Category: Market Action

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

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

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

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

But Citigroup says ‘calm down, people!’:

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

Freddie of McLean, Virginia, will have $12.7 billion of capital above the minimum requirement, according to slides provided by Citigroup for a conference call with investors. Washington-based Fannie will have $20.3 billion.
…
The bank’s interest rate strategists led by Scott Peng in New York said last week that the beleaguered mortgage-finance companies don’t need to be nationalized and the U.S. should resist being “stampeded” into a bailout.

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

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

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

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

Freddie was downgraded by S&P today:

Standard & Poor’s Ratings Services said today that it affirmed its ‘AAA/A-1+’ senior unsecured debt rating on Freddie Mac with a stable outlook. At the same time, we lowered the risk-to-the-government stand-alone issuer credit rating to ‘A-‘ from ‘A’, the subordinated debt rating to ‘BBB+’, and the preferred stock rating to ‘BBB-‘ from ‘A-‘. The ratings that were lowered are all placed on CreditWatch Negative.
…
It could be straightforward funding support through expansion of the Treasury line, buying Freddie Mac’s debt or its agency mortgage-backed securities, or it could consider an equity investment. The possibility of an equity investment is driving Freddie Mac’s equity price lower and the yield on its preferred stock higher. An equity investment by
Treasury could be accompanied by the consideration of nonpayment of existing preferred stock and common dividends.

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

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

But!

Wait a minute!

I just remembered!

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

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

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

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

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

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

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

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

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

But Accrued Interest‘s main suggestion is:

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

So what if in the future the GSEs provided some limited guarantee on covered bonds?
…
This a plan combines the best parts of both the covered bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered bond market, because it would give investors a known set of outcomes when buying the new bond sector.

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

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

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

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

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

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

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

Freddie Mac had a gushing review on Bloomberg today:

Freddie Mac rose 17 percent in New York trading after a $2 billion sale of short-term debt stoked confidence the second-largest U.S. mortgage-finance company can still attract investors.
…
Freddie Mac sold $1 billion of three-month notes at a yield of 2.58 percent, the company said today. That translates to about 90 basis points more than similar-maturity U.S. Treasuries and 23 basis points less than the three-month London interbank offered rate. The spreads from last week’s sale were 61 basis points over Treasuries and 32 basis points below Libor, according to Stone & McCarthy Research Associates.

The company also sold $1 billion of six-month debt at a yield of 2.858 percent, a spread of about 92 basis points above Treasuries and 25.5 basis points below Libor; compared with 80 basis points and 32 basis points last week. A basis point is 0.01 percentage point.

Well … it’s nice that they were able to finance through LIBOR, but let’s not get carried away! Let’s see how well they can finance the next month’s needs:

Fannie has about $120 billion of debt maturing through Sept. 30, while Freddie has $103 billion, according to figures provided by the companies and data compiled by Bloomberg.

… on the bond market, rather than the Money-Market, before breaking out the champagne. Unless my trusty calculator has let me down, $2-billion is less than half their daily quota until September 30 … each.

Fortunately for oenophiles, there is an excuse for some bubbly. PerpetualDiscounts were up 21bp today, bringing the total return index back to slightly above its June 30 levels … OK now it’s time to start working on June (a really, really lousy month).

The perpetualDiscount index now has a weighted average mean yield to maturity of 6.11%, equivalent to 8.55% interest at the standard 1.4x equivalency factor. Long corporates now yield in the 6.15-6.20% range, so the pre-tax interest-equivalent spread is now about 235bp.

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

Update: Dealbreaker passes on a rumour that Fed Pressures Treasury Not To Wipe Out Fannie Mae Preferreds:

The Federal Reserve has been quietly pressuring the Treasury Department not to adopt a rescue plan for Fannie Mae and Freddie Mac that would wipe out the value of their preferred shares, according to a source familiar with the matter. The Fed fears that any move that hurt the preferred could worsen the crisis in regional banks that is already under way.
…
The situation is complicated, however, by the large share of preferred stock held by regional banks, many of which are viewed as possible candidates for failure in these credit crunched times. As the Financial Times reported over the weekened regional banks and US insurers hold the majority of Fannie and Freddie’soutstanding preferred stock. The Fed has begun advocating against wiping out these shares, saying the threat to stability of the banks is greater than the ‘moral hazard’ argument, a source familiar with the matter says.

As usual, it’s not clear what is meant by “wiping out”.

An Assiduous Reader sent me an article from Barrons today The Endgame Nears for Fannie and Freddie:

Should the agencies fail to raise fresh capital, the administration is likely to mount its own recapitalization, with Treasury infusing taxpayer money into the enterprises, according to our source. The infusion would take the form of a preferred stock with such seniority, dividend preference and convertibility rights that Fannie’s and Freddie’s existing common shares effectively would be wiped out, and their preferred shares left bereft of dividends. Then again, the administration might show minimal kindness to preferred shareholders; local and regional bankers have been lobbying the Bushies not to wipe out the preferred since the bankers own a lot of that paper and rely on the bank preferred-stock market for much of their own equity capital.

