PrefBlog

There’s a scuffle brewing over FASB’s proposal that bank loans be marked-to-market:

A U.S. accounting board’s proposal that would require banks to report the fair value of loans on their books will lead to reduced lending, a former chairman of the Federal Deposit Insurance Corp. said.

“This is a terribly destructive idea to even propose,” William Isaac said in a telephone interview today. Just by making the proposal, the Financial Accounting Standards Board will lead banks to quit making loans without an easily discernable market value, and keep the ones they do make to shorter maturities, Isaac said.
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The proposal comes “in the face of worldwide condemnation,” Isaac said. It conflicts with the recommendations of the Group of 20 nations, the Basel Committee on Banking Supervision and the International Accounting Standards Board, according to the American Bankers Association, which also opposes the plan.

David Larsen, who serves on FASB’s Valuation Resource Group, said the volatility created by markets and fair value “is there whether or not it is measured.”

“It comes down to the question, is greater transparency of help to users of financial statements?” said Larsen, a managing director at New York-based Duff & Phelps Corp.

Mark-to-market accounting destroyed $500 billion of bank capital as traders marked down all assets during the crisis by a total of 27 percent, and many of those values have now returned to near par, Isaac said. “Now FASB is going to spread this disease throughout the system,” he said.

The trouble with mark-to-market is that it assumes an infinitely liquid market. Sometimes, this embedded assumption gets a little frayed around the edges.

Congrats to my nephew Sam Arfin:

TORONTO INVITATIONAL

Rowing – Champions … Boys’ – 1000 m T1x – Sam Arfin, Birchmount Park, 4:39; 1000 m T2x – Sam Arfin and Oscar Kahu, Birchmount Park, 4:15;

It was a quiet but positive day for Canadian preferred shares, with PerpetualDiscounts gaining 15bp and FixedResets up 8bp.

PerpetualDiscounts now yield 6.29%, equivalent to 8.81% interest at the standard equivalency factor of 1.4x. Long corporates now yield 5.65% (maybe a hair more?) after scoring a total return of +0.46% for the month, so the pre-tax interest-equivalent spread (also called the Seniority Spread) now stands at 315bp, a 10bp tightening from the 325bp recorded on May 26.

And that’s it for another month!

Two of the eight new BMO ETFs are of interest:

BMO Long Federal Bond Index ETF (ZFL)
BMO Real Return Bond Index ETF (ZRR)

These have management fees of 20bp and 25bp respectively.

Interesting mea culpa from Scottwood Capital, indicating that yes, there are some investors who believe that a short term credit line will solve structural deficit problems:

As the situation in Greece continued to deteriorate and spread in May, we were indeed watching closely for how that could affect our market and Scottwood’s positions. However, when the EU and IMF announced their $1Trillion rescue package, we believed that that would eliminate many of the – real and perceived – potential macro risks that had been hanging over what had been up to that time extremely healthy and vibrant US credit markets. Our belief was based on the fact that, as opposed to 2008, the Euro governments now had the entire US playbook to show exactly what programs worked (and how, and why) and what did not (and how, and why).

Scottwood does not publish performance figures.

The SEC is holding a public meeting on Market Structure:

The Commission already has proposed rules that would:

• Establish a consolidated audit trail system to help regulators keep pace with new technology and trading patterns in the markets.
• Generally require that information about an investor’s interest in buying or selling a stock be made available to the public, instead of just to a select group operating with a dark pool.
• Effectively prohibit broker-dealers from providing their customers with unfiltered access to exchanges and alternative trading systems and ensure that broker-dealers implement appropriate risk controls.
• Create a large trader reporting system to enhance the Commission’s ability to identify large market participants, collect information on their trades, and analyze their trading activity.

As an old bond buy, I am flabbergasted by point 2. That information is GOLD. I suspect that implentation of point 2 will reduce liquidity, since participants will be less willing to make such indications if it’s going to be broadcast. What’s next? Making it illegal for brokers to work a block trade?

