Archive for August, 2008

Fannie Mae Preferreds: Count Towards Bank Capital?

Wednesday, August 27th, 2008

Via Dealbreaker comes a WSJ Deal Journal post that makes the following rather odd claim:

But the fact remains that the government allowed banks to count Fannie and Freddie preferred shares toward their capital ratios, which made them appear safe.

I don’t understand this. I do see from the enormous Federal Reserve Bank Supervision Manual that:

U.S. government–sponsored agencies are agencies originally established or chartered by the federal government to serve public purposes specified by the U.S. Congress. Such agencies generally carry out functions performed directly by the central government in other countries. The obligations of government-sponsored agencies generally are not explicitly guaranteed by the full faith and credit of the U.S. government. Claims (including securities, loans, and leases) on, or guaranteed by, such agencies are assigned to the 20 percent risk category. U.S. government–sponsored agencies include, but are not limited to, the College Construction Loan Insurance Association, Farm Credit Administration, Federal Agricultural Mortgage Corporation, Federal Home Loan Bank System, Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac), Federal National Mortgage Association (FNMA or Fannie Mae), Financing Corporation (FICO), Postal Service, Resolution Funding Corporation (REFCORP), Student Loan Marketing Association (SLMA or Sallie Mae), Smithsonian Institution, and Tennessee Valley Authority (TVA).

I assume “securities” includes preferred shares, but I can’t find that in so many words. If so, then FNM prefs would be assigned a 20% risk weight rather than the normal 100% … in much the same way as AAA sub-prime paper was assigned a 20% risk-weight! See The role of ratings in structured finance: issues and implications :

Standardised risk weights for securitisation exposures: AAA to AA–, 20%; A+ to A–, 50%; BBB+ to BBB–, 100%; BB+ to BB– receive 350% for investors, but deduction for originators; B+ and below and unrated positions will have to be deducted in all cases, with the exceptions mentioned above. See Himino (2004) for a short overview of the Basel II framework.

This little example of what I suspect is a simple error would not normally be worth a post all to itself – but I think I’ve seen this claim elsewhere and find it puzzling. What on earth does the WSJ mean by saying that Fannie Mae prefs can count towards a bank’s capital? Any elucidation would be appreciated.

Update: Dealbreaker says:

Regulators require to banks to maintain a capital cushion against losses on loans. This capital requirement can be met by holding cash or cash equivalents and certain investments that were considered relatively risk-free.

… which makes no sense to me at all. I’ve asked for clarification in the comments.

Felix Salmon asks why the prefs were being held at all; the first commenter responds:

I believe that the capital requirements for GSE equity differ among the regulators. I think the risk weight is as low as 20% for GSE equity per at least one of the agencies.

… which makes perfect sense, but is not what is being said by Dealbreaker and the WSJ.

Update: OK, there’s a commentator on Dealbreaker who states:

The biggest owners of GSE pfds relative to the size of their balance sheet are smaller banks — state-chartered and thrifts. State-chartered banks and thrifts have a 100% risk weighting on GSE preferreds, while national banks have only a 20% risk weighting.

… but he doesn’t give chapter and verse.

In the “oldie but goodie” category comes a paper from the Cato Institute – The Mounting Case for Privatizing Fannie Mae and Freddie Mac … dated December 29, 1997! Anyway, any specifics in this paper with respect to bank supervision will have been long superseded, but it is claimed that:

12 C.F.R. 3-Appendix A(3)(a)(2)(vi) (Office of the Comptroller national bank regulations). Such securities are given a 20 percent risk weight, which is not as favorable as the 0 percent risk weight of U.S. government securities, but is more favorable than the 50 percent risk weight generally placed on privately issued mortgage-backed securities. The Office of Thrift Supervision’s regulation, 12 C.F.R. 567.6(a)(1)(ii)(H), has slightly different standards than the banking agencies, allowing certain “high quality mortgage-related securities” other than GSE securities to be accorded a 20 percent risk weight. 12 U.S.C. 24(7) details diversification standards for national banks.

And finally … the Holy Grail … Assessing the Banking Industry’s Exposure to an Implicit Government Guarantee of GSEs … and FDIC paper from 2004. Now I have to find something more recent that links to it!

There were no links I could find … but there is a fascinating letter from the Federal Home Loan Bank of New York.

August 27, 2008

Wednesday, August 27th, 2008

Yesterday, Citigroup was reported to have advised that Fannie & Freddie aren’t dead yet. Today it was Merrill’s turn:

Merrill Lynch & Co. analysts said a bailout of the mortgage-finance companies is “premature” because losses won’t cause capital to deplete for several quarters.

The market may be premature in expecting a rescue is imminent because the companies may not need to raise more capital to meet current requirements, the analysts said.

It’s not clear that Fannie and Freddie “need a capital injection,” [Kenneth] Bruce and [Cyrus] Lowe said in two separate reports. Still “policy makers may be forced by the controversy playing out in the market to consider various options to stabilize” the companies.

The two mortgage-finance companies “will likely be plagued by poor visibility into the future of credit losses and the uncertainty surrounding the possible public policy actions that could jeopardize shareholders,” the analysts wrote. “Risks of further contraction in the mortgage market are as unpalatable as a high-profile bail-out.”

