PrefBlog

The EU is now openly discussing mechanisms for sovereign default:

European Union leaders endorsed German calls for a rewrite of EU treaties to create a permanent debt-crisis mechanism, while sparring over whether to force bondholders to help pay the bill for rescuing financially distressed states.

As the biggest contributor to this year’s hastily arranged 860 billion euros ($1.2 trillion) in loans and pledges to stem the debt crisis, Germany won backing to set up a permanent system by 2013. Deficit-strapped Spain warned that provisions to reschedule or cancel some debts would expose its markets to renewed selling pressure.

“We won’t allow only the taxpayers to bear all the costs of a future crisis,” German Chancellor Angela Merkel told a press conference in Brussels today after a summit of EU leaders. There is “a justified desire to see that it’s not just taxpayers who are on the hook, but also private investors.”
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Germany rules out extending this year’s emergency taxpayer- funded financial assistance mechanisms when they expire in 2013. Merkel’s follow-up system would extend debt maturities, suspend interest payments and waive creditor claims, Handelsblatt newspaper reported yesterday, citing an unidentified government official.

Assiduous Readers will remember that on July 23 I reported:

But the best line in the farce comes from a central banker:

ECB Vice President Vitor Constancio called the tests “severe” and explained they didn’t include a scenario of a national default because “we don’t believe there will be a default.”

That’s just great, Vitor! Maybe you’ll be put in charge of the government run credit rating agency the Europeans are thinking about, you know, the ones that will be much nicer to sovereigns than those mean old-style CRAs!

There is no word yet regarding whether Vitor Constancio has resigned.

The Bank of Canada has released a working paper by Ali Dib titled Capital Requirement and Financial Frictions in Banking: Macroeconomic Implications:

The author develops a dynamic stochastic general-equilibrium model with an active banking sector, a financial accelerator, and financial frictions in the interbank and bank capital markets. He investigates the importance of banking sector frictions on business cycle fluctuations and assesses the role of a regulatory capital requirement in propagating the effects of shocks in the real economy. Bank capital is introduced to satisfy the regulatory capital requirement, and serves as collateral for borrowing in the interbank market. Financial frictions are introduced by assuming asymmetric information between lenders and borrowers that creates moral hazard and adverse selection problems in the interbank and bank capital markets, respectively. Highly leveraged banks are vulnerable and therefore pay higher costs when raising funds. The author finds that financial frictions in the interbank and bank capital markets amplify and propagate the effects of shocks; however, the capital requirement attenuates the real impacts of aggregate shocks (including financial shocks), reduces macroeconomic volatilities, and stabilizes the economy.

Commissioner Elisse B. Walter of the SEC delivered an interesting speech regarding the SEC review of the US Municipal market. A lot of familiar cross currents – exchanges for bonds! the Credit Rating Agencies are no good! brokers should tell us what to buy! – and discussion of the move from the Municipal rating scale to the global scale:

Three participants endorsed the principle of a global rating scale. However, one pointed out that during this time — where some rating agencies are moving to a global scale — investors may find it increasingly difficult to compare municipal credits against each other. Further, he thinks that despite recalibration, investors will continue to have a hard time comparing munis to corporates because municipal risk remains overstated relative to corporate risk.

Several others were critical of the notion of a global rating scale, arguing that municipal bonds and corporate securities are just not comparable. One panelist stated that munis should not be rated on a scale that focuses on default risk and recovery, since governments rarely default. Some of the participants would prefer a new rating scale for governments that could be tailored to the unique characteristics of governmental entities. We heard suggestions for a simple pass/fail scale, a three-part scale or a scale of 1-100.

Another area of concern was the impact of ratings on the cost of issuance. One panelist pointed out that higher ratings lead to lower borrowing costs and lower ratings lead to higher borrowing costs. He and a co-panelist highlighted the consequence of lower ratings: increased costs to taxpayers for financing critical infrastructure projects.

That last panelist should take a tip from the Europeans: set up a new rating agency with a mandate to be chipper and upbeat at all times.

Themis Trading points out signs of a high-level regulatory battle, with the NYSE opining:

NYSE Euronext Chief Executive Officer Duncan Niederauer said regulators will probably respond to the May 6 stock-market crash by extending obligations to buy and sell shares to more traders.

Niederauer, speaking in Washington today, said too many traders reap the benefits of making markets without responsibilities to keep providing liquidity when stocks are plunging. New rules may be in place as soon as January, he said.

