PrefBlog

The FOMC was gloomy yesterday; the BoE is gloomy today:

Bank of England Governor Mervyn King said inflation will probably slow below the bank’s target in 2012 and growth will be weaker than previously forecast, signaling the U.K. economy may need more emergency stimulus.

Inflation will be about 1.5 percent in two years, below the 2 percent goal, the central bank said in its quarterly Inflation Report today. Inflation will undershoot the target even if the bank keeps its benchmark interest rate at the current 0.5 percent, the forecasts show. Growth may peak at a 3 percent annual pace instead of the 3.6 percent rate forecast in May.

The full inflation report uses the highly-touted fan charts that were recommended for central bank communications a few years back.

Click for big

An Assiduous Reader draws my attention to the 3Q10 Report of the Treasury Borrowing Advisory Committee:

The bulk of the reduction in coupon issuance should continue to be in the two-year, three-year, five-year and seven-year maturities. Although this is broadly consistent with the Committee’s desire to increase the average maturity of the outstanding debt, some felt that given the meaningful progress thus far, reductions in ten-year notes and thirty-year bonds could be justified.
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Finally, the Committee felt that growing TIPS from roughly $80 billion gross issuance in fiscal year 2010, to over $100 billion in fiscal year 2011, was still appropriate.
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The presentation (see attached) highlights that municipal bonds outstanding rose over the last decade by $1 trillion to $2.8 trillion. Despite some of the recent headline risks and the challenging economic outlook, the member concluded the municipal market appears to be in reasonably good condition. Broadly, municipalities still have a low probability of default, historically high recoveries, low absolute cost of funds, access to a broader investor base via the Build America Bonds program, and a largely unlevered existing retail investor base. Implicit in this analysis is the Federal government’s willingness to intervene in the event the municipal market ceases to function.
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…the presentation (see attached) highlights the absence of mortgage hedging needs as a stabilizing force underpinning long term yields. In addition, the member referenced the secular increase in demand for long duration assets from asset managers, insurance companies, and pension funds. Furthermore, cyclically, the member showed that investor confidence in the path of central bank policy rates tends to anchor long term yields.

The seeds of something very interesting may have been planted in Greece:

Slovakia’s parliament rejected the nation’s participation in a loan for Greece after the month-old government overturned the previous Cabinet’s policy and said poor countries shouldn’t pay for the profligacy of richer peers.

Of the 84 lawmakers present in the Bratislava-based assembly, one voted in favor while 69 were against and 14 abstained, reversing a decision by the previous Cabinet to lend Greece 816 million euros ($1.1 billion). The funds were to be part of a loan package pledged by the European Union to help Greece avoid a default. The current Slovak government of Iveta Radicova, which took office last month, is against the aid.

The vote breaks the euro region’s unity in handling the sovereign-debt crisis, though the decision won’t prevent Greece from drawing the loan.

Assiduous Readers will remember the whispers that Lehman failed in part because its peers wouldn’t give it emergency relief, which in turn was because it did not participate in the Long Term Capital Management bail-out of 1998. Now, I like to think that the full story is a little more hard-nosed and a little less school-girlish than that … but I will agree it may have had some influence.

The SEC/CFTC inquiry into the Flash Crash is continuing:

As part of the SEC and CFTC review of market events on May 6, we are pursuing two related courses of inquiry. The first is empirical and data driven. SEC staff have been reviewing raw transaction and order data, order book “snapshots,” trade summaries, information about broken trades, and information related to initiation of LRPs and self-help. The second is focused on extensive interviews with market participants — their first-hand accounts of what occurred on May 6 and their responses to those events. These efforts will culminate in an SEC-CFTC joint report that will be presented to this Committee for its consideration next month and, of course, shared with the public, as well.We are considering, as well, whether other steps are appropriate to reduce the risk of sudden disruptions and clearly erroneous trades, including deterring or prohibiting the use of “stub” quotes by market makers.

The comments have been published. BlackRock wants:

We believe those reforms should include:

• Uniform “circuit breakers” for stocks and ETFs across all exchanges;
• Making exchange trade error cancellation rules less arbitrary and more transparent in a manner that does not discourage liquidity providers from providing liquidity at times of market stress
• Clearer guidelines for inter-market order routing rules
• Replacing “stop loss” orders with “stop loss limit” orders to specify a limit price; and
• Expanding the role of lead market makers to ensure orderly market functioning.

