PrefBlog

Not much news, in light of the holiday in the US and preparations for tomorrow’s Obama-rama.

Willem Buiter writes a piece with a rather startling message: Time to Take the Banks Into Full Public Ownership.

He points out the Bagehot prescription of readily available expensive liquidity can have an unfortunate side-effect:

But if the state’s financial assistance is priced punitively or has other painful conditionality attached to it, existing shareholders and management will do everything to avoid making use of these government facilities. If a bank has no option but to take the government’s money, it will try to repay it as soon as possible – to get the government out of its hair. Such a bank will therefore be reluctant to take any risk, including the risk of lending to the non-financial private sector. Such a bank will hoard liquidity (sometimes in the form of deposits/reserves with the central bank) to regain its independence from the government. Still independent banks will hoard liquidity to stay out of the clutches of the government.

I believe that this mechanism is at work in a powerful way both in the UK, the US and in continental Europe. Hans Werner Sinn in a recent Financial Times OpED piece pointed out that the German rescue package for banks was fatally flawed for precisely this reason: the acceptance by banks of an injection of public sector capital brings with it a cap on managerial salaries. Rather than accepting a cap on their salaries, managers would prefer to totter along with an under-capitalised bank and restrict the scope and scale of their lending operations.

However, I am unconvinced that the alternatives he suggests are really any better:

By throwing cheap money with little conditionality at the banks, the Fed and the US Treasury may get bank lending going again. By subsidizing new capital injections, they reward bad porfolio choices by the existing shareholders. By letting the executive leadership and the board stay on, they further increase moral hazard, by rewarding failed managers and boards that have failed in their fiduciary duties. All this strengthens the incentives for future excessive risk taking.

There is a better alternative. The alternative is to inject additional capital into the banks by taking all the banks into full public ownership. With the state as sole owner, the existing top executives and the existing board members can be fired without any golden handshakes. That takes care of one important form of moral hazard. Although publicly owned, the banks would be mandated to operate on ordinary commercial principles.

The implicit presumption is that government will be able to do it better. I’m not so convinced; political control over the lending process will – inevitably – mean a relaxation of lending standards to handicapped black lesbians and other disadvantaged groups, on the basis of their disadvantage and political advantage, not ability to pay. We are seeing movement towards of this conditionality in the States already, a by-product of TARP’s cheap money:

House Financial Services Committee chairman Barney Frank, D-Mass., on Friday released proposed legislation to reform the TARP and increase program accountability. Under Frank’s proposed makeover of the TARP, the second half of the $700 billion funds will be “conditioned on the use of a minimum of $50 billion for foreclosure mitigation.” His language would require Paulson to develop a comprehensive plan to prevent and mitigate residential mortgage foreclosures by March 15, 2009. The required elements of the plan include a guarantee program for qualifying loan modifications under a systematic plan and bringing down the costs of Hope for Homeowner loans “either through coverage of fees, purchasing H4H mortgages to ensure affordable rates, or both.” The plan would also need to establish a program for loans to pay down second lien mortgages that are impeding a loan modification, grant servicer incentives and assistance to stimulate modifications, and include the purchase of whole loans for the purpose of modifying or refinancing them.

I suggest that a better alternative to full nationalization that addresses Mr. Buiter’s concerns is to give the funding government a fair bit of call protection on its capital injection, while allowing the subject banks to operate on a business-like basis. The current terms do not allow this:

Our current understanding is that that the preference shares to be acquired by the government will rank pari passu with existing Tier 1 instruments in payment and in liquidation. The new preference shares will carry a 12% coupon and will be callable after five years. Banks selling preference shares to the government may not pay dividends on common equity while any of those preference shares remain outstanding. This clearly gives the banks an incentive to repay the government preference shares as soon as possible.

The five year call-protection makes sense; the restriction on common dividends does not. And, what’s more, these should be public issues, with a prospectus, stock-exchange listing and government guarantee of successful issuance.

