Category: Market Action

There were massive rate cuts in Europe:

The Bank of England led European central banks in reducing borrowing costs to counter the worst financial crisis in almost a century, cutting its key rate by 1.5 percentage points to the lowest level since 1955.

The U.K. central bank reduced its key rate by the most since 1992, taking it to 3 percent. The European Central Bank lowered its benchmark by 50 basis points to 3.25 percent and Swiss policy makers cut their main lending rate by the same margin to 2 percent after an unscheduled meeting.

The BoE press release is unusually sombre:

Since mid-September, the global banking system has experienced its most serious disruption for almost a century. While the measures taken on bank capital, funding and liquidity in several countries, including our own, have begun to ease the situation, the availability of credit to households and businesses is likely to remain restricted for some time. As a consequence, money and credit conditions have tightened sharply. Equity prices have fallen substantially in many countries.

In the United Kingdom, output fell sharply in the third quarter. Business surveys and reports by the Bank’s regional Agents point to continued severe contraction in the near term. Consumer spending has faltered in the face of a squeeze on household budgets and tighter credit. Residential investment has fallen sharply and the prospects for business investment have weakened. Economic conditions have also deteriorated in the UK’s main export markets.

With the expansion of the Fed’s balance sheet comes an extraordinary level of Treasury issuance:

Over the October – December 2008 quarter, the Treasury expects to borrow $550 billion of marketable debt, assuming an end-of-December cash balance of $300 billion, which includes $260 billion for the Supplementary Financing Program (SFP). Without the SFP, the end-of-December cash balance is expected to be $40 billion. This borrowing estimate is $408 billion higher than announced in July 2008. The increase in borrowing is primarily due to higher outlays related to economic assistance programs, lower receipts, and lower net issuances of State and Local Government Series securities.

Over the January – March 2009 quarter, the Treasury expects to borrow $368 billion of marketable debt, assuming an end-of-March cash balance of $75 billion.

This issuance is causing dislocation in the Treasury yield curve:

One trader pointed out some amazing anomalies on the 3 year /4 year portion of the curve. For instance, one can sell the 3 3/8s of November 2012 and buy the new 3 year (November 2011) at even yield. The curve is quite steep so unless one expects dramatic flattening soon that trader is a winner,

Similarly, an investor can sell the 4 1/4s September 2012 and buy a combination of three year notes and 5 year notes and pick up 88 basis points of gross yield. That just does not make sense and anyone owning those bonds should sell them in favor of most anything else.

There are rumours GMAC will become a bank:

Cerberus is weighing a plan to distribute its GMAC stake to investors in its private-equity funds, according to the people, who declined to be identified because the deliberations aren’t public. The tactic, one of several options under discussion, may enable Detroit-based GMAC to become a bank and get funding from the U.S. Treasury and Federal Reserve without subjecting Cerberus to banking regulations.

In a bit of good news Wells Farge raised significant equity:

Wells Fargo & Co., the biggest bank on the U.S. West Coast, raised $11 billion in a stock sale to help fund its purchase of Wachovia Corp., exceeding its estimate for the offering.

The bank sold 407.5 million shares for $27 each, 6.2 percent below today’s closing price of $28.77, according to a company statement. The company may sell an additional 61 million shares if demand warrants. The San Francisco-based lender had planned to raise $10 billion.

The U.S. Treasury bought $25 billion of Wells Fargo’s preferred shares in October as part of its rescue of the banking industry. Wells Fargo is expanding its deposit base to the East Coast and creating the biggest U.S. bank by branches with its purchase of Charlotte, North Carolina-based Wachovia.

Wells Fargo joins other banks in raising capital, including JPMorgan Chase & Co’s $11.5 billion offering in September and $10 billion pulled in by Bank of America Corp. in October.

A day enlivened by news of the new GWO Fixed-Reset 6.00%+307 issue; PerpetualDiscounts gave up some of the gains they made in the first part of the week. Volume remained vigorous.

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

Willem Buiter & Anne Sibert write a review of The collapse of Iceland’s banks: the predictable end of a non-viable business model. As an aside, they note:

In addition, outrageous bullying behaviour by the UK authorities (who invoked the 2001 Anti-Terrorism, Crime and Security Act, passed after the September 11, 2001 terrorist attacks in the USA, to justify the freezing of the UK assets of the of Landsbanki and Kaupthing) probably precipitated the collapse of Kaupthing – the last Icelandic bank still standing at the time. The official excuse of the British government for its thuggish behaviour was that the Icelandic authorities had informed it that they would not honour Iceland’s deposit guarantees for the UK subsidiaries of its banks. Transcripts of the key conversation on the issue between British and Icelandic authorities suggest that, if the story of Pinocchio is anything to go by, a lot of people in HM Treasury today have noses that are rather longer than they used to be.

