PrefBlog

The SEC has announced that it:

today issued a report cautioning credit rating agencies about deceptive ratings conduct and the importance of sufficient internal controls over the policies, procedures, and methodologies the firms use to determine credit ratings.

The SEC’s Report of Investigation stems from an Enforcement Division inquiry into whether Moody’s Investors Service, Inc. (MIS) — the credit rating business segment of Moody’s Corporation — violated the registration provisions or the antifraud provisions of the federal securities laws.
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According to the Report, an MIS analyst discovered in early 2007 that a computer coding error had upwardly impacted by 1.5 to 3.5 notches the model output used to determine MIS credit ratings for certain constant proportion debt obligation notes. Nevertheless, shortly thereafter during a meeting in Europe, an MIS rating committee voted against taking responsive rating action, in part because of concerns that doing so would negatively impact MIS’s business reputation.

MIS applied in June 2007 to be registered with the Commission as an NRSRO. The Report notes that the European rating committee’s self-serving consideration of non-credit related factors in support of the decision to maintain the credit ratings constituted conduct that was contrary to the MIS procedures used to determine credit ratings as described in the MIS application to the SEC.

Was this a Very Bad Thing by Moody’s? Yes.

Does Moody’s deserve to lose some credibility over this? Yes.

Should this be any of the SEC’s business? Ummm … that part’s not so clear. However, I eagerly anticipate an immense volume of paper out of the brokerages once their salesmen analysts start making the same kind of disclosure … on stuff they actually made a buy/sell recommendation about.

JP Morgan is closing their energy prop desk:

JPMorgan Chase & Co., the second- largest U.S. lender by assets, told traders who bet on commodities for the firm’s account that their unit will be closed as the company begins to shut down all its proprietary trading, according to a person briefed on the matter.

The bank eventually will end all proprietary trading to comply with new curbs on investment banks, said the person, who asked not to be identified because JPMorgan’s decision isn’t public. The New York-based bank will shut proprietary trading in fixed-income and equities later, the person said.

At the very least, the exercise will give us some data on the importance of dealer risk capital to the market – although how you can sort out prop strategies from regular market making remains something of a mystery to me. Maybe they just change the name.

The FDIC has released its 2Q10 Quarterly Banking Profile, with headlines:

• Quarterly Earnings Are Highest in Almost Three Years
• Reduced Loan-Loss Provisions Boost Net Income
• Margins Improve at a Majority of Banks
• Noninterest Income Is Lower
• Charge-Offs Fall for First Time Since 2006
• Noncurrent Loans Post First Decline in More than Four Years
• Reserves Fall as Large Banks Reduce Loan-Loss Provisions
• Rising Securities Values Contribute to Equity Capital Growth
• Loan Balances Continue to Decline
• Banks Reduce Nondeposit Funding
• No New Charters Were Added During the Quarter

EWT LLP writes a highly informative comment letter on market microstructure:

Based upon our vantage point on that day, taken in combination with our years of experience in various markets throughout the world and their handling of unexpected volatility and erroneous transactions,1 we respectfully offer our observations on both these events and some related recommendations. In so doing, we have focused on the following four key areas:

• Inaccurate NBBO feeds. Market center trading system problems (e.g., severely lagged and discontinuous market data) revealed single points-offailure in the market infrastructure. In particular, as illustrated below, the poor performance of National Best Bid or Offer (“NBBO”) feeds was a significant contributor to the aberrant events of that day. In our view, these feeds could be improved significantly through investment in available technology.
• Inconsistent and Ambiguous Market Center Practices. While they may be well-intentioned, certain inconsistent market center practices (e.g., Liquidity Replenishment Points or “LRPs”) and ambiguous rules regarding potentially erroneous transactions fragmented and curtailed liquidity provision on May 6 by increasing uncertainty under extreme market conditions. Replacing these practices and rules with uniform, industry-wide rules establishing limits on upward and downward price movement in a given period of time (i.e., a limitup/limit-down approach) and consistent rules for canceling erroneous transactions would accomplish the same objectives with fewer unintended consequences.
• Market Orders. “Market” and “stop” orders likely steepened the market decline on May 6 by intensifying selling pressure. A limit-up/limit-down approach would address this issue by providing a de facto collar on market orders. In the absence of a limit-up/limit-down approach, we recommend that customer market orders be collared or converted to limit orders by their brokers prior to submission to a trading center and that broker-dealers be required to specify a limit price on all orders.
• Concentrations of Liquidity Risk. Reliance on a small subset of firms or systems to provide or control liquidity as a result of exchange-specific incentive programs left the National Market System vulnerable on May 6 to failures by single firms or systems. To address these issues, the Commission should set uniform standards for market making, and require that all exchange-based market maker incentive programs be non-exclusionary and open to all who qualify.

