Category: Market Action

Preferreds were off again today but it could have been worse … much worse. The market was affected by lousy equity markets … bids disappeared for some issues, but some came back to rescue the day’s results from its depths. Time will tell whether these (relatively small) bids stand up:

gauge of financial stocks in the S&P/TSX slipped 3.5 percent to its lowest level since November 2002, as nine of 10 industries in the Canadian benchmark dropped. Economic reports stoked concern that the impact of the global recession is worsening in a country that relies on exports, half of which are commodities, for about a third of its overall output.

PerpetualDiscounts closed today at 7.07%, equivalent to 9.90% interest at the standard equivalency factor of 1.4x. Long Corporates are doing really well, up 3.03% on the month and 1.37% year-to-date and are yielding 7.5% … maybe just a shade under. The pre-tax interest-equivalent spread has thus increased to about 240bp.

Well, did everybody have a lovely Moron Day? It’s very important to celebrate the fact that there is absolutely no point to a February long weekend. It’s like booking a holiday in Hamilton.

Anyway, DBRS has responded to a policy questionaire on Credit Rating Agencies. There’s the usual blather about how wonderful it is to tick extra boxes thoughtfully prepared by IOSCO, following which we get to the more interesting stuff:

[CRA asks] Is a requirement to disclose all information provided by an issuer and used by a CRA in determining and monitoring a credit rating an appropriate way to address the lack of transparency of asset-backed securities? Should the CSA impose a disclosure obligation directly on issuers of asset-backed securities? Should a disclosure obligation apply regardless of whether such securities have a rating?

To ensure timely and consistent disclosure of useful information in the market, it is critical that disclosure be conducted by the party who is in the best position to determine that the information serves the purpose for which the disclosure is intended. DBRS suggests that the appropriate party for the proposed disclosure requirement would be the originator or the issuer of the information. Similarly, it is not an appropriate role for CRAs to monitor issuers to ensure that other parties meet their responsibilities in respect of the investing public.

As proposed, there may be an inconsistency in the information disclosed if the requirement is crafted in such a way that the information is geared to CRAs for their purposes only. Different CRAs have different information requirements. Moreover, what CRAs receive from issuers and need for rating purposes may be different from what investors require for their purposes. A credit rating is only one factor and not the sole determinant in risk measurement and investment decision making.

The interesting part about this proposal is that essentially it suggests that Regulation FD (National Policy 51-201 in Canada) be rescinded for Asset Backed Paper. Assiduous Readers will remember that I have suggested these policies – which mean that the CRAs get preferential access to material non-public information, that I would go to jail for using in the course of investing – be rescinded in their entirety.

In limiting their proposal to ABS, the regulators are fighting the last war. I have no idea where the next embarrassing scandal is going to come from, but I’ll bet a nickel that it won’t be ABS.

Across the Curve notes that Treasuries were very strong today, just in time for a basketful of new issuance:

The yield on the 2 year note dropped 9 basis points to 0.87 percent. The yield on the 3 year note declined 14 basis points to 1.23 percent. The yield on the 5 year note tumbled 19 basis points to 1.68 percent. The yield on the 10 year note plummeted 22 basis points to 2.67 percent. The yield on the Long Bond danced to the same music and fell 16 basis points to 3.51 percent.
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Some spoke of the package of securities which the Treasury will announce on Thursday when they will announce the 2 year, the 5 year and the debut performance of the 7 year note. I think they will bring $42 billion, $32 billion and $15 billion respectively. That would be $89 billion of coupons which would be record shattering. (Until next month.)

Canadas were strong too, with the 2-year yield down 8bp and everything else in the low double-digits. Stocks got hammered, both in the US:

U.S. stocks tumbled to a three-month low, extending a global slump, as a record contraction in New York manufacturing spurred concern the government’s stimulus package won’t be enough to curb the deepening recession.

Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. each lost 12 percent. Exxon Mobil Corp. was the biggest drag on the Standard & Poor’s 500 Index as oil slid almost 7 percent. General Motors Corp., the largest U.S. carmaker, sank 13 percent as it took its case for more government support to the Treasury Department. Banks led declines in Europe and Asia on concern they may face ratings downgrades and more losses.

… and in Canada …

Canadian stocks fell the most in four weeks as financial and energy companies tumbled on concern the deepening global recession will cause more losses at banks and insurers, and cut demand for the nation’s commodity exports.

Manulife Financial Corp. dropped 11 percent to a six-year low as equities tumbled worldwide, stoking concern insurers face further losses on their stock portfolios. EnCana Corp. slid 5.2 percent after oil prices slumped below $35 a barrel on a report that manufacturing in New York contracted at the fastest pace on record.

