PrefBlog

Treasury Bond trading may soon enter the 18th century – the Treasury Market Practices Group is recommending penalties for ignoring a contract:

The underlying problem is the Treasury market contracting convention that a seller can deliver securities after the originally scheduled settlement date at an unchanged invoice price, i.e., without incurring any penalty. Introduction of a dynamic fails penalty with a finite cap rate would remedy this problem. In particular, a dynamic fails penalty would provide an incentive for sellers to resolve fails promptly, and could lead to repo contracting conventions that would give beneficial owners of Treasury securities an opportunity to earn as much as the cap rate in securities loan fee income regardless of the level of nominal interest rates.

The TMPG recommends that market participants agree that the invoice price–that is, the cash amount that a buyer has agreed to pay against the delivery of securities–on any cash or financing transaction that fails to settle on the originally scheduled date be reduced at a
fails penalty rate equal to the greater of (a) 3 percent per annum minus the fed funds target rate at 5 p.m. EST on the business day prior to the originally scheduled settlement date, and (b) zero.
…
2. Margining of settlement fails: When sellers fail to deliver securities in settlement of agreed upon trades, counterparty risk exposures grow and can become acute as these fails age. To mitigate counterparty risk and to better incentivize delivery by increasing the cost of aged fails, the TMPG recommends that market participants take prompt steps to study the most efficient way to commence margining of fails in all cash and financing transactions in Treasury securities. The TMPG plans to convene a working group on this subject to make a recommendation by January 5, 2009.

Point two may be taken as criticism of the SEC for allowing counterparty risk to go unmargined. It is definitely criticism of bonehead risk control in the industry. Assiduous Readers will recall that on November 18 Scotia announced a big loss on trades – equities, admittedly – that were affected by that there counter-whatsit thingamajig.

RBC has announced that 4Q08 will include some market-related write-downs … but not without some accounting gymnastics:

we reclassified most of our U.S. auction rate securities and U.S. agency and non-agency mortgage-backed securities from held-for-trading to available-for-sale. This reclassification is effective August 1, 2008. Accordingly, any unrealized changes in the fair value of these securities will not be reflected in our fourth quarter earnings

.

Realized pre-tax losses include

• $645-million loss on trading inventory
• $355-million loss on permanent impairment of available-for-sale securities
• $330-million gain on RBC’s liabilities designated as held-for-trading

RBC’s 2007 Annual Report notes that:

The decrease of $18 billion in financial assets classified as
held-for-trading and the increase of $8 billion in financial liabilities classified as held-for-trading in 2007 are primarily due to our equity and bond securities held related to our proprietary equity arbitrage and fixed income trading businesses, where we offset the risks from our securities holdings by short selling other securities that are of similar risks to those in our portfolios. The increase of $29 billion in derivative assets and of $30 billion in derivative liabilities in 2007,
primarily in foreign exchange and interest rate contracts, are largely due to increased volatility, strong shifts in exchange rates and interest rates, and higher client and trading activity, partially offset by the weakening of the U.S. dollar relative to the Canadian dollar. These
activities are consistent with our strategy for these businesses and the increases in 2007 are within the approved risk limits.

… and …

For the year ended October 31, 2007, we recognized a gain of $18 million in Trading revenue as a result of the net increase in fair values in various trading portfolios previously measured at amortized cost. This gain includes a $59 million gain on our deposit liabilities designated as held-for-trading resulting from the widening of our own
credit spread during the year.

… and …

liabilities designated as held-for-trading include (i) deposits and structured notes with embedded derivatives that are not closely related to the host contracts; (ii) assets sold under repurchase agreements that form part of our trading portfolio which is
managed and evaluated on a fair value basis; and (iii) certain deposits to offset the impact of related hedging derivatives measured at fair value. Fair value designation for these financial assets and financial liabilities significantly reduces the measurement inconsistencies.

Econbrowser‘s James Hamilton discusses the deflation problem in his latest post. Assiduous Readers will recall that I am completely unimpressed by the so-called evidence of deflation so far, but Dr. Hamilton takes the view that it doesn’t matter whether low yields on Treasuries are evidence of deflation or of flight to quality:

But a second and equally troubling suggestion of expected deflation is the extremely low yields on short-term Treasury bills. Again there may be those who interpret this not as a harbinger of deflation but instead as a reflection of the astonishing (and equally frightening) flight to quality that we have been witnessing.

Even if you don’t interpret the October CPI, TIPS yields, and nominal T-bill yields as warning flags of deflation, they nonetheless raise what is to me the core question: If the Fed wanted to use monetary policy to stimulate the economy at the moment, as I believe it should, what would it do?

TIPS yields are discussed in a John Dizard column in the Financial Times:

Yet, if you believe the yields on US Treasury inflation protected bonds, or Tips, we shall have a 2.2 per cent fall in prices in 2009, a 2.5 per cent decline in 2010 and only flat prices in 2011. If that turns out to be true, the real interest rate burden on even the highest-rated borrowers will be extremely hard to bear.

As a practical matter, long before we had significant “negative prints” of consumer prices, the Federal Reserve would just flat out buy Treasury bonds and monetise away with “quantitative easing”. Gold dealers would replace hedge fund managers at the art auctions, model agency parties and Congressional hearings.

What’s really going on is another effect of the disappearance of dealer and arbitrageur capital. The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds.

The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry and then were sold off by merciless prime brokers.

