Category: Market Action

As a side-benefit to my preparation of a post that will, in years to come, be widely recognized as the finest blog post ever written, I have updated Bank Regulation: The Assets to Capital Multiple with an interesting chart.

I don’t see a press release from CIBC, but DBRS has released a provisional ratings opinion on a new issue of covered bonds:

DBRS has assigned a provisional rating of AAA with a Stable trend to the Series [1] to be issued by CIBC under its Global Public Sector Covered Bond Programme. This is the first issuance of a covered bond programme collateralized entirely by CMHC-insured Canadian residential mortgages.

Covered bonds are a relatively new thing in Canada.

A mixed day on the market, but volume continues to hold up.

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

On the weekend, Naked Capitalism republished an interesting account of a CDS lawsuit … in a nutshell, UBS bought credit protection for $1.3-billion in super-senior CDO notes from a hedge fund’s special purpose subsidiary capitalized with $4.6-million. The sub has not met its margin calls.

I’ll bet a nickel that this was a back-to-back deal … e.g., UBS wanted to insure its position and a monoline wanted to insure it, but (a) UBS was up to its position limits with the monoline, and (b) the monoline refused to consider posting collateral. In this scenario, UBS would put together a back-to-back deal, whereby they would buy protection from the sub at 15.5bp and the sub would buy protection from the monoline at 10.5bp. Hey, presto, 5bp on $1.3-billion = $650,000 p.a. free money.

Trouble ensues when the mark-to-market hits. The sub has agreed to post collateral, but the monoline hasn’t. There may also be a certain amount of doubt regarding the value of the monoline’s contract.

Sounds far-fetched? It’s my understanding that this is exactly what happened with CIBC and their big writedown. Anybody with more information on the lawsuit or the sub’s total position – let me know! You might even win a nickel!

Accrued Interest has written some more about the Bear Stearns affair with an emphasis on the idea that Lehman now finds itself in much the same position. He also links to a three-part review by the WSJ which, as he says, is excellent.

Prof. Daniel Cohen writes a piece on VoxEU that blames the sub-prime crisis on moral hazard. His answer:

Panglossian principles first explain why finance requires regulation. Prudential rules set a minimum ratio of banks’ equity capital to the amount of their investments. The idea is to oblige them to hold at their disposal the liquidity necessary to pay, and therefore to anticipate, their potential losses.

Ah, it would be a much better world if only there were more rules! I don’t have time to address this issue at the moment – but I’ll try to get to it tomorrow.

According to me, the market drifted up reasonably well today, but according to the TSX, the index drifted down. Take your choice! At least volume was good!

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

On VoxEU, Francesco Giavazzi writes about the suddenly topical OIS / LIBOR spread.

BCE received leave to appeal to the Supreme Court; the case will be heard June 17.

The market drifted downwards, perhaps due to the National Bank Fixed Reset, 5.375%+205 new issue.

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

Naked Capitalism republishes a review of potential problems in the CDS market.

Changes were rumoured the LIBOR setting mechanism:

The group that sets the London interbank offered rate can restore its credibility by following the example of Australia and New Zealand, said Morgan Stanley. Or, the British Bankers’ Association could look to the U.S., according to UBS AG and Credit Suisse Group.

The loss of confidence in the benchmark rate for $350 trillion in derivatives and corporate bonds and 6 million U.S. mortgages spurred the world’s biggest banks to recommend fixes, though they reached no consensus. The BBA plans to announce after 5 p.m. today the first changes to Libor in 10 years after the Basel-based Bank for International Settlements suggested in March that some lenders were misstating borrowing costs to avoid speculation that they were in financial straits.

I imagine that being a world-scale benchmark is very useful for the participants; but the rumours were unfounded:

The group that oversees the London interbank offered rate will implement no changes to the way the measure is set, confounding critics who said it has become unreliable as a gauge of the cost of borrowing.

“The committee will be strengthening the oversight of BBA Libor,” the British Bankers’ Association said in an e-mailed statement today. “The details will be published in due course.” The composition of the bank panels that contribute rates were left unchanged, it said.

Berger and Nitsch have an interesting piece on VoxEU regarding the optimal size of Central Bank Governing Councils … there are concerns that too much democracy is enough!

A few weeks ago, the European Commission recommended that Slovakia should be allowed to join the eurozone as of January 1, 2009. When the member states follow this recommendation and accept Slovakia’s adoption of the euro, the country will become the sixteenth member of the European single currency zone. At the same time, the Governor of the National Bank of Slovakia, Ivan Sramko, will take a seat at the Governing Council of the European Central Bank (ECB), thereby increasing the membership size of the eurozone’s interest-setting body to 22 members.
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Moreover, with the expected future enlargement of the eurozone, the Governing Council will expand further, perhaps soon comprising 30 or more members.

It sounds very political and reminiscent of Canadian federal cabinets … perhaps five actual decision-makers and twenty-five-odd regional makeweights. By all means, let the ECB have a regionally representative governing council – but devolve the actual decision making to a sub-committee. For instance, like the Fed:

The Federal Open Market Committee (FOMC) consists of twelve members–the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee’s assessment of the economy and policy options.

Willem Buiter posts an interesting essay (verging on polemic) regarding Lessons from the North Atlantic Financial Crisis:

I conclude that although the Fed did a reasonable job dealing with the immediate financial crisis, it did significantly worse than the other two central banks as regards macroeconomic stability and the prevention or mitigation of future financial crises.

