Category: Market Action

The recent rally in junk bonds is having some interesting knock-on effects:

The biggest high-yield rally ever is punishing the lowest- rated companies that may no longer be able to afford avoiding bankruptcy by exchanging or buying back debt at the lowest prices on record. The “cruel irony” of rising prices means the neediest businesses will have a harder time finding financing, Morgan Stanley analysts led by Jocelyn Chu in New York said in a May 15 report. That may lead to more defaults than anticipated.

Freescale Semiconductor Inc., part-owned by 62-year-old Schwarzman’s Blackstone Group LP, wiped away $1.9 billion of debt in March by giving investors an average of 32 cents on the dollar in loans. Since the bond exchange was announced March 4, the securities have tripled to as high as 54.1 cents on the dollar, curtailing the chipmaker’s ability to cut the rest of its $7.5 billion debt load.

C-EBS is hosting a public hearing on liquidity buffers, in an attempt to finalize a framework for EU national bank supervision. There is a a wide range of industry practices:

– Within the industry, most banks either formally define a liquidity buffer or alternatively it is a concept implicit in their liquidity management policy.

– One institution formally defines its liquidity buffer as highly liquid unencumbered assets set at a level to get through the initial stages of a liquidity shock. It also defines a maximum amount of collateral that may be needed for intraday payment system purposes and deducts this from the stock of unencumbered assets. Buffers are formed for each of the currencies in which it is active. A survival period of 90 days is defined and liquidity shock scenarios developed to calibrate the size of the buffer.

– Another bank defines the buffer as a liquidity gap based on a runoff scenario (all maturing assets and liabilities not renewed during a 4 week period) that can be covered from high quality funding sources.

– Another bank defines the buffer over 30 days but does not use stress tests to measure the required size of buffer. Instead, expert judgement from the ALCO sets the buffer level. The quality of the assets in the buffer also impacts the level of buffer held.

– Another bank does not formally define a buffer. Instead it manages its overall counterbalancing capacity. As part of this, it uses projected flows to estimate a level of unencumbered assets that will cover the liquidity gap such that no change to the bank’s business model is required. This output is an input to the overall policy on managing its counterbalancing capacity.

The Globe and Mail has a story on Property & Casualty insurers:

The Office of the Superintendent of Financial Institutions (OSFI), which regulates about 200 companies in the sector, is worried about capital levels in the industry.

“It’s a period of great uncertainty right now,” said Bruce Thompson, a director in the supervision sector of OSFI’s Toronto office. “Our expectation is that 2009 is going to be a difficult year for the industry.”
…
Its total capital level dropped last year for the first time since 2003. The key measure of a property and casualty insurer’s financial cushion is called the Minimum Capital Test. The sector-wide ratio fell to 238 per cent at the end of 2008, from 252 per cent at the end of 2007. (Regulators require it to remain above a floor of 150 per cent, but Mr. Thompson pointed out that “companies know darn well that 150 is a territory you don’t go.”)

A basically flat day for preferreds amidst continued heavy volume.

The IMF has released a working paper by Peter Stella, The Federal Reserve System Balance Sheet: What Happened and Why it Matters:

The recent expansion of the balance sheet of the consolidated Federal Reserve Banks (FRB) is analyzed in an historical context. The analysis reveals that the nature of Fed involvement in U.S. financial markets has changed dramatically and its expansion is several orders of magnitude beyond what is usually reported. The associated fiscal risks and potential exit strategies are then considered. Although risks are considerable in certain unlikely scenarios, FRB capital, earnings capacity, and reserves are more than ample to preserve their financial independence. Nevertheless, the occurrence of losses or a significant drop in FRB profit might lead to an eventual curtailment of Fed operational independence. The paper concludes by considering options to enhance FRB risk management and to assign responsibilities for monetary, financial stability and fiscal policies once the current crisis is overcome.

Bank of America expects to complete its capital raise shortly:

Bank of America Corporation today said it has raised almost $33 billion towards the $33.9 billion capital buffer identified by the Federal Reserve’s Supervisory Capital Assessment Program (SCAP) and now believes it will comfortably exceed that number.