This is the real danger of counter-terrorism laws … they will be twisted to justify anything the bosses want to justify. And be re-elected in a landslide by frightened sheep. Anyway, back to economics … the authors claim that Iceland’s business model was not viable due to:

the “vulnerable quartet” of (1) a small country with (2) a large banking sector, (3) its own currency and (4) limited fiscal capacity

With this in mind, they warn:

Iceland’s circumstances were extreme, but there are other countries suffering from milder versions of the same fundamental inconsistent – or at least vulnerable – quartet:
…
Countries that come to mind are:

Switzerland,
Denmark,
Sweden
and even to some extent the UK, although it is significantly larger than the others and has a minor-league legacy reserve currency.

Ireland, Belgium, the Netherland and Luxembourg possess the advantage of having the euro, a global reserve currency, as their national currency. Illiquidity alone should therefore not become a fatal problem for their banking sectors. But with limited fiscal spare capacity, their ability to address serious fundamental banking sector insolvency issues may well be in doubt.

Coincidentally, I’m sure, Dennis P. Quinn & Hans-Joachim Voth argue that benefits of international diversification are declining:

After Bretton Woods, it took half a century to restore the full openness of capital accounts in advanced countries. Many Eurozone countries only revoked the last restriction in the 1990s, in the run-up to the euro’s introduction.

We argue that it is no accident that the age of restrictive capital accounts also saw remarkably low equity market correlations. Cross-border diversification opportunities identified by early papers (Grubel 1968) were indeed “too good to be true.” Once investors can take advantage of low correlations elsewhere, they will rise. Initial investors may benefit since liberalisations tend to be followed by capital gains (Henry 2000). Yet risks will not fall anywhere near as much as initially hoped, as the covariance with other stock markets inevitably increases.

How tight is the bond market? The credit card companies have maxed-out:

Credit card companies were shut out of the market for bonds backed by customer payments in October for the first time in more than 15 years, as investors shunned the debt amid the global credit freeze.
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It’s the first month since April 1993 that there have been no sales, according to Wachovia Corp. data. Issuers sold $17.1 billion of the debt in October 2007, the data show.
…
Top-rated credit card-backed securities maturing in three years traded at a gap, or spread, of 475 basis points over the London interbank offered rate, or Libor, during the week ended Oct. 30, JPMorgan Chase & Co. data show, 25 basis points higher than the previous week. The debt was trading at 50 basis points more than Libor in January.

PerpetualDiscounts eased off today, but volume was strong. There are many very strange yield relationships between issuers in the market; its hard to tell whether the degree of credit stratification is more or less surprising than the degree of credit inversion!

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

Another good day for prefs, with the PerpetualDiscounts again up over a point for the third day in a row. Before anybody gets too excited though … we’ve not yet recovered to October 22 levels and the 6.77% yield is almost 50bp over the September 30 level of 6.29%.

The 6.77% yield is equivalent to 9.48% interest at the standard 1.4x factor, while long corporates are still chugging along in the 7.5% area … so we’re back to a spread of about 200bp. Long corporates are actually down fractionally on the month-to-day and recovery in this market should, logically, now become a major factor in preferred share performance.

On the other hand, the market hasn’t really behaved logically for over a year and a half, so who knows?

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

Assiduous Readers will remember that the Fed’s balance sheet has been swollen as it has borrowed from Treasury and lent to … various third parties. The fact that Treasuries are being sold to finance the lending makes the various programmes monetarily neutral and therefore, to a first approximation, non-inflationary (inflation may still result if the process generates false signals regarding use of capital funds, but that’s a second order effect). Today the butcher’s bill came in:

The U.S. Treasury predicted it would borrow this quarter more than three times the amount initially forecast as weaker economic growth and the costs of a new bank rescue package swell the budget deficit.

Borrowing needs will rise to $550 billion in the three months to Dec. 31, compared with the $142 billion predicted in July, the Treasury said in a statement in Washington. That would be more than double the largest ever — a record $244 billion in new marketable debt in the first three months of this year.

I am an enthusiastic supporter of the Fed’s actions, but this is illustrative of the need for fiscal restraint in good times – which has been sorely lacking. At some point – as has happened in Taiwan with insurers and agency paper, as mentioned October 28 – the rest of the world will decide it has quite enough US paper, thank you very much, and then we’re all in trouble.

Econbrowser‘s (admittedly partisan) Menzie Chinn provides a comparison of the McCain and Obama tax ‘n’ stimulus plans:

Dr. Chinn also provides a link to the Committee for a Responsible Federal Budget’s Guide to Stimulus Proposals: The 2008 Presidential Election. I confess I have not investigated campaign or third-party reactions to this analysis – but it makes for good reading!

He also performs calculations based on analyses of the Tax Policy Centre:

I have added a bonus spreadsheet to the post regarding my essay on CPD.

A very strong day for PerpetualDiscounts, but volume returned to normal levels.

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

The Apocalyptionists will be upset! Not only did DTCC close out Lehman’s CDS book without loss:

it successfully closed out over $500 billion in market participants’ exposure from the Lehman Brothers, Inc. (Lehman) bankruptcy which occurred the week of Sept. 22. This was the largest close-out in DTCC’s history. DTCC reports it does not expect there to be any impact to its retained earnings or to market participants’ clearing fund deposits as a result of closing out these pending trade obligations.

