Archive for August, 2007

HIMIPref™ Indices : August 31, 2000

Friday, August 31st, 2007

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2000-08-31
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,491.9 0 0 0 0 0 0
FixedFloater 1,910.4 9 1.88 6.44% 4.4 232M 5.49%
Floater 1,404.8 2 2.00 -0.09% 0.08 99M 7.09%
OpRet 1,391.1 33 1.21 5.15% 3.9 70M 6.06%
SplitShare 1,408.4 4 1.75 6.36% 5.6 122M 6.00%
Interest-Bearing 1,548.5 7 2.00 8.01% 11.0 190M 8.08%
Perpetual-Premium 1,112.1 1 2.00 5.76% 4.3 4,535M 6.19%
Perpetual-Discount 1,143.7 13 1.54 5.89% 14.0 125M 6.01%

Index Constitution, 2000-08-31, Pre-rebalancing

Index Constitution, 2000-08-31, Post-rebalancing

Note: The “PerpetualPremium” Index contained the issue NA.PR.J from date of issue, 2000-7-13 until 2000-11-29. This is an error; this issue is a FixedFloater. Since this was the sole issue in the “PerpetualPremium” index, the results for this index should have been reported as having a performance equal to the “PerpetualDiscount” index.
In the period 2000-7-12 to 2000-11-29, performance of relevant indices was:


  • FixedFloater: +2.50%

  • PerpetualPremium: +3.30%

  • PerpetualDiscount: +3.42%

Indices will not be recalculated – for now! I regret the error.

Sub-Prime! An Idea for a Master's Thesis

Friday, August 31st, 2007

I have developed a hypothesis regarding sub-prime that I will be researching more carefully over the next month or so, with the idea of writing an article about it. I don’t think there’s a full book in the idea – but I can quite easily see it becoming somebody’s master’s thesis, or a chapter in a book.

Hypothesis: A sub-prime-crisis-equivalent has almost happened before. It has also been deliberately avoided before

Abstract: So far, the nasty bits of the crisis have not had much to do with sub-prime mortgages themselves, or even their RMBS (Residential Mortgage Backed Security) pools, but with highly leveraged pools of RMBS – see, for example, the sad stories of Cairn High Grade Funding I and Global DIGIT. These vehicles failed not through any problems with the RMBS themselves, but through the fear of such problems and the subsequent evaporation of a market for ABCP (Asset Backed Commercial Paper) with such underlying security.

This may be compared with the market on Bank Perpetuals in the ’80’s. The basic idea behind the perps was for a bank to offer a 100-year Floating Rate Note at a spread to the appropriate floating rate. At the time (I confess, I’m not sure about right now) such issues could be considered equity by the banks; simultaneously portfolio managers could consider them short term instruments due to their floating rate coupon. At least one such issue made its way into a money market fund.

I wasn’t a market participant at the time these things were sexy, which was somewhere around the 1983-88 period when rates were coming down quickly and banks wanted long money but didn’t want to pay long rates for a long time. But very scrappy recollections involve the idea that the problem with these things was that the market was too homogeneous … all the issuers were all issuing them for the same reasons; all the buyers were all buying them for the same reasons. When the reason for the buyers went away, so did the market.

Nowadays, for instance, I’m seeing a chunk of RBC FRN Oct 1, 2083, which pays CDOR + 40bp  being offered at $94.50. I suspect that a buyer willing to take the whole block could put in a stink bid and be filled, but what do I know? Anyway, a salesman whom I respect (at a firm other than the one stuck with these turkeys) had to be prodded to remember the existence of such things. It would appear that they are the by-appointment-only traders to end all by-appointment-only traders.

Now, in the ’80’s when they were sexy, rates were still pretty high. What if they’d been low (like they have been, relatively, for the past five years)? Would it not have been a tempting idea to put together a vehicle that, with $100 equity you went out and bought $1,000 of these perps and financed with $900 commercial paper at, I don’t know, CDOR + 10? That’s a pretty good return, provided you can roll your paper for 100 years!

There are two reasons I can think of right away that this didn’t happen:

  • There was not so much innovation in the markets then. Hell, at that point the junk bond market hadn’t even been invented.
  • There was lots and lots of government issued short term paper at the time, which (to an extent) was crowding out more innovative issues

Food for thought.

The part where I’m thinking this was deliberately avoided before is the bond futures market. Bond futures are not the easiest things in the world to analyze quantitatively. The big problem is that there’s a basket of deliverables and a cheapest to deliver. The Cheapest to Deliver bond can change since the bond delivered against a contract is at the seller’s option, which gives the contract negative convexity. There are also delivery options that confuse the issue.

It is my understanding that this complexity was introduced deliberately when the contract was being designed. The CBOT wanted complexity so that it would be hard to analyze so that the fair price would vary by a bit depending on what assumptions you plugged into your model. This ensured that there would be disagreement over what the thing was worth depending on your views, which in turn ensured that there would be an actual market with some depth.