To date, Bank of America has entered into agreements with certain holders of (non-government) perpetual preferred shares to exchange their holdings of approximately $9.5 billion of perpetual preferred stock into approximately 704 million shares of common stock. This results in a total benefit to Tier 1 common capital of $9.5 billion.

Their exchange offer was announced May 28:

Bank of America is offering to issue shares of common stock in the exchange offer in the applicable consideration amount per depositary share specified in the table below. The number of shares of common stock issuable for each exchanged depositary share will be equal to this consideration amount divided by the average of the daily per share volume-weighted average price of Bank of America common stock for each of the five consecutive trading days ending on and including June 22, 2009 (the second business day prior to the scheduled expiration date of the exchange offer). Bank of America will announce this common stock average price no later than 9 a.m., New York City time, on June 23, 2009. One of the conditions of the exchange offer that must be satisfied or waived is that the common stock average price be $10 or greater.

To give you an idea of the rates, the consideration for the Series I is $17.50; it pays 1.65624 annually.

DBRS has changed the trend on Ontario’s long-term debt to negative:

DBRS has today changed the trend on the long-term debt rating of the Province of Ontario (the Province or Ontario) to Negative from Stable. The trend on the Province’s short-term rating remains Stable. The rating action reflects the material erosion observed in the Province’s already depressed fiscal outlook since the beginning of the fiscal year, due in part to the larger-than-expected government bailouts recently announced for two large North American auto companies, amidst significant economic and fiscal uncertainty. As a result, while DBRS takes comfort in the economic diversification and moderately low debt burden of the Province, concerns have increased with respect to the Province’s ability to weather the global recession and the crisis of its auto sector without unduly weakening its credit metrics.

Hardly a surprise. The charlatans of the mid-90’s to mid-00’s cut the good-time surplus to nothing and the current bozos felt they had to compete. The lesson of 1994 has been forgotten; I’d say we’ll hit it again in 10-20 years.

I had a quick look for a historical budgetary balance graph that would include Rae’s recession … unfortunately, no politician wants to admit that the good-time surplus was derisory – the Conservatives because it betrays their fiscal ineptitude, the Liberals because they’ve made a point of complaining about the ever-so-horrible spending reductions in that period, the NDP because they don’t understand the question.

Fortunately, by the time we hit the wall, we’ll be able to push our expensive electric cars to work instead of taking the expensive hybrid busses. But at least we’ll be precious.

The Globe and Mail reports:

Unable to win over the recalcitrant investors, sources said GM Canada officials called for help. Their plea went to Ottawa. Could the government help break the stalemate?

The answer came at shortly after 8 p.m. ET Sunday, when the government announced that Prime Minister Stephen Harper, Industry Minister Tony Clement and Ontario Premier Dalton McGuinty would be speaking at 1 p.m. yesterday in Toronto. No public explanation was offered for the news conference. Privately, however, sources said General Motors officials and their advisers worked the phones through the night to warn the investors that the notice meant the Prime Minister was preparing to single out the bondholders for failing to support a bailout of the troubled auto maker.

“We told the bondholders that the Prime Minister of Canada was going to stand up before the country and say that a reasonable corporate solution had failed and the Canadian operations had landed in bankruptcy proceedings because of the bondholders,” said one person involved in the discussions.

Assuming that these unsupported and anonymous allegations are correct, it’s not clear who is more contemptible: GM Canada, for even thinking of the idea; What-Debt?, for enthusiastically offering to attack on command; the Portfolio Managers, for knuckling under instead of representing their clients; or the regulators who, you may be sure, will not be investigating the matter for possible breach of duty.

The immediate practical implications are, I suggest, an increased chance of increased credit notching for Tier 1 (and equivalent) capital; which is to say, lower credit quality. Throwing your weight around in the capital markets is like eating peanuts…

Knock-on implications – which have probably been ignored when making these decisions – are interesting. I suggest that Recovery-Lock Credit Default Swaps will become more popular.