TD Ameritrade makes the startling revelation:

The firm has noted previously that the May 6th market event demonstrated that today’s markets contain many players who use their liquidity opportunistically – applying it when in their favor, but pulling it during times of market duress.

… and defends stop orders without any quantification:

Finally, as to the specific allegation that retail market orders and stop orders contributed to the downturn, I can tell you from TD Ameritrade’s perspective, such orders are important to our clients, and looking at our own data, we do not believe there is any factual basis to assert that these types of orders contributed to the problem. In fact, TD Ameritrade clients’ market and stop orders were within average daily volume, on a percentage basis. Prohibiting market and stop orders would be a significantly adverse, misguided, and unnecessary over-reaction to the underlying causes of the May 6th market event, which would unduly deny to retail investors the access to the markets that they enjoy today.

Knight Capital, on the other hand, highlights stop orders:

When the S&P 500 traded at 1120, stop orders were triggered and the market traded lower. When the market did not promptly bounce back, buyers became sellers and the market traded down another 5% -6%. During this period, the NYSE triggered its liquidity refreshment points (LRPs) in a number of securities. Orders were then routed away from the NYSE to other destinations where liquidity in certain stocks was thinner and prices wider.

Invesco has a different view:

As an institution, we have long understood the significant risk of using market orders particularly as the market has become more fragmented. We abandoned their use many years ago in favor of marketable limit and limit orders. In light of the events of May 6 and the continuing issues small market orders have had in the market (i.e., electing newly imposed single-stock circuit breakers on WPO, CSCO, C, APC), Invesco strongly supports the examination of the current practices surrounding the use of market orders, particularly the use of “stop loss” orders. We would recommend at the very least that exchanges or broker dealers who continue to use market orders do so using collars on the market orders they submit. A collared market order should only allow execution of the order within a certain percentage of the reference price (i.e., 3% from the last sale). This would give their clients some level of protection from the impact market orders can have in the current environment and would likely reduce or altogether eliminate the issue of small share amounts triggering circuit breakers.

Invesco also wants examination of HFT:

Additionally, regulators should act to address the increasing number of order cancellations in the securities markets. It has been theorized that as many as 95% of all orders entered by high frequency traders are subsequently cancelled. Incentives that currently exist for market participants to route orders to particular venues, such as liquidity rebates, and any related conflicts of interest that may arise due to these incentives also need to be examined.

Dow Jones has a report focussing on market-making obligations titled DJ New Obligations For Market Liquidity Providers Questioned:

Getco LLC, Virtu Financial LLC and Knight Capital Group Inc. (KCG) have proposed to the SEC a range of new rules for market makers. The rules under consideration could include a requirement for market makers to provide quotes to buy or sell a stock no more than 10% above or below the current price.

Mendelson said new market making obligations would increase costs for retail and institutional investors. “On those rare occasions when markets are severely disrupted, market-maker obligations will accomplish nothing,” he said. “Let’s not do it here. It will just add a burden for investors.”

Me, I think the whole concept of allowing special privileges to market makers in exchange for obligations of any type really needs to be examined. It is at least generally accepted as ludicrous that the obligations can be met with a stub-quote.

But to get total insanity, you need a politician and Senator Charles Schumer fills the void:

Many institutional investors and trading firms left the market that day as volatility peaked during the session, according to an SEC investigation detailed Wednesday during a joint hearing held by the SEC and the Commodity Futures Trading Commission. A final report on the flash crash is due in September.

Sen. Schumer said in his letter that any trader or firm making markets in 25 or more stocks or exchange-traded funds ought to bear trading obligations, according to a draft seen by Dow Jones Newswires.

His recommendations for market makers closely align with several proposals made last month by trading firms Knight Capital Group Inc., Getco LLC and Virtu Financial LLC.

Market makers are traders who stand ready to take the other side of an incoming order. The evolution of markets has seen the practice evolve into a competitive industry dominated by computer-driven trading systems.

The SEC must update its definition of market makers to account for this shift, Sen. Schumer said. He proposed requiring such participants to quote prices between the highest bid and lowest offer for a certain period of the trading day, depending on the stock.

I don’t see anything remotely like this proposal in the Knight Capital letter on the Flash Crash, it’s in another letter entirely, Comment Letter on File No. S7-02-10, which is the Concept Release on Equity Market Structure. I wish journalists would realize that their beloved quill pen era has gone for good, and start footnoting their damn stories.