“The liquidation of Lehman was complex, involved multiple asset classes, and required a methodical approach to mitigate potential losses from outstanding trading obligations,” said Donald F. Donahue, DTCC chairman and CEO. “Without question, our ability to manage risk and see exposure from a central vantage point was instrumental in helping us ensure that market risk – and systemic risk – was avoided.

… but settlement of CDS obligations on Lehman itself proceeded seamlessly …

On Oct. 21, DTCC also completed, without incident, the automated credit event processing of Lehman Brothers Holdings Inc. (LBHI) involving $72 billion of credit default swaps. DTCC calculated and bilaterally netted all amounts due on credit default swaps written on LBHI. This resulted in approximately US$5.2 billion owed from net sellers of protection on LBHI to net buyers of protection. The portion of this net funds settlement allocable to trades between major dealers was handled through the normal settlement procedures of CLS Bank International, DTCC’s settlement partner for the Warehouse and the world’s central settlement bank for foreign exchange.

DTCC also announced:

it will begin to publish aggregate market data from its Trade Information Warehouse (Warehouse), the worldwide central trade registry it maintains on credit derivatives. Starting Tuesday, November 4 and continuing weekly, DTCC will post on its website www.dtcc.com/derivserv the outstanding gross and net notional values (“stock” values) of credit default swap (CDS) contracts registered in the Warehouse for the top 1,000 underlying single-name reference entities and all indices, as well as certain aggregates of this data on a gross notional basis only. The data is intended to address market concerns about transparency.

According to their 2007 Annual Report:

While the total outstanding of credit default swaps (CDS) has grown to $45.5 trillion in 2007 from $3.7 trillion in 2003, our Deriv/SERV platform has been credited with significantly reducing the risk previously associated with unconfirmed trades. Today, over 90% of CDS trades are matched and confirmed through Deriv/SERV, compared with 15% late in 2003.

I have added the warehouse information address to the links, under “US Fixed Income Data”.

The Treasury guarantee of bank debt – reported on October 27 as seeming cheap – is mired in confusion:

Almost three weeks after the government threw its guarantee behind new bank bonds, no U.S. finance company has braved the market.

While Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. were the three largest U.S. banks issuing debt last year, they haven’t sold dollar-denominated corporate bonds since August.
…
Banks are hamstrung because they’re waiting for the “fine print,” said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. Because they don’t know if the debt will be guaranteed under all circumstances, bonds are difficult to price, he said.

Mind you, the Commercial Paper programme – that is busily grossing up the Fed’s balance sheet – is working great!

Interest rates on U.S. commercial paper fell to about the lowest in four years after the Federal Reserve said it absorbed more than 9 percent of the market.

Interest rates on the highest-ranked 30-day commercial paper dropped 39 basis points to 2.02 percent, about the lowest in four years, according to yields offered by companies and compiled by Bloomberg. Yields on overnight and seven-day paper fell to the lowest levels in at least 13 years, Bloomberg data show.

Naked Capitalism reprints a Financial Times article regarding the effect of changes in bankruptcy law on the recent investment bank collapses:

The 2005 changes made clear that certain derivatives and financial transactions were exempt from provisions in the bankruptcy code that freeze a failed company’s assets until a court decides how to apportion them among creditors.
…
Lawyers said under the old rules, creditors of companies facing financial difficulties were wary of settling trades or seeking extra collateral because they knew such demands could precipitate a bankruptcy filing and potentially freeze their claims.

However, when the financial health of Bear, Lehman and AIG took a sharp turn for the worse this year, their trading counterparties – mainly hedge funds and other banks – were not deterred from seeking to settle their trades or forcing the three companies to put up more collateral.

Such pressure exacerbated the liquidity squeeze that ultimately forced the three companies to hoist the white flag. Bear was sold to JPMorgan in a cut-price deal in March, while Lehman filed for bankruptcy last month and AIG was rescued by a $120bn government loan.

Calculated Risk provides a thoroughly fascinating graph (via Dealbreaker and Abnormal Returns) [click for big]:

And, just to make Hallowe’en a little scarier, the FDIC closed down another bank:

As of October 17, 2008, Freedom Bank had total assets of $287 million and total deposits of $254 million. Fifth Third agreed to assume all the deposits for a premium of 1.16 percent. In addition to assuming the failed bank’s deposits, Fifth Third will purchase approximately $36 million of assets. The FDIC will retain the remaining assets for later disposition.
…
The FDIC estimates that the cost to the Deposit Insurance Fund will be between $80 million and $104 million. Fifth Third’s acquisition of all deposits was the “least costly” resolution for the FDIC’s Deposit Insurance Fund compared to alternatives. The last failure in Florida was First Priority Bank, Bradenton, which was closed on August 1, 2008. Freedom Bank is the seventeenth FDIC-insured institution to be closed this year.

A small bank, but look at the proportions! They had $287-million in assets, and Fifth Third is buying $36-million of them. That leaves the FDIC with $251-million and they’re expecting a loss of between $80-million and $100-million. Now that’s a whacking!