The preferred share market squeaked out another win today, on continued heavy volume.

Econbrowser‘s James Hamilton has put together a very good collection of links regarding the Credit Crisis.

Treasuries got hit today, with a Bloomberg story suggesting a cyclical shift:

“Money is rotating out of Treasuries and into other areas,” said Thomas Roth, head of U.S. government-bond trading in New York at Dresdner Kleinwort, one of 16 primary dealers that trade with the Federal Reserve. “There has been a tremendous flight into Treasuries over the past year and if things get better we will see a flight out.”

The yield on the benchmark 10-year note rose 20 basis points, or 0.20 percentage points, to 3.67 percent at 4:03 p.m. in New York, according to BGCantor Market Data. The yield earlier rose as much as 27.74 basis points, the most since advancing 32.97 basis points on Oct. 8. The 3.125 percent security due in May 2019 dropped 1 5/8, or $16.25 per $1,000 face value, to 95 1/2.

Ten-year yields have risen more than 165 basis points since falling to a record low of 2.03 percent last year.

The yield on the 30-year bond climbed 18 basis points to 4.53 percent.

… and Across the curve agrees:

I also believe that we are seeing a reversal of the flight to quality. Investors had piled into risk averse government bonds and they are now fleeing them for equities and investment grade corporate bonds. The change of heart could not come at a worse time as it collides with the massive financing needs of the US Government.

Place yer bets, gents!

June got off to a strong start on continued high volume.

Remember Jefferson County? It was last mentioned on September 28 … it’s becoming more farcical all the time:

Circuit Judge David Rains allowed the county in March to collect and spend the tax while the Legislature considered alternatives to the levy whose repeal was affirmed in January. Lawmakers adjourned on May 18 without approving a new measure, and the county couldn’t draw upon those funds.

Preferreds closed the month on a winning note on continued heavy volume. PerpetualDiscounts now yield 6.33%, equivalent to 8.86% interest at the standard equivalency factor of 1.4x. This compares with long corporates at 7.0%, indicating a pre-tax interest-equivalent spread of 186bp … wow! Getting lower by the day!

The Treasury Market Practices Group has released a new closing-time convention that should help the Treasury fails situation – at least to some extent:

Some buy-side market participants expressed dissatisfaction with the existing market convention under which dealers can deliver securities to customers until 3:15 p.m., but customers can usually only deliver securities to dealers until 3:00 p.m.6 This convention can sometimes leave a customer who had, at 3:00 p.m., an uncompleted obligation to receive securities and a matching uncompleted obligation to deliver the same securities in the position of taking in the securities after 3:00 p.m. without being able to turn the securities around and redeliver them on the same day. Instead of a pair of matched fails, the customer is left with an unmatched fail to deliver, resulting in higher interest expenses and/or an overdraft charge. Some buy-side market participants expressed the view that closing times should treat all market participants the same, regardless of whether they are real money investors, leveraged investors, or dealers.

It will now be 3:00pm for everybody and 3:15pm for sophisticated participants (who will mostly be dealers).

It is unusual, but not unheard of, for “real money” accounts to buy and sell the same issue on the same day; but it would be more of a problem for hot money accounts like hedge funds.

Not much price volatility today, as the market eased off a little bit on continued good volume. I forgot to do the spreads-to-corporates yesterday … today PerpetualDiscounts closed to yield 6.42%, equivalent to 8.99% at the standard 1.4x equivalency factor. Long Corporates currently yield about 7.0%, so the pre-tax interest-equivalent spread is now about 199bp – in line with what may be considered Credit-Crunch-but-not-Credit-Terror levels.

The FDIC has issued a call for papers to be delivered at the 9th Annual Bank Research Conference. Guess what the focus is:

The on-going financial sector crisis has focused attention on compensation and governance practices. It has been alleged that compensation and governance systems reward management for risk taking and short term profits and the size and scope of corporate operations expanded at the expense of shareholders and taxpayers. In response to incentives, the management of many financial services firms pursued investment strategies that proved to be unsustainable despite extensive resources devoted to prudential oversight and financial stability monitoring. Recent events highlight the need to examine the management incentives and governance structures in place in the financial services industry, including the supervisory agencies and central banks that regulate and service the industry.

