November 19, 2007

Gary Stern, President of the Minneapolis Fed, gave a speech in Singapore titled “Credit Market Developments: Lessons for Central Banking, which has provoked sharp disagreement from Yves Smith of Naked Capitalism

The theme of Mr. Stern’s speech is that there are no easy answers:

certainly some situations are far from resolved, and thus identification of principal lessons learned from the disruption will necessarily be incomplete and probably prioritized inadequately as well. Nevertheless, I think we can say something meaningful about potential reforms and about the tradeoffs inherent in their adoption. These are important matters; if I am right about tradeoffs, then some reforms might impose significant costs and contribute to outcomes we would prefer to avoid.

Policymakers will certainly find opportunities to improve current regulations and practices; the status quo will need to change in some areas. But, as we will see, and as foreshadowed previously, tradeoffs suggest that policymakers will want to be extraordinarily careful in addressing perceived inadequacies in the current environment.

This seems reasonable enough, but Mr. Smith says:

How do you want to count the damage that we need to count on one side of this tradeoff? Let’s see, we have subprimes at anywhere from $150 to $500 billion. We have the train wreck that is just starting in commercial real estate, which may be a mere $100 to $150 billion. Then we have losses and writeoffs on collateralized debt obligations, which we have said could add up to $750 billion (although some of that is already included in subprime losses). Of we could simply rely on the forecast by Goldman chief economist Jan Hatzius that home foreclosures could reach $400 billion and will trigger a $2 trillion reduction in lending, which in turn will trigger a “substantial recession.”

Even though regulation entails costs in terms of reduced efficiency and reduced profitability, the scale of the damage argues for incurring those costs. Yet, incredibly, Stern is arguing against meaningful change despite overwhelming evidence of serious problems.

… which doesn’t strike me as being a particularly useful response. There are certainly Bad Things happening, but this doesn’t mean that the system is not working as it should. As has so often been reiterated, markets exist in order that risks might be transferred. The fact that sometimes those risks have large effects – perhaps unforseen effects – is not sufficient to justify a full-court press on the regulatory front. Most importantly, before implementing regulatory changes, it is necessary to have a pretty good idea that rule changes will, in fact, be a net benefit … which is all that Mr. Stern is saying.

Mr. Stern’s first example is the “Originate and Distribute” model that results in so much asset securitization:

Because of the many hand-offs in the process—and the terms of the contracts between at least some of the firms—a number of the firms involved in the process did not have a clear stake in the longer-run performance of the mortgage. The incentives in this model, then, may have encouraged large-scale production of low-quality mortgages.

And the alternative—the originate to distribute model—has a core and fundamental economic advantage propelling it: specialization. Over time, firms have developed that specialize in the distinct steps of the lending process, from originating the loan to funding it. Such specialization contributes importantly to cost efficiencies, innovation, and a broadening of access to financial capital.  Another advantage of the model is diversification; the originate to distribute process allows a firm to significantly diversity the asset side of its balance sheet.

… to which Mr. Smith replies …

Ahem, don’t the 15% to 20% fall in housing prices, a falling dollar, and the recession that Hatzius and his colleagues increasingly predict represent an “adverse consequence for living standards’?

And Stern seeks to scare his audience into submission with a false dichotomy: you either accept the originate to distribute model as is, or you go back to having banks hold loans on their balance sheets. There is no willingness to consider methods to improve incentives or information flow, or more clearly define liability, that may reduce the bad outcomes of this system while keeping many of its virtues.

Mr. Smith’s suggestion for incremental improvement of the system is:

All residential mortgage brokers will be subject to Federal reporting and oversight (presumably at least along the lines of the requirements for brokers employed by regulated banks, although those may need to be toughened too).

… which is more than just a little vague. Federal reporting of what? oversight of what? you qualify for a license how? what do you need to do to lose it? Mr. Smith does not provide any argument for mortgage broker registration, merely the assertion that Rules Will Make Life Better.