I’ve suggested Dubai on occasion as an alternative financial centre for hedge funds et al. Well, they’ll have to reform their justice system a little:

In all, about 40 percent of the 1,200 people in Dubai Central Prison have been convicted of defaulting on bank loans, Human Rights Watch said in a report in January. Even after completing their sentences, the New York-based group said, prisoners are likely to remain in jail until their debt is paid off, unlike in the U.S. or the U.K., where debtors’ prisons were abolished in the 19th century.

Over-lengthy sentences and insufficiently developed laws for prosecuting financial crime threaten to discourage investment in Dubai, said Habib al-Mulla, the former chairman of the Dubai Financial Services Authority, an industry regulator. The U.S. State Department said in a March report that while the country’s constitution guarantees an independent judiciary, the U.A.E. court system remains “subject to review by the political leadership.” Defendants can spend months without being charged and are often unfairly denied bail, according to lawyers.

The European sovereign debt crisis is bad enough for Spain, but the regions are being hit worse:

Catalonia, which accounts for a fifth of Spanish gross domestic product, has been shut out of public bond markets since March and the extra yield it pays over national government debt has almost tripled this year. Galicia, in the northwest, has asked to freeze payments of debt it owes the central government and the Madrid region postponed a bond sale last month.

Spain’s regions, which borrowed at similar rates to the central government before the global credit crisis started in 2007, are key players in Zapatero’s drive to get his budget in order and push down the country’s borrowing costs. They control around twice as much spending as the state, employ more than half of all public workers and piled on debt during the recession.
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The yield on 10-year Spanish government bonds has dropped 78 basis points to 4.102 percent since June 16. The extra return investors demand to hold the debt rather than German equivalents was at 168 basis points yesterday, down from a euro-era high of 221 points two months ago.

Banks are nevertheless charging Catalonia more for loans than the building companies stung by Spain’s construction slump.

The region, which attracts more tourists than any other in Spain, paid 300 basis points more than three-month Euribor for 1 billion euros of four-year bank loans last month, a spokesman said. Fomento de Construcciones & Contratas SA, Spain’s fourth- largest builder, said on Aug. 2 it agreed to pay a 260-basis point spread to extend 1.1 billion euros of loans until 2014.

The Canadian preferred share market edged higher on good volume today, with PerpetualDiscounts gaining 9bp and FixedResets up 6bp.

PerpetualDiscounts now yield 5.82%, equivalent to 8.15% at the standard equivalency factor of 1.4x. Long Corporates now yield about 5.4% (!) so the pre-tax interest-equivalent spread (also called the Seniority Spread) now stands at about 275bp, a small (and perhaps meaningless) widening from the 270bp reported August 4.

On August 6 I reported that one guy with a good track record was calling for low Fed rates for a long time. Another guy with a good track record seems to think otherwise:

Warren Buffett shortened the duration of bonds held by his Berkshire Hathaway Inc. after warning that deficit spending could force inflation higher.

Twenty-one percent of holdings including Treasuries, municipal debt, foreign-government securities and corporate bonds were due in one year or less as of June 30, Omaha, Nebraska-based Berkshire said in a filing Aug. 6. That compares with 18 percent on March 31, and 16 percent at the end of last year’s second quarter.

Econbrowser‘s Menzie Chinn discusses the inflation/deflation arguments in his post From Disinflation to Deflation?.

I have long advocated the consolidation of Money Market Funds into the balance sheets of their sponsoring institutions, but the industry declares (and their future employees in the regulators’ offices accept) that credit risk can be completely eliminated via box-ticking. Now Moody’s reports on the scale of support required during the crisis:

At least 36 money-market funds in the U.S. and about 26 in Europe had to be supported during the global financial crisis, according to a report from Moody’s Investors Service.

At least 20 managers pumped more than a combined $12.1 billion into their prime funds, or money funds that can invest in corporate debt, during the crisis from August 2007 till December 2009, according to the report.

Dan Hallett had a piece in the Globe today titled Some tax-friendly investing alternatives to RRSPs in which he was kind enough to mention my firm:

There are two preferred share mutual funds (from Omega Funds and Manulife/AIC), an ETF from Claymore and a pooled fund from Hymas Investment Management Inc.