Treasuries got hammered today:

The so-called yield curve steepened to 2.75 percentage points, surpassing the previous record of 2.74 percentage points set on Aug. 13, 2003. Yields on 10-year notes have risen more than 100 basis points since Fed officials said in March they would buy up to $300 billion of U.S. debt over six months to drive consumer rates down and lift the economy from recession.

“The markets are starting to grapple with the issue of what happens when the Fed exits and the Treasury needs to continue at the same pace,” said David Greenlaw, the chief financial economist in New York at Morgan Stanley, one of the 16 primary dealers that trade with the Fed and are required to bid at government bond auctions.

U.S. 10-year notes have lost 8.7 percent this year, according to Merrill Lynch & Co. indexes, while 30-year bonds have lost 25.5 percent. Two-year notes have gained 0.3 percent.

Across the Curve reports that:

The yield on the 2 year note increased 2 basis points to 0.97 percent. The yield on the 3 year note climbed 3 basis points to 1,49 percent. The yield on the 5 year note soared 11 basis points to 2.41 percent. The yield on the 10 year note catapulted 17 basis points higher to 3.72 percent. The yield on the bond rocketed 14 basis points to 4.63.

The 2year/10 year spread is a record 275 basis points.

The 2year/30 year spread is 366 basis points. The record on that is 369 on October 05 1992 at about 1130 AM.

Continued heavy volume for preferred shares today; PerpetualDiscounts took a break from their ascent; BAM issues were (presumably) hurt by the new issue announcement.

Bloomberg reports that low reported LIBOR rates are masking a high level of credit stratification.

It appears that – to nobody’s surprise – dubious loans were marked down too low during the crisis and buyers of these loans will make a killing as the cash trickles in:

When JPMorgan bought WaMu out of receivership last September for $1.9 billion, the New York-based bank used purchase accounting, which allows it to record impaired loans at fair value, marking down $118.2 billion of assets by 25 percent. Now, as borrowers pay their debts, the bank says it may gain $29.1 billion over the life of the loans in pretax income before taxes and expenses.

Spend-every-penny has stated the federal deficit will be $50-billion this year. Interest – just the interest – on this amount alone – never mind next year’s deficit, or the accumulated national debt, or any other trivialities – will soak up the $2-billion annually he neglected to spend during the boom. So much for the party of fiscal probity. Throw the rascals out!

Holy smokes, look at them Floaters go! Now up 31% ON THE MONTH … looks like a few speculators are betting on increased prime AND decreased yields AND a lower than 100% bankruptcy rate …

Volume was quite heavy again today, PerpetualDiscounts continued their ascent and FixedResets continued their pause.

Click for big

Holy smokes, how ’bout them floaters, eh? I’ll have to write a follow-up to my article … maybe give another another seminar.

Volume continued to be elevated on what was supposed to be a sleepy day, given the US holiday, assisted by large blocks in SLF issues, which went ex-Dividend today.

Every now and then an Assiduous Reader writes in and asks whether the banks will be purchasing thier deeply discounted prefs on the market to save themselves a few bucks …. and every now and then I have to resort to handwaving about leverage, Tier 1 capital, OSFI permissions and all that.

It is something of a relief to see that similar questions are being asked in New York:

The state, without bothering to take advantage of market interest rates, paid face value for auction-rate bonds in February and March when the same debt traded at discounts of as much as 40 percent, Municipal Securities Rulemaking Board prices show. The securities, maturing in 2011 and 2022, are part of $1.13 billion of auction-rate debt New York has remaining, which it might be able to repurchase at a discount of 10 percent, according to Kevin O’Connor, a managing director at New York- based Secondmarket.com.
…
“There are legal and investor relations issues involved, and we are reviewing these issues,” said Jeffrey Gordon a spokesman for the Division of Budget, in an e-mail.
…
Anticipation that government issuers will pay face value is keeping prices higher than they would be otherwise, said O’Connor, a former banker who helped start the auction-rate bond trading desk at New York-based JPMorgan Chase & Co. in 2000.
…
The 2011 and 2022 New York bonds’ indentures, or documents that spell out the rights of issuers and investors, say “the state may from time to time purchase bonds” at the prevailing price and retire them.

