PrefBlog

More Teachers’ / BCE news! I don’t think anybody will be surprised to learn that:

The arrangement was approved this morning at a Special Meeting of shareholders by more than 97% of the votes cast by holders of common and preferred shares, voting as a single class, greatly exceeding the required 66 2/3% approval. Of the total outstanding common and preferred shares, 62.5% were voted at the meeting either in person or by proxy.

In a sign that things are starting to return to normal, junk bond indices hit a two-month high amidst signs that deals are starting to move off the dealers’ balance sheets. I should stress here that by “normal” I do not mean “good”. What I mean is that we are returning to an environment in which investors are willing to take a look at possible trades and price them according to normal risk/return forecasts, rather than simply sitting on cash, petrified by fear.

In what must be taken as a good sign of this, it looks like the buy-out of Harman International Industries is dead:

Kohlberg Kravis Roberts & Co. and Goldman Sachs Group Inc. abandoned their $8 billion takeover of Harman International Industries Inc., maker of Infinity and JBL audio equipment, citing a decline in the firm’s performance. 

Issuance is, in fact, picking up a bit:

R.H. Donnelley, the biggest independent publisher of Yellow Pages telephone directories, led the biggest week for junk bond sales since July after the Federal Reserve’s rate cut spurred demand for high-yield, high-risk debt.

Speculative-grade borrowers issued $1.83 billion of fixed- income securities, according to data compiled by Bloomberg. Corporate bond sales totaled $28.2 billion, compared with $26.6 billion last week and the average this year of $23.4 billion. Cary, North Carolina-based R.H. Donnelley sold $1 billion of bonds to repay debt, increasing the offering from $650 million.

Junk-rated companies sold bonds for the first time in three weeks as the Fed’s half-percentage-point reduction in its benchmark rate on Sept. 18 helped lower the yield premium that companies pay to borrow over similar maturity Treasuries by the most in four years, Merrill Lynch & Co. index data show.

While in signs that nobody really expects a return to frenetic trading levels, RBC fired 40 US bond salesmen and HSBC is closing its sub-prime business, which will throw 750 out of work.

US equities rose, capping a fine week (send a thank-you not to Bernanke) as did those in Canada.

Treasuries managed a dead-cat bounce, as did Canadas

The pref market was unable to sustain yesterday’s volume increases, but put in a good solid performance. The perpetuals look a little uncertain – whether that’s worries over inflation or simply noise, I cannot begin to guess.

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

The USD has been hammered to the point where it is at parity with CAD. Fortunately for Americans, however, there is some evidence that import prices remain constant in USD terms:

“Foreign exporters have simply been more willing to vary their margins when selling into the U.S. market. Moreover, this difference in pricing behavior seems, if anything, to have become more pronounced in recent years,” the study says.

Unfortunately:

There is an important caveat to the study’s implications for the dollar’s recent fall. It notes that local-currency profit margins for foreign companies selling to the U.S. peaked in 2002 and have since declined, showing the dollar’s fall is taking a toll on profit margins. “It remains an open issue as to whether profit margins on exports to the United States are now ‘too narrow’ or margins were unusually high several years ago,” they say. Left unsaid: if indeed margins are “too low” now, then exporters may be reaching the limit of their ability to keep prices in the U.S. stable, and the dollar’s drop may be more inflationary in coming years than it has been to date.

The USA will not return to fiscal sanity until forced – the way Canada was forced to get religion in the ’90’s and that wasn’t a whole lot of fun for a lot of people. We’ll see.

US ABCP outstanding declined again this week, as reported by Bloomberg:

The U.S. commercial paper market shrank for a sixth week, extending the biggest slump in at least seven years and signaling Federal Reserve interest rate cuts haven’t yet drawn investors back to short-term debt.

I suggest that confidence is an awfully hard thing to regain, once lost. There are a lot of firms dancing close to the edge; a lot of financing is still being done at high rates, with all terms of USD ABCP yielding more than 5% – about half a point more than financial paper. And those, remember are average rates. While the cuts will have put a lot of companies back into positive carry territory, they will be much more risk averse than they were; at the margins, structures will be delevered and terms will be extended into bonds.

My guess is that we’ll see continued delevering at least until Christmas, as the market adjusts to whatever the new paradigm is. But who knows? Pays yer money and take yer chances.

Charles Wyplosz makes an argument at Voxeu in defense of the wholesale liquidity injection, accepting as a necessary evil the fact that ‘bad banks’ will benefit from this injection as much as bad banks. While agreeing with his conclusions, I disagree with his arguments, which are very interventionist –

Once the dust settles, the time of punishment will come. Inquiries should be conducted and those who violated the law must be brought to account.