Dan was even more effusive in his blog post, Tax Friendly Bond Exposure:

Hymas Investment Management’s Malachite Aggressive Preferred fund, however, deserves a special mention. While it is only available to accredited investors – i.e. it is sold by Declaration of Trust, not by Prospectus – the fund offers more transparency than any prospectus-sold mutual fund. For example, while mutual funds now refuse to show trading summaries (because they don’t have to), Hymas freely posts statements of portfolio transactions on his website.

Hymas, who previously ran the GBC Bond Fund, also boasts a track record that is nothing short of superb. With large investors having exited the preferred share market over the past 15 years, the opportunity grew for astute investors like Hymas to capitalize on this inefficient market. While we have yet to complete our formal work on Hymas and his fund, there is a lot to like. You can also peek into Hymas’ brain by checking out his blog – PrefBlog.

Thanks, Dan! Note that a lot of other clients were run at the time of GBC Bond Fund – GBA had $1.7-billion under management.

There’s a new trend in the States that uncovers a peculiar ethical question:

Harvey Collier, a mortgage broker in Fort Lauderdale, Florida, says he gets as many as 10 calls a month from people planning to default on their loans. The twist: They first want financing to buy another home.

Real estate professionals call it “buy and bail,” acquiring a new house before the buyer’s credit rating is ruined by walking away from the old one because it’s “underwater,” or worth less than the mortgage. It’s an attempt to escape payments on a home whose value may never recover while securing a new property, often at a lower price with a more affordable loan.
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About 12 percent of residential-loan defaults in February were strategic, meaning homeowners decided not to make payments even though they could afford to, New York-based Morgan Stanley said in an April 29 report.
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People who choose to default typically have lost $100,000 or more in property value, said Brent White, a law professor at the University of Arizona in Tucson. No data exist on strategic defaults done in tandem with buy-and-bail purchases.

Buy and bail is most often pursued by people with big enough paychecks and low enough debt to qualify for two homes, according to Mark Goldman, a broker at Cobalt Financial Corp. in San Diego.
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“We’re always looking for ways to discourage the practice of buy and bail, but it still seems to be going on,” said Brad German, a Freddie Mac spokesman. “It ultimately leads to higher costs for everyone as investors and others look for ways to price in the risk.”
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Even if owners have underwater loans, walking away is unethical, said Scott LeForce, president of Realty World Northern California Inc.

“A loss of value doesn’t mean you have permission to run from your obligations,” he said.

In about two-thirds of U.S. states, including Florida, lenders may pursue a borrower after foreclosure by seeking a deficiency judgment allowing a lien on new property for the amount still owed on a previous mortgage. In states such as California and Arizona, lenders may not have that option if the original home was a primary residence.

“Making it possible to pursue people who do this particular kind of default would go a long way to addressing the buy-and-bail problem,” said Jay Brinkmann, chief economist for the Mortgage Bankers Association in Washington.

OK – for the life of me, I don’t understan why buy-and-bail should be considered an ethical problem. The lender either has recourse, or he doesn’t have recourse. That’s the lender’s decision (possibly affected by state law) … why has Freddie Mac, one of the largest mortgage lenders in the world, joined the boo-hoo-hoo brigade?

Assiduous Readers will remember that one reason why I consider Brookfield’s debt to be not as scary as the consolidated balance sheets might otherwise indicate is because most of it’s non-recourse. I don’t think they’ve ever sent their lenders jingle-mail, but H&R REIT has:

[Mortgages Payable on Demand in Note 8 of the 2009 Annual Report] Relates to 10 non-recourse mortgages to the REIT for income properties in which the tenants, Boscov’s Department Stores, Circuit City and Bruno’s Supermarkets, LLC, have filed for protection under Chapter 11 of the United States Bankruptcy Code. The REIT has handed over control of seven of these income properties to the lenders and therefore expects to be released from any further obligations under these non-recourse mortgages upon the transfer of title to the lenders.

Is H&R REIT unethical? Not if they’ve fulfilled their contract. So why are the buy-and-bail guys unethical? Why are big-time lenders, with their multiple billions, legions of lawyers and thousands of whip-smart MBAs pleading for sympathy and rule-changes because they are completely unable to write a contract competently? Why doesn’t Freddie Mac differentiate between recourse and non-recourse mortgages when pricing and repackaging mortgages. I just don’t get it. But then, quite a lot has happened in the past few years that I just don’t get.

