November 28, 2007

Arthur Levitt brought his travelling anti-Credit Rating Agency roadshow to Toronto yesterday, giving a speech at the 2007 Dialogue with the OSC. The Globe has a video of his remarks; they were reported as the same old same old:

Credit rating agencies have lost the trust of investors following the recent meltdown in commercial paper markets, leading to a “systemic shock” in capital markets, a former chairman of the U.S. Securities and Exchange Commission said yesterday.

Arthur Levitt, who led the SEC between 1993 and 2001, told an Ontario Securities Commission conference yesterday the rating agencies are deeply conflicted because they take money from companies to rate their securities, and also offer them consulting services.

“The agencies have become both coach and referee,” he said. “Indeed, I believe we’re facing the prospect of a systemic shock directly as a result of investors’ loss of confidence in the ratings that they have relied upon for so long to evaluate risk.”

He said regulators must examine the conflicts of interest that “plague” rating agencies. Beyond simply prohibiting them from doing additional consulting work for companies they rate, he said the SEC should be given more authority to regulate agencies.

Well, fine. Levitt believes the agencies have lost the trust of investors. My first question is “Where’s the evidence?” and my second is “So what?”. There are plenty of shops around, well staffed and just aching to sell a subscription to their services to anybody who wants to pony up the cash. Unless, of course, having decided that the agencies screwed up, the regulators want to start awarding and yanking licenses on the basis of track record …

David Wilson, Chair of the OSC, mentioned them briefly in his published remarks:

And, we’re talking with credit rating agencies that do business in Canada.
Global securities regulators are carefully reviewing:
• the use of credit ratings in regulated instruments;
• the conflicts inherent in the rating process for structured products; and
• the transparency of the assets held and leverage embedded in these structured product vehicles.

Wilson’s remarks are reasonable enough (a regulator should certainly have some vague idea of what’s happening in capital markets!), but the fact that they invited Levitt to speak at their showcase event is more than just a little odd. 

It’s worrisome. Same old story. If there’s one thing that drives a regulator crazy, it’s the thought that somebody, somewhere, is not filling out a form. To address this issue, the agencies should hire some staff away from the regulators at, say, $200,000 p.a. + benefits, and get some of that good old revolving door regulation going – just like RS is so proud of.

Perhaps I’m feeling a little grumpy today, but I didn’t really see anything new and interesting in a Financial Times essay on the credit crunch referenced by Naked Capitalism. There was an interesting graphic, though:

Note that the sawtooth pattern for the Euribor rate is due to anticipation of well-telegraphed policy increases.

There’s more on the story about the Florida government money-market funds, which were briefly mentioned on November 14 (with friend Levitt labelling them “disgraceful”). Clients are pulling out their money:

Florida local governments and school districts pulled $8 billion out of a state-run investment pool, or 30 percent of its assets, after learning that the money- market fund contained more than $700 million of defaulted debt.

The Florida pool, which was the largest of its kind in the U.S. at $27 billion before the recent spate of withdrawals, has invested $2 billion in SIVs and other subprime-tainted debt, state records show. Connecticut, Maine, Montana and King County, Washington, are among other governments holding similar investments, in smaller quantities.

The Florida pool’s $900 million of defaulted asset-backed commercial paper now amounts to almost 5 percent of its holdings. The paper, which carried top ratings from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings as recently as August, was downgraded after declines in the value of collateral affected by the subprime mortgage slump.

I’ve had a look at the State Board’s 2005-06 Investment Report, an extremely glossy puff-piece with little worthwhile investment reporting, but there is a description of the fund in question.

When local governments in Florida have surplus funds to invest, they often rely on the Local Government Investment Pool (LGIP). As a money market fund, the LGIP invests in short-term, highquality money market instruments issued by financial institutions, non-financial corporations, the U.S. government and federal agencies. In managing the pool, the SBA strives to maximize returns on invested surplus funds to generate revenue that helps local governments
reduce the need to impose additional taxes.

It will be most interesting to see how this pans out!

There was some bad news on the US Housing front brought to us via a National Association of Realtors press release:

Single-family home sales were unchanged from September at the seasonally adjusted annual rate of 4.37 million in October, and are 20.8 percent below 5.52 million-unit level in October 2006.  The median existing single-family home price was $205,700 in October, down 6.3 percent from a year ago.

Existing condominium and co-op sales fell 9.1 percent to a seasonally adjusted annual rate of 600,000 units in October from 660,000 in September, but are 20.2 percent below the 752,000-unit pace in October 2006.  The median existing condo price4 was $223,500 in October, up 4.9 percent from a year ago.

The month/month figures is just noise; it’s the year/year statistics that look worrisome. The Wall Street Journal prepared a graphic of inventory:

I love the handy little arrow they added, to ensure we didn’t look at the chart upside-down or something. They also provided a round-up of commentary.