Securities and Exchange Commission Chairman Mary Schapiro called on the agency in September to examine whether the loss of “old specialist obligations” has hurt investors after measures such as trading stocks in penny increments cut the number of market makers. With the facilitation of trading now dominated by hundreds of automated firms with few rules for when they must buy and sell, the SEC is considering ways to keep the biggest from abandoning the market at the first sign of trouble.

The astonishing part is in the third paragraph. Imagine! The regulators made it less profitable to be a specialist … and fewer firms wanted to be specialists. Well, who woulda thunk it?

NASDAQ takes the other view:

The head of Nasdaq OMX Group Inc (NasdaqGS:NDAQ – News) said on Friday he does not expect any new obligations or privileges for U.S. “market-makers” until 2012 at the earliest, calling any regulatory change “a slippery slope.”
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“I don’t think something will happen in 2011,” Nasdaq OMX Chief Executive Officer Robert Greifeld said on a conference call, adding it would be “a difficult road to try to properly define what responsibility and privileges to give participants.”

Mervyn King made an excellent point in a speech at the Second Bagehot Lecture:

Second, the Basel approach calculates the amount of capital required by using a measure of “risk-weighted” assets. Those risk weights are computed from past experience. Yet the circumstances in which capital needs to be available to absorb potential losses are precisely those when earlier judgements about the risk of different assets and their correlation are shown to be wrong. One might well say that a financial crisis occurs when the Basel risk weights turn out to be poor estimates of underlying risk. And that is not because investors, banks or regulators are incompetent. It is because the relevant risks are often impossible to assess in terms of fixed probabilities. Events can take place that we could not have envisaged, let alone to which we could attach probabilities. If only banks were playing in a casino then we probably could calculate appropriate risk weights. Unfortunately, the world is more complicated. So the regulatory framework needs to contain elements that are robust with respect to changes in the appropriate risk weights, and that is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements.

He also mentioned the Too Big To Fail problem:

But in most other countries, identifying in advance a group of financial institutions whose failure would be intolerable, and so are “too important to fail”, is a hazardous undertaking. In itself it would simply increase the subsidy by making it explicit. And it is hard to see why institutions whose failure cannot be contemplated should be in the private sector in the first place. But if international regulators failed to agree on higher capital requirements in general, adding to the loss-absorbing capacity of large institutions could be a second-best outcome.

… which has been a hot issue lately:

“Are we a systemically important bank in the world? I think (we’re) not. Nothing in my strategy is trying to make us that,” Toronto-Dominion Bank CEO Ed Clark said last week, although he also acknowledged that regulators may not agree with him.

“It’s not obvious that there will be no impact on us, and I don’t know that and I can’t get any assurance on that,” he said at a presentation in Toronto. TD is Canada’s No. 2 bank.

Rick Waugh, CEO of third-ranked Bank of Nova Scotia , has also said his bank is not systemically important.

Gord Nixon, head of Royal Bank of Canada , which is considered the Canadian bank most likely to be deemed “too big to fail,” said at a presentation Wednesday that the whole debate was “ridiculous” and suggested labeling a bank “too big” might compel it to shed assets to shrink.

It’s so far unclear how many banks will fit the bill, with some speculating regulators could name 30 or more lenders.

Canada’s bank regulator, which has objected to the idea of singling out large banks, is also pushing the point that Canadian banks should be left off the list.

“I’d say that 80 per cent of global financial intermediation goes through 20 institutions … and no Canadian financial institutions fit that bill,” said Julie Dickson, Canada’s Superintendent of Financial Institutions.

It is precisely to avoid such irresolvable arguments that I propose that regulation eschew the TBTF label; what should happen is that there should be a progressive surcharge on Risk-Weighted-Assets, so that the first 100-billion is requires less capital than the next 100-billion and so on.

The SEC has $450-million available for paid informers! Denounce your neighbor today!

Alackaday! TMX DataLinx has advised:

The daily Toronto Stock Exchange and TSX Venture Exchange Trades & Quotes files for Friday October 29, 2010 will be delayed due to systems testing and are expected to be available by 5:00 AM, Sunday October 31, 2010. We regret any inconvenience this may cause.

They like to do this on PrefLetter weekends and monthends. So we’re all gonna hafta wait. I will update with the day’s action when I can.

Update, 2010-10-31: The Canadian preferred share market closed the month with a small gain, PerpetualDiscounts up 3bp and FixedResets winning 2bp. Volume continued at elevated levels.