Point 3 also has interesting implications. It would be nice to see Exchange membership opened up to large funds and chip away at the brokerage oligopoly. Unfiltered access was discussed on January 19; to it’s credit, the SEC addressed such a possibility in its request for comments:

The Commission seeks comment on any other potential costs to brokers or dealers that may result from the proposed rule. While the Commission does not anticipate that there would be significant adverse consequences to a broker or dealer’s business, activities, or financial condition as a result of the proposed rule, it seeks commenters’ views regarding the possibility of any such impact. For instance, would the proposed rule impact a broker or dealer’s ability to attract or retain its market access customers? Could a broker or dealer lose order flow, because its customer might seek other arrangements in order to access the securities markets, such as becoming a member of a particular exchange or becoming a broker or dealer? The Commission requests for commenters to quantify those costs, where possible.

I saw what I’m reasonably sure was an Eight-Spotted Forester Moth in my garden today. Apparently my neighbor’s Virginia Creeper is a larval host, which is the first use I’ve ever heard of for the disgusting stuff.

It was another zippetty-doo-dah day in the Canadian preferred share market, with PerpetualDiscounts rocketting up another 57bp, while FixedResets were up 5bp. The gain brings the PerpetualDiscount total return index to its highest level since April 20 and the yields (basically the price index) to their lowest level April 21.

PerpetualDiscounts have returned -0.35% from April 20 and +1.23% month-to-date. Figures for FixedResets are -0.02% and +1.25%, respectively. Three consecutive nice days don’t make a rally – but it’s a lot better than the steady drip-drip-drip of price declines in the sector we’ve been seing all year!

GWO PerpetualDiscounts did especially well on the day, occupying the best five places on the performance table. This was their first day of trading ex-dividend. See comments.

Update, 2010-5-31: Revised figures for PerpetualDiscounts and FixedResets after correction of erroneous dividends (see comments):

The legislation to close the loophole on taxation of “carried interest” (discussed on May 20) has a rather peculiar feature:

Private-equity firms, trying to derail legislation that would boost taxes on their leaders’ pay, are attacking a provision that would make it more costly for executives to sell their own management firms.

The provision, which also would affect operators of hedge funds, would make executives pay ordinary income tax rates on profits from selling a stake in their own management companies. Founders of other types of businesses would remain eligible to pay lower capital-gains rates when they sell. The House is scheduled to vote on the legislation today.
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The sales provision is intended to stop executives at buyout, venture-capital and real-estate partnerships from circumventing the higher taxes on their pay imposed by the bill, said Matthew Beck, a spokesman for the House Ways and Means Committee. Otherwise, he said, fund managers would sell their stake — and pay the lower tax rate — just before receiving income subject to higher taxes.

Well – I haven’t read the legislation and I’m not a tax lawyer anyway. But this sounds like a ridiculous punitive provision that will pass anyway because it bashes those evil Wall Street Types. I find it very difficult to believe that the income vs. Capital Gain question used as justification is applicable only to private equity firms.

Another day of elevated volume and fine returns, as PerpetualDiscounts gained 60bp to take the total return subindex for this class to its highest level since April 21. FixedResets gained 5bp and continue their record of outperforming PerpetualDiscounts from both that date and month-to-date.

Regulatory capture is getting some media attention (hat tip: Financial Webring Forum):

A CBS News analysis of the revolving door between Goldman and government reveals at least four dozen former employees, lobbyists or advisers at the highest reaches of power both in Washington and around the world.

For example, former Treasury Secretary Henry Paulson is a former Goldman CEO; Arthur Levitt, the head of the Securities and Exchange Commission is a now a Goldman adviser; and former House Majority Leader Dick Gephardt is now a paid lobbyist for the firm.

There’s more, less well written. Automatically branding every instance of revolving door regulation as “corruption” is an extreme view; conflicts of interest are everywhere and – even in the finance world! – most people are not crooks.

A lot of it has simply to do with the nature of the world: I’ve seen ads for very senior risk management officials at salaries best described as “pathetic”. Anybody smart enough and knowledgable enough and tough enough to do a good job at the post could make a lot more doing something else.

