PrefBlog

Revolving door regulation is usually more subtle than this:

Lerner, 60, pleaded guilty this week to public-corruption charges. Commerzbank hired him from the Internal Revenue Service in 2011 while he was an examiner responsible for negotiating a tax-fraud settlement with the bank, according to the criminal complaint that prosecutors filed in September. Commerzbank paid the IRS $210 million one day before offering Lerner the job, which he accepted immediately. The figure was 62 percent of the potential taxes due. Bank employees later told federal investigators it had been willing to pay much more money to settle the audit.
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The government’s complaint said Lerner met in New York with unidentified Commerzbank executives in July and August 2011 to discuss the IRS’s audit and his possible employment at the bank. After Lerner told the IRS he was resigning in August 2011, his supervisor there gave him a document describing his lifetime prohibition on attempting to influence IRS employees regarding matters he had worked on at the agency. Lerner’s resignation letter didn’t identify Commerzbank as his new employer. Later that month, Lerner participated in a meeting at the IRS about the bank’s settlement, according to the government’s complaint.

The $210 million tax settlement Lerner negotiated with Commerzbank was still pending final approval when he left the IRS. After Lerner began working at Commerzbank in September 2011, the government said he spoke repeatedly with IRS examiners involved in the audit, asking about the status of the case and arguing on Commerzbank’s behalf to bring it to a close. Some of the discussions took place with another Commerzbank employee present.

I have previously criticized Modigliani-Miller in the context of bank capitalization. Here’s another critique:

Capital gains on a private equity investment reflect any value added in restructuring the company, for example by raising revenues and increasing margins. These gains should, to a certain extent, be determined by the skill of the general partner in setting strategy and, in some cases, introducing new management. But they are also a function of deal leverage: in certain cases, the total cost of an acquisition will fall with the amount of debt funding used, implying that returns can be increased through greater leverage.[Footnote]

[Footnote reads:] This results from a failure of the Modigliani-Miller (M-M) Capital Irrelevance Theorem (1958). A failure of M-M rests on there being financial frictions that distort the relationship between the cost of debt and the amount of equity. If capital markets were fully efficient, the capital structure of a transaction would have no impact on its overall cost of funding. A variety of information and incentive problems and policy distortions (for example the tax deductibility of debt) are widely believed to cause deviations from this theoretical equilibrium.

That paper, by the way, had the usual things to say about private equity:

Private equity fund performance and leverage

Data published by trade bodies (for example, the British Venture Capital Association and European Venture Capital Association) show that buyout fund returns consistently outperform other forms of private equity investment, as well as other, alternative, asset classes.

Academic studies, however, reveal more mixed results. For example Kaplan and Schoar (2005) and Phalippou and Gottschalg (2009) show that private equity funds earn gross returns that exceed the S&P 500 average, but that once fees are taken into account, the net return is equal to or lower than S&P 500 average returns.

Axelson, Strömberg and Weisbach (2009) highlight the procyclical nature of the private equity industry, with a theoretical paper arguing that general partners have the incentive to invest in ‘bad deals’ in periods of loose credit conditions. A follow-up empirical paper by Axelson et al (2012) finds that variation in economy-wide credit conditions is the main determinant of leverage in buyouts, and that greater deal leverage is associated with higher deal values and lower investor returns.

That paper appeared in The Bank of England Quarterly Bulletin. One interesting point they made was:

Click for Big

The lack of primary issuance has made it difficult to know for certain at what cost UK banks would be able to finance themselves were they to issue new debt. Available secondary market bond spreads imply that there has been little change in the cost of market funding over the period (Chart 7).

Meanwhile, UK bank credit default swap (CDS) premia, which represent the cost of insuring against default on bank debt, and are sometimes used as an indicative measure of long-term wholesale market funding costs, have fallen (Chart 7). But they remain well above comparable secondary market bond spreads. That gap reflects, in large part, the lack of supply of cash bonds, in conjunction with limited arbitrage between the cash and CDS markets. On balance, while contacts tend to consider secondary market spreads to be a better proxy of bank funding costs than CDS, it may be that secondary spreads would rise were banks to begin to issue more debt.