PerpetualDiscounts now yield 5.41%, equivalent to 7.57% at the standard equivalency factor of 1.4x. Long Corporates now yield about … oh, call it a hair over 5.2%, so the pre-tax interest-equivalent spread is now about 235bp, a slight (and perhaps meaningless) increase from the 230bp reported on October 27, but a sharp decline from the 260bp reported on September 30. The tightening was driven on both sides, as PerpetualDiscount yields fell while long corporate yields rose modestly; the performance of the BMO Long Corporate ETF shows how returns on the asset class plateaued in October.

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Econbrowser‘s James Hamilton discusses Negative real interest rates:

In terms of the Fed’s policy objectives at the moment, one of the problems with deflation is that it guarantees a positive real return just from stuffing cash under your mattress. A primary purpose of the Fed’s contemplated QE2 is to prevent this and spur consumers and firms to invest funds productively rather than hoard cash. Insofar as the recent moves in TIPS and other yields represent the market already pricing in the Fed’s next steps, one might conclude from the latest TIPS readings that this aspect of the Fed’s strategy is already working.

He attaches a good graph:

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Although this appears to be the first time that newly issued TIPS have locked in a negative real return, that’s because TIPS have only been offered to U.S. investors since 1997. You can get a longer time series by comparing the yield on a 6-month T-bill at any date with what the CPI inflation rate actually turned out to be over the subsequent 6 months for which investors held that bill, a magnitude sometimes described as the “ex-post real interest rate.” That series is plotted below. We’ve actually been in a period for several years in which short-term loans to the government were a losing proposition in real terms, and the longer-term real yields such as the 5-year TIPS are only now coming down to join them. The recent era of negative real yields was briefly (if spectacularly) interrupted in the fall of 2008, when a sharp deflation in the CPI made short-term loans to the government an excellent deal for the lender in ex-post real terms.

The Canadian preferred share market continued its recent (boring) pattern with a good day on elevated, if somewhat lower than recent norms, volume. PerpetualDiscounts gained 10bp and FixedResets squeaked out a win of 2bp. It should be noted that, given about 250 trading days in a year, a daily win of just over 1bp is expected.

Forbes has an unusual perspective on the flash-crash:

In a talk at Columbia University’s sociology department, renowned social scientist Donald MacKenzie gave some words of warning and advice about the financial markets. MacKenzie, a professor of science and technological studies at the University of Edinburgh, compared the flash crash with Black Monday crisis of October 19, 1987.
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“Computer systems don’t have a sense of morality,” exclaims MacKenzie, noting the take-one-for-the-team role played by floor specialists in keeping an orderly market–a role that’s been marginalized with trading so widely dispersed. A specialist’s duty was to keep price continuity and to intervene when they found imbalances, “and they did so at a certain risk to themselves,” remembered MacKenzie, “In ’87, on aggregate these specialists lost about two-thirds of their capital” to save the markets, he says. The intervention of specialists becomes harder today because high-frequency trading algorithms are extremely explicit and are largely devoid of such considerations of civic duty.

I haven’t met a trader yet with a sense of civic duty, quite frankly, but what I found most interesting was the claim that specialists took large losses in the Crash of ’87. I don’t have any such recollection, and I would very much like to see MacKenzie’s source for this statement.

There is this, from the Brady Report:

According to a rough survey conducted by the NYSE, specialists’ buying power fell by more than 60 percent from $2,308 million at the close of business on October 16 to $852 million at the close of business on October 19. Whatever the cause for the reduced extent of specialist intervention later on October 19, the road picture that emerges from the analysis of half hourly activity is one of significant intervention to support the market early in the day, net sales during the midday decline and much less extensive (and less effective) support of the market in the sharp decline in the last hour of trading.

However, loss of buying power is not equivalent to loss of capital – it simply means that a good chunk of their capital was committed. However, one point in favour of the specialist system is that the figures mean they were willing to hold their position overnight (although, as the report shows, they squared their books the next day).

So here’s yet another idea for a MBA thesis, assuming those guys have theses: is there any way of telling how much hot money is out there? I mean, really really hot money, for which “overnight” is a lengthy hold. Has this amount increased or decreased (relative to market value, or even relative to market fluctuations) since the Crash of ’87. We can be sure that the amount of formal market-maker capital has decreased, but how about hedge funds and HFT?

My guess is that the total capital has increased, but the amount of capital prepared to hold a position overnight has decreased. Prove me wrong!

Meanwhile, emerging markets are choosing survival over altruism:

Finance chiefs from South Korea to South Africa signaled they may act to slow gains in their currencies, just four days after the Group of 20 vowed to soothe trade tensions in the $4 trillion-a-day foreign-exchange market.

