Dr. Booth’s Responses to Mr. Aaron Engen’s Information Request No.1
Answer 1.1
Temporary refers to the normal fluctuations that we see in spreads through the
business cycle.
Answer 1.2
No. Dr. Booth recommends that the Regie not use ATWACC and allow Gaz Metro to pass
on the embedded cost of debt in its cost of service, so that these costs and the associated risks are
borne by ratepayers. He sees little advantage to changing the regulatory compact and making Gaz
Metro’s shareholders bear these risks
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Answer 2.1
No, they are Canadian spreads.
Answer 2.2
Cansim series V121812 for CP, V121778 for the 91 day Treasury Bills and V121775 for
Bankers Acceptances.
Answer 2.3
They can be downloaded directly from StatsCanada or the Bank of Canada’s web site at
http://www.bankofcanada.ca/en/rates/interest-look.html
Answer 3.1
Dr. Booth is not familiar enough with US taxes which vary significantly by state to
prepare such a schedule. However, to support his general statement he has attached extracts from his
testimony in the 2009 Alberta generic hearing. These sections were excised from Dr. Booth’s current
testimony since he felt that the marginal contribution was low. Of note is that the US ownership of
TransCanada Corporation has dropped from 30% to 10%.
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Answer 4.1
The “evidence” is the fact that the agencies clearly made serious valuation errors, which
lead to catastrophic losses both in the US and Canada. This prompted calls for increased regulation of
the credit rating agencies and has coincided with the dramatic increase in spreads. As Dr. Booth
mentions this is the first recession that he is aware of that has caused Canadian A spreads to spike to
record highs, so the question is why have A spreads behaved like BBB spreads? One plausible answer is
the credibility of the rating agencies given their clear valuation failures in the US. However, Dr. Booth
would be the first to admit that this is correlation not causation.
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Answer 5.1
The corporate bond market and the structured note market.
Answer 5.2
This is a time varying question as liquidity comes and goes. The standard answer is that
you realise the value of liquidity when it isn’t there and it wasn’t there in the Fall into the Winter when
the major US investment banks were selling assets to generate cash to survive. Liquidity now seems to
have returned to normal as spreads are approaching normal cyclical levels.
Answer 5.3
Bonds are traded out of inventory in a dealer market. As banks were forced to sell their
inventory to raise cash bond trades reverted to an agency rather than a principal basis with the
associated loss of liquidity. Liquidity returned as the major US banks started to make principal trades
again.
Answer 5.4
Partly by the spreads and the time to make trades. Liquidity means that less can be
traded at higher transactions costs.
Answer 5.5
Spreads. Dr. Booth would like to see bid-ask prices but these are not available to him as
the major banks regard this as proprietary. Some banks will not even provide historic yield data as part
of an information request since they regard it as proprietary.
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Answer 6.1
Of course, all required rates of return hinge off GOC yields. However, GOC bond yields
have behaved in a predictable fashion given the change in inflationary expectations, so there is no
puzzle to explain in their level or behaviour. In contrast A spreads were a puzzle and needed explaining.
Answer 6.2
As Dr. Booth states on page 6 “trying to unravel the factors behind the corporate
spreads is very difficult,” it will take a ph.d dissertation to show the direct link. However, the following
paper was a dissertation looking at the causes of spread increases in the US and the author attributed
2/3 of the spread widening to liquidity and only 1/3 to credit risk changes. Dr. Booth expects more such
research to emerge as finance professors seek to understand recent market behaviour.
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Answer 6.3
Dr. Booth does not have access to that data since Mr. Engen refused to provide it
answer to information request 4.2. His answer is given below. If the company and its witnesses are not
cooperative in answering information requests it is difficult for interveners to do the analysis. Further
Dr. Booth’s judgment is not based on this level of analysis but commentary in the media on the liquidity
problems in the financial markets during the crisis period, discussion with market participants and his
knowledge of financial markets.
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Answer 6.4
Dr. Booth uses “no accident” to mean that correlation does not imply causality but it is
indicative. That is, why we know that the solvency of the US banking system improved during this period
whereas there were no changes in the credit risk of utilities. The implication is that it was liquidity not
credit risk factors that were driving the spreads.
Answer 6.5
Dr Booth believes that there were “knock on” effects of the US financial crisis around
the world and that some of these showed up in the Canadian bond market. The following Reuters
article indicates some of the wind down of the knock on liquidity effects on the Canadian banks.
Canada mortgage purchase plan may wind down: CMHC
Tue Mar 24, 1:31 PM
By Louise Egan
OTTAWA (Reuters) - Canadian banks have less need of a government program to buy up to C$125 billion ($103 billion) in
insured mortgages, based on the results of the latest auctions, a senior official at the government's housing agency said on
Tuesday.
"In the last two auctions, the takeup has been less than what we have offered," Karen Kinsley, president and chief
executive of Canada Mortgage and Housing Corp, told the Senate finance committee.
As Kinsley was speaking, CMHC was completing its 10th reverse auction under the plan, and for the third time in a row
bank participation was much lower than in previous auctions.