According to a study released in 2005:

Among the findings for 2004 are these: there are 53,000 operating brokerages and they accounted for 68% of last year’s total origination activity; the mean firm originated $34.5 million with a mean of 7.9 employees; employment at the nation’s brokerages totaled 418,700; subprime and Alt-A loans accounted for 42.7% of brokerage’s total production volume; the average LO originated 26 loans in 2004; the average brokerage used a mean of 13 wholesale lenders; and average gross income per loan was 170 bp.

It’s a pretty big industry! What’s more, there is a host of existing laws and regulatory authorities at the State level already extant. What benefits are intended by federal regulation? What problems would these seek to correct?

Remember: it is not enough to say ‘there is a problem’. A solid argument that the proposed fix would be of net benefit is also necessary. It should also be remembered that the archetypal sub-prime borrower is not a Dickensian poor but honest family of four. The archetypal sub-prime borrower is a speculator, who put up the minimum downpayment while thinking of it as an “option to buy” more than anything else. I alluded to this on October 10 and a looking at data that is in this speech:

A first finding is that recent foreclosures have been disproportionately related to multifamily dwellings. In Middlesex County, Massachusetts, multi-family properties accounted for approximately 10 percent of all homes, but 27 percent of foreclosures in 2007. This highlights a potentially serious problem for tenants, who may not have known that the owner might be in a precarious financial position.

Yes, I know it’s not the most conclusive evidence that may be generalized! If anybody has any good data on the speculator/poor-but-honest-homeowner split amongst defaulting sub-prime, let me know!

Mr. Stern next addresses the Credit Ratings Agency issue in a manner that warms the cockles of my heart:

To be specific, it could be exceptionally costly for each investor to build the infrastructure required to conduct serious credit analysis, and these costs need to be weighed against the losses suffered by investors in the current regime. Moreover, were the agencies unique in underestimating the losses in, say, the subprime mortgage market?  It is not obvious that a different infrastructure will produce better results.
More positively, the rating agencies represent one way of economizing on the production of information on credit instruments. And by charging issuers, they also try to address the public nature of this information for, once the information is produced, there is almost no cost to distributing it and hence it is otherwise difficult to get paid. Absent these charges, there could be too little credit information produced.  Overall then, reforms that might compromise the viability of the agencies or discourage use of ratings present the tradeoff of potentially raising costs and ultimately requiring another solution to the issues the agencies help to address.

Now, I would like to hear more information about the proposal to lift the exemption from Regulation FD that now applies. But Mr. Stern admirably summarizes the major issue.

The next section is “Excess Liquidity”; I won’t re-hash the arguments about whether central banks should target asset prices here. In the conclusion to this section, Mr. Stern states:

Interestingly, the excesses in asset prices perceived in recent years seem related, at least casually, to innovation. Consider the run-up in prices of technology stocks in the late 1990’s and this year’s turbulence linked to pricing of structured financial products and subprime mortgages.  It may be costly to try to address these situations ex ante if, in fact, such actions would inhibit the underlying innovation. Common to all of these concerns is the difficulty of appropriately valuing financial assets.  It is quite plausible that, in pursuing preemptive action, the unintended consequences rival or exceed the desired outcomes.

which attracts the ire of Mr. Smith, who appears somewhat confused:

Similarly, his argument about innovation is specious. Innovation is not a virtue like faith or charity. A particular innovation is not valuable by virtue of merely being innovative (if so, virtually every venture capital proposal would be funded and become a barn-burning success); the measure of the value of an innovation is whether on balance it is beneficial. The jury is out on subprimes, but is it already clear that a lot of the so-called innovations, like no-doc loans, teasers, and high LTV loans, particularly in combination, weren’t innovations, but simply bad ideas.

Big Pharma is full of examples of promising drugs that never made it to market. Why? Either they failed to show sufficient efficacy, meaning they didn’t offer a compelling benefit, or they had potentially dangerous side effects. Why should the world of financial services innovation be any different? Their so-called innovations often deliver limited user benefits (but are more attractive for the producer) and in the case of products like subprime loans, came with toxic side effects, like bankruptcy.

