Category: Market Action

The PerpetualDiscount winning streak ended today – the index was down less than a beep, but it was down! Volume continues fairly light.

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

PerpetualDiscounts had a good strong day on light volume: up 0.41% to finish just short of the July 10 level. They are now down a mere 4.24% on the month; yield 6.37% or 8.92% interest-equivalent at the standard 1.4x equivalency factor; long corporates continue to yield 6.2%, so the spread is now 272bp.

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

Update, 2008-7-28: Newly Assiduous Reader newtoprefs comments that he she has been advised to sell BAM.PR.O short. I have uploaded the HIMIPref™ OpRet Index for 7/25. It is unclear to me why, if you were going to shortsell anything in this index (a big if, in my opinion, but what do I know?) AND you were going to shortsell one of the BAM issues … why wouldn’t you shortsell BAM.PR.I? The yield is 30bp lower than that of BAM.PR.O.

A story on Bloomberg discussed the repercussions of the liquidity freeze-up in US Auction Rate Securities:

New York Attorney General Andrew Cuomo filed a lawsuit against UBS AG over its role in the sale of auction-rate securities, five months after the market collapsed, stranding investors.

Cuomo alleges the Zurich-based bank committed fraud by misleading investors in its marketing of the long-term securities as money market-like instruments that were easy to buy and sell. UBS continued selling the debt even as the market unraveled and top bank executives unloaded $21 million in personal auction-rate holdings, Cuomo’s suit alleges.

… and, to my gratification, included a link to the Massachusetts lawsuit site. The complaint against UBS alleges many things, but what it all boils down to is that some people have made an investment that didn’t work out as intended.

Just where to draw the regulatory line is a matter of opinion. I just hope the regulators and politicians know where their current hard line attitude is taking us: to a world where brokerages are on the hook for whatever they sell their clients and therefore offer nothing but the blandest investments possible. It’s regulation by headline and it will ultimately cost us all a great deal of money.

It leads to another interesting thought … if banks are to be on the hook for short-term paper they sell to their retail clients, shouldn’t this be recognized as credit risk (in addition to operational risk) for capital calculation purposes? I’ve already advocated that their exposure to their branded MMFs be recognized.

As far as today is concerned … so much for the financial rally:

U.S. stocks tumbled, sending financial shares to their worst drop in eight years, after home sales slid more than forecast …
…
Financial stocks in the S&P 500 fell 6.7 percent as a group, the third drop in the past three weeks greater than 5 percent. Today’s slump follows a six-day, 30 percent rally spurred by better-than-estimated earnings reports from Citigroup, JPMorgan and Wells Fargo and legislation to rescue Fannie Mae and Freddie Mac.

I wonder how many sigmas that makes?

PerpetualDiscounts managed to eke out a two-basis-point gain today (which, when you annualize it, is about right) keeping the streak alive: there have been six consecutive gains.

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

PerpetualDiscounts had a wonderful day today, up nearly a point and closing just short of their value on July 10. They are now down a mere 4.66% on the month, with a weighted-mean-average pre-tax bid-Yield-to-Worst of 6.40% (up 37bp on the month), interest-equivalent to 8.96%, which is a spread of +276bp to long corporates.

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

Wachovia and Thornberg prefs were mentioned yesterday and as it happens both are in the news today.

Wachovia announced horrible results:

reported a record quarterly loss of $8.9 billion, slashed the dividend and announced 6,350 job cuts. The stock slumped as much as 10 percent in New York trading.
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The stock fell $1.18, or 9 percent, to $12 at 9:55 a.m. The cost of protecting the bank’s debt rose 10 basis points to 315, according to broker Phoenix Partners Group. Fitch Ratings cut Wachovia one level to A+ from AA-, citing its mortgage business, and Moody’s downgraded the bank to A1 from Aa3.

Wachovia, whose job cuts amount to about 5 percent of the bank’s workforce, lowered the dividend to 5 cents a share from 37.5 cents and will leave 4,440 positions open, according to a presentation to analysts today.

As of noon, the prefs at issue (WBPRC – NYSE) were actually up over 5%, to $16.49. Their dividend didn’t get cut!

And there is an offer for the Thornburg prefs:

Preferred shareholders will receive $5 in cash and 3.5 common shares if two-thirds of holders tender their stakes by Sept. 30. Were the deal to close today, holders would receive cash and stock totaling $6.09 for each preferred share, which closed yesterday between $4.46 and $4.62.
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In the question-and-answer session that followed, investors expressed their dismay. Those who bought preferred shares at $25 and expected a dividend must sell for $5 in cash plus stock that today is worth $1.09.

