PrefBlog

Today’s Workers’ Day, so I’m not doing much. Geez, if I get any lazier, I’m gonna have to become an investor advocate!

But I can’t resist commenting on US Pension Bonds:

Pension bonds are making a comeback, as states and cities from Alaska to Philadelphia bet they can use the proceeds to help fill deficits in their retirement funds and still generate a higher return than what they pay in interest.

Officials may sell a record $35 billion of the securities this year after offerings declined since 2003, according to data compiled by Bloomberg. Connecticut issued $2.2 billion of pension debt last month, paying an average rate of 5.88 percent on money state officials project will earn 8.5 percent when invested.

Hmmm … leveraging up a pension account to hell-‘n’-gone … I have to agree with Jon Corzine:

“It’s the dumbest idea I ever heard,” said New Jersey Governor Jon Corzine, the Democrat and former chairman of investment bank Goldman, Sachs & Co.

Naked Capitalism republishes a Financial Times commentary on the CDS basis:

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”

We need more people trading the basis, that’s what we need! Unfortunately, shorting cash bonds is fraught with peril and expense on the borrowing front, so straightforward arbitrage will not happen … what needs to happen is more real-money bond investors willing to write covered CDS as a synthetic bond. As has been noted, though, there are counterparty and convergence problems with such a process so, if it ever happens, it will be the province of big, big shops who can afford to set up a specialty unit.

Avinash Persaud writes in VoxEU on a topic close to my heart: The Inappropriateness of Financial Regulation. He argues that the root of the problem is:

A good bank is one that lends to a borrower that other banks would not lend to because of their superior knowledge of the borrower or one that would not lend to a borrower to which everyone lends because of their superior knowledge of the borrower. Modern regulators believe this is too quaint, and, to be fair, many banks were not any good at it. But instead of removing banking licenses from these banks, regulators decided to do away with relationship banking altogether and promoted a switch away from bank finance to market finance where loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and a control is applied based on public ratings.

… but cautions that …

Almost every economic model will tell you that if all the players have the same tastes (reduce capital adequacy requirements) and have the same information (public ratings, approved risk-models using market prices) that the system will sooner or later send the herd off the cliff edge (Persaud 2000). And no degree of greater sophistication in the modelling of the price of risk will get around this fact.

Instead he suggests that:

• Capital charges (when computing regulatory ratios of financial strength) should be contra-cyclical (rising when credit risk is cheap and vice versa)
• regulation should be based on asset-liability mismatches, not bank/non-bank.
• “requiring banks to pay an insurance premium to tax payers against the risk that the tax payer will be required to bail them out.”

The first item sounds great, but might be a little difficult to apply in practice. Who decides whether risk is cheap or expensive? The weakness of the current system is also its strength: it provides a rules-based framework.

I disagree with the second item. Shadow banks are wonderful and the sector should be encouraged, to ensure the banks don’t get too fat on the fruits of regulation: insurance, central bank access and cheap financing.

The third item sounds like an attempt to intervene in the current UK debate on deposit insurance. The principle is great … let deposit insurance premia vary according to financial strength, as measured by standard capital ratios. I believe – although I’m not sure, and frankly, today I’m too damn lazy to check – that CDIC premia in Canada do vary, at least to some extent.

“Gummy” has announced a new spreadsheet that allows intraday updating of home-made indices. But watch out for dividend ex-dates!

There’s some fairly unclear reporting about BoC Governor Carney’s Senate appearance today. Bloomberg says:

The central bank would be hard-pressed to rescue financial institutions as the U.S. Federal Reserve did with Bear Stearns Cos. earlier this year, Carney hinted.

“People bear the cost of their decisions,” he said. “In the case of financial institutions which would have taken excessive risk, the people who bear the consequences of that are the shareholders and the senior management. There should never have been any doubt about that.”

The Bloomberg story also says, by the way:

Carney said potential losses from the global credit crisis are hard to gauge, because financial institutions have used derivatives to estimate the value of some assets that are difficult to trade. The derivatives have “implied default probabilities” that are “substantially higher” than history would indicate and thus may be overstated, he said.

… which is just what I’ve said about the IMF report. The Bloomberg story was picked up essentially unchanged by the Financial Post. As far as I can tell, the Globe doesn’t mention the Bear Stearns speculation, even in the story about acceptable collateral. The Canadian Press story says:

Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

“If you cannot make a judgment (on the value of an asset), you should not own the security,” Carney told a Senate committee Thursday.