This is similar to the scary-scenario-base-case I outlined yesterday … but the airy assertion that the result would be “preferred shares left bereft of dividends” is more than just a little vague. Left bereft for how long? That’s the key.

As with all investing, it’s important to look behind the headlines and put actual numbers together … to date, I’ve seen no actual analysis that goes beyond “The sky is falling!”.

As an illustration – a very rough one! – of what I mean, let’s work out the value of FNMPRG under the scenario above – and let’s say that the dividend is halted for five years. Given the uncertainty in the market, we’ll say we want a yield of 10%.

FNMPRG pays a dividend of $2.29 annually; we’ll assume that this is in one payment, due exactly one year from now. At ten percent, this would imply a value of $22.90 for these prefs, before accounting for five years of missed dividends.

The five years of missed dividends, discounted at 10%, have a present value of $8.44. Subtracting this from the $22.90 that the perpetual annuity is worth, we arrive at a fair value of $14.46 for the prefs, compared to their market value of $9.76. Under this scenario, the prefs are a bargain.

This, at least, represents an attempt to put numbers on the table. Is the scenario too harsh? Too lax? Change it. Put some percentage chances on it and stick it in a pot with all your other scenarios, come up with a range of values and – if it turns out to be an attractive speculation – put a little bit of money into it, with all the other little bets in your portfolio. And, if you’ve done your homework properly, and you have kept all your bets sufficiently small that a run of bad luck or bad analysis won’t hurt you – you’ll do fine.

Naturally, if you do your homework and decide that …

• Dividends will be stopped immediately, probability 100%
• There will be no recovery, ever, probability 100%

… then your analysis will result in a fair value estimate of the prefs of $0 and you will consider them expensive. But at least you will have done your homework and put your assumptions and scenarios on the table where you can look at them.

You can let the yumps who cry Oh, the dividend might be stopped and everything is worthless boo-hoo-hoo run along home to play with their dollies.

Amidst all this, I will stress again that I am not taking a view, one way or another, on the investment merits of the GSE prefs. I haven’t done my homework. All I’ve done is try to find an actual reference to actual analysis in the press reports and been disappointed.

Accrued Interest has passed on some GSE speculation from Merrill.

Moody’s downgraded Fannie’s prefs today:

The preferred stock ratings and BFSRs remain on review for possible further downgrade. Fannie Mae’s and Freddie Mac’s Aaa senior long-term debt and Prime-1 short-term debt ratings were affirmed with stable outlooks. The firms’ Aa2 subordinated debt ratings were affirmed, but the outlook was changed to negative from stable.
…
Moody’s believes these firms currently have limited access to common and preferred equity capital at economically attractive terms.
…
The downgrade and continued review for further downgrade of the preferred stock ratings reflects a greater risk of dividend omission on the preferred stock.
…
Should a capital injection result in the subordination of the existing preferred stock, or should it result in any missed preferred dividends, then the preferred stock rating would be lowered further.

I will point out that the Moody’s downgrade still leaves the prefs at investment grade, although not by much; I will further point out that the rating is an opinion on the probability of the prefs not deferring any dividends at all – in which case, the yield will be about 25%, not the 10% net that I demanded in my scenario.

All this is reminiscent of my musings on the proper analysis of FTU.PR.A; there is some doubt as to whether this will be able to pay all its dividends and 100% of principal, so its credit rating has suffered; but it’s so cheap right now that that particular scenario results in a phenomenal return. Formally, the asset coverage is only about 1.2:1, as of August 15 according to the company – but that asset coverage figure is based on the par value of $10 and the unit value of $12. Based on the current market price of the preferreds of about $7.50, asset coverage is 1.6:1 of the amount invested, a much nicer number! Even if the underlying US Financials do terribly over the next few years and the prefs eventually recover only the current price of $7.50 (which counts as a default), interim dividends (if actually received, of course) of $0.525 p.a. will have resulted in a yield of 7%, which some might consider to be rather good. There are other scenarios, which result in returns being “extremely good” … and yet other scenarios, which result in returns ranging from “lousy” to “disastrous”. Do yer homework, gents, and place yer bets! Small ones!

Oh! And I like to keep abreast of the Thornburg Mortgage situation, since that’s been the most spectacular flame-out so far into the current crunch or preferreds in North America. Investing Thoughts brings to my attention a press release on the story so far:

As of 5:00 p.m., New York City time, on August 19, 2008, holders of Preferred Stock had tendered approximately (i) 88.7% (5,786,035 shares) of the Series C Preferred Stock; (ii) 83.5% (3,340,873 shares) of the Series D Preferred Stock; (iii) 91.7% (2,900,546 shares) of the Series E Preferred Stock and (iv) 96.2% (29,161,031 shares) of the Series F Preferred Stock.

Shareholders who participate in the Exchange Offer will receive $5.00 in cash and 3.5 shares of the company’s common stock for each share of Preferred Stock validly tendered and accepted. Holders of the Preferred Stock who have previously tendered their shares of Preferred Stock continue to have the right to revoke such tenders at any time prior to the new expiration date by complying with the revocation procedures set forth in the Offering Circular relating to the Exchange Offer.