The FOMC Statement was gloomy:

Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.
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To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.1 The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.
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Voting against the policy was Thomas M. Hoenig, who judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the Committee’s ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve’s holdings of longer-term securities at their current level was required to support a return to the Committee’s policy objectives.

Due consideration of the Panic of 2007 has resulted in action that has been successful in reducing unemployment:

The FDIC board today also approved creation of two new divisions to help carry out the agency’s responsibilities under the regulatory overhaul. The Office of Complex Financial Institutions will oversee bank-holding companies with more than $100 billion in assets and non-bank firms deemed systemically important by the new Financial Stability Oversight Council.

The office will be responsible for liquidating failed bank- holding companies and non-bank firms.

The agency also established a Division of Depositor and Consumer Protection to help enforce rules that will be created by the new Bureau of Consumer Financial Protection. The FDIC will be responsible for policing banks with less than $10 billion in assets.

There’s a rather odd US court battle over Germany’s sovereign default:

Germany must face a lawsuit over bonds defaulted under Adolf Hitler in the 1930s, a U.S. appeals court ruled, saying the nation isn’t immune from the claims and that American courts have jurisdiction to decide whether the bonds are enforceable.

World Holdings LLC, based in Tampa, Florida, claimed it owns a “significant number” of $208 million in bonds sold to U.S. purchasers following World War I and has been rebuffed when it sought repayment by the German government. The firm is seeking “hundreds of millions of dollars” in the suit, said Michel Elsner, an attorney for the investors.

Germany sold the bonds in an effort to finance rebuilding following the conclusion of the war, according to court papers. By the mid-1930s, after Hitler became chancellor, Germany had stopped making payments on the bonds in the run up to World War II, according to the ruling issued yesterday by a federal appeals court in Atlanta.
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The case is World Holdings LLC v. The Federal Republic of Germany, 09-14359, U.S. Court of Appeals for the Eleventh Circuit (Atlanta).

It’s not quite as ludicrous as it sounds … it’s another one of those nightmarish lawsuits that seeks to maintain property rights despite interim government action, war, looting …

DBRS today confirmed thirty-eiqht split share ratings:

Each of the Issuers has invested in a portfolio of securities (the Portfolio) funded by issuing two classes of shares – dividend-yielding preferred shares or securities (the Preferred Shares) and capital shares or units (the Capital Shares). The main form of credit enhancement available to the Preferred Shares is a buffer of downside protection. Downside protection corresponds to the percentage decline in market value of the Portfolio that must be experienced before the Preferred Shares would be in a loss position. The amount of downside protection available to the Preferred Shares will fluctuate over time, based on changes in the market value of the Portfolio.

Canadian equity performance has been relatively stable in 2010 to date, following the extraordinary decline and rebound experienced during 2008 and 2009. The difference between the minimum and maximum values of the S&P/TSX Composite Index observed during 2010 is approximately 10% of the average level, compared with roughly 40% in 2009 and 60% in 2008. The increased stability in prices has contributed to today’s confirmation of the Preferred Share ratings.

You see that, everybody? DBRS says volatility has gone away forever or, if not forever, than at least through the cycle! Yay!

Volume increased to above-average levels in the Canadian preferred share market, with PerpetualDiscounts gaining 11bp and FixedResets down 3bp on the day.

A firm called Nanex has a fascinating explanation for the May 6 Flash Crash:

Beginning at 14:42:46, bids from the NYSE started crossing above the National Best Ask prices in about 100 NYSE listed stocks, expanding to over 250 stocks within 2 minutes (See Part 1, Chart 1-b). Detailed inspection indicates NYSE quote prices started lagging quotes from other markets; their bid prices were not dropping fast enough to keep below the other exchange’s falling offer prices. The time stamp on NYSE quotes matched that of other exchange quotes, indicating they were valid and fresh.

With NYSE’s bid above the offer price at other exchanges, HFT systems would attempt to profit from this difference by sending buy orders to other exchanges and sell orders to the NYSE. Hence the NYSE would bear the brunt of the selling pressure for those stocks that were crossed.

