PrefBlog

Bloomberg has some chatter on the Fed derby:

Investors are increasingly seeking advice on how the potential nomination of Lawrence Summers as chairman of the Federal Reserve instead of Vice Chairman Janet Yellen might influence monetary policy and financial markets.

Inquiries about Summers’s chances “are picking up a lot,” said Matthew Benjamin, an analyst at Medley Global Advisors LLC in Washington, a firm that provides political intelligence to hedge funds. “Wall Street is very interested in this, and there is a perception that there is a difference between Yellen and Summers” in their approach to monetary stimulus.
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The possibility of a Summers chairmanship has contributed to the increase in borrowing costs because he is seen as likely to end the Fed’s quantitative easing sooner than Yellen would, said Krishna Memani, New York-based chief investment officer of fixed income at Oppenheimer Funds Inc., with about $208 billion under management.
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While former Treasury Secretary Summers, 58, has no record making monetary policy, he expressed skepticism about the effectiveness of QE in an April conference hosted by Drobny Global Advisors.

By contrast, Yellen’s views are well known after more than a decade at the central bank. Yellen, 67, was a Fed governor from 1994 to 1997, president of the San Francisco Fed from 2004 to 2010 and vice chairman since 2010.

She has been an architect of the current stimulus campaign and Fed communication strategy and has never dissented from a monetary policy decision under Bernanke.

“We know with Yellen that she will continue with their current program,” Memani said. “With Summers it’s a lot less certain.”

Organized labour – such as it is – has indicated a preference for Yellen:

[AFL-CIO President Richard] TRUMKA: Well, what I said is, if you look at history and their records, she seems to have the edge, she seems to be a better candidate from our point of view, and here’s why. One, when things were going wrong in the economy, in each one of those instances, she predicted them accurately. Larry didn’t. Larry we thought at that time was too close to Wall Street, and it allowed him to jade his thought process.
The second thing is, Janet Yellen has been for a balanced approach to the Federal Reserve. That means that – they have two mandates, fight inflation and create full employment. Larry and everyone before, all the way back to Paul Volcker, have said we’re not going to worry about full employment, we’re only going to worry –
[Talking Head Al] HUNT: But Larry does say he worries about full employment.
TRUMKA: Recently. And I hope that that continues on. And if he becomes the – the chair of the Fed, I hope he continues on and – and aggressively enforces that part of his mandate, as he does the inflation mandate.
HUNT: So, therefore, if Obama were to nominate Summers rather than your preference, which would be Yellen, you wouldn’t oppose the Summers nomination?
TRUMKA: I don’t know. It would all depend on what happens, you know, what’s said and what he’s going to do.

The Canadian preferred share market closed the month with another good day, with PerpetualDiscounts winning 40bp, FixedResets gaining 12bp and DeemedRetractibles up 26bp. The Performance Highlights table reflects the move, although it is much shorter than it has been in the past couple of weeks. Volume was on the low side of average.

In the latest tapering chatter:

Tapering talk has already sent 10-year note yields up 120 basis points. Almost the entire increase has been in the real yield, not in inflation expectations. Long-term interest rates aren’t about to retreat if the Fed delays the inevitable until October or December. So if rising long-term rates have policy makers tied in knots, doing nothing buys them time, not yield relief.

The real 10-year yield (from the 10-year inflation-indexed Treasury note) is 0.6 percent. JPMorgan Chase economist Jim Glassman says that before the recession and introduction of the Fed’s unconventional policies, real long-term rates averaged 2 percent to 2.5 percent. The implied five-year forward real rate — the expected real rate five to 10 years from now, which captures the anticipated normalization of monetary policy — is about 1.75 percent, according to Glassman. “That indicates that much of the adjustment in interest-rate markets has been done already,” he says.

Of course, markets tend to overshoot, and there’s no reason to think they won’t this time. But that’s the reaction to any Fed action.

