November 15, 2007

Well, there won’t be much today, I’m afraid! What with fixing (well, patching, anyway) my server problem and a … rather exciting day in the markets, there hasn’t been much time to Stay Abreast of Current Events.

Richard Portes of the London Business School has written a very good essay on VoxEU: International Stability by Design which serves as an executive summary for a major work that he co-authored International Financial Stability.

Now, it is a little fishy of me to comment on his VoxEU essay without purchasing and reading the work on which it is based – but hey! I’m sure he doesn’t mind a little publicity. He deals with hedge funds first, denying any pressing need for regulation:

Many regulators in the US and other major markets believe that the best way to monitor hedge fund activity is indirectly, through their sources of funds.

We see no clear benefit from additional regulation.

So far so good! It was only yesterday that I reiterated my prediliction for a non-regulated – lightly regulated, anyway! Things like insider trading and false advertising still need to be looked at! – sector of the financial markets, where innovation is king.

He is not concerned about the potential for financial market destabilization due to carry trades.

He is concerned, however, about the regulation of Large Complex Financial Institutions:

This suggests that not only regulators, but also the major central banks must cooperate more closely in dealing with liquidity shocks.

but does not provide any specifics – in this summary – of what he means by this. The Bank of England lists LCFIs as:

LCFIs include the world’s largest banks, securities houses and other financial intermediaries that carry out a diverse and complex range of activities in major financial centres. The group of LCFIs is identified currently as: ABN Amro, Bank of America, Barclays, BNP Paribas, Citi (formerly Citigroup), Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JPMorgan Chase & Co., Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS, Société Générale and UBS.

LCFIs had the incomprehensible total of USD 23-trillion in assets in 2006, according to Chart 10 of the Bank of England’s April 2007 Financial Stability Report. The Financial Times had a very good report on this at the time.

The next section of Portes’ essay deals with the somewhat related issue of new financial instruments:

Given all the benefits from innovative financial instruments, the appropriate question is how to make these instruments safer. First, market-driven, but regulatory- and supervisory-authority-guided, approaches are necessary for successful financial risk management. As new instruments are designed, regulation must keep pace. Second, financial risk-management solutions must be global.

Finally, having prepared the ground by addressing LCFI regulation and financial novelty regulation, we get to the heart of the matter (and without this section my review of the essay would have been much more cursory!):

Transactions that do not transfer risk should not be treated by regulators as if they do

Many of the new instruments are illiquid, and the role of ratings firms in evaluating them is highly controversial. There has been a transfer of activity from regulated to unregulated investors.

The shift from ‘buy and hold’ to the ‘originate to distribute’ model should not (and probably cannot) be reversed. Policy-makers and industry bodies can try to make it work better, to push it towards a more balanced, market-based model through reforms that include:

  • Regulators and market participants should pay particular attention to “tail risk”
  • New regulations could require originators to retain equity pieces of their structured finance products.
  • Regulators need aggregate information on structured finance instrument holdings and on the concentration of risk to assist in the regulatory process.
  • Industry bodies should promote product standardisation and accurate pricing in the structured finance market.
  • Credit market transactions that do not definitively transfer risk should not be treated by regulators or risk managers as if they do.
  • Ratings firms should provide a range for the risk of each instrument rather than a point estimate, or should develop a distinct rating scale for structured finance products.

I consider these recommendations rather breathtaking – but there is doubtless argument to support the conclusions in the full report. I will merely point out that:

  • the industry, to at least some extent, likes non-standardized products and inaccurate pricing. They can make more money trading that stuff against players who have no idea what they’re doing.
  • how is the requirement that originators hold equity pieces of their transactions to be enforced? If I have some kind of risky revenue stream that I want to monetize, are the regulators really going to stop me? My instinct is to leave this kind of thing with the market and make the ability to say ‘We’ve got skin in this game’ a competitive advantage.
  • the ‘new credit ratings scale’ recommendation has been floated so many times it is acquiring a veneer of inevitability. But Joe Broker does not want a new ratings scale. He wants something easy to explain to his client and his client just wants his hand held. I don’t know what kind of practical effect this cosmetic measure will have.
  • all these recommendations will come to nothing for as long as investors don’t care about their returns – that is, forever.

My last point deserves at least a little elucidation. I have never talked to an investor who didn’t claim he was after performance … sometimes with less risk, sometimes with more risk, but all these guys have been pretty tough cookies, you know, and want good performance … or so they say.

The OSC issued a press release today regarding their review of ICPM marketting practices. I was on the long-list for their preliminary review – I believe every ICPM was. I had to provide them with a list of my websites and a copy of all printed marketting material; after submitting it, I never heard from them again.

