PrefBlog

Bloomberg highlighted a study by A. Joseph Warburton, Deniz Anginer and Viral V. Acharya titled The End of Market Discipline? Investor Expectations of Implicit State Guarantees:

We find that bondholders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk. While bond credit spreads are sensitive to risk for most financial institutions, credit spreads lack risk sensitivity for the largest institutions. This expectation of public support constitutes a subsidy to large financial institutions, allowing them to borrow at government-subsidized rates. The implicit subsidy provided large institutions an annual funding cost advantage of approximately 28 basis points on average over the 1990-2010 period, peaking at more than 120 basis points in 2009. The total value of the subsidy amounted to about $20 billion per year, topping $100 billion in 2009. Passage of Dodd-Frank did not eliminate expectations of government support. The cost of this implicit insurance could be internalized by imposing a corrective tax. Requiring financial institutions to shoulder the full cost of their debt would help create a more stable and efficient financial system.

I don’t like the taxation idea – that’s just going to lead to a hopeless mess, and there won’t be anything in the kitty when it’s needed. I have previously advocated, and continue to advocate, a progressive increase in capital requirements based on size and, perhaps, other measures of systemic importance if these can be measured objectively. Thus, a $20-billion bank might have required CET1 Capital of 8%, but at $200-billion bank might have a 10% requirement. Such a regime has the same objectives as the surcharges for G-SIBs and D-SIBs, but is less prone to regulatory corruption.

The situation with respect to Chesapeake’s junk bond redemption (that I mentioned on March 18) has been resolved:

Prices on the second-biggest U.S. natural gas producer’s notes have fallen by as much as 9 cents on the dollar, erasing $117 million, after a judge ruled May 8 that Chesapeake could redeem the securities at par. Investors including the hedge-fund firm run by former Lehman Brothers Holdings Inc. President Bart McDade were betting the Oklahoma City-based company had missed a deadline and would have to pay as much as $400 million to retire the debt early.

A search for returns has highlighted the dangers implicit in wagering on disputes in which borrowers traditionally had the upper hand after yields on junk debt dropped to a record 5.98 percent and prices soared to an unprecedented 107.2 cents on the dollar on May 9.
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Any company that drafts ambiguous deal documents may receive similar legal treatment to the “get out of jail free card” that U.S. District Judge Paul Engelmayer in Manhattan handed to Chesapeake, according to Brian Gibbons Jr., an analyst at debt researcher CreditSights Inc. in New York.

“The assumption now will be that indenture readers need to be on the lookout for sections of documents where they might
need ‘time to apply thoughtfully the canons of contractual interpretations,’” Gibbons wrote in a May 8 report. “The risks
are to be laid on the bondholder for bad drafting.”

Transmission of monetary policy is – somewhat surprisingly – getting media attention after a blog post by Mark Dow:

We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.
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How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

Assiduous Readers will doubtless remember my mockery of HAMP in 2009. I just stumbled across some S&P Commentary dated 2013-4-26:

In June of last year, Standard & Poor’s Ratings Services contended that principal forgiveness was more likely to keep U.S. mortgage borrowers current than more commonly used modification tools (see “The Best Way to Limit U.S. Mortgage Redefaults May Be Principal Forgiveness,” June 15, 2012). Data gathered since then not only support this view but also demonstrate servicers’ growing adoption of this form of loss mitigation. (Watch the related CreditMatters TV segment titled, “Principal Forgiveness Remains The Best Way To Limit U.S. Mortgage Redefaults,” dated May 7, 2013.)

As of February of this year, more than 1.5 million homeowners have received a permanent modification through the U.S. federal government’s Home Affordable Modification Program (HAMP). Since the publication of our June 2012 article, there have been more than 400,000 additional modifications on outstanding mortgages (as of March 2013). This translates to roughly a 22% rate of growth in the number of modifications on an additional $2.4 billion in mortgage debt.

Under the HAMP Principal Reduction Alternative (PRA) program, which provides monetary incentives to servicers that reduce principal, borrowers have received approximately $9.6 billion in principal forgiveness as of March 2013. Interestingly, servicers have ramped up their use of principal forgiveness on loans that don’t necessarily qualify for PRA assistance. Indeed, among the top five servicers for non-agency loans, we’ve noted that principal forgiveness, as a percentage of average modifications performed on a monthly basis, has increased by about 200% since the latter half of 2011 (see Chart 1). We attribute part of this to the $25 billion settlement in February 2012 with 49 state attorneys general and these same five servicers: Ally/GMAC, Bank of America, Citi, JPMorgan Chase, and Wells Fargo). In fact, although principal reduction remains the least common type of loan modification among servicers, the percentage of non-agency modified loans that have received principal forgiveness has increased by 3% since June 2012 (see Chart 2). Since 2009, servicers have forgiven principal on approximately $45 billion of outstanding non-agency mortgages.