Stacey Anderson, Jean-Philippe Dion and Hector Perez Saiz have published a BoC Working Paper titled To Link or Not To Link? Netting and Exposures Between Central Counterparties:

This paper provides a framework to compare linked and unlinked CCP configurations in terms of total netting achieved by market participants and the total system default exposures that exist between participants and CCPs. A total system perspective, taking both market participant and CCP exposures into account, is required to answer an important policy question faced by some smaller jurisdictions: whether or not to consider linking a domestic CCP with one or more offshore CCPs. Generally, a single global CCP results in the lowest total system exposure as it allows for multilateral netting across all participants while avoiding the creation of inter-CCP exposures via links. However, global clearing may not be appropriate for all markets. Using a two country model, with a global CCP serving both markets and a local CCP clearing only domestic country participants’ transactions, we show that establishing links between two CCPs leads to higher exposures for the domestic CCP and can result in a decrease in overall netting efficiency and higher total system exposures when the number of participants at the local CCP is small relative to the number of participants at the global CCP. As the relative weight applied by decision makers to CCP exposures as compared to market participants’ exposures increases, so does the number of domestic participants required to make the linked case preferred from a total system perspective. Our results imply that the establishment of a link between a small domestic CCP and a larger global CCP is unlikely to be desirable from a total system perspective in the majority of cases.
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Establishing links between CCPs in di¤erent jurisdictions could allow any of the above mentioned lost netting opportunities to be regained. Links are contractual agreements whereby two CCPs agree to multilaterally net exposures across their combined membership. Market participants, through their access to a linked domestic CCP, would therefore net exposures across a broader range of counterparties. The creation of links between CCPs does, however, pose challenges. By creating credit exposures between CCPs themselves, links create new channels for risk propagation. If a linked CCP were to default, the surviving CCP would need to ful…ll the contractual obligations of cleared contracts to its members. Although not the subject of this paper, links may also create oversight challenges due to additional operational, legal and liquidity risks and increase complexity while reducing the transparency of exposures in the clearing system (CGFS (2011)).

I am pleased to see an acknowledgement that placing all of one’s eggs in a single Too Big To Fail basket is not necessarily a wonderful idea. Perhaps at some point the Bank will sponsor research into risk propogation via CCPs, but I’m not holding my breath on that one.

There’s an interesting point in Rohinton Medhora’s Global rankings: Although inequality between countries is falling, inequality within countries is rising:

>First, integral to the rise of the South is the growth of a middle class the world over. Citing a Brookings Institution study, the UN report estimates that the middle class numbered 1.8 billion in 2009, about one billion of whom lived in Europe and North America. Globally, the number is expected to rise to 3.3 billion in 2020 and 4.9 billion in 2030, the entire growth occurring in Asia, Africa and Latin America.

At the same time, although inequality between countries is falling, inequality within countries – especially the growth success stories such as China and India – is rising.

Just like their counterparts in developed countries, policymakers in developing countries will increasingly be preoccupied with managing middle-class vulnerability. Their challenge will be to fight inequality, not poverty, so as to preserve political stability.

So now, instead of the also-rans in rich countries living well by sponging off the local hot-shots at the expense of everybody in poor countries, we now have more localized inequality that can’t be enforced militarily. It will be most interesting to see how the localized tension plays out…

On an obscurely related note, I had great fun today arguing in favour of a downtown casino in the Globe’s comments section. My comment is the most disliked comment of all – the place of honour!