Have a look at their summary of results … and bear in mind that these are Investment Counsel / Portfolio Managers that are being looked at, not mere stockbrokers:

Most of the deficiencies fall into one of the following areas:

1. preparation and use of hypothetical performance data
2. linking actual performance of the ICPM’s investment fund or investment strategy with the performance of another fund or investment strategy
3. construction and marketing of performance composites
4. construction and use of benchmarks in marketing materials
5. use of exaggerated and unsubstantiated claims in marketing materials

In the absence of actual deceit, not a single one of the sharp practices listed will withstand two minutes of questioning by a client who is concerned about performance. While the OSC’s efforts in this area are to be applauded, you cannot regulate common sense.

And, briefly, the bond-insurer saga continues, with fears of a USD 200-billion hit to markets if the insurers are downgraded … but the math looks bad enough without being as pessimistic as the very gloomy assumption required to get that high:

Then there is the $1 trillion market for insured securities backed by assets such as home-equity and consumer loans. Concerns about the underlying quality of the assets and the viability of the guarantors have caused investors to price some securities relative to the credit-default swaps of the insurers, according to David Land, a mortgage-bond fund manager at Advantus Capital Management. Advantus, based in St. Paul, Minnesota, oversees about $18 billion.

Insured securities backed by home equity-lines of credit have fallen by 15 percent, based on the rise in credit-default swap rates this year on Ambac’s insurance company. If the entire insured market were to drop that far, it would reduce the value of the securities by $150 billion.

There are some reports of a change in accounting treatment of credit losses by Fannie Mae – which readers will remember is a grossly undercapitalized Government Sponsored Enterprise. As I mentioned on September 20, the GSEs are helping to bail out the mortgage sector, to the condemnation of all right-thinking individuals and cheers from Congress.

As far as I can make out from the FDIC supervision manual, the change in accounting treatment relates to the discounts at which loans are purchased from a third party. If a $100,000 loan is purchased at $60,000 (due to credit concerns), it is no longer booked as a $100,000 loan with a $40,000 credit reserve; it’s booked as a $60,000 loan.

Given that the GSEs are now purchasing impaired loans (at least, to a far greater extent than they have in the past), one would definitely expect there to be a large difference between results from the old and new calculation methodologies. In other words, the issue sounds like a lot of fuss over nothing – but to confirm that I’d have to look very carefully at the source documents and I don’t have time. I’ll leave it as an exercise for the student.

A busy day in the preferred market, with prices falling amidst the now usual amount of completely strange relative pricing.

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 4.79% 4.78 156,168 15.82 2 +0.5941% 1,052.5
Fixed-Floater 4.86% 4.83% 83,857 15.79 8 -0.3642% 1,046.4
Floater 4.56% 4.59% 61,880 16.15 3 -0.5510% 1,031.0
Op. Retract 4.86% 3.90% 79,392 3.32 16 +0.1525% 1,032.0
Split-Share 5.26% 5.48% 88,059 4.14 15 -0.3778% 1,027.2
Interest Bearing 6.29% 6.41% 63,333 3.51 4 -0.3282% 1,051.5
Perpetual-Premium 5.84% 5.49% 82,000 6.99 11 -0.2175% 1,009.3
Perpetual-Discount 5.58% 5.62% 326,297 14.23 55 -0.1810% 905.7
Major Price Changes
Issue Index Change Notes
HSB.PR.C PerpetualDiscount -2.1053% Now with a pre-tax bid-YTW of 5.56% based on a bid of 23.25 and a limitMaturity.
BNA.PR.C SplitShare -1.7481% Asset coverage of 3.8+:1 as of July 31, according to the company. Now with a pre-tax bid-YTW of 7.69% (as DIVIDENDS! The interest equivalent is 10.77% based on a conversion factor of 1.4) based on a bid of 19.11 and a hardMaturity 2019-1-10 at 25.00. I’ve just about given up attempting to rationalize the performance of these things … BNA.PR.A yields 6.59% (hardMaturity 2010-9-30) and BNA.PR.B yields 5.30% (hardMaturity 2016-3-25).
ELF.PR.F PerpetualDiscount -1.4375% Now with a pre-tax bid-YTW of 6.53% based on a bid of 20.57 and a limitMaturity.
SBN.PR.A SplitShare -1.3820% Asset coverage of 2.3+:1 as of Nov. 8, according to Mulvihill. Now with a pre-tax bid-YTW of 5.29% based on a bid of 9.99 and a hardMaturity 2014-12-1 at 10.00.
BMO.PR.J PerpetualDiscount -1.2048% Now with a pre-tax bid-YTW of 5.51% based on a bid of 20.50 and a limitMaturity.
BAM.PR.N PerpetualDiscount -1.1407% Now with a pre-tax bid-YTW of 6.65% based on a bid of 18.20 and a limitMaturity.
SLF.PR.B PerpetualDiscount -1.0787% Now with a pre-tax bid-YTW of 5.53% based on a bid of 22.01 and a limitMaturity.
BCE.PR.B FixFloat +1.0204%  
Volume Highlights
Issue Index Volume Notes
TD.PR.P PerpetualDiscount 651,899 Scotia bought 12,000 from “Anonymous”, crossed 85,000, and crossed 297,600, all at 24.05. Inventory Blow-Out started yesterday. Now with a pre-tax bid-YTW of 5.49% based on a bid of 24.09 and a limitMaturity.
TD.PR.O PerpetualDiscount 110,700 RBC crossed 50,000 at 22.20. Now with a pre-tax bid-YTW of 5.51% based on a bid of 22.17 and a limitMaturity.
CM.PR.A OpRet 80,410 Now with a pre-tax bid-YTW of 4.25% based on a bid of 25.81 and a call 2008-11-30 at 25.00.
RY.PR.E PerpetualDiscount 36,839 Now with a pre-tax bid-YTW of 5.53% based on a bid of 20.45 and a limitMaturity.
CM.PR.G PerpetualDiscount 34,075 Now with a pre-tax bid-YTW of 5.55% based on a bid of 24.51 and a limitMaturity.

