PrefBlog

Nothing happened today either, just like yesterday.

It was a day of modest gains for the Canadian preferred share market, with PerpetualPremiums gaining 2bp and both FixedResets and DeemedRetractibles up 5bp. Volatility was minimal. Volume was quite low.

Nothing happened today.

As noted by the Globe & Mail, the CD Howe Institute has released a paper by Paul R. Masson titled The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now:

In this Commentary, I argue that short-term rates are therefore too low in Canada, a situation that is starting to build in pervasive problems for the economy. Below-equilibrium interest rates for an extended period distort investment decisions, leading to excessive risk taking and inefficient and ultimately unprofitable investments. They also encourage the formation of asset bubbles whose collapse could lead to a recurrence of the recent financial crisis.

Some of the symptoms of inefficient investment and asset price bubbles are already evident in Canada, in the housing sector for instance. The cumulative effect of artificially low interest rates also risks fuelling an underlying inflationary process. Therefore, I recommend that the Bank of Canada start now to reverse some of the monetary stimulus and begin raising interest rates.
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Raising interest rates is never popular, but keeping rates low for too long builds in pervasive problems for the economy. Interest rates in nominal terms are at record low levels and negative in real terms, even though Canada’s GDP is only slightly below capacity. At the same time, there are symptoms of distortions created by low interest rates in financial markets: unfunded pensions, losses by insurance companies, excessive household debt, high house prices, and a bias toward high-yielding equities. Extremely low interest rates mean that the Bank of Canada has a long way to go before they approach a neutral setting. The time has come for the Bank to start raising interest rates gradually to lessen the continued build-up of financial imbalances.

This is a timely report because Assiduous Reader AG has sent me a link to a alarmist report on client communications at UBS:

UBS is planning a mass mailing to many of its brokerage clients alerting them that they have been reclassified as “aggressive” investors following a recent change in its market outlook that some people inside the firm say reflects growing bearishness in the bond market, particularly over the long term, the FOX Business Network has learned.
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In late January, UBS (UBS) changed its “strategic asset allocation guidelines,” or the broad parameters used to classify its brokerage clients depending on their mix of stocks, bonds and other investments in their portfolio, people at the company tell FOX Business.

According to brokers inside UBS, new guidelines will reflect a growing belief among the firm’s market strategists that the bull market in bonds has largely run its course, and that those investors who believed they had constructed a “conservative” portfolio by being heavily invested in bonds could be reclassified as “aggressive.” Some also believe the move may be an attempt by the firm to lessen its liability in the event clients who are holding large positions in bonds decide to take legal action against UBS.

Mike Ryan, the chief investment strategist for UBS, said so-called “non consent” letters will be sent out to investors in the coming weeks alerting them of their changed classification – but he says it has little to do with a firm-wide bias against bonds. Rather, UBS is changing “its long-term view” reflecting what it views as a “volatile market…not just in fixed income.”

The concerns regarding legal liability are dumbfounding, but seem reasonable enough. One ambulance-chaser writes:

On February 14, 2013, FINRA, the Financial Industry Regulatory Authority, sent a very sober Valentine’s Day card to bond investors in the form of an Investor Alert. The Alert probably should have been sent much earlier. It acknowledges what most brokerages already know: 1) that the bond bubble is about to burst; 2) that investors should beware of ever increasing risks in bond investing; and 3) that the life’s savings of bond investors is at risk of evaporating. Most bond investors are risk adverse, so this comes as very unwelcome news. Making matters even worse, most bond investors will never see this warning since most bond investors are also unsophisticated investors who are unaware of things like FINRA Investor Alerts.

Brokerage firms are taking very different approaches to pass this information along to investors. As reported in the Investment News on February 1, 2013, TD Ameritrade is sending a warning to its investors that the popping of the bond bubble is not a question of “if” but a question of “when”.

Fox Business reports UBS has taken the unprecedented step of changing the objectives of all of its bond investors from “conservative” to “aggressive.” www.foxbusiness.com/investing/2013/02/01/ubs-set-to-classify-bond-buyers-as-aggressive/ . This is akin to reclassifying Titanic passengers as Olympic swimmers in the hours prior to hitting the iceberg – you can call them what you want but it does not increase their chances of survival when the impending tragedy strikes.

Investors have rights to obtain recovery if the bond bubble bursts. They can seek recovery if their portfolios were over-concentrated in bonds prior to the bubble bursting. Additionally, bond investments will be seen as unsuitable since the investment would be for a much greater risk than most bond investors agreed to take. The bubble bursting will not be much of a Valentine’s Day present, but at least investors have recourse.

