PrefBlog

There’s a smoking gun in the LIBOR fixing scandal:

According to transcripts released by the U.K. Financial Services Authority today, an employee identified as Trader A led efforts to influence Japanese Yen Libor submissions included paying brokers as much as 15,000 pounds ($24,400) a quarter and offering a payment to another for helping him keep that day’s rate low. Trader A worked at UBS in Tokyo from 2006 to 2009 and directly contacted employees at other banks to influence their submissions at least 80 times.

“I need you to keep it as low as possible,” Trader A wrote to the broker on Sept. 18, 2008, referring to six-month yen Libor. “If you do that … I’ll pay you, you know, $50,000, $100,000… whatever you want … I’m a man of my word,” according to the transcripts.
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Between Sept. 19 and Aug. 25, 2008, Trader A and a colleague entered into nine so-called wash trades as a means of rewarding an unidentified broker with more than 170,000 pounds for helping rig the rate. Wash trades are where a trader puts through two or more risk-free trades through a broker which cancel each other out while leading to a payment of brokerage fees to the broker arranging the trade.

For how long will the Greeks tolerate this?

In the Greek mountain town of Kastoria, less than an hour from the Albanian border, Kostas Tsitskos, 88, can’t afford fuel to heat his home against the winter’s cold. So he and his son live in a single bedroom, warmed by a small electric heater.

“One room is enough,” said Tsitskos, who lives on a 734 euro-a-month ($971) pension and doesn’t have the 1,000 euros a month he needs to buy heating oil.

Greece is facing a heating-oil crisis. With an economy that has contracted for five years and an unemployment rate at a record 25 percent, residents in northern Greece can’t heat their homes. Kastoria hasn’t received funds from the central government to warm schools and the mayor said he will close all 53 of them rather than let children freeze, a step already taken in a nearby town. Truckloads of wood are arriving from Bulgaria as families search for alternative fuels.

Canadians shouldn’t get too cocky:

The Canadian economy is expected to pick up speed – a little – by the middle of next year, though external risks still “loom large,” a new forecast said Wednesday.

The country’s gross domestic product will grow 1.8 per cent next year and accelerate to 2.25 per cent in 2014, the International Monetary Fund said in its preliminary assessment of the Canadian economy. That’s down slightly from its October forecast of 2 per cent growth for next year.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums off 2bp, FixedResets gaining 7bp and DeemedRetractibles up 12bp. Volatility was average, but the highlights are all negative. Volume was quite high – presumably due to traders trying to get ready for year-end before the holiday lull.

PerpetualDiscounts now yield 4.88%, equivalent to 6.34% interest at the standard equivalency factor of 1.3x. Long corporates yield just under 4.3%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 205bp, a slight (and perhaps spurious) decline from the 210bp reported December 12.

As mentioned yesterday, I received a query from an Assiduous Reader asking me to clarify my remarks of December 13 regarding the recent CSA Discussion Paper and Request for Comments on Mutual Fund Fees.

Having reviewed my comments, I confess to some surprise that clarification should be required – they seem plain enough to me. But here goes:

i) The CSA is concerned that:

investors have no say in the extent to which their mutual fund assets are used to pay for advisor compensation.

I pointed out that this is like every other product sold to retail. When I buy a can of beans for $2.49 at the grocery story, I have no say in how that $2.49 is split between the producer, the middlemen and the store itself. Why should I? The deal’s right there: $2.49 for a can of beans, take it or leave it. What’s wrong with that? The price is disclosed and the nature of the product is disclosed: it makes no difference to me whether the Chilean farmer who planted and harvested the beans gets a nickel or quarter out of the deal.

Some people, of course, get all worked up about things like this and start “Fair Trade” organizations with the stated intent of increasing the proportion of the retail price paid to the producer, even if this increases the retail price. Well, more power to them! But most people don’t care because the question is totally irrelevant to them.

As far as mutual funds are concerned – the amount to be taken from the fund by the sponsor as management fees is stated in the prospectus and this figure is (as pointed out by Assiduous Reader mclachlan8) widely publicized. What happens to the fees afterwards is irrelevant to the investor.

ii) I found the following bland assertion rather breathtaking:

Using fund assets to pay for trailing commissions could encourage additional sales of the fund. This could increase the fund’s assets under management, which would increase the management fees payable. This creates an actual or a perceived conflict of interest between the mutual fund manufacturer and the fund’s investors. [footnote]

[Footnote reads:] G. Stromberg, supra note 81, at pages 16-17, comments on this conflict of interest as follows: “A result of this perspective is that independent investment fund organizations have increasingly become marketing companies, more focussed on gaining market share than on being investment management companies focussed on managing investment funds for the benefit of the investors in these funds. The major concern that arises from the focus on marketing considerations is whether marketing considerations are prevailing over investment management decisions and resulting in conflicts of interest between the fund manager and the fund investors.