After all, if something’s known to be worth $110.87 and everybody knows that, who’s gonna trade? It will be quoted at $110.86-88, zero volume, forever.

The complexity helped develop a heterogeneous market which has been quite successful, to say the least.

The evaporation of the ABCP market has a tipping-monkey (or is it “100th monkey”? You know, where there’s a very rapid change of state of a large system once you reach the critical point) feel to it.

I’m thinking it would be most interesting to compare ABCP with the above two markets – especially the Bank Perps market – with a view to isolating the similarities and seeing if any conclusions may be drawn relating market risk and market homogeniety … and who knows, maybe doing a little forecasting!

Triple-A Jump-to-Default!

Friday, August 31st, 2007

In what must rank as one of the fastest restructurings on record, Cairn Capital & Barclays have announced:

the successful restructuring of Cairn High Grade Funding I (“CHGF”). The restructuring was made necessary by the closure of the ABCP market on which CHGF had relied for funding.The restructuring has eliminated market value triggers and the reliance of CHGF upon the ABCP market. CHGF has now been converted into a cash flow CDO. As a result, the full notional of outstanding ABCP will be redeemed as it matures and replaced by term funding.

Barclays Capital will provide the senior financing on the restructured transaction and has fully hedged its credit exposure from this financing. This restructuring has received all required investor consent. Investors have agreed to full participation in the costs of the restructuring.

The problem was triggered in a now familiar way: the ABCP market is no longer functional. Barclays is extending a $1.6-billion line.

S&P has announced:

The ratings were placed on CreditWatch with negative implications on Aug. 21, 2007.
The ratings on the original Tier 1 and Tier 2 mezzanine notes were lowered to ‘D’ and removed from CreditWatch negative, since Standard & Poor’s considers the restructuring of the notes in a manner that does not pay accrued interest in accordance with the terms of the notes to be a default.

Under the new structure, the Tier 1 and Tier 2 notes bear no interest, but are entitled to a ratable distribution of excess cash flows after the principal is reduced to $1. Receipts on the underlying asset pool are used first to pay interest on the CP and liquidity facilities and then to pay down the Tier 1 and Tier 2 note principal sequentially until the principal is reduced to $1. Thereafter, the remaining cash flows on the underlying assets are allocated 60% to the Tier 1 notes, 20% to the Tier 2 notes, and 20% to the capital notes. Standard & Poor’s ratings do not address the likelihood of receipt of excess distributions.

US$1,638 million Euro/U.S. commercial paper, US$126 million mezzanine notes and US$36 million capital notes

This may well turn out to be a very good deal for the Tier 1 and Tier 2 noteholders but I wouldn’t want to commit to that statement without ripping apart the structure’s financial statements, which I have no intent of doing!

Essentially, their deal is:

  • They lose the accrued interest on their notes that has been earned but not yet paid. I assume the notes had a semi-annual coupon, but I don’t know this for sure; I will further assume that the notes paid 6%, but I don’t know that for sure either. If both assumptions are true, that’s a maximum 3% loss
  • They are gaining what is, essentially, an equity interest in the underlying portfolio.

The difference between this and the Montreal Proposal is that there is a line being extended to refinance the CP; thus, the underlying portfolio remains leveraged to hell-and-gone, like about 10:1 according to the S&P reporting of the principal amounts … this is almost certainly better for them than the alternative of a forced sale of assets to redeem the CP. Whether or not the Montreal Proposal (in which the CP would not be refinanced, but would gain a proportional interest in the underlying) would be better for the noteholders depends a lot on the quality of assets and on the terms of the Barclays refinancing.

It’s not clear to me how much Barclays is charging for the line, or what the interest rate on the line will be set at … presumably some frightening spread to LIBOR. It’s also not clear from the information above how the principal on the credit line gets paid down. These are kind-of crucial questions!

There will be many who consider the Triple-A Jump-to-Default to be a black eye for S&P … I’ll be the first to agree that it doesn’t make them look good! But here, as we are seeing so much of nowadays, the structure was acting like a bank (borrowing short and lending long) and hence was subject to the great terror of bank treasurers: a run. Depending on the quality of the assets, they have a chance at a recovery after default in excess of 100% … we shall see!

August 30, 2007

Thursday, August 30th, 2007

A relatively quiet day!

The Fed’s discount window is less dusty nowadays, averaging $1.3-billion in loans – but $1.3-billion isn’t a lot in the great scheme of things.

“There are very few people in the money markets that I talk to who think it is providing any relief beyond psychological relief,” said Christopher Low, chief economist at FTN Financial in New York. “It is too expensive. If a bank has decent credit, they can get a much lower rate in the market” than the discount rate.

True enough … but I’d hate to see what the market would look like if it didn’t have some psychological relief!

