PrefBlog

An article in VoxEU draws attention to Chapter 3 of the IMF April 2008 World Economic Outlook, specifically Chapter 3, The Changing Housing Cycle and the Implications for Monetary Policy:

The main conclusion of this analysis is that changes in housing finance systems have affected the role played by the housing sector in the business cycle in two different ways. First, the increased use of homes as collateral has amplified the impact of housing sector activity on the rest of the economy by strengthening the positive effect of rising house prices on consumption via increased household borrowing—the “financial accelerator” effect. Second, monetary policy is now transmitted more through the price of homes than through residential investment. In particular, the evidence suggests that more flexible and competitive mortgage markets have amplified the impact of monetary policy on house prices and thus, ultimately, on consumer spending and output. Furthermore, easy monetary policy seems to have contributed to the recent run-up in house prices and residential investment in the United States, although its effect was probably magnified by the loosening of lending standards and by excessive risk-taking by lenders.

In other words, a well developed mortgage market has had the effect of increasing the liquidity of real-estate, and this effect must be explicitly considered when setting monetary policy.

I have to quibble with their table 3.1, which states that the average term of a Canadian mortgage is 25 years; it may be the average amortization, but the average term will be a lot closer to 5 years … perhaps much less, depending on the call provisions embedded in floating rate mortgages. Those who have endured my grumbling over the financing of long-term assets with short-term debt will note that financing houses with 5-year mortgages is a good example!

Box 3.1 is interesting, indicating (from IMF analysis) that while the US housing market appeared to get about 15% ahead of its fundamentals in the period 1997-2007, the crown is held by Ireland, with a 30+% pricing gap! Canada was negative – so those of us who are “property rich” can breathe a sigh of relief directly proportional to our trust in IMF analysis.

And, skipping along to the practical conclusions:

This chapter also examines the implications for monetary policy of changes in mortgage markets. First, it suggests that monetary policymakers may need to respond more aggressively to housing demand shocks in economies with more developed mortgage markets—that is, with higher LTV ratios and thus, presumably, higher stocks of mortgage debt. They may also need to respond more aggressively to financial shocks that affect the amount of credit available for any given level of house prices. Hence, the model would “predict” a more aggressive reduction of interest rates in the United States compared with the euro area in the face of recent turmoil in the credit markets—and this is in line with what has occurred so far.

Today’s fascinating fact is brought to you by Professors Kish & Robak in a paper published in September 2000:

Attaching a call feature to new debt for any reason was the norm for most of the twentieth century. For example, the majority of new bonds issued prior to 1986 contain a call provision. But over the past ten years, we observe that the number of call options on new debt is now a minority component. The intent of this study is to reproduce the work of Kish and Livingston (1992) for the period 1987-1996. The major structural change that occurred in the debt market warrants the reproduction of this study for the recent decade. For the 1977-1986 period, the ratio of callable to non-callable bonds is approximately 4:1, whereas the ratio during the 1987-1996 period approximates 0.5:1.

Thirty-year treasuries used to be callable after 25-years. One possibility that the authors did not examine was the possibility that embedded options may have simply been unbundled and are sold to the corporation as part of the underwriting package – which would certainly achieve the same sort of interest-rate protection to the company (albeit without the capital-structure flexibility) while giving the dealers some more chance to turn over their inventory. I honestly don’t know the answer to that question.

Main Man Flaherty was self-promoting again today:

Flaherty said the Canadian banks will establish and adopt leading practices for disclosure within 100 days, and expects the Bank of Canada to play a leadership role in some areas.

The minister said he plans to meet with the banks again “before the summer” to review the progress.

Sadly, there was no word regarding whether the seniority of Bankers’ Acceptances would ever be properly disclosed.

In what may well be related news, former World Bank President James Wolfensohn said:

said he’s “pessimistic” on the outlook for financial markets and predicted losses from the global credit turmoil may climb to $1 trillion.
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“It does seem to be a major adjustment on any level,” Wolfensohn said, after addressing the European Pensions and Savings Summit 2008. “There may be a $1,000 billion worth of losses in it somewhere.” He said he “cannot recall anything similar, certainly in the last 30 to 40 years that I’ve worked.”