I identify two main causes for this underperformance by the Fed. As regards macroeconomic stability, there are flaws in its model of the transmission mechanism of monetary policy and other macroeconomic shocks. Two prominent errors are the overestimation of the effect of changes in house prices on consumer demand and the unfortunate focus on the will-o’-the-wisp of core inflation rather than on medium-term headline inflation. The Fed also either ignores the need for a major increase in the US saving-investment balance or believes that this can be achieved without passing through an extended spell of below-capacity growth of demand.

Second, the Fed, unlike the Bank of England and the ECB, has regulatory and supervisory responsbility for part of the US banking system. This has the advantage of giving it institution-specific information of a kind not available to the Bank of England or the ECB. The disadvantage is that the Fed’s position invites regulatory capture.
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The macroeconomic stability records of the Bank of England and of the ECB have been superior to those of the Fed. After climbing a quite steep liquidity learning curve in the early months of the crisis, the Bank of England is now performing its lender of last resort and market maker of last resort roles more effectively. It would be desirable to have the information in the public domain that is required to determine whether the ECB (through the Eurosystem) is pricing illiquid collateral appropriately. There is reason for concern that the ECB may be accepting collateral in repos and at its discount window at inflated valuations, thus joining the Fed in boosting future moral hazard through the present encouragement of adverse selection.
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Future regulation will have to be base on size and leverage of institutions. It will have to be universal (applying to all leveraged institutions above a certain size), uniform, countercyclical and global.

Financial crises will always be with us.

The full version of the paper is published by NBER; it is an update of a previous paper that has been reviewed on PrefBlog. The current paper has also been given its own post.

Hard on the heels of Accrued Interest‘s speculations on the future of leveraged fixed income (linked on PrefBlog yesterday) comes news that Deutsche Bank is creating REMICs:

Deutsche Bank AG’s asset management business may join other firms in repackaging their home-loan bonds into new securities without creating collateralized debt obligations, which are being shunned by investors.

The unit of the Frankfurt-based bank has studied using the technique on bonds in the portfolios it oversees, Julian Evans, a director who helps manage insurer money at Deutsche Asset Management, said in an interview yesterday. Bankers including Goldman Sachs Group Inc. and JPMorgan Chase & Co. have created more than $5 billion of new home-loan securities called Re-REMICs out of existing ones this year, newsletter Inside MBS & ABS says.

The difference between a REMIC and a CDO is that a CDO can be actively managed, while a REMIC is brain-dead.

While finding that last link, by the way, I found Calculated Risk‘s Compleat Ubernerd page … links to some of the more … er … technical posts on that excellent blog.

The market was up slightly to end the month with the CPD Exchange Traded Fund up 0.28% on the day to make it up 1.42% on the month. It looks like Malachite Fund will be up somewhat less … only a few basis points behind, but rather annoying after spending most of the month up 25-50bp against CPD. But that’s what happens when the former price is based on trades in a thin market, while the other is based on bids!

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

Accrued Interest opines on the future of CDOs.

Naked Capitalism collects some opinions on credit conditions.

Bloomberg reports on LIBOR reporting problems.

Bloomberg reports on how OIS is overtaking LIBOR as a measure.

Lou Crandall comments (a long time ago) on how LIBOR overtook US T-Bills as a measure.

Jeffrey Frankel defends his thesis that low real interest rates cause commodities to rise.

Standard & Poor’s points out that sub-prime borrowers bought cheap houses, which have less volatile prices than expensive ones … the mortgage carry quickly becomes comparable to renting, no matter how far underwater you are.

Standard & Poor’s Ratings Services’ current ratings on the 2006 subprime U.S. residential mortgage-backed securities (RMBS) vintage reflect, in part, an assumed loss severity of 45%. That assumption includes our estimate that, based on our views on the current housing market environment, foreclosure costs and market value declines account for losses of 26.3% and 18.7%, respectively, in the loan balances of these mortgages. We project a 19% aggregate loss for subprime mortgages backing U.S. RMBS sold in 2006 based on assumptions for foreclosure and loss severity. The 19% assumption is the product of projected foreclosures of approximately 42% and the assumed loss severity of 45%.

Standard & Poor’s current house price decline assumption is 33.4%, which is a 72% increase over the maximum price decline of 19.4% observed to date (see table 1). We believe this assumption appropriately protects against forecasted price declines through the housing downturn.

Dates have been set for the redemption of FAL.PR.A & FAL.PR.H; the post has been updated.

Plans – well, rumours of plans, anyway – are moving forward for a CDS Clearinghouse. I have updated my most recent post on the issue.

For those fascinated with all aspects of the David Berry affair, I’ve had a look at the career of Cecilia Williams, Scotia’s compliance officer, and have updated the most recent relevant post.

In case you missed the announcements amidst the Bank Capitalization posts, note that RY.PR.K has been called for redemption and TD has a new Fixed Reset, 5+160 … and the argument about the structure’s merits rages on. It takes two to make a market!

Good volume on the day, with some nice sized blocks going through for some Operating Retractibles. Prices were down … surely, people can’t be selling straights to buy fixed-resets?

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

It seems like most of the interesting news lately has been sufficiently important to merit separate posts, so these daily reviews have been suffering!

Today Mishkin announced his resignation from the Fed Board:

Mishkin, 57, on a leave of absence from [Columbia University], will step down as of Aug. 31, the Fed said in a statement today, also releasing his letter of resignation to President George W. Bush.

The departure may create an unprecedented third vacancy on the seven-member Fed Board of Governors this year as the central bank tries to ease the credit crisis. The vacancies mean that a new U.S. president to be inaugurated in January may have an opportunity to influence monetary and regulatory policy by nominating new members to the board.
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Senate Banking Committee Chairman Christopher Dodd, a Democrat from Connecticut, has already delayed a confirmation vote for three board nominees for more than a year. After gaining support from the committee, the nominations would go to the full Senate for a vote of final approval.

