PrefBlog

US Inflation numbers were announced today and seem relatively benign – while the headline number ticked up for the month and trailing year, the core rate remained steady at 2.1% for the year. Housing starts continued to decline to the horror of many so it would appear that, whatever else we have to worry about, a superheated US economy is not the greatest concern! As the Bank of Canada said yesterday when announcing that the bank rate would be unchanged:

the outlook for the U.S. economy has weakened because of greater-than-expected slowing in the housing sector. The Bank has revised down its projection for U.S. growth to 1.9 per cent in 2007 and 2.1 per cent in 2008. U.S. growth is expected to pick up to 3 per cent in 2009.

What’s going to happen in the US? Brad Setser is worried:

The August TIC Data was really bad.  Even Fox Business News would have trouble putting a happy face on it.

The net outflow in August – from a combination of foreign investors reducing their claims on the US and Americans adding to their claims on the world – was around $160b.   Most of that — $140b – came from the private sector, but the official sector also reduced its claims on the US.  The total monthly outflow works out to a bit more than 1% of US GDP.   Annualized, that is a 12% of GDP outflow.    To put a 12% of GDP outflow in context, it is roughly the magnitude of the private outflow from Argentina in 2001, at the peak of its crisis.

Meanwhile, there is on sub-prime securitization:

Many of the mortgages underpinning this housing expansion were resold. They were securitized – meaning a loan would become a tradable asset – and packaged – meaning many loans were put together to form a single asset. The resulting bundles, called credit derivatives, were then sold worldwide, most of them with high AAA ratings because the large number of loans that they included meant a very small risk on any single one of them.

As PrefBlog’s readers will know, that’s not how it works. The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.

The number of loans is basically irrelevant – you want to have enough diversification that you’re eliminating asystemic risk and reflecting the asset class’ systemic risk, but after that you’re simply increassing the size of the pool. The AAA ratings are only available through subordination.Ordinarily, of course, I’d make a snarky comment about the writer … but Angel Ubide is the Director of Global Economics at Tudor Investment Corporation. Well, I won’t be putting any money into that firm until I see some clarification!

A much more informed review is available on Econbrowser, where James Hamilton has put together some fascinating graphs and asks the question:

So here’s my question– why did the “most sophisticated” investors apparently become less and less sophisticated as time went on?

It depends on how you define “sophisticated”, doesn’t it? I suggest that

• if one performs a regression between trailing long term performance and assets under management, you’ll find little correlation
• regress trailing short term performance and AUM, high correlation
• AUM and future performance, little correlation
• trailing change in AUM and future performance, high negative correlation

The investment business is NOT, generally speaking, about returns.

The MLEC (or “Super-Conduit”) that was discussed yesterday and Monday got some public disclosure of its rationale today:

Cheyne Finance Plc, the structured investment vehicle managed by hedge fund Cheyne Capital Management Ltd., will stop paying its debts, a receiver from Deloitte & Touche LLP said.

Deloitte is negotiating a refinancing of the SIV or a sale of its assets, according to an e-mailed statement today. Cheyne Finance’s debt with different maturities will now be pooled together, rather than shorter term debt being repaid sooner, Neville Kahn, a receiver from Deloitte said today in a telephone interview.

“It doesn’t mean we have to go out and fire-sell any assets, quite the opposite in fact,” Kahn said. “The paper that falls due today or tomorrow won’t be paid as it falls due.”

I discussed Cheyne on August 28. Meanwhile the debate regarding the advisability of the Super-Conduit / MLEC / Whatever continued to rage. Naked Capitalism heaped scorn on the idea; but it seems to me that his initial opposition to the scheme is what’s driving his arguments:

the biggest one being pricing of the assets to be sold to the MLEC, since the interests of current SIV owners and prospective funding sources seem hopelessly in conflict

Well, sort of. Conflict is what makes a market, after all – buyers and sellers are always in conflict. My suggestion is that the conflict will be resolved by the prospective funding sources riding roughshod over the current SIV owners/investors, who will be forced to take a hit; I suggest that current SIV owners will be forced to pay off their ABCP holders and leave their junior tranche holders with nothing … or not much, anyway.