In a somewhat-sort-of related post, Tom Graff looked at Fed Funds today, as did the WSJ.

A reporter joined in the ‘blame the rating agency’ chorus today:

Moody’s recently added some new phrases to its lexicon of code words. When the rating company refers to “updating its methodology” or “refining its risk assessments,” what it really means is that its historical models say absolutely nothing about how the future might turn out.

Last week, for example, Moody’s summarized “the most recent refinements” to how it treats bonds backed by so-called Alternative-A mortgages. “In aggregate, the change in our loss estimates is projected to range from an increase of approximately 10 percent for strong Alt-A pools to an increase of more than 100 percent for weak Alt-A pools,” Moody’s said.

So a mortgage-backed security with a rating based on, say, a 1.5 percent loss rate might now suffer 3 percent losses in its collateral, Moody’s said. How’s that for missing something the first time?

The reporter did not disclose his track record; nor did he provide an indication of what it is he thought that Moody’s missed. The story was about the Solent & Avendis meltdown – the structures have been forced to sell assets for anything they would fetch after failing to refinance their ABCP. Quite a few shops haven’t refinanced! Commercial Paper outstanding continued to decline and is now down $244-billion in three weeks:

The total fall in the commercial paper may end up at $300 billion, the amount of mortgages funded by asset-backed commercial paper, wrote Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co. LLC, in a note today.

Poor Bernanke! Despite plaudits from Barrington Research (and me, by the way), he’s going to get an earful at the Jacksons Hole conference this weekend: 

The “big debate” will be about how subprime mortgages were turned into gold-plated securities, especially the collateralized debt obligations that have caused the headaches, said Hale, president of Hale Advisors LLC in Chicago.

Headaches is definitely the word, as investors and principals of Basis Capital can tell you:

The Yield Alpha Fund has assets of $100 million. That’s down from $436 million at Jan. 31, according to Bloomberg data. 

Basis Capital asked a Cayman Islands court for permission to liquidate the fund, according to a petition filed in New York yesterday

There is a growing school of thought that feels the problem is asymmetric information but, frankly, I’m not sure if any regulatory regime that addressed that issue in particular will have the desired effect. In order for information to be useful, the purchasing portfolio manager must

  • be able to get the information
  • analyze the information
  • draw logical conclusions from the information

I’m not convinced that a regulatory solution to step one will necessarily lead to steps two and three. And I suspect that it’s impossible to enforce due diligence in a broad and consistent manner. “Due Diligence” means “Having a bunch of binders in your office somewhere”.

The investment business is more about sales than performance and diligence. And to the extent that performance does matter:

Pushed by fierce competition to make it to the “funds-of-the week” top-ten list of pseudo-specialised financial reviews, with the comfortable belief that one will be handsomely compensated in the case of success and allured by the possibility of diversifying much of the risk away, many funds’ managers have probably taken up an increasingly inefficient amount of risk. A correct assessment of risk should instead consist in compensating funds managers just slightly less if the fund is listed, e.g., eleventh in the ranking (if only such an ideal ranking existed!)3. To be sure, this potential source of inefficiency does not lie in the funding of subprime loans per se, but in the excess funding of risky projects due to a perverse/distorted assessment of risk.

And it’s not just sub-prime:

Freddie Mac, the second-biggest U.S. mortgage finance company, reported quarterly profit fell 45 percent after setting aside $320 million for losses as the housing slump deepened.

as a lot of mortgage defaults are investments. However, there’s still plenty of money for good credits:

Rio Tinto Group, the world’s third- largest mining company, raised $40 billion in loans for the purchase of aluminum producer Alcan Inc., a record for a U.K. borrower.

…even for American companies:

General Electric Capital Corp., the financing arm of the world’s second-biggest company by market value, sold $3.2 billion of hybrid bonds in pounds and euros.

US Equities were off a bit, led by financials:

Lehman reduced its earnings estimates for investment banks two days after Merrill Lynch analysts slashed their projections. Financial shares in the S&P 500, which comprise about one-fifth of the index’s value, are headed for their worst quarter in five years amid concern that higher borrowing costs spurred by mortgage defaults by the riskiest borrowers will erode earnings.

It’s not just cost of funds that will have the investment banks worried – it’s possible wind-up or delevering of their best customers that is causing concern:

“The recent expansion of hedge-fund positions and trading activity has been so rapid and consistent that it is now no exaggeration to say that hedge funds are no longer just an important part of the market in some fixed-income products; they are the market,” according to the report, which covered the 12 months ended in April.

Hedge funds accounted for more than 80 percent of trading in the debt of financially distressed companies and high-yield derivatives such as credit-default swaps, the Greenwich, Connecticut-based consulting and research firm said. The loosely regulated investment pools generated almost half of U.S. trading volume in structured credit.

Canadian equities fell too, on growth concerns. Silly traders! John Tory’s election platform calls for continued normal growth and we all know what superstars of fiscal acumen the Ontario PCs are!