Both stocks are rated “underperform” at Merrill, the reports said.

Fannie & Freddie sold some more money market paper today:

Investors have been watching the debt sales for any “tell- tale” signs that Washington-based Fannie and McLean, Virginia- based Freddie can’t fund themselves, UBS AG analysts in New York including William O’Donnell wrote in a report. Today’s spreads were wide enough to attract demand, yet narrow enough to dim speculation that the government-sponsored enterprises will be forced to turn to Treasury Secretary Henry Paulson for support.

Fannie sold $1 billion of three-month notes at a yield of 2.58 percent, the company said.

Freddie raised $1 billion of one-month debt at a yield of 2.28 percent, or 66 basis points more than Treasuries and 18 basis points less than one-month Libor, separate data shows.

Fannie also sold $1 billion of six-month debt today at a yield of 2.87 percent, about 93 basis points above Treasury bills

Geez, I wish that reporters would learn some of the jargon of the trade! I was all excited about the “short term notes” headline – indicating a 1-5 year term – only to find out it was money-market paper.

Assiduous Reader prefhound noted in yesterday’s comments:

You noted the other day that they needed to rollover about $120B of debt in the next 35 days. This looks to be about 7.5% of their combined debt of $1.6T, which seems an odd calendar concentration. Their recent tendency to go short term (in response to market conditions?) could make rollovers get bigger quite quickly.

Some long overdue poking around in Fannie Mae’s website uncovered their Monthly Summary Archive, which includes their Summary for July 2008. According to Table 7 of this summary, FNM has slightly under $273-billion in money market issuance outstanding and $573-billion in bonds, for a total of $846-billion. The ratio of Money-Market to Bonds outstanding has increased from 1:3.7 in July 2007 to 1:2.0 in July 2008, which is kind of interesting. It might be analytically important; it might be a cause for concern; it might not be. It is certainly something that should be understood before plunking money down on the table, however!

Anyway, if we say that one-quarter of the MM paper outstanding needs to be rolled every month (which assumes an average 4-month initial term; I have no idea how accurate this assumption might be), we arrive at required gross issuance of $68-billion monthly in MM paper simply to refinance the programme.

Bond issuance has totalled $190-billion year-to-date (compared to $194-billion for all of 2007!). If we assume that the YTD rate is representative, this comes to monthly gross issuance of $16-billion bonds.

The total comes to $84-billion to be financed monthly, which makes the figure of $120-billion in the five weeks to September 30 that I passed on in the August 25 report look at least halfway credible.

This level of dependence upon the wholesale market has been blamed for (among other things) the Northern Rock debacle; the Economist has dealt with the subject:

Start with liquidity, the obvious gap in the regulatory firewall. Liquidity risk is barely mentioned in the Basel 2 accord, largely because capital and liquidity were seen as separate (if entwined). The Basel rulemakers are due to issue an updated set of liquidity standards later this year, but devising a sensible regime is no easy task. “Liquidity risk is a kind of catastrophic risk—you either have it or you don’t,” says a senior regulator.

Authoritative references to the Northern Rock fiasco may be found in my post Earth to Regulators: Keep Out!.

Now, I don’t want anybody running out and shorting Fannie Mae because I’ve pointed out that they have an awful lot of short term financing to roll! I will simply point out that a rational investor will understand the nature and vulnerability of their funding mismatch – if any – prior to plunking money down on the table. I will stress yet again that I do not have a view on the investment merits of Fannie Mae preferreds; I’m simply pointing out the various considerations that never make it into the press due to the number of syllables in the words required to explain them.

Scared enough yet? Bloomberg reported a Moody’s press release on prime-Jumbo loans, inter alia:

The performance of mortgage pools in Jumbo transactions from 2006 and 2007 has also weakened relative to that of prior years. While the absolute level of delinquencies remains low in comparison to other RMBS segments, Jumbo delinquencies are building more quickly in recent months.

Moody’s had previously identified some recent-vintage Jumbo transactions that were at risk of downgrade based upon the performance data available at the beginning of 2008. Given the continued performance deterioration in the Jumbo sector, Moody’s is currently reviewing all Jumbo transactions that were originated in 2006 and 2007 .

Second lien pools, a much smaller proportion of RMBS issuance in comparison to first liens, have also experienced extreme poor performance. Moody’s expects 2005 vintage subprime closed-end second (CES) pools to lose 17% on average, 2006 vintage pools to lose 42% on average, and 2007 pools to lose 45% on average. However, given the wide range of deal characteristics and pool performance among transactions, Moody’s expectations for any given transactions can vary significantly.

Prime CES pools have experienced far lower losses than have subprime ones, although, like in every other RMBS sector, 2006 and 2007 vintage delinquencies and losses have been increasing. On average, Moody’s expects 2005 vintage prime CES pools to lose about 6% of their original balance, 2006 vintage pools to lose about 13%, and 2007 vintage pools to lose about 17%.