I’m still upset about police actions during the G-20 meeting. So are some others, but there are few who really couldn’t care less, one way or another:

The largest mass arrest of Canadians in history and the Grits primary concern is that the cops were overwhelmed.
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At a wintry moment in the history of Canadian civil rights, the Liberal Party is AWOL.

We are poorly served by our politicians of all stripes. Still, with the pseudo-opposition being led by Torture Boy, I suppose we should be grateful nothing worse than vindictive time-wasting seems to have occurred. This time.

The Canadian preferred share market closed the month with another good day on elevated volume, with PerpetualDiscounts up 19bp and FixedResets winning 9bp.

PerpetualDiscount now yield 5.69%, equivalent to 7.97% interest at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.1% (!) 5.3%, so the pre-tax interest-equivalent spread is now about 285bp 265bp, a significant increase decrease from the 275bp reported on August 25 and the 275bp reported July 30. For another month, it’s simply a case of the preferred share market showing more inertia than the red-hot corporate bond market!

Click for Big

Econbrowser‘s Jim Hamilton has been busy building a database on the term structure of Treasuries. One of the byproducts is a graph of the average term of publicly held US debt:

Click for big

Senator Kaufman’s letter to the SEC, highlighted here on August 27, attracted comment in the Financial Times which was in turn republished on the Themis Trading blog under Fixing Equity Markets Ain’t Easy:

The challenge of fixing our equity markets is not as simple as “fixing” the market structure by widening spreads. Widening spreads across the board will only remove trading opportunities and increase trading costs. I would love to say widen spreads and tax the HFTs and everything will be fine, but in the end, I think increased spreads will only force institutional and retail investors to pay more for execution and make it harder to get in or out of an investment . . . and profits will just be re-allocated from the fast and fleet to slower players with larger pockets.

If we think by taxing high-frequency firms we will go back to a time when markets were slow and humans made trading decisions – forget it. When was the last time we replaced computers with humans?

For “slower players with larger pockets”, read ‘established dinosaurs with more money than brains who are currently having their lunch eaten’.

A good day with continued elevated volume on the Canadian preferred share market today, with PerpetualDiscounts up 27bp and FixedResets gaining 2bp.

Regulators are seeking to ensure that their post-regulatory employment options include non-competitive alternative exchanges:

The fine shows regulators are getting serious about demanding that brokerage firms hook up to all the alternative trading systems in Canada to ensure they are shopping around for investors to get the best price on trade orders.

BMO Nesbitt dallied in hooking up to Omega, long the smallest ATS, and it wasn’t alone. Sources say regulators are also looking at firms like RBC Dominion Securities and have put them on notice that there have been too many so-called trade-throughs taking place in the market.

Trade-throughs in industry parlance are trades that don’t take place at the best price available in the marketplace.
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The industry has griped that some marketplaces are too small to warrant the expense of a hookup.
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Regulators clearly aren’t buying that. They have been sending long lists of trade-throughs spotted by market surveillance systems to offending desks. BMO got two warnings, IIROC said, in December, 2008, and February, 2009 “that it was responsible for a larger-than-average number of ‘trade through’ alerts.”

The focus on trade-throughs puts pressure on not only the big firms, but tiny shops that are already stretched thin for resources in a tough market. However, given that the end result is supposed to be protection for investors, it’s hard for regulators to look the other way.

The settlement notice specifies:

Pursuant to the Settlement Agreement, BMONB admitted to the following misconduct:

• Between October 2008 and October 2009, it failed to make reasonable efforts to connect to the Omega ATS protected marketplace, contrary to UMIR 5.2 and UMIR Policy 5.2.

Pursuant to the Settlement Agreement, BMONB agreed to pay a fine in the amount of $250,000 and costs of $15,000.

Fortunately, however, no individual was disciplined or even named by IIROC. This serious misconduct, worth a quarter of a million bucks, did not occur as a result of a decision, or negligence, or human behaviour of any kind, in fact … it just happened.

I think it fair to say that Omega ATS is not a particularly important exchange:

In terms of market share, Omega ATS is still relatively small, says Eric Stoop, chairman of Omega ATS, “We’re around 1% of the market this year,” he explained.

It is interesting to consider how this might tie in with sub-pennying; I speculated in a post about Alpha Trading Systems that the extant exchanges might be introducing order types to forestall the big brokers from setting up captive dark pools.

I would be quite happy with a statement from any brokerage house with whom I might deal as to just which exchanges they belonged to; if the regulators want some busy-work, they could always specify that this disclosure should include statistics on trade-throughs. But such a system would involve consumer choice and competition; anathema to the regulatory mind.