Total book value of all series of Thornburg’s preferreds was around $832-million as of Dec. 31/07.

I suppose that every now and then I should mention something about the Canadian preferred market, seeing as that’s what this blog is supposed to be about … although the market has rationalized itself somewhat over the past month, there’s still plenty of craziness left. For instance, good old BAM.PR.O, which had a very poorly received underwriting in June and performed poorly in the last half of July. Credit concerns, possibly? Well, riddle me this: Why does it yield more than the perps? It is bid at 22.90 to yield 7.33% until optionCertainty 2013-6-30, while the perpetuals BAM.PR.M and BAM.PR.N are both bid at 16.90 to yield 7.17%.

An extremely quiet day on the preferred share market today, but PerpetualDiscounts did creep up and have almost repaired July’s damage.

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

More excitement and speculation regarding Fannie and Freddie today, with some rather vague television commentary:

The companies’ preferred securities are typically held by insurance companies, mutual funds and banks, analysts said. That may cause Paulson to stop short of eliminating their holdings in any government intervention.

“The common shareholders will probably be completely wiped out,” Paul Miller, an analyst at FBR Capital Markets, said in a Bloomberg Television interview. “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.”

The mechanism for wiping out preferreds was not specified – even the gloomiest commentary Naked Capitalism could dig up did not make Fannie’s net worth significantly negative. Forced sales of inventory could make things worse, of course – but would any responsible receiver or creditor’s committee do this?

Freddie Mac is in a much worse position, according to a somewhat more credible commentator:

Chances are increasing that the U.S. may need to bail out Fannie Mae and the smaller Freddie Mac, former St. Louis Federal Reserve President William Poole said in an interview. Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair value accounting rules, he said. The fair value of Fannie Mae’s assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, Poole said.

It should be noted that all this kerfuffle isn’t just of interest to bloated plutocrats: the troubles are being passed through to retail mortgage rates:

Rates on average 30-year fixed mortgages rose to 6.37 percent this week, about the highest in six years, as yields on bonds guaranteed by Fannie Mae and Freddie Mac increased to almost the highest since 1986 relative to Treasuries. More than 70 percent of new home loans are bought or guaranteed by the government-chartered companies, known as “prime” mortgages.

I will note, yet again, that I am not taking a view on the merits or lack thereof of the Fannie and Freddie prefs – but the matter holds some general interest, at the very least, for preferred share investors because it’s an example of a situation in which the common dividend of a financial corporation has been cut and the prefs have plummetted. And I won’t say that the resolution of the problem will set a precedent … but to some extent, it will set a benchmark.

Besides, it annoys me to read stuff like: “Preferred will also see a lot of pain. But that is up in the air because a lot of banks own the preferred. You put a lot of banks in trouble if you just wipe out the preferred also.” without any indication of the mechanism or rationale underlying “wipe out” and “lot of pain”. Just once, it would be nice to see some actual analysis!

In further fallout from the unwinding of irrational exuberance, CMBS spreads are widening:

Yields on commercial real estate securities relative to benchmarks rose to near record highs on concern that Riverton Apartments, a high-rise complex in Manhattan’s Harlem neighborhood, will default on a loan.

AAA rated commercial mortgage-backed bonds widened about 37 basis points to 305.57 basis points more than 10-year swap rates during the week ended yesterday according to data from Bank of America Corp. A basis point is 0.01 percentage point.

The gap, or spread, jumped after a trustee report showed payments wouldn’t be made in September on a $225 million loan on the 1,230-unit Riverton.
…
Almost 93 percent of the New York property’s units were rent stabilized when the loan was originated, according to a JPMorgan report on Aug. 15 from analysts led by Todd. The owners intended to deregulate 53 percent of all the apartments by 2011, more than doubling the average monthly rent on those units from $894 to $2,261.

Only 10 percent of the units in the 12 buildings were converted to fair-market rents as of July, according to the Aug. 13 report from trustee LaSalle Global Trust Services Ltd. in Chicago.

Maybe the investors can run crying to mommy.

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

Update: A bit more speculation on the Fannie/Freddie prefs was reported by Bloomberg:

Small, regional banks may have the most to lose from the stumbles in Fannie and Freddie, and Paulson may risk bank failures unless he protects preferred stockholders, said Ira Jersey, an interest-rate strategist at Credit Suisse Group AG in New York. The impact on the preferred holders “may be an important driver” in Paulson’s decisions, Jersey said.

“Any wipeout of the preferreds could have implications for the capital of the greater financial system and these regional banks that might have reasonably precarious capital situations,” Jersey said. “You don’t want to make that worse if you’re the government.”

This nuance was noted by Accrued Interest in a post last Monday. Back to Bloomberg…

Treasury probably will get preferred shares as part of any bailout, eliminating the value of the common shares and causing “a lot of pain” for preferred shareholders, who will rank behind the government in payments and may have their dividend cut, according to Friedman Billings Ramsey & Co. analyst Paul Miller in Arlington, Virginia. CreditSights Inc. analyst Richard Hofmann in New York said holders should “brace” for a deferral of dividends.