The performance of recent vintages of home equity line of credit (HELOC) pools has also weakened significantly. Moody’s projects that pool losses on 2005 vintage HELOC transactions will average about 9%, while 2006 vintage transactions will on average lose around 24% and 2007 vintage around 26%.

PerpetualDiscounts were off a bit today, with reasonable volume but a much higher than usual number of big blocks. The average YTW is 6.13%, equivalent to 8.58% interest at the standard conversion factor of 1.4x. Given that long corporates yield about 6.18%, this represents a spread of 240bp; still quite high by historical standards.

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 N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.59% 4.37% 57,583 16.43 7 +0.2953% 1,114.7
Floater 4.06% 4.10% 43,131 17.15 3 +0.0031% 909.7
Op. Retract 4.96% 3.85% 111,064 2.61 17 +0.0625% 1,054.8
Split-Share 5.36% 5.92% 54,780 4.42 14 +0.0097% 1,040.4
Interest Bearing 6.25% 6.62% 45,625 5.26 2 +0.7662% 1,129.2
Perpetual-Premium 6.14% 5.92% 64,885 2.22 1 +0.2362% 995.9
Perpetual-Discount 6.07% 6.13% 191,823 13.71 70 -0.1534% 877.1
Major Price Changes
Issue Index Change Notes
MFC.PR.C PerpetualDiscount -3.0211% Now with a pre-tax bid-YTW of 5.86% based on a bid of 19.26 and a limitMaturity.
BAM.PR.N PerpetualDiscount -1.6471% Now with a pre-tax bid-YTW of 7.26% based on a bid of 16.72 and a limitMaturity.
BMO.PR.H PerpetualDiscount -1.1786% Now with a pre-tax bid-YTW of 6.11% based on a bid of 21.80 and a limitMaturity.
PWF.PR.J OpRet -1.0728% Now with a pre-tax bid-YTW of 4.06% based on a bid of 25.82 and a softMaturity 2013-7-30 at 25.00.
BMO.PR.K PerpetualDiscount -1.0698% Now with a pre-tax bid-YTW of 6.22% based on a bid of 21.27 and a limitMaturity.
IGM.PR.A OpRet +1.3204% Now with a pre-tax bid-YTW of 3.08% based on a bid of 26.45 and a call 2009-7-30 at 26.00.
BSD.PR.A InterestBearing +1.6771% Asset coverage of just under 1.6:1 as of August 22, according to Brookfield Funds. Now with a pre-tax bid-YTW of 6.86% based on a bid of 9.55 and a hardMaturity 2015-3-31 at 10.00. Went ex-Dividend today, but nobody noticed.
IAG.PR.A PerpetualDiscount +1.7457% Now with a pre-tax bid-YTW of 6.12% based on a bid of 18.80 and a limitMaturity.
Volume Highlights
Issue Index Volume Notes
SLF.PR.B PerpetualDiscount 234,957 Desjardins crossed 30,000 at 19.71 and 150,000 at 19.75. RBC crossed 50,000 at 19.70. Now with a pre-tax bid-YTW of 6.13% based on a bid of 19.61 and a limitMaturity.
BNS.PR.M PerpetualDiscount 218,850 CIBC crossed 109,200 at 19.31 and National Bank crossed 10,000 at 19.25. Now with a pre-tax bid-YTW of 5.94% based on a bid of 19.20 and a limitMaturity.
TD.PR.P PerpetualDiscount 187,243 National Bank crossed blocks of 100,000 and 85,000, both at 23.05. Now with a pre-tax bid-YTW of 5.76% based on a bid of 23.05 and a limitMaturity.
CM.PR.I PerpetualDiscount 126,960 Nesbitt crossed 100,000 at 18.50. Now with a pre-tax bid-YTW of 6.43% based on a bid of 18.53 and a limitMaturity.
BNS.PR.L PerpetualDiscount 123,429 National Bank crossed 100,000 at 19.25. Now with a pre-tax bid-YTW of 5.93% based on a bid of 19.23 and a limitMaturity.
RY.PR.B PerpetualDiscount 118,990 CIBC crossed 100,000 at 19.51. Now with a pre-tax bid-YTW of 6.10% based on a bid of 19.41 and a limitMaturity.

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

IIAC 2Q08 Issuance Report

Wednesday, August 27th, 2008

The IIAC has released its Equity New Issues and Trading 2Q08 Report:

Preferred share issuance continued to rise with $2.3 billion in capital raised — up 59% from Q1 and 49.2% from a year ago (Chart 4). For the second straight quarter we saw increased issuance from financial institutions in measures to beef up their balance sheets in the wake of a series of write downs in the sector.

Hat Tip: Streetwise Blog.

New Issue: CM Fixed-Reset 5.35%+218bp

Wednesday, August 27th, 2008

And now there are nine. One more and I’ve got to get cracking with a – thankfully, rather minor – HIMIPref™ upgrade to put them in the database.

CM has announced:

it had entered into an agreement with a group of underwriters led by CIBC World Markets Inc. for an issue of 9 million non-cumulative Rate Reset Class A Preferred Shares, Series 33 (the “Series 33 Shares”) priced at $25.00 per Series 33 Share to raise gross proceeds of $225 million.