Terence Corcoran gave bank capital regulation another try, but assumes that an increase in global capital requirements will be matched in Canada. This is not necessarily the case, since Canadian banks are capitalized well above the current minimum.

I have previously remarked that a good deal of all the whining regarding overwhelming message traffic generated by High Frequency Traders could be eliminated through a novel proposal – charging for message traffic. I am pleased to see that a variant of this idea has been proposed by BMOCM’s Quantitative Execution Services team in a paper titled Drowning in Data:

We have suggested in the past that the street’s regulatory bill be split into two portions – human resources and technology. The HR cost, that is the cost of having regulatory staff, should be divided amongst the street based on either volume of shares traded, or number of trades. This reflects the fact that staff time is spent looking at actual trades. The technology portion should then be allocated based on share of message traffic. This reflects the fact that technology costs are driven by message traffic not traded volume. This type of allocation system would result in inefficient strategies having to pay a higher portion of the total bill. This would be true of any inefficient strategy, whether it be an agency pairs trading algorithm or a passive rebate HFT strategy. (Currently the total cost is allocated to trading venues based on volume traded market share, which they then charge back to the dealers using the same metric).

They also talked about trade-through protection:

Canada is the only developed marketplace that enforces full depth of book trade-through as opposed to top of book for each marketplace venue. This implies that the Smart Order Routers in Canada have to process the entire depth of book in all markets in order to satisfy trade-through obligations. The order changes on the entire depth of book dwarf the order changes on just top of book and thus force the Canadian market participants to be consumers of this glut of data. We feel the regulators need to review the trade-through obligations from a technology lens.

The BMOCM idea regarding charging has been picked up by Senator Edward Kaufman, who has written to the SEC suggesting:

Accordingly, the Commission should require trading venues to allocate system costs at least partially based on message traffic rather than traded volume. A similar framework should be applied to pay for the consolidated audit trail and other technology and surveillance costs that regulatory agencies incur.

Sen. Kaufman also suggests:

It may seem counterintuitive, but the Commission should even examine whether regulation should aim not to facilitate narrow spreads with little size or depth of orders, but instead promote deep order books -and if necessary -wider markets with large protected quote size. Wider spreads with a large protected quote size on both sides may facilitate certainty of execution with predictable transparent costs. Narrow fluctuating spreads, on the other hand, with small protected size and thin markets, can mean just the opposite -and actual trading costs can be high, hidden and uncertain. Deep stable markets will bring back confidence, facilitate the capital formation function of the markets and diminish the current dependence on the dark pool concept. At a minimum, the Commission must carefully scrutinize and empirically challenge the mantra that investors are best served by narrow spreads. In reality, narrow spreads of small order size may be an illusion that masks a very “thin crust” of liquidity (which leave markets vulnerable to another flash crash when markets fail their price discovery function only next time . within the bounds of circuit breakers) and difficult-to-measure price impacts (that might be harmful to average investors and which diminish investor confidence), both of which the Commission must examine and possibly address.

This leads to an interesting conundrum: there is lots of academic evidence (e.g., from TRACE and from the Toronto Exchange’s changes to limit book transparency in the early nineties) that increasing transparency results in thinner books with tighter spreads. I suspect, however, that prohibiting dissemination of Level 2 – or Level 1 – pricing information will prove to be unpopular should anybody have the guts to make the suggestion.

ProPublica has published a good investigative piece on CDO Tranche Retention (otherwise known as self-dealing) titled Banks’ Self-Dealing Super-Charged Financial Crisis:

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged.

Independent manager? Independent schmanager!:

There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

“All these banks for years were spawning trading partners,” says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. “You don’t have a trading partner? Create one.”
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It remains unclear whether any of this violated laws. The SEC has said [5] that it is actively looking at as many as 50 CDO managers as part of its broad examination of the CDO business’ role in the financial crisis. In particular, the agency is focusing on the relationship between the banks and the managers. The SEC is exploring how deals were structured, if any quid pro quo arrangements existed, and whether banks pressured managers to take bad assets.
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A Wall Street Journal article [9] ($) from late 2007, one of the first of its kind, described how Margolis worked with one inexperienced CDO manager called NIR on a CDO named Norma, in the spring of that year. The Long Island-based NIR made about $1.5 million a year for managing Norma, a CDO that imploded.