And that’s the end of another month – and it was a pretty horrible one for prefs, believe me! I’ll be doing all the usual posts shortly, but a brief examination is sufficient to conclude that CPD lost 7.21% on the month … a huge number for such a thoroughly diversified fund. MAPF, on the other hand, traded like gangbusters – an absolutely massive trading month – and, while still having lost money, will have out-performed CPD substantially.

The key to portfolio management is to arrange your portfolio into various asset classes that will meet your long terms goals without subjecting the portfolio as a whole to extreme short term risk. Then – and this is where I come in – you attempt to outperform within each asset class.

What a day on the market! Hefty volume, some very chunky crosses and a sharp move upwards! If only there had been more days like that this month!

PerpetualDiscounts were up 1.6586% to yield 6.90% (pre-tax price-weighted mean YTW). At the standard 1.4x equivalency factor, this is equivalent to 9.66% interest; long corporates ar at 7.5%, so the pre-tax interest-equivalent spread is 216bp … starting to narrow, but the bonds are wide!

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

There is news of a substantial drop in LIBOR:

The swap agreements with central banks, which also followed rate cuts from China to Norway, led to a drop in three-month rates in Asia. The London interbank offered rate, or Libor, for three- month loans in dollars slid 23 basis points to 3.19 percent today, its 14th consecutive drop, according to the British Bankers’ Association. The overnight dollar rate tumbled 41 basis points to 0.73 percent, the lowest level since at least January 2001.
…
The three-month Libor for dollars remains 219 basis points above the Fed’s rate, up from 82 basis points the day Lehman failed. It was 192 basis points yesterday before the rate cut.

The re-intermediation (novo-intermediation? It hasn’t really been done before) by the Fed in the US commercial paper markets (discussed last weekend) has continued big-time with the Fed’s latest H.4.1 release showing an increase of nearly $200-billion in deposits from banks, offset by a decline of $36-billion in Treasury balances, an increase of $145-billion in commercial paper holdings and an increase of $22-billion in foreign currency assets.

I expressed concern yesterday that the Excess Reserves / Discount Window spread, at 60bp, was too small to encourage reintermediation by the the banks – I’d like to see that bumped to 85bp just for starters. But I’m less concerned about the spread on the Commercial Paper Funding Facility – at 235bp for regular commercial paper, it’s high enough to encourage reintermediation by the banks as soon as they’re feeling a little braver.

Derek DeCloet has a column in today’s Globe cackling with glee over hedge funds that didn’t hedge; in this category comes a fund from Deephaven which is being deep-sixed:

Deephaven Capital Management LLC, the hedge-fund unit of stockbroker Knight Capital Group Inc., froze a $1.6 billion fund after investors asked to get back 30 percent of their money.

Withdrawals from the Deephaven Global Multistrategy Fund were suspended so managers wouldn’t be forced to sell assets in falling stock and debt markets, the Minnetonka, Minnesota-based firm said today in a letter to investors. Lenders and trading partners also imposed stricter financing requirements, according to the letter.

If it was an actual hedge fund, of course, they would be buying just as much as selling. But perhaps I quibble.

Treasury today released guidance on tax breaks for Fannie & Freddie preferred share investors (as long as they’re banks):

The Treasury Department and the Internal Revenue Service today issued Revenue Procedure 2008-64 (Rev. Proc. 2008-64), which provides that certain gains and losses from indirect ownership of Fannie Mae and Freddie Mac preferred stock can be treated as ordinary income and loss.

The Emergency Economic Stabilization Act of 2008 (EESA) provided banks and certain financial institutions ordinary treatment for gains and losses on direct investments in preferred stock of Fannie Mae and Freddie Mac. It also directed the Treasury Department to issue guidance with respect to the treatment of these gains or losses when realized indirectly through certain investment vehicles.

Rev. Proc. 2008-64 provides banks and certain other financial institutions the benefit of ordinary treatment on gains and losses that they are experiencing on certain indirect investments in this preferred stock.

And, just to ensure everybody is cheerful, there is news of a lock-up in the Japanese bond market:

Japanese yen corporate bond sales dried up in the second half of October as the seizure in global credit markets, plunging equity values and volatility in the Asian nation’s currency deterred investors.

Toyota Finance Corp. was the last company to sell yen bonds when it issued 42 billion yen ($428 million) of three- and five- year notes on Oct. 15, data compiled by Bloomberg show. The Tokyo-based lessor reduced that sale from a planned 50 billion yen after market turmoil pushed up borrowing costs, a company official said at the time.

“The credit market is dead,” said Kazuaki Oh’e, a debt salesman in Tokyo at CIBC World Markets Japan, part of Canada’s fifth-biggest bank. “Investors don’t want to buy anything because there’s so much credit risk right now.”

An active day for prefs – and there were many lower-quality issues trading in good volume that weren’t included in the tally.

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

Deflation? Econbrowser‘s James Hamilton doesn’t think so!