The handwringing over FINRA’s notice seems somewhat overwrought. As well as I can determine, the reference is to the Investor Alert Duration—What an Interest Rate Hike Could Do to Your Bond Portfolio:

Currently, interest rates are hovering near historic lows. Many economists believe that interest rates are not likely to get much lower and will eventually rise. If that is true, then outstanding bonds, particularly those with a low interest rate and high duration may experience significant price drops as interest rates rise along the way. If you have money in a bond fund that holds primarily long-term bonds, expect the value of that fund to decline, perhaps significantly, when interest rates rise.

So, taking these three straws in the wind in reverse order, the FINRA statement is nothing more than a well-timed reminder of the price volatility of long-dated instruments. It is not so long ago since the first quarter of 2007, when a huge number of Straight Perpetuals were sold to highly unsophisticated investors who were astonished when the price declines reached 40% at the nadir. In a recent speech reported on PrefBlog on May 10, Bernanke went so far as to say:

In light of the current low interest rate environment, we are watching particularly closely for instances of “reaching for yield” and other forms of excessive risk-taking, which may affect asset prices and their relationships with fundamentals. It is worth emphasizing that looking for historically unusual patterns or relationships in asset prices can be useful even if you believe that asset markets are generally efficient in setting prices. For the purpose of safeguarding financial stability, we are less concerned about whether a given asset price is justified in some average sense than in the possibility of a sharp move. Asset prices that are far from historically normal levels would seem to be more susceptible to such destabilizing moves.
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Also to be considered are factors such as the leverage and degree of maturity mismatch being used by the holders of the asset, the liquidity of the asset, and the sensitivity of the asset’s value to changes in broad financial conditions.

In other words, the Fed is perfectly well-aware that its policies encourage risk-taking – that is the whole point of monetary policy in the first place – but is desirous, insofar as possible, that this risk-taking take place within a rational framework; that the risk-takers understand that they are taking risks.

When one who has been oblivious to risk is suddenly confronted with the fact that risk not only exists but has worked significantly against him, panic ensues. We saw plenty of that in the crisis.

So I regard the FINRA statement as being nothing more than a reminder of the nature of risk: Don’t buy Fund A simply because the yield is reported as 3% as opposed to 2% on what you hold now! Be aware of interest rate risk, and how it is measured by duration, at the very least!

The ambulance-chaser’s assertions are ludicrous and simplistic, but probably a decent enough piece of marketing. I will fault it for its completely unwarranted inference that:

It acknowledges what most brokerages already know: 1) that the bond bubble is about to burst; 2) that investors should beware of ever increasing risks in bond investing; and 3) that the life’s savings of bond investors is at risk of evaporating.

The first is completely nuts. The brokerages know nothing. One of the great myths of finance is that brokerages have some kind of clue about what’s going to happen in the future and it continues to surprise me that this myth has survived the Credit Crunch.

Brokerages are trading operations. Their objective is to buy something from me for a nickel and sell it to you for a dime. They do not care, nor should they care, about which of us will be happier about the trade after a year has passed.

And the idea that the entire life’s savings of bond investors is at risk of evaporating is nonsensical. It will take a very severe bond market indeed to make even long-bond investors lose half their money. If we consider a current-coupon thirty-year Treasury at 3%, the price only breaches $50 at yields of 7%. Could it happen? Of course. Will it happen? That’s a much more difficult question; I suggest it’s unlikely as long as inflation expectations remain anchored at somewhere below 4%. If it does happen, can such a situation be described as the evaporation of life’s savings? Well, you tell me. Better yet, tell the judge.

However, I will reserve most of my ire for the UBS plans regarding bond investors – and I will take the time to note that I can find no commentary indicating that they actually followed through on these plans, nor any that would indicate the details of such plans. It seems reasonable to assume, for instance, an account holding solely short-term bonds would receive a different classification from one exclusively invested in long-term, but such refinements are not discussed in the stem article.

It seems likely that the plans, such as they were, were indeed “an attempt by the firm to lessen its liability in the event clients who are holding large positions in bonds decide to take legal action against UBS.”, which simply illustrates a prevalent attitude today that anybody who suffers the loss of so much as a nickel in the markets is obviously an innocent victim of cunning stockbrokers who knew precisely what was going to happen but didn’t care. I can only be grateful that there are still some vestiges of sanity left in the world:

Click for Big

But there are other problems, for instance:

new guidelines will reflect a growing belief among the firm’s market strategists that the bull market in bonds has largely run its course

This is nonsensical. This represents a market call by the firm’s “market strategists” and to reclassify investors on such a basis is saying that they represent the benchmark for prudent investment and that riskiness is measured by the degree of deviation from their recommendations. Not just nonsensical, but egomaniacal. Not just egomaniacal but narcissist.

