PrefBlog

There is a kerfuffle in the UK regarding the FSA’s attempt to increase the bank’s liquidity requirements, in accordance with the Turner Review (previously discussed on PrefBlog):

Similarly, if banks have to hold more assets in liquid form, and more of those in super-liquid form, like cash or government bonds, their income will decline. The FSA’s proposals on the subject accept these increased costs, though they are only sketchily estimated. Against these vague costs it sets a massive “reduction in the costs of systemic instability” of “3 billion to 5 billion bounds on an annualised basis.”

The problem for the banks is that, in contrast to the past, they will bear the costs of increased stability, while the taxpayer will enjoy the benefits.

The BBA’s tactic of playing the UK competitiveness card to stall the unilateral introduction of liquidity requirements is a clever one: international agreements can take years to complete.

It is also politically astute to play up the tension for banks between increasing their liquidity reserves at a time when the government is pressing them to increase lending to homeowners and businesses.
While Knight did not exactly put it like this, the FSA is asking banks to lend to government at the expense of the private sector. But the government is very strapped for cash right now. With regulatory and political interests fully aligned in favour of reform, this looks like a battle the banks will lose.

Those interested in hedging hyperinflation may wish to follow the strategy of Excelsior Fund:

The Excelsior Fund targets returns that will be five times the average annual rate of inflation of the Group of Five economies — France, Germany, Japan, the U.K. and the U.S. — should the rate exceed 5 percent, Jerry Haworth, co-founder of the firm, said yesterday. Raising $100 million for the fund would be a “good” amount, he said.
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36 South’s Excelsior Fund will buy long-dated options it considers cheap and that “stand a good chance of outperforming in an inflationary environment,” Haworth said. Options are contracts to buy or sell a security by a certain date at a specific price.

The fund will wager on an increase in commodity and equity prices, bond yields and increased currency volatility.

“It’s a very high-risk, high-return fund,” said Haworth, who has been trading derivatives for more than 20 years as the former head of equity derivatives at Johannesburg-based Investec Ltd., and co-founder of Peregrine Holdings Ltd., a South African money manager and stockbroker.

The General Secretary of United Soviet Socialist America gave an indication of his plans today:

“Wall Street seems to maybe have a shorter memory about how close we were to the abyss than I would have expected,” Obama said in an interview with Bloomberg Television today at the White House. “All we’re doing is cleaning up after the mess that was made.”
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Crafted by Treasury Secretary Timothy Geithner and National Economic Council Director Lawrence Summers, Obama’s plan would put the Federal Reserve in charge of regulating companies whose collapse could damage the entire financial system. It would also create a new agency for overseeing consumer financial products, such as mortgages and credit cards.

The proposal encompasses areas ranging from derivatives to executive pay to the mortgage-backed securities that helped fuel the housing boom and then touch off the credit crisis.
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Obama called the derivatives market “an entire shadow system of enormous risk” and pledged to make it more transparent.

“Derivatives are a huge potential risk to the system,” he said. “We are going to make sure that they have to register, that they are regulated, that you have clearinghouses.”

However, I like this bit, somewhat:

Financial firms deemed too-big-to-fail will be required to maintain extra capital cushions, which are designed to curb the excessive risk taking that led to the collapse of last year of Bear Stearns Cos. and Lehman Brothers Holdings Inc. and the government seizure of insurer American International Group Inc.

I would like it a lot more if it was rules based … with a progressive risk-weight surcharge applied to risk-weighted assets in excess of a manageable level.

I find it most interesting that political culpability in the crisis has been ignored. If prime mortgages had yielded a little more, maybe the banks wouldn’t have plunged so heavily into sub-prime. But prime mortgages were wink-wink NOT guaranteed by Treasury nudge-nudge and hence traded at razor-thin spreads to Treasuries.

PrefBlog’s One-Born-Every-Minute Department passes on this SEC news release:

The Securities and Exchange Commission today obtained a court order halting an $11 million Ponzi scheme in which a Chicago-based promoter who is a convicted felon promised investors unusually high returns from purported investments in payday advance stores.

