PrefBlog

Looks like Canadian shadow banking is picking up:

Canada’s banks developed their commercial banking arms over decades by lending to companies that typically generate annual revenue of $50-million or less, nurturing scores of client relationships. Since the financial crisis, however, private equity firms have been scooping up smaller companies, shaking up their historical banking relationships.
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Anatol von Hahn, Bank of Nova Scotia’s head of personal and commercial banking, said he would be “be very surprised if we don’t have double, triple” the number of small Canadian companies that are owned by private equity firms twenty years from now. Because they are flush with cash that they simply can’t sit on, private equity firms are often willing to pay big multiples to buy small businesses. “They’re playing a huge role,” he said.
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To adapt to the changing dynamics, Scotiabank has gone so far as to invest in certain private equity funds in order to get access to the companies they acquire, according to Mr. von Hahn, allowing the bank to pitch itself as a potential banking partner.

The trend isn’t playing out in Canada alone. U.S. firms are looking for mid-market acquisitions north of the border. In May, New Jersey-based private equity player Swander Pace Capital acquired Montreal’s Recochem, marking its 10th acquisition north of the border in the past decade. More acquisitions could come because the firm recently raised a brand new $350-million fund.

Could we be heading towards European banking crisis redux?

Shares in Banco Espírito Santo SA … were suspended from trading Thursday after falling an additional 17%. Shares of the lender’s controlling shareholder, Espírito Santo Financial Group SA, were also suspended because, it said, of “ongoing material difficulties” at its parent company, Espírito Santo International. “ESFG is currently assessing the financial impact of its exposure to ESI.”

A spokesman for Espírito Santo International declined to comment.

This week’s downward spiral has knocked 32% off the bank’s market value and has dragged down Portugal’s main stock index with it.

On Thursday, the turmoil spread elsewhere in Southern Europe, illustrating how investors remain nervous about the fragility of the continent’s financial system. In Spain, a bank and a construction company each called off planned bond sales. In Italy, a drug company pulled its stock offering. In Greece, a government-bond sale came in smaller than expected. And stock markets across the continent fell, along with the euro.
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It has been more than a year since fears about the health of a European bank rattled markets. Lately, after years of crisis, investors, bankers and regulators have been growing more confident about the stability of the continent’s financial system. Regulators hoped the banking industry’s improving health would be on display in coming months as they conduct so-called stress tests on more than 120 large banks.

Instead, Espírito Santo’s rapid descent, and the collateral damage in other European markets, suggests that conditions remain precarious.

Critics of Espírito Santo’s complex corporate structure have worried for years about the linkages among companies within the conglomerate. Among the concerns: whether the group’s nonfinancial companies—including a hotel chain and a hospital operator—were using the bank and its customers to raise funds.

Here in Ontario, our wise masters are protecting us from lower prices:

Ontario’s governing Liberals say they want to remove barriers to interprovincial trade, but suggest they’re reluctant to lift some restrictions that give Ontario companies an advantage.

Finance Minister Charles Sousa says there are a number of sectors within Ontario’s economy that are strong because they’re protected.

Sousa says he’s open to talks on how to grow the economy, but he doesn’t want to jeopardize the livelihood of Ontario companies.
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Sousa’s comments come after the leaders of three western provinces called for the removal of trade barriers to reduce the cost of doing business and help provincial economies grow.

As far as I can tell, Mr. Sousa did not explain why strong companies need protection.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 4bp, FixedResets gaining 14bp and DeemedRetractibles off 3bp. Volatility was average, but uniformly positive. Volume was below average overall, and concentrated in a handful of issues.

The National Securities Regulator has just gotten a little more national:

Two more provinces have agreed to join a voluntary national securities regulator expected to begin operations in the fall of 2015, bringing the total number on board to four and giving the upcoming capital markets watchdog a more pan-Canadian scope.

Sources say Saskatchewan and New Brunswick will sign on to the Cooperative Capital Markets Regulator Wednesday in a ceremony in Ottawa with federal Finance Minister Joe Oliver, embracing a plan backed by Ontario and British Columbia last September.

Marketwatch has a nice chart on market trends:

This chart shows how much money is flooding into investment vehicles — index mutual funds and exchange-traded funds — that track stock indexes. These two types of funds have grabbed about 24% of the U.S. mutual fund and ETF market, down from less than 5% in 1998, according to Deutsche Bank data.

Big full-service brokerages, “which control 50% of all invested household wealth in America, have successfully pushed the majority of their advisors’ practices toward more hands-off investing approaches,” said Josh Brown of The Reformed Broker in a recent blog post, referring to charging a flat percentage fee on assets, rather than commissions. “At the same time, do-it-yourselfers have made Vanguard, State Street and BlackRock’s iShares three of the world’s largest asset managers — and they are primarily purveyors of passive indexing products.”