Finance Minister Jim Flaherty first announced the temporary mortgage purchase plan in October 2008 to help cushion
banks from the global financial crisis and to counter a scarcity of private-sector lending. The program -- which began with
plans to buy C$25 billion in insured mortgage pools and was later expanded -- aims to provide stable funding to banks so
that they can lend more freely.
Kinsley said talks with financial institutions indicated that credit flows have improved due to CMHC's purchases of insured
mortgage pools, which now total about C$55 billion.
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"We believe at this point in time there is a fair amount of liquidity in the system," she said.
"I don't think we would say that the program isn't going to be taken up as we go forward but I think that given the pace
that we've been operating at, we're probably going to want to slow it down a bit given the needs that lenders have at the
moment."
In the auction on Tuesday, CMHC offered to purchase up to C$4 billion in the mortgage assets, but weak demand resulted
in it buying only C$1.6 billion. In the previous two auctions, demand by banks was for less than half the amount CMHC
offered whereas in auctions on February 9 and earlier the demand was for the full, larger amounts offered.
Canada's six largest banks have not needed direct bailouts as have some of their global counterparts due to more
conservative lending practices and stronger balance sheets.
But a tightening in both the availability and pricing of credit have forced the government and Bank of Canada to provide
extraordinary liquidity through a variety of mechanisms to grease the wheels of the lending market.
Kinsley said CMHC has about a 67 percent market share of the mortgage insurance market, with the Canadian units of AIG
and Genworth Financial sharing the remainder.
She said it was likely that the mortgages that have been purchased by the government reflect the companies' respective
market shares.
In response to one senator's concerns about AIG's solvency and suggestions that Canadian taxpayers were effectively
involved in a "bailout", Kinsley answered that AIG Canada was distinct from its U.S. counterpart.
"They (AIG) will indicate that they are strongly capitalized here in Canada. But also it's important to note that the private
sector competitors have a 90 percent government guarantee on their loans," she said.
($1=$1.22 Canadian)
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Answer 7.1
In the Fortune article that analyzed a particular Goldman Sachs SPV deal 58% were no or
low documentation mortgages. The article is provided as “sub prime Goldman deal.pdf.” Dr. Booth is
not aware of any aggregate statistics in terms of how many were no or low documentation Ninja loans.
However, the Federal Reserve’s web site has a county by county listing of mortgages that are 90 days
past due.
Answer 7.2
The mortgages were repackaged in the sense that the income stream from the
mortgages was divided amongst different mortgage backed securities. What was amazing is not that
they were repackaged but that S&P could rate 93% of a portfolio of junk second mortgages as
investment grade.
Answers 7.3 & 7.4
Dr. Booth does not mention Canada and his position is that the securitisation of
mortgages in Canada was never a problem since most of them were guaranteed by CMHC. For this Mr.
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Engen can talk to his security analysis colleagues who cover the Canadian banks and their July 22, 2008
Financial Services research report, where they indicated that only 23% of mortgages in Canada had been
securitized versus 51% in the US. For the anatomy of a typical deal see the Fortune article provided in
answer to 7.1. Further, Dr. Booth has only looked at the implications of the securitisation on the health
of the US banking system and the resulting bailout of Citigroup and Bank of America. Dr. Booth has read
a large number of research reports including many by BMO Capital Markets, received copies of
presentations, as well as written two articles on the topic himself and made presentations to the
accounting standards setting committee of the CICA and the Canadian trade counsellors of Foreign
Affairs and International Trade (DFAIT) of the GOC.
Answer 8.1
That is correct which is why Dr. Booth mentions this in his testimony and indicates that
this is probably because the CDN$ has been moved by commodity prices, rather than reflecting internal
monetary policy.
Answer 8.2
The Bank of Canada still provides all the data for the index on its web site at
http://www.bankofcanada.ca/en/graphs/a1-table.html
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Answer 8.3
The data is available on the Bank of Canada web site at the URL listed in answer to 8.2
Answer 8.4
Dr. Booth indicates “probably” since he is not intimate with the internal deliberations of
the Bank of Canada and can only speculate. However, monetary theory indicates that it works through
both interest rates and exchange rates. The following is a schematic taken directly from the Bank of
Canada’s web site at http://www.bankofcanada.ca/en/monetary_mod/mechanism/index.html
The schematic shows the two channels by which monetary policy affects the economy: interest rates
and exchange rates which is what the MCI estimates and presumably why the Bank developed it in the
first place. However, as Dr. Booth’s testimony indicates the exchange rate is no longer being driven by
internal monetary policy. His Schedule 9 indicates that commodity prices have been driving the CDN$,
so much so that the bank has been trying to talk down the appreciating currency since it could remove
some of the stimulus being injected into the economy through lower interest rates. Dr. Booth provides
the latest July 2009 Monetary policy update by the Bank of Canada as update July 2009.pdf to indicate
the Bank’s concern that the appreciating currency could retard what it anticipates to be a second half
recovery by the Canadian economy.
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Answer 9.1
Dr. Booth uses the words “seems” since it is an implication of rising spreads and yet no
change in the credit worthiness of the borrowers given the ratings applied by the agencies.