This doesn’t mean “getting it over with” is a good reason to taper; it’s just better than the economic justifications being offered. At the July 30-31 meeting, “almost all members” thought it was too soon to taper. What will have transpired in the six weeks between the July and September meetings? Two more employment reports, that’s what. There is really no quantitative difference between an increase in non-farm payrolls of 162,000 (July) and 199,000 (April). If you don’t believe me, listen to the statisticians at the Bureau of Labor Statistics.

Inflation is below the Fed’s target. The jobless rate, now 7.4 percent, is being driven as much by declining labor-force participation as new hiring. And Fed officials could look at the 13.4 percent decline in new home sales in July as a harbinger and get squeamish about selling some of the central bank’s stockpile of mortgage-backed securities.

Four months of tapering chatter has given wannabe sellers adequate notice. The deed itself seems fully priced into the market, and time isn’t on the Fed’s side.

But it looks like business has cranked up issuance of cheap debt in advance:

Company debt loads in the U.S. are approaching the highest level since the aftermath of the financial crisis as borrowing to finance mergers and shareholder payouts exceeds earnings growth.

Debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times earnings before interest, taxes, depreciation and amortization, according to JPMorgan Chase & Co. That’s up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009, when it peaked after the deepest recession since the Great Depression.
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While heavier debt burdens have been supported by a Fed policy that pushed average U.S. corporate-bond yields to a record-low 2.65 percent in May, JPMorgan strategists said they expect issuance to slow as interest rates increase. Speculation is mounting that Chairman Ben S. Bernanke will reduce the central bank’s $85 billion in monthly debt purchases as soon as next month.

With a greater sense of urgency to tap debt markets before rates climb higher, companies may continue to increase leverage through the end of the year, Bank of America Corp. debt strategist Yuriy Shchuchinov said in an Aug. 26 note.

There’s an interesting allegation about CMHC lending:

A friend who is an economist further went on to say that when lending rules were liberalized to take into account two incomes in a household it in effect imprisoned families to needing two incomes to afford a house. This did not help families, but rather increased the price of housing, with the outcome that young families are hard pressed not to farm out their children to daycare or grandparents. Single-income households need a really high single income or they face very limited housing options. As individuals, families and a society we’re not any better off, and the outcome only has been higher prices.

A recent article by Canso Investment newsletter reported one troubling trend – “gaming” with CMHC’s online automated appraisal system, EMILI. The system was created in 1996 to allow lenders to quickly check if the house price involved in a mortgage transaction was reasonable. According to Canso, while this streamlined the process of mortgage insurance and origination, it also removed any human check and balance.

EMILI uses an algorithm which looks at the address, and particularly the postal code, and metrics of the house to be insured. The key variables are “the square footage of the house and the prior sale prices for the geographic area of the house.”

According to Canso, “there has been extensive ‘gaming’ of this system and excessive prices generated by this system. If a higher price is required for CMHC insurance coverage, the square footage, which is input by the lender and supplied by the mortgage broker, can be increased as required.”

“Gaming” is a polite term. What this really looks like is fraud. Having said that, the impact of this fraud will, for the most part, be limited to excessive lending on a single property, as opposed to the greater problem of excessive money supply for mortgages. This excess money supply has floated the buyers’ market to extraordinary heights with very few real winners. Recent homebuyers may be able to afford their mortgage payments – providing interest rates remain low during the amortization term. But some amortization terms in the past decade have reached 40 years and it’s unreasonable to expect interest rates to remain low three to four decades down the road.

I believe that the CMHC is a major part of the problem: they’re insuring far too many mortgages and Canadian banks now have record amounts of mortgage debts on their books, both in absolute terms and in terms of the proportion of their assets. They can do this because the mortgages are insured – or, at least, they can be counted as insured until they default and CMHC suddenly gets more interested in the house’s square footage!

Eliminate the insurance and – business risks aside – the risk weight will go up. Risk Weight goes up, Risk Adjustjed Assets go up. Risk Adjusted Assets go up, capital requirement goes up. Capital Requirement goes up, banks’ cost of funds goes up. Cost of funds goes up, mortgage rates go up. Mortgage rates go up, mortgage demand goes down.