Preferreds fell in sympathy with common, but to nowhere near the same extent, a refreshing change from the horror of 4Q08. The fall was led by split-shares, perhaps due to their direct exposure to equity prices, perhaps in response to the mass downgrade.

In an encouraging sign, an increasing amount of loans from banks are being converted into term junk debt:

High-yield, high-risk bond sales almost tripled to $2.38 billion this week, the most in seven months, as borrowers took advantage of a rally in corporate debt to increase cash reserves and pay down credit lines.
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Borrowers concerned that a weakening economy and deteriorating earnings may shut off their access to the debt markets are taking advantage of the lowest yields since October relative to Treasuries to issue debt. Companies see an opportunity to raise cash and repay credit lines, said Pete Brady, managing director of high-yield bond trading at Broadpoint Capital Inc.
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Junk-rated companies paid as little as 15.98 percentage points more than Treasuries on debt this week, down from a peak of 21.82 percentage points on Dec. 15, and the lowest since Oct. 30, according to Merrill’s U.S. High Yield Master II index. Overall yields narrowed two basis points to 18.03 percentage points from 18.05 on Feb. 6.

The Fed has, apparently, been taking its responsibilities seriously. I have often observed that the Fed is doing exactly what Central Banks are supposed to do: make credit available at punitive rates against good collateral. As most recently discussed on February 10, many commentators, including Across the Curve and Econbrowser, have expressed the fear that the Fed is crossing the line from monetary policy into fiscal policy – which I agree would be a Bad Thing. Virtually everybody agrees that the discount window should not be used to prop up insolvent banks. There’s another bill being talked up that will allow retroactive confiscation of bonuses. Remember January 22, when I suggested bonus-eligible employess discount deferred bonuses by 50%? Better make it 80%. And keep a reserve against all cash received.

So, it was with great pleasure that I read:

Hartford Financial Services Group Inc., the insurer that lost $2.75 billion last year, dropped 7.8 percent in New York trading after being ousted from the federal program that buys short-term debt.

The insurer, which was excluded after its credit ratings were downgraded, will have to repay the $375 million in commercial paper “from existing sources of liquidity,” the company said in its annual report today. “Future deterioration of our capital position at a time when we are unable to access the commercial paper markets due to prevailing market conditions could have a material adverse effect on our liquidity.”

The exclusion of a somewhat shaky company from the liquidity provisions of the Commercial Paper Funding Facility is a good sign. Bloomberg has noted continued slow shrinking in the Fed’s balance sheet, but cautions that TALF (discussed February 10) will probably expand it again.

Dealbreaker passes along a note that the “Derivatives Markets Transparency and Accountability Act of 2009” otherwise known as the “Protect America from BONUSES while being kind to Small Furry Animals Act” (at least, that’s what it’s known as here). has been introduced. Let’s just hope it’s ordinary grandstanding.

Volume in the pref market picked up a little today, but there’s little discernable trend or volatility in prices. To an extent this is good for traders, as swaps can be legged (er … that means you can sell one to buy another, without fussing too much about simultaneity) with a lower chance that the market will move $2 against you before you blink.

Enrico Perotti & Javier Suarez write a piece on VoxEU, Liquidity Insurance for Systemic Crises, proposing:

to establish a mandatory liquidity charge, to be paid continuously to a regulator who is able to provide emergency liquidity (and perhaps capital) during systemic crisis. The charge should be increasing in the maturity mismatch of assets and liabilities, and would be applicable to all institutions with access to safety net guarantees. Its effect should be to make short and medium term (up to one year) bank funding comparable in cost. Retail deposits would be exempted, as they are more stable thanks to their own separate insurance.

Revenues would go into an Emergency Liquidity Insurance Fund (ELIF), with legal autonomy and pre-packaged access to central bank liquidity and government funds backing. Upon significant aggregate liquidity runs (not concerning single banks), the payment of insurance would be triggered by the relevant supervisor, resulting in immediate liquidity support, guarantees on uninsured wholesale funding, and some automatic capital injections. Specific conditions may be attached, such as restrictions on compensation and dividends, as well as on some strategic choices.

The insurance charges could be thought of as prepayment for future rescue costs.

Restrictions on compensation have certainly become fashionable!