Let’s start with first principles – Wyplosz states that the root of the problem to be addressed is:

What each financial institution does not know, and should not know, is what is on the books of the other financial institutions with which it trades daily. The old result, which goes under the colourful name of lemon’s markets, is that, suspecting the worst, no financial institution wants to lend to the others. The consequence is that liquidity is plentiful inside most financial institutions, but not available on the interbank market

I take the view that the problem is not so much one of the financial institutions not trusting one another – although that clearly is a factor – as one whereby the banks do not know which of their contingent lines will be drawn on in the near future. Countrywide Credit rather famously drew down USD 11.5-billion in one shot in August; this will not have been an isolated occurance. The banks will, I suspect, be happily engaged in the practice of grossing up their balance sheets by lending to their own customers right now, at penalty rates. This will be consistent with the work of Gatev & Strahan which I quoted on September 14. The banks, wishing to keep their powder dry, will not make term loans to one another (a term loan meaning, in this, ‘longer than overnight’) because their customers might want the lines tomorrow.

In such a case, liquidity injection is the desired policy since as long as there is liquidity then well-capitalized banks will be able to make term loans while at the same time retaining the extra capacity required to meet their commitments. My concern – which I am sure will be explicitly addressed by regulators over the next year – is whether such contingent claims from customers and off-balance sheet entities (e.g., bank controlled ABCP issuers) are adequately reflected in risk-weighted assets.

As far as punishment for excessive risk-taking is concerned … the market is meting that out quite efficiently, as Northern Rock’s shareholders can testify. Coventree’s employees are in a position to confirm this. The ‘real banks’ have bailed out the ‘non-banks’ to a greater or lesser extent, which is their function, at a greater or lesser cost to the non-bank’s shareholders, which is their punishment.

BoE Governor King testified to a parliamentary committee that:

U.K. banking laws prevented the central bank from a covert rescue of Northern Rock Plc, which it would have preferred.

“The bank would have preferred to have acted covertly as lender as last resort, to have lent to Northern Rock without publishing it,” King told a parliamentary committee in London today. “As a result of the market abuses directive (of 2005) we were unable to carry that out.”

This is interesting. Those with long memories will remember the Panic of 1825 and commentary by Larry Neal that:

The first mention of the crisis occurs on December 8, 1825, when “The Governor [Cornelius Buller] acquainted the Court that he had with the concurrence of the Deputy Governor [John Baker Richards] and several of the Committee of Treasury afforded assistance to the banking house of Sir Peter Pole, etc.” This episode is described in vivid detail by the sister of Henry Thornton Jr., the active partner of Pole, Thornton & Co. at the time. On the previous Saturday, the governor and deputy governor counted out £400,000 in bills personally to Henry Thornton, Jr., at the Bank without any clerks present. All this was done to keep it secret so that other large London banks would not press their claims as well. A responsible lender of last resort would have publicized the cash infusion to reassure the public in general. Instead, the run on Pole & Thornton continued unabated, causing the company to fail by the end of the week. Then the deluge of demands for advances by other banks overwhelmed the Bank’s Drawing Office.

The propriety of the BoE’s actions will surely be debated for decades. If the two views can be reconciled at all, one mechanism is through introduction of the idea that the public no longer trusts public institutions – at least, not to the extent that they did in 1825, when a man’s word was his bond. There have been far too many instances in recent history when those in authority have stated ‘We will not devalue, we will not devalue, we will not devalue, we have just devalued, we will not devalue again, we will not devalue again …’

And they do this, of course, without blushing.

Another way to reconcile the two theses is through introducing the idea of discretion; it may well be that Governor King agrees with the publicity desired by Neal in general, but not in this particular instance, for very well-founded reasons. And it may be that Neal will agree with him. It has always amazed me to see how much money is being paid to people – judges, regulators, high-school principals, whatever – while at the same time their discretion is circumscribed to ludicrous extremes with often ludicrous results. Perhaps Northern Rock was one of these time … perhaps not. The facts will emerge at some time long after public interest has evaporated, and become the topic of discussion in specialized journals.

In sub-prime news, it appears that credit anticipation plays by Goldman Sachs and Bear Stearns were right and wrong, respectively. And … a CDO has blown up, a victim of mark-to-market:

TCW Asset Management, the money manager owned by France’s second-biggest bank, is selling $3.2 billion of mortgage securities backing collateralized debt obligations after the value of the bonds fell.
…
Fitch Ratings last week said another five Westways Funding CDOs might have to sell assets under the CDOs’ rules.
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A $200 million CDO in the Enhanced Mortgage-Backed Securities series of market-value CDOs managed by MassMutual Financial Group’s Babson Capital Management LLC has finished liquidating after failing a similar test, Fitch said yesterday.