NASDAQ has provided an explanation for last week’s shutdown:

The malfunction began when NYSE Arca sent more than 20 “connect and disconnect sequences” as well as a stream of quotes for inaccurate stock symbols, according to Nasdaq’s summary. At one point, Nasdaq received over 2 1/2 times more data per second than the system’s tested capacity.

After being inundated with orders, the flaw in the SIP software prevented redundancy that is built into the system from “failing over cleanly” to a backup program, it said.

It was another day of modest advance in the Canadian preferred share market, with PerpetualDiscounts gaining 2bp, FixedResets up 8bp and DeemedRetractibles full steam ahead with a win of 46bp. The Performance Highlights table was heavily weighted towards winners. Volume was high.

The SEC and five other agencies in the US alphabet soup have release a securitization risk-retention rule for comment:

The original proposal generally measured compliance with the risk retention requirements based on the par value of securities issued in a securitization transaction and included a so-called premium capture provision. The agencies are now proposing that risk retention generally be based on fair value measurements without a premium capture provision.

As required by the Dodd-Frank Act, the proposal would define “qualified residential mortgage” (QRM) and exempt securitizations of QRMs from risk retention. The new proposal would define QRMs to have the same meaning as the term qualified mortgages as defined by the Consumer Financial Protection Bureau. The new proposal also requests comment on an alternative definition of QRM that would include certain underwriting standards in addition to the qualified mortgage criteria.

Similar to the original proposal, under the new proposal, securitizations of commercial loans, commercial mortgages, or automobile loans of low credit risk would not be subject to risk retention. Further, the rule would recognize the full guarantee on payments of principal and interest provided by Fannie Mae and Freddie Mac for their residential mortgage-backed securities as meeting the risk retention requirements while Fannie Mae and Freddie Mac are in conservatorship or receivership and have capital support from the U.S. government. This provision also is unchanged from the original proposal.

The agencies are requesting comment on the revised proposed rule by Oct. 30, 2013.

Some of us might observe that it was risk-retention that caused the problem in the first place, but logic never stopped Congress and regulators from doing anything.

What makes this interesting, however, is the dissenting statement from SEC Commissioner Michael S. Piwowar:

As a general principle, I believe that regulatory agencies should make greater use of reproposals. Reproposals offer regulators the opportunity to improve the efficiency and effectiveness of their rulemaking processes and provide the public the regulatory transparency and accountability they deserve. Such a measure of discipline is critically important in connection with Dodd-Frank, which requires regulators to promulgate hundreds of new, complex, and interrelated rules that affect every American by impacting capital formation, job creation, and economic growth. I am pleased that the agencies approving today’s release saw fit to repropose the rule to take into account public comment. However, because of my concerns about two serious deficiencies in this particular reproposal, I cannot support it and I respectfully dissent.

The Agencies Issuing The Reproposal Did Not Perform Necessary Economic Analyses
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The FSOC Report concludes that the macroeconomic implications of credit risk retention requirements are complex and cautions that “[I]f overly restrictive, risk retention could constrain the formation of credit, which could adversely impact economic growth. The challenge is to design a risk retention framework that maximizes benefits while minimizing its costs.”[7] Notably, the reproposal does not contain any analysis of the macroeconomic implications identified in the FSOC Report.

The failure by the Rulemaking Agencies to articulate necessary economic analyses to support the reproposal is a significant omission and fundamental flaw that cannot be overlooked.

The Reproposal Does Not Adequately Consider Alternatives to Credit Risk Retention Requirements
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In my view, the reproposal should have included disclosure requirements that, contingent on the availability of information regarding secondary market transactions,[14] could facilitate better, more informed decisions by both regulators and investors. Mandatory disclosure also would have the potential to directly reduce informational asymmetries and moral hazard problems. The Rulemaking Agencies could have, for example, proposed and sought comment on enhanced disclosures of loan level characteristics along with mandatory disclosures of the amount, type, and duration of the credit risk that the originators and securitizers voluntarily retained in each ABS.