DBRS confirmed Enbridge Gas Distribution at Pfd-2(low):

EGD’s low business risk profile is supported by a large customer base (approximately two million customers, the largest in Canada), which has allowed the Company to achieve operational efficiency and generate stable earnings and cash flow. In 2013, the rebasing year, EGD’s approved return on equity increased to 8.93% (8.39% in 2012) and distribution rates increased to $1,021 million ($1,004 million in 2012). However, the deemed equity component of the Company’s capital structure remained unchanged at 36%. The Company benefits from a stable regulatory system, having no exposure to gas price risk in Ontario, where it generates approximately 98% of its revenue. EGD’s franchise area (largely in the Greater Toronto Area) is viewed as one of the most rapidly growing and economically strong service areas in Canada. Approximately 94% of the Company’s earnings are generated from relatively stable regulated distribution, transportation and storage business. The remainder is generated from the unregulated storage business, which benefits from strong demand due to its strategic locations.

Note that Enbridge Gas Distribution is a different company than Enbridge Inc., which is its parent:

The Company owns 100% of the outstanding common shares of EGD; however, the four million Cumulative Redeemable EGD Preferred Shares held by third parties are entitled to a claim on the assets of EGD prior to the common shareholder. The preferred shares have no fixed maturity date and have floating adjustable cash dividends that are payable at 80% of the prime rate. EGD may, at is option, redeem all or a portion of the outstanding shares for $25 per share plus all accrued and unpaid dividends to the redemption date. As at December 31, 2012, no preferred shares have been redeemed.

EGD’s Annual Report (SEDAR) states these are:

Group 3, Series D, Fixed / Floating Cumulative Redeemable
Convertible

There are four million oustanding at $25.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums up 11bp, FixedResets down 13bp and DeemedRetractibles gaining 4bp. Volatility was low. Volume was below average.

To the astonishment of many, a Senate committee criticized a bank:

JPMorgan Chase & Co. (JPM) Chief Executive Officer Jamie Dimon sought to hide escalating trading losses that surpassed $6.2 billion, misled investors and dodged regulators as a “monstrous” derivatives bet deteriorated last year, a Senate probe found.

The largest U.S. bank “mischaracterized high-risk trading as hedging,” and withheld key information from its primary regulator, sometimes at Dimon’s behest, according to a report yesterday by the Senate Permanent Subcommittee on Investigations. The 301-page document also shows how managers manipulated internal risk models and pressured traders to overvalue their positions in an effort to hide growing losses in a credit derivatives portfolio in London.

“We found a trading operation that piled on risk, ignored limits on risk taking, hid losses, dodged oversight and misinformed the public,” Chairman Carl Levin, a Michigan Democrat, told reporters yesterday after his investigators spent nine months combing through 90,000 documents and interviewing current and former executives.

The full report is available on the committee’s website. The conclusion is fore-ordained:

The JPMorgan Chase whale trades provide a startling and instructive case history of how synthetic credit derivatives have become a multi-billion dollar source of risk within the U.S. banking system. They also demonstrate how inadequate derivative valuation practices enabled traders to hide substantial losses for months at a time; lax hedging practices obscured whether derivatives were being used to offset risk or take risk; risk limit breaches were routinely disregarded; risk evaluation models were manipulated to downplay risk; inadequate regulatory oversight was too easily dodged or stonewalled; and derivative trading and financial results were misrepresented to investors, regulators, policymakers, and the taxpaying public who, when banks lose big, may be required to finance multi-billion-dollar bailouts.

However, there are points of interest for the connoisseur. It appears that gross incompetence in back- and mid- offices is still just as much a problem as it ever was:

For five days, from March 12 to 16, 2012, Mr. Grout prepared a spreadsheet tracking the differences between the daily SCP values he was reporting and the values that would have been reported using midpoint prices. According to the spreadsheet, by March 16, 2012, the Synthetic Credit Portfolio had reported year-to-date losses of $161 million, but if midpoint prices had been used, those losses would have swelled by another $432 million to a total of $593 million.
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One result of the CIO’s using more favorable valuations was that two different business lines within JPMorgan Chase, the Chief Investment Office and the Investment Bank, assigned different values to identical credit derivative holdings. Beginning in March 2012, as CIO counterparties learned of the price differences, several objected to the CIO’s values, resulting in collateral disputes peaking at $690 million. In May, the bank’s Deputy Chief Risk Officer Ashley Bacon directed the CIO to mark its books in the same manner as the Investment Bank, which used an independent pricing service to identify the midpoints in the relevant price ranges. That change in valuation methodology resolved the collateral valuation disputes in favor of the CIO’s counterparties and, at the same time, put an end to the mismarking.
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According to Ina Drew, the large collateral disputes generated a series of questions internally about the CIO’s valuation process. She told the Subcommittee that Jamie Dimon “felt that one way to find out [about the validity of the disputes] was to ask [head of the CIO’s International Office] Mr. Macris, [head of the CIO’s equity and credit trading operation] Mr. Martin, and [senior CIO trader] Mr. Iksil to narrow the bid-offer spreads.

