PrefBlog

Treasury Bond trading may soon enter the 18th century – the Treasury Market Practices Group is recommending penalties for ignoring a contract:

The underlying problem is the Treasury market contracting convention that a seller can deliver securities after the originally scheduled settlement date at an unchanged invoice price, i.e., without incurring any penalty. Introduction of a dynamic fails penalty with a finite cap rate would remedy this problem. In particular, a dynamic fails penalty would provide an incentive for sellers to resolve fails promptly, and could lead to repo contracting conventions that would give beneficial owners of Treasury securities an opportunity to earn as much as the cap rate in securities loan fee income regardless of the level of nominal interest rates.

The TMPG recommends that market participants agree that the invoice price–that is, the cash amount that a buyer has agreed to pay against the delivery of securities–on any cash or financing transaction that fails to settle on the originally scheduled date be reduced at a
fails penalty rate equal to the greater of (a) 3 percent per annum minus the fed funds target rate at 5 p.m. EST on the business day prior to the originally scheduled settlement date, and (b) zero.
…
2. Margining of settlement fails: When sellers fail to deliver securities in settlement of agreed upon trades, counterparty risk exposures grow and can become acute as these fails age. To mitigate counterparty risk and to better incentivize delivery by increasing the cost of aged fails, the TMPG recommends that market participants take prompt steps to study the most efficient way to commence margining of fails in all cash and financing transactions in Treasury securities. The TMPG plans to convene a working group on this subject to make a recommendation by January 5, 2009.

Point two may be taken as criticism of the SEC for allowing counterparty risk to go unmargined. It is definitely criticism of bonehead risk control in the industry. Assiduous Readers will recall that on November 18 Scotia announced a big loss on trades – equities, admittedly – that were affected by that there counter-whatsit thingamajig.

RBC has announced that 4Q08 will include some market-related write-downs … but not without some accounting gymnastics:

we reclassified most of our U.S. auction rate securities and U.S. agency and non-agency mortgage-backed securities from held-for-trading to available-for-sale. This reclassification is effective August 1, 2008. Accordingly, any unrealized changes in the fair value of these securities will not be reflected in our fourth quarter earnings

.

Realized pre-tax losses include

• $645-million loss on trading inventory
• $355-million loss on permanent impairment of available-for-sale securities
• $330-million gain on RBC’s liabilities designated as held-for-trading

RBC’s 2007 Annual Report notes that:

The decrease of $18 billion in financial assets classified as
held-for-trading and the increase of $8 billion in financial liabilities classified as held-for-trading in 2007 are primarily due to our equity and bond securities held related to our proprietary equity arbitrage and fixed income trading businesses, where we offset the risks from our securities holdings by short selling other securities that are of similar risks to those in our portfolios. The increase of $29 billion in derivative assets and of $30 billion in derivative liabilities in 2007,
primarily in foreign exchange and interest rate contracts, are largely due to increased volatility, strong shifts in exchange rates and interest rates, and higher client and trading activity, partially offset by the weakening of the U.S. dollar relative to the Canadian dollar. These
activities are consistent with our strategy for these businesses and the increases in 2007 are within the approved risk limits.

… and …

For the year ended October 31, 2007, we recognized a gain of $18 million in Trading revenue as a result of the net increase in fair values in various trading portfolios previously measured at amortized cost. This gain includes a $59 million gain on our deposit liabilities designated as held-for-trading resulting from the widening of our own
credit spread during the year.

… and …

liabilities designated as held-for-trading include (i) deposits and structured notes with embedded derivatives that are not closely related to the host contracts; (ii) assets sold under repurchase agreements that form part of our trading portfolio which is
managed and evaluated on a fair value basis; and (iii) certain deposits to offset the impact of related hedging derivatives measured at fair value. Fair value designation for these financial assets and financial liabilities significantly reduces the measurement inconsistencies.

Econbrowser‘s James Hamilton discusses the deflation problem in his latest post. Assiduous Readers will recall that I am completely unimpressed by the so-called evidence of deflation so far, but Dr. Hamilton takes the view that it doesn’t matter whether low yields on Treasuries are evidence of deflation or of flight to quality:

But a second and equally troubling suggestion of expected deflation is the extremely low yields on short-term Treasury bills. Again there may be those who interpret this not as a harbinger of deflation but instead as a reflection of the astonishing (and equally frightening) flight to quality that we have been witnessing.