UBS, in fact, is a poster-child for total cluelessness regarding market direction.

Particularly irritating is one of the other possible rationales for the putative decision:

Rather, UBS is changing “its long-term view” reflecting what it views as a “volatile market…not just in fixed income.”

Classifying investment risk as a function of volatility is a sign of ignorance whole-heartedly endorsed by regulators and incompetent investors because they read it in a book.

Investment risk is, as I have argued on many occasions, a function of the probability of meeting your investment goals.

Say your investment goal is to make $3,000 p.a. and you have $100,000. Then, I suggest, one of the least risky investments you can make is to plunk the whole damn thing into a thirty year treasury; nothing else is as likely to continue paying you the $3,000 p.a. for thirty years. Naturally, it would be better to plunk the money into a diversified portfolio with the same broad characteristics because, as is known to everybody except regulators and incompetent portfolio managers, risk is a vector. There are different kinds of risk, and to talk of risk as a scalar quantity is to destroy the point of the conversation.

I will go further. Even safer than the thirty year Treasury recommended for the purpose above would be a US Government perpetual bond, if any existed. This would be somewhat more volatile than the thirty-year bond in price terms, but would reduce the risk of the portfolio by addressing the question of ‘What happens after thirty years?’.

Naturally, different portfolio objectives will lead to different perspectives on the riskiness of various methods used to accomplish those goals. If I have $100,000 and my portfolio objective is to use the money to buy a house in one month’s time, then investing the whole thing in a government perpetual would be insanely risky. Far better would be a one-month treasury bill.

And if my portfolio objective is to make $3,000 p.a. AFTER INFLATION, then holy-smokes, the thirty-year treasury bond just got risky again. How about that?

And, in my favourite example ever, if you have $1 and your portfolio objective is to make $1-million before next Tuesday, then your least risky investment is a lottery ticket. The chances of success, while miniscule, are higher than with anything else – although a prudent person will be well-advised to redefine his portfolio objectives until a significant chance of success can be reasonably estimated.

To talk of “risk” in the absence of clearly defined desirable rewards is just craziness. I should work this up into a proper article some day.

Speaking of market forecasting, the Bank of Canada published a paper by Ian Christensen and Fuchun Li titled A Semiparametric Early Warning Model of Financial Stress Events:

The authors use the Financial Stress Index created by the International Monetary Fund to predict the likelihood of financial stress events for five developed countries: Canada, France, Germany, the United Kingdom and the United States. They use a semiparametric panel data model with nonparametric specification of the link functions and linear index function. The empirical results show that the semiparametric early warning model captures some well-known financial stress events. For Canada, Germany, the United Kingdom and the United States, the semiparametric model can provide much better out of-sample predicted probabilities than the logit model for the time period from 2007Q2 to 2010Q2, while for France, the logit model provides better performance for non-financial stress events than the semiparametric model.

Me, I just use a Magic 8-Ball: Reply Hazy. Try Again Later.

It was a modestly negative day for the Canadian preferred share market, with PerpetualPremiums off 11bp, FixedResets down 12bp and DeemedRetractibles flat. Volatility was minimal. Volume was a little below average.

PerpetualDiscounts now yield 4.89%, equivalent to 6.36% interest at the standard equivalency factor of 1.3x. Long Corporates now yield about 4.15%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 220bp, a slight – and perhaps spurious – narrowing from the 225bp reported May 8.

There was a most interesting story on Bloomberg about the travails of the brokerage business:

Alex Freemon was so eager to be a stockbroker after graduating from the Georgia Institute of Technology last year that he said he was happy to go door to door selling mutual funds for Edward Jones & Co.

The brokerage flew him to St. Louis, where he practiced knocking on a model door in a classroom of would-be brokers at the company’s headquarters, then sent him back to Atlanta to walk the streets for 10 hours a day for about $30,000 a year plus commissions. Freemon said he quit in March after realizing he would have to spend five years struggling to meet sales goals before he could focus on helping clients make financial plans.
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Breaking into the brokerage business is getting tougher as declining fees make small accounts less profitable and government restrictions on unsolicited calls make phone sales taboo. That’s leaving big firms struggling to replace a retiring generation of advisers who helped accumulate trillions of dollars of assets and generated steady profits for years.