Hands up who wants, say, the head of the Ontario Securities Commission or the Superintendent of Financial Institutions to get a government salary of – say – $5-million p.a. … didn’t think so.

The influence of retail investors on markets is getting more interesting to track. During the crunch, we saw how US – MMF redemptions exacerbated the funding crisis and forced (encouraged?) the Fed to set up dollar swaps. Now junk bonds are getting the same treatment:

Yields on junk bonds rose to the highest since December relative to Treasuries, with prices declining on debt from American International Group Inc. to Harrah’s Entertainment Inc. on concern Europe’s debt strains will derail the global economic recovery.

Spreads widened 27 basis points yesterday to 724 basis points, or 7.24 percentage points, the highest since Dec. 9, according to Bank of America Merrill Lynch index data. That’s up from a low this year of 542 basis points on April 26.

High-yield debt has lost 4.6 percent in May, on pace for the first drop in 15 months, after gaining 73 percent from the market bottom in March 2009 through last month. Investors withdrew more than $3.1 billion in the past two weeks from junk funds amid growing concern that European efforts to control government deficits would interrupt the recovery, making it harder for the neediest companies to reduce and refinance their borrowings.
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“Due to low levels of cash at mutual funds, redemptions are forcing sales,” said Brian Yelvington, head of fixed-income strategy at Knight Libertas LLC in Greenwich, Connecticut.

This looks like an unintended consequence of the electronic era – now that it is so easy to switch between funds of the same family at 3am, people are doing it. Retail is, in general, more jumpy than institutional money, so it’s interesting to speculate where all this might lead. One possibility is a greater emphasis by issuers on long term debt, paying up if they need to.

Volume picked up today to levels approaching the average of the past two months and PerpetualDiscounts caught fire, gaining 65bp. FixedResets were up 12bp.

PerpetualDiscounts now yield 6.36%, equivalent to 8.90% interest at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.65%, so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 325bp, a mild (and perhaps spurious) decline from the 330bp reported on May 16.

Monday’s Globe & Mail had a book review by Adriana Barton (on page 3, no less!), Gorillas that we missed: The deceptive powers of perception regarding a new book by Christopher Chabris and Daniel Simons, The Invisible Gorilla: And Other Ways Our Intuitions Deceive Us.

The centerpiece of the book is an experiment in psychology:

It’s not a joke – it’s psychology’s famous “gorilla experiment,” used in schools, corporations and anti-terrorism units to show how blind we can be when we’re paying attention.

In the test, observers are asked to count basketball passes between two teams – half of them don’t see a woman in a gorilla suit walking into the action and thumping her chest.

It illustrates the phenomenon of “inattentional blindness”- how people can miss events occurring directly in front of them.

So why am a highlighting it on PrefBlog? Three of the six “distorted beliefs about our brains” are directly related to the investment business:

• Confidence: We equate self-assurance with competence, in ourselves and others.
• Knowledge: We mistake familiarity with subject matter for knowledge.
• Cause:We draw conclusions about a root cause based on the order and relationship of events.

Most successful brokers – and money managers, for that matter – exude confidence and spend a great deal of time “staying abreast of the market”, which in general has little, if any, effect on actual returns earned by actual dollars. The third point will be familiar to anybody who has ever watched a talking head confidently recapitulating the day’s market action in terms of the Knowledge he has so arduously gained.

I’ve ordered the book and look forward to reading it: it provides an academic sheen to my beliefs. I’m no more immune to perceptual bias than the next guy! I can only hope it reinforces my prejudices by as much as The Fortune Sellers did.

Additional reviews may be found in The Washington Post and National Public Radio, inter alia.

So – what’s happening with Fannie & Freddie? Nothing:

Fannie Mae and Freddie Mac, the mortgage-finance giants that are now wards of the government, are on their way to becoming the single-biggest cost to taxpayers from the financial crisis—ahead of the banks, auto makers, or even insurer American International Group.