Isn’t forced liquidation fun? Boy, the guys who have all their analytical ducks in a row and have some capital available must be making a killing. Unfortunately, these buyers include the US GSE’s, who are able to finance themselves due only to the implicit guarantee of the US Government – the market would never allow them to survive as independent companies with their current capital structure. There is some pressure to reduce this source of false economic signals. Tom Graff has prepared a numerical example of why you need players in the system who are prepared to increase leverage when nobody else will – currently this role is being played largely by the banks and the US GSEs.

US Equities had a bad day, attributed to fears that the Fed Cut – and more like it? – will cause inflation; the excuse for Canadian equities was the fear of expropriation … er … I mean, a fairer royalty sharing scheme in the oil patch. CNR was in the news again …

Canadian National Railway Co. (CNR CN) declined C$1.19, or 2.1 percent, to C$56.65. The country’s largest railroad agreed to sell its Central Station complex in Montreal to Homburg Invest Inc. (HII/B CN) for C$355 million ($350 million). Canadian National will lease back its headquarters and passenger rail facilities from Homburg as part of the agreement, the Montreal-based carrier said in a statement. Homburg shares fell 15 cents, or 2.7 percent, to C$5.50.

Yesterday I mentioned CNR’s new bond issue … they seem to be raising a substantial amount of cash. An answer may – may! – be these notes in their financials:

Revolving credit facility
As at June 30, 2007, the Company had letters of credit drawn on its U.S.$1 billion revolving credit facility of $303 million ($308 million as at December 31, 2006) and had U.S.$442 million (Cdn$471 million) of borrowings under its commercial paper program (nil as at December 31, 2006) at an average interest rate of 5.29%.

Accounts receivable securitization
The Company has a five-year agreement, expiring in May 2011, to sell an undivided co-ownership interest of up to a maximum of $600 million in a revolving pool of freight receivables to an unrelated trust.
At June 30, 2007, the Company had sold receivables that resulted in proceeds of $575 million under this program ($393 million at December 31, 2006). The retained interest in the receivables was approximately 10% of this amount and is recorded in Other current assets. At June 30, 2007, the servicing asset and liability were not significant.

Delevering time! Term Extension Time! Note that I spent a grand total of about 45 seconds looking at their financials … I bring this up as something interesting to be investigated further. If anybody has any (links to) interesting commentary, let me know!

Treasuries had a horrible day, with the ten-year falling in price over a buck, with steepening. Would you like your Fed Cut with a side of inflation? I’m unable to find a good link to Canadian bonds – not surprising, given the pathetic state of Canadian media, and even good old Reuters let me down today – but trust me, Canadas did horribly too. Just not as horribly as Treasuries.

Volume returned to the preferred share market today, with some nice chunky crosses getting done. The various floating rate indices were dragged down by BCE issues, presumably a reaction to yesterday’s news that the bondholders are going to fight the Teachers’ deal in court.

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

Thanks, Rebel Traders (via WSJ)! 

Inflation numbers came out today, with the core rate in the US easing to 2.1% yoy, which some have taken as a validation of the Fed’s rate cut. The core rate in Canada is 2.1% yoy, but there are storm clouds on the horizon:

Signs inflation may pick up include a Sept. 14 Statistics Canada report showing unit labor costs, the cost of paying workers to produce an extra unit of a good, jumped 4.8 percent in the second quarter from a year earlier, the fastest since 1991. Also, average hourly wages rose the fastest in six years in August with the jobless rate at a 33-year low of 6 percent.

There are hopes that the PCE index will also come down – we will see! 

Another interesting trend is the increased linkage between energy and foodstuff prices. We’ve heard about the Italian pasta strike and Mexican tortilla protests. We may well see Canadian Jos. Louis riots if the trend continues.  

The authorities in general are loosening standards! Do they know something we don’t or what? The Bank of England has reversed its position on loosing loan standards, while the portfolio limits on the US Government Sponsored mortgage lenders are being relaxed. I suspect that James Hamilton will not be pleased. In addition to raising the portfolio limits, there is also pressure to increase the permitted size of each mortgage: Bernanke is not pleased:

“Both the size and composition of the portfolios should be tied to reforms that both reduce the systemic risks posed by the portfolios and also clarify the public purpose,” Bernanke said.