There were modest gains for the Canadian preferred share market, with PerpetualDiscounts winning 7bp, FixedResets gaining 1bp and DeemedRetractibles up 2bp. Volatility was minimal. Volume was average.

PerpetualDiscounts now yield 5.17%, equivalent to 6.72% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.3%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 240bp, a slight (and perhaps spurious) narrowing from the 245bp reported July 2.

Banks engage in maturity transformation and this sometimes gets them in trouble. Many mutual funds and ETFs engage in liquidity transformation, and this is getting some people worried:

Junk-loan funds harbor a significant, structural risk that’s been masked by a three-year rally: Managers may struggle to raise enough cash to meet investor redemptions if too many try to get out at once.

While investors have plowed into the loan market by purchasing mutual-fund shares that trade daily, it typically takes more than two weeks for a money manager selling loans to get cash in exchange for the debt. The concern is that this discrepancy will make it difficult for fund investors to leave the $750 billion leveraged-loan market, where individuals have been playing a bigger role than ever.

“Should investor flows reverse, the mismatch in bank-loan funds could pose a material risk,” Moody’s Investors Service analysts led by Stephen Tu wrote in a July 7 report. “Methods to address sizable investor redemptions in bank loan funds are inadequate.”

In the US Regulation NMS is coming under attack:

The Securities and Exchange Commission’s rules for a national market system have come under scrutiny as lawmakers examine whether high-frequency traders have exploited changes introduced by regulators, exchanges and brokers. The SEC’s rules require all exchanges and brokers to connect to one another to ensure that investors receive the best available prices when they buy shares.

The Senate Banking Committee’s hearing today could intensify pressure on the SEC to change rules it enacted over the past decade. SEC Chair Mary Jo White has said the agency will examine whether its rules have pushed trading away from public markets in favor of private venues such as dark pools.

“The costs associated with maintaining access to each venue, retaining technologists and regulatory staff, and developing increasingly sophisticated risk controls are passed on to investors and result in unnecessary systemic risk,” exchange operator Intercontinental Exchange Inc. (ICE) Chief Executive Officer Jeffrey Sprecher told lawmakers.

Certainly, requirements that everybody connect everywhere are ridiculous; antithetical to the entire concept of competition. It will be quite enough if brokerages disclose the names of the exchanges to which they connect directly and those to which they are indirectly connected by virtue of jitney arrangements with other brokers.

It was an off day for the Canadian preferred share market, with PerpetualDiscounts and DeemedRetractibles both off 2bp and FixedResets down 16bp. The Performance Highlights table is dominated by losing Enbridge issues (which saw yet another new issue announcement today) and winning Power Financial issues (which went ex-dividend). Volume was low.

For all the recent hope about the US – given its recent jobs number – the rest of the world isn’t doing all that well:

International Monetary Fund Managing Director Christine Lagarde signaled a cut in the institution’s global growth forecasts, saying investment is still weak and that risks remain in the U.S. even as its rebound accelerates.

“The global economy is gathering speed, though the pace may be a bit less than we previously predicted because the growth potential is lower and investment” spending remains lackluster, Lagarde told the Cercle des Economistes conference in Aix-en-Provence, France.

The remarks underline the threats to global economic growth at a time when the U.S. Federal Reserve is trimming stimulus and the European Central Bank is fighting inflation that is less than half its targeted level. The IMF is preparing to update its economic forecasts this month after predicting April 8 that the global economy will expand 3.6 percent this year and 3.9 percent in 2015.

In the meantime, all the new rules are disrupting the repo market:

The Federal Reserve’s bond purchases combined with demand from banks to meet tightened regulatory requirements is making it harder for traders to easily borrow and lend certain desired securities in the $1.6 trillion-a-day market for repurchase agreements. That’s causing such trades to go uncompleted at some of the highest rates since the financial crisis.

Disruptions in so-called repos, which Wall Street’s biggest banks rely on for their day-to-day financing needs, are another unintended consequence of extraordinary central-bank policies that pulled the economy out of the worst financial crisis since the Great Depression. They also belie the stability projected by bond yields at about record lows.
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Negative rates happen when certain Treasuries are in such high demand or short supply that lenders of cash are actually paying collateral providers interest so they can obtain the needed securities. Traders said that is a big reason why repo rates on desired Treasuries have recently gotten as low as negative 3 percent.

Now, more repo trades are going uncompleted, or failing, because it’s either too difficult or expensive for the borrower to obtain and deliver Treasuries. Such failures to deliver Treasuries have averaged $65.6 billion a week this year, reaching as much as $197.6 billion in the week ended June 18, Fed data show.

Uncompleted trades averaged $51.6 billion in 2013, and $28.8 billion in 2012, according to the Fed.
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“The effect of all the collateral issues we see now is an indication of not so much how things are, but how bad things will be when you really need liquidity,” said Jeffrey Snider, chief investment strategist at West Palm Beach, Florida-based Alhambra Investment Partners LLC, in a telephone interview June 30. “That’s when you get into potentially dire situations.”

