PrefBlog

Jon Danielsson, Hyun Song Shin & Jean-Pierre Zigrand (there’s a multicultural author’s list for you!) write a piece in VoxEU, Modelling financial turmoil through endogenous risk, based on their Risk Appetite and Endogenous Risk, in which they show that regulating individual banks and trading institutions according to the same template leads to cliff risk:If the purpose of financial regulation is to shield the financial system from collapse, then basing regulation on individually optimal risk management may not be enough.

The bane of quants and the downfall of pseudo-quants is the fact that different things are important at different times; these effects are best minimized by ensuring that datasets are as homogeneous as meaningfully possible. But it’s particularly aggravating when the authorities change relationships on purpose:

Trichet is allowing the ECB’s deposit rate, which lenders earn on overnight deposits with the central bank, to usurp the benchmark refinancing rate and become the main driver of short- term borrowing costs. At just 0.5 percent, the deposit rate matches the Bank of England’s key setting and is only a step away from the zero-to-0.25-percent range the Federal Reserve uses.
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The deposit rate is “very, very low,” Trichet said three times in an hour at a press conference on March 5.

He “is implicitly admitting that the deposit rate has now become the key barometer of the ECB’s policy,” said Nick Kounis, chief European economist at Fortis in Amsterdam. “The ECB has become more and more comfortable in pointing that out, not least because it’s been accused of keeping interest rates too high.”

There’s some excitement in ABCP-land! The Master Asset Vehicles (I & II) are the successors to Canadian Non-Bank ABCP … and now CIBC has delivered a collateral call:

DBRS has today commented on the recent series of trigger event notices delivered by Canadian Imperial Bank of Commerce (CIBC) to Master Asset Vehicle I (MAVI) and Master Asset Vehicle II (MAVII; collectively, the MAVs) requesting additional collateral.

As described in the DBRS Canadian Structured Finance Newsletter dated February 19, 2009, CIBC is the swap counterparty for four leveraged credit default swaps (CDS) collateralized by the MAVs that are not subject to the 18-month moratorium period applicable to all other CDS transactions entered into by the MAVs. The collateralization triggers on these transactions were breached on March 3, 2009, prompting CIBC to deliver trigger event notices to the MAVs requesting additional collateral. On March 6, 2009, and March 9, 2009, CIBC delivered subsequent trigger event notices to the MAVs with respect to subsequent trigger breaches. The additional collateral demanded under the March 9, 2009, trigger event notice was withdrawn on March 11, 2009. The total amount of additional collateral demanded by CIBC now stands at $95.4 million for MAVI and $19.3 million for MAVII. CIBC has stated that the deadline for providing additional collateral is 5:00 p.m. on March 13, 2009.

At the time of issuance of this press release, DBRS had not been informed of the posting of additional collateral. As noted in the March 3, 2009, Canadian Structured Finance Newsletter, the failure of the MAVs to post additional collateral will result in a partial or total unwind of the CIBC transactions with the MAVs. For MAVII, the resulting reduction in collateral supporting the notes is capped at $107,742,597 (or approximately 1.1% of the assets of MAVII).

Canadian equities had a great day, led by financials:

Canadian stocks notched their best three-day gain since November as financial and energy shares soared after better-than-estimated U.S. retail sales fanned speculation that the worst of the credit crisis may have passed.

Royal Bank of Canada climbed 4.3 percent, sending financial shares to their steepest three-day gain in 21 years after Bank of America Corp. became the latest U.S. bank to say it made a profit in the past two months. Suncor Energy Inc. rallied to the highest price since October as crude oil rose more than $4 a barrel.

The Standard & Poor’s/TSX Composite Index added 3.4 percent to 8,282.27 in Toronto, its highest close in three weeks, as six stocks rose for each that fell.
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Royal Bank, Canada’s biggest lender, added C$1.43 to C$35. Bank of Montreal, the fourth-largest, rose 6.1 percent to C$31.93. Canadian Imperial Bank of Commerce, the fifth-biggest, advanced 4.9 percent to C$43.96. Manulife Financial Corp., the country’s biggest insurance company, rose 13 percent to C$12.70. Sun Life Financial Inc. soared 11 percent to C$19.96.

U.S. stocks rallied, led by financial companies, after General Electric Co. said that the loss today of its top credit rating from Standard & Poor’s won’t hurt its business or that of its finance arm.

Financial shares in the S&P/TSX added 5.6 percent, pacing gains in eight of the index’s 10 industries. The gauge rose 20 percent in three days, the best such rally since at least 1987.

XFN, the capped financial index fund, is now back to where it was on February 13, but PerpetualDiscounts are down 7.56% from that date. So go figure.

Still, a few more days like this could be fun!

There is a report that the London Office of AIG’s now notorious Financial Products Group took on notional exposure of USD 500-billion in sub-prime CDSs … not bad leverage for one office of one division, considering AIG’s total equity was $104-billion in June 07, just before the fun started.

Econbrowser‘s James Hamilton advocates having AIG default on its CDSs:

But the issue for me has always been not to exact retribution or instill market discipline, but instead the very pragmatic question of how to use available resources to minimize collateral damage. I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?

The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund.
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Then there’s the domino effect to consider. What do we do when this brings down the next player who can’t continue operations without those payments AIG (or the taxpayers) were supposedly going to deliver? I say, we implement the parallel operation there.

I can’t agree. This would have knock-on effects akin to another Lehman; the cure would be worse than the disease. The policy focus should not be on minimizing cost, but on minimizing harm.