With all these scares US T-Bills continued their amazing journey and yield less than 4% again. Treasuries had another good day, with a parallel shift 5bp downwards. Canadas underperformed quietly.

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 4.84% 4.86% 22,463 15.84 1 +0.0000% 1,044.5
Fixed-Floater 4.98% 4.79% 113,193 15.85 8 -0.2042% 1,023.6
Floater 4.94% -0.41% 74,295 7.92 4 -0.0606% 1,036.5
Op. Retract 4.84% 3.96% 79,729 2.99 15 -0.0169% 1,025.3
Split-Share 5.08% 4.78% 94,039 3.97 15 +0.0121% 1,044.4
Interest Bearing 6.24% 6.67% 67,487 4.60 3 -0.4001% 1,039.8
Perpetual-Premium 5.52% 5.09% 93,596 5.74 24 +0.1183% 1,027.8
Perpetual-Discount 5.11% 5.14% 266,383 15.26 39 -0.0337% 973.3
Major Price Changes
Issue Index Change Notes
BSD.PR.A InterestBearing -1.6895% Asset coverage of just under 1.8:1 as of August 24, according to Brookfield Funds. Now with a pre-tax bid-YTW of 7.21% based on a bid of 9.31 and a hardMaturity 2015-3-31 at 10.00.
IAG.PR.A PerpetualDiscount -1.3129% Now with a pre-tax bid-YTW of 5.09% based on a bid of 22.55 and a limitMaturity.
RY.PR.F PerpetualDiscount -1.1062% Now with a pre-tax bid-YTW of 5.01% based on a bid of 22.35 and a limitMaturity.
FBS.PR.B SplitShare +1.1863% Asset coverage of just over 1.9:1 according to TD Sponsored Companies. Now with a pre-tax bid-YTW of 3.89% based on a bid of 10.01 and a call 2008-1-14 at 10.00.
Volume Highlights
Issue Index Volume Notes
GWO.PR.H PerpetualDiscount 53,300 Desjardins crossed 50,000 at 23.63. Now with a pre-tax bid-YTW of 5.13% based on a bid of 23.60 and a limitMaturity.
ALB.PR.A SplitShare 15,439 Scotia crossed 14,900 at 25.00. Asset coverage of just over 2.0:1 as of August 23, according to Scotia Managed Companies. Now with a pre-tax bid-YTW of 4.37% based on a bid of 24.92 and a hardMaturity 2011-2-28 at 25.00.
RY.PR.G PerpetualDiscount 15,400 Now with a pre-tax bid-YTW of 5.04% based on a bid of 22.45 and a limitMaturity.
BAM.PR.N PerpetualDiscount 13,065 Now with a pre-tax bid-YTW of 6.00% based on a bid of 20.16 and a limitMaturity.
CM.PR.E PerpetualPremium 12,700 Now with a pre-tax bid-YTW of 4.73% based on a bid of 26.16 and a call 2012-11-30 at 25.00.

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

HIMIPref™ Indices : July 31, 2000

Thursday, August 30th, 2007

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2000-07-31
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,470.4 0 0 0 0 0 0
FixedFloater 1,890.6 9 1.88 6.55% 4.4 256M 5.54%
Floater 1,384.5 2 2.00 0.03% 0.08 112M 7.12%
OpRet 1,379.9 33 1.21 5.28% 3.6 85M 6.10%
SplitShare 1,417.1 4 1.75 6.02% 5.7 106M 5.96%
Interest-Bearing 1,517.5 7 2.00 8.07% 10.6 187M 8.24%
Perpetual-Premium 1,094.8 1 2.00 6.14% 4.3 10,124M 6.29%
Perpetual-Discount 1,115.1 12 1.58 5.98% 13.8 125M 6.16%

Index Constitution, 2000-07-31, Pre-rebalancing

Index Constitution, 2000-07-31, Post-rebalancing

Note: The “PerpetualPremium” Index contained the issue NA.PR.J from date of issue, 2000-7-13 until 2000-11-29. This is an error; this issue is a FixedFloater. Since this was the sole issue in the “PerpetualPremium” index, the results for this index should have been reported as having a performance equal to the “PerpetualDiscount” index.
In the period 2000-7-12 to 2000-11-29, performance of relevant indices was:


  • FixedFloater: +2.50%

  • PerpetualPremium: +3.30%

  • PerpetualDiscount: +3.42%

Indices will not be recalculated – for now! I regret the error.

IQW.PR.C / IQW.PR.D Downgraded by DBRS

Thursday, August 30th, 2007

DBRS has announced that it:

has today downgraded the long-term debt ratings of Quebecor World Inc. (Quebecor World or the Company) to B (high) from BB, and downgraded the preferred share rating to Pfd-5 (high) from Pfd-4. The trend on all ratings is Negative. Commensurate with the ratings downgrade, the ratings have been removed from Under Review with Negative Implications.