If the U.S. were ever to arrive at such a situation, here’s what I’d recommend. First, have the Federal Reserve buy up the entire outstanding debt of the U.S. Treasury, which it can do easily enough by just creating new dollars to pay for the Treasury securities. No need to worry about those burdens on future taxpayers now! Then buy up all the commercial paper anybody cares to issue. Bye-bye credit crunch! In fact, you might as well buy up all the equities on the Tokyo Stock Exchange. Fix that nasty trade deficit while we’re at it! Print an arbitrarily large quantity of money with which you’re allowed to buy whatever you like at fixed nominal prices, and the sky’s the limit on what you might set out to do.

Of course, the reason I don’t advocate such policies is that they would cause a wee bit of inflation. It’s ridiculous to think that people would continue to sell these claims against real assets at a fixed exchange rate against dollar bills when we’re flooding the market with a tsunami of newly created dollars. But if inflation is what you want, put me in charge of the Federal Reserve and believe me, I can give you some inflation.

The Fed announced:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.
…
In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

The cut to 1.00% Fed Funds was widely anticipated. Remember that interest on excess reserves is Fed Funds less 35bp … the Fed is earning a spread of only 60bp on excess reserves to Discount Window. I would have been much more comfortable had the discount rate been lowered only 25bp to 1.50%.

There are indications that CDS rates are being used to price loans:

Nestle SA, the biggest food producer, Nokia Oyj, the largest mobile-phone maker, FirstEnergy Corp., the Ohio-based owner of electric utilities, and at least three other companies bowed to banks’ demands to link the interest rate on credit lines to the swaps, which are used to bet on borrowers’ likelihood of default.
…
[First Energy] would pay Libor plus 3 percentage points to draw on the line, according to company filings. Based on yesterday’s levels, FirstEnergy would be charged an additional 1.70 percentage points, reflecting the levels of its credit- default swaps, and another 1.35 percent to account for the bank’s own spread, according to [First Energy Assistant Treasurer Randy] Scilla.

This is a worrisome development. Events of the past year have shown that the ease of shorting corporate debt with CDSs has led to huge volatility, with some credits (e.g., CIT Group) trading at amazing levels … 2500bp or more, while maintaining an “A(low)” rating that seems entirely justified. While I in favour of market based pricing in a general way, we have seen (in the pricing of AAA sub-prime tranches) that total reliance on market pricing implies total reliance on infinite liquidity … and we ain’t there, by a long shot.

Simply put, there isn’t enough depth in the CDS market to ensure that there will be sufficient supply of protection writers when the cowboys take a run at these companies.

On the other hand, the facilities arranged – so far – with these CDS-linked rates are commercial paper back-up lines. Together with the Big Scare due to the recent lock-up of the the CP market, we may see a reduced corporate reliance on money market paper, with a massive term extension – at least to five year notes – to handle the funding instead. This part is a Good Thing, because it will decrease the term mismatch between assets and liabilities on corporate balance sheets.

So right now, it is unclear how this will play out, as is the case with so much of the structural change that taking place in financial markets right now.

Speaking of shorts how about that VW, eh?:

Porsche, a rival seeking to build one of Europe’s great car dynasties, revealed it had increased its holdings in VW, giving it an economic stake equal to about 75 percent of the company’s voting shares.

Volkswagen’s stock soared to as high as 1,005 euros a share, about $1,258, on Tuesday before closing at 918 euros. The shares ended last week at 210 euros.
…
On Sunday, Porsche said it raised its stake in Volkswagen to 42.6 percent from 35 percent, and that it had taken options for another 31.5 percent.

Porsche said it made the announcement to give investors who sold the stock short “the opportunity to close their positions unhurriedly and without bigger risk.”

The opposite happened. The risk soared, and the short sellers were forced to act quickly.
…
Volkswagen is one of the 30 companies in the DAX index, Germany’s most prominent stock index, and index funds own a significant number of shares.

Those funds, however, may sell shares Wednesday. On Tuesday night the German stock exchange said it would reduce from 27 percent to 10 percent the weighting of VW in the index. To rebalance, the funds will have to sell VW and buy the 29 other companies.

The re-weighting of VW in DAX is a disgrace:

“This adjustment is an extraordinary measure,” Deutsche Boerse said in a statement yesterday. The reduction will take place on Nov. 3, and the weightings of other DAX companies will also be adjusted at that time.

Changing the rules because some short-sellers are getting toasted? That’s not your job, guys! If you want to create a capped index – as the Toronto Exchange did after the Nortel fiasco – that’s fine … but the occasional gruesome loss is part of the risk of being short, and the occasional bonus profit is part of the reward of being long.

As Dealbreaker so eloquently states:

That’s the other shoe dropping right there. Shares drop 50%, it’s a regulatory failure. Shares spike 400%, its a regulatory failure.
…
When are we going to let risk be risk? These are all big boys playing with Volkswagen. Had it gone right, they would have made big profits.

BCE has announced its 3Q08 Operating Results, and it doesn’t seem – to me – to help the chances for a successful conclusion of the takeover much.