But while Washington is on the cusp of enacting a broad revamp of the financial regulatory infrastructure, it’s in no hurry to touch Fannie and Freddie.

“The administration has put it on the ‘too hard’ pile,” says David Felt, a former senior lawyer at the companies’ federal regulator who presided over the government takeover of the companies in 2008.

Why address a problem when you can score cheap political points by vilifying bit players like Goldman Sachs?

Even when …:

Fannie Mae and Freddie Mac, the mortgage companies operating under U.S. conservatorship, will require additional government aid amid losses stemming from the 2008 credit crisis, the nation’s top housing regulator said in its annual report to Congress.

“While critical to supporting the ongoing functioning of the nation’s housing finance system, the enterprises would be unable to serve the mortgage market in the absence of the ongoing financial support,” said Edward DeMarco, acting director of the Federal Housing Finance Agency, said in the report released today.

Corporate debt is getting less liquid:

The gap between the cost to buy and sell corporate credit reached the widest in nine months in another sign that investors are increasingly wary of all but the safest government securities amid Europe’s sovereign debt crisis.

The bid-ask spread for credit-default swaps on U.S. investment-grade bonds surged to an average 8.86 basis points as of May 21 from 5.42 basis points a month ago, according to CMA DataVision prices. The difference jumped to a one-year high of 10.57 on May 7, from as low as 3.1 in 2007.
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Global corporate bond sales are poised for the worst month in a decade, with companies issuing $48.4 billion of debt this month, down from $183 billion in April, according to data compiled by Bloomberg.

Undeterred by the political and market reaction to the partial short-sale ban, Germany is pressing ahead with a complete ban on short-sales:

Germany’s Finance Ministry proposed legislation extending a partial ban on naked short selling adopted last week to all German stocks and certain euro-currency derivatives.

The plan would ban naked short selling in stocks of all German companies listed on a domestic exchange and would also outlaw naked credit-default swaps on some euro-region bonds as well as certain euro currency derivatives, the ministry said in what it termed a “discussion paper,” distributed to banks and industry groups.

“The financial crisis has curbed confidence in the financial markets and has revealed the need for further substantial improvement of oversight rules,” according to the document. “The crisis has reached a new dimension with turbulence increasing on the European Union member countries’ bond markets and the volatility of the euro.”

They’d be better off if they paid attention to their own rules and committments:

With Greece’s debt crisis now exposing the weakness of fiscal oversight in the 16-nation economy, governments missed one or both of the European Union’s two budget requirements 57 percent of the time since they adopted the euro. Those rules limit debt to 60 percent of gross domestic product and budget deficits to 3 percent of GDP, as set out in the 1997 Stability and Growth Pact.
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Of the economies that have been in the euro since it started trading in 1999, Belgium and Italy missed one or both of the targets in all 11 years. Greece failed in all nine years in which it used the euro. Finland and Luxembourg satisfied both goals every year.

There is an increasing amount of retail option trading:

Volume in the U.S. has tripled since 2004 to a record 3.61 billion contracts in 2009, while trading by individual investors in the same period has increased fivefold at Fidelity Investments, the world’s largest mutual-fund firm. Sophisticated online software and the growth in training offered by industry groups and brokerages, such as Charles Schwab Corp. and TD Ameritrade Holding Corp., are enabling individuals to execute advanced techniques on home computers that had been the province of professionals.
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The number of contracts traded at Schwab, the largest independent brokerage by client assets, rose 9 percent in 2009 from 2008, according to Randy Frederick, the San Francisco-based company’s director of trading and derivatives. TD Ameritrade, based in Omaha, Nebraska, had a 3 percent growth rate in clients trading options from October 2009 to March 2010, according to spokeswoman Fran Del Valle.

But at least the ban is creating jobs!

Germany’s unilateral move to curb speculative trading of government bonds and some naked short selling last week forced lawyers to work long hours to interpret rules enacted with less than a day’s notice.

The nation’s financial regulator, BaFin, has been posting guidance about the rules online, while lawyers toiled over what countries the rules apply in, what constitutes a “naked” deal and whether the ban covers derivatives.