CIBC has granted the underwriters an option, exercisable in whole or in part prior to closing, to purchase an additional 3 million Series 33 Shares at the same offering price. Should the underwriters’ option be fully exercised, the total gross proceeds of the financing will be $300 million.

The Series 33 Shares will yield 5.35% per annum, payable quarterly, as and when declared by the Board of Directors of CIBC, for an initial period ending July 31, 2014. On July 31, 2014 and on July 31 every five years thereafter, the dividend rate will reset to be equal to the then current five-year Government of Canada bond yield plus 2.18%.

Holders of the Series 33 Shares will have the right to convert their shares into non-cumulative Floating Rate Class A Preferred Shares, Series 34 (the “Series 34 Shares”), subject to certain conditions, on July 31, 2014 and on July 31 every five years thereafter. Holders of the Series 34 Shares will be entitled to receive a quarterly floating rate dividend, as and when declared by the Board of Directors of CIBC, equal to the three-month Government of Canada Treasury Bill yield plus 2.18%.

Holders of the Series 34 Shares may convert their Series 34 Shares into Series 33 Shares, subject to certain conditions, on July 31, 2019 and on July 31 every five years thereafter.

The expected closing date is September 10, 2008. The net proceeds of this offering will be used for general purposes of CIBC.

Issue: Canadian Imperial Bank of Commerce Non-Cumulative Rate Reset Class A Preferred Shares, Series 33

Size: 9-million shares (=$225-million), greenshoe for 3-million shares (=$75-million) exercisable before closing.

Initial Dividend: 5.35% p.a., paid quarterly, until the first Exchange Date

Subsequent Dividends: 5-year Canadas +218bp, reset on Exchange Dates

Exchange Date: July 31, 2014 and every five years thereafter.

Exchange Option: Exchangeable to and from Series 34, which pays 3-month bills + 218bp, on Exchange Dates, reset quarterly.

Redemption: Series 33 (5-year-rate) redeemable every Exchange Date at $25.00. Series 34 (floater) is redeemable every Exchange Date at $25.00 and at all other times at $25.50.

It is interesting that the spread to the BNS new issue announced yesterday is 35bp for the initial period and 30bp thereafter. There are currently seven CM perpetualDiscounts, trading to yield between 6.43% and 6.68% at their bids; there are six BNS perpetualDiscounts, trading to yield between 5.73% and 5.90% at their bids. So the spread for seasoned issues is about 70bp, roughly double the spread on new issues. Live and learn.

CM announced this issue immediately after their 3Q08 Earnings Release … this is getting to be a habit!

I have written an article on the analysis of Fixed-Resets.

Update, 2014-05-06: Trades as CM.PR.K

CM Capitalization: 3Q08

Wednesday, August 27th, 2008

CIBC (Stock symbol CM … I can never quite decide how to present it!) has released its Third Quarter 2008 Report and Supplementary Package, so it’s time to recalculate how much room they have to issue new preferred shares – assuming they want to!

Step One is to analyze their Tier 1 Capital, reproducing the prior format:

CM Capital Structure
October, 2007
& July, 2008
  4Q07 3Q08
Total Tier 1 Capital 12,379 11,626
Common Shareholders’ Equity 90.1% 92.7%
Preferred Shares 23.7% 25.2%
Innovative Tier 1 Capital Instruments 0% 0%
Non-Controlling Interests in Subsidiaries 1.1% 1.3%
Goodwill -14.9% -16.6%
Misc. NA -2.6%
‘Misc.’ is comprised of Basel II adjustments to Tier 1 Equity

Next, the issuance capacity (from Part 3 of the introductory series):

Tier 1 Issuance Capacity
October 2007
& July 2008
  4Q07 3Q08
Equity Capital (A) 9,448 8,695
Non-Equity Tier 1 Limit (B=A/3), 4Q07
(B=0.428*A), 3Q08
3,149 3,721
Innovative Tier 1 Capital (C) 0 0
Preferred Limit (D=B-C) 3,149 3,721
Preferred Actual (E) 2,931 2,931
New Issuance Capacity (F=D-E) 218 790
Items A, C & E are taken from the table
“Regulatory Capital”
of the supplementary information;
Note that Item A includes Goodwill, FX losses, non-controlling interest, Gains on sale of securitizations and 50/50 deductions

Item B is as per OSFI Guidelines; the limit was recently increased.
Items D & F are my calculations

and the all important Risk-Weighted Asset Ratios!

Risk-Weighted Asset Ratios
October 2007
& July 2008
  Note 4Q07 3Q08
Equity Capital A 9,448 8,695
Risk-Weighted Assets B 127,424 118,500
Equity/RWA C=A/B 7.41% 7.33%
Tier 1 Ratio D 9.7% 9.8%
Capital Ratio E 13.9% 14.4%
Assets to Capital Multiple F 19.0x 17.7x
A is taken from the table “Issuance Capacity”, above
B, D & E are taken from CM’s Supplementary Report
C is my calculation.
F is from Page 26 of the quarterly report
Note that CM reports “Common Equity to risk-weighted assets” of 9.1%. They do not include “non-controlling interests”, “goodwill” and the Basel II adjustments in the numerator; I do.