Hey, who cares about the direction of the world’s most important Central Bank when when there are political games that can be played?

It’s not like the Fed doesn’t have a plateful of problems – JPMorgan is calling for US Inflation of over 5%

Not bad, with long treasuries at 4.6%, eh? Fisher is continuing his anti-inflation drum-beating:

Federal Reserve Bank of Dallas President Richard Fisher said he expects the central bank would raise the benchmark U.S. interest rate should the public begin to expect greater gains in consumer prices.

“If inflationary developments and, more important, inflation expectations continue to worsen, I would expect a change of course in monetary policy to occur sooner rather than later, even in the face of an anemic” economy, Fisher said today in the text of a speech in San Francisco.

Fed bank presidents, including Gary Stern of Minneapolis and Thomas Hoenig of Kansas City, have expressed growing concern this month about rising prices. Fisher, 59, is the only member of the Federal Open Market Committee to dissent three times from decisions to lower the overnight bank-lending rate, favoring either no change or less aggressive reduction.

There’s an interesting and rather heretical piece on VoxEU by Cournand and Heinemann titled Can Central Banks Talk too Much?:

Public information is a double-edged sword: it conveys valuable information, but it leads agents pursuing coordination to condition their actions on public announcements more than optimal. In this respect, Morris and Shin (2002) have shown that noisy public announcements may be detrimental to welfare. They conclude that central banks should commit to withholding relevant information or deliberately reduce its precision. This result has received a great deal of attention in the academic literature, in the financial press (see for example the Economist (2004)), and among central banks.
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Far from being perfect, all these means of communication allow the central bank to provide partially public information and avoid market overreactions to information of poor quality. To some extent, these means play a role in the actual policy of central banks already. Therefore, our results give a rationale for central banks releasing partially public information in addition to official publications. Our main result shows that these means of partial publicity should only be employed for announcements of low precision.

In other words … the bond market is excitable, so let’s just feed it pablum.

I don’t like the idea: it’s too big-brotherish. Much better would be the use of fan charts, as mentioned on January 18 with other methods of conveying the idea that such-and-such information is only a best guess. Excitable bond markets are great! A long term investor with half a brain can make good money out of them! Why should I – or any other PrefBlog reader – seek to prevent cowboys from losing all their clients’ money?

As reported by Bloomberg, S&P today downgraded a swath of Alt-A paper:

The classes affected by the negative rating actions represent an issuance amount of approximately $33.95 billion, or about 13.92% of the par amount of U.S. RMBS transactions backed by Alt-A mortgage loans rated by Standard & Poor’s in the first half of 2007.
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Due to current market conditions,
we are assuming that it will take approximately 15 months to liquidate loans in foreclosure and approximately eight months to liquidate loans categorized as real estate owned (REO). In addition, we are assuming a loss severity of 34% for U.S. Alt-A RMBS transactions backed by fixed-rate and long-rest hybrid (fixed-rate period of at least five years) loan collateral issued in 2007. We are assuming a loss severity of 35% for transactions issued in 2007 that are backed by mortgage loans that have a negative amortization feature. We are also assuming a loss severity of 35% for transactions backed by adjustable-rate and short-rest hybrid loan collateral (fixed-rate period of less than five years).
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Monthly performance data reveal that delinquencies and foreclosures continue to accumulate for the 2007-vintage U.S. Alt-A RMBS transactions. As of the April 2008 distribution date, serious delinquencies (90-day, foreclosures, and REOs) among all U.S. Alt-A RMBS transactions issued during 2007 were 6.64%, up 64.76% since January 2008. During this same time, cumulative realized losses for 2007-vintage Alt-A deals increased to 0.08% from 0.02%.

The analysis performed during this review has allowed Standard & Poor’s to project losses for each of the three types of Alt-A transactions issued during the first half of 2007. We project aggregate lifetime losses of 8.15%-8.65% of the original balance for the transactions with negative amortizing collateral. We project aggregate lifetime losses of 6.40%-6.90% for the transactions backed by fixed-rate and long-reset hybrid collateral. Finally, we project
aggregate lifetime losses of 7.00%-7.50% for the transactions backed by adjustable-rate and short-rest hybrid collateral.
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Unless we observe a significant change in the macroeconomic environment, Standard & Poor’s considers today’s actions, except for the CreditWatch placements, to be the last major changes to the ratings on the U.S. Alt-A RMBS classes issued during the first half of 2007.

Moody’s has released a report (available to subscribers only) regarding the CDS market. According to their press release:

“The notion that credit default swaps represent this $62 trillion long credit exposure is not an accurate depiction of the market nor particularly helpful to investors in determining where the true risks lie,” says Moody’s AVP/Analyst Alexander Yavorsky, one of the authors of the report, referring to the oft-cited figure for the notional amount of CDS contracts outstanding.
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Yavorsky says a more useful number when looking at the CDS market is the gross replacement value, of outstanding contracts, which at just over $2 trillion is under 3.5% of the notional amount.
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More concerning to Moody’s than an increase in underlying credit losses is the potential for market disruption through the failure of a major bank or broker-dealer.

If a large CDS counterparty failed, this would very likely have a substantial market-wide re-pricing effect on the cost of CDS protection, and, by extension, the underlying cash bonds. The effect of this would be especially problematic for firms needing to replace the CDS trades they had with the failed counterparty. Until the trades were replaced — an operationally challenging and unprecedented undertaking — the firms that lost protection would be left with unhedged exposures amid what is likely to be a very volatile market environment.
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Moody’s also notes, however, that the systemic importance of the largest CDS dealers provides powerful incentives to regulators to prevent their disorderly failure, as demonstrated by the recent case of Bear Stearns. The more important the role played by an institution the more likely regulators will consider it to be too systemically important to fail.