I certainly agree that it is unfortunated that taxpayers are getting hurt and it is clear that regulation must be improved. However, pain is part of the game. Western economies in general and Amercian taxpayers in particular have been well served by the financial system.

Who wants to live in a country without a functional banking system, particularly the mortgage market? I don’t know what the system is like now, but I understand the Indian mortgage market was basically non-existent not too many years ago. So the middle class had to save all their lives to buy a place and maybe be able to look around by the time they were 55. Housing 55! There’s a good insurance slogan!

However, the drumbeat of retribution continues:

Debt investors are an attractive target because of the size of their holdings — more than $1 trillion just at the four largest U.S. banks — and because they’ve emerged almost unscathed so far. Since any reduction in debt at a bank helps boost capital ratios, members of Congress including U.S. Representative Brad Sherman, a California Democrat, say it’s time for bondholders to share the pain.

“These banks can go into receivership, shed their shareholders, shed or reduce the amount they owe to their bondholders and come back out much stronger institutions,” said Sherman, who sits on the House Financial Services Committee, in a statement to Bloomberg News. More U.S. capital might be offered as part of the package, he said.

Go for it, Sherman. Regardless of the situation a year ago, these institutions now have TARP money and bond-holders are senior to TARP money. You might find yourself on the wrong end of a cramdown.

With this kind of talk floating around, is it any wonder the US Corporate market is dysfunctional?:

I think the corporate bond market is still fractured. It is not as dysfunctional as it was in October and November but the realization that solid well established companies need to provide as much of a concession as these entities are here is a sign that there is a very long road to travel before the corporate bond market functions with a degree of normality.

Meanwhile, the GSEs are a continuing disaster:

Freddie Mac, the mortgage-finance company thrust into a leading role in President Barack Obama’s homeowner rescue plans, said it will tap $30.8 billion in federal aid as its loan holdings and other assets deteriorated.

The company, which owns or guarantees more than 20 percent of U.S. home loans, today posted a wider fourth-quarter net loss of $23.9 billion, or $7.37 a share. The results pushed the value of Freddie’s assets below its liabilities, the McLean, Virginia- based company said in a statement, and come as Chief Executive Officer David Moffett leaves after six months on the job.
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Freddie and larger competitor Fannie Mae have been pressured to carry out policy initiatives, including offering low-cost mortgage refinancings, since the government takeover. The often conflicting demands of appeasing regulators and pursuing profit may have led Moffett to resign, [F&R Capital Markets analyst Paul] Miller said.

“They want these guys to refi mortgages without new appraisals and to keep mortgage rates very low; those are not sound business decisions,” Miller said. “They are being used as a public policy tool to save the housing market. That is just going to make it more difficult for them to be floated out as public companies down the road.”

In what is almost certainly an orchestrated move, Bernanke’s proposed Financial Stability Regulator has attracted support:

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the U.S. needs a “systemic risk regulator” and should set up procedures to deal with potential failures of large financial institutions.

“Failure is fine as long as it’s orderly, controlled, leads to resolution and doesn’t cause systemic failure,” Dimon, 52, said at a conference hosted by the U.S. Chamber of Commerce in Washington.

Dimon said at a Feb. 3 conference that he believed the Federal Reserve should have the authority to regulate all companies within the banking system.

CDS junkies, by the way, may wish to read the Observations on Management of Recent Credit Default Swap Credit Events.

The Cleveland Fed has released its March Econotrends, with an interesting chart-pack on the impact of credit easing so far. The Fed’s balance sheet has begun to bloat again:

Annoyed at having been called insane, PerpetualDiscounts rose 90bp to yield 7.52%, equivalent to 10.53% interest at the standard equivalency factor of 1.4x. Long Corporates now yield 7.6%, so the pre-tax interest-equivalent spread is now about 290bp … certainly at the high end of its range, although nowhere near the November end-of-the-world levels.

Julia Dickson of OFSI made some remarks to the Commons Finance Committee, but there was nothing startling there. She emphasized the importance of having high quality capital in the banks (lots of common!) but neglected to highlight OSFI’s recent debasement of capital quality.

More and more, I am taking the view that OSFI made a very serious mistake when changing the MCCSR rules at Manulife’s behest. To preserve the integrity of the regulatory system, they should have insisted on seeing some pain – in the form of forced equity issuance – first. There’s no point in having rules if they’ll be relaxed at the first hint of trouble; that attitude is coming home to roost with the GM Pension Plan.

Pierre Duguay of the Bank of Canada also made some remarks.

The end of the world appears to have been postponed:

Manulife Financial Corp. shares rallied from their lowest level in nine years, climbing 18 percent after CEO Vikram Pandit said Citigroup was profitable in January and February. Royal Bank of Canada surged 14 percent.
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Canadian insurance companies, beaten down to the lowest in more than 11 years yesterday on concern that plunging equity markets will further erode their capital, led the rally in Toronto today.

Manulife, Canada’s largest insurer, advanced C$1.68 to C$10.88, rising from the lowest since March 2000. Smaller competitor Sun Life Financial Inc. gained 17 percent to C$17.53. Power Financial Corp. added 14 percent, the most more than 21 years.
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Also helping financial shares today were remarks from Federal Reserve Chairman Ben S. Bernanke urging an overhaul of financial regulations. Lawmakers and supervisors should rethink everything from the amounts firms set aside against potential trading losses and deposit-insurance fees to protections for money-market funds, Bernanke said in remarks prepared for an address to the Council on Foreign Relations in Washington.

The speech was important enough to merit its own post.

A very sloppy day today, with prices all over the map; PerpetualDiscounts were modestly lower once the dust had cleared.