The SEC alleges that David J. Hernandez, who was convicted in 1998 for wire fraud arising from his previous employment at a bank, sold “guaranteed investment contracts” through his company that, unbeknownst to investors, was actually out of business. Hernandez promised returns of 10 percent to 16 percent per month and made false and misleading statements about his background, the use of investor proceeds, and the safety of the investment.

Actually, I only looked at the SEC site hoping for a definitive statement regarding a rumoured Madoff settlement, but nothing shows up yet.

Good performance from preferreds of all classes (well … except the single member of the FixedFloater subindex) with continued elevated volume.

Was it Joseph Mason who said it? Added 2009-7-15: Yes. It was. The fundamental problem with credit ratings and regulations thereof is that while the assumption is that you have a conservative investor looking for a conservative opinion, the regulatory use of credit ratings means that you have regulated investors looking for a license to invest. So, into the breach steps Realpoint:

U.S. credit rating company Realpoint on Thursday said insurers may soon be allowed to use its commercial mortgage bond ratings and preserve capital if rival Standard & Poor’s moves to slash its designations
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The NAIC move would give insurers more flexibility in choosing ratings that determine their capital levels and avoid forced selling of the assets if S&P adopts more conservative models. Insurers can use the middle rating, if there are three, according to [Realpoint CEO] Dobilas.

S&P shocked the the CMBS market last week by advising that its new models, if adopted, would likely prompt ratings cuts on 95 percent of top bonds issued during the peak of the real estate cycle in 2007 and 85 percent of CMBS from 2006. S&P is mulling responses from a formal request for comment.

Some 50 insurers have contacted Horsham, Pennsylvania-based Realpoint over the last few days, saying, “you guys need to get approved” by the NAIC, Dobilas said.

This is of particular interest in light of today’s release of the BIS paper Stocktaking on the use of credit ratings:

In the United States, insurance regulators require bonds and preferred stocks to be reported in statutory financial statements in one of six National Association of Insurance Commissioners (NAIC) designations categories that denote credit quality. If an accepted rating organisation (ARO) has rated the security, the security is not required to be filed with the NAIC’s Securities Valuation Office (SVO). Rather, the ARO rating is used to map the security to one of the six NAIC designation categories.18 The NAIC designations are primarily designed to assist regulators (as opposed to investors) to monitor the financial condition of their insurers.

Finally, in light of the impact that the credit market crisis had on the credit ratings of the financial guarantors and the bonds they insure, the NAIC announced that the SVO will be issuing “substitute” ratings for some municipal bonds. In doing so, the NAIC will be assessing the creditworthiness of the municipality that issued the debt. These credit ratings will be used to determine the risk based capital charge for the security. The insurance regulators indicated that the proposal will “decouple” the NAIC rating from the rating agency process.

So NAIC is not just a regulator, it’s also a credit rating agency! Ain’t no conflict of interest there, eh? It sure is a good thing that regulators are infallible!

In Canada, by the way:

In Canada, a significant portion of an insurer’s capital requirement (especially for a life insurer) arises from its exposure to credit risk. This component of the overall insurer capital requirement is determined using asset default factors. For rated short term securities, bonds, loans and private placements, these factors are based on the rating agency grade. In its life insurer capital guideline, the Office of the Superintendent of Financial Institutions (OSFI) states that:

“A company must consistently follow the latest ratings from a recognized, widely followed credit rating agency. Only where that rating agency does not rate a particular instrument, the rating of another recognized, widely followed credit rating agency may be used. However, if the Office believes that the results are inappropriate, a higher capital charge would be required.” [page 3-1-3]

Further, in Canada, asset default factors for preferred shares, where rated, are based on the rating agency grade. For financial leases where rated, and the lease is also secured by the general credit of the lessee, the asset default factor is based on the rating agency grade.

IIROC has (Notice 09-0172) done its bit to ensure that investors are restricted to investments offered by large banks that employ many former regulators:

Leveraged exchange traded funds (ETFs) are probably not suitable for retail investors, the Investment Industry Regulatory Organization of Canada is warning its dealer members.
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Leveraged ETFs are reset daily by the provider. This means if an investor does not rebalance their leveraged ETFs on a daily basis, there will be tracking error, which will be exacerbated the longer the investment is held.

Investors need to have both the right call on a market direction, and more importantly a stable path of direction for these products to work in buy and hold strategies. Volatility can seriously impair the performance of these ETFs if held for the long term.