The Canada Pension Plan released its 2008 Annual Report, showing a benchmark portfolio of 25% Canadian Equities, 40% Foreign Equities, 25% Fixed Income and 10% Canadian Real Return Bonds; benchmark performance for the year was -2.7% as foreign equities got hammered. They outperformed by 241bp; actual allocations – as reported – were 23.5% Canadian Equities, 39.2% Foreign Equities, 24.3% Fixed Income and 11.7% “Inflation Sensitive Assets”, which includes real-estate and infrastructure, not just RRBs.

So … it’s only one year and you’d have to do a whole lot more work before you took a view on their skill …. but it shows what you can do when you have a captive client and don’t have to worry about explaining the latest headline. For example:

As a result, in September, we committed a total of US$2 billion ($2 billion) in funds managed by Apollo Management and the Blackstone Group to begin to establish a diversified portfolio of senior secured loans that were available at significant discounts to face value, of which approximately US$667 million ($666 million) has been invested to date. The CPP Investment Board had both the liquidity and knowledge needed to prudently purchase this senior performing debt at discounted prices and we are confident that this investment will deliver superior long term risk-adjusted returns.

The second example is our investment in distressed mortgage funds to take advantage of heavily discounted prices following the credit crisis. During the fiscal year, we committed a total of $750 million to two distressed mortgage funds run by very experienced fund managers, Pacific Investment Management Company (PIMCO) and BlackRock, Inc. To date, approximately US$500 million ($513 million) has been invested.

It appears probable, therefore, that at least part of the CPP money was involved in the Hapaolim / PIMCO deal mentioned May 22 – which I suggested was a fantastic buy for PIMCO. You won’t find too many pension plans doing that sort of thing … first, it involved fund management hiring an external specialist (which, for most firms, involves sharing the fee) and second, everybody knows that all sub-prime securities are level-3 toxic trash that will go to zero soon, if not negative. It said so in the paper yesterday!

Volume was normal today, with no particularly violent price trends apparent.

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

Menzie Chinn of Econbrowser posted a good piece over the weekend, How Effective Will Monetary Easing Be? The Bank Lending Channel and the Implications of Increasingly Internationalized Banks, reviewing a paper presented at a recent Bundesbank conference:

The results of this paper are consistent with the view that while loosening of US monetary policy might induce greater lending overseas by branches of US banks, thereby tending to support rest-of-world economic activity, they also imply that negative shocks to the assets of US banks will also tend to reduce lending abroad. Hence, deleveraging by domestic banks has global (or at least rest-of-OECD) implications. That means both negative and positive shocks will be propagated abroad. In this sense, I think decoupling of the major developed economies is even less likely to occur.

It seems to me that this in turn will have some effect on currency rates, because whenever the banks deliberately mismatch their balance sheet in different currencies they are, for all intents and purposes, engaged in a carry trade.

It is my guess – as a non-specialist! – that these transactions would incur an additional capital charge equivalent to that of a long dated currency forward, according to the schedule given on page 73 (paragraph 92) of the OSFI Guidelines for Basel II … with the assumption that such loans would be unhedged. Hedging such transactions would largely reduce their point, as long-date FX trades at spot + government yield difference; therefore hedging would destroy the point.

The OSFI guidelines look reasonable to me … if my interpretation is correct … but I’d sure like to see some specialist discussion of the issue!

Every now and then I mention revolving-door regulation on this blog … like, f’rinstance, yesterday. I should emphasize that ill effects stemming from this can arise without anybody having any venal intent, as opined by Willem Buiter:

It is rather rare, I believe, in well-established parliamentary democracies, for the process through which power corrupts to be a direct and conscious one: “I have power. I control this license that you want; I can give you a tax break; I can make sure government procurement favours your company; I can acquit your useless son on manslaughter while DUI charges. Here is the number of my Swiss bank account. ”

It may happen, but more common and possibly more insidious and dangerous is the gradual transformation (I would say, distortion) of both the value system and the world-view or perception of reality that afflicts those elected or appointed to high office. This occurs through a gradual re-socialisation of those in power, which results in them gradually identifying with different peer groups and with different reference groups for benchmarking normal or acceptable behaviour.

A quiet day today on the preferred market, with no real trends evident.

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

Memorial Day in the US … very little interesting news!

The chatter regarding the SocGen / Kerviel fiasco continues:

“It validates what Jerome has said,” Guillaume Selnet, Kerviel’s defense lawyer, said yesterday in a telephone interview. “The only possible explanation is negligence, individual and systemic negligence.”

The full SocGen report is available via the SocGen Press Releases page. The report itself is illuminating. Essentially, their bookkeeping procedures did not produce exception reporting, or have adequate drill-down capability. Gross incompetence – an accident waiting to happen.

The report, while publicly available, has been encrypted to make extracts hard – I can only imagine they don’t want their various howlers discussed too readily! However, I’ll retype:

Furthermore, the Futures Back Office did not identify the significant frequency of cash complements paid in order to meet deposit requirements as such supervision is not within its mandate. Between January 1 and 18, 2008, in the absence of a sufficient quantity of bonds to cover an IMR requirement undergoing strong growth due to JK’s activities, the Futures Back Office paid a cash complement of over EUR 500 million on five occasions in order to meet deposit requirements, as opposed to one such payment made during 2007 (on March 13, 2007 for a total of EUR 699 million). In the absence of any supervision and of any alert threshold for cash amounts paid as deposits in the procedures in place at that time, Back Office failed to detect the substantial increase in cash payments made under IMR from January 2008 onward. Back Office in fact makes a global cash payment, including by currency and by clearer, other than the deposit paid in cash, margin calls, commissions and interest payments. The controls concern solely any discrepencies between the amounts claimed by the clearer and those calculated by the SG accounting system (GMI/clearer reconciliation). But it is not Back Office’s role to carry out checks on the consistency of the amounts concerned.