Answer 10.1 Such an exercise is fruitless and hopelessly biased. Further it has to be stressed that
these charts were produced by Yahoo.com where anyone can track the price performance of any two
securities to see how they have performed. All Dr. Booth did is type in the numeric for the TSX index
(GSPTSE) and each utility in turn. The time period was fixed by Yahoo not by Dr. Booth at one year which
happens to be prior to the major stock market collapse. What this means is that we can see how the
utilities have fared throughout the crisis.
In contrast March 9, 2009 was the bottom of the stock market and constitutes a hopelessly biased start
date since we know that as low risk securities the utilities will not have performed as well as the beaten
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down stocks like Citibank and Bank America that were close to bankruptcy. Further Dr. Booth does not
even know how he can do this within Yahoo.com since Yahoo controls all the parameters except which
stocks to compare.
Answer 11.1 The data is from the ScotiaCapital markets indices. They were published by the Bank of
Canada until June 2007 when as far as Dr. Booth is aware Scotia Capital stopped providing them. The
series are available for download from the Bank of Canada’s website at
http://www.bankofcanada.ca/en/rates/bond-look.html
Answer 11.2
The bonds are long term.
Answer 11.3 They are indexes maintained by Scotia Capital and the composition is constantly
changing to reflect the universe of bonds.
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Answers 12.1 & 12.2 The speech follows. As Dr. Booth indicates on page 76 of his testimony
Governor Longworth’s remarks were in connection with the initial liquidity crisis and the freeze in the
Canadian ABCP market. All securities are never equally affected by a common event, which is why betas
differ.
CHECK AGAINST DELIVERY
Remarks by David Longworth
Deputy Governor of the Bank of Canada
to the Investment Industry Association of Canada
Toronto, Ontario
3 October 2007
Liquidity, Liquidity, Liquidity
Good evening. It's a pleasure to be here.
Sound financial investment is important to individuals, to firms, and to society as a whole. By definition,
investment is forward looking, and thus our future financial well-being is shaped by the soundness of the
investment decisions we make today.
History shows that sound investment requires confidence, and one of the key elements that underpin
confidence is liquidity. Indeed, Governor Kevin Warsh of the Federal Reserve Board says that liquidity, is, in
fact, a form of confidence.1 The events that ensued from the U.S. subprime-mortgage crisis have tested the
confidence of many investors, and raised questions about where all the liquidity – which seemed so plentiful
a few months ago – has gone.
Now, one of the great things about our two official languages is that we often have several words to
describe one thing – or more accurately, to distinguish between slightly different forms of one thing. We
have snow, sleet, and slush – though not, I hope, until December. Et nous avons des amis, des copains, et
des camarades. But sometimes, when it might be useful to have several words to distinguish between
similar concepts, we have only one word, and that word is forced to take on several meanings. "Liquidity" is
such a word – it's used to mean slightly different things in different contexts.
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In my remarks this evening, I'd like to examine three concepts of liquidity that are of interest in economics
and finance. The first I'll call macroeconomic liquidity, which has to do with "overall monetary conditions,"
including interest rates, credit conditions, and the growth of monetary and credit aggregates. The second is
market liquidity, which refers to how readily one can buy or sell a financial asset without causing a
significant movement in its price. A third form of liquidity that I'll be touching on very briefly is balance
sheet liquidity, which refers broadly to the cash-like assets on the balance sheet of a firm (or household).
For non-financial firms, balance sheet liquidity is often measured by the short-term liquid assets on their
balance sheet. For banks, which must manage their liquidity very closely, balance sheet liquidity is reflected
in a detailed breakdown, by maturity, of their assets and liabilities – especially those coming due in the
short term. The ability of banks to fund themselves is often referred to as funding liquidity. The common
element in these concepts is that liquidity is the ability to obtain cash – either by turning assets into cash on
short notice or by having access to credit.
I'll focus largely on the first two concepts, macroeconomic and market liquidity. In each case, I'll suggest
why liquidity matters, both in a general sense and to policy-makers, and I'll describe how it's measured.
Then, I'll discuss the state of liquidity, in its various forms, both before the summer turbulence and after. I'll
conclude by describing the current situation and saying a few words about the Bank of Canada's role with
respect to each type of liquidity.
Macroeconomic Liquidity
As I noted earlier, I am using the term macroeconomic liquidity to refer to "overall monetary conditions."
Any economy, whether national or global, functions best when there's enough – but not too much –
liquidity.
So, how much is the right amount in a national economy? The answer depends on the central bank's
objectives. In Canada, our monetary policy objective is to meet the inflation target. This goal has been
achieved with considerable success since the target was introduced in 1991. In general, when inflation is
tending to remain on target, liquidity is adequate. If there were too much liquidity in the economy, inflation
would threaten to rise above target. If there were too little, inflation would tend to fall below it. To put this
same notion in different terms, the risk of having too much, or too little, liquidity in our domestic economy is
essentially the same risk that is posed by future inflation being higher or lower than the target.
