Focus: Europe or China?
While much of the focus of late is on the coordinated central bank action to cheapen USD borrowing for European institutions - clearly the stock market took it as an all clear sign - an event of more lasting occurred yesterday. And that was the dropping of reserve requirements in China. Borrowing is dropping and the Chinese economy is slowing. When I point this out to many, the answer is generally "well, you cannot grow at 15% forever! It has to slow down from that pace." I could not agree more.
However - note how lacklustre global growth has been - and especially in the English-speaking country in which you likely reside dear reader. Think of that slow growth with China expanding at 15% / year and then think of it with Chinese growth at 5% - not a pretty picture, I dare say. Caution on the economy is warranted. The stock market is trading very technically and is hitting resistance - I would suggest caution is warranted on that front as well.
Too Big to Fail?
The Globe and Mail recently quoted an article supporting the merging of government sponsored pension plans. I understand the motivation for decreasing cost and that is certainly a potential justification for such a move. However, as financial institutions have increased in size, the benefits to the public remain in question. Risk has become more centralized with greater exposure to fewer missteps by a select number of institutions. Think for a moment about the diverse performance of pension funds through 2008. Ontario Teachers' performance trailed that of OMERS and HOOPP was a strong performer, having decreased its equity allocation in favour of fixed income. Could the Ontario taxpayer been better served with performance similar to that of OTPP? There is a "too big to fail" aspect which concerns me regarding this proposal.
I share the concern that the plans may be bidding against each other for private assets but I would guess that they just as easily collaborate. Pension plans also famously collaborate with managers of private investments to spread the risk. Would a superfund of the nature suggested by the author have the ability to comanage investments? Why is this management style useful? It alows the sharing of ideas on company strategy.
Different liability characteristics further bring into question whether consolidation makes sense. Liabilities should be the underpinning of asset strategy. In this case, asset strategies would be combined to manage a diverse set of liabilities.
In short, there are excellent reasons for thinking about consolidating plans but the bottom line is they are better off separate.
LDI 1.0, 2.0 and 3.0?
Excellent article in aiCIO on the deficiencies of LDI.
Does it entail some sacrifice of return? Generally yes, though it depends what one may assume for returns on non-fixed income assets. Equity returns in the 2000's were close to 0%, while previously they were above 10% - what is the right expectation for the 2010's?
And with respect to the use of leverage - while I am not fundamentally opposed to it, one must tread carefully as leverage is fraught with risk. Consider the issue of liquidity risk: if hedging one's interest rate risk with derivatives, let us imagine a scenario where rates increase significantly. Margin will be required for the derivative counterparty, yet margin cannot be extracted from the fact that the present value of liabilities has decreased. How does one manage that risk?
Bottom line is that CIOs of private pension funds are willing to sacrifice return for lower volatility (isn't that what mean-variance optimization is all about?), due to many factors which I discussed at the IQPC conference on pension risk management in NYC a couple weeks ago.
Regulator Warns Banks, not Government Agency?
In a world of constrained capital and loan losses, OSFI, the Canadian regulator of financial institutions, warned Canada's banks regarding prudent underwriting standards on mortgages. The quote on Bloomberg news cited "uncertainty and volatility in global capital markets, historically low interest rates, higher Canadian borrower debt-to-income levels, and relatively strong housing price appreciation"
How are we to understand this warning?
Are the banks really responsible for the booming housing market in Canada? Or is it the CMHC?
Let's analyze the quote to understand OSFI's concern:
1. "uncertainty and volatility in capital markets" - fair enough as a consideration, though I question the impact on the banks...are they concerned the banks will not be able to fund the mortgages? That is not the case, since the banks fund them via CMHC securitization programs
2. "low rates" - the banks run tightly managed asset-liability gaps; if they are receiving low rates on one end, it is because they are paying low rates on the other and pocketing the spread
3. "higher debt-to-income" - and therefore borrowers may be mortgaged to the hilt...which the banks should not care about since the first 20% is insured by CMHC
4. "strong price appreciation" - see #3 - the banks will only care if housing falls by more than 20% and those mortgagees are borrowing to the max
Clearly the risks to banks are limited...which begs the question: could this have been a backhand way of warning CMHC to temper its portfolio risk?
Forget Europe, Focus on China
Changing California's Public Pension
Selective Default - How Now for Sovereign Bonds?