Finally, the detailed breakdown of the collateral re-invoicing by GOP, which should have allowed the abnormally high amounts to be identified, was not sent to JK’s direct heirarchal superiors. GOP 2A represented 10% on average of the re-invoicing of the securities deposit financing paid by GEDS to FIMAT Frankfurt since April 2007 (see Table no. 1). This re-invoicing is carried out on a monthly basis by the Securities treasury Middle Office on a pro rata basis in the form of an Excell spreadsheet to the GEDS/TRD manager only (who became GEDS manager on December 18, 2007), i.e. to JK’s L+5, a level which is too high for such data to be analyzed in detail. The DLP and DELTA ONE desk managers (JK’s L+1 and L+2 respectively), who could have identified this significant level of GOP 2A deposit expenditure, directly visible on such re-invoicing statement, were not recipients of this spreadsheet.

In other words, no accountability, no risk management, no brains at all. I’d say the onus is on senior management at this point to show that they should retain their jobs.

Michael J. Orlando, formerly of the Kansas City Fed, has written a piece for VoxEU: Let Form Follow Function: In Defense of Central Bank Independence. Somewhat cursory, but the basic assertion is sound:

Finally, recent events have demonstrated that the Fed may find it necessary to employ new and innovative approaches to target liquidity injections in times of crisis. For example, on December 12 the Fed established a new program to allow discount window borrowers to bid for additional liquidity extended for a fixed period of time. On March 11, the Fed established a program to lend U.S. Treasury securities against a pledge of other, presumably lower quality assets. And on March 16, the Fed initiated another new program to lend directly to primary dealers of government securities. Along with the Fed-arranged marriage between Bear Stearns and JPMorgan Chase, these programs merit continued debate and analysis. However, it is not obvious that the Fed’s ability to respond to this crisis in a timely and effective manner would be enhanced by more immediate legislative or executive oversight.

Willem Buiter disappoints me today with a rather breathtaking “therefore”:

Fundamentally, the key asymmetry is that the authorities are unable or unwilling, whether for good or bad reasons does not matter here, to let large leveraged financial institutions collapse. There is no matching inclination to expropriate or otherwise financially punish or restrain highly profitable financial institutions. This asymmetry has to be corrected. Therefore, any large leveraged financial institution, commercial bank, investment bank, hedge fund, private equity fund, SIV, Conduit or whatever it calls itself, whatever it does and whatever its legal form, will have to be regulated according to the same principles.

Dr. Buiter’s policy aim with this recommendation is, I’m afraid, not particularly clear to me. Additionally, I don’t see a lot of support for his premise that authorities are “unable or unwilling … to let large leveraged financial institutions collapse”. One may quibble over definitions, but I don’t think shareholders of Bear Stears are in 100% agreement with this assertion; neither are the beneficiaries of Carlyle’s leveraged mortgage fund or Amaranth – to name but two.

Protect the core, by all means! But to make all financial institutions as safe as the banks would be contrary to the ultimate public good.

Today’s BCE news (hat tip: Financial Webring Forum) is that the Supreme Court will move quickly on the BCE file:

Canada’s Supreme Court has agreed to speed up the process of deciding whether to hear BCE Inc.’s appeal of a lower court decision that threw the company’s $35-billion planned sale to a group of private-equity funds into doubt.

BCE had requested an expedited process to enable the company to try to stick to a plan to close the deal by June 30.

If leave to appeal is granted, the court said it will hear the case starting on June 17, with each side getting one hour for oral arguments.

Such excitement! There’s not just BCE news, but there’s Barry Critchley has asked a rather important question about the David Berry issue (emphasis added):

The current edition of Toronto Life has a major article on Berry that focuses on his time at Scotia — where he was the firm’s highest-paid employee — his $100-million lawsuit against his former employer and regulatory issues he is facing. Berry, his former associate Mark McQuillen and Scotia all faced allegations brought by Market Regulation Services: the latter two settled while Berry opted for a contested hearing.
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Berry said the settlement materials are relevant and necessary because RS’s Discipline Notices “explicitly states that proceedings in respect of Scotia’s supervision of Berry and McQuillen were not taken by RS.

There is no information, however, that addresses why Scotia was not held responsible for failing to supervise Berry under [UMIR].”

Berry added that “the agreed facts in the settlement agreement entered into between RS and Scotia do not refer to Scotia’s supervisory obligations, and the agreed sanctions represent a simple disgorgement of financial benefits obtained by Scotia through Berry’s trading.”
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When RS and Scotia settled, RS’s Maureen Jensen said, “We are pleased that Scotia Capital recognized in this settlement that, even though supervision was not an issue, it would not be appropriate to retain profits generated by the wrongdoing of its employees.” Which raises the question: Did Scotia get a special deal from RS?

It should be noted that it’s not too long ago that the Globe was oohing and ahhing over the fat paycheques handed out to dealers’ compliance staff … and RS was very proud of its role as a training ground. Why is revolving-door regulation permitted?

My last major post on the Berry issue was with respect to the OSC decision. There was some more detail given on May 23. Kerviel … Berry … motivations, methods and results were very different. But the basic issue is the same: does management have any responsibility at all to design a risk management system, use it and take responsibility for it? Or is it just there as an after-the-fact ass-covering and blame-casting device?