These issues were put on Review-Negative on August 14, 2007. They were downgraded from Pfd-4(high) on August 9, 2006.

It ain’t because of sub-prime, at least not directly:

DBRS had placed the ratings of Quebecor World Under Review with Negative Implications on August 14, 2007, as a result of concerns over the Company’s near-term liquidity, the uncertainty in terms of the outcome of negotiations regarding the Company’s bank agreements and the Company’s strategic review of its European printing operations. (Please see separate DBRS press release dated August 14, 2007.)

The downgrade reflects DBRS’s heightened concern over the Company’s near-term financial health which has been materially impacted by liquidity constraints and increased pressure on existing financial covenants.

Quebecor World’s liquidity continues to be adversely impacted by declining EBITDA and cash flow from operations, and could be further constrained should the Company violate debt covenants which could result in early debt redemption. Additionally, DBRS notes the Company’s near-term liquidity issues could be further impacted by restricted access to financing as a result of current capital market conditions.

S&P downgraded these issues to P-5(Watch Negative) from P-5(high)(Watch Negative) on August 28, 2007.

Sub-Prime! Why Does Tranching Work?

Thursday, August 30th, 2007

I gave an example of tranching when looking at the Bear Stearns product a few days ago. Now I want to clear up some possible confusion regarding the practice.

Quality is Very Expensive

Let us say, just for the sake of an argument, that we have a pile of AA rated securities that we want to securitize. We have two choices:

  • We can securitize them in one big bucket, rated AA, or
  • We can divide it in two tranches. The first gets priority in distributions and will be rated AAA; the second will be junior and rated A

The second choice will be familiar to preferred share afficionados – it’s the same process that is used in split share corporations. The holders of the senior tranche (the preferred shares) don’t really care a lot about the underlying portfolio, as long as it’s reasonably good quality and there’s a lot of it! The junior tranche holders care a lot, because they’re taking the risk they’ll get paid less than expected in exchange for an expected reward of getting paid more.

It will always be more profitable to the underwriter to split the issue because bond investors pay up for quality. I might get 10 cents less than base price for the junior tranche, but I’ll get 25 cents more for the senior tranche.

This is even more important with the mortgages, because it’s not a 50-50 proposition … there is a better than even chance any particular mortgage in the underlying pool will behave exactly as expected. There is, shall we say, some debate over just what the default probability is, but let’s make up some numbers. The mortgages are all one-year term. I expect  10% of the underlying to disappear completely; interest is received equal to 20% of the original pool; therefore, my return on the overall pool will be 10%.

These numbers are obviously very exaggerated. If anybody wants to make up better numbers – or, even better, wants to dig through ratings reports to get actual numbers – be my guest and let me know what you come up with. Put it in the comments or eMail me and I’ll put it in the post.

OK, so I look at the market and I see that AAA instruments yield 5%, while A instruments yield 20%. So what I do, is I create two tranches. The first tranche is senior and comprises $80 of the original pool of $100. It gets an AAA rating because the pool as a whole can lose 20% of its original value and this tranche won’t even notice. That’s double the loss rate I expect.

On the senior issue, I pay only 5% interest, which comes to $4.

The second tranche, worth $20, takes the first loss, which is expected to be 10% of the original pool, or $10. If the end value of the second tranche is $24 at the end of the year, it will have yielded 20% on invested capital. So on this tranche, I pay $14 from my interest receipts and the expected value of the tranche is $20 (invested) – $10 (loss on pool) + $14 (interest) = $24.

Now I work out my expectations: I’m going to receive $20 interest from the underlying pool. I pay $5 interest to the first tranche and $14 to the second tranche. Hey, looky looky! There’s $1 left over! I’ll invent an IO (Interest Only) tranche to receive that interest and keep that tranche for myself!

Bingo! Financial alchemy!

Why is Quality Expensive?

The basic reason is segmentation, which will be familiar to readers of my paper on Portfolio Construction. There might be some investors who don’t have a portfolio big enough to diversify. Maybe they can buy only one bond; maybe they’re just a little bigger and are only buying 5 bonds to make a ladder. Five bonds is not a lot. If one goes bad, that’s 20% of the portfolio. Such players, too small to diversify away specific risk, should stick to higher quality instruments so that their portfolios have a greater chance of behaving as expected. So these players are logically restricted to higher quality instruments and shouldn’t invest in our junior tranche. They have to buy the senior tranche virtually irrespective of how much extra they could expect from the junior, because they are highly risk-averse.

Another reason for quality segmentation is fiduciary policies. Maybe the East Podunk Widows’ and Orphans’ Fund has a set policy: AAA only. They’ll go to jail if they buy our junior tranche.