Minutes later, trade executions from the NYSE started coming through in many stocks at prices slightly below the National Best Bid, setting new lows for the day. (See Part 1, Chart 2). This is unexpected, the execution prices from the NYSE should have been higher — matching NYSE’s higher bid price, unless the time stamps are not reflecting when quotes and trades actually occurred.
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Because many of the stocks involved were high capitalization bellwether stocks and represented a wide range of industries, and because quotes and trades from the NYSE are given higher credibility in many HFT systems, when the results of these trades were published, the HFT systems detected the sudden price drop and automatically went short, betting on capturing the developing downward momentum. This caused a short term feed-back loop to develop and panic ensued.

Some trading firms have stated that they detected a problem with the accuracy of the data feed and decided to shut down which further reduced liquidity. We think the delay in NYSE quotes was at the root of this detection.

Nanex publishes some graphical representations of patterns in quote time-series, refering to them as “Crop Circles” … somebody’s doing something, but what? They are publishing new interesting Crop Circles daily … for instance:

NASDAQ “Blue Wave”. Very interesting Bid price/size repeater. 30,000 quotes at approx. 480 quotes per second.
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NASDAQ “The Waste Pool”. Over 5500 quotes in 2 seconds, alternating the bid size up for 2 quotes, down for 2 quotes, etc., effecting the BBO along the way.
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“Boston Shuffle”. 1250 quotes in 2 seconds, cycling the ask price up 1 penny a quote for a 1.0 rise, then back down again in a single quote (and drop the bid size at that time for a few cycles).

Most interesting, but I wish their graphics were better quality and there was a little more explanation of just what was being charted. Traders’ games … you gotta love ’em!

Nanex is mentioned in an article in The Atlantic, titled Explaining Bizarre Robot Stock Trader Behavior:

“It’s possible that the observed patterns are not malicious, in error, or for testing, but for information-gathering,” [University of Pennsylvania’s Michael] Kearns observed. “One could easily imagine a HFT shop wanting to regularly examine (e.g.) the latency they experienced from the different exchanges under different conditions, including conditions involving high order volume, rapid changes in prices and volumes, etc. And one might want such information not just when getting started, but on a regular basis, since latency and other exchange properties might well be expected to change over time, exhibit seasonality of various kind, etc. The super-HFT groups might even make co-location decisions based on such benchmarks.”

MIT’s Andrew Lo, who is the director of the school’s Financial Engineering laboratory, offered a variation on that thesis. He contends that the algorithms are being used not to test latency but to probe the actual market conditions.

“What I think is going on is that there are algorithms that have been designed to monitor the markets and essentially create a kind of trolling function to try to identify orders that might be executed and to do that in a regular and relatively systematic way,” he said.

Themis Trading is outraged:

Forget the awesome graphs; ask yourselves this: what economic non-nefarious reasoning could there be for the quote patterns in this link?

It’s poker guys … it’s poker. You can always nail a bluffer eventually, as long you’re patient.

Freddie Mac wants more money:

Government-controlled mortgage buyer Freddie Mac is asking for $1.8 billion in additional federal aid after posting a larger loss in the second quarter.

Freddie Mac said Monday it lost $6 billion, or $1.85 per share, in the April-to-June period. That takes into account $1.3 billion in dividends paid to the Treasury Department. It compares with a loss of $840 million, or 26 cents a share, in the second quarter a year ago.

The government rescued McLean, Va.-based Freddie Mac and sibling company Fannie Mae from the brink of failure nearly two years ago. The new request means they have needed $148.2 billion to stay afloat, about $63.1 billion of which is being used by Freddie Mac.

Do you want to know one reason why the regulators get away with extortion? Here’s nine million:

In the hearing today, before U.S. Magistrate Judge Michael Dolinger, the parties discussed possible outlines for pretrial discovery in the case. Reisner said the SEC is turning over 9 million pages of investigative documents to Tourre’s lawyers. He said the agency may seek to take pretrial testimony from 25 witnesses.

Pamela Chepiga, one of Tourre’s lawyers, said Tourre may seek to take testimony from as many as 50 witnesses. Chepiga said the parties may also need to pursue evidence in the U.K. and Germany in addition to the U.S.

And remember, Fabulous Fabio was a salesman. Just a damn salesman. But the SEC will continue to throw lawyers and papers and mud at him until he realizes that the US Government has a lot more money than he does.

The Canadian preferred share market turned in mixed results on below-average volume today, with PerpetualDiscounts gaining 13bp and FixedReset losing 8bp.