The Treasury may wait until Fannie and Freddie’s capital is so eroded that regulators can put them into a receivership, said Andrew Laperriere, managing director at International Strategy & Investment Group, a money management and research firm in Washington.
…
Paulson must also weigh whether hurting preferred shareholders would cripple the $350 billion market that banks across the country also rely on for financing, said CreditSights’ Hoffman. Banks sold $76 billion of preferreds this year to bolster capital after more than $500 billion of credit losses and writedowns

Well … at least there’s been a bit of discussion of the possibilities! The trigger could be an inability to roll debt:

If either company has trouble selling bonds to finance maturing debt, Paulson’s hand may be pressed. They have about $20 billion of unsecured debt due on average every week, with more than $220 billion maturing by the end of next month.

A takeover could also be triggered if either company fails to meet its regulatory capital standards, to be released by the Federal Housing Finance Agency next month.

It should be noted that a failure to meet regulatory capital guidelines – which, as has been noted repeatedly – are pretty lax to begin with, is not the same thing as insolvency. Even Naked Capitalism was able to get that one right:

Mere solvency is not an appropriate standard for the GSEs. In their role of providing/guaranteeing mortgages, they have to be able to fund at the very best rates. That means they need to be an AAA credit, or at worst, a very strong AA. Mere solvency is BBB, perhaps even BB or B. Simply being solvent doesn’t cut it.

But … mere solvency does pay off the preferreds.

So … here’s my take on the most likely scary scenario:

• GSE can’t roll debt on terms that allow them to make a profit
• Treasury buys senior prefs, convertible into common in X years at $1
• GSE cuts dividend on junior prefs, for an indefinite period

With respect to the “indefinite period” part … it would be in the company’s best interests for the highly dilutive conversion to take place as soon as possible, since this would – presumably – reduce the dividend outflow. But it may also be assumed that no holder in his right mind will convert for as long as he gets a fat dividend while retaining convertability. Treasury might – possibly – account for this and

• Keep the conversion period short
• Step up the conversion price within the conversion period

In any event, it may be assumed that dividends to the junior prefs would resume very shortly after conversion of the senior prefs.

Have a look at the books, make up your own minds! I am not taking a view on the investment merits of the GSE prefs – but I will observe that the market can usually be counted upon to grossly overreact to adverse news; and (provided one does one’s homework, makes only bets that are favorable according to fundamentals, and KEEPS THOSE BETS SMALL AND DIVERSIFIED) … taking an informed contrary opinion (as opposed to an opinion that is simply contrary) can often be rather profitable.

Excitement over the Fannie and Freddie preferreds continues, with Accrued Interest noting in a late post that they showed good strength in the last hour of trading yesterday.

Amidst all this talk about how the preferred shareholders could be hurt by a bail-out, I think it’s time to take a better look at the mechanics of how they could be hurt. What can be done to them?

It’s easy to figure out how to hurt the common shareholders. Their dividend has already been slashed, the companies could just walk to the end of that road and cut it completely. After that, they could be diluted all to hell – for instance, the Treasury could backstop an issue of senior preferreds, convertable into common at $1. Presto! Permanent impairment for the common holders.

But pain by dilution is not a worry for the preferred shareholders. They have a claim for $X annual dividend and $Y liquidation value on the company, and that claim is not affected by how many prefs are outstanding. The enforcibility of that claim is affected – there’s the potential, for instance, for a liquidation to pay less than 100% – but (a) the claim is unchanged and (b) the company needs to be liquidated for this to happen. Liquidation is the ultimate step and will be a political decision – I don’t consider it too likely, frankly, but make up your own minds.

Another possibility is an offer they can’t refuse – as happened with the Thornberg prefs reported on PrefBlog on July 22. They were given the opportunity to exchange into a new series at twenty cents on the dollar, and all sorts of horrible outcomes were threatened if they didn’t accept. They had to accept; in liquidation they almost certainly would have gotten less, while there was an offer on the table to recapitalize the company provided they allowed impairment of their claim.

Is this scenario a valid fear for the Fannie and Freddie prefs? Well, make up your own minds – there’s plenty of people willing to state pseudonymously on the internet that everything is worthless. I’m not convinced. If such an offer were to be made to the Fannie and Freddie prefholders, I think that they could very well win a staring contest.

The most likely scary scenario that their dividends get cut off. This is basically the only action the company can unilaterally take – but it means no dividends to the common shareholders, either. Not a single penny until the preferred dividends re-start; and there may be other remedies in the prospectuses that I haven’t read. Such an action will make the common a little difficult to sell, eh? Even at $1.

And finally, Treasury could simply expropriate their rights – re-write the law and do whatever they like. Frankly, I don’t consider this a credible outcome; not when the base-case scenario of issuing senior, convertable preferred accomplishes the policy objective of wiping out the common shareholders and recapitalizing the company. If Treasury wants to punish the preferred shareholders, they might insist that dividends get suspended for ‘the duration of the crisis’; interested readers may work out for themselves what the yields are when dividends are suspended for a variety of periods. Sadly, all series of FNM prefs are non-cumulative – I haven’t done much investigation of the particulars, but I did check that!