There’s liquidity as well. The senior tranche is worth $80, the junior tranche $20. It’s not unreasonable to expect four times as much trading of the senior tranche in the secondary market. Market timers, for instance, will have a prediliction for the senior tranche because they’ll be able to trade out of it more cheaply if the market moves their way and they want to realize a capital gain.

All these factors conspire to ensure that interest rates on the lower grades of paper will (normally) be higher than they would need to be if default risk was the sole consideration. Therefore, an investor who (i) has no arbitrary limits, and (ii) can purchase a well diversified portfolio and (iii) has no intention of trading a lot can (normally!) achieve excess returns by moving down the quality scale.

This was exploited in the late ’80’s, when the junk bond market was invented.

August 29, 2007

Wednesday, August 29th, 2007

OK, everybody! The end of the world, previously scheduled for Friday, has been cancelled. You are encouraged to make plans for the long weekend.

Loyal readers will know that I’ve become sufficiently irritated by calls for increased regulation to write a post on the topic (well, it’s really just a commentary on another essay) and even to initiate a category for what promises to be a series of posts. I don’t think the issue is going to go away any time soon … the New York Times has published an article with many interesting statements:

“In a globalized economy with hedge funds, leveraged buyouts and all these investment funds, we have to ask the question about more transparency,” said Claude Bébéar, the chairman of the supervisory board of the insurance company AXA

I have some free advice for M. Bébéar: ask these questions before investing.

Washington and London rebuffed the German government earlier when it pushed for an international code of conduct for hedge funds. Now some economic advisers to the German government are going further, suggesting that rating agencies should be nationalized, that large-scale loans be registered publicly and that minimum standards be developed for complex debt securities.

Super. “We’re from the German Government and we’re here to help you”. Can’t wait for that. Trouble is, the US national debt, fiscal deficit and trade deficit are all in such lousy shape that the US is not in a strong position to tell its creditors where to stuff their nationalized credit rating agencies. We shall see!

Christian de Boissieu, president of the group and a member of the Committee for Credit and Investment Institutions, which helps regulate French banks, is calling for a global register of hedge funds. In addition, he said, complex securities should be scrutinized before being sold to bank portfolios.

Is M. de Boissieu claiming that complex securities were not scrutinized before being bought by bank portfolios? Quick, tell me which banks! I want to buy a lot of puts on such poorly run stocks … except … um … French banks are halfway nationalized already aren’t they? And thoroughly scrutinized by … um … M. de Boissieu?

“It’s not just the U.S. regulators that failed, though they did fail,” Mr. Rosner said. International regulators have “thrown the keys to the rating agencies,” which have been left in charge of the safety and soundness of bank capital, insurance and pension money.

The article did not specify where the regulators are alleged to have failed. Pension money? Sorry, Mr. Rosner. Responsibility for pension money rests with the pension fund board. If they’ve been sleeping there are lots and lots of regulations on the books about that already.

Oooh, all this jockeying for regulatory power and salaries makes me angry! I do want to stress again, however, that my defense of the ratings agencies does not have an origin in any thought that they’re perfect. They’re not: Credit Anticipation is a perfectly good fixed income management strategy, one that Deutsche Bank has done very well with recently, although maybe that’s just because they’re German and have good connections with the German Government Credit Ratings Analysis Department.

However … in the first place, they offer investment advice. See that word? I’ll bold it. advice. If you don’t trust their advice, don’t take it. If you think their advice is sort-of usually OK but not perfect, then listen to it while checking it and staying diversified. If you believe so completely in their advice that you’re willing to lever up 15:1 (with all your money, not just a small chunk of it as your ‘hedge fund flutter’), on the basis that not only is it perfect but that everybody else will also always believe it’s perfect … then go home and play with your dollies.

In the second place, they major agencies have extremely good track records. Better than virtually all of their critics are willing to disclose, anyway.

And in the third place, I have yet to see any actual evidence that they’ve made any mistakes other than, possibly, the defaults on some ABCP issues. This is a black eye, definitely, but are due to market convulsions rather than actual deterioration of the underlying; market convulsions are very hard to predict. Shall we fault them, for instance, for the fact that 100-year floaters (e.g. Royal Bank) are now almost impossible to sell at a decent price [CUSIP# 780087AK8. Indicated at $94.50]? If recovery is (eventually) 100% it’s not the worst catastrophe finance has ever seen.

So there.

Return to my usual boring drone about economics, there is renewed discussion of the efficiacy of the yield curve in predicting recessions. Some of the data looks a little dated already:

The spread has turned negative with the 10-year rate at 4.79 percent and the 3-month rate at 4.83 percent (both for the week ending August 10).

With luck, however, the German government will soon regulate yield curve slopes and then we’ll never have a recession again. Econbrowser notes that the Fed Funds market is starting to look almost normal again. Tomorrow the US Treasury will release statistics on Commercial Paper Outstandings, which should be quite interesting. RAMS is liquidating as well as Cheyne, to name but two.