“NIR’s collateral management business had arisen from efforts by Merrill Lynch to assemble a stable of captive small firms to manage its CDOs that would be beholden to Merrill Lynch on account of the business it funneled to them,” alleged a lawsuit filed in New York state court against Merrill over Norma that was settled quietly after the plaintiffs received internal Merrill documents.
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“I would go to Merrill and tell them that I wanted to buy, say, a Citi bond,” recalls a CDO manager. “They would say ‘no.’ I would suggest a UBS bond, they would say ‘no.’ Eventually, you got the joke.” Managers could choose assets to put into their CDOs but they had to come from Merrill CDOs. One rival investment banker says Merrill treated CDO managers the way Henry Ford treated his Model T customers: You can have any color you want, as long as it’s black.

Once, Merrill’s Ken Margolis pushed a manager to buy a CDO slice for a Merrill-produced CDO called Port Jackson that was completed in the beginning of 2007: “‘You don’t have to buy the deal but you are crazy if you don’t because of your business,'” an executive at the management firm recalls Margolis telling him. “‘We have a big pipeline and only so many more mandates to give you.’ You got the message.” In other words: Take our stuff and we’ll send you more business. If not, forget it.’

And that, boys and girls, is the way the investment business works. Which is why you should always check the performance track record of a manager and ignore the “experience” so beloved of the regulators.

On an unrelated note, I will leave you with a weekend thought: it is striking just how many people urgently tell me how friendly their dogs are, as if I care. Hardly anybody ever says “My dog is aggressive and obnoxious. I’m too stupid and lazy to train it”.

It was a very nice day for the Canadian preferred share market today, with PerpetualDiscounts up 11bp and FixedResets gaining 15bp, on continued elevated volume.

Algos gone wild!:

Infinium, a household name in Chicago’s burgeoning trading community, relies on computer horsepower and quantitative models to earn razor-thin profits from short-term trading. It uses its own money to make markets and capitalize on tiny imbalances, a common high-frequency strategy. The documents, dated March, reveal that Infinium used an algorithm that was less than a day old to execute a “lead/lag” strategy between an exchange-traded fund called United States Oil Fund (USO.P: Quote), which tracks oil prices, and the U.S. crude benchmark future, West Texas Intermediate

The algorithm was turned on at 2:26:28 p.m. (Eastern) on Feb. 3, less than four minutes before NYMEX closed floor trading and settled oil prices. It immediately started uncontrollably buying oil futures, according to the documents, which include letters from Infinium’s lawyer to the regulation unit of CME Group, and cite notes from a company developer. Infinium placed 2,000 to 3,000 orders per second before its flooded order router “choked” and was “dead in the water” a few seconds later, the developer’s notes said. The algorithm was shut down five seconds after it was turned on. By then, the documents show, the firm had sent 4,612 “buy limit” orders into the market. It quickly offset the position, mostly with large “block” trades in the next few minutes, leaving it with a $1.03-million loss.

Econbrowser‘s Jim Hamilton speculates that the Fed is setting up for a new round of quantitative easing in his post More thoughts on what to expect from the Fed. He notes an article from the Wall Street Journal, Commercial Property Owners Choose to Default:

“We don’t do this lightly,” said Robert Taubman, chief executive of Taubman Centers Inc. The luxury-mall owner, with upscale properties such as the Beverly Center in Los Angeles, decided earlier this year to stop covering interest payments on its $135 million mortgage on the Pier Shops at Caesars in Atlantic City, N.J.

Taubman, which estimates the mall is now worth only $52 million, gave it back to its mortgage holder.

The Canadian preferred share market had a down day amid continued elevated volume, with PerpetualDiscounts down 4bp and FixedResets losing 1bp.

As I have previously noted, I am very pleased to see that we are finally having a debate on the cost of bank regulation. Less, more, whatever … but let’s get some idea of the cost before swallowing OSFI’s Kool-Aid and saying more is always better. I’ve highlighted the BoC study and the BIS report … so our first debater is Terence Corcoran, who wrote a column titled The high cost of bank regulation … the web version is encouragingly headed by:

CORRECTION: Terence Corcoran’s column, The High Cost of Bank Regulation, contained several factual errors regarding a Bank of Canada report on increased bank capital ratios.

An increase in capital of 2% results in a long-run annual impact on the level of GDP of -0.3%, or cumulative -6.0 % (or $92-billion) in present value terms, not -0.5 or -13.0% (or $200-billion). If the increase is 4%, the costs are -10% (or $153-billion) in present value terms , which does not equal $300-billion.

By avoiding future financial crises, the economy will benefit anywhere from 21.6% to 32.0% in present value terms, which is $332-billion to $492-billion. The chances of a financial crisis elsewhere is every 20 to 25 years if the probability is 4.5%, not every 60 years. The benefits to Canada were based on the reduced chance of a foreign crisis.