It was a modestly negative day for the Canadian preferred share market, with PerpetualPremiums down 10bp, FixedResets flat and DeemedRetractibles off 4bp. Volatility was average. Volume was below average.

Bernanke gave a speech of note titled Monitoring the Financial System:

A fair summary is that, while the shadow banking sector is smaller today than before the crisis and some of its least stable components have either disappeared or been reformed, regulators and the private sector need to address remaining vulnerabilities. For example, although money market funds were strengthened by reforms undertaken by the Securities and Exchange Commission (SEC) in 2010, the possibility of a run on these funds remains–for instance, if a fund should “break the buck,” or report a net asset value below 99.5 cents, as the Reserve Primary Fund did in 2008. The risk is increased by the fact that the Treasury no longer has the power to guarantee investors’ holdings in money funds, an authority that was critical for stopping the 2008 run. In November 2012, the FSOC proposed for public comment some alternative approaches for the reform of money funds. The SEC is currently considering these and other possible steps.
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In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.

From a financial stability perspective, however, the assessment of asset valuations is only the first step of the analysis. Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset’s value to changes in broad financial conditions. Differences in these factors help explain why the correction in equity markets in 2000 and 2001 did not induce widespread systemic disruptions, while the collapse in house prices and in the quality of mortgage credit during the 2007-09 crisis had much more far-reaching effects: The losses from the stock market declines in 2000 and 2001 were widely diffused, while mortgage losses were concentrated–and, through various financial instruments, amplified–in critical parts of the financial system, resulting ultimately in panic, asset fire sales, and the collapse of credit markets.

It was a mildly negative day for the Canadian preferred share market, with PerpetualPremiums down 5bp, FixedResets off 2bp and DeemedRetractibles flat. Volatility was ho-hum. Volume was low.

The Kansas City Fed has published a very interesting evaluation of the Basel Rules on liquidity buffers by Michał Kowalik titled Basel Liquidity Regulation: Was It Improved with the 2013 Revisions?:

However, important shortcomings remain. The new Basel provisions,
like the original ones, still determine liquidity buffer size and composition without taking into account the nature of an individual financial institution’s risk profile, capital, and business activity—all factors that determine the institution’s ability to withstand liquidity shocks. One reason the BCBS opted not to pursue a more flexible, individualized approach is that such an approach would be hard to apply consistently across national borders and the comparability of liquidity positions among financial institutions would not be guaranteed. The inflexible approach, however, raises concerns that some financial institutions may be required to hold buffers larger or smaller than necessary given the nature of their own operations. Moreover, an inflexible approach to determining buffer size and composition can invite “regulatory arbitrage.” Financial institutions may devise strategies that exploit loopholes in the Basel provisions, undermining the integrity of the liquidity buffers.

Shadow banking is making a comeback:

Cerberus Capital Management LP is entering the booming market for single-family homes to rent, planning to lend billions of dollars to investors too big for government programs and too small to get Wall Street funding.
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The New York-based firm is seeking to fill a void left by regional lenders that prior to the housing crash were the primary source of loans for landlords buying properties. At least 475 banks have failed since the real-estate collapse, according to the Federal Deposit Insurance Corp., while larger banks have tightened mortgage underwriting standards and are focusing on the biggest investors.

“There’s a real vacuum and Cerberus sees that and they are filling it,” said Jack BeVier, partner at Baltimore-based Dominion Group, which buys and renovates homes. “That niche used to be filled by commercial banks, the local savings and loans or the small regional banks, which would do blanket mortgages across many rental properties, but those players are largely out of the market right now.”

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums off 1bp, FixedResets gaining 3bp and DeemedRetractibles down 5bp. Volatility was average. Volume was average.