The International Monetary Fund predicts that losses from the crisis, including those tied to commercial real-estate, may total $945 billion and says global economic expansion may be the slowest since 2003 this year. Wolfensohn said the fund’s loss forecast of about $1 trillion is now a “consensus estimate.”

Now, I don’t want to give the impression that I’m taking serious issue with any scary kind of number anybody wants to throw around. I don’t have easy access to the source data and I wouldn’t have time to look at them carefully even if I did. But we’re seeing in Canada that Flaherty is using the credit crisis in general and ABCP in particular to promote a federal securities regulator. And there are problems with the consistency of calculations in the IMF report. It seems to me that if I was a typical bureaucrat and I thought that scaring people to death would advance my own regulatory agenda, I’d ensure that my estimates erred on the generous side … that’s an old trick.

You can’t trust anybody.

Volume was lightish today, but enlivened by some activity in SplitShares … some managers, perhaps, adjusting positions after Friday’s downgrades? Market direction was mixed with a downward bias … we’re not far off the trough, you know! Total return on CPD (as an indicator) hasn’t been much more than zero since the mark was set in November – so things could prove interesting.

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

Lots of speculation and exhortation in the air about the Fed FOMC meeting next week! Econbrowser‘s James Hamilton wants the rate constant at 2.25%:

…there is a compelling case that by rapidly bringing the yield on short-term Treasury bills well below the prevailing inflation rate, the Fed has played a role in the significant depreciation of the dollar and increase in the dollar price of virtually every storable commodity that we’ve seen since the beginning of January.
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If the Fed surprises the market with a pause, we should have unambiguous confirmation or refutation of the hypothesis that the Fed has been contributing to the commodity price run-up within 48 hours of the FOMC’s announcement. That knowledge in itself would also be extremely valuable– valuable to the Fed in calculating how to chart its course from here, and valuable in terms of making clear to the public why sometimes higher interest rates are the better choice for public policy.

Accrued Interest, however, is watching the unemployment numbers with more interest:

I think the worst of the liquidity crisis is past us, but we still have a weak economy will still be dealing with housing-related problems for a while. That will probably keep the Fed in a easy money mode for a while, which will be supportive of interest rates generally.

The thing to watch is primarily inflation data. I think bad housing data is mostly priced in (today’s rally supports this thesis), and while it could turn out worse than currently expected, inflation is actually the more important element for rates. Food and energy inflation has been problematic for a while, but the leakage into core inflation measures has been mild so far. The Fed has been gambling that it could afford to cut rates to improve liquidity because weaker employment would take care of the inflation problem.

If either employment is not as weak as currently expected and/or unemployment fails to contain inflation, the Fed will make a U-turn on rates.

Traders of 2-Years are betting there will be a pause:

“There’s been quite a shift in bond-market sentiment over the past few weeks,” said Nick Stamenkovic, a fixed-income strategist at RIA Capital Market Ltd. in Edinburgh. “The market has become increasingly confident that the worst is over for the financial sector and that the Fed is nearing the end of its easing cycle.”

Government bonds have lost 1.3 percent in April, indexes compiled by Merrill Lynch & Co. showed. The last time the securities declined was in June, when they fell 0.5 percent. The drop is the steepest since July 2003, when they shed 1.9 percent.

The two-year U.S. Treasury note yield rose to a three-month high of 2.50 percent today, before trading at 2.39 percent by 10:40 a.m. in New York, according to bond broker BGCantor Market Data. It has risen 65 basis points in the last two weeks. Yesterday’s government auction of $19 billion of five-year notes drew the least demand since 2003.

And, while financial companies are having to pay up for term money, they are able to issue in size:

Citigroup Inc. and Merrill Lynch & Co. led $43.3 billion of U.S. corporate bond sales, the busiest week on record, as financial companies sold debt at the highest yields since May 2001.

Sales compare with $31.2 billion last week and an average this year of $18 billion, according to data compiled by Bloomberg. Citigroup, the biggest U.S. bank by assets, sold $6 billion of hybrid bonds in the company’s largest public debt offering, while New York-based securities firm Merrill Lynch raised $9.55 billion by issuing debt and preferred securities.