There’s no prohibition on local governments buying their bonds in the open market, said Troy Kilpatrick, a managing director at Bank of New York Mellon in Pittsburgh, a trustee of auction-rate bonds. “You just don’t see a lot of it happen.”

My guess? Bureaucratic inertia. Remember, this is the financial world we’re talking about, folks. Today was a short trading day because Monday is a holiday – a feature of the bond market that has irritated me since I first calculated a yield.

The Canadian Life Insurers Assurance Facility (whereby insurers can get a government guarantee for their debt in exchange for a fee) is officially under way.

The Fed has published as special rule allowing TARP preferreds to be part of Tier 1 Capital (as well as sub-debt, for smaller banks who were caught in a legalistic tangle and couldn’t issue preferred). There were problems with the dividend step-up and the issuance limits:

In particular, the Senior Perpetual Preferred Stock issued under the CPP has an initial dividend rate of five percent per annum, which will increase to nine percent per annum five years after issuance. In addition, following the redemption of all the Senior Perpetual Preferred Stock issued under the CPP, a banking organization will have the right to repurchase any other equity security of the organization (such as warrants or equity securities acquired through the exercise of such warrants) held by Treasury.

In the preamble to the interim rule, the Board recognized that some of the features of the Senior Perpetual Preferred Stock issued under the CPP if included in preferred stock issued to private investors would render the preferred stock ineligible for tier 1 capital treatment or limit its inclusion in tier 1 capital under the Board’s capital guidelines for bank holding companies. Bank holding companies generally may not include in tier 1 capital perpetual preferred stock (whether cumulative or noncumulative) that has a dividend rate step-up. Furthermore, the amount of eligible cumulative perpetual preferred stock that a bank holding company may include in its tier 1 capital generally is subject to a 25 percent limit.

In part of his continuing plan to make Dubai the world’s financial centre, Geithner’s about to unveil regulated pay scales:

Treasury Secretary Timothy Geithner called for major changes in compensation practices at financial companies and said the Obama administration’s plan to help realign pay with performance will be rolled out by mid-June.

“I don’t think we can go back to the way it was,” Geithner said in an interview on Bloomberg Television’s “Political Capital with Al Hunt,” to be aired tonight and over the weekend. “We’re going to need to see very, very substantial change.”

He said that Wall Street’s pay practices, which include big year-end bonuses, encouraged excessive risk-taking and helped precipitate the financial crisis. What’s needed is a set of broad standards that financial supervisors can use to make sure that doesn’t happen again, he said.

Typical penis-envy: he can’t negotiate worth a damn himself:

While 17 financial institutions have repaid TARP funds, only two have come to terms with the U.S. on the value of the rights to buy stock that taxpayers received for the risk of recapitalizing the industry. The first was Old National Bancorp in Evansville, Indiana, which gave the Treasury Department $1.2 million last week for warrants that may have been worth $5.81 million, according to the data.

If Geithner makes the same deal for all companies in the rescue program, lenders may walk away with 80 percent of profits taxpayers might have claimed.

All this interference might lead to the death of dealers. There is no reason why a hedge fund can’t make it known that it is willing to call a market on any security it pleases; and creating a trading desk organized on the same principles as an institutional desk. Dealers will be left trading governments. Hell, I’ve been trying to organize such a hedge fund for preferred shares for years; sadly, the pension funds I’ve talked to have advised me that one can’t make any money trading preferred shares as principal.