The key indicators of macroeconomic liquidity, in terms of price, are the policy interest rates and the term
structure of interest rates paid by borrowers. In terms of quantity, the key indicators are the growth of
monetary and credit aggregates and the state of credit conditions more generally. In normal times, central
bankers tend to place more emphasis on interest rates than on monetary and credit measures.
Nevertheless, the growth rates of monetary and credit aggregates do appear to have some explanatory
power regarding the future evolution of spending and inflation, and are thus useful additional indicators of
liquidity. For example, in Canada, real M1 measures help to predict near-term growth in real GDP. And the
M2-family aggregates help to predict core CPI inflation one to two years ahead.2
One particularly important aspect of macroeconomic liquidity is the liquidity that central banks make
available to the financial system on a day-to-day basis – often referred to as central bank money. In
Canada, this typically comes through the provision of settlement balances in the wholesale payments system
– the Large Value Transfer System (LVTS) – supplemented, when required, by open market purchase and
resale agreements. The goal of this provision is to keep our key policy rate, the overnight rate, close to the
target we set for it. As well, our standing liquidity facilities, made available to LVTS participants at the end of
the day, provide liquidity, as required, to individual financial institutions at 25 basis points above the
overnight rate.3,4
Finally, to get a sense of global macroeconomic liquidity, one can aggregate macroeconomic liquidity across
countries to obtain average world real interest rates and the average growth of monetary and credit
aggregates. These measures will tend to be reflected over time in the behaviour of global spending and
average global inflation rates.
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Global macroeconomic liquidity sets the backdrop against which we make monetary policy in Canada. This
liquidity can affect the foreign demand for Canadian products and, at times, can influence the prices of
Canadian imports.
A key point is that, because Canada has a flexible exchange rate regime, we can achieve the inflation target
over time – regardless of the degree of liquidity in the global economy. This is because such a regime allows
us to have a monetary policy that is independent of other countries.
Now I'll turn to liquidity in financial markets.
Liquidity in Financial Markets
Market liquidity refers to the extent to which one is able to quickly and easily buy and sell financial assets in
the market, without moving the price. Market liquidity captures the aspects of immediacy, breadth, depth,
and resiliency in markets. Immediacy refers to the speed with which a trade of a given size and cost can be
completed. Breadth, often measured by the bid/ask spread, refers to the costs of providing liquidity. Depth
refers to the maximum size of a trade for any given bid/ask spread. Resiliency refers to how quickly prices
revert to fundamental values after a large transaction.
Generally speaking, the more liquid the market, the better. But there is an important caveat – if market
participants come to expect that market liquidity will always be ample, and they acquire assets with the
assumption that they can liquidate their positions quickly and at fairly predictable prices, they may end up
taking on more risk than has been factored into the purchase price. And this could sow the seeds of a nasty
correction in the event of a shock and a rapid decline in market liquidity. That said, liquidity is the lifeblood
of markets.
Over the past 50 years, and particularly in the past 10 to 15 years, we've seen a significant trend increase in
liquidity in financial markets around the world, including the markets for bonds and other fixed-income
products, and those for equities, derivatives, foreign exchange, and commodities.
What gave rise to this increase in market liquidity?
First, there have been structural factors in markets themselves. The appearance of new players, the
introduction of new financial instruments, and advances in technology have all added to the liquidity of
financial markets. New participants, such as hedge funds, have become active in many financial markets,
thus introducing new capital into these markets, adding to their liquidity. Financial innovation, typically
enabled by technology, has often supported the liquidity of financial markets. The growth of electronic
trading systems and innovation in back-office systems have lowered trading costs and increased price
transparency and competition, and, in the end, resulted in greater liquidity.
In addition to these structural factors, two other significant long-term developments have underpinned the
growth of liquidity in financial markets. First, efficiency gains in the financial sector, better inventory
management, and better macro policy – including monetary policy – resulted in what has come to be called
the "Great Moderation," which was a significant reduction in the variability of output, inflation, and longterm interest rates across most G-7 countries, starting in the mid-1980s.5 And this moderation has, in turn,
contributed to the liquidity of financial markets by reducing some of the fundamental sources of financial
volatility and risk. Second, globalization has resulted in more liquid financial markets. Globalization has
significantly increased international capital flows, since many emerging-market countries have relaxed their
capital controls. Globalization has also helped to spread financial innovation, in part through the operations
of large international banks.
This increase in market liquidity has generally been beneficial. It has tended to place downward pressure on
volatility – prices have typically become less sensitive to large transactions and usually absorb news more
easily.
So that's a look at macroeconomic and market liquidity. Now I'd like to provide a snapshot of the liquidity
situation before the summer turbulence.
Liquidity Before the Summer Turbulence
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Let me start with the state of macroeconomic liquidity.
For several years, the world economy has been characterized by ample liquidity. In comparison with historic
norms, long-term real interest rates have been low, and money and credit have grown fairly quickly in most
G-7 countries and in such emerging-market countries as China and India. The major reason for the
unusually low long-term real interest rates appears to be a high level of desired savings relative to desired
investment. Interestingly, despite ample (or perhaps overly ample) global liquidity – which historically has
led to rising inflation – inflation has been fairly well contained around the globe. Central banks have been
keeping their eyes on inflation and have not hesitated to raise policy rates as required.