“The only way you can do it is if your dad is rich and he’s got country-club buddies he can send you or you’re a psycho who can work 20 hours a day,” said Josh Brown, who helps oversee about $350 million at Fusion Analytics Investment Partners LLC in New York.
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The shift to discount brokerages is happening as individual investors return to the stock market. Charles Schwab Corp. (SCHW)’s client assets rose 14 percent in the first quarter, as the Standard & Poor’s 500 Index (SPX) headed toward a record 1633.77 yesterday. That’s more than twice the 6 percent increase for Bank of America Corp. (BAC)’s wealth-management unit.

Brokers also are leaving the biggest firms to join or start smaller money-management businesses, known as registered investment advisers, that don’t take commissions. From 2009 to 2012, the ranks of investment advisers increased 7 percent while the number of brokers fell 9 percent, according Aite Group LLC, a financial-research company based in Boston.

Luis Aguilar, the SEC Commissioner I most often quote unfavourably here, was weeping and wailing about credit rating agencies today:

Although AAA-rated securities have historically had less than 1% probability of incurring defaults, over 90% of the AAA ratings given to subprime RMBS securities that originated in 2006 and 2007 were later downgraded by the NRSROs to junk status.[Footnote]

Footnote reads: Id. (Financial instruments bearing below BBB- (or Baa3) ratings are referred to as “below investment grade” or as having “junk” status). [nb: “Id.” refers to the US Senate Report

I find it very interesting to see just how carefully he chooses his words: he discusses the incidence of default of AAA securities, then discusses the downgrades-to-junk of subprime paper – and even then, only of 2006/07 cohorts.

As those familiar with the ratings of Split Share Corporations are aware, a good rule of thumb is that ratings for structured notes will be volatile, but defaults are highly mitigated by a relatively low severity of default. I continue to be fascinated by the question of just what proportion of AAA actually defaulted (broken down by cohort and security type) and what the severity of these defaults was, but I have never seen any figures … the regulators and other hand-wringers are too busy whipping up hysteria about the Evil Credit Rating Agencies to worry about picayune facts. Why is this information being suppressed by people who should know better such as SEC Commissioner Luis Aguilar?

What’s a Grecian Urn? An upgrade from Fitch!

Greece won an upgrade by one level from Fitch Ratings, which cited the country’s progress in rebalancing the economy and bringing its deficits under control.

Greece was raised to B- from CCC and given a stable outlook, according to a statement from Fitch in London today. The ratings company said there is a “semblance of political and social stability” with the government showing more ownership over its adjustment program and a lower risk of exit from the euro area.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums up 7bp, FixedResets down 7bp and DeemedRetractibles gaining 3bp. Volatility was low. Volume was average.

Bloomberg highlighted a study by A. Joseph Warburton, Deniz Anginer and Viral V. Acharya titled The End of Market Discipline? Investor Expectations of Implicit State Guarantees:

We find that bondholders of major financial institutions have an expectation that the government will shield them from losses and, as a result, they do not accurately price risk. While bond credit spreads are sensitive to risk for most financial institutions, credit spreads lack risk sensitivity for the largest institutions. This expectation of public support constitutes a subsidy to large financial institutions, allowing them to borrow at government-subsidized rates. The implicit subsidy provided large institutions an annual funding cost advantage of approximately 28 basis points on average over the 1990-2010 period, peaking at more than 120 basis points in 2009. The total value of the subsidy amounted to about $20 billion per year, topping $100 billion in 2009. Passage of Dodd-Frank did not eliminate expectations of government support. The cost of this implicit insurance could be internalized by imposing a corrective tax. Requiring financial institutions to shoulder the full cost of their debt would help create a more stable and efficient financial system.

I don’t like the taxation idea – that’s just going to lead to a hopeless mess, and there won’t be anything in the kitty when it’s needed. I have previously advocated, and continue to advocate, a progressive increase in capital requirements based on size and, perhaps, other measures of systemic importance if these can be measured objectively. Thus, a $20-billion bank might have required CET1 Capital of 8%, but at $200-billion bank might have a 10% requirement. Such a regime has the same objectives as the surcharges for G-SIBs and D-SIBs, but is less prone to regulatory corruption.

The situation with respect to Chesapeake’s junk bond redemption (that I mentioned on March 18) has been resolved:

Prices on the second-biggest U.S. natural gas producer’s notes have fallen by as much as 9 cents on the dollar, erasing $117 million, after a judge ruled May 8 that Chesapeake could redeem the securities at par. Investors including the hedge-fund firm run by former Lehman Brothers Holdings Inc. President Bart McDade were betting the Oklahoma City-based company had missed a deadline and would have to pay as much as $400 million to retire the debt early.