BCE’s cash from operating activities was $1,649 million this quarter, up 2.7% from last year. BCE’s free cash flow [footnote 3] of $89 million this quarter was lower than $425 million in Q3 2007 due to the expenditure of $741 million for AWS spectrum licences partly offset by a reduction of $293 million in common dividends paid.
…
[Footnote 3 – extract] We define free cash flow as cash from operating activities after capital expenditures, total dividends and other investing activities.

BCE is also looking at a significant mark-to-market hit on its pension obligations.

Another fairly active day on the preferred market, with players trying to figure out where things are supposed to be! There are plenty of instances of yield relationships between issuers being completely haywire.

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

The Fed is pushing hard for a CDS Clearinghouse:

The Federal Reserve has given U.S. futures exchanges until Oct. 31 to present written plans on how they’ll make the $55 trillion credit swaps market less risky, according to four people familiar with the discussions.
…
Federal Reserve officials are not aiming to pick a winner to operate a clearinghouse, the people said. Rather, the central bank is hoping to set up a framework for the eventual winner.
…
The four groups vying to operate clearing operations include partnerships of Chicago-based CME Group and Citadel Investment Group LLC, and Intercontinental Exchange, dealer-owned Clearing Corp. and credit-swap index owner Markit Group Ltd. Eurex AG and NYSE Euronext also have submitted proposals.

The last major review of the clearinghouse on PrefBlog was my reaction to Accrued Interest‘s plan. On September 22 I deprecated his idea of trading only CDSs with a recovery lock.

On VoxEU, John Kiff, Paul Mills and Carolyne Spackman project a resurgence of covered bonds. While the essay suffers from the mind-set that the credit crunch happened because credit rating agencies are dumb and more rules will make them smart, the provide some interesting charts:

In a welcome piece of news, Bloomberg reports:

Sales of longer-term commercial paper soared 10-fold after the Federal Reserve began buying the corporate IOUs, a sign that the central bank’s efforts to unlock the market may be working.

Companies yesterday sold more than 1,500 issues totaling a record $67.1 billion of the debt due in more than 80 days, compared with a daily average of 340 issues valued at $6.7 billion last week, according to data published by the Fed. Most of the difference was probably absorbed by the Fed, said Adolfo Laurenti, a senior economist at Mesirow Financial Inc.

The source data from the Fed shows that the increase in issuance was almost entirely at the long-end, probably 90-day paper.

Accrued Interest looks at agency paper and likes it, despite the fact that position limits for Taiwanese insurers are being reduced:

The danger is that Asia doesn’t seem to agree. Selling of both Agency debt and MBS securities have been concentrated in Asia the last several days. We know that that Taiwanese insurance regulators are limiting allowable exposure to U.S. agency mortgage-backed securities, claiming the credit rating cannot be believed. If China or Japan were to come to the same conclusion, there would be real problems real fast.

The good news is that despite heavy selling from Asia, agency spreads (and MBS spreads for that matter) have moved wider slowly. Agency spreads are about 60bps wider this month, whereas corporate spreads have moved 117bps wider.

The Taiwanese rule change is:

Where previously there was no limit to investments in MBS issued by US federal housing loan agencies, namely Fannie Mae, Freddie Mac and Ginnie Mae, insurers will now be given a maximum ceiling of 50% of their offshore investment limit to such products by the three institutions. Maximum exposure to MBS and collateralised issues by any of the individual agencies will be set at 25%.

Now, this is the danger. On the weekend, I discussed the Fed’s balance sheet in terms of the Fed intermediating between the banks and credit risk, in the same manner as banks intermediate between Granny Oakum and credit risk. This is a natural thing and this is a good thing, but the Fed’s ability to do so is constrained by the ability to sell Treasury debt. Eight years of fiscal profligacy have eroded the available excess capacity … I don’t think we’re in trouble yet, but this is the type of thing that signifies trouble.

Just because equities were up so much today doesn’t mean we can relax! There are rumours that Barclays has foreclosed a hedge fund:

Barclays Plc, the U.K.’s second- largest bank, is seeking bids for $1.5 billion of bonds and $3.5 billion of credit-default swap contracts held by a hedge fund, according to people with knowledge of the auction.

The bank is selling bonds from European, Asian and U.S. issuers, according to the people, who asked not to be identified because the sales aren’t being made public. Barclays is also selling $970 million of assets, primarily high-yield, high-risk loans, the people said. Bids on both portfolios are due today.

Somewhat to my chagrin, I see that FixedReset issues are trading as if they were actually 5-year paper, rather than as perpetual paper with a five year call. The recently announced new issues offer a 5.60% coupon, with a continued reset to 5.60 if 5-year Canadas remain unchanged; rather than falling a lot, to offer equivalent perpetual yields, extant Fixed-Resets have fallen a little, to offer equivalent five-year yields with the assumption of a call at par.

In fact, yields to first call of the extant fixed resets are in excess of 5.60%, implying that the new issues will trade at an immediate (small) discount, rather than at the premium they would command otherwise. It’s a funny old world.

Another day of heavy volume, with a number of dealers crossing significant blocks.