On the other hand, the 30-day Fed Funds Contract is showing expectations of a hair over 2.00% until September, in line with the consensus reported by the WSJ of ‘one more, then stop’. Finally, the Cleveland Fed’s analysis of the options on this contract show an overwhelming expectation of 2.00%, with the “2.25% prediction” coming out of nowhere to take second place from the once strongly challenging “1.75% prediction”. We shall see!

There is a good story on Credit Rating Agencies published by the New York Times magazine:

Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

It’s all reasonably fair minded – as reasonable as one can expect, these days! The author saves himself the unpleasant experience of PrefBlog’s wrath by prefacing his suggestion that the Fed, inter alia bring credit analysis in house with the word “if”.

It’s all craziness. There is no good way to forecast credit. It’s all forecasting, as prone to error and changing circumstances as any other forecast … you do the best you can and diversify, by name, by asset class, by any other source of risk exposure. The only solution for such apparent failures of forecasting as sub-prime and Canadian ABCP is to say something along the lines of … “You put all your money in this stuff and now it’s all gone? Well, you’re stupid. Go away.” But it won’t happen.

My other quibble with the author’s conclusion is:

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future.

How about … rely on your own credit analysis or don’t buy it?

The vote on the Canadian ABCP restructuring has, apparently, approved the proposed plan, although with some reservations:

However, Jeffrey Carhart, a representative for the ad hoc committee read a statement prepared by the group disputing part of the plan that could potentially release certain financial institutions from lawsuits over selling ABCP to their clients.

“Those who are voting Yes by proxy are preserving their ability to argue both the validity and fairness of the planned release” from legal challenges, Carhart read.

… and the final (?) hurdle comes next week:

Mr. Crawford acknowledged that the committee has “some work to do next week” to face the legal challenges, which the judge overseeing the restructuring will consider at a fairness hearing scheduled for next Friday. Without the judge’s approval, the plan cannot go ahead.

In a ruling this week, the judge said that the corporate challengers had raised “very forceful arguments” about “a very serious issue of law” – whether the plan to extend immunity from lawsuits is legal.

I’ll just bet the corporate challengers have raised very forceful arguments! In some cases, it would appear that glorified bookkeepers recklessly overinvested in the asset class … the investing corporations could well be looking at a few investor lawsuits themselves.

On another topic, the Ontario Teachers Pension Plan has released its 2007 results (hat tip:FWF). Very impressive! Most debates regarding the value of active management implicitly consider all active managers to be equal, which is not the case … active management needs to be marketted, with the result that (i) marketers are in control of the process, not investment managers, and (ii) even investment managers must give some thought to explaining their choices. The split is not passive/active, but passive/active-captive/active-marketted. I have no data, but I’m willing to bet a nickel that active-captive, as a class, handsomely outperforms its benchmarks.

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

Willem Buiter has commented on the BoE liquidity operation discussed by PrefBlog on April 21:

The Bank of England is now wholeheartedly committed to acting as market marker of last resort for systemically important securities for which the markets have become illiquid, not to say defunct, since the start of the crisis in August 2007.

Dr. Buiter’s phrase “market maker of last resort” was introduced in his post from last August.

The market maker of last resort function can be fulfilled in two ways. First, outright purchases and sales of a wide range of private sector securities. Second, acceptance of a wide range of private sector securities as collateral in repos, and in collateralised loans and advances at the discount window.

I cannot help but feel that this phrasing is imprecise, because “Market Maker” implies a transfer of ownership; in the current agreement, the participating banks continue to bear the risk of the instruments used to collateralize their loans. Dr. Buiter argued last August that injection of liquidity in the market sector where it was needed most to the participants who wanted it most would achieve desirable effects with less disruption to the general market than across-the-board reductions in the lending rate:

Central banks have not been doing the job of market maker of last resort effectively, indeed they have barely been doing it at all. Following the stock market collapse of 1987, the Russian default of 1998 and the tech bubble crash of 2001, all that the key monetary authorities have done is (1) lower the short risk-free interest rate and (2) provide vast amounts of liquidity against high-grade collateral only, and nothing against illiquid collateral. The result has been that the ‘resolution’ of each of these financial crises created massive amounts of high-grade excess liquidity that was not withdrawn when market order was restored and provided the fuel that would produce the next credit boom and bust. By focusing instead on illiquid collateral, it should have been possible to achieve the same effect with a much smaller injection of liquidity.