In its notice IIROC said a Canadian ETFs that seeks to deliver twice the daily return of the COMEX Gold Bullion Index fell 5% between January 22, 2008 and May 29, 2009. However, its inverse fund (twice the inverse daily return of the index) fell 38% in the same time period even though the underlying COMEX Gold Bullion Index increased by 6% during this period IIROC.

“Due to the effects of compounding, their performance over longer periods of time can differ significantly from their stated daily objective. Therefore, leveraged and inverse ETFs that are reset daily typically are unsuitable for retail investors who plan to hold them for longer than one trading session, particularly in volatile markets,” the notice says.

I mentioned some trader-games in the CDS market on June 12 – James Hamilton of Econbrowser comments:

For my money, the first rule we need would be a law, not a rule, that notional not exceed actual.

Barring that, here’s another rule I trust: a fool and his money are soon parted.

I’m OK with the second rule, but strongly disagree with the first. Some idiot made a dumb trade and lost money. Why does this demand a regulatory response?

C-EBS has announced consultation on Large Exposure guidelines for banks. Sadly, these proposed measures appear to be all about reporting, giving more discretion to supervisory authorities. There are no current plans to make regulatory response fair and reasonable by simply applying a surcharge to the Risk-Weighted-Assets calculation.

There are mutterings that CAD strength may hasten (more) quantitative easing:

Bank of Canada Governor Mark Carney, who says a strengthening currency could choke the economic recovery, may be pressed into creating dollars and buying assets such as government bonds to offset the dollar’s rise.

A 16 percent gain for the Canadian dollar since March 9 is threatening to undermine the country’s already battered exporters. This raises the likelihood that Carney will follow the Federal Reserve, Bank of England and Swiss National Bank in pursuing so-called quantitative easing, said Nicholas Rowe, an economist at Carleton University in Ottawa.

Volume came down a little from the recent frenzy, but remains strong. A nothing day for PerpetualDiscounts, Floating Rate issues were down a bit and FixedResets continued to shine.

More trader games in the CDS market – and now the rules might change:

At issue in the Amherst trades is whether sellers of protection on mortgage bonds can purchase loans underlying the debt at above-market prices to prevent a default that would trigger payments to buyers of the contracts. Credit-default swaps pay the buyer if the securities aren’t repaid as expected.

The call of the securities at their face value of $29 million, the amount remaining in the 2005 subprime-mortgage bond issue, caused the banks to lose money. Bankers on the American Securitization Forum call probably couldn’t ban the strategy for existing trades, the people said.

Proposals included creating agreements for new swaps that would force sellers to disclose whether they have the right to call the securities, and “best practices” guidelines to say such trades shouldn’t be executed, they said.

$29-million? Banks are prepared to admit that their traders lost a lot of money in a $29-million market?

They haven’t learned a damn thing, have they? Giving a block of capital to some kid with an MBA but not enough brains to realize you don’t play in a rigged market – or one that’s small enough to rig. $29-million? That’s not even a big ticket.

What does buying CDS protection mean, anyway? It’s nothing more nor less than shorting a bond. What kind of moron shorts into a $29-million market? What kind of useless twerp is the moron’s supervisor?

Let’s not have any more rules. Let’s just see a few bozos get fired. Or, at least, eating their losses like big boys and learning from the experience. As I have stressed many times on this blog, debt decoupling can result in strange things happening … particularly in a rinky dink $29-million market.

The Federal Reserve Bank of Boston has released a working paper by Todd Prono that looks interesting, but which I don’t have time to read now. So, without comment, here’s the abstract:

A pricing restriction is developed to test the validity of the CAPM conditional on a prior belief about the correlation between the true market return and the proxy return used in the test. Distinguishing this pricing restriction from competing tests also based upon the relative efficiency of the proxy return is a consideration for the proxy’s mismeasurement of the market return. Failure to account for this mismeasurement biases tests of the CAPM towards rejection by overstating the inefficiency of the proxy. A time-varying version of this pricing restriction links mismeasurement of the market return to time-variation in beta

Pretty much a nothing day in the major sectors of the market, but volume continued heavy and Floating Rate issues continued to shine.