Parenthetically, I would add that a number of other developments – developments that did not really
contribute to global macroeconomic liquidity – may have left the impression that there was a "wall of
liquidity" out there. These developments include the rapid growth, in real terms, of the global economy; an
increase in the ratio of financial assets to GDP; increases in corporate holdings of cash; growth in many of
the major "real-money accounts," such as pension funds, central bank reserves, and sovereign wealth
funds; the ongoing reinvestment of fixed-income assets that come to maturity; and the payouts that occur
when firms are acquired. Against a backdrop of low real interest rates, much of this money was involved in a
"search for yield," and, in this search, the prices of risky assets were bid up.
The situation in Canada before August was similar to the global one – that is, it was marked by ample
macroeconomic liquidity. Indeed, the Bank of Canada's July Monetary Policy Report Update noted that there
were upward pressures on inflation, and that the growth of household and business credit, as well as the
growth of monetary aggregates, was robust. We therefore raised the policy interest rate to 4.5 per cent and
expressed the view that "some modest further increase in the overnight rate" might be required to bring
inflation back to target over the medium term.
As for market liquidity, it had generally been growing over the past few years. Bid/ask spreads were narrow,
and volatility was low in foreign exchange markets and in equity and fixed-income markets. Shocks, when
they occurred, were contained – that is to say, they didn't spread widely across markets – and episodes of
volatility subsided fairly quickly.
And shocks did occur. Four episodes come to mind: the May 2005 downgrade of Ford and GM debt; the selloff of risky assets in May and June of 2006; the collapse of the American hedge fund, Amaranth Advisors, in
September of 2006; and finally, the "flight to quality" in February of this year.
These episodes were apt to be costly for those directly affected and reminded investors that investments
pose risks, and that prudence requires that these risks be understood and managed. Overall, however,
because these episodes were well contained and of short duration, they may have left investors too
complacent, and therefore contributed to postponing an overdue repricing of risk. Indeed, central banks,
including the Bank of Canada, had for some time identified the possibility of "a significant price reversal in
riskier assets."6
Let me now describe how the late summer turbulence in financial markets affected various forms of liquidity.
How Recent Events in Financial Markets Have Affected Liquidity
Throughout the year, delinquency rates and foreclosures associated with subprime mortgages in the United
States have been rising. These mortgages have, over the years, been increasingly repackaged, or
securitized, into asset-backed securities (ABSs) such as residential mortgage-backed securities (RMBSs).
More recently, these RMBSs, along with other assets and ABSs, have been further repackaged into other
structured products, such as collateralized debt obligations (CDOs) and asset-backed commercial paper
(ABCP). Because the magnitude of the delinquencies and foreclosures was unexpected, it is not surprising
that we have seen a repricing of many assets with exposure to the U.S. subprime-mortgage market.
The subsequent downgrade by credit agencies of many CDO tranches – especially those that included U.S.
subprime mortgages – made market participants aware of the risk inherent in these products, and also
made them realize that credit risk more broadly may not have been priced appropriately. So, to the extent
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that the repricing of credit risk that we have seen in recent months has, in fact, been a renormalization of
the value of risk, these events are to be welcomed.
Many of these structured products lack transparency – particularly those backed by other structured or
securitized products, such as ABCP backed by CDOs. It is often difficult for investors to determine the
underlying assets that ultimately provide the cash flow for these products – and, therefore, to determine
their direct exposures. While securitization helps disperse risk to those more willing to bear it, it can also
obscure to the investor in which instruments and with which actual and potential counterparties the ultimate
risk resides. Because of this lack of transparency, uncertainty among market participants began to build in
early August, and perceptions of counterparty risk rose. Bid/ask spreads widened, market depth diminished,
and market liquidity evaporated.
As events unfolded around the world, the rate on overnight collateralized transactions in Canada moved
above the target overnight rate in the second week of August. This market response was not unique to
Canada. The overnight interbank rates in the United States and Europe also moved above the respective
target policy rates and became very volatile.
As a result, central banks, including the Bank of Canada, moved quickly to provide significant amounts of
liquidity to their financial systems in the form of central bank money, which, as I noted earlier, is a key
aspect of macroeconomic liquidity. Shortly after mid-August, conditions in the Canadian overnight market
began to improve. From that time until the recent technical pressure, stemming partly from month-end
payment flows, the Bank of Canada had not had to intervene intraday: total settlement balances had
steadily decreased, and the overnight rate had remained slightly below target.
After all that has occurred over the past two months, it would seem that the most pronounced impact –
aside from major, ongoing concerns regarding the structured-product market – has been an increase in the
spreads in money markets – whether in ABCP, corporate paper, or bankers' acceptances – of most
industrialized countries. Market liquidity in these particular markets has not returned to its former state.