With the selective default of Greek bonds (private institutions take the haircut, not public) we enter a period with a bifurcated sovereign bond market. Central banks can continue to buy without consideration of the default risk while private institutions must consider that risk. Absent capital requirements, I start to wonder why private institutions would want to own government bonds of many countries with default potentially on the table. It really comes down to: are you being paid for the risk? And when central bank flows are not inconsequential and they do not have to consider the risk, then everyone else should be exiting the pool. This is even more applicable when you consider Jim Bianco's view of the bond market prior to the selective default: central banks are non-price sensitive buyers of bonds and until they stop buying, bond bears will have to sit at the sidelines.
I appreciate that my comments assume that subsequent defaults will have a similar structure to that of Greece; the precedent has been set and in my view it will continue until it does not suit the central bank in question.
Longevity Risk in Canada
I welcome the recent research by Swiss Re concerning longevity risk in Canada, but I believe the focus of pension fund managers should be on asset-liability management (ALM) and not on longevity management. There are many benefits to be gained by focusing on ALM with limited cost and changes can be taken in small steps. By contrast, the bid-offer in longevity will presumably remain large (reinsurers are not here to give away spread!), every deal will take significant time to negotiate and therefore the size of deals must be significant enough to justify the time and effort.
Finally, consider the life expectancy of the average Canadian versus the average American. Who do you think would live longer? And by how much? Here is where I start to consider the potential self-serving nature of the report: take a look at page 5 of the report and notice that Canadians are expected to live longer than Americans. If you go back to the report by the UN on world life expectancies you find 2.5 years differential from birth. Think relative value for a minute: if you had the choice would you buy or sell Canada life expectancy for 2.5 years more than the US?
That having been said, I look forward to seeing indicative pricing on longevity product in Canada; it is good progress for our capital markets.
Pensions and Derivatives
Occupy Wall Street?
As a capitalist, my knee-jerk reaction to a protest such as "Occupy Wall Street" is disdain for those who think that bankers control the financial coffers of democracies. In this case, I pause and reconsider. Here is why:
When Sweden went through a similar real estate bubble and bust in the early '90s, the government nationalized the banks - they guaranteed the loans by taking equity stakes in the banks. By some accounts, the cost of the bailout was close to zero as equity returns more than compensated for loans which capitalized the banks.
In the USA, the banks are printing money daily on behalf of the Federal Reserve. Velocity of money is close to zero, meaning money that has been borrowed by banks from the Fed is not making its way through the system; consumers are not borrowing that money, it actually sits on bank balance sheets as US Treasury investments. Borrow at 0% overnight and invest at 2% in 5 or 10 year bonds (started as 5 years, now 10 years yield 2%). Repeat on billions of dollars and now banks are being capitalized in almost risk free methods by the Fed. More importantly, by not owning an equity stake in the banks, the Fed has no say in the ability for banks to pay bonuses on low risk revenue.
Bank management and equity investors have benefitted unfairly by Fed policies.
I wonder whether the income shifted from the Federal Reserve to banks would not have been better serving to the US taxpayer by taking equity in the banks and limiting expenditures such as bonuses. Certainly "Occupy Wall Street" would not exist in that case. And the divergence between Main Street and Wall Street would have been held in check.
CMHC - what is the risk?
Over the past few years the growth in CMHC's balance sheet has been astounding. Since 2006, Assets and liabilities have more than doubled - see here for the evidence. Why you might ask? Because they purchase all new mortgages being written in Canada and fund it with Canada Mortgage Bonds (CMBs).
Canadian banks are paid to originate mortgages and have no sensitivity to the credit of the mortgagee, since the mortgage is sold to CMHC. Sound familiar? Yes there are similarities to the US mortgage market circa 2006 except (I hope) there are no liars applying for mortgages with false data and no real subprime market.
What is particularly frustrating is the lack of insight into what risk they retain. Flip through the 2010 annual report and tell me what happens to CMHC if house prices drop by 20%. Can't find it? Me neither. As a taxpayer should I not have access to this kind of information? Especially considering the events in the US over the past 5 years.
Continuing to flip through the report, I find frustration at every corner - for example, assets are bucketed as maturing in 1 year or less, 1-3 years, 3-5 years and longer than 5 years while liabilities are bucketed by year of maturity. Furthermore, some details are given for the loan portfolio but not to the same extent as the other assets.