DBRS has published its 2012 DBRS Corporate Rating Transition and Default Study:

Click for Big

The Boston Fed has released a paper by Oz Shy titled Window Shopping:

The terms “window shopping” and “showrooming” refer to the activity in which potential buyers visit a brick-and-mortar store to examine a product but end up either not buying it or buying the product from an online retailer. This paper analyzes potential buyers who differ in their preference for after-sale service that is not offered by online retailers. For some buyers, making a trip to the brick-and-mortar store is costly; however, going to the store to examine the product has the advantage of mitigating the uncertainty as to whether the product will suit the buyer’s needs. The model shows that the number of buyers engaged in window shopping behavior exceeds the optimal number, both under duopoly and under joint ownership of the online and walk-in store outlets.
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Second, the retail industry environment is evolving in many ways. Fearing a loss of customers to online retailers, many large brick-and-mortar retailers now offer online shopping with either home delivery or store pickups. In addition, many online retailers offer easy returns, some offer “free returns,” and some provide links to webpages where customers can find aftermarket service providers in their area. In addition, online sellers keep introducing more and more products, such as eyeglasses, that until recently were available only in walk-in stores. This is accomplished by offering significant price reductions that are possible because online merchants learn how to bypass the middlemen and shorten the supply chain.

I believe that at some point it will become attractive to the manufacturers to pay retailers explicitly for showrooming their product and cut out the on-line retailer middleman.

I had an interesting conversation with my furnace repairman (*sigh*) a few weeks ago. He complained that the distributors were cutting back on staff, staff experience and staff training, so it wasn’t enough for him any more to say he needed a pilot light detector for a Heat-Yer-House Model 71; he had to say he needed part number HYH-71-ABC45D. They would then supply him with the part.

I suggested that if the distributors were not providing all that great service, it would be to the manufacturers’ advantage to sell the parts directly (you could get really fancy with a website for this. Cutaway photos or diagrams of the appliance, for instance – click on the area, pop up an order form with all the information). He responded that that’s already starting to happen.

We live in a world of change!

Scandal in LatteLand! Timmy’s is under Review-Negative:

DBRS has today placed the A (low) ratings of Tim Hortons Inc. (THI or the Company) Under Review with Negative Implications following the Company’s announcement that it is actively evaluating possible changes to its capital structure (i.e., optimal debt level within the context of maintaining an investment grade credit rating).

The Under Review with Negative Implications status reflects DBRS’s concerns that an increase in financial leverage – potentially triggered by the Company’s review of its optimal capital structure, including consideration of potential share repurchase activity and other uses of leverage – could result in a credit risk profile that would no longer be consistent with the A (low) rating category.

The priorities of the world have become so skewed that there is now handwringing that some scholarships are based on merit:

To increase their standing on college rankings, more private colleges are giving “merit aid” to top students, who are often affluent, while charging unaffordable prices to the needy, according to the report. The percentage of students receiving merit aid jumped to 44 percent in 2007-2008 from 24 percent in 1995-1996, the report found. To a lesser extent, public universities are using some of the same practices,[report writer Stephen] Burd said.
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Colleges use merit aid for talented middle- and upper-income students because it is less costly than pursuing similar prospects from poor families, said Catharine Hill, Vassar’s president. Enrolling low-income students costs schools money because they are giving up a spot for those who can pay full freight — or close to it.

If American universities want to fix the problem they should address the problem:

University spending is driven by the need to compete in university league tables that tend to rank almost everything about a university except the (hard-to-measure) quality of the graduates it produces. Roger Geiger of Pennsylvania State University and Donald Heller of Michigan State University say that since 1990, in both public and private colleges, expenditures on instruction have risen more slowly than in any other category of spending, even as student numbers have risen. Universities are, however, spending plenty more on administration and support services (see chart 2).

Another problem is tuition discounting:

The practice of tuition discounting, in which a college awards financial aid from its own funds, is responsible for 27% to 32% of the increase in college tuition. On an absolute scale, tuition discounting accounts for 2 to 3 percentage points of the college tuition inflation rate. Tuition charges would be 22% to 25% lower without tuition discounting, but lower income families would be unable to afford to pay for a college education.

I think the basic problem is that there are simply too many people going to university.

It was a modestly positive day for the Canadian preferred share market, with PerpetualPremiums and DeemedRetractibles both up 5bp and FixedResets gaining 2bp. Volatility was minimal. Volume continued to be high – but not as ridiculously high as yesterday.

PerpetualDiscounts now yield 4.88%, equivalent to 6.34% interest at the standard equivalency factor of 1.3x. Long Corporates now yield about 4.1%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 225bp, a slight – and perhaps spurious – narrowing from the 230bp reported May 1.

I am pleased to announce that the regulatory response to the Credit Crunch has achieved its goal:

Job vacancies at London’s financial- services companies climbed 19 percent last month as tougher regulation of banks spurred hiring in compliance and anti-money laundering, recruitment firm Astbury Marsden said.
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Firms in the City, the world’s number one financial center, according to consulting firm Z/Yen Group Ltd., have been hiring to improve compliance and reduce risk amid regulatory scrutiny following scandals including interest-rate rigging and money laundering. Banks, insurers and asset managers may add 4,000 jobs in the first half of the year, ending three consecutive quarters of cuts, the Confederation of British Industry said last month.