The conditions for repo stress were on display last month. The 2.5 percent note due in May 2024 reached negative 3 percentage points in repo in the days preceding a June 11 Treasury auction of $21 billion in notes to finance government operations.

Repo rates have been most prone to go negative, a situation known as specials in the market, in the days preceding an auction as traders who previously sold the debt seek to buy the securities to cover those positions.

Those fascinated by the topic might want to read the New York Fed paper Key Mechanics of The U.S. Tri-Party Repo Market.

League Assets Corp. and its IGW REIT have given us what may well be a foretaste of the market’s next disaster – private equity:

League made a name for itself by telling investors that their money was safer within a private REIT because it wouldn’t be subject to fluctuations in the public markets. However, cracks started to show over the past few years, and major caution flags were raised in 2013 when League tried to restructure itself by going public. Some investors worried that tapping new, unknowing public investors for fresh funds was the only way League would be able to resolve its cash crunch. (The detailed story of League’s rise and fall was reported in Report on Business Magazine earlier this year.)

Since League filed for protection under the Companies’ Creditors Arrangement Act, PwC has tried to untangle the company’s complex structure and determine who would get paid what. Through this process, the firm concluded that the following were the main problems that led to League’s undoing:
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At the time of its CCAA filing, League hoped it would be able to restructure itself and continue operating. PwC disagreed. Instead, all of the buildings are being sold off, and only two have yet to be sold. While this process has generated funds to help pay back creditors and investors, it has only generated $235-million because League had to sell its properties in what has quickly become a weak commercial property market.

Norm Cham of the SEC had this to say about Private Equity recently:

There is no single methodology for determining the fair value of a security or other asset because fair value depends upon the facts and circumstances of each situation. As a general principle, however, the fair value of a security or other asset held by a fund would be the amount that the fund might reasonably expect to receive for the security or other asset upon its current sale. When determining the fair value of a security or other asset held by an alternative mutual fund, all indications of value that are available must be taken into account.[6] One key to effective valuation is the development of robust valuation policies and procedures. Issues that alternative mutual fund managers may consider addressing in their policies and procedures include: (1) the requirement that the fund monitor for circumstances that may necessitate the use of fair value prices, (2) the provision of a methodology by which a fund determines fair value, (3) the process for price overrides, (4) assurance that controls are in place to review, monitor and approve all overrides in a timely manner, and (5) the prompt notification to, and review and approval by, persons not directly involved in portfolio management to mitigate conflicts of interest.[7]

In other words … “tick the box”. And the blind led the blind into the abyss.

Japan has learned nothing from the western solar energy boondoggle:

The Japanese government’s subsidy program originally paid about triple the amount Germany extended for its solar industries.

Japan approved a cut in tariffs for solar power as a building boom meant the technology made up 97 percent of new renewable capacity since it offered incentives.

The tariff was reduced in April 2013 to 37.8 yen per kilowatt hour from 42 yen. Japan’s method of subsidy for the industry is similar to the program Germany, Spain and the U.K. implemented, offering an above-market rate for solar power.

Japan gave final approval in March for the 11 percent cut to 32 yen a kilowatt-hour for the 20 years from the fiscal year starting April and offered 36 yen for offshore wind, the Ministry of Economy, Trade and Industry said in a statement.

The recent Ontari-ari-ari-Owe election has brought with it the promise of a new fund that will provide citizens with extra pension income – provided, of course, that all the Ontario Bonds this fund will buy doesn’t go bust! The US Treasury has other ideas:

Retirees with 401(k) plans and individual retirement accounts will have more flexibility to purchase annuities that don’t start paying out until age 80 or 85, under final rules from the U.S. Treasury Department.

The rules announced today provide a new way for retirees to limit the drawdowns of their account balances that are now required starting after age 70 1/2. Instead, under the rules, they could use as much as 25 percent of their account balances up to $125,000 to purchase deferred annuities.
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The Treasury Department’s final rules give the government’s blessing to the concept of longevity insurance, which hasn’t taken hold in the market, in part because of the required distribution rules and because of relatively high fees that deter potential purchasers.
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In 2013, deferred income annuities were a $2.2 billion market, less than 1 percent of all annuity sales, according to the Limra Secure Retirement Institute. Deferred income annuity sales have more than doubled for each of the past two years.

A man who purchases a deferred annuity at age 60 for $50,000 can receive $17,614 in annual income for life starting at age 80, according to New York Life.

And that’s with today’s rates!

There was little overall movement in the Canadian preferred share market today, with PerpetualDiscounts and FixedResets both up 2bp and DeemedRetractibles flat. Volatility was minimal. Volume was average.