“The situation has been tough for all of us, lawyers and regulators alike,” said Jochen Kindermann, a capital markets lawyer at Simmons & Simmons in Frankfurt. “The step was dropped on us like a bomb and no one really had any time to prepare.”

Woes in Europe coule lead to a new bank crisis:

European leaders must now address debt sold by nations such as Greece and Spain to avoid a costlier bank bailout later, said JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon.

“If they don’t fix the problem now, they’re still going to have to fix it later by bailing out their banks,” Dimon said at the Japan Society’s annual awards dinner in New York last night. “If they have to bail out their banks, it will be far worse than making that sovereign debt good.”
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“A lot of that sovereign debt is owned by European banks, so when these countries have problems, so will their banks,” Dimon said, answering a question from former Federal Reserve Chairman Paul Volcker, who is now an economic adviser to President Barack Obama.

Europe’s looming debt crisis shouldn’t come as a surprise, Dimon said, because European Union nations have failed to live up to promises to keep their deficits and outstanding debt within target levels.

I have crossed SEC Commissioner Luis A. Aguilar off my Christmas card list. He is using very inflammatory language:

The financial crisis and its enormous costs to society were the direct result of years of deregulation, and they have sounded the alarm for change. The perils of fragmented regulation may also be seen in the May 6th market break — the so-called “flash crash.” This market breakdown and the difficulty in determining how and why it occurred are yet further stark reminders of the dangers of weak oversight of our tightly interconnected financial markets.

“Direct result”? I haven’t seen any proof of that. “[D]ifficulty in determining” the cause of the flash crash? It’s been three weeks, buddy. Note, however, that I will agree that we might never know The Reason. Even as we may never know The Reason why Greek bonds are so cheap when all the politicians have already said everything’s OK.

It is clear that the public is clamoring for significant reform and expects Washington to deliver.(5) Against this backdrop of deregulation and confusion, it is apparent that Wall Street and Main Street are in a tug-of-war to see who wins the legislative debate. This struggle will continue as the House and Senate financial reform bills are reconciled in conference. Throughout this debate, the voices of Main Street investors have been few.

Setting up the debate as Main Street vs. Wall Street is a cheap rhetorical trick – not something I would expect to hear from an SEC Commissioner. His footnote justifying his word “clamoring” is a poll with the question “Do you support or oppose stricter federal regulations on the way [banks and other financial institutions] / [Wall Street firms] conduct their business?” Does he really consider such a poll to be justifiable as a driver of public policy? And I must say, I find it surprising that the public is clamouring for stricter regulation, while at the same time the “voices of Main Street investors have been few”. Which is it?

By contrast, the voices from Wall Street are active, well-organized, well-financed, and extremely well-connected. And they are quick to argue that one proposed reform or another would certainly lead to undesirable effects.6 They argue this even though their powers of foresight failed utterly to anticipate the severity of the financial crisis before they were swept up in it.

More cheap rhetoric. Note that he is claiming that the Credit Crunch proves the financial sector knows nothing about anything, despite the fact that regulators and central banks are heavily implicated.

As with penalties, I think that the SEC has been too often willing to compromise on remedial sanctions because they can be a sticking point in settlement negotiations. Defendants and respondents fight hardest against accepting these sanctions is because they are, in many ways, the most meaningful measures we have to protect investors.

So, Luis? All that means is: Stop Regulatory Extortion. Now. If you think somebody’s done wrong – don’t settle without an admission of guilt.

In the meantime, I consider it a disgrace that such a senior regulator be using such inflammatory language and indulging in such public advocacy. New directions, whatever they might be, are the responsibility of politicians to decide, advised in a judicious and neutral manner of what the effects – and unintended consequences – of proposed changes might be.

I am saddened to see that Queers against Israeli Apartheid has been excluded from the Pride parade:

Pride Toronto’s Board of Directors voted Friday to ban the term from all Pride-related events, Councillor Kyle Rae confirmed.

No one from Pride Toronto would comment Friday, although they said a news conference will be held Tuesday.