“Regulation is still driving recruitment in the City, as banks focus on trimming their businesses back to their most profitable areas in order to manage new capital requirements,” said Astbury Marsden in the statement.

European corporate and investment banks face a reduction in profitability from increased taxation, compensation restrictions and regulatory burdens, according to a report by Oliver Wyman and Morgan Stanley last month.

A rather audacious fraud has been uncovered:

The Securities and Exchange Commission today charged four individuals with ties to a New York City brokerage firm in a scheme involving millions of dollars in illicit bribes paid to a high-ranking Venezuelan finance official to secure the bond trading business of a state-owned Venezuelan bank.

According to the SEC’s complaint filed in federal court in Manhattan, the global markets group at broker-dealer Direct Access Partners (DAP) executed fixed income trades for customers in foreign sovereign debt. DAP Global generated more than $66 million in revenue for DAP from transaction fees – in the form of markups and markdowns – on riskless principal trade executions in Venezuelan sovereign or state-sponsored bonds for Banco de Desarrollo Económico y Social de Venezuela (BANDES). A portion of this revenue was illicitly paid to BANDES Vice President of Finance, María de los Ángeles González de Hernandez, who authorized the fraudulent trades.

There’s a few more words on Lapdog Carney’s legacy, this time from Philip Cross, Research Coordinator at the Macdonald-Laurier Institute and former Chief Economic Analyst at Statistics Canada:

The Bank of Canada proudly defends its independence. However, this independence places responsibilities on both the government and the Bank. The government is obliged to allow the Bank to set monetary policy, notably interest rates, without political interference. In return, the Bank is obliged to act in a non-partisan way. It is the latter that was tarnished during Carney’s tenure, not the former.

There are several examples of Carney over-stepping the constraints of non-partisanship. Most obvious was his dalliance with Liberal powerbrokers over their leadership.

I wasn’t really disturbed by the Grit thing. It was clear that that was all about Carney the man, not Carney the Bank Boss. My complaints about Carney relate to his eagerness to be a stalking horse for political pronouncements, e.g. “Ban the Bond” and the idiotic Central Clearing for Derivatives. But it worked! He got his reward! Firstly as boss of the Financial Stability Board and next as Monetary Puppet for another micromanaging western government.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums down 16bp, FixedResets gaining 4bp and DeemedRetractibles off 1bp. Volatility was low. Volume was ENORMOUS! Absolutely ENORMOUS! I don’t know what happened.

PrefBlog’s “There’s One Born Every Minute” Department has uncovered some exciting news:

In about a week, a structured product offering, the Manulife Floating Rate Senior Loan Fund, will close.
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On Manulife’s deal, holders are slated to receive 6.75%.
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It will try and achieve that 6.75% yield by investing in a broadly diversified portfolio consisting mostly of senior floating rate loans. Those loans will be at a spread above LIBOR. The sub-advisor is also allowed to invest up to 20% of the total in short duration debt securities.

Given that the talk is that retail investors have committed almost $150-million to the offering, what does the success of Manulife’s deal mean?

From the prospectus – to which I am unable to link, given CDS’ abuse of its regulatory monopoly – we learn how they’re going to make that “6.75%”:

Click for Big

The following helpful table is also provided:

Regretably, the term “Option Adjusted Duration” is not defined in the prospectus; I presume that the fact that this is much lower than the Average Maturity indicates at least qualitatively that a huge proportion of the portfolio is trading at or above its current call price. It is equally regrettable that they do not report the Option Adjusted Yield for the Indicative Portfolio. What a pity. I wonder why not.

So let’s see … they’re plan to pay 6.75% p.a., after paying new issue commission a little in excess of 5% and issue expenses of somewhere between 0.3% and 1.5% (depending on how much gets sold); and after paying Management & Service Fees totaling 1.5% p.a.; and after paying expenses, estimated at between 8bp and 100bp p.a. (depending on how much gets sold). And they’re planning to do this with a low-quality portfolio of floating rate issues which could substantially called away in the next year or so, and is now yielding 6.50%.

Nice work if you can get it.

It was another good day for the Canadian preferred share market, with FixedResets continuing their recent pattern of being decoupled from the returns of other preferred share classes: PerpetualPremiums and DeemedRetractibles were up 5bp, while FixedResets won 27bp. Volatility was low. Volume was on the low side of average, but dominated by FixedResets.