“I don’t ever think I have ever seen in my years on the Street, a $25 par being called in at $5,” said Shelley Bergman, of New York-based Morgan Stanley, who said he owned shares for himself and clients.

WaMu has announced horrible results:

Washington Mutual Inc., the biggest U.S. savings and loan, reported a $3.3 billion second-quarter loss as tumbling home prices left a record number of borrowers unable to keep up with mortgage payments. The shares surged 10 percent as the company announced it would cut costs.

The loss of $6.58 a share compared with net income of $830 million, or 92 cents a share, a year earlier, the Seattle-based company said today in a statement. The cost of uncollectible loans jumped 58 percent to $2.2 billion from the first quarter.

… and their earnings release notes:

On July 15, WaMu’s Board of Directors declared a cash dividend of $0.01 per share on the company’s common stock. Dividends on the common stock are payable on Aug. 15, 2008 to shareholders of record as of Jul. 31, 2008. In addition to declaring a dividend on the company’s common stock, the company will pay a dividend of $0.2528 per depository share of Series K Preferred Stock to be payable on Sept. 15, 2008 to holders of record on Sept. 1, 2008, a dividend of $19.8056 per share of Series R Preferred Stock to be payable on Sept. 15, 2008 to holders of record on Sept. 1, 2008.

So … as mentioned yesterday, Accrued Interest propounded the “worst of both worlds” argument … as these events show, it is also possible to propound the “best of both worlds” argument (although Thornburg pref holders might quibble at the use of the word “best”, at least they’re getting some pickings off the carcass).

Prefs are oval pegs; no attempt should be made to fit them neatly into either square or circular holes. Investors should look at prefs for what they are, and not overweight any particular scenario for future developments.

Catching up on a little miscellaneous banking system stuff … Charles Wyplosz reviews the bank-bailout question on VoxEU; not much substance, frankly, but he did point out:

Bagehot principles can be applied when one or two banks fail, but when the whole system is under threat, this is no longer an option.

Also, it looks like the HBOS rights issue has flopped:

HBOS was facing a further period of uncertainty last night, with underwriters holding more than 60 per cent of the bank’s rights issue shares and the City waiting anxiously for the bank’s interim results next week.
As a result of the banking giant’s £4 billion rights issue flop, underwriters Morgan Stanley and Dresdner Kleinwort are likely to have the stake – worth more than £2.4bn – after this evening’s 4:30pm deadline for them to sell the shares on.

That gives them a substantial share in the Edinburgh-based company which has an estimated overall stock market value after the rights issue of about £15bn.

Accrued Interest points out that negative convexity on Agency paper is more negative than usual:

There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that the average life of a mortgage is longer than is currently being assumed.
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As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant but extending the average life to 9 years causes the price to drop by over 3%.

The OSC is attempting to ensure that self-regulatory-organizations have jurisdiction over individuals’ conduct within the industry even after they have quit:

On July 15, 2008, the Ontario Superior Court of Justice, Divisional Court, allowed an appeal by Stephen Taub on the basis that the Securities Act does not authorize self-regulatory organizations (SROs) that have been recognized by the OSC to discipline former members. The Commission’s recognition of an SRO is designed to provide protection to investors from unfair, improper or fraudulent practices and to foster fair and efficient capital markets.

“The Commission is concerned that investor protection would be weakened if a registered representative could avoid the consequences of breaching SRO rules by resigning from his or her SRO member firm,” said OSC Executive Director Peggy Dowdall-Logie. “An SRO’s ability to take disciplinary action against former members, and former representatives of its member firms, is fundamental to effective investor protection and the functioning of an effective SRO.”

This has implications for the David Berry saga … RS ruled that it has jurisdiction over him (and could therefore judge whether he violated UMIR) – this ruling was, presumably, jeopardized by the Taub ruling.

Another good strong day for PerpetualDiscounts, but volume was light. Have all the sportin’ gents placed their bets? Despite the gains, the index has not yet recovered to where it was July 11 … we’re still trying to recover from the awful, awful July 14, as Louis XVI used to say. The PerpetualDiscount weighted-mean-average pre-tax yield-to-worst is now 6.46%, or 9.04% pre-tax interest-equivalent at the standard 1.4x equivalency factor. Long Corporates now yield 6.20%, so the PTIE spread now stands at 284bp, still way through the old, recently smashed, record of 250bp.

