PrefBlog

The Bank of England has announced the release of the 2009 Q3 issue of the Bank of England Quarterly Bulletin with the usual top-notch research. This quarter’s articles are:

• Foreword
• Markets and operations
• Global imbalances and the financial crisis
• Household saving
• Interpreting recent movements in sterling
• What can be said about the rise and fall in oil prices?
• Bank of England Systemic Risk Survey
• Monetary Policy Roundtable

The article on Global imbalances seeks to challenge Taylor’s assertion that there was no global saving glut by focussing on gross, not net numbers:

An important factor was the adoption of managed exchange rate policies by some EAEs [East Asian Economies],(2) whereby a particular level of their currency was targeted, usually against the US dollar. This policy was prompted, in part, by the aim of spurring economic development through exports, thereby addressing extensive rural underemployment.(3)(4) The desire to accumulate foreign exchange reserves as insurance against a repeat of the 1997–98 Asian currency crises was an additional motivation.(5) Another factor may have been the slow pace of financial development in many EAEs which meant that there was a dearth of domestic investment opportunities (see Caballero et al (2008)). This may have necessitated savings being channelled to the deeper and more liquid financial markets in western economies.
…
Bernanke (2005) has argued that the low and falling savings rates in deficit countries which accompanied the credit boom, were principally the outcome of an endogenous process by which the excess savings of the surplus countries — the ‘global
savings glut’ — were recycled.

Meanwhile, banks were exposing themselves to liquidity risk:

An associated innovation was that banks changed their funding models. In particular, banks sold the new types of securities to
end-investors via the so-called ‘shadow banking system’, encompassing structured investment vehicles (SIVs) and conduits, which provided a framework for lending and borrowing without accepting deposits. This was termed the ‘originate to distribute’ model: aiming to spread the risks associated with securitised assets off their balance sheets, banks sold them to SIVs, which then aimed to sell them on to end-investors.(1) At the same time, banks increasingly relied on wholesale funding markets, including in selling the securitised assets, see the October 2008 Financial Stability Report. The magenta bars in Chart 8 show that the share of funding by UK banks derived from securitisations increased between 2000 and 2008.(2)

The authors repeatedly emphasize this point:

The funding structure of financial institutions, with its reliance on wholesale markets and the use of securitised assets (Chart 8), was a related vulnerability. In particular, this funding model relied on the continued functioning of those markets. This funding often came from foreign investors and this, together with banks’ increased lending overseas and the growth of the shadow banking system, generated the further vulnerability of increased and complex cross-border linkages between both financial institutions and between countries more generally. Such complex international linkages potentially give rise to unappreciated, but potent, interconnections between firms in the global financial system.

The article on oil prices makes a claim of regulatory significance:

The price of oil rose steadily between the middle of 2003 and the end of 2007, rose further and more rapidly until mid-2008 and fell sharply until the end of that year. Commentators agree that a significant part of the increase in the oil price over that period was due to rapid demand growth from emerging markets, but there are substantial differences of view about the relative importance of other factors, and limited work thus far in explaining the large fall in oil prices in the second half of 2008. The purpose of this article is to analyse the main explanations for the rise and fall in oil prices in the five years until the end of 2008. It argues that shocks to oil demand and supply, coupled with the institutional factors of the oil market, are qualitatively consistent with the direction of price movements, although the magnitude of the rise and subsequent fall during 2008 is more difficult to justify. The available empirical evidence suggests that financial flows into oil markets have not been an important factor over the period as a whole. Nonetheless, one cannot rule out the possibility that some part of the sharp rise and fall in the oil price in 2008 might have had some of the characteristics of an asset price bubble.

I recently highlighted a paper by Alistair Murdoch of the University of Manitoba in which he showed that, in terms of the effect on the CAPM Beta of the common stock, preferred shares that were not convertible at a fixed rate into common were perceived by the market as being debt-like.

This paper was used as evidence to support the accounting reclassification of retractible preferred shares as debt for audited balance sheet purposes.

He then wrote a follow-up paper examining the effects of this change, titled Management Reaction to Mandatory Accounting Changes: The Canadian Preferred Shares Case:

The new Canadian accounting standards for financial instruments require that retractable preferred shares be classified as debt, thus negatively affecting the debt/equity ratio. Previous research, most of which has examined the impact of a change in American accounting standards affecting the determination of earnings, indicates that firms with such shares will act to mitigate the negative impact of the accounting change on their financial statements. Specifically, firms are likely to: a) reduce the amount of retractable preferred shares outstanding, and/or b) reduce the amount of other liabilities, and/or c) increase the amount of equity outstanding.