The US mortgage market is tightening, with banks both having less money to lend AND not being able to securitize as efficiently as they used to. The mortgage curve is now inverted, which seems very strange. All the short money has been sucked up by distressed ABCP issuers. Bernanke has opined that US Agencies should stick to securitization and not increase their leverage for the time being, which probably disappoints many.

US Equities roared back from the horror of yesterday and were accompanied by their Canadian cousins. Three-Month US T-Bills continued their wild ride (this is really strange, by the way) even as Treasury notes got whacked. Canadas were hurt as well, in what may be dubbed a Flight to Equity.

There has as yet been no comment from the German Government concerning the correct level of bond yields.

It took nine straight days of gains, but the PerpetualDiscount index is now up on the month, albeit marginally. Only floaters and splitShares are still under water.


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 4.83% 4.85% 22,739 15.86 1 +0.0358% 1,044.5
Fixed-Floater 4.97% 4.79% 113,942 15.87 8 +0.2634% 1,025.7
Floater 4.93% -0.41% 74,627 7.93 4 -0.0913% 1,037.1
Op. Retract 4.84% 4.00% 81,200 3.05 15 +0.2936% 1,025.5
Split-Share 5.07% 4.87% 94,994 3.85 15 +0.1115% 1,044.3
Interest Bearing 6.21% 6.59% 67,257 4.61 3 +0.6483% 1,044.0
Perpetual-Premium 5.52% 5.10% 93,750 5.67 24 +0.1590% 1,026.6
Perpetual-Discount 5.11% 5.14% 268,800 15.27 39 +0.2064% 973.7
Major Price Changes
Issue Index Change Notes
BNA.PR.A SplitShare -1.4961% These BNA issues all have massive asset coverage; the constraint on their rating is simply that their sole holding is BAM.A, and therefore their credit ceiling is equal to the BAM preferreds. Now with a pre-tax bid-YTW of 6.21% based on a bid of 25.02 and a hardMaturity 2010-9-30 at 25.00.
CL.PR.B PerpetualPremium +1.1594% Now with a pre-tax bid-YTW of 4.07% based on a bid of 25.84 and a call 2008-1-30 at 25.75.
FTU.PR.A SplitShare +1.2228% Asset coverage of just over 2.0:1 as of August 15 according to Quadravest. Now with a pre-tax bid-YTW of 4.83% based on a bid of 10.20 and a hardMaturity 2012-12-1 at 10.00.
RY.PR.F PerpetualDiscount +1.2545% Now with a pre-tax bid-YTW of 4.95% based on a bid of 22.60 and a limitMaturity.
IAG.PR.A PerpetualDiscount +1.2582% Now with a pre-tax bid-YTW of 5.03% based on a bid of 22.85 and a limitMaturity.
RY.PR.E PerpetualDiscount +1.2826% Now with a pre-tax bid-YTW of 4.94% based on a bid of 22.90 and a limitMaturity.
BSD.PR.A InterestBearing +1.7989% Asset coverage of just under 1.8:1 as of August 24, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.92% (mainly as interest) based on a bid of 9.47 and a hardMaturity 2015-3-31 at 10.00
IGM.PR.A OpRet +2.5221% Now with a pre-tax bid-YTW of 3.52% based on a bid of 26.85 and a call 2009-7-30 at 26.00. Even with an equivalency factor of 1.4, why wouldn’t you just buy a bond?
Volume Highlights
Issue Index Volume Notes
TOC.PR.B Floater 88,100 Desjardins crossed 73,600 at 25.24.
BCE.PR.A FixFloat 61,100 RBC crossed 50,000 at 24.50.
PWF.PR.F PerpetualDiscount 45,775 National Bank crossed 30,800 at 24.74. Now with a pre-tax bid-YTW of 5.35% based on a bid of 24.75 and a limitMaturity.
PWF.PR.K PerpetualDiscount 39,738 Nesbitt crossed 35,500 at 24.00. Now with a pre-tax bid-YTW of 5.19% based on a bid of 24.06 and a limitMaturity.
TD.PR.O PerpetualDiscount 33,900 Scotia crossed 30,000 at 24.70. Now with a pre-tax bid-YTW of 4.97% based on a bid of 24.61 and a limitMaturity.

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

HIMIPref™ Indices : June 30, 2000

Wednesday, August 29th, 2007

All indices were assigned a value of 1000.0 as of December 31, 1993.

HIMI Index Values 2000-06-30
Index Closing Value (Total Return) Issues Mean Credit Quality Median YTW Median DTW Median Daily Trading Mean Current Yield
Ratchet 1,434.2 0 0 0 0 0 0
FixedFloater 1,869.5 9 1.88 6.57% 12.6 269M 5.58%
Floater 1,350.5 2 2.00 -0.07% 0.08 135M 7.30%
OpRet 1,370.6 32 1.22 5.35% 3.9 75M 6.10%
SplitShare 1,378.3 3 1.66 6.14% 6.1 65M 5.79%
Interest-Bearing 1,497.5 7 2.00 8.24% 10.5 190M 8.35%
Perpetual-Premium 1,066.8 0 0 0 0 0 0
Perpetual-Discount 1,092.2 12 1.58 6.15% 13.7 140M 6.28%

Index Constitution, 2000-06-30, Pre-rebalancing

Index Constitution, 2000-06-30, Post-rebalancing

To Arms! The Regulators are Coming!