The market drifted slightly upwards today on light-ish volume.

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

A trader at Merrill in London has been naughty, apparently overpricing his inventory by something less USD 20-million. It’s bad news for him, it’s bad news for his supervisor and it’s not all that great for Merrill … but it wouldn’t be news if everybody wasn’t so nervous! Unless more cockroaches scuttle out from under that fridge, I’m inclined to accept their official position:

“The firm routinely reviews the marks our traders set,” Merrill spokesman Jezz Farr said today in an e-mailed statement. “Our preliminary review determined that one desk used marks that appear to be outside of our accepted policy. We have suspended a trader and we continue to review this matter.”
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“This case shows our oversight system works,” Farr said in the statement, referring to the firm’s detection of the suspended trader’s conduct.

As noted by Calculated Risk, US mortgage delinquencies are rising. I haven’t seen anything yet about whether these increases are sufficiently severe and unexpected to affect credit.

I have made some observations on one of the papers referenced in the Bank of Canada Review : Spring 2008 … you can chase it down through that post.

As noted in a Bloomberg story, the FASB has announced that it:

today issued FASB Statement No. 163, Accounting for Financial Guarantee Insurance Contracts. The new standard clarifies how FASB Statement No. 60, Accounting and Reporting by Insurance Enterprises, applies to financial guarantee insurance contracts issued by insurance enterprises, including the recognition and measurement of premium revenue and claim liabilities.
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Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation. It also requires disclosure about (a) the risk-management activities used by an insurance enterprise to evaluate credit deterioration in its insured financial obligations and (b) the insurance enterprise’s surveillance or watch list.

To my mind, the critical paragraphs in the statement are:

25. Expected net cash outflows (cash outflows, net of potential recoveries, expected to be paid to the holder of the insured financial obligation, excluding reinsurance) are probability-weighted cash flows that reflect the likelihood of all possible outcomes. For purposes of this Statement, the expected net cash outflows shall be developed using the insurance enterprise’s own assumptions about the likelihood of all possible outcomes based on all information available to the insurance enterprise (including relevant market information). Those assumptions shall consider all relevant facts and circumstances and, where applicable, be consistent with the information tracked and monitored through the insurance enterprise’s risk-management activities and used to assist in making operational decisions.
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29. An insurance enterprise shall disclose information that enables users of its financial statements to understand the factors affecting the present and future recognition and measurement of financial guarantee insurance contracts.

It is interesting to consider this change in terms of the Fitch / MBIA battle reported briefly on PrefBlog on March 24, with much better discussion available from Floyd Norris’ NYT blogs If you don’t like your grade, fire the teacher and Jay Brown Keeps Fighting.

FASB Statement 163 seems like a step in the right direction, but whether there will be enough information made available that investors can rationally check the credit ratings is something I have not – yet – seen discussed.

Vallejo has filed for bankruptcy as indicated on May 7. According to Markit 10-Year MCDX closed at 49bp today, essentially unchanged from its opening levels.

And in quite possibly the most astonishing news to hit the street since the last bulletin that the sun rose in the east this morning, SocGen management winked at Kerviel’s trading positions:

Jerome Kerviel was able to amass 50 billion euros ($78.7 billion) in unauthorized futures positions at Societe Generale SA because of fragmented internal controls, a report commissioned by the bank said today.

Kerviel’s supervisors failed to “react in an appropriate manner to several alert signals” and missed at least 1,071 bogus trades, a special committee of the bank’s board found. Unwinding those positions cost a record 4.9 billion euros, the biggest trading loss in banking history.

His supervisors missed the level of his gains, cash flows, brokerage expenses and overlooked warnings from Eurex AG, Europe’s biggest futures exchange, the report said.
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Kerviel’s manager “tolerated” bets on the direction of index futures and certain equities that were unjustified by his “assignment and level of seniority,” the document said. As a trader on the bank’s “Delta One” desk, his job was to use large volumes to arbitrage small price differences between equity index futures and forwards.
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In the first three months of 2007, when most of Kerviel’s “massive fraudulent and concealed positions on index futures” were built up, he had no direct supervisor, the report said. His new manager “did not carry out any detailed analysis of the earnings generated by his traders” and received insufficient support from the head of the Delta One desk, the committee found.

Eric Cordelle, who wasn’t identified in the report, was brought in as Kerviel’s direct supervisor in April 2007.

I am unable to determine whether Eric Cordelle went to a good school, or if he’s just another disposable barrow-boy.

The Globe has some more detail:

The internal report, the second published by SocGen into the debacle, said the unidentified assistant had manually entered a large number of fraudulent transactions done by Mr. Kerviel.

It said the assistant registered “several abnormally high intra-monthly provision flows, without having obtained any valid explanations as to their validity.”

It added that the assistant had registered a total of almost 15 per cent of Mr. Kerviel’s fictitious trades.

Thus, they have grounds to pin a big chunk of the blame on a $30,000 p.a. trading assistant … and from the sounds of SocGen’s operation, it wouldn’t surprise me if traders had license to bully the trading clerks. If I remember correctly, that was part of the explanation at RT Capital.

Update, 2008-5-24: Kerviel’s lawyer had a great comment reported in today’s Globe:

“We notice that while protecting the superiors of Jerome Kerviel, the Société Générale has found a new scapegoat – who just happens to be a 23-year-old assistant,” said Guillaume Selnet, a lawyer for Mr. Kerviel.

He noted that the directors’ report was prepared by the bank’s own services and insisted that SocGen’s version of events keeps changing.