Note that this is not intended to be an endorsement of the Fannie and Freddie prefs – I haven’t looked at the financials for myself and I haven’t parsed all of the political statements for myself. I am merely trying to point out that the common shareholders’ pain will not necessarily be transmitted 100% to the preferred shareholders.

However, Accrued Interest posted his latest thinking on the issue today – interestingly, his plan is very pref-favourable, and involves recapitalizing the GSEs to bank levels, although he does not explicitly support my desired outcome of turning them into banks, plain and simple. He notes:

Today both Fannie Mae and Freddie Mac management are meeting with Treasury officials. My take is that Treasury is setting a deadline for them to raise new capital before the Treasury acts.

As far as the common goes … well, the short interest is something fierce!

Marco Onado of Boccini University, Milan, writes a good review article in VoxEU regarding Bank Losses and Capital. He makes the points:

• Total assets grew much faster than the risk-weighted assets against which banks must hold capital – in other words, there is a good indication that European investment banks were “gaming the system”, by concentrating on assets with a low risk weight as defined by the Basel accords. At the same time, the Assets to Capital multiple of these players increased dramatically.
• The tangible component of equity decreased, which means that a part of the capital cushion was largely made of intangible assets deriving from the merger process within the banking system.
• new capital trails write-downs (i.e. the emergence of unexpected losses) by some $ 100 billion (See the IMF July Update to the Global Financial Stability Report)
• Much of the capital has been replaced with hybrid instruments (e.g., preferred shares and Innovative Tier 1 Capital), which has a lower equity content than the 100% equity content of the losses

Basically, he wants more regulation in future:

But regulators must face the hard truth, as Merrill Lynch did: “the credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects”. This means that regulation must be thoroughly revised and capital adequacy rules must be strengthened

I must point out that his interpretation is logically fallacious. The failure of capital markets to achieve 100% efficiency does not imply that their level of efficiency can be increased by central planning. It could be – I’m willing to grant that much – I’ll listen to arguments! But it’s a non-sequiter.

PerpetualDiscounts had their second straight down-day on light volume.

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

Fannie and Freddie continue to be the focus of attention; Accrued Interest reminds us of an important point:

FRE and FNM preferreds are down another 20% or so today, threatening the $10 area on FRE Z. One trader told me he’s started to see bottom fishing here, which seems incredibly stupid to me. Bottom fishing can work as a strategy, but no one can put odds on whether the impending GSE nationalization will make preferred shareholders whole or not. This isn’t about financial analysis anymore.

Lacker just wants the damn things privatized:

Richmond Federal Reserve Bank President Jeffrey Lacker called for “demonstrably” privatizing Fannie Mae and Freddie Mac, becoming the first Fed official to publicly clash with the Bush administration’s strategy of keeping them as federally backed firms.

“I would prefer to see them credibly and demonstrably privatized,” Lacker said today in an interview with Bloomberg Television. He agreed with former Fed Chairman Alan Greenspan’s view that the two largest U.S. mortgage finance firms ought to be nationalized, then split up and sold off.

Amidst all this, there is speculation that Lehman will write off $4-billion this quarter and Naked Capitalism passes on reports that the Lehman delevering process continues:

From the New York Times

There has been widespread speculation that Lehman was contemplating a sale of Neuberger Berman, whose value is estimated by analysts to vary from less than $7 billion to as high as $13 billion (Lehman’s entire market capitalization is about $10.5 billion).

And here’s a report from the front lines:

“I’ve been at National City for 30 years and a month and for 29 of those we’ve seen nothing like it,” Thomas Richlovsky, National City’s 57-year-old treasurer, said in a telephone interview. “In past cycles certainly lending, or credit, has gotten more difficult. The cost of credit would go up. In this particular phenomenon of the last year it’s not like you can borrow money and the price went up. No, the market’s closed.”

National City on July 24 reported a $1.76 billion second- quarter loss and increased its 2008 forecast for uncollectible debt to as much as $2.9 billion. The Cleveland-based bank raised $7 billion of capital in April, which Richlovsky said is more than enough to weather the seizure in the credit markets.

The stock sale wasn’t enough to stop National City’s bonds from tumbling. Its $700 million of 6.875 percent notes due in 2019 traded last week at 61 cents on the dollar, down from 77.5 cents in June and 99 cents at the beginning of the year, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Ontario judgement on non-bank ABCP will be challenged by Ivanhoe, perhaps with others.

Amidst all this certainty, we can be glad that one thing in life is constant – there’s a lot of regulatory posturing on the US Auction rate market:

U.S. Securities and Exchange Commission Chairman Christopher Cox said investigations into the collapse of the auction-rate bond market extend beyond the banks that created the debt and settled with regulators to include brokerages that sold the investments.