“There is very high value if a situation came about to ensuring the shareholders and senior managers bear the full consequences of their actions,” Carney said.

“The Bank of Canada has a role to become lender of last resort, but we would do that on the advice of the Superintendent of Financial Institutions that the institution is solvent, not because the institution needed money.”

Carney said the central bank would come to the rescue of a chartered bank in the case of a temporary liquidity problem, if the institution had sufficient capital to be considered viable.

But he added if investors and managers thought there would always be a safety net, they would be encouraged to take inordinate risks in order to maximize profits.

What got me interested in this was the implied criticism of the Fed in the first quoted sentence, Mark Carney says the central bank won’t be bailing out Canadian financial institutions like the U.S. government did when the Bear Stearns brokerage, one of the giants of Wall Street, ran afoul of the subprime mortgage mess.

So … did he actually mention BSC or is this merely reporter’s interpretation? Further, he’s saying that they’ll be the lender of last resort to solvent institutions … but BSC was solvent at the time according to all the information I have (which is confirmed by the SEC, which serves the same role that OSFI would serve in such a case) … so there’s no real contradiction there, in the remarks which are directly quoted. The rest is all standard Central Banker Talk and doesn’t need further interpretation.

A good, solid, positive day for the preferred share market. Volume was a little unusual – there were six issues trading in excess of 100,000 shares, but volume breadth was down.

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

Professor Dennis Snower reminds us on VoxEU that the effects of the credit crisis will be with us for a while, due to influences that both lag and interact:

• reduced interbank lending leads to less firm & household lending leads to reduced consumption and investment leads to reduced sales of goods and services leads to lower stock market valuations leads to lower interbank liquidity.
• unpaid mortgages leads to increased foreclosures leads to forced sales leads to lower prices leads to increased foreclosures.
• decreased household wealth leads to lower consumption leads to lower profits leads to lower investment leads to lower employment lads to lower labour income leads to lower consumption
• reduced US lending rates leads to a lower dollar leads to higher import prices leads to inflation leads to lower consumption and investment

Cheery fellow, isn’t he?

With respect to lagging effects, a Reuters story picked up by Calculated Risk quotes S&P:

“Due to current market conditions, we are assuming that it will take approximately 15 months to liquidate loans in foreclosure and approximately eight months to liquidate loans categorized as real estate owned (REO),”

The Fed announced:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

You, too, can be a Fed Watcher! According to me, the most telling change from the March 18 Statement is that April is missing the March sentence “However, downside risks to growth remain.” By me, I’d say the Fed’s done cutting. But what do I know? At least the Bear Stearns guy agrees with me. The fear is, as has often been mentioned here, that cuts in the Fed Funds rate are very broad in effect – perhaps too broad, they may be pushing on a string.

Accrued Interest, while careful not to get too precise, thinks that the 2-year note is cheap:

Unless the Fed’s favorite inflation gauges start rising, or the Fed really believes inflation expectations are rising, there will be no impetus for hikes any time in 2008.

Look back at the 2-year Treasury. The long-term spread between short-term inter-bank lending rates and Treasury rates is about 40bps. So if Fed Funds were going to remain at 2.25% for the next 2 years, fair value for the 2-year Treasury would be 1.85%. So with the 2-year actually in the 2.30% range, the market seems to be expecting Fed Funds to average something like 2.70% over the next 2-years.

Feels to me like that expectation is a bit high. If the Fed holds at 2% for 9 months, the Fed would have to hike 112bps immediately thereafter for Funds to average 2.70%. The hike would have to be more extreme if we used a discounting method rather than a straight average.

I’m not sure how much this analysis should be trusted, because the 2-year / FF spread is very sensitive to economics (it would be most interesting to know precisely how good a predictor of future Fed Funds rates the two year note is. I’m sure this has been looked at – post a link in the comments if you have one). AI has been taken to task in the comments …

Meanwhile, Carney said in Ottawa:

We at the Bank project that the Canadian economy will grow by 1.4 per cent this year, 2.4 per cent in 2009, and 3.3 per cent in 2010. The emergence of excess supply in the economy should keep inflation below 2 per cent through 2009. Both core and total inflation are projected to move up to 2 per cent in 2010 as the economy moves back into balance. There are both upside and downside risks to the Bank’s new projection for inflation; these risks appear to be balanced.