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

6 Responses to “November 15, 2007”

  1. kaspu says:

    Notwithstanding your befuddlement regarding BNA.PR.C, especially ignoring the 3.8 coverage, the question still remains that something is very wrong here. Either there is some incredibly horrendous pitfall that only the sellers are aware of, or this is the absolute deal of the century. At the risk of sounding very naive, how can such an inefficiency exist in a small market such as Canada prefs?

  2. jiHymas says:

    It is possible that the sellers of BNA.PR.C know something that I don’t know. However, this information is also unknown to the holders of BAM.A, the bond market, the CDS market and the holders of the other series of BNA prefs. Occam’s razor demands that we assume simply that the sellers of BNA.PR.C at these prices are bozos. We will also remember the Portfolio Managers Postscript But what if I’m wrong and refrain from mortgaging the farm to pile into these things wholesale.

    When you see a sure thing, the first thing you do is review your risk-control guidelines!

    Such inefficiency exists because there’s not enough hot money chasing these inefficiencies. I’ve been trying for years to get some Pension Money to sponsor a hedge fund to go long/short in the preferred share market (it has to be pension money because there are horrendous tax implications to being short a preferred share when the dividend is earned. Since pensions aren’t taxable, such a fund could ignore these implications).

    How much pension money’s come in the door? Zero. “Well, you know, Mr. Hymas, I bought a preferred share back in 1963. It went down.” It’s very, very frustrating.

    Strike a blow for my mental health! Write your pension fund today and DEMAND that they invest in the contemplated “Malachite Long/Short Preferred Fund”!

  3. kaspu says:

    ok…let me try a different tack.
    With Canadian, and for that matter US prefs, trading at multi year lows, would it be correct to say that the prefs are trading more as a reaction to movement in the common shares. As well, does it not seem to you that regardless of credit quality, any fixed income that is not a government issue seems to be getting slammed? And finally, in your opinion, what will it take for some sort of equilibrium to be re-established. Would it be lower rates (which so far has not helped the pref market)?

  4. jiHymas says:

    I don’t know about US Prefs.

    There is certainly something very strange going on in the Canadian preferred share market. There is a steepening of the yield curve and widening of spreads that are far in excess of anything seen in the bond universe.

    It is possible that this movement is a rational reaction to movement in the common shares; certainly, common shares take the first loss in the event of default. A lower common share price implies a market view that a loss is more likely and that the buffer enjoyed by preferreds is smaller and therefore that preferreds have become riskier and therefore that the curve should steepen and spreads widen. However, I do not think that a rational reaction to this phenomenon includes the carnage seen recently.

    Slammed? I don’t know what you mean by slammed. According to the DEX Universe, All-Governments have returned +3.09% YTD, All-Corporates have returned +1.41%. I would call that ‘a chunky amount of spread widening, about 25-30bp worth’, not ‘slammed’.

    As far as the Long DEX Indices are concerned, All-Govvies is +2.03% YTD, All-Corps is -0.81%. That’s about 20-25bp worth of spread-widening.

    Equilibrium? I don’t know what you’re talking about, equilibrium. I’m not even going to try timing the market. Deciding that one issue’s cash flows are worth ten cents more than another issue’s cash flows is about my limit.

  5. […] Anyway … there was a bit more clarification on the Fannie Mae accounting panic discussed briefly yesterday. Fannie was so worried, they held a conference call. From what I could make out – without having done any prep on this, you understand; the kerfuffle is over one table in a set of three filed documents each being 100-odd pages long – what happens is this: […]

  6. […] The use of a different scale has been proposed before – it was mentioned by the Bank of Canada and has been advocated elsewhere – like, f’rinstance, by Richard Portes on VoxEU as discussed on November 15. Frankly, I have difficulty understanding why it’s considered worthy of discussion. […]

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