“Nobody is getting a pass,” Cox said at a news conference in Washington today.
…
Regulators should force Wall Street banks to buy back all the auction-rate securities they created instead of investigating brokers that sold the debt, the Washington-based Regional Bond Dealers Association said in a letter to the SEC and other regulators last week.
…
Regulators focused first on the biggest underwriters, claiming they pitched securities as safe alternatives to money- market investments, even as the risk grew that the market would freeze.

Safe? What does “safe” mean? Are they talking about credit risk, liquidity risk, term risk, taxation risk, inflation risk, or one of the other million things that can go wrong? My view is that it should be treated in the same way as Canadian non-Bank ABCP should have been treated: brokers should be held liable for recommending overexposure to the asset class, but not for reasonable exposure. The credit was fine – and, as far as I know, remains fine (there are two exceptions to this generalization, I think). Liquidity … not so good.

However, consideration of more than one kind of risk – and genuine acceptance of the fact that black swans happen and all you can hope for is loss limitation by diversification – will make news reports longer than 500 words and involve a little judgement, so it won’t happen.

Amazingly, PerpetualDiscounts were weak today, losing 0.14% in their second down-day since July 16. From the close July 16 to the close today, they’ve gained 8.60%, with yields dropping from 6.63% to 6.13%. So … er … let me see … one month at 6.63% is about 0.55%, call it, so capital gain is 8.60-0.55 = call it 8% on a yield drop of 0.5% … the effective modified duration was about 16 years. Give or take. Remember, HIMIPref™ under-calculates modified duration (which is precisely 1/YTM) as a matter of computational and reporting convenience.

Today’s closing yield of 6.13% is equivalent to 8.58% interest at the standard conversion factor of 1.4x. Long Corporates currently yield a little under 6.1% … I think we can say the spread is maintaining itself around 250bp without anybody fussing too much. That used to be a long-term record!

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

Rumours swirled around Fannie and Freddie today, after a gloomy story in Barrons:

It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer’s dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies’ common stock, with preferred shareholders and even holders of the two entities’ $19 billion of subordinated debt also suffering losses.

Bloomberg’s rumours are more detailed:

Both Fannie and Freddie slid as much as 12 percent after Barron’s said government officials anticipate the companies will fail to raise the equity capital they need, prompting the U.S. Treasury to step in. Fannie is down 82 percent this year. Freddie has fallen 85 percent.
…
A rescue would include preferred stock with a seniority, dividend preference and convertibility right that would wipe out common stockholders, Barron’s reported, citing an unidentified source in the Bush administration. Treasury Secretary Henry Paulson, who received the authority he requested from Congress to help the companies, has said a bailout won’t be needed.
…
Standard & Poor’s cut Fannie and Freddie’s preferred stock and subordinated debt ratings by three levels last week to A- from AA-. S&P affirmed the companies’ AAA senior debt rating, reflecting perceived government support.

At the close, Accrued Interest made some good observations:

GSE securities of all types getting hit hard today. Interestingly, both the common and preferred shares are down ~20%. Sub debt some 200bps wider with poor liquidity.
…
The ultimate problem here is best described by Merrill Lynch’s Ken Bruce. You can dive into Freddie Mac or Fannie Mae’s balance sheet and make a good case that they don’t need new capital, at least under current forecasts for housing. You’d therefore conclude that if they were a truly private company, they’d best serve shareholders by trying to stick it out. But they aren’t a truly private company. As the perception of their capital strength wanes, policy makers are going to conclude that we are better off nationalizing the GSEs.
…
As for wiping out preferred shareholders… Remember that the big preferred shareholders are smaller banks. I don’t think it would make sense for the Administration to bolster one part of the banking system (Fannie and Freddie) at the expense of another part of the banking system (regional banks). And besides, I don’t think its necessary to protect tax-payers interests.
…
The trade is to be long senior Agency debt. There is just no way the Treasury allows anything to happen to senior debt holders. I don’t know who is playing in sub notes or preferred shares in here. No amount of investment analysis is going to help you figure what the Treasury’s next move is.

There was some discussion of the Fannie and Freddie prefs on August 8.

There was a great graph published by the Cleveland Fed in a discussion of the Student Loans Market:

Note: The spread is the three-month LIBOR rate minus the three-month financial commercial paper rate.
Sources: The Board of Governors of the Federal Reserve System; Financial Times.

The enormous volatility seems much more illustrative to me of the credit crunch than the more usual graphs of enormous spread increases:

Sunlife issues did very well today – it would appear that nobody noticed they went ex-Dividend today. PerpetualDiscounts had yet another up-day today, but the total return index is still a fraction under the June 30 value of 877.24. The fact that there has been a gain of almost exactly 8.75% since the July 16 nadir – with only one down-day in that period – should really rub it in about just how bad the first half of July was!

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

James Hamilton of Econbrowser takes a brief look at the US Inflation numbers and concludes:

there is a clear need to net out the May-to-July energy price increase– it’s already been reversed. The US national average gas price is back to $3.78/gallon, right where it was in mid-May. Thus, even without any further drop in the price of gasoline– and personally, I do expect further drops– the 4-1/2% number is a better summary of where we stand right at the moment than 5-1/2%.