It is not apparent how Mr. Smith would test financial innovation prior to putting it on the marketplace.

Mr. Stern’s concluding example is with respect to government support. He suggests:

In fact, by taking steps to reduce the threat that the failure of a large bank, or decline in asset values in one market, will spillover to other institutions or markets, policymakers can actually increase market discipline and simultaneously achieve greater financial stability.

… which suggests to me that if policy makers have sufficiently guarded against contagion to ensure that one failure won’t topple the system, they will be a lot more willing to allow that one failure; knowing this, banks will strive more carefully to ensure that they don’t become that isolated example; and creditors will strive more carefully to ensure they’re not (overly) exposed to that one example. It seems perfectly clear – but not to Mr. Smith:

“Limiting the size of losses” means “intervening earlier.” The lower the downside for taking risk, the greater the incentive to be reckless. How could this possibly increase moral hazard?

No, Mr. Smith, “Limiting the size of losses” does not necessarily mean “intervening earlier”. It may also mean “limiting contagion”. Mr. Stern made that clear.

All in all, a rather bland speech by Mr. Stern, a violent over-reaction by Mr. Smith.

Stephen Cecchetti was briefly mentioned here on August 27, and has now written another piece for VoxEU: Preparing for the Next Financial Crisis. He is apparently conducting a campaign to force as much financial trading as possible to occur on organized (and regulated!) exchanges; a previous essay that I missed was the topic of another Naked Capitalism post.

The core of Prof. Cecchetti’s argument is:

In order to reduce the risk that it faces, the clearinghouse requires parties to contracts to maintain deposits whose size depends on the details of the contracts. And at the end of every day, the clearinghouse posts gains and losses on each contract to the parties that are involved – positions are marked to market.

Since margin accounts act as buffers against potential losses, they serve the same role as capital does in a bank.   And marking to market creates a mechanism for the continuously monitoring the level of each participants capital.

It is important to realise that because they reduce risk in the system as a whole, clearinghouses are good for everyone. They are what economists refer to as “public goods”.

Well … I don’t buy it, although I would like to see further argument. If a particular security is 20 bid, 90 offered right now on the OTC market, I can think of all kinds of reasons why it will probably be 10 bid, par offered on a public exchange. The major effect of such a change will be to add a lot of instruments to the publicly quoted market that will be an awful lot like preferred shares … sure, you can trade small amounts through open outcry, but to get a big piece done you’ve got to call up a dealer who (if you’re lucky) will get busy and set up a cross.

Mainly, what you’re going to get is another big bureaucracy and 100,000 listed intruments with ludicrous spreads and no volume. Better pricing? Maybe sometimes. But Malachite Aggressive Preferred Fund has a section in the offering memorandum about pricing … if I don’t like the posted bid and offer, I can substitute my best guess (within limits!). I have seen lots of instruments quoted with no bid; many quoted with no offer; and lots quoted at spreads that make your eyes go pop. And believe me, prefs trade a lot more often than a lot of corporate bonds.

Mr. Ceccetti goes on to say:

On the information side, it is important that less-sophisticated investors realise the importance of sticking with exchange-traded products.  The treasurer who manages the short-term cash balances for a small-town government should not be willing to purchase commercial paper, or any security, that is not exchange traded. 

It is not and should not be the exclusive purpose of financial regulation to make life safer for the little guy. The treasurer in this example – and we shall assume for the moment that he’s just another wage-slave accountant, making a good faith effort to Do The Right Thing, but without the experience or the available time to be considered a market professional – should not purchase commercial paper at all. As I’ve pointed out before … there are plenty of institutional money market funds out there, available for 10bp per annum – if that – that provide all the good things regular mutual funds do for Joe Lunchbucket: instant diversification and professional management.

Mr. Cecchetti does not make clear just what problems exist in the current system that will be fixed – with net benefit – by a move to exchange trading. More information is urgently required!

There is good news today! Michael Mendelson (ex-president of Portus Asset Management) has been convicted of fraud. Hurrah!