A search for returns has highlighted the dangers implicit in wagering on disputes in which borrowers traditionally had the upper hand after yields on junk debt dropped to a record 5.98 percent and prices soared to an unprecedented 107.2 cents on the dollar on May 9.
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Any company that drafts ambiguous deal documents may receive similar legal treatment to the “get out of jail free card” that U.S. District Judge Paul Engelmayer in Manhattan handed to Chesapeake, according to Brian Gibbons Jr., an analyst at debt researcher CreditSights Inc. in New York.

“The assumption now will be that indenture readers need to be on the lookout for sections of documents where they might
need ‘time to apply thoughtfully the canons of contractual interpretations,’” Gibbons wrote in a May 8 report. “The risks
are to be laid on the bondholder for bad drafting.”

Transmission of monetary policy is – somewhat surprisingly – getting media attention after a blog post by Mark Dow:

We’re all, to varying degrees, slaves to our experiences. Their formative experiences, almost to a man, were in the early 80s. This is when they built their knowledge and assembled their financial playbooks. They learned words like Milton Freidman, money multiplier, Paul Volcker, Ronald Reagan, and the superneutrality of money. Above all, they internalized one dictum: real men have hard money.

This understanding implies that an increase in bank reserves deposited at the Fed (i.e. “printing”) eventually feeds credit growth and thereby inflationary pressures; in other words, no base money increase, no credit growth. Only one problem: reality disagrees.

From 1981 to 2006 total credit assets held by US financial institutions grew by $32.3 trillion (744%). How much do you think bank reserves at the Federal Reserve grew by over that same period? They fell by $6.5 billion.
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How is that possible? I thought in a fractional reserve system base money had to grow for credit to expand?

The answer is structural. The financial deregulation that began in the early 80s (significantly, the abolition of regulation Q) and the consequent development of repo markets fundamentally changed the transmission mechanism of monetary policy. Collateral lending is now king. Today, length of collateral chains and haircut rates—neither of which are determined by the Fed—define the upper bounds of the money supply, not base money and reserve requirements.

Assiduous Readers will doubtless remember my mockery of HAMP in 2009. I just stumbled across some S&P Commentary dated 2013-4-26:

In June of last year, Standard & Poor’s Ratings Services contended that principal forgiveness was more likely to keep U.S. mortgage borrowers current than more commonly used modification tools (see “The Best Way to Limit U.S. Mortgage Redefaults May Be Principal Forgiveness,” June 15, 2012). Data gathered since then not only support this view but also demonstrate servicers’ growing adoption of this form of loss mitigation. (Watch the related CreditMatters TV segment titled, “Principal Forgiveness Remains The Best Way To Limit U.S. Mortgage Redefaults,” dated May 7, 2013.)

As of February of this year, more than 1.5 million homeowners have received a permanent modification through the U.S. federal government’s Home Affordable Modification Program (HAMP). Since the publication of our June 2012 article, there have been more than 400,000 additional modifications on outstanding mortgages (as of March 2013). This translates to roughly a 22% rate of growth in the number of modifications on an additional $2.4 billion in mortgage debt.

Under the HAMP Principal Reduction Alternative (PRA) program, which provides monetary incentives to servicers that reduce principal, borrowers have received approximately $9.6 billion in principal forgiveness as of March 2013. Interestingly, servicers have ramped up their use of principal forgiveness on loans that don’t necessarily qualify for PRA assistance. Indeed, among the top five servicers for non-agency loans, we’ve noted that principal forgiveness, as a percentage of average modifications performed on a monthly basis, has increased by about 200% since the latter half of 2011 (see Chart 1). We attribute part of this to the $25 billion settlement in February 2012 with 49 state attorneys general and these same five servicers: Ally/GMAC, Bank of America, Citi, JPMorgan Chase, and Wells Fargo). In fact, although principal reduction remains the least common type of loan modification among servicers, the percentage of non-agency modified loans that have received principal forgiveness has increased by 3% since June 2012 (see Chart 2). Since 2009, servicers have forgiven principal on approximately $45 billion of outstanding non-agency mortgages.

It was a modestly negative day for the Canadian preferred share market, with PerpetualPremiums down 10bp, FixedResets flat and DeemedRetractibles off 4bp. Volatility was average. Volume was below average.