But – look at the situation: record foreclosures:

U.S. home prices fell by a record 3.2 percent in the second quarter, according to the S&P/Case-Shiller Index. Lawrence Yun, chief economist for the Chicago-based National Association of Realtors, has warned that year-over-year prices will fall for the first time since the Great Depression of the 1930s.

And the Congressional Budget Office has adopted a somewhat gloomy tone:

The recent market turmoil and a weakening of consumer confidence could “pose serious economic risks,” and as a result have “heightened” the chance of a recession, Congressional Budget Office Director Peter Orszag says in testimony before the Joint Economic Committee this morning.

The Brookings institution has published a commentary on current economic and regulatory issues – the author concludes, inter alia, that although the Fed wasn’t perfect in the 2004-06 period, they weren’t all that wrong, either. He also agrees with most of Levitt’s credit rating agency recommendations. 

On September 10 I noted a report of the destabilizing effect of mark-to-market accounting;  Moody’s has produced an interesting commentary:

The world would be a much safer place if all securities were held by “real money” buy-and-hold investors who did not have to mark to market, and who therefore did not have to make forced sales into panicked markets. Unfortunately, literally trillions of dollars of securities are now held by leveraged mark-to-market institutions relying on other people’s money to finance sometimes opaque, complex and risky investments.

CNR had a new bond issue today for USD 550-million that showed a few signs of the times: the purpose of the issue is to repay commercial paper and reduce the size of the accounts receivable securitization programme; and there is a poison put, whereby the bonds are puttable to the company at $101 upon a credit downgrade. While as a bond-guy I like the poison-put feature (and will pay more for the issue than its comparables because of it), as an amateur-economist guy and equity-guy, I’m not so sure. This will have the effect of forcing the bond market’s mark-to-market woes onto the operating company, which will have to find financing (or sweeten the terms of the deal and negotiate their way out of it) at the worst possible time. Hmm …

Other issuers today were Lehman and GE as well as Suncor. Money abounds for solid credits; the market is operating as it should in this, the most perfect of all possible worlds.

Another hedge fund has stopped redemptions, in what seems like a rather complex story in which the portfolio manager quit:

Homm said yesterday he quit after directors declined to follow his lead by turning down bonuses and contributing shares to support the funds during market turmoil. Absolute Capital said today it approved the bonuses Homm recommended.

Homm didn’t answer calls to his mobile phone, and Chief Executive Officer Jonathan Treacher didn’t immediately return calls to his office and mobile phone. In an interview yesterday, Treacher said he was “surprised” by Homm’s departure. “We never discussed him resigning,” he said.

The BCE saga, last reviewed about five weeks ago has taken another twist: the bondholders are going to court:

They want the deal declared a “reorganization” under the terms of the 1976 and 1996 trust indentures, which would require bondholder approval.

BCE bondholders argue the takeover is unfair will see them take “significant losses” since the debentures have lost “hundreds of millions of dollars” in market value since talks of the company going private began earlier this year.

As well, the debt for the leveraged buyout and related interest costs have caused one rating agency to downgrade the debentures from investment grade to junk status, the bonderholders argue.

It’s interesting that a rating agency downgrade should be considered worthy of mention – I thought we weren’t paying attention to them any more. PrefBlog’s crack investigative reporting team has discovered the fact that the issuer, BCE, is paying the credit ratings agencies! Video at 11.

Brad Setser has reviewed the larger implications of the liquidity crunch:

My wild guess is that some kind of new financial innovation will be necessary to end the (financial) droid wars …

Either that or there may be a lot of CDOs containing some housing exposure may be sitting around on various firms balance sheets for a very long time.

My guess? Hedge funds will arise that are more than happy to take care of the problem at a discount to market. I don’t think the banks will mind – the big losses will have been taken by by the original owners that were forced to sell. Not a big deal, really.

Cleveland Fed researchers have reviewed the slope of the yield curve again and its implications for recession probabilities, but note:

First, probabilities are themselves subject to error, as is the case with all statistical estimates. Second, other researchers have postulated that the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades. Differences could arise from changes in international capital flows and inflation expectations, for example.

I suggest that any such readings taken now will reflect plain and simple panic. Let’s wait until panic has subsided and uncertainty has returned to normal levels before drawing any conclusions from the slope of the government yield curve.

US Equities continued their huge rally, but Canadian equities fell:

Canadian stocks fell, led by Suncor Energy Inc., on concern that a proposed oil and gas royalty increase may cut energy companies’ profits.

The province of Alberta should raise royalty rates to reap the benefits of rising prices, a report from a government-appointed task force said yesterday after markets closed.

The phrase “markets closed” should be read “markets closed Tuesday“, by the way.