Again, the 4Q07 figures are not directly comparable with the 3Q08 figures due to the change from Basel I to Basel II.

On a Basel I basis, the Tier I and Total Capital ratios got a big boost in the first quarter with the capital raise, but have since declined; the Tier 1 ratio is now the lowest it has been in the last two years, but the total capital ratio has improved since the second quarter. The improvement in the total capital ratio over the quarter may be attributed to issues of sub-debt.

Further, on a Basel I basis, Total Risk Weighted Assets have increased somewhat since 4Q07, basically due to an increase of $5-billion in the risk-weight of “Other Loans”. It is not entirely clear what these other loans are; the balance sheet amounts for Personal Loans and Credit Card Loans are up $2.2-billion and $1.4-billion, respectively, but that doesn’t account for the increase. It may possibly be the risk weighting that has changed rather than the unadjusted balance sheet value.

Research: Split Shares and the Credit Crunch

Wednesday, August 27th, 2008

OK, we all know that The Great Credit Crunch of 2007-?? had a grim effect on financial companies and an even more grim effect on their share prices. But, for preferred share investors, the important thing is: what was the effect on preferred shares of split-share corporations backed by financial issues?

The July, 2008, edition of Canadian Moneysaver includes my efforts to review the situation. Look for the research link!

And I can offer a bonus spreadsheet that includes a little information that couldn’t be squashed in to the article.

August 26, 2008

Tuesday, August 26th, 2008

The Fannie & Freddie reporters highlighted what they believe to be startlingly new information today – sub-debt does not default with deferred dividends:

Buyers of credit-default swap contracts that protect against losses on Fannie Mae or Freddie Mac subordinated debt may not get paid immediately if the mortgage-finance companies were to defer interest payments as part of a government bailout, according to Bank of America Corp.

While a failure to make the payments permits credit-default swap buyers to cash in on their protection, Freddie and Fannie subordinated bond indentures allow interest to be deferred for as long as five years, or until maturity, if capital cushions breach certain thresholds, Bank of America strategist Glen Taksler in New York wrote in a note to clients yesterday.

Bank sub-debt has been discussed on PrefBlog before, as have Credit Default Swaps. The place of sub-debt in a bank’s capital structure has been mentioned in a review article.

But Citigroup says ‘calm down, people!’:

Fannie Mae and Freddie Mac can withstand losses through the end of the year and still keep a cushion above their minimum capital requirements, according to Citigroup Inc. analysts.

Freddie of McLean, Virginia, will have $12.7 billion of capital above the minimum requirement, according to slides provided by Citigroup for a conference call with investors. Washington-based Fannie will have $20.3 billion.

The bank’s interest rate strategists led by Scott Peng in New York said last week that the beleaguered mortgage-finance companies don’t need to be nationalized and the U.S. should resist being “stampeded” into a bailout.

Speaking of Fannie, I am thrilled to announce that I have finally seen a definition of “wiped out”, as used in the phrase “Fannie Mae preferred shareholders may get wiped out!!!!!”. According to Dealbreaker:

There had been widespread fear that a government rescue of Freddie would wipe out the preferred shareholders, possibly by subordinating them to new government-owned preferred shares.

I fail to see how the simple fact of subordination to another series of prefs can be equated to a “wipe out”. They’re already subordinated to sub-debt and ordinary liabilities. Would the phrase “wipe out” continue to apply if it was simply more sub-debt being loaded on to the balance sheet? As I discussed on August 22, in the absence of (a credible threat of) liquidation or expropriation, any talk of a preferred share wipe-out at Fannie Mae is simply hysterical nonsense.

If you want to say that Fannie Mae will be liquidated with little or no value to the preferred shareholders, that’s one thing to argue. Or Treasury making an offer they can’t refuse with the threat of liquidation, that’s another. Or Treasury simply expropriating the preferred shares, that’s a third avenue of argument. But simple, straightforward subordination is not equivalent to wipe-out unless one of those arguments holds.

Freddie was downgraded by S&P today:

Standard & Poor’s Ratings Services said today that it affirmed its ‘AAA/A-1+’ senior unsecured debt rating on Freddie Mac with a stable outlook. At the same time, we lowered the risk-to-the-government stand-alone issuer credit rating to ‘A-‘ from ‘A’, the subordinated debt rating to ‘BBB+’, and the preferred stock rating to ‘BBB-‘ from ‘A-‘. The ratings that were lowered are all placed on CreditWatch Negative.

It could be straightforward funding support through expansion of the Treasury line, buying Freddie Mac’s debt or its agency mortgage-backed securities, or it could consider an equity investment. The possibility of an equity investment is driving Freddie Mac’s equity price lower and the yield on its preferred stock higher. An equity investment by
Treasury could be accompanied by the consideration of nonpayment of existing preferred stock and common dividends.

The subordinated notes pose incremental risk to investors because of an interest deferral feature given certain trigger events tied to Freddie Mac’s regulatory capital levels. The subordinated debt covenant language also states that a deferral of the subordinated debt interest payment triggers the nonpayment of all preferred stock and common dividends, arguing for a close alignment of preferred stock and subordinated debt ratings. However, we now rate the preferred stock two notches below the subordinated debt to reflect the increased risk of nonpayment of dividends as a means of capital preservation. Furthermore, there are no covenants restricting the payment of interest on the subordinated debentures, while the preferred dividends are suspended.