Two months to resolve a collateral deficiency? and at J.P. Morgan, collateral disputes being resolved by the trading department? Ridiculous.

Westjet hopes to have seen the last of Ottawa’s golden boys:

Competitor WestJet Airlines Ltd., which has a very different pension structure based on share purchase plans rather than Air Canada’s more traditional pension packages, opposed the arrangement. “While we recognize this has been a difficult decision for the government, we are disappointed with this announcement,” said WestJet president and chief executive officer Gregg Saretsky.

“We are supportive of a strong and competitive aviation industry in Canada. To that end, we trust this marks the end of special treatment for Air Canada as such treatment at the expense of other industry players has become too common,” he added in a written statement.

They (and we) will be lucky. Air Canada isn’t good at much, but it is good at sucking federal arse.

Capital Power Corporation, proud issuer of CPX.PR.A, CPX.PR.C and the new CPX.PR.E, was confirmed today at Pfd-3(low) by DBRS:

DBRS has today confirmed the ratings of the Preferred Shares of Capital Power Corporation (CPC or the Company) at Pfd-3 (low) with a Stable trend. CPC’s preferred shares rating is based on the credit quality of its subsidiary, Capital Power L.P. (CPLP; rated BBB). The one-notch differential in the ratings of CPC and CPLP reflects structural subordination at CPC, which is largely dependent on its own resources and dividends from CPLP. Dividends from CPLP could be curtailed if the viability of CPLP needs to be safeguarded.
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CPC has no debt issued at the parent level and is not expected to issue any debt in the foreseeable future. In March 2013, CPC issued $200 million of preferred shares, with the net proceeds (approximately $194 million) to be lent to CPLP to repay the outstanding balance under its credit facilities and to finance growth projects, including the Shepard Energy Centre. Pro forma the $194 million issuance, CPC will have $462 million of preferred shares outstanding, $131 million of which is treated as debt by DBRS in CPC’s adjusted debt-to-capital calculation (with a pro forma adjusted debt-to-capital ratio of approximately 6%). In the adjusted debt-to-capital calculation, the amount of preferred shares over the 20% preferred shares-to-equity threshold (defined as the percentage of preferred shares outstanding divided by total equity, excluding preferreds and minority interest) is treated as debt. CPC’s adjusted debt-to-capital ratio remains in line with its rating category. In addition, the pro forma unconsolidated fixed charge coverage ratio is expected to remain high, at above five times.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums gaining 3bp, FixedResets down 8bp and DeemedRetractibles off 1bp. Volatility was minimal, but the floaters continue their usual gyrations. Volume was average.

Boyd Erman made some good points on mortgages yesterday:

Imagine the federal government lauding cellphone carriers for keeping rates high, or airlines for declining to match each other’s fare cuts. There would be an outcry. Yet Finance Minister Jim Flaherty congratulates banks for not competing to offer the best loan price on what will likely be the biggest purchase most Canadians’ ever make, their home, and nobody can gin up much outrage.
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Mortgage debt seems to becoming one of those perceived ills, like booze and cigarettes, where the government not only regulates how they can be sold, but sets minimum prices aimed at preventing people from overindulging. If that’s the case, maybe the government ought to come right out and say it.

I don’t agree with everything he said, but by and large – well done, Mr. Erman!