I don’t want to dismiss the idea out of hand; I will certainly agree that the next Basel Accord should address the degree of maturity transformation in some way. But:

• Liquidity crunches are black swan events. Any level of insurance premium will be a guess.
• It is the job of the central bank to address liquidity crunches, by making funds available against good collateral at a punitive rate of interest. A liquidity crunch, per se, is profitable for the central bank

From Across the Curve via PrefBlog’s Liquidity is Valuable Department comes another reminder:

One unintended consequence of the Fed [Agency] purchases is that the purchases have been concentrated in the large liquid issues. That has led to a substantial gulf between that paper and some smaller older illiquid paper. The illiquid securities now trading as much as 50 basis points cheap to the more liquid stuff.

PerpetualDiscounts eked out a small gain today to close with a pre-tax bid-YTW of 6.95%, equivalent to 9.73% interest at the standard conversion factor of 1.4x. Long corporates continue to yield 7.6%, so the spread remains fairly constant at 213bp. A fairly unexciting day, with volumes continuing normal, with pockets of frantic activity from recent Fixed-Reset issues.

However, today’s excitement was the downgrade of the BCE Prefs, which had no real effect on prices, but does mean that the HIMIPref™ Ratchet and Fixed-Floater sub-indices are about to disappear.

The Fed has announced:

that it is prepared to undertake a substantial expansion of the Term Asset-Backed Securities Loan Facility (TALF). The expansion could increase the size of the TALF to as much as $1 trillion and could broaden the eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities, private-label residential mortgage-backed securities, and other asset-backed securities. An expansion of the TALF would be supported by the provision by the Treasury of additional funds from the Troubled Asset Relief Program.

The Board’s objective in expanding the TALF would be to provide additional assistance to financial markets and institutions in meeting the credit needs of households and businesses and thus to support overall economic growth in the current period of severe financial strains. Decisions concerning the expansion of the TALF, which will be made in consultation with the Treasury Department, will draw on initial experience in administering the program and the Board’s assessment of the likely effectiveness of possible enhancements to the program in advancing its broad economic goals.

Under the current specification of the TALF, the Federal Reserve Bank of New York will lend to eligible owners of certain AAA-rated asset-backed securities (ABS). The Federal Reserve had previously announced that it would accept AAA-rated asset-backed securities backed by newly and recently originated auto loans, credit card loans, student loans, and SBA-guaranteed small business loans as collateral for TALF loans. The date that the TALF will commence operations will be announced later this month.

They will make credit available against good collateral – exactly what a central bank is supposed to do – but I will note that Across the Curve disagrees:

If I read the literature correctly, I would conclude that the TALF will be financed with a large scoop of funding from the central bank. Maybe I am being rigid in my thinking but that does not seem like something which should properly fall within the purview of the central bank.

This sounds like fiscal policy and not monetary policy and it would seem to me that the proper path would be for the elected representatives of the people should authorize the expenditure of one of the largest pools of money in human history. Allowing the Federal Reserve that much latitude, without a proper grant of authority from Congress seems literally undemocratic.

It also begs the question of Federal Reserve independence. The central bank has surrendered independence as the crisis has unfolded and Congress should step forward and provide a clear demarcation and definition of [roles] for the Treasury and its companion.

I disagree. I take the view that it only becomes fiscal policy if and when credit losses are expected and until then it’s monetary policy. I will presume that Bernanke & Co. are insisting on good enough collateral with high enough haircuts to keep it in the latter camp; and I will defend their authority to make the decision until it has been clearly shown otherwise.

Canadian auto subsidies have attracted notice from a Belgian academic, Johannes Van Biesebroeck, in a VoxEU piece Money for Nothing?:

Firms can draw on a long list of programmes for investment support. As of January 2009, the Ontario government’s web portal for initiatives to attract foreign investors listed 78 programmes offering subsidies or tax credits. Among the most important programmes are the Advanced Manufacturing Investment Strategy ($500 million over five years) geared towards innovation and advanced technologies, Strategic Manufacturing Investment grants (average annual budget of $63 million), and the Next Generation Jobs Fund ($650 million over five years) for green technologies.

Total support from just the four largest Ontario programmes has averaged a staggering $400 million per year, much of it for automotive investments.
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Government discretion is often viewed with suspicion on political economy grounds, but a pure rules-based approach runs the risk of the winner’s curse if there is competition with other jurisdictions (Van Biesebroeck 2008). The largest subsidy package will be offered by the participant with the most upwardly biased information on potential benefits of the project. When the actual benefits become clear over time, the winner might regret having won.
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On the day of the announcement, Canadian Press Harris-Decima completed a four-day survey showing strong popular support for a bailout of the carmakers. Supporters outnumbered opponents by a large margin – 56% versus 33% of respondents. This makes it easier to understand why the politicians stepped in. Ontario Premier McGuinty said “Our choice is to passively preside over the demise of the industry in Canada and observe its consolidation in the (US) or to act. We chose to act.” Apart from slowing down the demise, they have not made it clear what they hope to achieve with their actions.