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

The extraordinary Money Market disintermediation (discussed on the weekend) continues, with Morgan Stanley badly hit:

Morgan Stanley clients withdrew almost one- third of their cash from money-market accounts last month, forcing the firm to buy $23 billion of securities held by the funds to keep them afloat.

Redemptions were $46 billion in September, mostly from funds that invest in corporate debt, Morgan Stanley said in an Oct. 9 regulatory filing. The New York-based company made sure the money-market funds had enough cash to repay investors by acquiring some of their assets with financing from “various available stabilization facilities.”

Not surprisingly, US Commercial Paper rates are spiking:

Yields on commercial paper rose as the Federal Reserve began buying the debt directly from companies, showing the central bank’s efforts to unfreeze short- term credit markets have yet to take hold.

Rates on the highest-ranked 30-day commercial paper, which many corporations use to finance their day-to-day operations, jumped 25 basis points to 2.88 percent, according to yields offered by companies and compiled by Bloomberg.
…
The Fed today set the rate it’s willing to accept for 90-day unsecured commercial paper at 1.88 percent plus a 1 percentage point credit surcharge. The 90-day secured asset-backed rate was set at 3.88 percent, according to Fed data compiled by Bloomberg.

The Fed’s graph tells the tale:

There is a note from Bloomberg that overnight US Equity futures and the cash market opening are decoupling:

U.S. stock-index futures are becoming less reliable as predictors of market moves.

With equity investors around the world contending with the worst drop since the Great Depression, futures on the Standard & Poor’s 500 Index misstated gains or losses by an average 1.4 percentage point in October, twice the gap in the third quarter, data compiled by Bloomberg show. One of the biggest misses was Oct. 24, when futures fell as much as 60 points, while the index itself dropped 37 points in the first half hour of trading, before closing down 31.

… which may be related to derivatives losses at Deutsche Bank:

Deutsche Bank AG, Germany’s biggest bank, lost more than $400 million on equity derivatives trades as stock markets headed for their biggest rout since the 1930s, two people with direct knowledge of the matter said.

The loss, equal to almost half of the Frankfurt-based company’s second-quarter revenue from equity sales and trading, is a black eye for Richard Carson, global head of equity derivatives, and may signal more job losses at the bank.

Econbrowser‘s James Hamilton has posted supporting a Fed cut to 1.00%, on grounds that:

• The three month bill rate is 1.00%
• inflation is unlikely with oil below $70; unemployment is a greater concern, and
• risks to the dollar are minimal considering the global nature of the crisis

Viral Acharya and Raghu Sundaram have posted an analysis of the UK & US bank loan guarantees on VoxEU:

In the UK, an institution seeking a guarantee on an issue will be charged an annual fee of 50 basis points plus that institution’s median 5-year credit-default swap (CDS) spread observed in the 12 months before 7 October 2008.
…
In the US, each participating institution will pay a flat 75 basis points per annum on the entire amount of its new senior unsecured liabilities (subject to the 125% cap mentioned above). If the institution has informed the FDIC of its intent to also issue non-guaranteed long-term debt, then the 75 basis points fee applies to the guaranteed portion of its new debt issues. But in the latter case, the institution must also pay a one-time fee of 37.5 basis points of that portion of its senior unsecured liabilities as of 30 September 2008, that will mature on or before 30 June 2009.
…
Even a casual glance at these numbers suggests that the British Treasury’s fees are a great deal higher than the proposed American flat fee structure (0.75% versus anything between 109 basis points for HSBC to over 178 basis points for Nationwide).
…
If the entire available guarantee amount of GBP 250 billion is taken up, the resulting subsidy to be borne by UK taxpayers is of the order of about GBP 0.675 billion per year, or about GBP 2 billion over the three years of the scheme.
…
Assuming a total guarantee figure of $1.5 trillion (an estimate that is likely on the lower side), this means an annual [US] government subsidy to the participating banks of $18 billion, or well over $50 billion over the three years of the scheme.

By way of comparison, the Canadian Lenders’ Assurance Fund:

Insurance provided through the facility will be priced on a commercial basis. The base annualized fee will be 135 basis points [note 2]. There will be a surcharge of 25 basis points for eligible institutions rated at or above A- or equivalent. There will be a further surcharge of 25 basis points for other eligible financial institutions. There will also be a further surcharge for insurance on non-Canadian dollar denominated debt.
…
Note 2: This is the average over the twelve months ending August 2008 of the spread between the yield on Canadian dollar five-year senior unsecured bonds issued by the five largest Canadian banks and the comparable Government of Canada bond

Spend-every-penny Flaherty announced today that Desjardins will be eligible for the facility.

I reported in early September that the five-year TIPS note was in danger … any more auctions like today’s will eliminate the uncertainty!

The average yield was 3.27 percent which means that the new bond yields more than the nominal 5 year note. The so called breakeven spread is the spread at which inflation would need to average for the holder of the TIPS to breakeven with the nominal bond and it generally predicts a positive rate of inflation.