So no, I don’t think that yesterday’s CPI numbers will cause the Fed to panic. Because yesterday’s news is already way of out of date.

Stephen Foley of The Independent looks at the Fed/SEC turf battle (hat tip: Naked Capitalism):

But [SEC Chairman Christopher Cox] starts an important battle for the soul of US financial regulation several laps behind the Federal Reserve and opponents on Wall Street who see this as the perfect time to take a few teeth out of the SEC.

A blueprint for regulatory reform by Mr Paulson, which envisages the Fed as a super-regulator with only a narrow role for the SEC, was forged out of Wall Street’s frustration with SEC red tape and what investment banks complained was their diminishing competitive advantage over London. Britain, they argued, had a risk-based approach to regulation that was light-touch in day-to-day matters and only descended on institutions regarded as risking damage to the financial system. The SEC, with its raft of rules, would be wrapped into a much-diminished third-tier regulator responsible for protecting investors and market participants from fraud and market manipulation.

Now, I don’t want it to seem as if I’m defending the SEC and its regulatory approach – for one thing, I’m simply not familiar enough with the issues. But although there are some very good arguments to be made that central banks should combine the regulatory and lender of last resort functions, I’m not sure how well this works in practice. Particularly when applied to investment banking – which is supposed to be wilder and riskier than regular banking, by design! – this simply places too much power in the hands of a single agency. Many nations separate the regulatory and lending functions (Canada, to name but one) without huge problems; it seems to me that separation of function is Good.

After all, isn’t this what the regulators are always telling us about separation of function when they pontificate? Bookkeepers should not cut cheques. Internal Audit should not sell IPOs. And lenders should not be regulators.

We may, eventually, be getting towards the end of the ABCP legal saga:

Investors in the frozen $32-billion asset-backed commercial paper market will find out on Monday what will happen to the money they put into the troubled paper when an appeals court renders its decision.

The Ontario Court of Appeal says it will release its decision on the restructuring plan on Monday at 5 p.m. ET.
…
An Ontario Superior Court judge accepted the plan, but the decision also left open a 21-day window for individual and corporate investors to file appeals on the case.

Several corporations with the paper filed appeals claiming that the plan wrongfully granted immunity from litigation to the banks, brokers and the rating agency involved in ABCP.
…
The decision will be posted on the court’s website …

The Canadian Press reporter was good enough to note that the decision will be posted on the court’s website, but got the address wrong. The announcement is here.

PerpetualDiscounts continued their recovery today, but the total return index remains a hair below its level of June 30. The weighted average yield to maturity for these issues is currently 6.13%, compared to 6.07% on June 30 and a high of 6.63% on July 16.

The fund is doing quite well this month; trading volume has been quite heavy since mid-July (when chaos and confusion reigned unchallenged in the sector) and these relative-value trades are starting to pay off handsomely. How handsomely? I’d better keep my mouth shut, but I will say that I’m feeling a lot happier halfway through August than I was halfway through July!

Volume was light today.

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

Accrued Interest comments on the extraordinary new-issue concession for Citigroup 5-years:

The new issue was sold at a yield spread of 337.5bps over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup’s 5.5% bond due in April 2013 was bid at +275.
…
First, this is an extreme concession for a plain vanilla debt sale of a Aa3 rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and 5-year swap spreads closed at +98.5.

Meanwhile, in an incident that doesn’t have the credit rating agencies looking all that good, Bluepoint’s gone BK:

Wachovia Corp.’s BluePoint Re Ltd. unit, which insures structured finance and municipal transactions, filed for bankruptcy protection, citing defaults on securitized mortgages.

BluePoint filed a petition in Manhattan yesterday, saying it has more than $100 million in debt.
…
Wachovia, the fourth-biggest U.S. bank, reported a $330 million charge in the second half of 2007 related to BluePoint’s losses on credit default swaps on collateralized debt obligations, or CDOs. BluePoint decided to liquidate after failing to negotiate a restructuring with banks including UBS AG that were counterparties to its swaps, according to court papers.
…
BluePoint Re, the smallest reinsurer in the bond-insurance industry according to Moody’s Investors Service, had its credit rating cut 14 levels to Ca from A2 by the agency yesterday. Moody’s had lowered its rating two notches from Aa3 on July 11.

The only possible excuse I can find for such a swift downgrade is found in Moody’s press release:

In contrast to most other financial guarantors, BluePoint Re is much more exposed to liquidity risk in its CDS contracts due to payment and settlement terms, including market value termination rating triggers that take effect below the single-A rating level.

… but it doesn’t look good! S&P said:

it lowered its financial strength and financial enhancement ratings on BluePoint Re Ltd. to ‘R’ from ‘A’. An insurer rated ‘R’ is under regulatory supervision because of its financial condition.

According to a S&P request for comment, the lowest 3-year projected rating for an issue currently rated A is B:

Under the proposal, when assigning and monitoring ratings, we would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991 and the European recession of 1991 or appropriate sector-specific stress scenarios). In such cases, we would assign the issuer or security a lower rating than we would have otherwise.