“My feeling is that – we are now on the second report – by the third report it’s going to be the fault of the cleaning ladies,” he added.

* end update.

I will say, however, that SocGen’s new-found frankness is refreshing compared with Scotia’s in the David Berry affair. The OSC has released its reasons for the David Berry decision. Of particular interest is the summary of Berry’s “Scotia Defence”, paragraphs 25-31. Those contemplating a career with a bank are urged to remember that:

• All your actions will be recorded in minute detail
• The bank may, or may not, review these actions
• If the bank needs a scapegoat – or wishes to win a contract dispute – it will find something in the records to hang you with

Preferreds had a good solid day, on what passes in these lackadaisical times for average volume.

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

Accrued Interest has a good piece today, elaborating his thoughts on the GSEs (which he insists on spelling with an apostrophe).

Did Freddie Mac move their ABS portfolio into Level 3 because they didn’t like the bid indications they were using for valuation? The company says no.
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Buddy Piszel, CFO: We made a determination in the first quarter, that given how widely the pricing we were getting on the ABS portfolio, that it no longer made sense to leave that in Level 2…. We were still using the mean price that we were getting from the pricing services and the dealers. So we are not using a model price
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So if you believe what he’s saying, that means that the actual valuation would be the same either way. By moving to Level 3, they are saying they no longer believe the valuations represent “observable inputs.”

It seems clear that The Financial Accounting Standards Board is feeling some heat about Level 3, the so-called “Mark to Make-Believe” level of financial assets. They have published an article rather desperately titled Some Facts about Fair Value:

Like the many other estimates used in financial reporting (some of which require complex calculations), Level 3 estimates can be difficult and require the use of significant judgments. However, many investors clearly have indicated that such estimates provide more relevant and useful information than alternatives that ignore current economic conditions and that can introduce management bias into the estimation process (for example, alternatives that involve “smoothing” techniques and predicting recoveries in value).

To increase investor awareness about Level 3 estimates, SFAS 157 requires expanded disclosures about the Level 3 estimates used for financial assets and liabilities that are reported at fair value on an ongoing basis. Those disclosures focus on the effect of the estimates on reported earnings and financial position. More recently, the staff of the Securities and Exchange Commission issued a letter that encourages public companies to provide additional disclosures about the Level 3 estimates used for financial assets (including asset-backed securities, loans, and derivatives) in their Management Discussion & Analysis. The letter does not, as some have asserted, interpret, amend, or otherwise change the application of SFAS 157.

The SEC letter referred to has been published in generic form by the SEC:

Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:
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• The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
• If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:
  • the significant inputs that you no longer consider to be observable; and
  • any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.

It was Bloomberg that first – I think – broke the story about $157-billion in Level 3 assets, and an example of the kind of comments it has attracted is:

Freddie told investors right to their faces, “We manipulated the numbers,” and investors applauded like a bunch of idiots, pushing Freddie Mac shares up more than 9%. I wish this was the end to the tragic comedy, but Freddie’s conference call was even more ridiculous.
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And Freddie Mac just moved its entire Asset-Backed Security [ABS] portfolio to Level 3.

As a result, its Level 3 assets ballooned from $39 billion to over $157 billion in the first quarter. Its reasoning? The pricing the market was giving these securities varied too much. In other words, when the market was responsible for figuring out how much these assets were worth, the price fluctuated dramatically, providing the potential for major losses. So Freddie moved these assets to Level 3, where the market no longer has any say in their value. It’s yet another nail hammered into the coffin of what was supposed to be a capitalist free market.

The author is a newsletter writer, not (so far as I can tell) a portfolio manager.

The “smoking gun” in the financials is note 3, page 13 of Financial Statements and Core Tables:

At March 31, 2008, our fair value results were impacted by several changes in our approach for estimating the fair value of certain financial instruments, primarily related to our valuation of our guarantee obligation as a result of our adoption of SFAS 157 on January 1, 2008. These changes resulted in a net increase in the fair value of total net assets of approximately $4.6 billion (after tax).

See update below for more Freddie

Anyway … one man’s pain is another man’s gain! I mentioned the UBS Close-Out Special at about 68 cents on the dollar yesterday … today, Naked Capitalism observes that Bank Hapoalim has done the same:

the second largest bank in Israel, sold its entire portfolio of MBS to Pimco for 75 cents on an already-written-dollar (or in this case, shekel). Note that the previous writedowns were at least $90 million on an portfolio valued before the sale at $3.42 billion.

And the war between the Credit Analysis Department and the Market Price Department continues:

Based on the model supplied by the company, the Bank applied an even more severe scenario in which housing prices in the USA (excluding California and Florida) fell by about 30% from their peak (by 22% when compared with the present price level) and in California and Florida by about 40% from their peak (by 28% when compared with the present price level). Given such an severe scenario and assuming that the rate of default by mortgage takers will be about 47%, the accumulated loss from the portfolio is liable to reach about 340 million US Dollars over the life span of the securities.

The loss on sale was $870-million. I said it about Blackrock … I’ll say it about PIMCO … they’re going to make out like bandits. These well-publicized moves into the asset class by “real money” accounts bode well for normalization of the credit markets – although I will admit that Hapaolim’s 3.5-billion portfolio is a small part of the 1,400-billion problem.

Those who take my encouraging words about normalization as being the ravings of a Pollyanna are reminded that “normal” does not mean “good”. Spreads are still elevated and credit is still relatively scarce … and corporate defaults are rising. By “normalizing”, I mean that the chances of apocalyptic financial meltdown are declining, that’s all.