Whatever the nature of the beast, Dr. Hamilton concurs with Mr. Dizard regarding the policy prescription:

So here’s my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That’s something that can be accomplished without rate cuts or lending facilities, and here’s how.
…
Step 3 is to start creating money and use it to buy up assets until the [3% inflation] goal set out in Step 1 is achieved. What sort of assets?
…
What specifically would such assets be? I’d start with those clearly undervalued TIPS. Next I’d buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we’re still seeing no improvement, the Fed can start to buy longer-term Treasuries.

TD Bank is diluting its common:

The Toronto-Dominion Bank (TD Bank Financial
Group or TDBFG) today announced it expects to further enhance its capital position by issuing common equity. TDBFG has entered into an agreement with a syndicate of underwriters led by TD Securities Inc. for an issue of 30.4 million common shares, at a price of $39.50 per common share, to raise gross proceeds of $1.2 billion.

The issue will qualify as Tier 1 capital for TDBFG and the expected closing date is December 5, 2008.

As announced last week, TDBFG’s Tier 1 capital ratio was 8.3% as of November 1, 2008. On a pro forma basis, adjusting for this $1.2 billion of common equity and the $220 million of Series AC preferred shares issued on November 5, 2008, TDBFG’s November 1st Tier 1 capital ratio would be approximately 9%.

Thanks, guys, for making the world a safer place for preferred share investors!

The preferred share world could use a little more safety, that’s for sure (provided one equates safety with price stability). Because it was yet another thoroughly appalling day. I don’t know where all the worry is coming from – how can people worry about preferred dividend cuts when the common dividend hasn’t even be touched yet? And not just not yet touched, but unlikely to be touched? I’m with Genuity Capital Markets analyst Mario Mendonca and an unnamed analyst quoted in the Globe today:

Mr. Mendonca said he does not expect any bank to cut dividends, and believes they would sooner turn to raising capital like CIBC did earlier this year when it tapped the market for a $2.9-billion equity injection.

“The odds are low, but not zero,” another analyst said of dividend cuts.

It could, just possibly, happen, to a limited extent (it’s more likely they do dilutive issues, like TD & CIBC this year, and keep the dividend steady for a long time). And I’m talking about the common dividends, people!

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

Across the Curve notes some dealer research that claims:

The NY Fed data released yesterday afternoon shows another huge reduction in Agency debt and MBS held for overseas investors. Of the $1.7tn in GSE debt and MBS held by overseas accounts, $885bn is held in these accounts. The decline in holdings for the week ending Nov 19th was $11.7bn, which is the 3rd largest drop on record, second only to Oct 15th (-18.6bn) and Oct 8th (-24.4bn).

I can’t find the NY Fed Release, but I do have a piece by Brad Setser:

At the end of July, China stopped buying Agencies and corporate bonds and started to pile into Treasuries. Over the last three months of data (i.e. the third quarter), the US data indicates that China has bought $81.1 billion in Treasuries ($45 billion short-term) and added $17.4 billion to its bank accounts — that is a flow of nearly $100 billion into the safest US assets China can find. Conversely, China sold $16 billion of Agencies, $1.8 billion of corporate bonds and a bit less than a billion of equity.

In the second quarter, by contrast, China bought only $13 billion of Treasuries and added only $2 billion to its US bank account while buying $17 billion of Agencies and $20 billion of corporate bonds.

That is a huge swing — and frankly a destabilizing swing. The notion that sovereign investors are always and at all times a stabilizing force in the market should be put to rest. China has clearly kept the RMB dollar stable — and been a big source of demand for Treasuries. But it has been a seller of other assets in a time of stress.

I noted in an update to the most recent post on Effective Fed Funds that the FDIC has finalized the new rule on debt guarantees – Accrued Interest predicts a flood of new US Bank paper – with Goldman Sachs first to go.

There’s a short piece in the WSJ Deal Blog regarding preferred share issuance by SEC regulated companies –

BDCs believe that there may be a substantial opportunity to issue preferred stock either in privately negotiated transactions or otherwise because preferred stock can be customized to some extent to the needs of potential investors. The 1940 act limits the ability of BDCs to issue senior securities, including preferred stock, by imposing a requirement that they maintain a ratio of assets to senior securities of 200%, or 2 to 1. Therefore, if a BDC, for example, has $10 in assets, it cannot have a total of borrowing or outstanding preferred stock of more than $5. If a BDC is already close to its asset coverage limit, it would be limited in its ability to issue preferred stock.

We finally get a decent inflation number and Bang! there are deflation fears. This is a completely crazy market.

Falling car prices and cheaper women’s clothing weighed on the consumer price index. Gasoline was still higher than a year ago, but was rising at a slower pace than in previous months, also bringing the annual inflation rate down, the agency said.

Core inflation, which excludes the most volatile items such as energy and some food, was 1.7 per cent higher on the year – the same as in September, and close to analysts’ expectations. On a month-over-month seasonally adjusted basis, core inflation showed no growth.

I think Econbrowser‘s James Hamilton has the anti-deflation recipe about right:

If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

The New York Times reports (to no-one’s great surprise) that Citibank is talking earnestly to Treasury & the Fed. A Sunday Night Special is widely anticipated.

Devastation. After another appalling day, PerpetualDiscounts now yield 8.22% pre-tax dividend, equivalent to 11.51% pre-tax interest at the standard equivalency factor of 1.4x. Long Corporates still yield 7.50% and are still up on the month … the pre-tax interest-equivalent spread is now 401bp.

There are complaints from retail that the preferred share market is way, way too exciting.

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