Even if you don’t interpret the October CPI, TIPS yields, and nominal T-bill yields as warning flags of deflation, they nonetheless raise what is to me the core question: If the Fed wanted to use monetary policy to stimulate the economy at the moment, as I believe it should, what would it do?

TIPS yields are discussed in a John Dizard column in the Financial Times:

Yet, if you believe the yields on US Treasury inflation protected bonds, or Tips, we shall have a 2.2 per cent fall in prices in 2009, a 2.5 per cent decline in 2010 and only flat prices in 2011. If that turns out to be true, the real interest rate burden on even the highest-rated borrowers will be extremely hard to bear.

As a practical matter, long before we had significant “negative prints” of consumer prices, the Federal Reserve would just flat out buy Treasury bonds and monetise away with “quantitative easing”. Gold dealers would replace hedge fund managers at the art auctions, model agency parties and Congressional hearings.

What’s really going on is another effect of the disappearance of dealer and arbitrageur capital. The dealers can’t afford to make efficient markets, given their decapitalisation, downsizing, and outright disappearance. That means anomalies sit there for weeks and months, where they would have disappeared in minutes or seconds.

The arbs, well, they thought they had risk-free books with perfectly offsetting positions. These turned out to be long-term, illiquid investments that first bled out negative carry and then were sold off by merciless prime brokers.

Whatever the nature of the beast, Dr. Hamilton concurs with Mr. Dizard regarding the policy prescription:

So here’s my suggested Plan C. The goal of monetary policy should be to achieve a core inflation rate of 3.0% (at an annual rate) over the next 6 months. That’s something that can be accomplished without rate cuts or lending facilities, and here’s how.
…
Step 3 is to start creating money and use it to buy up assets until the [3% inflation] goal set out in Step 1 is achieved. What sort of assets?
…
What specifically would such assets be? I’d start with those clearly undervalued TIPS. Next I’d buy short-term securities in the currencies relative to which the dollar has been appreciating. Here again if the Fed has to sell these off in a sudden change in perceptions, the Fed will have both made a profit and, by selling, be a stabilizing force. If we’re still seeing no improvement, the Fed can start to buy longer-term Treasuries.

TD Bank is diluting its common:

The Toronto-Dominion Bank (TD Bank Financial
Group or TDBFG) today announced it expects to further enhance its capital position by issuing common equity. TDBFG has entered into an agreement with a syndicate of underwriters led by TD Securities Inc. for an issue of 30.4 million common shares, at a price of $39.50 per common share, to raise gross proceeds of $1.2 billion.

The issue will qualify as Tier 1 capital for TDBFG and the expected closing date is December 5, 2008.

As announced last week, TDBFG’s Tier 1 capital ratio was 8.3% as of November 1, 2008. On a pro forma basis, adjusting for this $1.2 billion of common equity and the $220 million of Series AC preferred shares issued on November 5, 2008, TDBFG’s November 1st Tier 1 capital ratio would be approximately 9%.

Thanks, guys, for making the world a safer place for preferred share investors!

The preferred share world could use a little more safety, that’s for sure (provided one equates safety with price stability). Because it was yet another thoroughly appalling day. I don’t know where all the worry is coming from – how can people worry about preferred dividend cuts when the common dividend hasn’t even be touched yet? And not just not yet touched, but unlikely to be touched? I’m with Genuity Capital Markets analyst Mario Mendonca and an unnamed analyst quoted in the Globe today:

Mr. Mendonca said he does not expect any bank to cut dividends, and believes they would sooner turn to raising capital like CIBC did earlier this year when it tapped the market for a $2.9-billion equity injection.

“The odds are low, but not zero,” another analyst said of dividend cuts.

It could, just possibly, happen, to a limited extent (it’s more likely they do dilutive issues, like TD & CIBC this year, and keep the dividend steady for a long time). And I’m talking about the common dividends, people!

There were fifty-one other index-included $25-pv-equivalent issues trading over 10,000 shares today.

This entry was posted on Tuesday, November 25th, 2008 at 12:49 am and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.