In line with this outlook, some further monetary stimulus will likely be required to achieve the inflation target over the medium term. Given the cumulative reduction in the target for the overnight rate of 150 basis points since December, including the 50-basis-point reduction announced last week, the timing of any further monetary stimulus will depend on the evolution of the global economy and domestic demand, and their impact on inflation in Canada.

Month end was no great shakes, with routine volume and few significant price changes. Of note was W.PR.H which, after a day of weakness, fell out of bed completely in the last hour.

And that’s another month! CPD finished the month with the same NAVPS as last month: $17.60, total return zip, zero, zilch. My actively managed fund did much better, returning … somewhere between 0.50% and 1.00% … the precise value, in all its four-decimal-place glory, will be posted on the weekend.

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

OK, finance geeks, there’s a big treat for you today! I’ve had a little look at the Fed’s push to accellerate payment of interest on reserve balances:

The Fed got the authority to start paying interest in October 2011 under the Financial Services Regulatory Relief Act of 2006, signed into law on Oct. 13, 2006. The reason for the late implementation was budgetary. Paying interest on reserves will reduce the amount of income the Fed earns on its securities portfolio and remits to Treasury each year. Congress pushed back the date of implementation to minimize the near-term impact on the deficit.

The cost isn’t astronomical. The Congressional Budget Office estimated that the cost in the first year would be $253 million, rising to $308 million by the fifth year, for a total $1.4 billion over five years.
…
The Fed has already raised the issue with Congress, although it hasn’t made a formal push. Getting Congress to agree to swallow the cost a few years early in principle shouldn’t be hard since Congress has already set aside its adherence to the principal of “Paygo” — that all revenue reductions and cost increases need to be offset elsewhere. The Fed could also further reduce the cost by arranging to pay interest only on excess reserves — the amount that exceeds the required minimum.

The idea of paying interest on reserve balances was mentioned briefly on PrefBlog in the post US Fed and Negative Non-Borrowed Reserves, which was largely a copy/paste from January 29, 2008. The former post has just been updated, by the way, with a note from the Fed confirming that negative non-borrowed reserves is a mathematical triviality.

As mentioned there, the Fed has advocated interest payments on reserves for a long time:

The Fed has long advocated the payment of interest on the reserves that banks maintain at Federal Reserve Banks. Such a step would have to be approved by Congress, which traditionally has been opposed because of the revenue loss that would result to the U.S. Treasury. Each year the Treasury receives the Fed’s revenue that is in excess of its expenses. The payment of interest on reserves would, of course, be an additional expense to the Fed.

The Fed didn’t put a number on this additional expense but, as noted above, the Congressional Budget Office did … roughly $250-million to $300-million annually.

The Fed’s arguments in favour of the idea are two-fold, based on ideas of market efficiency and considerations of monetary policy implementation, as described by then-governor Laurence Meyer in 1998:

Reserve requirements are now 10 percent of all transaction deposits above a threshold level. Requirements may be satisfied either with vault cash or with balances held in accounts at Federal Reserve Banks. Depositories have naturally always attempted to reduce such non-interest-bearing balances to the minimum. For over two decades, some commercial banks have done so in part by sweeping the reservable transaction deposits of businesses into nonreservable instruments. These business sweeps not only avoid reserve requirements, but also allow firms to earn interest on instruments that are, effectively, equivalent to demand deposits.

In recent years, developments in computer technology have allowed depositories to begin sweeping consumer transaction deposits into nonreservable accounts. In consequence, the balances that depositories hold at Reserve Banks to meet reserve requirements have fallen to quite low levels. These consumer sweep programs are expected to spread further, threatening to lower required reserve balances to levels that may begin to impair the implementation of monetary policy. Should this occur, the Federal Reserve would need to adapt its monetary policy instruments, which could involve disruptions and costs to private parties as well as to the Federal Reserve. However, if interest were allowed to be paid on required reserve balances and on demand deposits, changes in the procedures used for implementing monetary policy might not be needed.
…
The prohibition of interest on demand deposits distorts the pricing of transaction deposits and associated bank services. In order to compete for the liquid assets of businesses, banks set up complicated procedures to pay implicit interest on what are called compensating balance accounts.
…
The payment of interest on required reserve balances could remove the incentives to engage in such reserve avoidance practices.

These arguments were largely repeated by then-governor Donald Kohn in 2004:

In conclusion, the Federal Reserve Board strongly supports, as its key priorities for regulatory relief, legislative proposals that would authorize the payment of interest on demand deposits and on balances held by depository institutions at Reserve Banks, as well as increased flexibility in the setting of reserve requirements. We believe these steps would improve the efficiency of our financial sector, make a wider variety of interest-bearing accounts available to more bank customers, and better ensure the efficient conduct of monetary policy in the future.