While short-term funding for banks was always accessible through the money market, we went through a
period in which it was very difficult to obtain funding beyond a week or two. Perceptions of increased
counterparty risk, combined with precautionary hoarding of funds by financial institutions, helped to create
that situation. This precautionary behaviour has occurred because financial institutions are uncertain about
the extent of their potential exposure to ABCP (which they will have to take back on to their balance sheets,
since they are the sponsors or liquidity providers), or to the financing of previous leveraged buyout
transactions.
In the past couple of weeks, however, there have been an increasing number of transactions at longer terms
in world money markets, including the Canadian market for bankers' acceptances, and spreads have
narrowed somewhat. However, liquidity in money markets is still quite limited in Canada and abroad.
The situation in money markets contrasts with that in other markets, such as spot foreign exchange and
equity markets, where repricing has occurred and market liquidity has returned. These markets are
functioning reasonably well. Liquidity in corporate bond markets is somewhere between these two
situations, with highly rated firms having little difficulty accessing market funding (though at higher spreads
than before August), while access for low-rated firms is significantly constrained.
I would now like to turn to the current situation. In particular, I will look at the Bank of Canada's role for
each type of liquidity.
The Current Situation and the Bank of Canada's role
With respect to the provision of central bank liquidity to the financial system, let me stress that the Bank's
goal continues to be to keep the overnight interest rate close to its target. We will continue to monitor the
situation in the overnight market and adjust settlement balances and undertake open market purchase and
resale operations as necessary, as we have done in recent days in response to upward technical pressure.
This pressure does not appear to be linked to changes in the rest of the money market.
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With respect to overall domestic macroeconomic liquidity, we set the overnight interest rate to keep inflation
near its 2 per cent target over the medium term. Our next fixed announcement date is 16 October. Between
now and then, we will be reviewing all the relevant factors affecting the inflation projection. At the time of
our last announcement, we noted that there are significant upside and downside risks to the outlook for
inflation. On the upside, there is a possibility that household demand in Canada could be stronger than
anticipated, while on the downside, the ongoing adjustment in the U.S. housing sector could be more severe
than anticipated and could spill over to the U.S. economy more broadly. Recently, the Canadian dollar has
moved sharply above the trading range assumed in the July Monetary Policy Report Update, and we need to
look at the causes of this strengthening, should it persist. And, as always, we need to assess the effect of
movements in the exchange rate on the balance of aggregate demand and supply in the Canadian economy.
In addition, there is uncertainty about the extent and duration of the tightening of credit conditions in
Canada and, hence, about the tempering effect this will have on the growth of domestic demand. As I noted
earlier, the Bank monitors Canadian credit conditions closely, and we will be looking at the level of interest
rates paid by households and firms, as well as at any changes in the availability of credit granted to them for
spending on goods and services. Over the summer, credit spreads rose all along the term structure, but,
because of significant declines in risk-free rates, increases in the level of interest rates paid by firms are
largely confined to short-term maturities, where credit spreads have risen the most.
With respect to the direct participants in the Large Value Transfer System, Canada's wholesale payments
system, the Bank of Canada's Standing Liquidity Facilities are available at the end of each day, on an
overnight basis, for individual institutions that have a shortfall in their settlement balances because of
temporary difficulties with their funding liquidity.
Many observers have asked whether there is more that the Bank of Canada could be doing to deal with the
market liquidity situation in money markets, as well as the funding liquidity situation of banks. We have
been asking ourselves the same question. While it is true that many term money market spreads remain
abnormally wide, the market is functioning. There have been increasing numbers of term money market
transactions, and spreads are beginning to narrow. In these circumstances, there does not appear to be
anything that the Bank of Canada could usefully do to improve the functioning of this market.
Indeed, the best contribution the Bank of Canada can make in this situation is to keep inflation low and
stable by maintaining macroeconomic liquidity at an appropriate level, and to keep the overnight interest
rate close to its target. With these conditions in place, market liquidity should be restored, over time,
through the operation of normal market forces. A helpful backdrop is the overall strength of the Canadian
economy, supported by a high level of balance-sheet liquidity in Canadian non-financial corporations.
Conclusion
Liquidity is essential to the well-functioning of both the real economy and financial markets.
The Bank of Canada carefully monitors and analyzes liquidity in all its guises as part of our ongoing
assessment of the economy and the financial system. Throughout this most recent period of financial market
stress, the Bank has paid particular attention to both the nature and the adequacy of liquidity – in the
macroeconomy, in financial markets, and in balance sheets.
We will continue to monitor events as they unfold, and we will take appropriate policy actions as required.
1.
K. Warsh. "Market Liquidity: Definitions and Implications." Speech to the Institute of International
Bankers Annual Washington Conference, in Washington, D.C., March 2007. Available at:
http://www.federalreserve.gov/newsevents/speech/Warsh20070305a.htm.
2. D. Longworth. "Money in the Bank (of Canada)." Bank of Canada Technical Report No. 93,
February 2003. Available at: http://www.bankofcanada.ca/en/res/tr/2003/tr93-e.html.
3. When LVTS participants are in deficit at the end of the day, and therefore need to access the
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standing liquidity facilities, aggregate participant deposits at the Bank of Canada will exceed the
target for net settlement balances.