What a strange day in the preferred share markets today! As far as I can tell, there is a “flight to brand-names” going on – sell everything that doesn’t have an ad on television!

Note that these indices are experimental; the absolute and relative daily values are expected to change in the final version. In this version, index values are based at 1,000.0 on 2006-6-30
Index Mean Current Yield (at bid) Mean YTW Mean Average Trading Value Mean Mod Dur (YTW) Issues Day’s Perf. Index Value
Ratchet 4.84% 4.77% 145,945 15.79 2 +0.1023% 1,046.5
Fixed-Floater 4.87% 4.85% 83,516 15.76 8 -0.0506% 1,044.4
Floater 4.63% 4.67% 60,369 15.99 3 -0.9632% 1,014.2
Op. Retract 4.86% 2.52% 77,119 3.25 16 +0.1538% 1,033.9
Split-Share 5.32% 5.73% 89,076 4.10 15 -0.4516% 1,016.9
Interest Bearing 6.28% 6.32% 64,052 3.50 4 +0.3268% 1,054.9
Perpetual-Premium 5.85% 5.46% 81,522 7.11 11 -0.0939% 1,007.3
Perpetual-Discount 5.61% 5.65% 331,508 14.43 55 -0.0989% 903.1
Major Price Changes
Issue Index Change Notes
ELF.PR.F PerpetualDiscount -4.8563% I don’t see any news. Do you see any news? It’s still rated P-2(high) by S&P. Still rated Pfd-2(low) by DBRS. The common’s about 15% off its highs, but so is everything else. So what gives? Now with a pre-tax bid-YTW of 7.01% based on a bid of 19.20 and a limitMaturity.
WFS.PR.A SplitShare -3.1000% Asset coverage of just over 2.0:1 as of November 8, according to Mulvihill. Now with a pre-tax bid-YTW of 6.51% based on a bid of 9.69 and a hardMaturity 2011-6-30 at 10.00. Hmm… it must be the word “financial” in its name!
BAM.PR.B Floater -2.7484% I’m beginning to detect a pattern! This one has the word “Asset” in its name!
FTU.PR.A SplitShare -2.6178% Asset coverage of just under 2.0:1 according to the company. Now with a pre-tax bid-YTW of 7.03% based on a bid of 9.30 and a hardMaturity 2012-12-1 at 10.00. Hah! You see? US Financial 15 Split! I think we’re on to something here!
SLF.PR.A PerpetualDiscount -2.1535% Now with a pre-tax bid-YTW of 5.60% based on a bid of 21.20 and a limitMaturity.
BNA.PR.C SplitShare -2.0997% Now with a pre-tax bid-YTW of 8.00% based on a bid of 18.65 and a hardMaturity 2019-1-10. We may compare this with 6.71% for BNA.PR.A (maturing 2010-9-30) and 6.23% for BNA.PR.B (maturing 2016-3-25). But does it make any difference?
BAM.PR.N PerpetualDiscount -1.5925% Now with a pre-tax bid-YTW of 6.76% based on a bid of 17.92 and a limitMaturity.
SLF.PR.B PerpetualDiscount -1.5801% Now with a pre-tax bid-YTW of 5.58% based on a bid of 21.50 and a limitMaturity.
FIG.PR.A InterestBearing -1.4056% Asset coverage of 2.1+:1 as of November 16, according to the company. Now with a pre-tax bid-YTW of 6.77% (mostly as interest) based on a bid of 9.82 and a hardMaturity 2014-12-31 at 10.00.
ELF.PR.G PerpetualDiscount -1.1532% Now with a pre-tax bid-YTW of 6.70% based on a bid of 18.00 and a limitMaturity. See ELF.PR.F, above, for expressions of disbelief.
HSB.PR.C PerpetualDiscount -1.1183% Now with a pre-tax bid-YTW of 5.62% based on a bid of 22.99 and a limitMaturity.
NA.PR.K PerpetualDiscount -1.0806% Now with a pre-tax bid-YTW of 6.18% based on a bid of 23.80 and a limitMaturity.
PIC.PR.A SplitShare +1.0000% Asset coverage of just under 1.7:1 as of November 8 according to Mulvihill. Now with a pre-tax bid-YTW of 5.52% based on a bid of 15.15 and a hardMaturity 2010-11-1 at 15.00.
BNA.PR.B SplitShare +1.0865% Asset coverage of 3.8+:1 as of July 31, according to the company. Now with a pre-tax bid-YTW of 6.23% based on a bid of 23.26 and a hardMaturity 2016-3-25 at 25.00. You weren’t expecting to see this issue in THIS section of the price moves, were you? But it’s only coming back a bit from the bid disappearance yesterday … those poor, naive, non-PrefBlog-reading souls who look only at close/close will be somewhat shocked, since it’s down $1.31 today, trading 240 shares in three lots in a nine-cent range.
PWF.PR.D OpRet +1.6551% Now with a pre-tax bid-YTW of -10.62% based on a bid of 26.41 and a call 2007-12-19 at 26.00. Presumably, those investors who check anything at all are checking the softMaturity 2012-10-30 at 25.00, which yields 4.01%, but who knows?
BSD.PR.A InterestBearing +2.7624% Asset coverage of just under 1.7:1 as of November 16 according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.50% (mostly as interest) based on a bid of 9.30 and a hardMaturity 2015-3-31 at 10.00.
POW.PR.D PerpetualDiscount +2.7817% Now with a pre-tax bid-YTW of 5.81% based on a bid of 21.80 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
GWO.PR.I PerpetualDiscount 357,831 Nesbitt crossed 330,000 for Delayed Delivery. Not, presumably, a dividend capture/avoidance trade predicated on the exDate 2007-11-29, since it was done inside the day’s range at 20.11. Now with a pre-tax bid-YTW of 5.72% based on a bid of 20.00 and a limitMaturity.
TD.PR.P PerpetualDiscount 331,313 Recent inventory blow-out. Now with a pre-tax bid-YTW of 5.50% based on a bid of 24.05 and a limitMaturity.
BNS.PR.M PerpetualDiscount 116,240 Now with a pre-tax bid-YTW of 5.45% based on a bid of 20.85 and a limitMaturity.
CM.PR.I PerpetualDiscount 94,550 Now with a pre-tax bid-YTW of 5.48% based on a bid of 21.60 and a limitMaturity.
SLF.PR.E PerpetualDiscount 93,100 Now with a pre-tax bid-YTW of 5.48% based on a bid of 20.50 and a limitMaturity.