The language is fairly similar in the release announcing the downgrade of Fannie Mae. I must say, a downgrade from A- to BBB- for the preferred stock given the potential for a suspension of the preferred dividend seems to me to be a far more appropriate response than hysterical screaming about wipe-outs.


Wait a minute!

I just remembered!

S&P, in its role as Evil Credit Rating Agency, is paid by the issuer! Geez, that sounds terrible.

And there’s a somewhat related story that Lehman is trying to sell or spin-out-for-cash its Commercial Mortgage assets.

Accrued Interest has engaged in some blue-sky thinking about the GSEs; there’s much with which I disagree:

its looking more and more like a bailout isn’t imminent (meaning its a matter of weeks or months, not days). I expect an interim step, probably some kind of purchase of MBS, to come before any actual injection of cash.

I don’t think there will be any interim step; I think such action would be economically and idealogically indefensible.

A big part of the inherent problem in the GSEs’ current business model is that it requires substantial leverage to generate a reasonable return on equity. Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie’s guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in tact.

Well … yes there is. The fee can become larger. And structural reforms in US mortgages are urgently needed:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

  • 30 years in term
  • refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
  • non-recourse to borrower (there may be exceptions in some states)
  • guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
  • Added 2008-3-8: How could I forget? Tax Deductible

But Accrued Interest‘s main suggestion is:

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We’d wind up with large banks dominating the mortgage market, which has its own systemic risk problems.

So what if in the future the GSEs provided some limited guarantee on covered bonds?

This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

It’s a very interesting idea … I’ll have to think about it a bit more. My first thought is that covered bonds are generally AAA anyway – how much could the GSEs charge for adding another layer of protection?

Covered bonds have been recently approved by the FDIC and were discussed on PrefBlog last fall.

When reviewing the 3Q08 BMO Financials, I noted that they were keeping assets constant while beefing up their capital – thus engaging in some gentle delevering. Bank borrowing is getting expensive:

Banks, securities firms and lenders have a record $871 billion of bonds maturing through 2009, according to JPMorgan Chase & Co., just as yields are at their most punitive compared with Treasuries. The increase in yields may cost them as much as $23 billion more in annual interest versus a year ago based on Merrill Lynch index data.

Higher refinancing expenses will restrict the ability of banks to borrow in the capital markets and lend, further cutting off credit to consumers and businesses and curbing what is already the slowest growing economy since 2001. Standard & Poor’s said last week that it had a “negative” outlook on almost half of the 50 highest-rated financial institutions in the U.S. as of June 30, the highest proportion in 15 years.

PerpetualDiscounts eased off a bit today, on reasonably average volume. What should I say? According to “Investment Punditry for Dummies”, I could say “profit taking”, “concern about this week’s bank earnings announcements”, “making room for a new BNS issue” … there’s lots of choices! I think I’ll just say “I have no idea. Ask a priest!” and leave it at that.

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 N/A N/A N/A N/A 0 N/A N/A
Fixed-Floater 4.61% 4.36% 57,351 16.42 7 +0.0643% 1,111.4
Floater 4.06% 4.10% 42,481 17.15 3 -0.5301% 909.6
Op. Retract 4.96% 4.02% 110,410 2.54 17 +0.2351% 1,054.2
Split-Share 5.35% 5.93% 54,295 4.42 14 +0.0413% 1,040.3
Interest Bearing 6.25% 6.76% 46,703 5.22 2 -0.5059% 1,120.6
Perpetual-Premium 6.15% 6.02% 64,903 2.22 1 +0.3953% 993.6
Perpetual-Discount 6.06% 6.12% 189,615 13.54 70 -0.0676% 878.5
Major Price Changes
Issue Index Change Notes
POW.PR.D PerpetualDiscount -1.9404% Now with a pre-tax bid-YTW of 6.13% based on a bid of 20.72 and a limitMaturity.
SLF.PR.E PerpetualDiscount -1.8858% Now with a pre-tax bid-YTW of 6.18% based on a bid of 18.21 and a limitMaturity.
BAM.PR.B Floater -1.4948%  
FBS.PR.B SplitShare -1.0246% Asset coverage of just under 1.5:1 as of August 21, according to TD Securities. Now with a pre-tax bid-YTW of 6.26% based on a bid of 9.66 and a hardMaturity 2011-12-15 at 10.00.
CM.PR.G PerpetualDiscount -1.0140% Now with a pre-tax bid-YTW of 6.68% based on a bid of 20.50 and a limitMaturity.
BAM.PR.I OpRet +2.6348% Now with a pre-tax bid-YTW of 5.44% based on a bid of 25.32 and a softMaturity 2013-12-30 at 25.00. Compare with BAM.PR.H (6.08% to 2012-3-30), BAM.PR.J (6.41% to 2018-3-30) and BAM.PR.O (7.37% to 2013-6-30).
Volume Highlights
Issue Index Volume Notes
SLF.PR.C PerpetualDiscount 108,100 CIBC crossed 105,000 at 18.31. Now with a pre-tax bid-YTW of 6.08% based on a bid of 18.31 and a limitMaturity.
CM.PR.R OpRet 83,450 TD crossed 25,000 at 25.80, then another 25,000 at 25.90. CIBC crossed 25,000 at 25.80. Now with a pre-tax bid-YTW of 4.57% based on a bid of 25.65 and a softMaturity 2013-4-29 at 25.00.
ENB.PR.A PerpetualDiscount 42,050 CIBC crossed 38,700 at 23.60. Now with a pre-tax bid-YTW of 5.85% based on a bid of 23.59 and a limitMaturity.
SLF.PR.B PerpetualDiscount 41,835 Desjardins crossed 25,000 at 19.71. Now with a pre-tax bid-YTW of 6.10% based on a bid of 19.70 and a limitMaturity.
TD.PR.O PerpetualDiscount 37,975 Desjardins crossed 25,000 at 21.05. Now with a pre-tax bid-YTW of 5.80% based on a bid of 21.14 and a limitMaturity.