It will be interesting to learn what effect the DBRS downgrade of MFC has on the market tomorrow. My guess: not much, but we could see some choppiness and I’ll emphasize the word “guess”. I’m more interested in learning whether they’ll announce a new issue tomorrow!

Most interest rate speculation is empty wind, but Bill Gross’ opinion comes with a track record:

Pacific Investment Management Co.’s Bill Gross said the Federal Reserve is unlikely to raise interest rates for two to three years as it seeks to keep the economy from slipping back into recession.

Treasury two-year note yields dropped below 0.50 percent for the first time today after the Labor Department said the economy lost more jobs in July than economists forecast. The difference in yields between 2- and 10-year notes is 2.34 percentage points, more than double the average of 1.11 percent for the so-called yield curve over the past 20 years.

“When you analyze that portion of the curve, it says the Fed is on hold for a long, long time,” Gross said today during a radio interview on “Bloomberg Surveillance” with Tom Keene. “When you get down to 50 basis points on two-years, that’s giving you a signal that there’s not much left on the table.”

Gross, manager of the world’s biggest bond fund, has been benefitting from the steep yield curve by buying five-year Treasuries, holding them for a year before selling to pick up capital appreciation as well as interest income.
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“Hopefully as long as the curve stays steep and as long as the Fed stays where it is, then you produce two- to two-and-a- half returns as opposed to 50 basis points,” Gross said.

Of course, what happened in 1994 was that everybody played that game and results were unfortunate when the music stopped.

There was a fine crop of papers released by the New York Fed today, led by a a Staff Report by Tobias Adrian and Erkko Etula titled Funding Liquidity Risk and the Cross-Section of Stock Returns:

We derive equilibrium pricing implications from an intertemporal capital asset pricing model where the tightness of financial intermediaries’ funding constraints enters the pricing kernel. We test the resulting factor model in the cross-section of stock returns. Our empirical results show that stocks that hedge against adverse shocks to funding liquidity earn lower average returns. The pricing performance of our three-factor model is surprisingly strong across specifications and test assets, including portfolios sorted by industry, size, book-to-market, momentum, and long-term reversal. Funding liquidity can thus account for well-known asset pricing anomalies.

There are some very nice ideas here, but the paper is marred by the authors’ insistence on shoe-horning the model into the antediluvian Capital Asset Pricing Model and their use of regression. Regression? How can you use regression for serious quantitative work? Look, say I have a two stock universe and I’m building a system that swaps between A and B periodically to earn incremental return (it will win when price changes are noise and lose when they’re unexplained signal; the point of the model is to explain as much signal as possible to increase the proportion of your trades that exploit noise). So I trade whenever I think I can get a 1% excess return on capital. Why 1%? Because I’ve tested the system and 1% gives me a better risk/return profile than 0.95% or 1.05%.

So I do the trade and wait. How long do I wait? I don’t know. I wait until I think I can make 1% going the other way, whether it’s three minutes or three years. The condition is met, briefly, after three weeks and I reverse the trade and start waiting again. The regression misses this trade reversal, because it uses fixed time periods of a month. Don’t talk to me about regression.

Still, there are good ideas here which will be incorporated and tested (properly!) in the next quant equity system I build … assuming anybody ever wants a quant equity system that, you know, works. Built one before (in the late ’90’s), I’ll probably build at least one more before I hang up my hat.

The FRBNY also released a staff report by Toni Dechario, Patricia Mosser, Joseph Tracy, James Vickery, and Joshua Wright titled A Private Lender Cooperative Model for Residential Mortgage Finance:

We describe a set of six design principles for the reorganization of the U.S. housing finance system and apply them to one model for replacing Fannie Mae and Freddie Mac that has so far received frequent mention but little sustained analysis – the lender cooperative utility. We discuss the pros and cons of such a model and propose a method for organizing participation in a mutual loss pool and an explicit, priced government insurance mechanism. We also discuss how these principles and this model are consistent with preserving the “to-be-announced,” or TBA, market – particularly if the fixed-rate mortgage remains a focus of public policy.

Their sixth design principle is of great interest:

The design of any successor to the GSEs must take a stand on whether the 30-year fixed rate amortizing mortgage with no prepayment penalty is going to remain a key mortgage product. We assume that U.S. households and policymakers will continue to have a preference for the fixed rate mortgage as a staple of housing finance because it insulates homeowners from fluctuations in interest rates. As a result, securitization will remain an attractive alternative for mortgage originators (because they do not wish to hold such assets on balance sheet against their short-term liabilities or devote capital and liquidity resources to supporting them) and so an active secondary market will be needed to support it.