Wednesday, August 29th, 2007

I can see that there is going to be a lot of debate over the next year (until the day after the US Presidential elections, anyway) about regulation, so I’ve started a new category in this blog for it.

Anyway … the forces of regulation are gathering and the issues need to be understood.

Menzie Chinn at Econbrowser abandons her usual highly technical approach to state:

While I haven’t drawn a particular conclusion regarding the right direction to move, one insight prompted by current commentary is that — if the Fed were to opt for looser monetary policy — greater regulation of the financial sector would make a lot of sense.

I don’t know. To me, that if-then logic looks like a complete non-sequiter, but I can’t really comment too much until there is something to comment about. Let’s hear some proposals – I’ll consider them!

Mark Thoma has written a piece titled Fed Intervention and Moral Hazard which, really, simply explains the concept of moral hazard in home-spun tones, but declares himself “in substantive agreement” with what must be deemed a polemic by Robert Reich, Stop the Hedge Fund Casinos:

Yet there’s precedent: in September 1998, despite growing evidence of inflation, the Fed lowered interest rates in order to forestall a global credit crisis after Russia defaulted on its loans (many had been underwritten, foolishly, by several large Wall Street investment banks).

No substantiation is offered for the word “foolishly”. Additionally, there is no acknowledgement of any role played by investors, as opposed to underwriters, in the process.

Oddly, private credit-rating agencies judged these “sub-prime” loans to be relatively good risks.

Mr. Reich does not substantiate his use of the word “Oddly”. Additionally, there is no indication of an awareness of a risk/return trade-off.

Meanwhile, hedge funds created what can only be described as giant betting pools — huge amalgamations of money from pension funds, university endowments, rich individuals, and corporations — whose assumptions about risk were derived from the assumed low risks of the home loans (hence the term “derivatives”).

This is a novel derivation of the word “derivatives”! One can, I suppose, characterize hedge funds as giant betting pools – but only to the extent that any investment that has ever been made in the history of the earth has been a bet.

Investors in these hedge funds had little or no understanding of what they were buying, because hedge funds don’t have to disclose much of anything.

No substantiation is offered for this rather surprising smear. In the first place, the fact that hedge funds don’t have to disclose much of anything to regulators doesn’t mean they don’t disclose anything to investors. It is up to investors to demand whatever they want to demand from those who want discretionary authority over their money – Mr. Reich does not make any sort of case that further disclosure to regulators is necessary.

An investor can do whatever he wants with his own money. If, however, someone is acting as a fiduciary (as will be the case with pension funds and university endowments) there is a standard of care required. There may well be cases in which the Prudent Man Rule has been violated – well, nail ’em to the wall, I say, and I’ll ask Mr. Reich to pass me the hammer; that is not only a separate issue, but it’s already regulated.

That doesn’t mean, though, that the irresponsibilities now so clearly revealed in American financial markets should be excused or forgotten.

Mr. Reich forgets that he has not, in fact, discussed even a single instance of irresponsibility.

Credit-rating agencies have cut corners or averted their eyes, unwilling to require the proof they need.

This is the first mention of credit-rating agencies in the entire essay. No supporting evidence or argument is brought forward to support this charge.

They’ve [the credit rating agencies] been too eager to make money off underwriting the new loans and other financial gimmicks on which they’re supposed to be objective judges.

I am not aware that any credit rating agency anywhere has acted as underwriter. I’m not even aware of any credit rating agency having a license to underwrite. Let’s have a few more details, Mr. Reich!

Banks and other mortgage lenders have been allowed to strong-arm people into taking on financial obligations they have no business taking on.

Strong arm? Let’s have some evidence, or some argument at the very least. I suspect that any wrong-doing of this nature is already regulated.

For the financial market to work well — to ensure fair dealing and to prevent speculative excess — government must oversee it.

There are no arguments, no details and no evidence in this essay to make this assertion even worthy of consideration.

This mess occurred because nobody was watching.

Nonsense. There ain’t nuthin’, anywhere on earth, watched as carefully as the financial markets. Investors, traders and Mr. Reich’s beloved regulators watch it very carefully indeed.

Credit-rating agencies must not have any relationship with underwriters.

What? They shouldn’t even accept details of the issue so they can assign a provisional rating prior to its sale to investors? Mr. Reich betrays complete ignorance of the credit rating process with this slogan.

Finance is too important to be left to the speculators.

I’m … speechless.