Prof. Stephen Cecchetti continued his VoxEU series today, which commenced on November 26. He concludes:

So, here’s the problem: discount lending requires discretionary evaluations based on incomplete information during a crisis. Deposit insurance is a set of pre-announced rules. The lesson I take away from this is that if you want to stop bank runs – and I think we all do – rules are better.

This all leads us to thinking more carefully about how to design deposit insurance. Here, we have quite a bit of experience. As is always the case, the details matter and not all schemes are created equal. A successful deposit-insurance system – one that insulates a commercial bank’s retail customers from financial crisis – has a number of essential elements. Prime among them is the ability of supervisors to close preemptively an institution prior to insolvency. This is what, in the United States, is called ‘prompt corrective action,” and it is part of the detailed regulatory and supervisory apparatus that must accompany deposit insurance.

In addition to this, there is a need for quick resolution that leaves depositors unaffected. Furthermore, since deposit insurance is about keeping depositors from withdrawing their balances, there must be a mechanism whereby institutions can be closed in a way that depositors do not notice. At its peak, during the clean-up of the US savings and loan crisis, American authorities were closing depository institutions at a rate in excess of 2 per working day – and they were doing it without any disruption to individuals’ access to their deposit balances.

Returning to my conclusion, I will reiterate that the current episode makes clear that a well-designed rules-based deposit insurance scheme should be the first step in protecting the banking system from future financial crises.

I quite agree with him. The Northern Rock episode – discussed in the context of deposit insurance on October 18, shows that politicians – and, by contagion, government sponsored departments – have squandered the trust placed in them. There have been too many broken promises, too many excuses. Additionally, it is completely unreasonable to expect small retail depositors to monitor the health of their friendly neighborhood bank, particularly at the height of a crisis. Banks should be supported by government sponsored deposit insurance as a social good; in exchange, they must pay insurance premiums based on their risk and submit to regulation of their capital adequacy.

The recent crisis is showing us that there is some cause for concern that this inner fortress of stability may not have been insulated enough from the outer, much less regulated, ring of the general capital markets; but I feel confident that the gnomes of Basel will be reviewing their stress tests over the next few years to account for new ways around the rules. As I mentioned on October 3, guarantees of liquidity and credit, particularly, need to be charged to risk-weighted assets at a higher rate. The default assumption must be that if the bank’s name is on a product – or if the bank is profitting from the product’s existence – then the risk of the product should be consolidated onto the bank’s books.

People invest in these things because of the banks’ reputations. The bank has a good name due largely due to regulation and deposit insurance. When – not if – a product fails, the banks’ reputation is harmed. Therefore, regulation should not pretend that there is no risk to capital from an off balance sheet sponsored product.

VoxEU also published an interesting paper on capital integration within the EU by Sørensen and Kalemli-Ozcan. Essentially, the authors argue that capital markets in the EU are, at least to a certain extent, balkanized, with saving regions refusing to invest in growing regions due to lack of trust.

Our findings suggest that Europe has a long way to go before its capital markets are as integrated as the U.S. market is internally. However, our work also suggests that much of the fragmentation stems from things that the EU cannot directly affect in the short run. Trust and confidence are things that evolve slowly. Policies that reward transparency and punish corruption may help but this is likely to take generations as exemplified by the low level of confidence in East Germany.

Good volume today – and at least some of the completely wierd prices that have become normal lately are starting to rationalize. I just hope there weren’t any Assiduous Readers waiting for the bottom on BNA.PR.C … but on the other hand, I don’t know where it’s going to open tomorrow. One shot wonder, or trend-reversal? Place yer bets, gents, place yer bets…