There were thirty other index-included $25.00-equivalent issues trading over 10,000 shares today.

4 Responses to “November 19, 2007”

  1. Drew says:

    Is it normal to see S&P and DBRS with what seem to be such different ratings on an issue life ELF?

  2. scomac says:

    I’m glad I don’t own both ELF.PR.G and ELF.PR.F. At least I can switch to harvest a tax loss. That will be the second switch this fall for that purpose. I’ve noticed that several prefs were trading down today on good volume despite Dodge more-or-less telegraphing a rate cut. I wonder if a lot of the activity in prefs has been spurred on by tax loss selling?

  3. kaspu says:

    My Bloomberg has ELF F and G at BBB+ (S&P) and P-2L (DBRS) and A- (Composite). I have the vast pleasure of owning both….buckets of them, actually. Happy, happy, happy.

  4. jiHymas says:

    Rather odd about the ratings … I say S&P has it as P-2(high) based on their website, but I do see that Mr. Bloomberg thinks they have it as P-2(low). Interesting.

    According to the prospectus on SEDAR:

    The First Preference Shares, Series 2 have been given a preliminary rating of P-2(high) by Standard & Poor’s Ratings Services.

    Let’s just keep this to ourselves, shall we? I LOVE finding errors on Bloomberg, because there’s lots of guys who look no further … so we can happily buy our P2(high)s from them at P2(low) prices.

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