In this case, the TIPS is yielding above the nominal bond by about 70 basis points in which case the market is saying that it thinks that inflation will average negative 0.7 percent per year for the next 4 ½ years.

Another post on VoxEU, by Romain Ranciere, Aaron Tornell and Frank Westermann, takes the somewhat heretical view that the credit crunch is not a big deal:

How big is the current US bailout? The $700 billion bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues – Bear Stearns, Freddie Mac and Fannie Mae, AIG – the total bailout costs could go up to $1,400 billion, which is around 10% of GDP. In contrast,

• Mexico incurred bailout costs of 18% of GDP following the 1994 Tequila crisis.
• In the aftermath of the 1997-98 Asian crisis, the bailout price tag was 18% of GDP in Thailand and a whopping 27% in South Korea.
• Somewhat lower costs, although of the same order of magnitude, were incurred by Scandinavian countries in the banking crises of the late 1980s. 11% in Finland (1991), 8% in Norway (1987), and 4% in Sweden (1990).

• Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of GDP.

The bailout costs that the taxpayers are facing today can be seen as an ex post payback for years of easy access to finance in the US economy. The implicit bailout guarantees against systemic crises have supported a high growth path for the economy – albeit a risky one. In effect, the guarantees act as an investment subsidy that leads investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors – such as housing, small businesses, internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government will make sure they get repaid (at least partially).

…
Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today and the IT sector in the late 1990s. But the bottom line remains that risk-taking has positive consequences in the long run even if it implies that crises will happen from time to time. Over history, the countries that have experienced (rare) crises are the ones that have grown the fastest.1 In those countries, investors and businesses take on more risks and as a result have greater investment and growth. Compare Thailand’s high-but-jumpy growth path with India’s slow-but-steady growth path before it implemented liberalisation a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per-capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.

Hear, hear! It is a natural human preference that things we cannot control be predictable … but to suffocate the financial system with scads of new rules and restrictions would be the equivalent of the school board banning running in the playground because occasionally a kid falls and skins his knee.

The loonie got killed today:

The Canadian dollar depreciated by as much as 1.5 percent to C$1.2972 per U.S. dollar, from C$1.2775 on Oct. 24, the lowest since Sept. 21, 2004. It traded at C$1.2914 at 2:24 p.m. in Toronto. One Canadian dollar buys 77.44 U.S. cents.

… as did Canadian equities …

The Standard & Poor’s/TSX Composite Index slid 8.1 percent to 8,537.34 in Toronto, the most since a 11 percent plunge on “Black Monday” of Oct. 19, 1987. The S&P/TSX, which derives three-quarters of its value from resource and finance shares, has fallen 27 percent in October, poised for its biggest monthly decline since January 1919.

Prefs did not escape unscathed, with PerpetualDiscounts closing at a yield of 7.00%, a level last seen in April 1995. This is equivalent to interest of 9.80% at the standard 1.4x equivalency factor, while long corporates now yield about 7.25% for a pre-tax interest-equivalent spread of 255bp.

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

Holy smokes. Thirty-year Treasuries hit an all-time low yield in the morning, 3.93%, following overnight carnage in overseas equities. Corporates were hugely wide. Sterling got slaughtered and Denmark bucked the trend hiking the policy rate by 50bp to defend the krone. Trading curbs were imposed on US equity futures after a 6% limit-drop overnight.

All this before the markets opened!

And then it fizzled. It did in Canada, anyway:

The Standard & Poor’s/TSX Composite Index dropped 0.4 percent to 9,294.09 in Toronto after earlier falling 7.5 percent, the most in eight years, to the lowest since September 2004. The S&P/TSX, which derives three-quarters of its value from finance, energy and materials shares, slid 2.8 percent this week and is poised for a 21 percent drop in October, the steepest since the crash of 1987.

… but US Equities tanked:

The Standard & Poor’s 500 Index lost 3.5 percent, a smaller decline than European and Asian equities, even after futures on the U.S. measure fell so far that trading was curbed.

… while Treasuries steepened on a volatile but light day:

The 2 year note is trading at 1.50 percent and is better by 10 basis points for the day. The yield on the 5 year note has tumbled 8 basis points to 2.55 percent. The yield on the 10 year note has declined 1 basis point to 3.66percent (it had traded as low as 3.53 percent this morning). The yield in the Long Bond is unchanged at 4.05 percent. As I noted in a previous posting the yield on the bond reached a modern era low earlier today at 3.88 percent.

The 2year/10 year spread has widened 9 basis points to 216 basis points.

Traders and sales persons report light flows in the Treasury market. Several participants reported that clients who did trade were only doing what they were compelled to do. Most activity seemed directed toward reducing risk and balance sheet.

There’s a report that marketting of the BCE takeover debt will commence next week, but I’m not convinced it means a row of beans. You can bet that on this deal, the lawyers are in charge and if there is the slightest possibility that the deal will fail, all parties want to be able to tell the judge they tried. Who knows? Somebody or other will be taking an immediate massive write-down if the deal proceeds.

Whoosh! And that’s the end of that week!

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