I mentioned the Too-Big-To-Fail subsidy on March 11 and complained that the banks’ rebuttal of estimates of the subsidy’s size was not available. Well, it has finally been released:

the Financial Services Forum, the Financial Services Roundtable, The Clearing House, Securities Industry and Financial Markets Association, and the American Bankers Association, released the following policy brief in response to questionable assertions of a “taxpayer subsidy” to large banks. The following points should be kept in mind:

• The recent estimation that large banking companies enjoy a subsidy worth $83 billion is based on a flawed methodology, and on the extrapolation of stale and unreliable financial market data collected before passage of the Dodd-Frank Act.
• An IMF analysis completed in 2010 – before passage of Dodd-Frank – estimated the cost of funding advantage enjoyed by large banking companies to be only “about 20 basis points on average.”
• Several more recent studies indicate that, since the passage of Dodd-Frank, any cost of funding advantage has been dramatically reduced or even eliminated. In fact, two recent studies conclude that markets are now imposing a cost of funding premium on large banks of up to 35 basis points.

Bloomberg’s editors continue the debate:

Finally, the two papers by Cyree and Balasubramnian represent good-faith efforts that the authors readily admit are far from ideal. They found that big banks’ borrowing costs increased relative to those of small banks in the second half of 2010, and attributed the change to Dodd-Frank’s elimination of the subsidy. They employed data on 30 banks, only 11 of which were not too big to fail, a small sample that might have skewed the estimated funding advantages of the bigger institutions. Also, their statistical controls could have missed important factors — such as the brewing European debt crisis — that might have had a differential effect on the borrowing costs of the biggest banks.

As Cyree put it: “I can’t tell you that this is strictly due to Dodd-Frank.”

Of course, no statistical study is perfect, particularly when dealing with something as difficult to estimate as the bank subsidy. That said, a paper by three economists — Viral Acharya of New York University, Deniz Anginer of Virginia Tech and A. Joseph Warburton of Syracuse University — looked at a larger sample of financial institutions and found that the too-big-to-fail subsidy amounted to almost $100 billion in 2010, the year Dodd-Frank was signed into law. The paper also included a separate test, which looked at bond yields immediately before and after the House and Senate reconciled their versions of the bill. It suggested that Dodd-Frank might have actually increased the subsidy.

One thing Bloomberg pointed out was a cheap-shot by the bank lobbyists:

Given these analytic shortcomings, it is not surprising that the title page of the paper bears a boxed disclaimer stating in bold font: “This working paper should not be reported as representing the views of the IMF.”

Bloomberg points out:

The disclaimer is standard boilerplate for IMF working papers.

I’m not aware of any central-bank-style research that does not carry such a disclaimer. The banks’ attempt to make it appear to be a deliberate distancing of the IMF from the research does nothing but harm their own credibility.

It would appear that there are now so many regulators they can’t all be hired by banks, so they’re widening the net:

A series of proposed rule changes from the country’s securities regulators would make hostile takeover bids harder to pull off, tightening a regime critics say has rendered corporate Canada easy hunting grounds for U.S. hedge funds.

On Wednesday, the Canadian Securities Administrators (CSA), which is the umbrella group for Canada’s provincial market watchdogs, officially unveiled its proposal to lower the “early warning” stock ownership threshold that forces would-be hostile takeover bidders to disclose their holdings in a target company. As previously reported in The Globe, bidders would have to go public after acquiring 5 per cent of a target company’s shares, down from 10 per cent. The CSA says the change would improve “market transparency.”

And on Thursday, the CSA will formally unveil a long-awaited proposal that would strengthen what are known as “poison pills”: tactics used by boards of directors to try to fend off hostile takeover bidders. The plan would see securities regulators allow companies to use poison pills indefinitely, provided they are approved by shareholders at the most recent annual meeting or at a special meeting held in the face of a hostile bid.

It was a mild day for the Canadian preferred share market (except for RON.PR.A!), with PerpetualPremiums flat, FixedResets off 4bp and DeemedRetractibles down 5bp. Volatility was muted. Volume was average.