I don’t like the proposal, by the way. I prefer a volatility modifier.

Yet another day of recovery for PerpetualDiscounts; their total return index has returned to above that of July 2, but still below the June 30 close. Average yield is 6.14%, equivalent to 8.60% interest (with the 1.4x equivalency factor), which is long corporates +250bp.

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

Asset- and mortgage-backed spreads are widening:

Fannie’s current-coupon 30-year fixed-rate bonds currently yield 6.04 percent, 212 basis points more than 10-year Treasuries, according to data compiled by Bloomberg. That’s 26 points from the 22-year high of 238 basis points reached March 6, a week before the Federal Reserve engineered a bailout of Bear Stearns & Co.
…
The yield over the one-month London interbank offered rate on AAA rated auto asset-backed bonds maturing in three years rose 25 basis points to a 12-month high of 200 in the week ended Aug. 7, according to Bank of America Corp. data. Spreads on similar credit-card securities rose 15 basis points to a three-month high of 110 over Libor. Libor is currently set at 2.47 percent.
…
BlackRock has out muscled competitors such as Legg Mason Inc. in the current crisis. The company collected $63.2 billion in new business from investors in the second quarter, including advisory assignments, the most of any publicly traded asset manager.

This may have to do with rumbling that Lehman is seeking to delever:

Lehman Brothers Holdings Inc., seeking to restore investor confidence after a $2.8 billion second-quarter loss, is negotiating to sell commercial real estate assets to a group including BlackRock Inc., said three people briefed on the discussions.

Lehman is seeking to sell about $14 billion of its $40 billion in commercial property and related securities by the end of the year, according to two potential buyers approached by the New York-based firm.
…
[Ladenburg Thalmann & Co. analyst Richard] Bove expects Lehman to sell its entire $29.4 billion commercial mortgage portfolio. The firm also owns $10.4 billion of property. It may record a loss of $4.9 billion on the sale of the commercial mortgages, Sanford C. Bernstein & Co. analyst Brad Hintz estimated in a report last week.

Last year, as the market collapsed, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, 44 percent more than Morgan Stanley’s and almost four times the $22.5 billion of shareholder equity Lehman had as a buffer against losses.

An interesting column on VoxEU looks at Optimal Central Bank Transparency, reasoning that since:

Inflation targeting has been the most popular monetary policy regime of recent decades. Under this policy, central banks effectively target inflation forecasts. To a large extent these forecasts are determined by expectations of economic agents. Communicating information is the central bank’s major instrument for managing expectations. It is therefore logical that the issue of central bank transparency came to the fore when inflation targeting became the dominant monetary policy strategy, often studied in the context of a New Keynesian model.

and:

More recently, the potential negative effects of higher transparency have attracted attention (see Ellen Meade’s Vox column).

Since transparency has positive and negative aspects, the obvious next step is to investigate the notion of an optimal degree of central bank transparency.

The authors make some good points more generally related to investments:

It is well known that people sometimes neglect important information when it is supplied with a lot of other information. People also fall back to simple rules of thumb if the content of the information becomes too complicated.
…
By providing more and more information, paradoxically central banks show how little they actually know.
This risk is especially relevant when the central bank provides information on all the uncertainties surrounding forecasts and analyses. By doing so, it may also convey how dependent the central bank ultimately is on the relatively powerless instrument that is the very short-term interest rate. Thus result may be a drop in the central bank’s credibility.

With respect to transparency, Willem Buiter has recently opined that The ECB should vote on interest rates and then publish its minutes:

Even French president Nicolas Sarkozy can be right about some things – malgré soi. He wants the ECB to publish the minutes of the rate-setting meetings of its Governing Council, including an account of each member’s view on the appropriate level of the ECB’s official policy rate – the inelegantly named Main refinancing operations Minimum bid rate. And about time too. But before it makes sense for the ECB to publish the minutes of its rate-setting meetings, the ECB has to start voting on its interest rate decisions.

Remarkably, the fact that the ECB’s Governing Council has never voted on the interest rate it sets does not appear to be widely known.
…
The ECB has never had a formal vote on interest rates. I know this straight from the mouths of horses who between them have attended every single one of the ECB Governing Council’s rate-setting meetings since the first one in January 1999. Instead of voting on the interest rate, the ECB’s Governing Council ‘reach a consensus’ without ever taking a vote.
…
To conclude: corruption of the mandate and purpose of the ECB are much more likely when there is no voting on rate decisions, when the individual votes are not in the public domain and when no informative minutes explaining individual votes are published.

It is clear that the Treaty and Protocols (a) require voting on interest rates (why bother with the voting procedures otherwise) and (b) permit the publication of individual voting records and minutes. Article 10.4 of the Protocol states: 10.4. The proceedings of the meetings shall be confidential. The Governing Council may decide to make the outcome of its deliberations public.

Another up-day for PerpetualDiscounts, making the eleventh straight trading day without a loss. There has only been one down-day (July 28) in the nineteen trading days since the nadir on July 16.

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