the current full-employment budget balance is probably around negative one percentage point of GDP, and we are facing an expanding deficit in the future, given the press of demographics and medical costs (see Orszag’s speech [pdf]).

The interesting stories in Canada are, of course, Quebecor and BCE. Quebecor is close enough to crisis that I gave it its own post today; Bloomberg has an interesting filler story:

A telephone repairman for Canada’s BCE Inc. barreled through a red light in May when the brakes on his company truck failed. He managed to stop only by shifting into low gear and hauling on the handbrake.

As investors led by a teachers’ retirement fund prepare to purchase BCE for C$52 billion ($51.1 billion), analysts say the cost of avoiding such perils may require selling all or part of its C$3.5 billion-a-year wireless business. Canada’s largest phone company needs to repair an aging fleet of trucks and add a TV service while paying down about C$34 billion in debt.
…
The wireless unit, whose growth is second only to the smaller satellite-TV division, may be the only BCE business that could attract investors, said Lawrence Surtees, an analyst at IDC Canada in Toronto who wrote a book on BCE. “Everything else is either flat or declining,” he said. He didn’t have an estimate for what the unit might fetch.

PerpetualDiscounts finally had a down day today, due largely to three issues of a certain bank that will remain nameless. The last down-day for this index was December 21 (the penultimate day of tax loss selling – and the last full day, since Dec 24 was an early-close); since then, the PerpetualDiscount index increased 4.56% to January 14, with thirteen consecutive trading days of gains. 

There were eighteen other index-included $25.00-equivalent issues trading over 10,000 shares today.