However, increased importance of hedge funds will make the insurers happy:

The cost of insuring hedge funds against negligence has risen as much as 20 percent in the past six months after Lehman Brothers Holdings Inc.’s bankruptcy and Bernard Madoff’s Ponzi scheme increased the threat of lawsuits.

A fund manager with $200 million of assets running a “straightforward” strategy is typically paying as much as $60,000 a year for $5 million of coverage, up from $50,000 at the end 2008, said Brian Horwell, director of professional risks at London-based Miller Insurance Services Ltd.

The FDIC has approved a proposal to increase the insurance premia charged to banks:

On October 7, 2008, the FDIC established a Restoration Plan for the DIF.2 The Restoration Plan called for the FDIC to set assessment rates such that the reserve ratio would return to 1.15 percent within five years. The plan also required the FDIC to update its loss and income projections for the fund and, if needed to ensure that the fund reserve ratio reached 1.15 percent within five years, increase assessment rates. The FDIC amended the Restoration Plan on February 27, 2009, and extended the time within which the reserve ratio must be returned to 1.15 percent from five years to seven years due to extraordinary circumstances.3 The FDIC also adopted a final rule (the assessments final rule) that, among other things, set quarterly initial base assessment rates at 12 to 45 basis points beginning in the second quarter of 2009.4 However, given the FDIC’s estimated losses from projected institution failures, these assessment rates will not be sufficient to return the fund reserve ratio to 1.15 percent within seven years and are unlikely to prevent the DIF fund balance and reserve ratio from falling to near zero or becoming negative in 2009.

The Designated Reserve Ratio is defined as the reserve fund size divided by insured deposits (which, by the way, makes the charging of premia on assets less Tier 1 capital a little suspicious; they should charge insurance premia only on what they’re insuring).

One may note that back here in Canada:

million.We increased our provision for insurance losses by $50 million to $650 million, a move that reflects CDIC’s increasing insurance risk. This provision, combined with retained earnings, resulted in our ex ante funding reaching $1.6 billion as at March 31, 2008. This represents 35 basis points of insured deposits, below our target range of 40 to 50 basis points.

Well, it’s a good thing our bankers are so smart, that’s all I can say!

PerpetualDiscounts continued their ascent on continued elevated – albeit declining, probably a knock-on effect from the short trading day in the US – volume, while FixedResets were basically unchanged.

The Bank of Canada has released a working paper by Hajime Tomura, Heterogeneous Beliefs and Housing-Market Boom-Bust Cycles in a Small Open Economy:

This paper introduces heterogeneous beliefs among households in a small open economy model for the Canadian economy. The model suggests that simultaneous boom-bust cycles in house prices, output, investment, consumption and hours worked emerge when credit-constrained mortgage borrowers expect that future house prices will rise and this expectation is neither shared by savers nor realized ex-post. With sticky prices and a standard monetary policy rule, the model shows that the nominal policy interest rate and the CPI inflation rate decline during housing booms and rise as house prices fall. These results replicate the stylized features of housing-market boom-bust cycles in industrialized countries. Policy experiments demonstrate that stronger policy responses to inflation amplify housing-market boom-bust cycles. Also, higher loan-to-value ratios amplify housing-market boom-bust cycles by encouraging speculative housing investments by mortgage borrowers during housing booms and increasing liquidation of housing collateral during housing busts.

OSFI has released a new Corporate Brochure. The Bank for International Settlements has released Principles for sound stress testing practices and supervision.

DBRS has downgraded ABN AMRO:

ABN AMRO Bank’s outstanding trust preferred securities have been downgraded from BBB to BB. The trend on these securities is Negative. Considering the significant cyclical and company-specific headwinds that RBS faces, DBRS sees an elevated risk of nonpayment of preferred dividends (which DBRS defines as a default on these instruments) which would likely entail a nonpayment of dividends on these securities.

Volume continued at its elevated levels but the market’s ascent was checked; PerpetualDiscounts only just barely managed to squeak out a gain, while FixedResets were slightly negative. But how ’bout them Floaters, eh? Up 17.2% on the month-to-date.