PrefBlog

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

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

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

You can’t trust anybody.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

My other quibble with the author’s conclusion is:

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

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

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

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

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

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

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

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

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

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

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