I test these predictions using data on firms required to file information on their preferred shares with Canadian securities commissions. Evidence based on a sample of 34 such firms indicates that they did indeed reduce the amounts of both retractable preferred shares and the amounts of other liabilities and issued additional common shares. Surprisingly, smaller firms did not make greater reductions (as a proportion of total assets) than larger firms.

He makes one statement about market efficiency that I consider worthy of comment:

The economic consequences of the replacement of retractable preferred shares by other sources of financing, primarily common shares, is not clear. If retractable preferred shares became a popular financial instrument during the 1970s and 1980s because they allowed firms to issue debt in the guise of equity, then their disappearance due to the standard change having stripped this disguise from them is desirable because it promotes informational efficiency.

This is of interest because it may be flipped upside down and used as an attack on the Efficient Market Hypothesis. The mandated change in classification is cosmetic only; no information is supplied to the marketplace by an auditor’s opinion as to whether a particular instrument is best placed in the shareholders’ equity section of the balance sheet or not. The prospectus contains all the necessary information for investors to judge the nature of the instrument for themselves and is not changed by this opinion.

Thus, any change in management or market behaviour due to such a change is evidence that the market’s efficiency has changed; and if the market’s efficiency can change, then the EMH does not hold.

In this particular case, I take the view that the change increased the efficiency of the market, by allowing bozos (who equate the term “research” with “looking stuff up in Compustat”) to more closely match the judgement of those who have actually examined the data and thus reduces the rewards for market professionals to think about what they are doing.

This supports the hypothesis that informtion has a value – it ain’t free!

Of interest in the paper was Table 1 “Number of publicly listed Canadian companies with outstanding retractable preferred shares”, which documents a nearly monotonic decline from 1988 (114 companies) to 1997 (32 companies). With the benefit of over a decade’s worth of additional data, we can now see that retractibles from Operating Companies (the HIMIPref™ subindex “OpRet”) has dwindled to virtual insignificance.

This is an old paper (1997) but interesting none-the-less.

Alistair Murdoch of the Deparment of Accounting and Finance, University of Manitoba wrote a paper Are Preferred Shares Debt or Equity?: Some Canadian Evidence with the abstract:

I test the appropriateness of new accounting standards that would treat some types of preferred shares as debt rather than equity. I develop a new model to examine whether capital markets view the (systematic) risk of preferred shares to be more like the risk of debt or more like the risk of common equity. The proposed model is compared to a traditional model tested on 1986 to 1994 data of thirty-nine companies that trade on the Toronto Stock Exchange and issued preferred shares during that period. Debt, retractable preferred shares and p lain vanilla preferred shares appear to be substantially less risky than common shares. Other types of preferred shares are more risky than debt; some appear to be more risky than common shares. These results support the view that some types of preferred shares should be classified as liabilities.

He reasons that:

A firm that increases its debt/(common) equity ratio increases the risk of the (common) equity and may increase the risk of the debt. If preferred shares are viewed as debt, then issuing preferred shares should have the same effect as increasing the debt/(common) equity ratio. If they are viewed as equity, then their issue should have the same effect as decreasing the debt/(common) equity ratio. Finally, if they are some intermediate form of financing, they may have no effect on the risk of the (common) equity.
…
… I confirm that debt is less risky than common equity. I find that retractable preferred shares and plain vanilla shares are also less risky than common equity and that in most of my tests their level of risk is not statistically significantly different from that of debt. Other kinds of preferred shares are more risky than debt. Convertible preferred shares are as risky as common shares, while preferred shares that are convertible at market or that are both retractible and convertible appear more risky than common shares

Risk is defined as Beta in the Capital Asset Pricing Model. The “Asset Beta” of each company is decomposed into the equity beta and terms representing the contributions of debt and the various flavours of preferred share, where:

A firm’s asset beta is a measure of the relation between the firm’s return on assets and the market return. Beta is usually estimated by regressing the firm’s return on the market return over some period during which beta is assumed to be constant.

After performing the regressions, the author concludes:

This paper has attempted to determine empirically whether during the past decade the Canadian market has viewed preferred shares as being more like debt or more like equity. It reports that retractable preferred shares have been viewed much like debt which supports the recent change in the accounting classification of these securities

An interesting paper in that it attempts to classify preferred shares according to the effect of their issuance on the Beta of the common, rather than considering the market price of the preferred shares themselves.