One reason this is breathtaking is lack of a logical connection between the footnote and the text. Ms. Stromberg was concerned about investment management decisions, which do not have anything to do with the level of fees charged.

An example of an investment management decision that could be influenced by marketing considerations is the decision to invest in security XYZ because it was popular with retail; or because it enabled the marketing department to trumpet the holding as a bold example of incisive logic; or some such rationale. If this rationale conflicted with the portfolio manager’s honest opinion of security XYZ as an investment – yes, that’s a clear breach of duty, that’s bad, take them out and shoot them.

But it has nothing to do with the fee charged.

However, the most offensive portion of the chain of thought lies in the implication that fund assets are used to pay trailer fees. This is, generally speaking, false: fund assets are not used to pay trailer fees. Fund assets are used to pay the Management Expense Ratio; once this payment has been received by the fund sponsor, the funds become property of the sponsor and lose their identity as fund assets. And the fund sponsor is perfectly entitled to do whatever it wants with its property.

There are some rare cases in which fund assets are used to pay trailers: for instance, CPD.A differs from CPD in that the former pays a trailer to the advisors of the holder. This is fully disclosed in the prospectus and reported in the financial statements – I fail to see any problem with this. The payments are included in the reported Management Expense Ratio, and investors can take it or leave it, as they see fit. One of the CSA’s proposed changes [# (iii)] envisions all mutual funds having such a carve-out of trailers … but this is a proposed CHANGE, not a reflection of the current state of affairs.

iii) However, the CSA logic becomes even more convoluted – and even more offensive – in the latter part of the paragraph quoted:

This practice could put the mutual fund manufacturer at odds with its statutory duty to act in the best interest of the mutual fund [First Footnote] to the extent the mutual fund manufacturer, rather than the fund and its investors, is the primary beneficiary of the fund’s asset growth. The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.[Second Footnote]

[First Footnote reads] See s. 2.1 of National Instrument 81-107 Independent Review Committee for Investment Funds, which requires the manager of the investment fund to (a) act honestly and in good faith, and in the best interests of the investment fund, and (b) exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. The Securities Acts of most of the CSA jurisdictions also contain a similar provision.

[Second Footnote reads] A mutual fund manufacturer could demonstrate this, for example, by reducing the management fees and expenses it charges to a mutual fund as its assets grow, thus yielding a benefit to the fund and its investors. Interestingly however, U.S. studies on trailing commissions, known in the U.S. as “12b-1 fees”, have concluded that trailing commissions don’t yield the expected benefit for investors. When 12b-1 fees were originally adopted in the U.S., mutual funds were experiencing net redemptions. The belief was that if fund flows could be attracted through the use of 12b-1 fees, existing investors would benefit through lower expense ratios as assets under management increased. Subsequent U.S. experience has shown this not to be the case with 12b-1 fees increasing expense ratios on a one-for-one basis even as assets under management increase. See S. Collins, The Effect of 12b-1 Plans on Mutual Fund Investors, Revisited (March 2004) ICI working paper, and L. Walsh, The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns (June 2004) SEC discussion paper available at: http://www.sec.gov/rules/proposed/s70904/lwalsh042604.pdf.

The logic of the part up to and including the first footnote is absurd. It continues the conflation of the roles of portfolio manager and sponsor discussed above. The Portfolio Manager certainly has a fiduciary duty to the fund to exert care and prudence in portfolio management – that much is basic. But this is an entirely separate topic from how much is charged for that Portfolio Manager’s care and prudence.

A criminal lawyer, for instance, owes fiduciary duty to his clients. But we don’t (often) see Clayton Ruby work for free, although I’m sure he does his share of pro bono work in the public interest. As a matter of general principle, most people will attempt to charge whatever the market will bear for their services, regardless of what those services might be. And why not? It’s certainly not unethical to ask your boss for a raise, or to find a better paying job.

The premise underlying the last sentence of the quoted CSA paragraph, leading up to the second footnote, is offensive to any conception of justice: “The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.” Since when, in Canada, has it been necessary to prove innocence? I assert that it is the regulators, or aggrieved parties, who bear the onus of proving that the fiduciary duty of the portfolio manager has been breached.

iv) With respect to the part (ii) of the “possible changes”:

ii. A standard class for DIY investors with no or reduced trailing commission
Every mutual fund could have a low-cost ‘execution-only’ series or class of securities available for direct purchase by investors. The lower management fees of this series or class would reflect that no or nominal trailing commissions are paid to advisors, in light of the lack of advice sought by DIY investors who purchase and hold securities of this series or class. This low-cost series or class of securities could be made available to investors through a discount brokerage, or alternatively, be distributed directly by the mutual fund manufacturer, in which case the mutual fund manufacturer would need to be registered as a mutual fund dealer.