Treasuries fell with steepening due to inflation fears.  Canadas followed.

Something of an odd Pref market today, with the PerpetualPremiums down and the PerpetualDiscounts up … given the action in the bond market, with the long end having an awful day, the opposite might have been expected. Assigning reasons to day-to-day fluctuations in any market, let alone the pref market, is something of an exercise in frustration, so we’ll just let that slide, shall we? Volume picked up a little today, a good sign.

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

The Fed cut by 50bp today, giving equities a big boost at the expense of long bonds and the greenback. As justification, their statement said:

Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

 For those keeping score, a handy guide to predictions of the Fed move by the brokerages houses was compiled by the WSJ Economics blog. Post-event reactions ranged from ‘Bold!’ to ‘Irresponsible!’. Tom Graff at Accrued Interest supplies an interesting prediction for the next two years.

James Hamilton of Econbrowser noted:

The Fed deliberately took a step back from its longer-run mission of containing inflation today. I don’t think Bernanke did so because he’d like to see 3-1/2 instead of 2-1/2 percent real growth next year. I’ve been saying all along that his intention is to squeeze inflation as much as possible without sending the economy into recession or financial crisis.

The verdict is still out on whether we’ve avoided one or both of those last two pitfalls. If we have, I’m not sure that the market’s confidence in another 50 basis points of cuts is warranted. If we haven’t, today’s exuberance in equity markets cannot be rational.

Well, US Core PPI looks OK anyway!

Over the past 12 months, producer prices rose 2.2 percent, down from a 4 percent increase in July. The year-over-year increase in costs excluding food and energy also eased to 2.2 percent compared with 2.3 percent in July.

In a highly interesting Canadian ABCP development, it looks like Dundee Bank flamed out:

Scotiabank will pay C$260 million in cash for Dundee Bank, a small bank that had been raking in deposits but was recently shaken by its exposure to a troubled corner of Canada’s asset-backed commercial paper sector, a short-term debt market that ground to a halt last month.
…
That was even after DundeeWealth said it will realize a net loss of about C$70 million on the sale of Dundee Bank “as a result of certain investments that are currently being valued below initial cost.”
…
DundeeWealth revealed on August 23 that the group was holding about C$400 million of commercial paper, instruments that are currently locked in a moratorium while the biggest players in that market try to hammer out a solution to prevent defaults.

I’d love to have more details on this. $70-million is an awful lot of mark-down on a $400-million position that, by all accounts, is reasonably well-secured with underlying assets anyway (albeit of a much longer term than originally intended). I wonder what else is going on with them? According to my interpretation of today’s DBRS rating confirmation, the problem was that they simply can’t place the money that has been deposited with them:

Aside from not yet achieving ongoing profitability, the Bank’s business model had become somewhat constrained given the recent credit market disruption. Without a lending operation, the Bank was relying on investments in collateralized loan obligations (CLOs) and asset-backed commercial paper (ABCP) to support its deposit liabilities, a strategy that is no longer practicable in the current market. The Bank grew to about $2 billion in assets since it began operations in September 2006.

Dundee Wealth has a ten-year retractible, DW.PR.A, in the preferred share market, rated Pfd-3 by DBRS. The issue soared on the news, presumably on market speculation that it is effectively an obligation of Scotiabank now and therefore of much higher quality.

Does everybody remember my speculation about the possibility of  a spectacular flame-out if a large bank suddenly discovered its risk controls weren’t exactly perfect? Looks like one shop, anyway, has come close:

Calyon, the investment banking arm of France’s Credit Agricole SA, said third-quarter profit will be “sharply down” after an unauthorized proprietary trade cost the bank 250 million euros ($347 million).

Calyon discovered an “unusually large market position” on diversified credit market indexes at its New York unit on Sept. 4, the Paris-based company said in a statement today. The trade, which breached authorized limits, has no relation to the subprime mortgage market, the bank added.

And, finally …

US Equities roared upwards after the Fed rate cut, as did the Canadian market.

Treasuries pivoted:

The difference in yield, or spread, between two- and 10-year notes widened to 0.5 percentage point, the most since Aug. 21. The gap was about 0.38 percentage point before the Fed statement.

Always remember: the short end trades on monetary policy while the long end trades on inflation expectations (the 10-years trade on futures & mortgage hedging!). One of the most educational graphs I’ve ever seen was of the Gilt market for a period of some years in the ’90’s … a beautiful, huge, smooth pivot, centered on the 10-year which barely moved.

Canadas pivoted.

The preferred share market continued its quiet ways. Volume continues to be light; entertainment was provided by the DW.PR.A mentioned above.

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