Why the lack of comparison between assets and liabilities? CMHC holds some assets at Fair Value and others are designated as Hold-to-Maturity. I am not an expert in financial statement analysis but I would guess that FV asset yields are current market yields while HTM yields are based on purchase price. Presumably liabilties are left on the books based on issuance. What I find curious is that (after sorting through the bucketing differentials) the average yield on assets is far lower than that of liabilities...
*Note that the assets appear low since loans are not incorporated due to lack of information.
This could be due to marking asset yields to market and not those of liabilities but I am not clear why this would be done. Furthermore, it could also be the case that gains have been taken historically and that losses appear to be on the horizon. In any case, I believe more transparency is in order and greater synchronicity in the bucketing of asset and liabilities would be helpful as well. This would help restore confidence in the CMHC and its financial position.
Negative Interest Rates?
Could interest rates ever turn negative?
One would expect the obvious answer to be "no". In fact, I recall in 2002, traders in the eurodollar option pits buying 100 calls which were effectively bets on negative interest rates. We speculated at the time that it must be a model hedge. Some interest rate models allow for negative rates and in order to ensure proper calculation of portfolio risk these options were purchased.
But now, in 2011, Swiss rates are negative. Not just government bonds but even euroswiss futures. Does this make sense? Would bank A really pay bank B for the privilege of lending it money and risk potential default of bank B?
In a pure domestic economy this makes little sense. Faced with a negative rate, any sane person would buy a fire proof safe and store cash at home rather than face the drag of negative rates*. But consider that Switzerland is overloaded by foreign investment due to a favourable banking environment. These foreigners do not have the option of buying fire proof safes - they need this money in a Swiss bank! And they are willling to pay for that privilege. Further, there clearly is not enough demand from domestic corporates to borrow funds.
Can this happen in Canada or the US? Ask anyone sitting through the past 5 years of markets, and the answer must be an unequivocal "Yes". Is it likely? I would venture to say no - unless real deflation takes hold. That would be something to worry about. If low rates are bad enough for pension funds, imagine how bad negative rates would be!
* in Canada, we receive zero on our deposits and banks charge us for keeping deposits with them by charging for checks, ATM fees, etc. This differs from negative rates since the amount charged is not based on account size. In fact, holding a minimal acct size discharges one from the obligation to pay many of these fees.
Operational Risk and $2B at UBS
It seems incredible that unauthorized trading continues to occur. And the media only hears about those that are so significant they impact earnings. There are more than enough trading errors that never make the news because they are too small - anything below a few million can easily be brushed under the rug. So what are the banks doing about it?
Rumours are that UBS will be scaling back on its trading, but scaling back cannot prevent another fraudulent occurrence. In the end, greater resources are required to monitor risk on the trading side - not just market risk, but operational risk. Reports can be generated reconciling trading account holdings externally with internal system generated holdings. Simple monitoring of irregular looking trades can prevent "fat-finger" errors. And in the end, reports can be generated but they are useless if nobody ever looks at them. The key is to find a format which can summarize all irregularities in a single report so that it is accessed by management on a daily basis.
The Unborn Vote
What does a Greek bankruptcy mean?
It seems more and more obvious that Greece will be unable to meet its debt obligations. What does this mean for the investment landscape?
- danger to the Euro - can Greece remain part of the Euro while not meeting any of the requirements? I question the future of the Euro with so many others such as Spain, Portugal, and Italy on the brink. Currency devaluation is the flexible component which allows sovereign default. How can you print money over which you have no control?
- danger to the banks - have European banks been marking Greek bonds to market? I doubt it - and this would mean a huge capital hit to many European banks - even those that do not own the bonds have exposure to those that do own and could be in trouble
- civil unrest - I would imagine it is about to get turned up a few notches - Germans are sick of subsidizing workers in other countries that retire prior to 55 while Germans work harder and longer than any other Western European nation. And if Germans stop subsidizing the Euro and its members then major changes will have to occur in Western Europe including longer working weeks and longer working lifetimes, something the unions will not take very quietly
- bonds - bonds will be acknowledged as riskier investments, credit spreads will continue to get pushed higher, more discussion around US management of its fiscal house and look for very high quality corporate spreads to turn negative in the long end against even high quality nations such as the US and France