As I remarked, it’s not clear how the discount brokerages will bet paid for this service; it’s also not clear what the manufacturers’ responsibility to the clients will be for this additional service, or how (if?) they will get paid.

With respect to the discount brokerages, I mentioned yesterday the sabre-rattling that has commenced in the UK, with the discount brokerage Hargreaves mulling over how it should be paid for its services given the pending illegality of trailer fees in the UK. The UK has already passed the damn law, and the resolution of this question is not clear!

v) My last remark was with respect to:

v. Cap commissions
There could be a maximum limit set on the portion of mutual fund assets that could be used to pay trailing commissions to advisors as a way to mitigate the perceived conflicts of interests and the lack of alignment of advisor compensation and services described in Part V. …

I stated that the level of trailers is “just plain none of the regulators’ damn business.”, and stand by that remark. Disclosure? Sure – that’s regulatorary business. Level? No way.

A further problem with the regulatory proposals with respect to trailers has arisen in the comments to yesterday’s post with respect to fiduciary duty. If fees are charged directly by the advisor to the investor, then the advisor will have a fiduciary duty towards that client. This is basic, and is currently embedded in the securities laws in the case of secondary trading, where a commission is paid with respect to a trade and the advisor has a number of explicit duties with respect to that trade, e.g., to seek best execution and not to front-run the order.

Now, if one feels that stockbrokers should have a fiduciary duty to clients, that’s all well and good – but is best addressed under the heading “Fiduciary Duty” rather than “Trailer Fees”. Many of the CSA suggested changes have the effect of imposing fiduciary duty on advisors without being quite brave enough to say the word – which is already the subject of a completely different set of regulatory proposals anyway.

It was a mildly positive day for the Canadian preferred share market, with PerpetualPremiums up 8bp, FixedResets flat and DeemedRetractibles gaining 2bp. Volatility was low. Volume was average.

The patron saint of lapdogs is getting a little tarnish on his halo:

There has been quiet talk for some time that Bank of Canada Governor Mark Carney was seriously considering a run at the Liberal leadership but, until this weekend, it was only in the form of whispers.

A Globe report, however, has revealed that Mr. Carney had serious discussions with Liberal party insiders on his ability to defeat Justin Trudeau in a leadership campaign and even stayed at Liberal MP Scott Brison’s house for a period of time – a likely violation of the bank’s conflict of interest guidelines. If true, the allegations reveal a serious lack of judgment and threatens to taint one of the country’s most vital institutions.

I think Carney has done plenty to taint it already – in acting as a stalking horse for his political masters. But our hero can do no wrong:

The Bank of Canada says it’s assessed Mark Carney’s family stay over at the seaside home of the Liberal Party finance critic this past summer and decided he was not in a conflict of interest for accepting this hospitality.

The Official Opposition NDP pointed out, however, that its finance critic could only get a phone call from the Bank of Canada governor when she asked for a meeting.

I mentioned the regulatory proposals on trailer fees on December 13 and will have more to say – in response to a query from an Assiduous Reader – shortly. In the mean-time, there’s a dogfight brewing in the UK:

Peter Hargreaves made himself a billionaire by selling mutual funds through his discount broker, Hargreaves Lansdown Plc. (HL/) Now, as planned rules threaten his business model, he intends to raid fund managers’ profits.

Hargreaves built the firm into the U.K.’s biggest retail broker, the country’s equivalent of Charles Schwab Corp. (SCHW), by selling funds and charging money managers rather than clients. Starting in 2014, U.K. brokers will have to charge clients directly, a move analysts say jeopardizes the firm’s 64 percent profit margin. Hargreaves says funds must eat the cost.

“All the groups are sitting there, smug, thinking we’re getting 0.75 percent and we’re not going to give Hargreaves anything anymore,” Hargreaves, 66, said in an interview at his office in Bristol, western England, where he started the firm in his spare bedroom 30 years ago. “That’s not going to happen. They need to bear some of it.”

The Financial Services Authority, the U.K. regulator, plans to ban brokers from receiving cash from money managers and require investors to pay brokerage fees directly to bolster transparency in an industry where costs are more than double those in the U.S. Hargreaves Landsown has increased earnings sixfold since 2007, and the stock has climbed 65 percent this year in London trading, making it the second-best performer in the FTSE 100 Index. (UKX) Still, the shares have slipped 7 percent this month on concern the rule change will crimp earnings.
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Hargreaves plans to introduce charges to replace the payments, called trail commission in the U.K., which would either be an annual fee based on the value of clients’ assets, a charge for each trade or a combination of the two. He declined to give more details on his pricing plans before the FSA approves the rules. The fees, which he called “competitive,” will probably apply to existing clients’ funds, he said.