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

Accrued Interest has deprecated US Preferreds as an investment, using what I call the ‘worst of both worlds’ argument; that the upside is limited compared to common and the downside is much greater (or at least more probable) than senior bonds.

I have written a short post with some background on US TruPS.

As I noted on FWF on the weekend:

I find – when having conversations such as this with stockbrokers – that it is very useful to look at actual numbers. In my article A Vale of Tiers, I looked at various Royal Bank investment vehicles and compared their expected returns to their degree of subordination.

Perhaps this thread could be profitably employed to update and expand the “Table 1” of my article.

Preferred shares represent a range on the risk/return spectrum that will be of interest to many investors. I will note that despite some alarmist stockbroker talk very few issues actually default. There are nine defaulted issues on the NYSE, according to Quantum Online; four of which are from Thornburg Mortgage. As counterexamples, one may consider Citibank and Fortis Bank, both of which have massively diluted their common shareholders and cut the common dividend (the latter to zero) without inconveniencing the preferred shareholders. For many battered companies, issuance of preferred stock is the only palatable option; they are not going to cut their own throats by cutting the dividend with gay abandon.

For investors in Canadian bank preferreds, it should be noted that preferred stock and innovative tier 1 capital are capped at a limit of 30% of total Tier 1 Equity. If they were to slowly drift into bankruptcy, they would be taken over by OFSI and the CDIC when their Tier 1 ratio declined below 4% (possibly at the 5% level). At these levels, there will still be some common equity left; preferred capital will not be impaired.

Therefore, the most realistic nightmare scenario is a jump to default; investors may assign their own probabilities to this.

Diversify!

I would have been much more impressed with the Accrued Interest post had he used actual numbers and made some effort to quantify risk. Yes, you can lose every dime investing in preferreds – you can lose every dime investing in any corporate security. But what are the odds? Let’s see an attempt to quantify risk whenever we quantify return.

That being said, it should be noted that Wachovia had a Tier 1 Ratio of 7.35% (well below the Canadian average of about 9.5%) and a Total Capital ratio of 11.82% (about the Canadian median). Determining the effective subordination of the issue highlighted by Accrued Interest is made a little more difficult by the prospectus note for the issue highlighted (NYSE: WBPRC):

Wachovia receives a significant portion of its revenue from dividends from its subsidiaries. Because it is a holding company, its right to participate in any distribution of the assets of its banking or nonbanking subsidiaries, upon a subsidiary’s dissolution, winding-up, liquidation or reorganization or otherwise, and thus your ability to benefit indirectly from such distribution, is subject to the prior claims of creditors of any such subsidiary, except to the extent that Wachovia may be a creditor of that subsidiary and its claims are recognized. There are legal limitations on the extent to which some of its subsidiaries may extend credit, pay dividends or otherwise supply funds to, or engage in transactions with, it or some of its other subsidiaries. Wachovia’s subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay amounts due under Wachovia’s contracts or otherwise to make any funds available to it. Accordingly, the payments on the LoTSSM, and therefore the Trust Preferred Securities, effectively will be subordinated to all existing and future liabilities of Wachovia’s subsidiaries. At December 31, 2006, Wachovia’s subsidiaries’ direct borrowings and deposit liabilities was $730 billion.

… and I ain’t gonna do it! I will say, however, that before opining on the merits or lack thereof on an investment in these TruPS, it should be done!

Incidentally, further down in the FWF thread where I made my comment, there was another post:

We were talking upthread about corporate versus preferred rates. While the IShares corporate bond ETF has not moved much, I noticed on the Waterhouse Fixed Income site that virtually all corporate banks now have a significant spread against their provincial same-rated counterparts. The spread approaches 1% starting three years out. Just a couple of years ago, that spread would have been maybe 0.2-0.3% (as I recall). So, it would appear that bank corporates have definitely been hit by the credit crisis.

See my note about the BoC Review of June 2008 … financials used to be 40-ish bp tight to industrials … now they’re even-ish.

Here’s another strangeness in which unitholders in the fund have an interest:

One of these things is not like the others! One of these things is not quite the same! This is a very sloppy market. I have noted the volatility of the BMO.PR.H / BMO.PR.J spread previously. BMO.PR.H has – just now – been deleted from the TXPR index, so that might – might! – have something to do with it.

Sloppiness aside, PerpetualDiscounts moved up again … but are still below the levels they were at on July 11 and are still down 5.94% on the month.