4. As discussed at the end of this speech, these facilities also respond to temporary difficulties in
funding liquidity experienced by LVTS participants.
5. D. Longworth. "Inflation and the Macroeconomy: Changes from the 1980s to the 1990s." Bank of
Canada Review, Spring 2002. Available at: http://www.bankofcanada.ca/en/review/2002/r02-3ea.html.
6. This phrase is taken from the Bank of Canada's December 2005 Financial System Review, p 4.
Answer 13.1
No that is incorrect. All the spreads in Dr. Booth’s testimony and the data banks
are based on secondary market data and are thus consistent. Adjusting for new issue costs etc
makes the data non-comparable.
Answer 13.2
Confirmed, but irrelevant to Dr. Booth’s testimony.
Answer 13.3
True but irrelevant to the reason why Dr. Booth used this updated data
provided by Mr. Engen. The all in rate after including other costs is always higher than the
secondary market rate. However, the point of the use of this data was to make comparisons with
the Regie’s formula and indicate that the panic conditions that seemed to have prompted the
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application have now passed not estimate Gaz Metro’s borrowing costs which are passed on to
ratepayers.
Answer 14.1
IR14.1.pdf
The data are Cansim V122501 and Cansim V122501 both included in Engen
Answer 15.1
For the November 25 financing TransCanada states
“The purchase price of $33.00 per Common Share resulted in gross proceeds of approximately $1.0
billion. The net proceeds of the offering will be used by TransCanada to partially fund capital
projects of the Corporation, including the Keystone Pipeline System, for general corporate purposes
and to repay short-term indebtedness.”
Dr. Booth is not aware of the specific purpose of Fortis’ financing; it is probably to refinance part of
the financing of the BC Pipeline it acquired in 2008. However, Fortis has subsequently had another
bond issue and an equity issue as reported below by the Globe and Mail.
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Thursday, May 28, 2009 05:07 PM
Manulife, Fortis tap booming bond market
The deals just keep coming in the bond market, as utility Fortis taps investors for $105-million and
Manulife Financial prepares a $1-billion debt offering.
Fortis (FTS-T25.16-0.59-2.29%)continued a busy week for deals by issuing a 20-year bond that pays 6.1
per cent interest, under an existing medium term note program. Scotia Capital led the transaction,
which was priced at 195 basis points over the comparable government of Canada bond.
Manulife (MFC-T22.09-0.27-1.21%) came to market Thursday with plans to raise $500-million of fiveyear debt, and has upsized the offering to $1-billion in the face of investor demand. Talk on bond
desks is this issue will be priced at 230 basis points over federal government debt.
More than $3-billion of Canadian corporate bonds have been sold this week, and the pace of financings
is at record levels this month, as investors take on the extra risk that comes with owning nongovernment debt in return for higher yields. This situation is a marked contrast what markets
experienced just a few short months ago, as the credit crunch and recession fears had investors
opting for low-risk governement bonds.
Globe and Mail
Thursday, April 9, 2009 06:48 PM
Fortis shows window open for financing
Andrew Willis
The window is wide open for stock sales by high quality Canadian companies, as utility Fortis tapped
the market late Tuesday for $300-million.
Fortis, a growth play among utilities if there is such a beast, did a bought deal with Scotia Capital,
CIBC World Markets and RBC Dominion Securities just a few hours after Manulife raised $2.125-billion.
On one side of this sale, you have institutions putting cash to work at relatively attractive valuations.
The other side of this transaction is a realization on the part of boards and CEOs that current markets
are reality. The fabulous valuations seen just a few short months ago? They, sadly, are part of your
history.
That change in mind set is evident in CEOs who were running companies with top-tier valuations Manulife's Dominic D'Alessandro and TD Bank's Ed Clark. If these guys are issuing stock at current
prices, that sends a message.
Fortis, which bought a massive B.C. natural gas pipeline network last year, will use the proceeds from
the share sale to knock back $200-million of debt that has come due. The deal came a week after a
$1-billion stock sale from pipeline operator TransCanada. Income-seeking investors are big buyers of
these utilities - Fortis features a 4 per cent dividend yield.
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Get used to seeing the bank-owned dealers leading deals for companies that are major borrowers.
CEOs value lending relationships these days, and are rewarding banks that provide credit. That's not
tied selling. It's smart business for both banks and borrowers.
Fortis sold 11.7 million shares for $25.65 each. If the underwriters opt to exercise an overallotment
option, the financing could raise $345-million.
Fortis shares closed Tuesday, ahead of the financing, at $27, so the offering came at a 2.7 per cent
discount. Fortis shares are changing hands Wednesday at $25.32, against the backdrop of weakness
in the overall market.
Answer 16.1
This is definitional. From basic accounting d= ROE*BVPS*(1-b), where ROE*BVPS
by definition is earnings per share and (1-b) is the payout rate.
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Answer 17.1
Provided as price to book in investment analysis.pdf
Answer 17.2
Dr. Booth can confirm that the focus was on earnings and their growth rates.