The impact of a Canadian crisis was based on the lower probability (1.7%) of a Canadian crisis. Finally, bank capital is made of equity, retained earnings, reserves, etc.

The Post regrets the errors.

Next debater, please!

The Congressional Oversight Panel has released – with very little press attention – its report The Global Context and International Effects of the TARP:

The dealings of Goldman Sachs with respect to the CDSs on CDOs that were eventually acquired by Maiden Lane III provide a compelling example of the effect of counterparty relationships on the flow of funds across borders, as 96.9 percent of the cash received by Goldman effectively flowed to non-U.S. institutions. (footnote) (These institutions, as well as other indirect foreign beneficiaries of the AIG rescue – entities that sold hedges on AIG to Goldman and benefited from not having to make good on that protection – are listed in Annex II.)

Footnote reads: According to recently released documents, there were 32 Goldman CDS counterparties that benefited directly from government assistance provided through the Maiden Lane III facility, and 31 of these entities are foreign. Each of the foreign entities listed below held a CDO for which Goldman had written CDS protection and entered into contracts with AIG laying off that risk. While Goldman was required to perform under its contracts whether or not AIG performed, when the government made the decision to pay AIG‟s counterparties at par –including Goldman – the following foreign entities were direct beneficiaries:…

And in Annex 2:

As the following data make clear, taxpayer aid to AIG became aid to Goldman, and aid to Goldman became aid to a number of domestic and foreign investors. In some cases, the aid was in the form of repayment in full of obligations that, without government help, could have ended in default. In other cases, the aid was in the form of guarantees that other parties did not have to pay because the government prevented any defaults.

AIG provided credit default swap (CDS) protection on a number of collateralized debt obligations (CDOs), which were the source of continuing collateral demands on AIG. As part of the AIG rescue, the CDOs underlying the CDSs were acquired by a special-purpose vehicle primarily funded by the government, Maiden Lane III. The entities set out in the table below held CDSs written by Goldman against the CDOs that were eventually acquired by Maiden Lane III. In order to sell those CDOs to Maiden Lane III, in most cases Goldman had to obtain them from these counterparties, so the Maiden Lane III funds effectively flowed to Goldman‟s counterparties. Nearly all of these second-level counterparties, both by number and dollar amount, were non-U.S. institutions, with European banks making up by far the largest contingent.

It will be remembered that the US Congress is almost the opposite of a sausage factory … what comes out of it may certainly be deprecated, but the research that goes into it is first rate (at some point I want to take a look for myself at exactly what they had in front of them when voting to invade Iraq – but that was an issue that never had the slightest amount of fact-motivation from the beginning).

It’s very odd, but I have not been able to find the conclusions regarding Goldman Sachs’ hedging reported on any of the lunatic fringe sites. I tried searching for the phrase “Investigation has concluded that Goldman Sachs was indeed well hedged in its dealings with AIG. Its risk management process was robust even to the events of September 2008, and if all financial firms had been half as competent in managing their exposures, the Panic of 2007 would have been a mere bad spell, a footnote in the history of banking.”, but I have not yet been able to find such a statement. I will post further on this subject when I find such a sentiment, or something approximating it, expressed on the sites of any of Goldman’s erstwhile critics.

There was heavy volume today and minimal overall movement in the market indices masked a surprisingly large amount of volatility in individual issues. MFC prefs were hurt again today – just look at that MFC.PR.D FixedReset, now yielding close to 5% to the call date from the bid price; there are currently five issues trading more than 200bp through that level! You can tell me that BMO is a better credit than MFC and I won’t blink; tell me it’s worth a spread of 200bp for four year money and we might have something to discuss! The strong performance by IAG is a little odd … not that there’s anything wrong with IAG, but those issues went ex-dividend today and it appears nobody noticed.

Nesbitt had a good day, volume-wise, but there is no information available to me regarding what kind of crosses they did … if they were internal crosses, for instance, (between different accounts under the same investment manager), then they won’t have got much commission out of it.

PerpetualDiscounts squeaked out a gain of 1bp, while FixedResets were up 9bp. The median average weighted yield-to-maturity on FixedResets is now a mere 3.16%.

PerpetualDiscounts now yield 5.77%, equivalent to 8.08% interest at the standard 1.4x equivalency factor. Long corporates now yield about 5.3% (!), so the pre-tax interest-equivalent spread (also called the Seniority Spread) is now about 275bp, up marginally – and perhaps spuriously – from the 270bp reported on August 18.