The group Queers Against Israeli Apartheid, which has marched in Toronto’s annual Pride parade for the past several years, has angered people who feel the name is discriminatory, anti-Semitic and anti-Israeli.

Discriminatory? Anti-Israeli? So what? Anti-Semitic? Those who feel that criticizing Israel – however wildly, inaccurately or vehemently – is equivalent to anti-Semitism have feelings that simply don’t matter. However, there’s a loop-hole:

“the Pride committee has voted to ban the use of the term Israeli apartheid at all Pride-related events.”

They’ll probably rename themselves “Queers against Israeli Genocide”, or something equally inflammatory.

The disgrace is that this has happened as the result of a bureacratic decision (on the part of city bureaucrats to threaten funding) – there has been no legislative, judicial or quasi-judicial involvement whatsoever. But then, city bureacrats are running amok, about to ban soda pop at arenas and community centers.

All this is going to backfire, the same way official disapproval of pornography fueled the growth of the Internet. You know why Harry Potter (and, to a lesser extent, Twilight) was such a sensational success? It’s because, after a steady diet of politically correct bilge, somebody sat down a wrote a story (and wrote it well, which is the hard part) with villains and conflict. Most kids, I am sure, embarked on the voyage with a suspicion that somewhere along the line Voldemort and Potter would discuss their differences, resolve them, hug and become best friends. And if they had, JK Rowling might well have done well – but not great.

Want to make community centres irrelevant? Simply make them irrelevant to people’s lives and ban soda.

On another day of relatively light volume, PerpetualDiscounts gained 10bp and FixedResets lost 6bp.

Gensler’s testimony regarding the May 6 Bungee Jump is available:

CME Globex has stop logic functionaility that protects against cascading stop orders – the domino effect of one stop order triggering others. Globex’s stop logic functionality pauses trading for five to ten secons – five seconds in the case of the E-Mini contract – when the trading engine recognizes that it has a series of resting stop orders that could lead to a cascade and move the market up or down beyond a specified amount. On May 6, the stop logic functionality occurred on two currency futures contracts and when the E-Mini contract hit bottom.
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On May 6, trading volume was very high. Usually, high volume indicates high liquidity. On this day, however, high volume could have been a misleading indicator of liquidty to market participants and their pre-programmed algorithms. Higher trading volume, when it is associated with high price change, may not be a good indicator of liquidity because many orders could have been executed at falling prices. This particular high trading volume was accompanied by significant fluctuations in trading volume. Further, the daily trading activity did not result in a significant number of futures contracts held by market participants at the end of May 6. This implies many investors participated in the market intraday, but on balance few investors increased their positions by the close of trading.
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The two other measures of liquidity we reviewed – the bid offer spread and the depth of the limit order book – suggest that liquidity was dislocated. When the CME’s stop logic functionality took effect on the E-Mini contract, the bid ask spread had widened significantly. This means the liquidity was lower and the transaction costs were higher.

Click for big

Click for big

One of the top ten most active trading accounts by gross volume between 2:00pm and 3:00pm only entered orders to sell. That trader entered the market at around 2:32pm and finished trading at roughly 2:51pm. The trader sold just less than half of its contracts as the market went down and just more than half as the price level rose.

We understand that this particular market participant sought to hedge its stock portfolio in the futures market by selling a pre-determined amount of futures through an executing broker’s automated execution system. In this circumstance, we further understand that the trade was executed through an executing broker’s algorithm that was meant to limit market impact by limiting volume at an average of nine percent of the volume traded during the period.
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From 2:30 pm to 3:00 pm, however, this market had 10 times higher volume than the average daily trading volume for the same intraday time period over the previous month, without the concurrent increase in liquidity. On May 6, it took about 21 minutes for the participant to execute their sell order. In markets with average volume, it would have taken significantly longer – perhaps hours.

The Canadian preferred share market had a day of low volume, especially when compared with levels of the past two months. Sell in May and pay and pay? PerpetualDiscounts were up 2bp and FixedResets gained 6bp.