However, the price to book is not simply an input it is also included in their valuation analysis as the
following table shows:
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Answer 17.3
Not confirmed as they are explicit in table 2.
Answer 17.4
on earnings.
As indicated in answer to 17.1 Dr. Booth confirms that the focus on this report is
Answer 17.5
Confirmed but if they weren’t useful they wouldn’t be there. For example the
price to book (market to book) is obviously felt to be more important than price to sales, which is
another valuation metric that is often used, since it is not even reported here.
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Answer 18.1
Provided as Bank PB multiples.pdf
Answer 18.2
Yes. Dr. Booth clearly indicates on page 105 that this is an RBC report on banks.
Answer 18.3
No. Dr. Booth has never said this and this is not the purpose of these references.
These references are provided to indicate that price-to-book multiples are a standard valuation
metric in finance. In reply testimony company witnesses frequently make patently incorrect
statements about price-to-book multiples and these references are designed to head off such
mischaracterisations of Dr. Booth’s testimony. Dr. Booth doubts that this will have any effect.
However, If Mr. Engen wants references to the use of price to book multiples in valuing utilities Dr.
Booth can provide as many references as he wishes. For example the following extract is included in
a TD Newcrest Pipelines and Utilities (13 Feb 2004) research report. It is an old report simply to
show that this is a long standing valuation metric.
Note that Dr. Booth is not saying that price-to-book is the only, or even the most important,
valuation metric, simply that it is an important valuation metric. As far as he is aware BMO Capital
Markets calculates price to book as a standard valuation metric when they do comparable firm
analysis for buyouts.
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Answer 19.1
The data is in Schedule 1 of Dr. Booth’s testimony
Answer 19.2
Graph follows
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Corporate And NEB Allowed ROE and BBB Spread
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
1990 1991 1992
1993 1994
1995 1996 1997
ROE
1998 1999
NEB ROE
2000 2001 2002
2003 2004
2005 2006 2007
Regie
Answer 19.3
Yes. It appears that apart from 1997 and 2004-2007 the StatsCanada ROE is
below the NEB or Regie’s formula allowed ROE. However, as Dr. Booth notes in his Appendix H
Canadian utilities invariable over earn their allowed ROEs so it is a slightly false comparison.
Answer 19.4
Not confirmed. Dr. Booth has never based his ROE recommendations on
comparable earnings or accounting ROEs. He presents Statistics Canada’s ROEs simply as business
cycle indicators and to gauge what typical ROEs look like and to show that the population average
ROE is so much lower than what utility witnesses present as comparable earnings. The Corporate
Canada ROE is a profit indicator of the stage in the business cycle.
Answer 19.5
Not confirmed. The discussion of Corporate Canada’s ROE is a part of the
necessary discussion of the business cycle and conditions in the money market as required by Mr.
Justice Lamont’s definition of the fair return that came out of “changed conditions in the money
market.” It is as relevant as the discussion of T Bill yields, inflation, GDP growth etc. Dr. Booth
applies no direct weight to the ROE estimates and his recommendations are not based on them. Dr.
Booth would suggest that the Regie bear this information in mind only in terms of a reasonableness
or fairness check.
Answer 19.6
Partly Confirmed. Gaz Metro’s current deemed common equity ratio is 38.5%,
so comparing “like with like” requires that the ROE be compared at the current deemed common
equity ratio. Otherwise there is a tendency to double count and here it is important to point out that
Gaz Metro’s current deemed common equity ratio exceeds the common equity ratio of its peers
such as ATCO Gas, Terasen Gas, Union Gas and Enbridge Gas. Gaz Metro indicates that their request
is equivalent to 12.39% on their regulated common equity ratio. It is splitting hairs to say that this is
not their request, since there is no separate analysis of changing Gaz Metro’s deemed common
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equity ratio. Increasing the common equity ratio to 46% and removing the deemed preferred share
component in and of itself should cause the allowed ROE to fall.
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Answers 20.1, 2, 3, 4
Dr. Booth disputes the assertion in this request. All of his graphs contain
standard economic or financial data and are accompanied by extensive discussion that makes the
data self evident particularly to people who present themselves as financial experts. In terms of the
requests labelled 20.1, 2, 3, 4
i)
The Statistics Canada data applies to Corporate Canada as a whole as such it includes all
companies. Statistics Canada does not list all companies in Canada. The data is included in
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Schedule 1 which includes all the Cansim numerics so that an expert can identify the proper
series used. It is published in the Canadian Economic Observer which is a free download
and Statistics Canada derives it from Cansim series V634672 and V634628. The Canada, A
and BBB bond yields are from Scotia Capital Markets indices and included as yields.pdf.
ii)
The bond yield are all from the Scotia Capital’s long term index. Typically the term is 17
years but has changed over time as capital markets have become more accommodating to
long term issues.
iii)
Scotia Capital does not indicate the actual bond issues and such information is of little use
since the composition of the indexes is constantly changing to ensure that the issues remain
long term.
iv)
The lines in Schedule 30 are in colour. Dr. Booth suggests that Mr. Engen print his testimony
using a colour printer.
HBdocs - 6864244v1
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