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

BAM Perps vs. BNA.PR.C … How Long is Forever?

Tuesday, August 26th, 2008

Remember the old days, when retractible issues yielded less than perpetuals? That inspired one of my first articles, in which I examined the question of just how bad things had to get before the tortoise outpaced the hare.

And, Assiduous Readers will recall, BNA.PR.C often exhibits puzzling behavior.

These two concepts have now met, with (at the closing bid) BNA.PR.C priced below BAM.PR.N.

BNA.PR.C yields 9.37%, based on a bid of 16.83 and a hardMaturity 2019-1-10 at 25.00, while BAM.PR.N yields 7.13% based on a bid of 17.00 and a limitMaturity. The former issue is a split share based solely on BAM.A, with asset coverage of 3.3+:1 as of July 31, according to the company. As of March 31, 2008, there were 19,032,000 Units outstanding, each unit comprised of one capital share and one preferred share – each series of preferreds has a $25 liquidation value. The company owns 46,161,000 shares of BAM.A, so the BAM.A:Unit ratio is 2.4:1, so at today’s closing price of $31.52, asset coverage is a hair over 3.0:1. Give or take.

Now, one thing that makes the BNA issues intrinsically fascinating is the fact that they are so well covered by a relatively poor credit. I wish I could be as poor a credit as Brookfield, at Pfd-2(low) according to DBRS, but it’s still worse than the banks! This means that the credit rating of BNA is constrained by the rating of the BAM prefs – which makes all kinds of sense. As a rough approximation – for conceptual purposes only – we can say that BNA prefholders get hurt when the common is below $10, while the BAM prefholders get hurt when the common is below $0.

Anyway, the upshot is:

  • the BNA prefs may be thought of as being junior to the BAM prefs, but
  • the BNA prefs have a fixed maturity date, while the BAM perps are … perps

I invite criticism on this point, but I suggest that the two influences cancel out, leaving credit quality of the two issues approximately equal for investment purposes.

But the spread between these issues has varied all over the place:

The wideness of the current spread really is most peculiar. The fund has recently swapped its BAM.PR.N holding for BNA.PR.C … we shall see how well it works out!

Update, 2008-09-06: BAM.PR.N was recently affirmed at Pfd-2(low) by DBRS.

FDIC Releases 2Q08 Report

Tuesday, August 26th, 2008

The full report is available on their website … which, by the way, highlights the amusingly exasperated notice:

The FDIC creates reports on problem or troubled banks in the aggregate. We do not make the details of this list publicly available. The FDIC does not, at any time, comment on open financial institutions.

The “problem list” is highlighted in stories on Bloomberg and Dealbreaker. So go there for that story – it’s interesting enough, but there are other interesting things.

The FDIC highlights a steep decline in net income:

Insured commercial banks and savings institutions reported net income of $5.0 billion for the second quarter of 2008. This is the second-lowest quarterly total since 1991 and is $31.8 billion (86.5 percent) less than the industry earned in the second quarter of 2007. Higher loan-loss provisions were the most significant factor in the earnings decline. Loss provisions totaled $50.2 billion, more than four times the $11.4 billion quarterly total of a year ago. Second-quarter provisions absorbed almost one-third (31.9 percent) of the industry’s net operating revenue (net interest income plus total noninterest income), the highest proportion since the third quarter of 1989.

Almost 18 percent of all insured institutions were unprofitable in the second quarter, compared to only 9.8 percent in the second quarter of 2007.

Noninterest income of $60.8 billion was $7.4 billion (10.9 percent) lower than in the second quarter of 2007. The decline in noninterest income was attributable to lower trading income (down $5.5 billion, or 88.6 percent); smaller gains from sales of loans, foreclosed properties, and other assets (down $1.7 billion, or 41.2 percent); and lower income from securitization activities (down $1.5 billion, or 28.3 percent). In addition to the decline in noninterest income, securities sales yielded $2.3 billion in net losses in the second quarter, compared to $573 million in net gains a year earlier. Expenses for goodwill and other intangibles totaled $4.5 billion, more than double the $2.1 billion incurred by the industry in the second quarter of 2007. Net interest income was one of the few bright spots in industry revenues, rising by $8.2 billion (9.3 percent) over year-earlier levels. Servicing fee income increased by $1.9 billion (35.9 percent). Service charges on deposit accounts increased by $853 million (8.6 percent) at insured commercial banks and state-chartered savings banks.