The TBA market, by the way, is:

The vast majority of agency MBS trading occurs in what is known as the TBA (“to-beannounced”) forward market. In a TBA trade, participants agree on a price to transact a given volume of agency MBS at a specified future date (the settlement date). As the name suggests, the defining feature of a TBA trade is that the actual identity of the securities to be delivered at settlement is not specified on the trade date. Instead, participants agree only on 6 general parameters of the securities to be delivered. A timeline for a typical TBA trade is shown in Figure 2, including three key dates. On the day of the trade, the buyer and the seller establish the 6 general parameters, including the date the corresponding cash and security will actually be exchanged, which may be anywhere from 3 to 90 days later.

There was light trading in the Canadian preferred share market today, with PerpetualDiscounts losing 9bp in a relatively rare pullback. However, FixedResets were able to gain 7bp, taking the median weighted average yield down to 3.40%, just a little above its level of August 4.

The hedge fund migration is continuing:

Goldman Sachs Group Inc.’s principal- strategies business, a group that makes bets with the firm’s own capital, plans to transform into a fund and raise outside money, a person with direct knowledge of the decision said.

Goldman Sachs may announce as soon as tomorrow plans to discontinue the business, which is part of the New York-based bank’s equities unit, the person said, declining to be named because the decision hasn’t been made public. The team, which aims to complete the process by the end of the year, hasn’t set a target for the amount it wants to raise, the person said.

Bad times are over! The UK has lots of money!

The U.K., known for rain and gray skies, enjoyed record installations of solar panels in July after the government guaranteed prices for electricity from renewable energy up to 10 times market rates.

Photovoltaic panels with the capacity to generate 4.6 megawatts were fitted last month, energy regulator Ofgem said on its website. That’s more than in the whole of 2009, according to Bloomberg New Energy Finance, which forecasts the nation’s solar market will increase 12-fold this year.
…
The National Farmers Union has had a “significant number” of inquiries from financiers and its members about using farmland and barn roofs to host panels, said Jonathan Scurlock, the union’s chief renewable adviser.

Farmers are being offered rent of 1,000 pounds to 2,000 pounds per hectare for their fields, more than they can make from livestock or crops, he said.

The BoC has released a working paper by Fuchun Li titled Identifying Asymmetric Comovements of International Stock Market Returns:

Based on a new approach for measuring the comovements between stock market returns, we provide a nonparametric test for asymmetric comovements in the sense that stock market downturns will lead to stronger comovements than market upturns. The test is used to detect whether asymmetric comovements exist in international stock markets. We find the following empirical facts. First, asymmetric comovements exist between the United States (U.S.) stock market and the stock markets for Canada, France, Germany, and the United Kingdom (U.K.), but the data are unable to reject the null hypothesis of the symmetric comovements between the U.S. and Japanese stock markets. Second, either a larger negative drop or a positive increase in stock prices leads to stronger comovements of stock market returns, indicating that comovements in the data are different from comovements implied by a bivariate symmetric distribution, which implies that comovements tend to zero as the market returns become more positive or more negative.

I don’t think there’s anything particularly startling in the conclusion (although those who swear by VaR and are surprised by 25-standard-deviation fluctuations in their asset values might be a little startled!); the main contribution of this paper is its critique and replacement of the Pearson Coefficient:

All the empirical evidence mentioned above in favor of asymmetric comovements is based on the Pearson correlation coefficient as the measure of comovements.1 It is well known that the validity of the Pearson correlation coefficient as the measure of comovements crucially depends on the assumptions that the relationship between two variables is linear and that the two variables are jointly normally distributed. However, a number of empirical studies have documented that a linear relationship based on the normal distribution assumption clearly fails to explain the stylized facts observed in data and that it is highly undesirable to perform various policy evaluations, risk management and financial forecasts (Granger (2002), Rodriguez (2007), and papers therein).

PerpetualDiscounts just kept on keeping on in the Canadian preferred share market today, gaining 7bp, while FixedResets were about as flat as they could be. Volume was light. MFC issues were noticable in both the performance and volume tables, presumably related to their lousy 2Q10 results and S&P Downgrade.