A custodial fee charged by discount brokerages will be interesting, to say the least, regardless of how much sense it makes. Geez, I can hear the howls from the DIY guys already … ‘you mean I have to pay as much to hold my ETF (and my common stocks? and my GICs?) as others do to hold their 2.5% MER mutual funds? What?’

What else can we think of by way of unintended consequences? How about tied selling? “Sorry, buddy, but we will no longer allow you to buy ABC funds through your DEF account, because there’s nothing in it for us. We offer DEF funds only.” or how about “If you want to buy the ABC funds, you have to open a ‘Wonder-Gizmo ABC Account’. It’s quite expensive, I’m afraid, and charges have to be paid in person and in cash at our Tuktoyuktuq branch. Here, fill out these forms.”

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums gaining 5bp, FixedResets down 8bp and DeemedRetractibles up 13bp. Volatility was average, but entirely negative. Volume was high.

Northern Securities is under the gun:

Following an expedited hearing held on December 14, 2012, in Toronto, Ontario with notice to Northern Securities Inc. (NSI) and with NSI’s consent, a Hearing Panel of the Investment Industry Regulatory Organization of Canada (IIROC) imposed the following terms and conditions on NSI’s continued approval and Membership:

1. By no later than the close of business on December 31, 2012, NSI must have a fully executed agreement with one or more Dealer Members to assign its client accounts, by bulk transfer, that would result in the transfer of all of NSI’s client accounts from NSI’s carrying broker, Penson Financial Services Canada (“Penson”) by the close of business on January 15, 2013.

2. If NSI does not have a fully executed agreement within the time prescribed in paragraph 1, NSI agrees to assign all of its client accounts to Penson forthwith.

3. As of the close of business on December 31, 2012, as a condition of its continuing approval and Membership, NSI shall (a) cease any sales and advisory activity for retail or institutional customers; and (b) restrict its activities to mergers and acquisitions, research and corporate finance.

4. Notwithstanding paragraph 3, NSI may seek approval from IIROC for any other registrable activities and must seek approval for any change in business set out in paragraph 3.
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Intact Financial, proud issuer of IFC.PR.A and IFC.PR.C, has been confirmed by DBRS:

DBRS Limited (DBRS) has today confirmed Intact Financial Corporation’s (Intact or the Company) Issuer Rating at A (low), its Senior Unsecured Debt at A (low) and its Non-Cumulative Preferred Shares at Pfd-2 (low). The trends are Stable. The Company’s operating subsidiaries continue to be among the strongest performers in the Canadian property and casualty (P&C) insurance industry in terms of underwriting profit and overall profitability.
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With the acquisition of AXA and Jevco, the Company has increased its financial leverage ratio to 27.8%, which is above the top end of our comfort zone for this particular rating category. (While the Company restricts its leverage target to a debt ratio of 20%, the DBRS methodology uses a total debt ratio that includes both debt and preferred shares with a 15% to 25% range for the “A” category). However, the successful integration of the acquired operations, the full realization of synergies and the Company’s ability to pay down debt according to its longer-term funding plan provides continuing confidence in the Company’s financial management. Fixed charge coverage ratios at just below ten times in the most recent nine month period are well above the threshold for the rating category, reflecting the Company’s strong profitability. The Company has indicated that it will retain more of this internally generated capital and use some of it to pay down some of the acquisition debt to help reduce financial leverage. Should Intact not succeed in reducing its financial leverage over the next few years to levels acceptable for an “A”-rated company in this industry, there would be downward pressure on the Company’s ratings.

FBS.PR.C has been confirmed by DBRS at Pfd-2(low):

DBRS has today confirmed the rating of the Class C Preferred Shares, Series 1 (the Preferred Shares) issued by 5Banc Split Inc. (the Company) at Pfd-2 (low). Approximately 2.58 million Preferred Shares were issued at $10 each on December 15, 2011, following the redemption of the Class B Preferred Shares in accordance with their original terms as part of a share capital reorganization. The final redemption date for the Preferred Shares is December 15, 2016.
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The downside protection available to holders of the Preferred Shares as of December 6, 2012, is 61.5%. The confirmation of the rating of the Preferred Shares is based primarily on the level of downside protection and dividend coverage available, as well as on the high credit quality and consistency of dividend distributions on the underlying names in the Portfolio.

The main constraints to the rating are the following:

(1) The downside protection provided to holders of the Preferred Shares is dependent on the value of the shares in the Portfolio.
(2) Volatility of price and changes in the dividend policies of the Canadian banks may result in significant reductions in downside protection from time to time.
(3) The concentration of the entire Portfolio is in the Canadian financial services industry.

There were uneven gains in the Canadian preferred share market today, with PerpetualPremiums gaining 1bp, FixedResets winning 20bp and DeemedRetractibles up 3bp. Volatility was minimal. Volume was below average.