Asian currencies fell to a one-week low after Bank of Korea Governor Kim Choong Soo said today that measures to mitigate capital flows could be “useful.” Hours later, the rand dropped as South African Finance Minister Pravin Gordhan said his government will use part of higher-than-expected tax revenue to build foreign reserves as it attempts to weaken the currency.

The shifts suggest G-20 members will keep trying to defend their economies from the slide of the dollar and capital inflows even after the group promised Oct. 23 to refrain from “competitive devaluation” and to increasingly embrace market- determined currencies.

Gee … I suppose those guys take their responsibilities to their own citizens more seriously than their responsibilities to me! How odd! How thoroughly unmutual!

BIS has released a paper titled Calibrating regulatory minimum capital requirements and capital buffers: a topdown approach.

BIS has also released a working paper by Stefan Avdjiev and Nathan S Balke titled Stochastic Volatility, Long Run Risks, and Aggregate Stock Market Fluctuations:

What are the main drivers of ‡uctuations in the aggregate US stock market? In this paper, we attempt to resolve the long-lasting debate surrounding this question by designing and solving a consumption-based asset pricing model which incorporates stochastic volatility, long-run risks in consumption and dividends, and Epstein-Zin preferences. Utilizing Bayesian MCMC techniques, we estimate the model by …tting it to US data on the level of the aggregate US stock market, the short-term real risk-free interest rate, real consumption growth, and real dividend growth. Our results indicate that, over short and medium horizons, ‡uctuations in the level of the aggregate US stock market are mainly driven by changes in expected excess returns. Conversely, low frequency movements in the aggregate stock market are primarily driven by changes in the expected long-run growth rate of real dividends.

The SEC is planning to ban one-third of the market and encourage paid informers:

SEC commissioners will vote Nov. 3 on a rule that would require brokerages to implement risk controls to monitor client trades, the agency said today in a statement on its website. SEC officials first proposed the regulation in January, saying they were concerned that a computer malfunction or human error might trigger an order that could erode a firm’s capital.
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The proposed rule would “effectively prohibit broker dealers from providing” so-called naked-sponsored access, in which a customer bypasses pre-trade risk controls, according to the agency’s statement. Naked access accounts for about 38 percent of U.S. equities trading, according to a December study by Aite Group LLC.

Commissioners will also vote next week on a proposal to expand the SEC’s ability to reward whistleblowers who provide tips on fraud.

Ah, the good old paid informers! They made the Roman Empire, the Soviet Union and East Germany what they are today!

Julie Dickson gave a remarkably unimportant speech today, titled Changing Times: The Regulatory Future and Canada’s Banking Sector:

In sum, there is no silver bullet to achieving a safe and sound financial sector. Rather, it is multi-dimensional – all parties that touch the sector have a role – bank management and boards, regulators and supervisors, governments, central banks, markets (investors, analyst and rating agencies), and auditors. Emphasis cannot be placed on one area to the exclusion of others.

Human nature trumps all of these. In an effort to save us all from ourselves, policies aimed at our own weaknesses and biases may be the most important of all.

The Toronto Star advises that the federal government writes Credit Default Swaps with no documentation at all:

The federal government does not know how often the loan program is a victim of fraud. About $1 billion a year is lent in small business loans. The number of defaulted loans is steadily increasing. Last year, $106 million of taxpayers money was paid back to banks for defaulted loans. That’s up from $75 million a year in defaulted loans three years before.
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Under the Canada Small Business Financing Program, Industry Canada gives banks the job of approving applications

It only sees the paperwork if the loan goes into default.

One of the problems the Star uncovered is there is little incentive for the banks to conduct detailed background checks.

That’s because banks get a guarantee that the federal government will refund up to 85 per cent of the money to the banks if the loan goes into default. The banks typically also take a personal guarantee from the borrower for the remaining 15 per cent.

Just one of life’s little mysteries! I can’t cash a cheque for $1.98 without a rectal probe, but that does not apply to everyone!

Another day of good performance on the Canadian preferred share market today, on continued heavy volume. This is getting dull. PerpetualDiscounts gained 11bp while FixedResets eked out a 1bp win.

PerpetualDiscounts now yield 5.41%, equivalent to 7.57% interest at the standard 1.4x equivalency factor. Long Corporates jerked up to about 5.3% (maybe a little under) so the pre-tax interest-equivalent spread is now about 230bp, a significant decline from the 240bp reported on October 20.