The Bank of Canada has released a discussion paper by Zhongfang He titled Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy:

The author evaluates the effect of the Bank of Canada’s conditional commitment regarding the target overnight rate on longer-term market interest rates by taking into account the relationship between interest rates, inflation, and unemployment rates. By using vector autoregressive models of monthly interest rates, month-over-month inflation, and unemployment rates for Canada and the United States, the author finds that the Canadian 1-year treasury bill rates and 1-year forward 3-month rates have generally been lower than their model-implied values since April 2009, while the difference between the U.S. realized rates and their model-implied values has been much smaller. The author also studies the effect of the conditional commitment on longer-term government bond yields with maturities of 2, 5, and 10 years, and finds lower actual Canadian longer-term interest rates than their model-implied values, though their difference diminishes as the maturities become longer. The evidence appears to suggest that the Bank of Canada’s conditional commitment likely has produced a persistent effect in lowering Canadian interest rates relative to what their historical relationship with inflation and unemployment rates would imply. However, this finding is not statistically strong and is subject to caveats such as possible in-sample model instability and the dependence of the results on the choice of inflation variable.

Ontario will tinker with pension guarantees:

The fund, which provides pensioners with up to $1,000 a month if their private-sector plan fails to provide its full benefit, has been an albatross for the governing Liberals, who have repeatedly warned that it hasn’t been funded properly since its inception 30 years ago.

That looming threat came to a head last year during the global recession, when the government was faced with a fund that didn’t have enough cash to help thousands of workers at corporate giants like General Motors of Canada Ltd. and Nortel Networks Corp. that were poised to collapse into bankruptcy.
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“These rules will help reduce – hopefully eliminate – the kind of moral hazard that I would associate with companies and employee groups agreeing to benefits without properly funding them.”

Mr. Duncan is also proposing some temporary relief for certain pension plans in the broader public sector by offering them more time to pay down solvency deficits, as long as they meet certain conditions, and a review of the pension system every five years.

This may be related politically to Nortel’s pension status:

On Sept. 30, 2010, the Nortel Defined Benefit Pension Plans will become orphans. The Financial Services Commission of Ontario (FSCO) will then take over as required by current law.

Unless the Ontario government takes prompt action, Nortel’s pensioners will then lose 36% of their pensions and possibly even more. A major part of their loss occurs because, under current regulations, FSCO will simply wind-up the pension funds by converting them to annuities. This forever locks-in the existing pension deficit and it adds major penalties, because the cost of annuities is presently at the worst they have even been in 25 years with no relief in sight.

In 2001 Nortel’s plan went from half a billion surplus to one billion deficit; to $1.8-billion in 2002 …

Manulife common (MFC-TO) got hammered today:

Manulife Financial Corp., North America’s third-largest insurer, decreased 5.4 percent to a 17-month low of $11.71. Bank of America Corp. analyst Steve Theriault yesterday increased his third-quarter loss estimate for the company to 94 cents a share from 37 cents a share, excluding certain items. Sun Life Financial Inc., Canada’s third-biggest insurance company, dropped 4.3 percent to C$24.17.

Fitch affirmed MFC:

Fitch Ratings has assigned an ‘A-‘ rating to Manulife Financial Corporations (MFC’s) recently issued C$900 million 4.079% medium-term notes due Aug. 20, 2015. At the same time Fitch affirmed all of MFC’s existing ratings. (A full list of rating actions follows at the end of this release.) The Rating Outlook is Stable.
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Within Fitch’s rating rationale are multiple considerations. If MFC were to materially deviate from any of these items, especially for an extended period, the ratings could be impacted. Included within these key rating rationale factors are the following:

–The annual 3Q’10 actuarial experience and methods adjustments of at least C$1 billion;
–MFC adjusted earnings of C$3 billion a year;
–Operating company Minimum Continuing Capital and Surplus Requirements (MCCSR) ratio above 190%;
–Holding company financial leverage not exceeding 20% on Fitch’s equity adjusted leverage basis;
–Current sensitivity to equity markets;
–Current volatility in earnings

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–C$$350 million 4.1% class A, series 1, preferred stock at ‘BBB’;
–C$350 million 4.65% class A, series 2, preferred stock at ‘BBB’;
–C$300 million 4.5% class A, series 3, preferred stock at ‘BBB’;
–C$450 million 6.6% non-cumulative, preferred class A, series 4 stock at ‘BBB’;
–C$350 million 5.60% non-cumulative rate reset, preferred class 1, series 1 stock at ‘BBB’.

S&P says Ireland needs a little more green:

Ireland’s long-term sovereign credit rating was cut one step to AA- from AA by Standard & Poor’s, which cited the projected cost of supporting the nation’s financial sector.

“The negative outlook reflects our view that a further downgrade is possible if the fiscal cost of supporting the banking sector rises further, or if other adverse economic developments weaken the government’s ability to meet its medium- term fiscal objectives,” S&P said today in a statement.