Floaters did poorly today, perhaps in a last minute panic about tomorrow’s BoC rate announcement amidst speculation that there will be a 50bp cut to 1.00%. I will be interested not so much as to what happens to the Bank Rate as what happens to prime – I can’t see a cut of more than 25bp in prime whatever happens, but … I’ve been wrong before!

The day was enlivened somewhat by reports of excited groupies at the Financial Forum and by the closing quote of BNS.PR.S at 26.00-99.99. Whatever happened to the good old days of bid-without? There is still no indication of what SunLife wants to do with its holding; but surely at some point Sections 711 & 712 of the TSX Company Manual will become applicable:

Sec. 711.

TSX will normally consider the delisting of securities of a listed issuer if, in the opinion of TSX, it appears that the public distribution, price, or trading activity of the securities has been so reduced as to make further dealings in the securities on TSX unwarranted.

Sec. 712.

Specifically, participating securities may be delisted if:

(a) the market value of the listed issuer’s issued securities that are listed on TSX is less than $3,000,000 over any period of 30 consecutive trading days; or
(b) the market value of the listed issuer’s freely-tradable, publicly held securities is less than $2,000,000 over any period of 30 consecutive trading days; or
(c) the number of freely-tradable, publicly held securities is less than 500,000; or
(d) the number of public security holders, each holding a board lot or more, is less than 150.
Non-participating securities will be subject to (b) above as well as Section 711

Still and all, you know, I’m sorely tempted to buy 100 shares at 99.99, just so I can insist on delivery!

PerpetualDiscounts were off a bit today, closing to yield 6.85% dividends, equivalent to 9.59% interest at the standard 1.4x conversion factor. Long corporates are still at about 7.5%, so the pre-tax interest-equivalent spread remains at around the 210bp level achieved on January 9.

Another piece of history gone! Across the Curve notes that Treasury has called the 13.25 of May 2014:

I recall that bond as the last bond to trade at 14 percent. It was issued as a 30 year bond in May 1984. In those days the treasury issued callable long bonds but the call protection was 25 years. Anyway, on the settlement day May 15 1984 the owners threw up all over their shoes and the futures market was down limit. The new bond traded to 14 percent in the cash market. The rest is history as its successor sees nothing but buyers today in the 2.80s.

The New York Fed has endorsed the recent TMPG initiative to charge for fails:

The Federal Reserve Bank of New York endorses the Fails Charge Trading Practice published today by the Treasury Market Practices Group (TMPG) and strongly encourages its adoption by all market participants. The Fails Charge Trading Practice provides a feasible method for market participants to implement the TMPG’s previously announced recommendations for addressing widespread settlement fails in the U.S. Treasury market. The New York Fed is convinced that universal adoption of the trading practice is a crucial step in alleviating the chronic fails problem that currently threatens to constrain Treasury market liquidity and function. The New York Fed will adopt this new trading practice in its own market operations.

Accrued Interest provides some interesting colour on Agencies & MBS, observing:

MBS suffer from a severe negative convexity problem. MBS investors have essentially sold short an interest rate option to the underlying mortgage borrowers. Those borrowers are now almost universally in the money. Many borrowers will have difficulty actually refinancing (more on that below) but regardless, the price for MBS securities will have difficulty rising above $104 or so with an embedded in-the-money option with a $100 strike.

To see what I mean, notice the price spread across the coupon stack (using Fannie Mae 30-year MBS for February settlement):

4.5% Coupon: $101.938
5%: $102.750
5.5%: $103.203
6%: $103.656
6.5%: $104.500
This is the current dollar price for a mortgage security with the indicated coupon.

Tomorrow is the last day of trading of TXPR prior to its rebalancing, which is effective at the opening on Monday 19th. Those with an interest in some of the lower volume issues affected (e.g., ACO.PR.A, NSI.PR.C, NSI.PR.D) may wish to put in stink-bids and stink-offers,as it is possible (possible!) that CPD and other indexers may be willing (or forced!) to trade at a spread to market.

Another day of pretty good volume. PerpetualDiscounts were off again … but having survived 4Q08, I’m decidedly unimpressed by any overall move of less than a point.