Why do we subsidize them? Because they’re good jobs. Why are they good jobs? Because they’re subsidized.

Here’s a cheery update from the CDO market:

Almost half of all the complex credit products ever built out of slices of other securitised bonds have now defaulted, according to analysts, and the proportion rises to more than two-thirds among deals created at the peak of the cycle.

The defaults have affected more than $300bn worth of these collateralised debt obligations, which were built from bits of other asset backed securities (ABS) such as mortgage bonds, other CDOs and structured bonds, or derivatives of any of these, according to analysts at Wachovia and Morgan Stanley.
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CDOs of ABS were used increasingly at the peak of the credit bubble to keep the securitisation machine moving by recycling hard to sell bits of subprime mortgage bonds and other risky tranches into new structures with top-notch credit ratings.

However, the ratings of these deals proved unsustainable, as evidenced by the fact they have accounted for 92.9 per cent of all 16,587 ratings downgrades globally from all rating agencies since the beginning of last year, according to Morgan Stanley.

The way these complex and risky transactions were exploited at the peak of the bubble can be seen in data from analysts at Wachovia, who reckon that 47.6 per cent of all CDOs of ABS by volume issued since the market substantively began in 2002 have now hit an event of default.

Equity markets expressed extreme disappointment with the Stimulus and Financing package as a whole, shocked that Obama didn’t wave his magic wand and make everything go away. Across the Curve has rather daringly republished a JP Morgan analysis of the Fed’s statements.

Canadian bonds had a reasonably good day, but the pref market simply yawned. Split shares did poorly, presumably due to asset coverage fears.

Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), in the Financial Times, 3 February 2009:

As today’s financial crisis progressively gets resolved, it will be necessary to start the process of preventing future crises. This will require substantial reform of the regulatory framework. Banks will have to strengthen their capital and their liquidity buffers. And financial regulation must have a less pro-cyclical effect. The objective must be to enable the banks to curb the impact of shocks on the economy, rather than to amplify them, as is the case now, where negative spirals are generated between the financial system and the real economy.

The trouble with attempting a counter-cyclical (or less pro-cyclical) regulatory policy is that it requires the authorities to determine what the cycle is – and I don’t believe that they are any smarter or better informed that the rest of the world. It also opens up a greater possibility of political interference in what is a rather dry, technical and confusing area … can’t you just hear What-Debt? as Pooh-Bah of banking regulation? ‘Thanks to my wise tax-cutting, we are all going to be rich forever. It is impossible for a bank to go bankrupt. Therefore …’

I have heard some things about a Spanish model of “Dynamic Provisioning”, but haven’t investigated any of the details.

Michael Pomerleano, Harald Scheule and Andrew Sheng write a nice piece of VoxEU, The devil is in the details, emphasizing the dangers of cliff risk through model homogeneity:

the price of all risky assets may have dropped below their fundamental value. Therefore, leveraged markets are prone to overshoot in booms and underprice in downturns. If this is true, the current losses in the trading book may be overestimated. If policy does not respond well (or is ineffective), the pessimistic view becomes self-reinforcing. Under the present “fair market value” regulatory regime, market risk exposures are marked to market and a large fraction of the losses reported to date relate to market-risk exposures.
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A little understood problem is that the model provider, financial intermediation, and model auditing industry is highly concentrated, leading to systemic risk. Several examples suffice: the small number of credit rating agencies for bond and structured finance issues, the growing market share of “too big to fail” financial institutions, and joint ventures in model construction designed to reduce costs. The problem is compounded by the use of similar quantitative frameworks and frameworks that are calibrated based on similar loss experiences.

An anecdote illustrates this point. Some years ago the chief risk officer of a major U.S. bank presented the asset correlation matrix used by his institution. Another major financial institution at the event confirmed its use of the same matrix. While the institutions were fundamentally different in nature, they shared the same reputable consulting firm. Neither this firm’s model nor any other model has been formally validated. The oligopolistic structure was nurtured by the limited data availability and the propensity of financial institutions to outsource risk modelling. A similar situation prevails in the accounting industry, which is dominated by the “Big Four.” The public sector has abdicated too much authority to vested interests in the private sector.