They (the current SIV sponsors and junior debt-holders) are between a rock and a hard place. I suspect that many of them are in a negative carry situation – this may be the reason why the Cheyne receiver has suspended redemptions – and if ABCP investors move to the new conduit, this will only get worse, if they’re able to finance at all. They will then be forced to give up all their equity in the SIV just to get out, by selling to the Super Conduit at the lowest possible prices – as suggested by the Financial Times:

Thus, if the M-LEC is to produce a genuine solution to the current financial woes, it is imperative that it buy assets at genuine, clearing prices – not artificial prices created by banks. If not, investors will retain nagging fears that prices have further to fall.

And, to repeat myself, it is my suggestion that the Super Conduit has been conceived as a vulture fund – that will seek to profit from the utter helplessness of the current SIVs. Another way of looking at it, perhaps, is as a cram-down: the senior note (ABCP) holders will get back their full amount (which might include Super-Conduits junior notes instead of cash); the junior note-holders will get Super-Conduits junior notes (if anything). I suggest that the current SIV junior noteholders will be forced to go along with the idea, because the ABCP holders always have the option of walking away as their notes mature … the current SIV junior noteholders are going to get what we in the investment management business refer to as “screwed”. And serve ’em right.

See my example with respect to the DG.UN holders (who are the junior noteholders of that particular SIV) yesterday.

Accrued Interest also discussed this issue today, but opined that operating as a vulture fund necessarily meant accepting second-rate assets. I’m not sure that’s the case … I suggest that Super Conduit aims to purchase first-class assets at second-class prices, using the power of (projected) lower funding costs and better liquidity guarantees.

I will be fascinated to see how this unfolds. There is no doubt that sub-prime is resulting in a big heap of losses; but it is my contention that market values have grossly over-compensated for these losses. Readers with good memories will remember the IMF Report which I have discussed previously:

Spreads have since widened across the capital structure, especially on lower-rated ABS and ABS CDO tranches, but also on AAA-rated senior tranches (Figure 1.9). Implied losses based on these spreads total roughly $200 billion, exceeding the high end of estimated realized losses by roughly $30 billion—an indication that market uncertainty and liquidity concerns may have pushed down prices further than warranted by fundamentals (Box 1.1). While many structured credit products were bought under the assumption that they would be held to maturity, those market participants who mark their securities to market have been (and will continue to be) forced to recognize much higher losses than those who do not mark their portfolios to market. So far, actual cash fl ow losses have been relatively small, suggesting that many highly rated structured credit products may have limited losses if held to maturity.

I’ll suggest that the discrepency between mark-to-market and hold-to-maturity values is even bigger today.

Meanwhile, back to sub-prime for a moment, Treasuries were up a lot today, helped by S&P’s mass downgrade of 2007-vintage RMBS:

Standard & Poor’s Ratings Services today lowered its ratings on 1,713 classes of U.S. RMBS backed by first-lien subprime mortgage loans, first-lien Alternative-A (Alt-A) mortgage loans, and closed-end second-lien mortgage loans issued from Jan. 1, 2007, through June 30, 2007. These classes are from 136 subprime transactions, 128 Alt-A transactions, and 19 closed-end second-lien transactions. The downgraded classes represent approximately $23.35 billion of original par amount, which is 6.28% of the $371.9 billion original par amount of these three types of U.S. RMBS rated by Standard & Poor’s between Jan. 1, 2007, and June 30, 2007, and 4.71% of the approximately $495 billion original par amount of all U.S. RMBS rated during this period.

In addition, we placed the ratings on 646 other classes from 109 transactions backed by U.S. RMBS first-lien subprime mortgage loans and U.S. RMBS first-lien Alt-A mortgage loans issued during the same period on CreditWatch with negative implications. We expect to resolve the CreditWatch placements within the next few weeks, and anticipate that the results of that review will be similar to the rating actions announced herein.

Finally, we affirmed the ratings on securities representing $245.1 billion original par value of U.S. RMBS backed by these three types of mortgage loans issued during the same period.

There’s a lot more detail in the S&P press release – read it all!

In preferred news, the PerpetualDiscount index actually rose today, making just the second trading day since September 19 that it has been in the black. It was aided in part by BAM.PR.M (which has been inaccurately “Distressed Preferred”) now bid at 20.45 to yield 5.87% while the virtually identical BAM.PR.N closed at 19.50 bid to yield 6.16%. Sometimes I despair of this market, I really do … especially since the fund swapped into the Ns when the spread was at a huge $0.35! *sigh* Oh well, sanity will return sooner or later. It always does.

There were twenty other index-included $25.00-equivalent issues trading over 10,000 shares today.

This entry was posted on Wednesday, October 17th, 2007 at 9:46 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.