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% 4.82% 118,740 15.80 2 +0.3363% 1,048.7
Fixed-Floater 4.90% 4.90% 89,976 15.65 8 +0.0212% 1,037.7
Floater 4.81% 4.86% 58,984 15.65 3 -0.5619% 977.9
Op. Retract 4.87% 3.61% 76,119 3.61 16 +0.0226% 1,032.8
Split-Share 5.40% 6.10% 92,812 4.08 15 +1.0102% 1,007.9
Interest Bearing 6.27% 6.37% 66,510 3.72 4 +1.6570% 1,060.3
Perpetual-Premium 5.88% 5.70% 85,149 8.25 11 -0.0016% 1,002.8
Perpetual-Discount 5.62% 5.66% 344,281 14.17 55 +0.2909% 901.7
Major Price Changes
Issue Index Change Notes
BAM.PR.B Floater -1.7179%  
POW.PR.A PerpetualDiscount -1.4980% Now with a pre-tax bid-YTW of 5.83% based on a bid of 24.33 and a limitMaturity.
BAM.PR.I OpRet -1.3462% Now with a pre-tax bid-YTW of 5.20% based on a bid of 25.65 and a softMaturity 2013-12-30 at 25.00.
PWF.PR.G PerpetualPremium -1.1853% Now with a pre-tax bid-YTW of 5.96% based on a bid of 25.01 and a limitMaturity.
ELF.PR.G PerpetualDiscount +1.1723% Now with a pre-tax bid-YTW of 7.00% based on a bid of 17.26 and a limitMaturity.
RY.PR.W PerpetualDiscount +1.2489% Now with a pre-tax bid-YTW of 5.43% based on a bid of 22.70 and a limitMaturity.
POW.PR.D PerpetualDiscount +1.3889% Now with a pre-tax bid-YTW of 5.79% based on a bid of 21.90 and a limitMaturity.
NA.PR.L PerpetualDiscount +1.5920% Now with a pre-tax bid-YTW of 6.00% based on a bid of 20.42 and a limitMaturity.
RY.PR.A PerpetualDiscount +1.6192% Now with a pre-tax bid-YTW of 5.41% based on a bid of 20.71 and a limitMaturity.
PIC.PR.A SplitShare +1.9849% Asset coverage of 1.6+:1 as of November 22, according to Mulvihill. Now with a pre-tax bid-YTW of 6.21% based on a bid of 14.90 and a hardMaturity 2010-11-1 at 15.00
HSB.PR.D PerpetualDiscount +2.0134% Now with a pre-tax bid-YTW of 5.99% based on a bid of 21.28 and a limitMaturity.
BNA.PR.B SplitShare +2.1687% Asset coverage of just under 4.0:1 as of October 31, according to the company. Now with a pre-tax bid-YTW of 7.46% based on a bid of 21.20 and a hardMaturity 2016-3-25 at 25.00.
DFN.PR.A SplitShare +2.4646% Asset coverage of 2.7+:1 as of November 15, according to the company. Now with a pre-tax bid-YTW of 5.12% based on a bid of 10.09 and a hardMaturity 2014-12-1 at 10.00
MST.PR.A InterestBearing +2.4826% Asset coverage of 2.1+:1 as of November 22, according to Sentry Select. Now with a pre-tax bid-YTW of 5.15% (as interest net of a capital loss) based on a bid of 10.32 and a hardMaturity 2009-9-30 at 10.00.
FTU.PR.A SplitShare +3.1493% Asset coverage of just under 2.8+:1 1.8+:1 as of November 15, according to the company. Now with a pre-tax bid-YTW of 7.09% based on a bid of 9.25 and a hardMaturity 2012-12-1 at 10.00.
BSD.PR.A InterestBearing +3.6842% Asset coverage of just under 1.7:1 as of November 23, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.52% (mostly as interest) based on a bid of 9.70 and a hardMaturity 2015-3-31 at 10.00
BNA.PR.C SplitShare +7.0817% Asset coverage of just under 4.0:1 as of October 31, according to the company. Now with a pre-tax bid-YTW of 7.78% based on a bid of 18.75 and a hardMaturity 2019-1-10 at 25.00. Holy Smokey! It’s about time this issue had an up day – but this is ridiculous! The yield may be compared with BNA.PR.A (6.84% to 2010-9-30) and BNA.PR.B (7.46% to 2016-3-25).
Volume Highlights
Issue Index Volume Notes
SLF.PR.D PerpetualDiscount 569,048 Now with a pre-tax bid-YTW of 5.51% based on a bid of 20.20 and a limitMaturity.
SLF.PR.B PerpetualDiscount 299,345 Now with a pre-tax bid-YTW of 5.64% based on a bid of 21.30 and a limitMaturity.
SLF.PR.E PerpetualDiscount 230,700 Now with a pre-tax bid-YTW of 5.54% based on a bid of 20.31 and a limitMaturity.
SLF.PR.A PerpetualDiscount 166,275 Now with a pre-tax bid-YTW of 5.61% based on a bid of 21.20 and a limitMaturity.
GWO.PR.H PerpetualDiscount 129,220 Now with a pre-tax bid-YTW of 5.67% based on a bid of 21.70 and a limitMaturity.
RY.PR.B PerpetualDiscount 100,465 Now with a pre-tax bid-YTW of 5.43% based on a bid of 21.78 and a limitMaturity.

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

Update: cowboylutrell in the comments points out I screwed up the asset coverage for FTU.PR.A in the ‘Price Changes’ table. It has been corrected. Sorry!

3 Responses to “November 28, 2007”

  1. cowboylutrell says:

    For FTU.PR.A, I guess you meant 1.8+:1 for the asset coverage as of November 15 (instead of 2.8+:1).

  2. […] I last reviewed Prof. Stephen Cecchetti’s series on subprime on November 28. Part 3 of the series, Why Central Banks should be Financial Supervisors talks about some countries’ separation of function that are elsewhere combined: In places like Italy, the Netherlands, Portugal, the United States and New Zealand, the central bank supervises banks. By contrast, in Australia, the United Kingdom, and Japan, supervision is done by an independent authority. […]

  3. […] SEC Chairman Arthur Levitt, who has been sharply criticized on PrefBlog, has said something sensible: Arthur Levitt warned the Obama administration and U.S. […]

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