The reproposal also should have given further consideration to subordinated performance fees that have components dependent on the performance of the overall pool or on junior tranches. Such fees could potentially mitigate concerns about misaligned incentives between originators, securitizers, and investors.

There’s also a dissenting statement from SEC Commissioner Daniel M.Gallagher.

Isn’t the US system great? They actually recognize that intelligent people can disagree, and that dissent is a sign of strength, not weakness. How unlike the pablum we get fed here in Canada.

It was another modestly good day for the Canadian preferred share market, with PerpetualDiscounts gaining 9bp, FixedResets up 18bp and DeemedRetractibles winning 19bp. Today’s Performance Highlights table is quite lengthy by normal standards, but is much shorter than we have been used to lately. Volume was quite high.

PerpetualDiscounts now yield 5.81%, equivalent to 7.55% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.8% (maybe a little under), so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 275bp, a slight (and perhaps spurious) decline from the 280bp reported August 21.

Is there high-closing in the FX market?

In the space of 20 minutes on the last Friday in June, the value of the U.S. dollar jumped 0.57 percent against its Canadian counterpart, the biggest move in a month. Within an hour, two-thirds of that gain had melted away.

The same pattern — a sudden surge minutes before 4 p.m. in London on the last trading day of the month, followed by a quick reversal — occurred 31 percent of the time across 14 currency pairs over two years, according to data compiled by Bloomberg. For the most frequently traded pairs, such as euro-dollar, it happened about half the time, the data show.

The recurring spikes take place at the same time financial benchmarks known as the WM/Reuters (TRI) rates are set based on those trades. Now fund managers and scholars say the patterns look like an attempt by currency dealers to manipulate the rates, distorting the value of trillions of dollars of investments in funds that track global indexes.
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Because they receive clients’ orders in advance of the close, and some traders discuss orders with counterparts at other firms, banks have an insight into the future direction of rates, five dealers interviewed in June said. That allows them to maximize profits on their clients’ orders and sometimes make their own additional bets, according to the dealers, who asked not to be identified because the practice is controversial.
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A large proportion of trading at that time is generated by index funds, which buy and sell stocks or bonds to match an underlying basket of securities, the traders said.

Banks that have agreed to make transactions for funds at the 4 p.m. WM/Reuters close need to push through the bulk of their trades during the window where possible to minimize losses from market movements, the traders said. That leads to a surge in trading volume, which can intensify any moves.
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Fund managers rarely complain about getting a bad deal because they’re assessed on their ability to track an index rather than minimize trading costs, according to consultants hired by companies and investors to help execute trades efficiently.

“Where possible, I would always advise clients not to trade at the fix — but minimizing tracking error is so important to them,” said Russell’s [head of foreign exchange Michael] DuCharme. “That doesn’t seem to be the right attitude to take when you have a fiduciary duty to seek the best execution for pension holders.”

Hurrah for Mr. Ducharme who, unlike most market participants, appears to have retained the brains he was born with. It seems to me that there’s an opening for a market player to run a trade matching service on a subscription basis … orders are put in by subscribers throughout the day, all net imbalances are disclosed (to subscribers only!), all matching orders are filled at the benchmark rate based on time-stamp, all non-matching orders are cancelled. There would have to be a few rules to enforce all this, but it could work…

The portfolio managers have my sympathies – investing or generating significant amounts of cash to meet client orders can have a huge effect, given that indices are calculated at the close. Perhaps what’s needed is indices and portfolio valuations based on VWAP rather than closes … but that’s only going to work in very liquid markets.

It was a modestly good day for the Canadian preferred share market, with PerpetualDiscounts winning 13bp, FixedResets gaining 7bp and DeemedRetractibles up 10bp. There’s a surprisingly lengthy Performance Highlights table, totally disproportionate to the market move. Volume was very high.