The average net interest margin (NIM) improved slightly compared to the first quarter, from 3.33 percent to 3.37 percent.

Net charge-offs of loans and leases totaled $26.4 billion in the second quarter, almost triple the $8.9 billion that was charged off in the second quarter of 2007. The annualized net charge-off rate in the second quarter was 1.32 percent, compared to 0.49 percent a year earlier. This is the highest quarterly charge-off rate for the industry since the fourth quarter of 1991.

For the third consecutive quarter, insured institutions added almost twice as much in loan-loss provisions to their reserves for losses as they charged-off for bad loans. Provisions exceeded charge-offs by $23.8 billion in the second quarter, and industry reserves rose by $23.1 billion (19.1 percent). The industry’s ratio of reserves to total loans and leases increased from 1.52 percent to 1.80 percent, its highest level since the middle of 1996. However, for the ninth consecutive quarter, increases in noncurrent loans surpassed growth in reserves, and the industry’s “coverage ratio” fell very slightly, from 88.9 cents in reserves for every $1.00 in noncurrent loans, to 88.5 cents, a 15-year low for the ratio.

The industry added $10.6 billion to its total regulatory capital in the second quarter, the smallest quarterly increase since the fourth quarter of 2003. A majority of institutions (60.0 percent) reported declines in their total risk-based capital ratios during the quarter. More than half (50.9 percent) of the 4,056 institutions that paid dividends in the second quarter of 2007 reported smaller dividend payments in the second quarter of 2008, including 673 institutions that paid no quarterly dividend. Dividend payments in the second quarter totaled $17.7 billion, less than half the $40.9 billion insured institutions paid a year earlier.

I also found it interesting that this highly touted ‘117 institutions on the problem list’ represents an increase of exactly one from the 2003 figure … though, to be fair, assets at 2003’s problem banks were only $30-billion, compared to $78-billion now.

New Issue: BNS Fixed-Reset 5.00%+188bp

Tuesday, August 26th, 2008

And now there are eight. Two more and I’ll add them to the HIMIPref™ database.

BNS has announced:

a domestic public offering of 8 million non-cumulative 5-year rate reset preferred shares Series 22 (the “Preferred Shares Series 22”) at a price of $25.00 per share, for gross proceeds of $200 million.

Holders of Preferred Shares Series 22 will be entitled to receive a non-cumulative quarterly fixed dividend for the initial period ending January 25, 2014 yielding 5.00% per annum, as and when declared by the Board of Directors of Scotiabank. Thereafter, the dividend rate will reset every five years at a rate equal to 1.88% over the 5-year Government of Canada bond yield.

Holders of Preferred Shares Series 22 will, subject to certain conditions, have the right to convert all or any part of their shares to non-cumulative floating rate preferred shares Series 23 (the “Preferred Shares Series 23”) of Scotiabank on January 26, 2014 and on January 26 every five years thereafter.

Holders of the Preferred Shares Series 23 will be entitled to receive a non-cumulative quarterly floating dividend at a rate equal to the 3-month Government of Canada Treasury Bill yield plus 1.88%, as and when declared by the Board of Directors of Scotiabank. Holders of Preferred Shares Series 23 will, subject to certain conditions, have the right to convert all or any part of their shares to Preferred Shares Series 22 on January 26, 2019 and on January 26 every five years thereafter.

The Bank has agreed to sell the Preferred Shares Series 22 to a syndicate of underwriters led by Scotia Capital Inc. on a bought deal basis. The Bank has granted to the underwriters an option to purchase up to an additional 2 million Preferred Shares Series 22 at closing, which option is exercisable by the underwriters any time up to 48 hours before closing.

Closing is expected to occur on or after September 9, 2008.

Issue: Bank of Nova Scotia Non-Cumulative 5-Year Rate Reset Preferred Shares Series 22

Size: 8-million shares (=$200-million), greenshoe for 2-million shares (=$50-million) exercisable before closing.

Initial Dividend: 5.00% p.a., paid quarterly, until the first Exchange Date

Subsequent Dividends: 5-year Canadas +188bp, reset on Exchange Dates

Exchange Date: January 26, 2014 and every five years thereafter.

Exchange Option: Exchangeable to and from Series 23, which pays 3-month bills + 188bp, on Exchange Dates, reset quarterly.

Redemption: Series 22 (5-year-rate) redeemable every Exchange Date at $25.00. Series 23 (floater) is redeemable every Exchange Date at $25.00 and at all other times at $25.50.

Scotia’s second issue paid 5.00%+170; their first issue paid 5.00%+205. Well … if I do add them to HIMIPref™, at least I’ll have a variety of resets to analyze! And this is a Good Thing.

I have written an article on the analysis of Fixed-Resets.