This behaviour is lauded and encouraged by regulators and large firms, under the twin banners of eliminating regulatory arbitrage and encouraging “best practices”. The authors recommend:

Deconcentration of risk models is another priority. This may involve generating a compulsory global warehouse for financial risk–related data (particularly regarding credit risk) and encouraging alternative modelling techniques. While limited data-sharing initiatives reportedly are being undertaken in Japan, they need to be far more extensive and systematic.

while – in a decision I consider to be inconsistent with their stated thesis – recommending:

Regulatory arbitrage has transferred risks to off-balance-sheet special-purpose vehicles and hedge funds. This practice may have to be limited by homogenising rules across financial instruments and institutions as well as across industries and countries.

The Fed is having difficulty coming to grips with the question of what to do next:

Federal Reserve officials have failed to resolve an internal debate over whether to purchase long-term Treasuries, even as rising yields on the securities threaten to undermine the central bank’s objective of cutting borrowing costs for consumers and businesses.
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“The Fed will get a lot more bang for its buck by buying mortgages than buying Treasuries,” said John Ryding, founder and chief economist of RDQ Economics LLC in New York and a former Fed economist.
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Lacker preferred to expand the money supply “by purchasing U.S. Treasury securities rather than through targeted credit programs,” the FOMC statement said.

Accrued Interest comments on pending revisions to TARP, which he states will include FDIC insured 10-year covered bonds. The source WSJ article does not reference covered bonds, but the idea has been floating around for a few weeks. As yet there is nothing on the FDIC website regarding such a guarantee – the last mention was a policy statement cleaning up legal loose ends in August.

The market ticked up today on reasonable volume bolstered by all the recent new issues.

Alea points out that the February 5 H.4.1 Fed release shows that the Fed Balance sheet continues to shrink. “Central Bank Liquidity Swaps” on the asset side and “Deposits – Depository Institutions” on the liability side are down $78-billion and $93-billion respectively.

Unfortunately – and somewhat surprisingly – Commercial Paper holdings increased by about $10.6-billion … but still way down from the peak.

The UK Financial Services Authority has released a consultation paper on Temporary Short-Selling Measures. It appears that they favour continuation of the “Disclosure Obligation” (large short positions must be disclosed), which I don’t have any problem with.

Speaking of disclosure obligations, the SEC has unveiled a raft of NRSRO rules, designed to ensure that future scapegoating will be easier to implement. Lots of disclosures that nobody will ever read, but good practice for the next regulation: a requirement that prices only go up. Surely this ultimate goal is only a few more box-ticks away!

All in all, it was a pretty quiet end to the week. Not much volume, not much movement.

The Russian Central Bank has come up with a novel bank recapitalization technique:

Russia’s central bank is exacerbating the ruble’s 34 percent plunge since August, even as it struggles to defend the exchange rate, by providing loans to banks that speculate on the currency, say Alfa Bank and UniCredit SpA.

Bank Rossii lent 7.7 trillion rubles ($214 billion) in overnight and seven-day loans secured with bonds or other collateral in the 16 trading days last month, about double the 4.8 trillion rubles provided in so-called repurchase auctions in December, central bank data show. Banks used “almost all” the money to bet against the ruble, said Natalia Orlova, chief economist at Alfa, Russia’s largest non-government bank. The ruble fell 18 percent against the dollar in January.

“A significant amount, if not all, of the speculative attacks on the ruble are funded by the central bank itself,” said Vladimir Osakovsky, Moscow-based economist for UniCredit, Italy’s largest bank.

Across the Curve believes that Treasury issuance is going to lead to higher government bond yields in the near future.

PerpetualDiscounts edged slightly lower today. Market volume was reasonable, but dominated by the recent Fixed-Reset issues.

It seems that PrefBlog is persuading the world that Bad Bank = Bad Idea:

The Obama administration, aiming to overhaul the $700 billion financial-rescue program, is refocusing on an effort to guarantee illiquid assets against losses without taking them off banks’ balance sheets.

Treasury Secretary Timothy Geithner is skeptical of setting up a so-called bad bank to hold the toxic securities, an option that still may form part of the final package, people familiar with the matter said. Senator Charles Schumer yesterday said debt guarantees are becoming “a favorite choice” of options because a bad bank would be too costly.

Across the curve is skeptical:

The process of repairing the banking system (read the nursery rhyme Humpty Dumpty) is proving to be a challenge for the Obama Administration. News reports indicate that the bad bank idea is losing followers and that the Administration seems to be turning to idea of massive guarantees of the flotsam and jetsam in bank portfolios. As one commentator noted, that has not worked out so well for the stock price of Citibank and B of A.

PerpetualDiscounts were off slightly today on good volume and now yield 6.98% – the equivalent of 9.77% interest at the standard equivalency factor of 1.4x. Long Corporates remain fairly steady at 7.6%, so the Pre-Tax Interest-Equivalent Spread has widened slightly to +217bp.