But real money is big-time sub-prime:

Gross, 64, anticipated the collapse of the U.S. housing market and the Fed’s subsequent interest-rate cuts. He shunned riskier corporate debt in 2006, a call that caused his fund to lag behind peers. Gross’s $128 billion Total Return Fund slipped as much as 4 percent in the first half of 2006.

The decision to sidestep subprime-linked debt has helped the fund surge 12 percent in the past year to beat 95 percent of its rivals, according to data compiled by Bloomberg.

Earlier this year, Gross started piling back into mortgage bonds to take advantage of slumping prices. In April, he lifted his holdings in mortgage-related debt to the highest since 2000, and lowered his stakes in U.S. Treasuries after calling them “overvalued.”

As of April 30, Gross’s Total Return Fund held 65 percent in mortgage debt, according to data posted on the firm’s Web site. The fund also holds 6 percent of assets in emerging-market debt. This year, Gross’s Total Return Fund has returned 4.1 percent, beating 94 percent of peers, Bloomberg data show.

As expected after the court ruling on BCE / Teachers’, BCE stock got slaughtered today, while Credit Default Swaps came in to 315bp from 595bp. Now, that’s a move! It appears that frenetic trading (over 26-million shares) gave the new Quantum trading system a work-out … BCE was halted in the mid-afternoon … a glitch this morning caused many issues (including CPD) to be temporarily halted. Finally, the TSX announced:

TSX Group has determined the root cause of a service disruption that affected trading on 37 of the more than 2100 issues trading on Toronto Stock Exchange.

The interruption was caused by a trading message protocol issue with one invalid message, and was entirely unrelated to TSX Quantum performance or capacity.

Corrective measures have been implemented.

Shares of BCE Inc. were halted at 2:14 p.m. to address data integrity concerns.

TSX expects trading in shares of BCE Inc. to open as usual tomorrow morning.

Not a lot of detail there, but there never is. It strikes me that if the system was compromised by a single “trading message protocol issue with one invalid message”, then Quantum probably needs a better input editor to prevent these data issues from fouling up the internal engine … but there isn’t enough information to make that conclusion firm.

There’s a bit more colour on BCE / Teachers’ … Bloomberg reports that a failure would help unwind the LBO crisis:

The potential cancellation of BCE Inc.’s C$52 billion ($52.9 billion) leveraged buyout may help loan prices recover by removing the largest portion of high- yield, high-risk debt banks need to sell from last year’s deals.

“If BCE is canceled it reduces the amount of debt on bank balance sheets substantially,” Chris Taggert, an analyst at fixed income research firm CreditSights Inc. in New York said in a telephone interview. “It’s the largest piece of the pipeline out there and would be a boost to the market.”

Loan prices have climbed as banks this year found a way to reduce their pipeline of loans promised last year to private- equity firms to $81.6 billion from $156 billion, according to Standard & Poor’s. Loans backing the acquisition of Montreal- based BCE, Canada’s biggest telephone company, comprise $16.8 billion, or 20.6 percent of the backlog.

Prices are up to an average 91.86 cents on the dollar, from a record low of 86.3 cents in February, according to S&P. Private-equity firms including Blackstone Group LP and Apollo Management LP have bought loans from banks, and the risk of financial institutions failing has subsided.
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“This is good news for” Toronto-Dominion, Desjardins Securities analyst Michael Goldberg wrote in a note to investors today. “A new deal or no deal would mean that TD would not experience losses on the syndication of its financing.”

The bank has probably marked down its BCE financing commitment by about C$150 million, mostly in the past two quarters, Goldberg said. The bank has said it agreed to finance about 10 percent of the equity portion of the BCE purchase, or about C$3.3 billion.

The excitement of the day was BCE, but the enormous price moves occurred on small volume. Apart from this name, the market was off slightly – not a lot, but enough to notice – on average volume.

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

Update: The specific disclosure of the move to level 3 is in the Supplement:

At March 31, 2008, we measured and recorded on a recurring basis $156.8 billion, or approximately 23% of total assets, at fair value using significant unobservable inputs (Level 3), before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 assets consist of non-agency residential mortgage-related securities and our guarantee asset. We also measured and recorded on a recurring basis $113 million, or less than 1% of total liabilities, at fair value using significant unobservable inputs, before the impact of counterparty and cash collateral netting across the levels of the fair value hierarchy. Our Level 3 liabilities consist of derivative liabilities, net.

During the first quarter of 2008, our Level 3 assets increased because the market for non-agency mortgage-related securities became less liquid, resulting in lower transaction volumes, wider credit spreads and less transparent pricing for these assets. In addition, we have observed more variability in the quotations received from dealers and third-party pricing services. Consequently, we transferred $153.8 billion of Level 2 assets to Level 3 during the first quarter of 2008. These transfers were primarily within non-agency mortgage-related securities backed by subprime and Alt-A mortgage loans where inputs that are significant to their valuation became limited or unavailable. We concluded that the prices on these securities received from pricing services and dealers were reflective of significant unobservable inputs. We recorded $11.2 billion in additional losses primarily in AOCI on these transferred assets during the first quarter of 2008, which were included in our Level 3 reconciliation. See “NOTE 14: FAIR VALUE DISCLOSURES— Table 14.2 —Fair Value Measurements of Assets and Liabilities Using Significant Unobservable Inputs” to our consolidated financial statements for the Level 3 reconciliation. For discussion of types and characteristics of mortgage loans underlying our mortgage-related securities, see “CREDIT RISKS” and “CONSOLIDATED BALANCE SHEETS ANALYSIS—Table 15 —Characteristics of Mortgage Loans and Mortgage-Related Securities in our Retained Portfolio.”

Update, 2008-5-23: Split-Share Performance, 2008-5-23