One gets the feeling that the Fed, if required, could supply an entire bibliography of its attempts to obtain this authority! So could the Treasury!

They finally got their wish in 2006:

Law Passed to Pay Interest on Reserves, Effective in 2011
The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve banks to pay interest on reserve balances and gave the Board of Governors authority to lower reserve requirements on all transaction deposits (applied to deposits above a certain threshold level) to as low as zero percent, from their previous minimum top marginal requirement ratio of eight percent. These changes are not effective until October 2011.

I must confess failure in attempting to determing whether Fed Funds Loans are currently themselves reservable. The Reserve Maintenance Manual doesn’t cite these transactions explicitly. Sorry!

Now, there is some concern that this move will reduce interbank lending:

Reserve balances are like checking accounts: they don’t earn interest. For that reason banks have little incentive to hold more reserves than they need to meet the Fed’s requirements and clear transactions. Any excess reserves are loaned to other banks. As Greg Ip explains, “if the Fed paid, say, 2% interest on reserves, banks would have no incentive to lend out excess reserves once the federal funds rate fell to that level.”

This measure would lead to a higher equilibrium level of reserve balances, for a given value of the federal funds interest rate. It would also reduce the amount of inter-bank lending, as banks would keep more of their cash in their safe-deposit box at the Fed. That lending would be replaced by loans from the Federal Reserve.

… and, of course, we can always rely on Naked Capitalism to highlight scary bits.

One of the objectives in paying interest on reserve balances is, in fact, to ensure that reserve balances are still held, as explained by Governor Kohn in 2003:

However, if interest rates were to return to higher levels, sweep activity could intensify again and potentially become a concern. To prevent the sum of required reserve and contractual clearing balances from dropping even lower and to diminish the incentives for depositories to engage in wasteful reserve-avoidance activities, the Federal Reserve has long sought authorization to pay interest on required reserve balances and to pay explicit interest on contractual clearing balances. H.R. 758 would provide such authorization. With interest paid on required reserve balances, some sweep programs would likely be unwound, and new programs would be less likely to be implemented, thereby helping to boost the level of such balances. Eliminating such wasteful reserve-avoidance activities would also tend to improve the efficiency of the financial sector.

Payment of explicit interest on contractual clearing balances could result in an increase in the level of these balances; some depositories are currently constrained in the amount of such balances that can earn usable credits because of their limited use of Federal Reserve services. Moreover, payment of explicit interest would help to maintain the level of clearing balances at a time of rising interest rates. At present, some depositories pay for all their Federal Reserve services with credits earned on clearing balances; these institutions would not be able to use their additional credits if interest rates were to rise. If enough institutions were in this position, contractual clearing balances might drop below levels needed to be helpful for the implementation of monetary policy. With explicit interest, the level of balances on which interest could be effectively earned would not be limited to the level of charges incurred for the use of Federal Reserve services. Therefore, these depositories would not be impelled to reduce their balances when interest rates rise.

In other words, the Fed wants to be able to influence the market via the Fed Funds rate (as well as through reserve requirements, the discount rate and the hoped-for rate paid on reserves), but it won’t be able to do so if there is no Fed Funds market. In addition to the projected business efficiencies to be gained by allowing interest to be paid on demand deposits, the Fed hopes, by paying interest on the balances, to encourage participants to participate in the market in the first place.

There has been an interesting dust-up in the normally sedate world of analyst reports on Canadian banking … Citibank says Royal Bank of Canada might have billions in credit losses this quarter and Royal Bank says that’s horse-patootie. The analyst report is here (hat tip:Yahoo Message Boards). Citibank, by the way, is raising yet another $3-billion equity.

Via Bloomberg comes news that Markit is establishing a Municipal CDS Index. Whether or not contracts on this index will have a delivery option is unclear – I sure hope it does! Markit, by the way, is engaging in a live test of their disaster recovery plan:

Due to a flood in the London Bridge area which has caused an evacuation of the entire More London business district, Markit Group London is currently operating from its Disaster Recovery (DR) site. We appreciate your support whilst we strive to maintain full delivery of our products and services.

… good luck to them!

The Royal Bank new issue closed successfully, but had little impact on the overall market, in which volumes were normal and significant price changes rare.

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

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.
…
“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.