S&P said its new projections suggest that Ireland’s net general government debt will rise toward 113 percent of gross domestic product in 2012. That’s more than 1.5 times the median for the average of euro zone sovereign nations, and “well above” the debt burdens the New York-based firm said it projects for similarly rated countries in the region such as Belgium at 98 percent and Spain at 65 percent.

The Canadian preferred share market edged a little higher today, with PerpetualDiscounts up 6bp and FixedResets gaining 10bp. Volume was above average. MFC’s preferreds were not immune to the woes of the common, with two issues figuring in the performance highlights – which were all losses today.

I should have mentioned this earlier … but it just seemed so trivial! S&P has announced:

the S&P/TSX North American Preferred Stock Index. The Index seeks to provide investors with the opportunity to achieve broad diversification and exposure to North American preferred stocks.

Preferred stocks are a class of securities that combine the characteristics of debt and common stocks. Their returns have low correlations with common stock returns and with bond returns, making them good diversifiers. While their expected volatility and returns lie between those of common stocks and bonds, their yields are typically higher than that of common stock, the bond market and the money market.
“Preferred stocks are attractive to investors in today’s low interest rate environment, due to their higher yields,” says Steve Rive, Managing Director at S&P Indices. “The S&P/TSX North American Preferred Stock Index will provide investors with a diversified and broadly representative exposure to this important segment of the market.”

The S&P/TSX North American Preferred Stock Index is comprised of a 50% equal weighting in the S&P/TSX Preferred Share Index and S&P U.S. Preferred Stock Index. The S&P/TSX Preferred Share Index is comprised of preferred stocks trading on the Toronto Stock Exchange that meet criteria relating to minimum size, liquidity, issuer rating, and exchange listing. The S&P U.S. Preferred Stock Index measures the yield and price performance of preferred stocks in the U.S. equity universe by using a rules-driven methodology. It is comprised of preferred stocks issued by U.S. entities that meet a set of defined criteria.

I don’t see the point of this. The US and Canadian preferred share markets are very different animals, with very different taxation profiles. My guess is that there will be an ETF announcement in the very near future. Thanks to Assiduous Readers MP and like_to_retire for reminding me that I’m supposed to report EVERYTHING about Canadian preferred shares, not just the news that investors might consider interesting or useful.

The FRBNY has released a staff report about a fascinating idea by Marco Del Negro, Fabrizio Perri, and Fabiano Schivardi titled Tax Buyouts:

The paper studies a fiscal policy instrument that can reduce fiscal distortions, without affecting revenues, in a politically viable way. The instrument is a private contract (tax buyout), offered by the government to each individual citizen, whereby the citizen can choose to pay a fixed price up front in exchange for a given reduction in her tax rate for a prespecified period of time. We consider a dynamic overlapping-generations economy, calibrated to match several features of the U.S. income and wealth distribution, and show that, under simple pricing, the introduction of the buyout is revenue neutral and at the same time can benefit a significant fraction of the population and lead to sizable increases in labor supply, income, consumption, and welfare.
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The baseline buyout we consider is a reduction in the marginal tax rate of at most 5% offered at a price of roughly $4500, which ensures revenue neutrality.

The FRBNY also released a staff report by James Vickery and Joshua Wright titled TBA Trading and Liquidity in the Agency MBS Market:

Most mortgages in the United States are securitized through the agency mortgage-backedsecurities (MBS) market. These securities are generally traded on a “to-be-announced,” or TBA, basis. This trading convention significantly improves agency MBS liquidity, leading to lower borrowing costs for households. Evaluation of potential reforms to the U.S. housing finance system should take into account the effects of those reforms on the operation of the TBA market.
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Consistent with the view that liquidity effects were important during this period, the timing of the increase in the jumbo-conforming spread corresponds closely to the collapse in non-agency MBS liquidity and mortgage securitization during the second half of 2007. Furthermore, this spread remains significantly elevated even today, despite normalization in many measures of credit risk premia.

I know a man who considers one thing to be an infallible contrarian indicator: when the little guy gets in … :

The amount of money flowing into bond funds is poised to exceed the cash that went into stock funds during the internet bubble, stoking concern that fixed- income markets are headed for a fall.

Investors poured $480.2 billion into mutual funds that focus on debt in the two years ending June, compared with the $496.9 billion received by equity funds from 1999 to 2000, according to data compiled by Bloomberg and the Washington-based Investment Company Institute.