This point, that overall liquidity changes can be minimized by a more careful targetting of liquidity injection, was mentioned on PrefBlog on March 31, quoting Xavier Vives. I haven’t seen anybody use the phrase “a rifle, not a shotgun” yet, but I’m sure it will be if the Central Bank actions become a political issue.

Anyway, back to Dr. Buiter’s remarks:

The “£50 billion bail-out for banks” headline of that fount of orginal analysis, the (free) London paper, is rubbish. The Special Liquidity Scheme is priced quite unpleasantly for the banks. The so-called fee (the difference between 3-month libor rate and the 3-month General collateral gilt repo rate) will be quite hefty, because it reflects not only bank default risk (libor is the rate for unsecured bank lending) but also liquidity risk. In addition, the haircuts (discounts) applied to the Bank of England’s valuation of the RMBS, covered bonds and credit card ABS ranges from 12 percent, for the shortest maturity to 22 percent for the longest maturity. That valuation will either be based on observed market prices that are independent and routinely publicly available or on the Bank of England’s own calculated prices. As most of the assets are illiquid, the prices of these assets will for the foreseeable future be set by the Bank of England. In that case it will also apply a higher haircut to the valuation. In addition, Bank officials have told me that should any of the assets lent by the banks to the Bank fall, during the life of the swap, below the required AAA rating, these assets will have to be replaced by AAA-rated securities.
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The UK scheme prices what amounts to a collateralised loan of Treasury bills by the Bank of England quite harshly. And appropriately so. There is no eartly reason for giving the banks a tax payer handout. The banks and their borrowers made the mistakes. They and their borrowers should pay the price.

He contrasts this with the valuation of securities accepted by the Fed:

All this is a lot more sensible and likely to minimise adverse selection than the insane valuation of the collateral offered by US Primary Dealers to the Fed at the Term Securities Lending Facility and the Primary Dealer Credit Facility. The collateral is priced by the clearing bank acting as agent for the Primary Dealer! If ever a scheme was designed to encourage collusion between Primary Dealer and Clearer to dump useless securities at inflated prices on the Fed, this is it.

I hadn’t been aware of that nuance! I am in complete agreement with Dr. Buiter: valuation should be performed by the Fed – with input and advice from the brokers and clearing banks, of course, but the final say should rest with the lender.

And finally, Dr. Buiter points out another nuance:

Unlike the US, where mortgages are non-recourse debt, the UK does not have mortgages that are non-recourse.

The standard terms on US mortgages are ridiculous and the standard provision of non-recourse loans is just one of the problems.

In a new development, a trader has been nailed for spreading false rumours:

Paul Berliner, 32, sought to profit by messaging traders at brokerages and hedge funds on Nov. 29, claiming Alliance Data’s board was meeting to discuss a reduced offer by Blackstone, the Securities and Exchange Commission said today in a suit at federal court in Manhattan. The shares plunged 17 percent in half an hour that day.
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Berliner, who was shorting the stock to profit from the drop in price, made more than $25,000 before the shares recovered, according to the SEC. He didn’t admit or deny the agency’s claims in agreeing to forfeit his gains, plus interest, and pay a $130,000 fine.

The trivial amounts for which a trader will put his reputation on the line never fails to astonish me … one can only imagine that the real-world repercussions for talking like an idiot to other idiots are not really all that harsh.

The story does not address what, if anything, happened to the morons who traded stock on the basis of an unverified text message. If they were acting as fiduciaries, one can only hope that their licenses will be yanked soon.

The market was off a bit today in what has now become normal volume. There were a few good crosses of the more liquid, high quality, perpetualDiscounts.

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

Not much today, folks! In the spirit of the day, I had to spend some time slaying dragons and was unable to assemble my List of Interesting Things.

A return of good volume, the market was up and the index was down. What a great day!

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