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

Naked Capitalism reports that the auction of Cheyne Finance’s assets, mentioned July 15 realized forty-four cents on the dollar. It remains to be seen how many of these assets will actually change hands, as Cheyne’s investors can elect to receive the securities rather than the cash.

The week ended well, but we’re still down from last Friday’s close. PerpetualDiscounts now yield 6.50% dividend, equivalent to 9.00% interest; long corporates … oh, call it 6.20, that’s close enough … PTIE spread of 280bp.

So now all you guys can spend the weekend worrying about whether this is a real rally or a sucker rally. My suggestion is that half of you engage in panic buying of the stuff I’m looking to sell, while the other half dump the stuff I want to buy at whatever price you can get.

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

There’s a story in Vanity Fair about the Bear Stearns collapse – good reading! All fluff, of course, but entertaining fluff.

Today’s factoid is the claim that US Financials have just experienced an 11-standard-deviation price move. But don’t tell Merrill!

Speaking of multiple standard deviation events … PerpetualDiscounts didn’t lose money today! The last up-day was June 24; since then, there were sixteen consecutive down days, in the course of which PerpetualDiscounts lost 8.85% of their value, with the weighted-mean dividend yield increasing from 6.01% to 6.63%. I hope that’s some kind of record … all this pain has to be worth something! We shall now wait with bated breath to see whether today’s return represents a turning of the tide or a dead cat bounce.

After the bounce, PerpetualDiscounts yield 6.56%, equivalent to 9.18% interest after the 1.4x conversion factor. Long corporates ticked up to about 6.18%, so the Pre-Tax Interest Equivalent Spread is now about 300bp.

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

James Hamilton of Econbrowser asks Did Fannie and Freddie Cause the Mortgage Crisis, reviewing an op-ed piece by Paul Krugman. Krugman states of the implicit guarantee of the GSE debt:

This implicit guarantee means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose.

This is certainly true to some extent, but more analysis is needed. What have Fannie & Freddie’s Return on Equity been, relative to “real banks”? To the extent that this ROE has exceeded the ROE on real banks, the profits have been privatized to the benefit of the common equity holders. And, importantly, to the extent that mortgage rates have been reduced – and all the other bells and whistles (reviewed on May 7, referencing Crony Capitalism) thrown in – the profits have been privatized to the benefit of the mortgage-borrowing public.

The distinction is important if for no other reason than, for better or worse, privatizing the profits to the mortgage-borrowing public was precisely the public policy purpose behind the GSE legislation. Which is not to say I agree with this purpose, mind you, but if we’re going to identify villains, let’s at least identify them correctly.

As pointed out Calculated Risk and by Michael Carliner, a large portion of the blame for excessively loose lending can be ascribed to a fight for market share between the GSEs and private lenders.

This, to me, looks like a natural consequence of reducing the risk premium on qualifying mortgages. There will always be investors who wish to outperform by taking risks – this may be a well-thought out strategy, or … er … otherwise. The risk premium on GSE mortgage-backeds has been much smaller than it should be:

“If the agencies’ debt and mortgage-backed securities (MBS) were priced based on their stand-alone financials, the paper would pay more than 100bp, rather than around 20bp over Treasuries,” [UC Berkeley finance professer Dwight] Jaffee says. So Fannie and Freddie have access to a more favourable funding on the back of a de facto credit guarantee.

Mind you, “risk premium” is an imprecise term. Credit risk? Liquidity risk? Prepayment risk? Ignoring such bond-geek adjustments, there is widespread agreement that agency MBS traded to yield a lot less than they would have had they been issued by normal corporations – but that was the whole point of the GSEs in the first place.

The miniscule risk premia available in normal corporate debt in the early part of this decade created an appetite for higher risk debt. The artificial lowering of the risk premia on agency MBS was a large factor in guiding this appetite towards riskier mortgages.

For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?

Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer– private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.

Is that the answer to the second question? I’m not sure. But if anybody has a better answer, I’d still like to hear it.

Well, I can’t answer the first question! I’ll just rather pedantically point out that there is an implicit assumption that 1980 was “right” and 2003 was “wrong” … probably a pretty safe assumption, but an assumption nevertheless. Either way, it can be fairly safely ascribed to the deliberate policy decision taken by the US Govt. when creating the GSEs – guarantee or no guarantee, they are subject to much less stringent capital rules than are commercial banks. At the very least, the ability to offer a steady series of MBS in size will reduce the liquidity premium on their issues.