Concern that the global economic recovery is faltering, with the U.S. growing at a slower-than-forecast 2.4 percent pace in the second quarter, is prompting investors to pile into fixed-income securities of all types even with some yields at record lows. The new cash has helped fuel a rally and drove yields on investment-grade U.S. corporate debt down to a record 3.79 percent last week, while two-year U.S. Treasury yields fell to an all-time low of less than 0.5 percent.

There’s increased chatter about century bonds:

“With credit spreads rallying, it’s the perfect environment for issuers to get away with 100-year bonds,” said one banker who has been selectively pitching the idea to institutional investors. “There is a natural trend to go long, so the obvious extension of that is to move past the 30-year bucket.”

As investors move “out on the curve” to longer-dated issues, the amount of three-year corporate debt offerings has fallen by 50% compared to 2009. The pace of 30-year issuance has risen by 30%, according to Dealogic.

New York State may be reducing return assumptions for its pension funds:

New York state’s $132.6 billion pension fund, the nation’s third-largest, will cut the assumed rate of return on its investments to less than the 8 percent it has used for a decade.

A reduction to 7.5 percent or 7.75 percent is likely, said Robert Whalen, a spokesman for Comptroller Thomas DiNapoli. The move “will increase the required contributions from the state and local governments but will keep the fund as strong as it is now,” Whalen said.

The plan, which covers 1 million current and retired workers, had assets equal to about 107 percent of its future liabilities, according to the fund. New York was one of only four states with pension systems in 2008 that fully funded their future obligations, according to a study by the Washington-based Pew Center on the States.

By way of comparison, the Ontario Teachers’ Pension Plan states:

A typical teacher retiring in 2009 has 26 years of pension credit and is expected to receive a pension for 30 years, plus a survivor may be paid after that. Working teachers can expect to collect their pensions for longer than they contributed to the plan.
…

FUNDING VALUATION ASSUMPTIONS (percent)
	2009 Filed	2009 Preliminary
Rate of return	5.00	4.90
Inflation rate	1.35	1.35
Real rate of return	3.65	3.55

The assumptions for 2010 are nominal 5.5% less inflation 2.55% equals real 2.95%. Since:

The OTF and the Ontario government adopted a Funding Management Policy in 2003. Under the policy:

• If assets are equal to or up to 10% greater than liabilities, the plan is in balance and no change is required.
• If assets are more than 10% greater than liabilities, the plan has a surplus that can be used to reduce contribution rates or improve benefits.
• If liabilities are greater than assets, the plan has a shortfall. The OTF and the government can address a shortfall by increasing contributions, invoking conditional inflation protection for pension credit earned after 2009, changing other benefits members will earn in the future, or adopting a combination of these measures.

… one cannot help but wonder if the relatively low return assumptions are simply yet another way of back-dooring some extra benefits to the plan members.

BIS has commenced publishing property price statistics. Oddly, there are no data available for Canada.

The Bank of Canada has released a working paper by Hajime Tomura titled Liquidity Transformation and Bank Capital Requirements:

This paper presents a dynamic general equilibrium model where asymmetric information about asset quality leads to asset illiquidity. Banking arises endogenously in this environment as banks can pool illiquid assets to average out their idiosyncratic qualities and issue liquid liabilities backed by pooled assets whose total quality is public information. Moreover, the liquidity mismatch in banks’ balance sheets leads to endogenous bank capital (outside equity) requirements for preventing bank runs. The model indicates that banking has both positive and negative effects on long-run economic growth and that business-cycle dynamics of asset prices, asset illiquidity and bank capital requirements are interconnected.
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The model, however, also shows that if a deterioration in asymmetric information in the asset market increases the illiquidity of bank assets significantly, then banks need to raise more bank capital during the liquidity crisis to prevent self-fulfilling bank runs. This result implies that the counter-cyclical capital buffer will not help to free up bank capital as designed in a liquidity crisis.

The (alleged) G-20 protesters had their day in court today:

Over 300 people facing G20-related charges appeared at a Toronto courthouse Monday, a legal tidal wave resulting from the largest mass arrests in Canadian history.

The court’s hallways are only designed to hold 176 people. Officers have been tasked with regulating the intake of defendants to ensure the building doesn’t break fire code. The court’s legal aid office brought in extra staff, including French-speakers.

I don’t know the name of the petty, vindictive ratshit who decided to make the scheduling an extra-judicial punishment … but I have a message for him: You have held the courts in contempt, and you have done more damage to the rule of law than any of those charged. Asshole.

It was a mixed day on good volume for the Canadian preferred share market, with PerpetualDiscounts gaining 23bp and FixedResets losing 5bp; the change narrowed the Bozo Spread (Current Yield PerpetualDiscounts less Current Yield FixedResets) slightly to 44bp.