PerpetualDiscounts now yield 4.82%, equivalent to 6.27% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.35%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 210bp, unchanged from the figure reported on March 6.

The What-Debt? government has given more help to its buddies at Air Canada:

The federal government has approved Air Canada’s request for a reprieve from funding its pension deficit, but has imposed a host of conditions – including a freeze on executive pay and a ban on dividends or share repurchases.

The deal requires the airline to make contributions to the plan of at least $150-million a year totalling at least $1.4-billion over seven years. The special contributions would be on top of the current service payments required by the pension plan.

More micro-managing and more interference in labour relations! This follows a suspension of the right to strike and protection from competition.

It was a fine day for the Canadian preferred share market, with PerpetualPremiums up 9bp, FixedResets winning 20bp and DeemedRetractibles gaining 7bp. Volatility was minimal. Volume was high.

Moody’s points out that the stock of US investment grade corporate bonds is heavily weighted towards lesser credits:

It would be remiss not to add that the risk profile of the US investment-grade corporate bond market also has risen considerably. Given how the share of investment-grade bonds outstanding rated either A3 or Baa has soared from year-end 2007’s 31% to year-end 2012’s record 62%, it’s unlikely that the investment-grade bond yield spread might quickly return to its medians of the two previous recoveries of 103 bp for industrial companies and of 78 bp for financial companies. According to Barclays Capital, these spreads were recently at 135 bp for the industrials and 138 bp for the financials. (Figure 8.)

In conclusion, this very much remains a subpar recovery of above-average risk. What happens to business sales and profits will not only determine the durability of the latest equity rally, it will also have much to say about whether or not Treasury bond yields rise and credit spreads narrow.

Click for Big

The Too-Big-To-Fail Banks, not surprisingly, claim there is no Too-Big-To-Fail subsidy:

Lobby groups for the largest U.S. banks pushed back against claims that they remain too big to fail, rebutting assertions by lawmakers and regulators that they enjoy a “taxpayer subsidy” because of their size.

The Dodd-Frank Act, passed by Congress in response to the 2008 credit crisis, greatly diminished whatever advantage the biggest lenders held over smaller rivals, five industry groups wrote today in a brief on the issue. Senator Elizabeth Warren, a Massachusetts Democrat, used outdated information when she raised the matter at a hearing last month, the groups said.

“There is substantial evidence that the market recognizes the impact Dodd-Frank has had on investor expectations,” the Clearing House, Financial Services Forum, Financial Services Roundtable, Securities Industry and Financial Markets Association and American Bankers Association said in their brief. “Given the sizable costs associated with new regulations, together with the new orderly liquidation framework, any purported TBTF-related funding advantage has clearly been reduced or even eliminated.”

I can’t find the actual brief, even when looking at tweets from the Financial Services Roundtable – the links don’t work. Perhaps they’re waiting for the recipients to publish it before making it public.

Bloomberg published a good article on complexity:

A highly unusual collaboration between economists and scientists offers an important insight for those who want to fix the world’s crisis-prone financial system: There’s no simple way to understand a complex network.

This month’s issue of the research journal Nature Physics features a handful of papers in which physicists, other natural scientists and leading experts in economics and finance — including prominent banking regulators and Nobel Prize-winning economist Joseph Stiglitz — put their minds together to figure out finance. What the scientists bring to the table is experience in studying networks, bewildering tangles of interlinked and interdependent things such as an ecological food web or the Internet.
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Fifty years ago, ecologists interested in the stability of food webs at first mistakenly concluded that more complexity — more species and a greater density of links among them — would tend to make an ecosystem more stable. This turned out to be wrong. Later work by noted ecologist Robert May demonstrated that while healthy ecological networks are rich and diverse, too much complexity tends to make them unstable and prone to collapse. Loosely speaking, networks with too much complexity can go wrong in too many ways.