Prof. Hamilton’s suggested answer to his second question strikes me as too clever. I will simply suggest that subPrime paper should – after structuring – trade at a reasonable spread to prime paper. When the risk premia on prime paper is artificially reduced, the premia on sub-prime paper will be reduced likewise – despite the fact that the sub-prime paper has no guarantee, implicit or explicit. And when there is sufficient demand for spread paper … it gets met!

Wells Fargo reported non-apocalyptic earnings, sparking a huge rally in US Financials:

U.S. stocks rallied after higher- than-estimated profit at Wells Fargo & Co. sparked the biggest- ever gain in financial shares and a two-day tumble in oil prices brightened the outlook for transportation companies.

Wells Fargo, which avoided the worst of the fallout from the subprime mortgage market’s collapse, jumped the most since at least 1980, leading Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. higher.

Accrued Interest ascribes the move to short covering:

CDS on WFC fell 25bps, with other banks 10ish tighter.

Now this is mostly short-covering, I’m sure. You have Wells Fargo, the most staid bank in the country, rallying 30% in a single day. Only panicky shorts can cause such a sudden shift in a name like Wells. Hell, the whole S&P Financials sector is up over 10%.
…
This bear market isn’t going to end with investors suddenly having confidence in financials. It will end when shorting financials doesn’t seem like an easy trade any more.
…
Anyway, we’ll see how J.P. Morgan and Merrill Lynch come out tomorrow. I expect a good market reaction either way after J.P Morgan’s numbers. Merrill is more risky. Continue to be short duration.

Merrill has some juicy assets on the block – Bloomberg and Blackrock.

Short duration? One rationale is a US refunding crisis. Naked Capitalism passes on some apocalyptic clippings.

Well, volume picked up a bit, there were some crosses put on the board … and the PerpetualDiscount index continued its plunge. I saw some activity that looked like bottom fishing … but I’m ALWAYS going to see activity that looks like bottom-fishing. You figure it out!

PerpetualDiscounts now have an average yield of 6.63%, which is 9.28% interest-equivalent at the standard 1.4x conversion factor. Since long corporates still haven’t noticed the world is about to end and continue to yield about 6.1%, this makes the spread 318bp.

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

The concept of credit protection on the United States of America has captured imaginations all around, with Accrued Interest referring to it as a “chaos trade” – defining this as “positions designed to produce big returns if all hell breaks loose” and Naked Capitalism comparing US Treasuries to senior debt of the GSEs. Certainly the greenback continues to sink against the Euro.

Equities did very poorly today, with General Motors suspending its dividend.

Cheyne Finance, last mentioned on October 22 and November 13, is having a $6-billion fire sale:

The first auction of assets by a structured investment vehicle drove Moody’s Investors Service to downgrade the Cheyne Finance Plc SIV by five levels, describing it as a “fire sale.”

The $6 billion SIV set up by London-based Cheyne Capital Management (UK) LLP is scheduled to auction its assets this week or transfer them to a new company under a reorganization by receivers Deloitte & Touche LLP and Goldman Sachs Group Inc. Moody’s said it cut the SIV’s senior debt to Ca, its second- lowest grade, in a report today.

And Willem Buiter fulminates on the real meaning of the GSE bailout:

The Treasury has taken another big step on the road to Utter Fiscal Obfuscation. It is doing everything it can to disguise the fact that it is entering in commitments that create potentially massive contingent liabilities for the US tax payer. Even if the purpose served by this increase in contingent liabilities is worth the cost, the manner in which it is done is designed to avoid fiscal accountability. This is as welcome to the Executive as it is to the Congress.

Note to all aspiring politicians: guarantees are not a cost-free method of accomplishing social goals. They will be called in at the most inopportune time.

Here’s an interesting factoid:

The S&P 500 Financials Index dropped 3 percent, capping its steepest-ever five-day retreat and giving the industry a smaller market value than health care for the first time since 1992, S&P data show.

Amidst all this gloom, I will remind readers that Bombardier first halved, then suspended its common dividend a few years back – the common dividend has only recently been reinstated. But the preferreds kept on paying through the period. First loss protection is not just a theoretical construct!

What a life! If anything, the panic is spreading … the price-movers list is longer today than it was, there were a number of block trades in the volume highlights and the PerpetualDiscount index was down more than a point for the second day running, to yield 6.58% … 9.21% interest-equivalent, long corporates +311bp. On the other hand, a few CM issues were up significantly on the day … which could imply the emergence of bottom fishers, it could be a dead-cat bounce, or it might mean absolutely nothing at all. I’ll let you know when it’s all over.

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