One of the papers referenced was by Caccioli, Marsili and Vivo, titled Eroding market stability by proliferation of financial instruments:

We contrast Arbitrage Pricing Theory (APT), the theoretical basis for the development of financial instruments, with a dynamical picture of an interacting market, in a simple setting. The proliferation of financial instruments apparently provides more means for risk diversification, making the market more efficient and complete. In the simple market of interacting traders discussed here, the proliferation of financial instruments erodes systemic stability and it drives the market to a critical state characterized by large susceptibility, strong fluctuations and enhanced correlations among risks. This suggests that the hypothesis of APT may not be compatible with a stable market dynamics. In this perspective, market stability acquires the properties of a common good, which suggests that appropriate measures should be introduced in derivative markets, to preserve stability.

This basic thesis has been known for some time. One of the reasons the US long bond futures contract was designed the way it was – with Cheapest To Deliver options for the seller, as well as a certain amount of leeway in delivery times – was to make it more complex. More complexity makes it harder to analyze, which encourages liquidity since there will be a range of views regarding the fair price of the instrument given the same data from the physical market.

In practice, markets are never perfectly liquid. The very fact that information can be aggregated into prices, requires that prices respond to trading (see e.g. [6] for evidence on FX markets or [5] for equity markets). In other words, it is because markets are illiquid that they can aggregate information into prices. Liquidity indeed is a matter of time scale and volume size [4, 5]. This calls for a view of financial markets as interacting systems. In this view, trading strategies can affect the market in important ways. Both theoretical models and empirical research, show that trading activity implied by derivatives affects the underlying market in non-trivial ways [10].
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The aim of this paper is to contrast, within a simple framework, the picture of APT with a dynamical picture of a market as an interacting system. We show that while the introduction of derivatives makes the market more efficient, competition between financial institutions naturally drives the market to a critical state characterized by a sharp singularity. Close to the singularity the market exhibits the three properties alluded to above: 1) a strong susceptibility to small perturbations and 2) strong fluctuations in the underlying stock market. Furthermore 3) while correlations across different derivatives is largely negligible in normal times, correlations in the derivative market are strongly enhanced in stress times, when the market is close to the critical state. In brief, this suggests that the hypothesis of APT may not be compatible with the requirement of a stable market.
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But it is precisely because these models are simple that one is able to point out why theoretical concepts such as efficient or complete markets and competitive equilibria have non-trivial implications. The reason being that these conditions hold only in special points of the phase diagram where singularity occurs (phase transitions). It is precisely when markets approach these ideal conditions that instabilities and strong
fluctuations appear [13, 14]. Loosely speaking, this arises from the fact that the market equilibrium becomes degenerate along some directions in the phase space. In a complete, arbitrage-free market, the introduction of a derivative contract creates a symmetry, as it introduces perfectly equivalent ways of realizing the same payoffs. Fluctuations along the direction of phase space identified by symmetries can grow unbounded. Loosely speaking, the financial industry is a factory of symmetries, which is why the proliferation of financial instruments can cause strong fluctuations and instabilities. In this respect, the study of competitive equilibria alone can be misleading. What is mostly important is their stability with respect to adaptive behavior of agents and the dynamical fluctuations they support and generate.
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It has been recently suggested that market stability appears to have the properties of a public good [22]. A public good is a good i) whose consumption by one individual does not reduce its availability for consumption by others (non-rivalry) and ii) such that no one can be eectively excluded from using the good (non-excludability). At the level of the present stylized description, the expansion in the repertoire of traded assets introduces an externality which drives the market to unstable states. This suggests that systemic instability may be prevented by the introduction of a tax on derivative markets, such as that advocated long ago for foreign exchange markets by Tobin [23], or by the introduction of “trading permits”, similar to those adopted to limit Carbon emissions [25]. The stabilizing effect of a Tobin tax has already been shown within a model of a dynamic market which is mathematically equivalent to the one presented here [24].
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The proliferation of financial instruments makes the market look more and more similar to an ideal arbitrage-free, efficient and complete market. But this occurs at the expense of market stability. This is reminiscent of the instability discussed long ago by Sir Robert May [20] which develops in ecosystems upon increasing bio-diversity13. For ecologies this result is only apparently paradoxical. Indeed the species which populate an ecosystem can hardly be thought of as being drawn at random, but are rather subject to natural selection. Indeed, on evolutionary time scales stability can be reconciled with bio-diversity, as shown e.g. in Ref. [21]. The diversity in the ecosystem of financial instruments has, by contrast, been increasing at a rate much faster than that at which selective forces likely operate.

While I suspect that a Tobin Tax might indeed work, it’s rather a blunt instrument. Far better to allow selective forces to operate, by allowing bankruptcies and firing incompetents. But nobody ever lost his job in the financial industry for incompetence.

Closer to home, Moody’s is taking care to be cautious:

A severe economic shock, such as the kind that hit Japan in the early 1990s and California and Nevada in 2006, could knock Canadian housing prices down by 44%, according to a formula devised by Moody’s Investors Service to rate securities linked to mortgages.

Such a decline would be driven primarily by the phenomenal upswing in Canadian home prices over the past decade, Moody’s said.

While house prices in Spain could plummet by a more severe 52%, Canada joins Spain, as well as the United Kingdom and Australia, in the ratings agency’s assessment of countries where growth in housing prices over the past 10 years has driven their values away from sustainable market fundamentals and into “overheated” territory.

… but TD emphasizes the central distribution of probabilities:

Canada’s real estate bonanza of the past decade has come to end and the long-term trend as one of the most profitable places to invest is also not encouraging, a new research paper from the TD Bank argues.

The “special report” from one of Canada’s largest banks makes the case that gains in housing prices have been exceptionally strong over the last 10 years, even when accounting for a sharp drop during the 2008-09 recession. But now is the time for a bit of a payback.

The report does not predict a collapse in house prices as some analysts have suggested. In fact, it sees prices rebounding after a few years of a correction to as high as eight per cent.

However, the longer term trend is for home price gains to average about two per cent over the next 10 years — flat once inflation is taken into account, says TD chief economist Craig Alexander.
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The problem with the housing collapse scenario, says Alexander, is that typically a sharp correction needs a trigger in terms of a steep increase in interest rates or unemployment, both of which appear unlikely at this point.
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Somewhat surprisingly, the report predicts Vancouver and Toronto, along with Victoria, Edmonton and Calgary will continue to outpace the national average in terms of home prices over the next 10 years.

Vancouver and Toronto are regarded as cities with the most inflated prices — despite recent corrections — but TD argues that the two cities will realize the biggest influx of immigrants, so demand will remain higher. The Alberta cities will do well because of both population growth and higher than average income growth.

Alexander says the two biggest factors in trend home prices are population growth and housing formation, which both favour Toronto and Vancouver.

CU Inc., proud issuer of CIU.PR.A, CIU.PR.B and CIU.PR.C was confirmed at Pfd-2(high) by DBRS:

DBRS has today confirmed the Issuer Rating, Commercial Paper, Unsecured Debentures & Medium-Term Notes and Cumulative Preferred Shares of CU Inc. (CUI or the Company) at A (high), R-1 (low), A (high) and Pfd-2 (high), respectively, all with Stable trends. The rating confirmations are based on CUI’s low business risk, which stems from the regulated nature of its operations supported by a reasonable regulatory environment; strong portfolio of diversified regulated businesses; and solid financial profile.

The Company’s business risk profile is viewed as strong as all of its earnings are generated from regulated electricity and gas businesses, which operate under a relatively stable, albeit evolving, regulatory framework.
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CUI is the highest rated publically owned utility and continues to grow through its investments in low risk assets. The Company has a conservative strategy of funding a significant portion of its capex with internally generated cash flows, conservative dividend payouts and equity injections from its parent (Canadian Utilities Limited; rated “A”). CUI has a proven track record of funding equity in a timely manner to remain in line with its regulatory capital structure. DBRS expects the parent to continue to provide support to CUI, if needed.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums off 4bp, FixedResets up 10bp and DeemedRetractibles down 8bp. Volatility was below average. Volume was average.